Leasehold to freehold conversion does not break holding period; capital gains remain long-term and indexation applies to borrowing cost.

Leasehold rights counted in the period of holding for capital gains purposes, and conversion of leasehold into freehold did not create a new short-term asset. On the facts, the assessee's continuous holding of the plot since 1973 preserved long-term capital asset status, so the transfer was taxable as long-term capital gain. Borrowing cost and interest incurred for construction, having been treated as part of the capital outlay, were eligible for indexation; the Revenue could not deny that benefit merely because of the timing of capitalization or alleged construction interruptions. Penalty issues were not decided on merits.

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Issues: (i) Whether capital gain arising on sale of land converted from leasehold to freehold was taxable as short-term capital gain or long-term capital gain; (ii) Whether indexation was allowable on borrowing cost or interest paid on funds used for construction of the property.

Issue (i): Whether capital gain arising on sale of land converted from leasehold to freehold was taxable as short-term capital gain or long-term capital gain.

Analysis: The period of holding for determining whether an asset is short-term or long-term has to be examined with reference to the assessee's holding of the capital asset and not merely with reference to the nature of title at the moment of conversion. Leasehold rights are also capital assets, and conversion of leasehold into freehold only improves or betterens the existing rights without necessarily bringing into existence a new asset for the purpose of section 2(42A) of the Income-tax Act, 1961. As the assessee had held and enjoyed the plot since 1973, the later conversion into freehold did not interrupt the continuity of holding.

Conclusion: The land remained a long-term capital asset and the gain on its transfer was taxable as long-term capital gain in favour of the assessee.

Issue (ii): Whether indexation was allowable on borrowing cost or interest paid on funds used for construction of the property.

Analysis: Borrowing cost incurred year after year for the development of the property formed part of the capital outlay and had been accepted in the computation of capital cost. The year in which such interest was capitalized in the books or the manner in which the work-in-progress was reflected was not decisive for denying indexation. Since the interest expenditure was incurred for the building and was treated as part of the capital asset cost, the statutory benefit of indexation could not be withheld merely on the basis of the Revenue's objections regarding interruptions in construction activity.

Conclusion: Indexation on the borrowing cost was allowable in favour of the assessee.

Final Conclusion: The assessment was modified by treating the land transfer as a long-term capital gain and by allowing indexation on the borrowing cost, while the penalty ground was not adjudicated on merits.

Ratio Decidendi: For capital gains purposes, the period of holding includes the assessee's continuous holding of leasehold rights, and conversion of leasehold into freehold does not by itself create a new short-term asset; borrowing cost actually incurred for the capital asset is eligible for indexation when computing capital gains.

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