Volume 6, Issue 4

27th April, 2013

Tax Alert

Categorisation of gain on sale of investment after conversion from stock in trade

The categorisation of income from sale of share as capital gains or business income has been a bone of contention since a long time and there are a plethora of decisions on the said issue. Each of the cases has been decided on peculiar facts of the case and although the Government has issued circulars in this regard from time to time, the matter is still not free from doubt. One has to study the guidelines issued by the Government along with the ratio of the various decisions before arriving at any conclusion as to whether the income constitutes capital gain or business income.

Recently, the Mumbai Bench of the Income Tax Appellate Tribunal (ITAT) in the case of ACIT vs. M/s. Superior Financial Consultancy Services (ITA No. 4208/Mum/2007) had the occasion to deal with a situation where shares were converted from stock in trade into capital assets and thereafter, a gain arose to the tax payer on sale of such shares. The ITAT had to decide whether the gain so arising was in the nature of capital gain or business income. The ITAT had to also decide whether it was permissible to have two separate portfolios viz one comprising of capital assets and other of stock in trade.  This tax alert discusses this interesting decision.

Facts of the case:

  • In the previous year relevant to assessment year 2004-05, the tax payer was engaged in the business of borrowing and lending of funds.
  • Prior to 31st March, 2002 the tax payer carried on the business of trading as well as speculation in shares. These shares were reflected as stock-in-trade in the Balance sheet for the year ended 31st March, 2002.
  • However, from 1st April, 2002 the tax payer discontinued delivery based trading of shares and converted the stock of shares into investments which was also duly reflected as Investments in the balance sheet as on 31st March, 2003 along with a suitable clarificatory note in the notes to accounts.
  • During  the previous year relevant  to assessment year 2004-05, the tax payer sold some of these shares held as investments and offered the gain arising therefrom amounting to Rs.7,13,29,191/- under the head “Capital Gains”. Since these shares were long term capital assets, the tax payer claimed exemption u/s 10(38) of the Income Tax Act (ITA).
  • The Assessing Officer (herein referred to as ‘AO’) was of the opinion that the conversion of shares from stock in trade to capital assets was not genuine and indicated a colourable tax saving device conceived by the tax payer. He accordingly, treated the income as “business income” and taxed it accordingly.
  • The Commissioner of Income Tax (Appeals) [CIT(A)] passed an order in favour of the tax payer and treated the gain as “capital gain”.
  • Aggrieved by the order of the CIT (A), the Revenue appealed to the ITAT.

Issues before ITAT:

The following issues were raised before the ITAT by the Revenue:

    1. Whether the conversion of stock-in-trade into investments is legally permissible?
    2. If yes, whether the conversion is motivated by tax avoidance?
    3. Whether a tax payer can be an investor and a speculator at the same time?

Contentions of the Revenue:

  • With regard to the first issue, the Revenue contended as under.
    • The stock-in-trade cannot be converted into investments till the time such stock remains in the business carried on by a tax payer.
    • The shares held by the assessee formed  part of stock-in-trade, since the same were held in the business and such stock has to be excluded from the definition of “capital asset” provided u/s 2(14) of  the ITA.
    • Conversion of the capital assets to stock-in-trade has legal sanctity since it has been clearly recognised u/s 45(2) of the ITA. However, there is no explicit provision in the ITA to capture the reverse scenario.

      Accordingly, the Revenue argued that the conversion of stock in trade into capital asset cannot be recognised and is only a colourable device to avoid tax.

    • With regard to the second issue, the Revenue placed reliance on the decision of the Bombay High Court in the case Twin Star Holdings Ltd. vs. Anand Kedia 260 ITR 6 (Bom.) and argued that such conversion is to be treated as sham transaction since the transaction was undertaken with the motive of tax evasion.
    • The Revenue did not raise any specific contention in support of the third question.

Contentions of the Tax Payer:

  • On the first issue, the tax payer relied on the decision rendered by the Honourable Supreme Court in case of Sir Kikabhai Premchand 24 ITR 506 wherein it was held that conversion of stock-in-trade into capital asset/investment is legally permissible.
  • On the  second  issue, the tax payer raised the following contentions :
    • The market conditions compelled it to discontinue its share trading business. This shift in business activity from share trading to financing business necessitated conversion of stock-in-trade into investment.
    • These shares were consistently shown as investments since the conversion.
    • Suitable clarificatory notes were also provided in the accounts.
  • With respect to the third issue, the tax payer relied on the decision of the Chandigarh Tribunal in the case of Vesta Investments & Trading Pvt Ltd. 70 ITD 200 wherein it was held that in a case where separate accounts are maintained for shares held as stock-in-trade and shares held as investments, sale of shares held as investments would give rise to capital gains and not business income.

ITAT’s Observation:

  • ITAT accepted the tax payer’s contention with respect to the first  question by placing reliance on the decision of the Supreme Court in case of Sir Kikabhai Premchand (Supra) wherein it has been held that such conversion is not something unknown to the commercial world and there is no legal bar on the same.
  • As regards the second issue, the tribunal upheld the order of the CIT (A) and concluded that the tax payer cannot be said to have entered into a sham transaction since the conversion is transparent from the audited accounts and the notes to accounts. Further, the Tribunal distinguished the judgement of Bombay High Court (Supra) on the ground that the facts of the said decision were quite different.
  • Lastly, the ITAT, agreeing with the view of CIT(A), held that the decision of Chandigarh Tribunal (Supra) would squarely apply to the present case and thus, a  tax payer may be an investor as well as a speculator at the same time. Further, if the Revenue accepts such shares held as investments then the gains accruing therefrom shall be considered as capital gains. 

SKP’s Comments:

This judgment clearly brings out the fact that there are no provisions that restrict the conversion of stock-in-trade into investments and hence, such conversion holds good in law. In our view, this is a welcome relief for tax payers and although the principle was laid down by the Supreme Court long back, due to passage of many years, the Revenue took the view that such conversion is not possible. This ITAT decision reaffirms this principle. The Tribunal has further gone into the intention behind the transaction and has held that based on the facts of the case, there is no motivation for any tax evasion. This should bring relief to those tax payers who genuinely convert their portfolio of stock in trade into investments based on the market conditions. Thus, if the transaction is genuine and there is supporting circumstantial evidence, there is a strong ground for defending the claim that the same has not been entered into only for the purpose of tax evasion/avoidance. Of course, one has to follow the accounting treatment consistently to prove that it is bonafide.