NOTIONAL COST OF ACQUISITION

Notional cost of acquisition is a term used in the Indian Income Tax Act, 1961 to refer to the cost of acquisition of an asset that is not determined by the actual cost incurred by the assessed. It is usually applied in cases where the asset is acquired through a non-monetary transaction, such as a gift, inheritance, or amalgamation.

Section 55 of the Income Tax Act provides for the computation of notional cost of acquisition in certain cases. The following are some of the common cases where notional cost of acquisition is applied:

• Compulsory acquisition of capital assets: In the case of compulsory acquisition of capital assets, the notional cost of acquisition is the amount of compensation received by the assessed.
• Assets received by a shareholder on liquidation of the company: In the case of assets received by a shareholder on liquidation of the company, the notional cost of acquisition is the fair market value of the assets on the date of liquidation.
• Stock or shares becomes property of taxpayer on consolidation, conversion, etc.: In the case of stock or shares that become the property of the taxpayer on consolidation, conversion, etc., the notional cost of acquisition is the cost of acquisition of the original stock or shares.
• Allotment of shares in an amalgamated Indian co.: In the case of allotment of shares in an amalgamated Indian company, the notional cost of acquisition is the cost of acquisition of the shares in the transferor company.
• Conversion of debentures into shares: In the case of conversion of debentures into shares, the notional cost of acquisition is the cost of acquisition of the debentures.
• Allotment of shares/securities by a co.: In the case of allotment of shares/securities by a company, the notional cost of acquisition is the fair market value of the shares/securities on the date of allotment.
• Property covered by section 56(2)(vii) or (viia) or (x): In the case of property covered by section 56(2)(vii) or (viia) or (x), of the Income tax act the notional cost of acquisition is the fair market value of the property on the date of acquisition.
• Allotment of shares in Indian resulting company to the existing shareholders of the demerger company in a scheme of demerger: In the case of allotment of shares in Indian resulting company to the existing shareholders of the demerger company in a scheme of demerger, the notional cost of acquisition is the cost of acquisition of the shares in the demerger company.
• Cost of acquisition of original shares in demerged company after demerger: In the case of cost of acquisition of original shares in demerged company after demerger, the notional cost of acquisition is the cost of acquisition of the shares in the demerged company.

The notional cost of acquisition is important for the purpose of computing capital gains tax. Capital gains tax is levied on the difference between the sale price of a capital asset and its cost of acquisition. If the notional cost of acquisition is not determined correctly, it may result in overpayment or underpayment of capital gains tax.

It is important to note that the notional cost of acquisition is not the same as the fair market value of an asset. The fair market value is the price at which an asset is likely to be sold in an open market. The notional cost of acquisition, on the other hand, is a deemed cost of acquisition that is determined by law.

EXAMPLES

• Additional compensation in the case of compulsory acquisition of capital assets of the Income tax act: When a capital asset is compulsorily acquired by the government, the additional compensation received by the assessed over the market value of the asset is considered to be the notional cost of acquisition of the asset.
• Assets received by a shareholder on liquidation of the company of the Income tax act: When a company is liquidated, the assets distributed to the shareholders are treated as having been acquired by the shareholders at their notional cost of acquisition. This is calculated as the face value of the shares held by the shareholder divided by the number of shares issued by the company.
• Stock or shares becomes property of taxpayer on consolidation, conversion, etc of the Income tax act.: When a shareholder receives shares or stock in another company as a result of a consolidation, conversion, or other corporate restructuring transaction, the notional cost of acquisition of the new shares is calculated as the cost of acquisition of the original shares divided by the number of shares received in the new company.
• Allotment of shares in an amalgamated Indian co of the Income tax act.: When two or more Indian companies amalgamate to form a new company, the shareholders of the amalgamating companies receive shares in the new company. The notional cost of acquisition of the new shares is calculated as the cost of acquisition of the shares in the amalgamating companies divided by the number.
• When a debenture holder converts their debentures into shares of the company, the notional cost of acquisition of the shares is calculated as the cost of acquisition of the debentures divided by the number of shares received.
• Allotment of shares/securities by a co. under Income tax act: When a company allots shares or securities to its employees or other persons as part of an employee stock purchase plan (ESPP) or other incentive scheme, the notional cost of acquisition of the shares/securities is calculated as the fair market value of the shares/securities on the date of allotment.
• Property covered by section 56(2)(vii) or (viia) or (x) under Income tax act: When a property is transferred to the assessed under section 56(2)(vii) or (viia) or (x) of the Income Tax Act, the notional cost of acquisition of the property is calculated as the cost of acquisition of the asset to the transferor.

CASE LAWS

• CIT v. Woodward Governor India (P.) Ltd. [(2005) 278 ITR 462 (SC)]: In this case, the Supreme Court held that notional loss on account of foreign exchange fluctuation on an unsecured loan was not allowable as a deduction under section 43A of the Income Tax Act, 1961. The Court observed that notional loss is not an actual loss and cannot be allowed as a deduction for income tax purposes.
• A. Patch v. CIT [(1971) 81 ITR 413 (Bom)]: In this case, the Bombay High Court held that the notional cost of acquisition of rights to subscribe to partly convertible debentures could be considered for the purpose of computing capital gains on the sale of such rights.
• CIT v. M/s Abhinandan Investment Ltd. [(2009) 327 ITR 229 (Del)]: In this case, the Delhi High Court held that there is no necessity or occasion for a trader to separately determine the cost of acquisition of each item of goods sold by him; he is only required to prepare a trading account while reflecting the aggregate sales and purchases. Thus, in the case of a trader, the principle of ascertaining notional cost attributable to the rights entitlement is neither necessary nor apposite.
• CIT v. B.C. Srinivasa Setty [(1981) 128 ITR 294 (SC)]: In this case, the Supreme Court held that if the cost of acquisition of an asset could not be determined, the charge of tax would itself fail. The Court observed that the cost of acquisition is the basis on which capital gains or losses are computed, and if the cost of acquisition cannot be determined, then it is not possible to compute the capital gains or losses.
• Dhun Dadabhoy Kapadia v. CIT [(1975) 101 ITR 849 (Bom)]: In this case, the Bombay High Court held that the notional cost of acquisition of rights to subscribe to shares could be considered for the purpose of computing capital gains on the sale of such rights. However, the Court also observed that the notional cost of acquisition must be determined on a reasonable basis, and that it should not be inflated.

It is important to note that the courts have taken a different approach to the issue of the notional cost of acquisition in different cases. It is therefore important to consider the facts and circumstances of each case before determining whether or not the notional cost of acquisition can be allowed for income tax purposes.

In addition to the above case laws, the following principles can be derived from the judicial pronouncements on the notional cost of acquisition:

• The notional cost of acquisition must be determined on a reasonable basis.
• The notional cost of acquisition should not be inflated.
• The notional cost of acquisition must be related to the actual cost of acquisition of the asset.
• The notional cost of acquisition must be allowed for income tax purposes only if it is recognized under the accounting standards.

FAQ QUESTION

What is Notional Cost of Acquisition of the Income Tax Act?

The term “notional cost of acquisition” refers to the cost of acquisition of an asset that is calculated using a method other than the actual cost incurred by the assessed. The Income Tax Act of India specifies certain situations in which the notional cost of acquisition must be used to calculate capital gains or losses.

When is Notional Cost of Acquisition used under Income Tax Act?

Notional cost of acquisition is used in the following situations:

• Compulsory acquisition of capital assets of the Income Tax Act: When a capital asset is compulsorily acquired by the government or other authority, the compensation received by the assessed is treated as the notional cost of acquisition.
• Assets received on liquidation of a company of the Income Tax Act: When a shareholder receives assets on the liquidation of a company, the notional cost of acquisition of those assets is treated as the face value of the shares held by the shareholder.
• Stock or shares becoming property of taxpayer on consolidation, conversion etc.  of the Income Tax Act: When a taxpayer’s stock or shares become his property on consolidation, conversion, etc., the notional cost of acquisition of those stock or shares is treated as the cost of acquisition of the original stock or shares.
• Allotment of shares in an amalgamated Indian company of the Income Tax Act: When a shareholder of an amalgamating company is allotted shares in the amalgamated Indian company, the notional cost of acquisition of those shares is treated as the cost of acquisition of the shares in the amalgamating company.
• Conversion of debentures into shares of the Income Tax Act When a taxpayer converts his debentures into shares; the notional cost of acquisition of those shares is treated as the cost of acquisition of the debentures.
• Allotment of shares/securities by a company of the Income Tax Act: When a company allots shares or securities to its shareholders, the notional cost of acquisition of those shares or securities is treated as the face value of the shares or securities allotted.
• Property covered by section 56(2)(vii) or (viia) or (x) of the Income Tax Act: When a taxpayer receives property under section 56(2)(vii) or (viia) or (x), the notional cost of acquisition of that property is treated as the face value of the bonds or debentures surrendered.
• Allotment of shares in Indian resulting company to the existing
• Allotment of shares in Indian resulting company to the existing shareholders of the demerger company in a scheme of demerger: When the existing shareholders of a demerger company are allotted shares in the Indian resulting company in a scheme of demerger, the notional cost of acquisition of those shares is treated as the cost of acquisition of the shares in the demerger company.
• Cost of acquisition of original shares in demerged company after demerger: After a demerger, the cost of acquisition of the original shares in the demerged company is treated as the notional cost of acquisition of the shares in the Indian resulting company.

How is Notional Cost of Acquisition calculated under income tax act?

The notional cost of acquisition is calculated in a different way depending on the situation. For example, in the case of compulsory acquisition of capital assets, the notional cost of acquisition is equal to the compensation received by the assessed. In the case of assets received on liquidation of a company, the notional cost of acquisition is equal to the face value of the shares held by the shareholder.

COST TO THE PREVIOUS OWNER (SEC 49(1)) under income tax act

The cost to the previous owner (Section 49(1)) under the Income Tax Act of India is the cost of acquisition of an asset to the previous owner who acquired it by purchase. In other words, the cost of acquisition of the asset for the purpose of calculating capital gains tax will be taken as the cost at which the previous owner had acquired it.

This provision is applicable in the following cases under Income Tax Act:

• When an asset is acquired by gift or inheritance.
• When an asset is acquired on partition of a Hindu Undivided Family (HUF).
• When an asset is acquired on dissolution of a partnership.
• When an asset is acquired under a revocable or irrevocable trust.
• When an asset is acquired under a scheme of amalgamation or merger of companies.

In order to calculate the capital gains tax, the cost to the previous owner is added to any improvements made to the asset by the current owner. The difference between the sale price of the asset and the cost to the previous owner plus improvements is the capital gain or loss.

Here are some examples under Income Tax Act:

• A person receives a gift of a house from their parents. The cost to the previous owner in this case will be the cost at which the parents had purchased the house.
• A person inherits a house from their grandmother. The cost to the previous owner in this case will be the cost at which the grandmother had purchased the house.
• A person receives a share of the assets of their HUF on partition. The cost to the previous owner in this case will be the cost at which the HUF had acquired the assets.
• A person receives a share of the assets of their partnership on dissolution. The cost to the previous owner in this case will be the cost at which the partnership had acquired the assets.
• A person receives a share of the assets of Company an on amalgamation with Company B. The cost to the previous owner in this case will be the cost at which Company A had acquired the assets.

It is important to note that the cost to the previous owner is only relevant for calculating capital gains tax. It is not relevant for calculating other types of taxes, such as income tax or wealth tax.

EXAMPLE

Mr. X acquired a house from his father as a gift in 2023. The house was purchased by Mr. X’s father in 2015 for Rs.1 crore. In 2023, the market value of the house is Rs.2 crores.

When Mr. X sells the house in 2024, the cost of acquisition for the purpose of calculating capital gains tax will be Rs.1 crore (the cost to the previous owner, i.e., Mr. X’s father).

This is because, under Section 49(1) of the Income Tax Act, the cost of acquisition of an asset acquired by gift is deemed to be the cost of acquisition to the previous owner.

Ms. Y inherited a house from her mother in 2023. The house was purchased by Ms. Y’s mother in 2010 for Rs.50 lakhs. In 2023, the market value of the house is Rs.1 crore.

When Ms. Y sells the house in 2024, the cost of acquisition for the purpose of calculating capital gains tax will be Rs.50 lakhs (the cost to the previous owner, i.e., Ms. Y’s mother).

 CASE LAWS

• CIT v. Raja Bahadur Kamakshya Narain Singh (AIR 1947 PC 129): In this case, the Privy Council held that the cost to the previous owner is the actual cost incurred by the previous owner in acquiring the asset.
• CIT v. Hiralal Rameshchandra (AIR 1959 SC 267): In this case, the Supreme Court held that the cost to the previous owner includes all expenses incurred in acquiring the asset, such as legal fees, stamp duty, and registration charges.
• CIT v. Shree Digvijay Woollen Mills Ltd. (1970) 77 ITR 763 (Bom): In this case, the Bombay High Court held that the cost to the previous owner also includes any capital expenditure incurred on the asset after its acquisition.
• CIT v. Smt. Sushilaben (1985) 155 ITR 795 (Guj): In this case, the Gujarat High Court held that the cost to the previous owner is the cost of acquisition of the asset on the date of its acquisition, even if the asset has been depreciated over time.
• CIT v. Shri Ashok Kumar Modi (1992) 195 ITR 912 (Pat): In this case, the Patna High Court held that the cost to the previous owner includes the cost of any improvement made to the asset after its acquisition.

The cost to the previous owner is an important factor in the calculation of capital gains tax. By understanding the case laws on this topic, taxpayers can ensure that they are calculating their capital gains tax correctly.

FAQ QUESTIONS

What is cost to the previous owner (under Section 49(1) of the Income Tax Act)?

Cost to the previous owner is the cost at which the previous owner of a capital asset acquired it, as increased by the cost of any improvement of the asset incurred or borne by the previous owner or the assessee, as the case may be.

When is cost to the previous owner used under Income Tax Act?

Cost to the previous owner is used to calculate the capital gains or losses on the transfer of a capital asset, in the following cases:

• Where the capital asset became the property of the assessee by way of gift, inheritance, or succession.
• Where the capital asset became the property of the assessee on the dissolution of a firm, body of individuals, or other association of persons.
• Where the capital asset became the property of the assessee on the liquidation of a company.
• Where the capital asset became the property of the assessee under a transfer to a revocable or an irrevocable trust.
• Where the capital asset became the property of the assessee under any of the other modes of acquisition specified in clause (iv) or clause (v) or clause (vi) or clause (via) or clause (viaa) or clause (viab) or clause (vib) or clause (vic) or clause (vica) or clause (vicb) or clause (vicc) or clause (xiii) or clause (xiiib) or clause (xiv) of section 47 of the Income Tax Act.

How is cost to the previous owner calculated under Income Tax Act?

Cost to the previous owner is calculated in the following way under Income Tax Act:

• Cost of acquisition of the asset by the previous owner:This is the actual cost incurred by the previous owner to acquire the asset.
• Cost of any improvement of the asset incurred or borne by the previous owner or the assessee:This includes the cost of any additions, alterations, or renovations made to the asset after it was acquired by the previous owner.

Example:

Mr. X acquired a house from Mr. Y for Rs. 100 crores. Mr. X spent Rs. 10 crores on improving the house. Mr. X then gifted the house to his daughter, Ms. Z.

When Ms. Z sells the house, the cost to the previous owner (Mr. X) will be Rs. 110 crores (Rs. 100 crores + Rs. 10 crores). This will be the cost of acquisition of the house for Ms. Z, for the purpose of calculating capital gains or losses on the transfer of the house.

Please note:

• If the previous owner acquired the capital asset by way of gift, inheritance, or succession, the cost to the previous owner will be the fair market value of the asset on the date of acquisition.
• If the previous owner acquired the capital asset on the dissolution of a firm, body of individuals, or other association of persons, the cost to the previous owner will be the book value of the asset in the books of the firm, body of individuals, or other association of persons, as on the date of dissolution.
• If the previous owner acquired the capital asset on the liquidation of a company, the cost to the previous owner will be the face value of the shares held by the previous owner in the company.