Capital gains on conversion of capital asset into stock-in-trade

Introduction

If a capital asset is converted by the owner thereof into, or is treated by him as, stock-in-trade of a business carried on by him, it shall be deemed that the capital asset is transferred during the tax year in which such conversation took place and capital gain is computed accordingly. Here, it is to be noted that the capital gain so computed in the year of conversion shall be charged to tax in the year in which the stock-in-trade is ultimately sold or otherwise transferred by the assessee. Thus, the two types of income shall be charged to tax in the year which stock-in-trade is sold. First, the capital gain computed on date of conversion and second, the business income which may arise on sale of stock.

Where a capital asset is converted by the owner into stock-in-trade of the business carried on by him, such conversion is treated as transfer of capital asset. In such a case, the capital asset is deemed to be transferred in the tax year in which it is converted into stock-in-trade and capital gain is computed accordingly. However, the capital gain so computed shall be charged to tax in the tax year in which stock-in trade is sold or otherwise transferred.

1. Scope of provision [Section 67(6)]

2. How to calculate capital gains?

The capital gains shall be computed in the following manner:

3. Factors for calculation of capital gains

Any profits or gains arising on conversion of capital assets into stock-in-trade shall be chargeable to tax under the head capital gains in the tax year in which the stock-in trade is ultimately sold or otherwise transferred by assessee. For computation of capital gains in case of such conversion, the following factors are considered:

(a) Period of holding;

(b) Full value of consideration;

(c) Cost of acquisition;

(d) Cost of improvement;

(e) Expenditure incurred in connection with transfer;

(f) Adjustment for the capital gains taxed under Section 67(10);

(g) Exemptions allowed under Section 82 to 88.

It should be noted that the indexation was traditionally allowed under the Income-tax Act when calculating long-term capital gain unless specifically restricted. However, the Finance (No. 2) Act, 2024 removed the indexation benefit and introduced a uniform tax rate of 12.5% on long-term capital gains under ITA 1961 to simplify the computation of capital gains.

However, to ease the transition, the Government introduced a grandfathering provision which provides a specific relief to resident individuals and resident HUFs in respect of land or building (or both) acquired before 23-07-2024. In such cases, the taxpayer has the option to compute tax either:

(a) at 12.5% without indexation benefit; or

(b) at 20% after claiming indexation benefit.

This simplified framework has also been continued under ITA 2025. Thus, no indexation benefit shall be available if a capital asset is converted into stock-in-trade except where the grandfathering provision applies.

3.1-1. Computation of period of holding

The period of holding of the capital asset shall be counted from the date of purchase or acquisition till the date such capital asset is converted into stock in trade. It should be noted that while the capital gain on conversion of capital asset into stock-in-trade is taxable in the year in which stock-in-trade is sold or otherwise transferred, the holding period is still counted up to the date of transfer, i.e., the date on which capital asset is converted into stock in trade.

3.1-2. Computation of full value of consideration

Where a capital asset is converted into stock-in-trade, it is treated as transfer. In this case, the fair market value of the capital asset on the date on which it is converted or treated as stock-in-trade is deemed to be the full value of the consideration received or accruing as a result of the transfer of the capital asset.

3.1-3. Computation of cost of acquisition

The cost of acquisition of the capital asset so converted into stock-in-trade shall be computed as per general provisions.

3.1-4. Computation of cost of improvement

The cost of improvement of the capital asset so converted into stock-in-trade shall be computed as per general provisions.

3.1-5. Indexed cost of acquisition or improvement

The indexation benefit is no longer available for computing long-term capital gains on capital assets. However, the Government has introduced a grandfathering provision. This provision allows resident individuals and resident HUFs to apply indexation on land or building acquired before 23-07-2024, but only if the tax calculated without indexation results in a higher amount.

Thus, where the grandfathering provision applies, the "Indexed Cost of Acquisition" and the "Indexed Cost of Improvement" are used to compute the capital gain instead of the original cost of acquisition and improvement.

3.1-6. Adjustment for the capital gain taxable under Section 67(10)

Where the amount is chargeable to tax as income of partnership firm under Section 67(10), the firm shall attribute such amount to the capital asset remaining with it, including capital assets forming part of block of asset. Such attribution is allowed, at the time of computation of capital gains from the transfer (including conversion) of such capital asset remaining with the partnership firm, by way of deduction under Section 72(5). The deduction under Section 72(5) is allowed if the following conditions are satisfied:

(a) There should be a reconstitution of the partnership firm;

(b) Capital asset or money or both should be given to the partner on such reconstitution;

(c) Capital gain is computed and taxed in the hands of the firm under Section 67(10); and

(d) The book value (or historical value or WDV) of at least one of the capital assets remaining with the firm after such reconstitution should be less than its fair market value. It may also include the self-generated asset.

The amount chargeable to tax under Section 67(10) shall relate to revaluation of any capital asset or valuation of self-generated asset or self-generated goodwill of firm if the revaluation is based on a valuation report obtained from a registered valuer defined under Rule 56.

3.1-7. Computation of exemptions

Certain exemptions can be claimed under Sections 82 to 88 from the capital gains arising on conversion of capital assets into stock-in-trade subject to fulfilment of certain conditions and investments in eligible capital assets within the prescribed time limit.

The CBDT has clarified

3.1-8. Year in which taxable

Liability to pay tax on the capital gain arising on conversion of capital asset into stock-in-trade shall arise in the tax year in which stock-in trade is sold or otherwise transferred. Thus, where capital asset is converted into stock in trade in the year 2025–2026 but the stock is actually sold in the tax year 2026–2027, the capital gain shall be taxable in the tax year 2026–2027

If stock-in-trade is sold in parts in different years, tax on capital gain computed at the time of conversion of capital asset into stock-in-trade shall be deemed to arise in parts in different years and not in one year in which first or last lot of stock-in-trade is sold

3.1-9. Computation of business profits on sale of Stock

For computation of business profits arising from transfer of stock-in-trade, being converted capital asset, the fair market value of the capital asset on the date of conversion shall be deemed as the cost of acquisition of the stock-in-trade. The profit or loss in such cases is computed as under:

References

Resident individuals and HUFs may opt for the benefit of indexation while computing long-term capital gains arising from the transfer of land or building acquired before 23-07-2024, where the tax without indexation exceeds the tax computed with indexation.

Resident individuals and HUFs may opt for the benefit of indexation while computing long-term capital gains arising from the transfer of land or building acquired before 23-07-2024, where the tax without indexation exceeds the tax computed with indexation.

Circular No. 791, dated June 2, 2000

CIT v. Crest Hotels Ltd. [2001] 78 ITD 213 (Mum.).

This article is general information and not tax advice. Provisions change. Confirm your position with a qualified professional before acting.