2014 (6) TMI 1017 - AT - Income Tax

Capital gain - anticipated profit to tax - assessment in which year - land held by the assessee as stock in trade - Held that - The conceptual foundation for this stock valuation principle are accounting principle of conservatism and business considerations of prudence which have been noticed and approved by Hon ble Courts above. It is for these reason that when market price of an item in the closing stock is less than its cost price to the business the notional loss is allowed as a deduction but when market price of an item in the closing stock is more than its cost price to the business the notional profit is not brought to tax. However by giving the impugned directions learned CIT(A) has ended up bringing that anticipated profit to tax. What the assessee has got today is only a right to sell the 1, 28, 940.26 fts of constructed area in the Alexandria project and the profits howsoever certain they may appear to be will only fructify and be realized and can even be quantified only when this right is exercised in part or in full. That stage has not yet come and until that stage comes in our considered view such profit cannot be taxed. Unlike in a case of a capital gain which arises on parting the capital asset at the first stage itself it is a case of business transaction which is completed when the rights so acquired by the assessee are exercised; none can make profits by dealing with himself as is the settled legal position in the light of the settled legal position in the case of Sir Kikabhai Premchand v. CIT 1953 (10) TMI 5 - SUPREME COURT . It is for this reason that we are unable to uphold the action of the authorities below on the facts of this case. The authorities below indeed erred in bringing to tax the anticipated business profits on assessee s entering into a development agreement with Menorah Realties Pvt Ltd in respect of the land held by the assessee as stock in trade - Decided in favour of assessee.

1. The core legal issues considered in this appeal are:

(a) Whether the notional gain arising from entering into a joint development agreement (JDA) involving land held as stock in trade can be taxed as short-term capital gains under the Income Tax Act, 1961;

(b) Whether the provisions of Section 2(47) defining "transfer" and the application of Section 53A of the Transfer of Property Act, 1882, are relevant to determine the timing and nature of the transfer for taxation purposes in the context of land held as stock in trade;

(c) Whether the notional profit arising from the JDA can be taxed as business income, considering the valuation of closing stock and the accounting principles governing such valuation;

(d) The applicability of the principles of valuation of closing stock at cost or market value, whichever is lower, and the treatment of unrealized profits in business income taxation;

(e) The correctness of the Assessing Officer's and Commissioner of Income Tax (Appeals)'s (CIT(A)) approach in computing and taxing the notional gains arising from the JDA.

2. Issue-wise detailed analysis:

(a) Taxability of notional gains as short-term capital gains on transfer of land held as stock in trade

The legal framework involves Section 45(1) of the Income Tax Act, which taxes capital gains arising from the transfer of a capital asset, and Section 2(14), which defines "capital asset" excluding stock in trade. Section 2(47) defines "transfer" for capital gains purposes, including transactions covered under Section 53A of the Transfer of Property Act.

The Assessing Officer (AO) held that the transfer of land under the JDA constituted a "transfer" under Section 2(47), triggering capital gains tax. The AO relied on judicial precedents holding that capital gains arise when possession and control are given to the developer, citing decisions from the jurisdictional High Court and Bombay High Court.

The CIT(A) agreed that notional profit could not be taxed as capital gains since the land was stock in trade but held that the gain was taxable as business income. The CIT(A) further relied on provisions of the Transfer of Property Act and Sale of Goods Act to conclude that the transaction amounted to a sale and that the transfer occurred in the year the JDA was entered.

The Tribunal noted that since the land was held as stock in trade, it did not qualify as a capital asset under Section 2(14), thus excluding the applicability of capital gains provisions. The Tribunal clarified that the definition of "transfer" under Section 2(47) and Section 53A of the Transfer of Property Act applies only for capital gains taxation and cannot be extended to business income taxation. The reliance on precedents concerning capital gains was held to be misplaced in this context.

Conclusion: The notional gain arising from the JDA involving land held as stock in trade cannot be taxed as short-term capital gains under the Income Tax Act.

(b) Relevance of Section 2(47) and Section 53A of the Transfer of Property Act in determining transfer and taxability

The AO and CIT(A) relied on Section 2(47)(v) and Section 53A to determine the timing and nature of transfer. Section 2(47)(v) includes transactions involving possession of immovable property in part performance of a contract for the purpose of capital gains taxation. Section 53A protects the transferee's possession in such contracts.

The Tribunal emphasized that these provisions are relevant only for capital gains taxation, which presupposes the existence of a capital asset. Since the land was stock in trade, not a capital asset, these provisions are irrelevant for taxing the transaction as business income. The CIT(A)'s conclusion that the transaction constituted a transfer and consequent sale under these provisions was held to be erroneous.

Conclusion: Section 2(47) and Section 53A of the Transfer of Property Act have no bearing on the taxability of notional profits arising from business transactions involving stock in trade.

(c) Taxability of notional profit as business income and valuation of closing stock

The CIT(A) held that the notional gain should be taxed as business income by reducing the closing stock of land by the share transferred and increasing the closing stock by the value of the right to constructed area received in consideration.

The Tribunal examined the accounting principles underlying valuation of closing stock, referring to the landmark Supreme Court decision in Chainrup Sampatram v. CIT, which mandates valuation of closing stock at cost or market value, whichever is lower, and disallows inclusion of unrealized profits in income. The principle of conservatism and prudence in accounting was emphasized, whereby anticipated losses are recognized but anticipated profits are not.

The Tribunal observed that the assessee's right to sell constructed area is a trading asset acquired in exchange for the land transferred and should be valued at cost. Since the cost of acquiring this right equals the cost of the land given up, no notional profit arises at this stage. The profits will only crystallize when the right is exercised and the constructed area sold.

Conclusion: The notional profit arising from the JDA cannot be taxed as business income at the stage of entering into the agreement; it can only be recognized upon actual realization.

(d) Treatment of unrealized profits and conceptual accounting principles

The Tribunal elaborated on the accounting standards and judicial precedents that disallow recognition of unrealized profits in closing stock valuation for income tax purposes. Accounting Standard 2 mandates valuation at cost or net realizable value, whichever is lower. The Supreme Court's decision in Chainrup Sampatram explains that unrealized appreciation should not be brought to tax, while unrealized losses are allowed.

The Tribunal underscored that the CIT(A)'s direction to tax the anticipated profit arising from the JDA contravenes these principles and is therefore unsustainable.

Conclusion: Anticipated profits embedded in closing stock valuation cannot be taxed before actual realization, consistent with accounting principles and judicial precedents.

(e) Overall correctness of the Assessing Officer's and CIT(A)'s approach

The AO computed short-term capital gains by taking the cost of construction of the assessee's share in the built-up area as deemed consideration for transfer of land, relying on the concept of transfer under Section 2(47). The CIT(A) modified this by treating the gain as business income but still recognized the profit in the year of the JDA.

The Tribunal found both approaches flawed. The AO's approach was incorrect because the land was stock in trade and not a capital asset, so capital gains provisions were inapplicable. The CIT(A)'s approach erred in taxing unrealized notional profits as business income prematurely, disregarding accounting principles and the fact that the right to constructed area was acquired at cost equal to the land given up.

The Tribunal held that the transaction resulted in substitution of one trading asset (land) with another (right to constructed area) at equivalent cost, hence no profit arises at the time of the JDA. The profit will only arise when the right is exercised and the constructed area sold.

Conclusion: Both the AO and CIT(A) erred in their computation and taxation of notional profits arising from the JDA; the addition was rightly deleted by the Tribunal.

3. Significant holdings:

"Once the land is held to be a part of the stock in trade, it ceases to be a capital asset... Clearly, therefore, the provisions regarding capital gains are admittedly not attracted on the facts of this case."

"The definition of 'transfer' under section 2(47) of the Act, and of Section 53A of the Transfer of Property Act... have no bearing on the adjudication about taxability of notional profits in the hands of the assessee."

"The principles of conservatism, and considerations of prudence, in the accounting treatment require that no anticipated profits be treated as income until the profits are realized... unrealised profits in the shape of appreciated value of goods remaining unsold at the end of an accounting year... are not brought into the charge as a matter of practice."

"What the assessee has got today is only a right to sell the 1,28,940.26 sq. ft. of constructed area... the profits... will only fructify and be realized... only when this right is exercised... such profit cannot be taxed."

"No matter how reasonable is it to assume that the assessee will make these profits, these profits cannot be brought to tax at this stage."

"The impugned addition of Rs. 17,28,81,276 is thus deleted."

← Previous Next →