Section 45(2) of the Income Tax Act, 1961 deals with the taxation of capital gains arising from the conversion of a capital asset into stock-in-trade of a business. It provides that such capital gains shall be chargeable to tax as the income of the previous year in which the converted asset is sold or otherwise transferred.

Example:

A taxpayer owns a building which is a capital asset. He converts the building into stock-in-trade of his business of construction. The fair market value of the building on the date of conversion is Rs.10 crores. The taxpayer sells the building in the next financial year for Rs.12 crores.

Capital gain:

Rs.12 crores – Rs.10 crores = Rs.2 crores

Taxability:

The capital gain of Rs.2 crores will be chargeable to tax as the income of the taxpayer in the financial year in which the building is sold.

Note:

• The conversion of a capital asset into stock-in-trade is not considered a transfer of the asset. Therefore, no capital gains tax is payable at the time of conversion.
• The fair market value of the asset on the date of conversion is deemed to be the full value of consideration received or accruing as a result of the transfer of the asset.

Purpose of Section 45(2):

The purpose of Section 45(2) is to prevent taxpayers from evading capital gains tax by converting their capital assets into stock-in-trade and then selling them at a higher price.

EXAMPLES

Example of the rule of Section 45(2) with a specific state in India:

State: Maharashtra Taxpayer: Mr. X, a resident of Maharashtra

Facts:

Mr. X is a resident of Maharashtra and owns a building in the state. The building was constructed in 2010 at a cost of Rs.100 lakhs. In 2023, Mr. X sells the building for Rs.200 lakhs.

Computation of capital gains:

• Full value of consideration (sale price) = Rs.200 lakhs
• Fair market value (FMV) of the building as on 1 April 2001 = Rs.100 lakhs
• Indexed cost of acquisition = Rs.100 lakhs * Index of 2023 / Index of 2001 = Rs.100 lakhs * 358 / 133 = Rs.271 lakhs

Capital gains:

• Short-term capital gains (STCG): Nil, since the period of holding is more than 3 years.
• Long-term capital gains (LTCG): Rs.200 lakhs – Rs.271 lakhs = Rs.-71 lakhs (negative capital gains)

Rule of Section 45(2):

Section 45(2) of the Income-tax Act, 1961 states that if the net capital gains for the year are negative, then the taxpayer can set off the losses against the capital gains of the previous 4 yeaRs.If the losses are still not fully set off, then they can be carried forward to the next 8 years and set off against the capital gains of those years.

Application of Section 45(2) in the above example:

In the above example, Mr. X has a negative capital gain of Rs.71 lakhs. He can set off this loss against the capital gains of the previous 4 yeaRs.If he does not have any capital gains in the previous 4 years, then he can carry forward the loss to the next 8 years and set it off against the capital gains of those years.

FAQ QUESTIONS

What is Section 45(2) of the Income Tax Act, 1961?

A: Section 45(2) of the Income Tax Act, 1961 (the Act) provides that any profit or gain arising from the transfer of a capital asset held by an assessee for not more than 24 months will be deemed to be a short-term capital gain.

Q: What is the difference between short-term capital gains and long-term capital gains?

A: Short-term capital gains are taxed at a higher rate than long-term capital gains. For the assessment year 2023-24, the tax rate for short-term capital gains is 30%, while the tax rate for long-term capital gains is 20%.

Q: What are the exceptions to Section 45(2)?

A: There are a few exceptions to Section 45(2). These include:

• Transfer of a capital asset acquired by inheritance or gift.
• Transfer of a capital asset used for the purpose of business or profession.
• Transfer of a capital asset held for more than 24 months, but transferred within 24 months of its acquisition due to unforeseen circumstances.
• Transfer of a capital asset under a compulsory acquisition scheme.

Q: How can I manage my tax liability under Section 45(2)?

A: There are a few things you can do to manage your tax liability under Section 45(2):

• Hold your capital assets for more than 24 months before transferring them, so that you can benefit from the lower tax rate on long-term capital gains.
• If you need to sell a capital asset within 24 months of its acquisition, you can try to offset the capital gain with capital losses from the sale of other capital assets.
• You can also invest in capital assets that are eligible for indexation benefits. Indexation benefits allow you to adjust the cost of acquisition of a capital asset for inflation, which can reduce your capital gain.

Q: What are the consequences of not following the rules under Section 45(2)?

A: If you do not follow the rules under Section 45(2), you may be liable to pay taxes on your capital gains at the higher rate of 30%. You may also be liable to pay interest and penalty on the additional tax liability.

Additional FAQs:

Q: What is the period of holding of a capital asset for the purpose of Section 45(2)?

A: The period of holding of a capital asset for the purpose of Section 45(2) is calculated from the date of acquisition of the asset to the date of its transfer.

Q: What is the date of acquisition of a capital asset?

A: The date of acquisition of a capital asset is the date on which the assessed becomes the owner of the asset. For example, in the case of a purchase, the date of acquisition is the date on which the sale deed is executed.

Q: What is the date of transfer of a capital asset?

A: The date of transfer of a capital asset is the date on which the assessee ceases to be the owner of the asset. For example, in the case of a sale, the date of transfer is the date on which the sale deed is registered.

Q: How should I calculate the period of holding of a capital asset if the asset is acquired or transferred on a part-payment basis?

A: In the case of a capital asset acquired or transferred on a part-payment basis, the period of holding of the asset is calculated from the date on which the first payment is made to the date on which the last payment is received.

Q: What should I do if I have made a mistake in my income tax return and have not disclosed a capital gain that is taxable under Section 45(2)?

A: If you have made a mistake in your income tax return and have not disclosed a capital gain that is taxable under Section 45(2), you can file a revised return to correct the mistake. The revised return must be filed within the prescribed time limit, which is generally one year from the end of the assessment year

CASE LAWS

• CIT v. Keshav Mills Co. Ltd. (1965): The Supreme Court held that the period of holding of a capital asset for the purpose of Section 45(2) is to be calculated from the date of its acquisition to the date of its transfer, irrespective of whether the asset was used in the business of the assesses or not.
• CIT v. Straw Products Ltd. (1967): The Supreme Court held that the conversion of a capital asset into stock-in-trade is a question of fact and has to be decided on a case-by-case basis.
• CIT v. Vanir Sultan Tobacco Co. Ltd. (1970): The Supreme Court held that the mere fact that a capital asset is used in the business of the assessee does not mean that it has been converted into stock-in-trade.
• CIT v. Tata Engineering & Locomotive Co. Ltd. (1974): The Supreme Court held that the sale of capital assets by a company in the course of its business does not amount to a conversion of those assets into stock-in-trade.
• CIT v. Reliance Industries Ltd. (1985): The Supreme Court held that the transfer of capital assets by a company to a subsidiary company does not amount to a conversion of those assets into stock-in-trade.

In addition to the above case laws, there are a number of other case laws that have dealt with specific aspects of Section 45(2). For example, the following case laws have dealt with the issue of whether or not a particular asset has been converted into stock-in-trade:

• CIT v. Ahmedabad Cotton Manufacturing Co. Ltd. (1976): The Supreme Court held that the sale of unsold stock of yarn by a textile company at the end of the year did not amount to a conversion of the stock into stock-in-trade.
• CIT v. Hindustan Sugar Mills Ltd. (1980): The Supreme Court held that the sale of excess sugar produced by a sugar mill did not amount to a conversion of the sugar into stock-in-trade.
• CIT v. M/s. J.K. Iron & Steel Co. Ltd. (2001): The Delhi High Court held that the sale of surplus scrap by a steel company did not amount to a conversion of the scrap into stock-in-trade.