Stock-in-trade conversion to capital asset permitted with bona fide business purpose, capital gains indexation allowed

ITAT Delhi held that conversion of stock-in-trade to capital asset is permissible, following SC precedent in Sir Kikabhai Premchand case. The tribunal ruled that absent specific legal prohibition and given bona fide business purpose, such conversion cannot be deemed a colorable device for tax avoidance. Income from subsequent sale qualified as long-term capital gains with indexation benefits. Commission payments made through banking channels with proper TDS deduction were allowed. Short-term capital loss on share transfer was upheld as genuine transaction through stock exchange, rejecting revenue's claim of bogus loss based on SEBI inquiry where assessee wasn't implicated as beneficiary. Assessee's appeal allowed.

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1. ISSUES PRESENTED and CONSIDERED

The core legal questions considered by the Tribunal were:

(a) Whether the reassessment proceedings initiated under Sections 147 and 148 of the Income Tax Act, 1961 were valid, including the sufficiency of reasons recorded and approval under Section 151.

(b) Whether the conversion of properties from stock-in-trade to capital assets by the assessee was legally permissible and whether the resulting gains should be treated as business income or long-term capital gains.

(c) Whether the assessee was entitled to claim indexed cost of acquisition and cost of improvement for the properties sold.

(d) Whether the commission expenses paid on sale of the properties were allowable deductions.

(e) Whether the short-term capital loss claimed on sale of shares of a penny stock company was allowable or liable to be disallowed as bogus.

Grounds relating to the validity of reopening (grounds 1 to 5) were not pressed and thus dismissed, focusing the analysis primarily on issues relating to classification of income, allowance of expenses, and genuineness of capital loss claimed.

2. ISSUE-WISE DETAILED ANALYSIS

(a) Validity of Reassessment Proceedings (Grounds 1 to 5)

Though initially raised, the assessee did not press these grounds before the Tribunal. Consequently, the Tribunal dismissed these grounds without detailed discussion, effectively upholding the reopening and reassessment as valid for the purposes of this appeal.

(b) Conversion of Stock-in-Trade to Capital Asset and Tax Treatment of Gains (Grounds 6 and 7)

Legal Framework and Precedents: The Income Tax Act prior to AY 2018-19 did not specifically address the tax consequences of conversion of stock-in-trade into capital asset. The Supreme Court in Sir Kikabhai Premchand (24 ITR 506) held that conversion between stock-in-trade and investment is not unknown in commercial practice and is legally permissible. The Memorandum to the Finance Bill, 2018 introduced provisions (effective from AY 2019-20) to tax profits arising on such conversions as business income, thereby filling a statutory gap.

Court's Interpretation and Reasoning: The Tribunal accepted that the assessee initially held the properties as stock-in-trade for business purposes (construction and development). However, due to adverse market conditions, the assessee decided to hold the properties as long-term investments, converting them into capital assets in FY 2010-11, reflected in the balance sheet as "long term investments."

The Tribunal relied on the Supreme Court ruling in Sir Kikabhai Premchand to hold that such conversion is legally permissible and not prohibited by law. It further noted that since the statutory provisions to tax such conversion as business income were introduced only from AY 2019-20, prior to that, no provision existed to tax such conversion. Therefore, the assessee's action could not be treated as a colorable device or tax evasion.

Evidence and Findings: The Tribunal found that the assessee's balance sheets consistently showed the properties as long-term investments from FY 2010-11 onwards. There was no evidence that the conversion was done with the primary motive of tax evasion. The Tribunal also referred to the Memorandum to the Finance Bill, 2018, which recognized the absence of provisions taxing such conversion prior to that year.

Application of Law to Facts: The Tribunal concluded that the gains arising from the sale of the properties should be taxed as long-term capital gains, allowing the assessee the benefit of indexation on cost of acquisition and improvement.

Competing Arguments: The Department argued that the conversion was a colorable device to avoid tax and relied on the Apex Court's decision in McDowell & Co. Ltd. v. CTO, which condemns dubious tax avoidance schemes. It also relied on a Bombay High Court decision holding that such conversion should be treated as business income. The Tribunal distinguished these arguments by emphasizing the absence of statutory provisions at the relevant time and the bona fide nature of the assessee's actions.

Conclusion: The Tribunal held that the income from sale of the properties was long-term capital gains, eligible for indexation benefits, and not business income.

(c) Allowability of Cost of Improvement (Ground 7(ii))

Legal Framework: Cost of improvement is allowable as part of cost of acquisition for capital gains calculation under the Income Tax Act, subject to proof of expenditure.

Court's Reasoning: The Tribunal found that the assessee had incurred improvement expenses of Rs. 61,21,258 in FY 2008-09, recorded in the books of accounts. Though the assessee could not produce original evidences such as bills due to the lapse of more than 10 years (beyond the seven-year record-keeping period under the Act), the entries were verifiable from the financial statements and the balance sheet showed outstanding payable to the sister concern which had made the payments.

Application to Facts: The Tribunal accepted the bona fide nature of the recorded expenses and allowed the cost of improvement with indexation.

Competing Arguments: The Department disallowed the claim solely on the ground of non-production of evidences. The Tribunal rejected this as unreasonable given the time elapsed and accepted the accounting records as sufficient proof.

Conclusion: Cost of improvement was allowed as part of indexed cost for capital gains computation.

(d) Allowability of Commission Paid on Sale (Ground 8)

Legal Framework: Commission paid for sale of capital assets is allowable as deduction against capital gains under the Income Tax Act.

Facts and Findings: The assessee paid commission totaling Rs. 19,00,000 to three persons, including a director and two others. Payments were made through banking channels with TDS deductions, and confirmations and ledger accounts were produced for the director and later for the other two persons.

Court's Reasoning: The Tribunal found the payments genuine and supported by documentary evidence, including TDS certificates and banking transactions. It recognized that commission payments are common in real estate transactions.

Competing Arguments: The Department disallowed the commission on the ground of lack of confirmation from two payees initially and questioned genuineness. The Tribunal rejected this, noting that confirmations were now available and payments were properly documented.

Conclusion: Commission payments were allowed as deductible expenses.

(e) Disallowance of Short-Term Capital Loss on Sale of Shares (Ground 9)

Legal Framework: Losses on sale of shares are allowable if the transactions are genuine and not bogus or sham. The burden lies on the assessee to prove genuineness.

Facts and Findings: The assessee claimed a short-term capital loss of Rs. 1,36,59,617 on sale of shares of M/s Ashutosh Paper Mills Ltd, a penny stock company. The AO disallowed the loss holding the transaction as bogus based on SEBI enquiries against the company.

Court's Reasoning: The Tribunal examined extensive evidence produced by the assessee, including contract notes for purchase and sale, bank statements, demat account statements, broker ledger accounts, and payment proofs. The Tribunal found no evidence implicating the assessee in any manipulation or sham transaction.

The Tribunal noted that the AO's disallowance was based solely on SEBI's enquiry against the company, with no adverse material against the assessee. The Tribunal relied on coordinate bench precedent holding that in absence of evidence against the assessee, mere association with a penny stock company does not render losses bogus.

Competing Arguments: The Department argued that the company's penny stock status and SEBI enquiry rendered the transactions suspect and loss disallowable.

Conclusion: The Tribunal allowed the short-term capital loss as genuinely incurred by the assessee.

3. SIGNIFICANT HOLDINGS

"There is no specific bar for conversion of stock in trade into investment and vice versa in view of the decision of the Hon'ble Supreme Court in the case of Sir Kikabhai Premchand (supra). The act of the assessee in converting the stock in trade into capital asset is not against any law prevailing at the relevant time."

"Where the stock in trade is converted into capital asset or investment, the existing law does not provide for its taxability and to provide symmetrical treatment and discourage deferring the tax payment, the amendments have been carried out [in Finance Act 2018]."

"As the assessee has acted in bonafide manner and in the interest of business for safeguard of future losses, it cannot be termed as colorable device developed to avoid tax liability."

"The income arisen from the sale of both the properties is to be charged to tax as long term capital gains and assessee is eligible for benefit of indexation as per the provisions of the Act."

"Expenses of improvement recorded in books of account and reflected in balance sheet as payable to sister concern cannot be disallowed merely on ground of non-availability of original evidences after lapse of more than 10 years."

"Commission payments made through banking channels with TDS deducted and supported by ledger accounts and confirmations are allowable deductions."

"Short term capital loss on sale of shares of penny stock company cannot be disallowed merely on basis of SEBI enquiry against the company, in absence of any adverse material against the assessee."

Final determinations:

• Reopening valid but not pressed for adjudication.
• Conversion of stock-in-trade to capital asset held legal and bonafide; gains taxable as long-term capital gains with indexation benefit.
• Cost of improvement allowed based on accounting records despite non-availability of original bills.
• Commission paid on sale allowed as deduction.
• Short-term capital loss on shares allowed as genuine.
• Appeal allowed accordingly.

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