REAL OCCUPATION OF ASSESSEE AND HIS ASSET IS IMPORTANT TO DECIDE ABOUT HEAD OF INCOME- an analysis in view of judgment of Delhi High Court.

[C.A. DEV KUMAR KOTHARI]

Important links of judgments:

COMMISSIONER OF INCOME-TAX Versus HITASHI ESTATES LTD. [2009 -TMI - 34038 - DELHI HIGH COURT]

Commissioner of Income-Tax Versus D. P. Sandu Bros. Chembur P. Ltd. [2008 -TMI - 6153 - SUPREME Court].

Kedarnath Jute Manufacturing Company Limited Versus Commissioner of Income-Tax Central), Calcutta [2008 -TMI - 6262 - SUPREME Court].

Natural way of holding as stock-in-trade or capital asset :

Depending on occupation of any person he can hold an items in its natural way either as a stock-in-trade or as capital asset. If an item is in natural way stock-in-trade as being an item in which he trade or which he hold for consumption, then it cannot, generally be capital assets.

Similarly, if the items is not held as stock-in-trade, in normal course and on consideration of occupation of a person, then it is a capital asset in its natural way.

Trader or investor :

The persons who generally purchase goods and sale to others and to whom people know as trader of such item is considered a trader of particular item or items. For example, a sugar trader, a paper trader, a tea trader. We also find some traders who trade in a group of items like a grocery shop, a stationary shop, a medical store, a hardware shop, electrical goods supplier.

GOS: We also find many traders who are general order suppliers; they supply to industries almost anything against order. Usually these traders specialize some items for which they keep stock, however, they are in a position to procure orders for other goods also and they purchase such goods and supply to the customers.

Whole sellers- specializes:

We find that in case of wholesale traders there is specialization and concentration of one or few items in which they trade, whereas in case of retail trader there are several items in which they trade.

Stock -in-trade and capital asset both can be held by same person :

For instance, a car dealer purchases cars for trading purposes; therefore, cars purchased by him will be his stock-in-trade in natural way. If he wants to use any car as fixed asset or capital asset, he will transfer stock-in-trade to fixed assets account. However, when a scooter dealer purchases a car for his business use, he purchases it as a capital asset in its natural course. He directly debit "Motor Car" account and classify it as an item of fixed asset.

We can further elaborate the example for a dealer on car of particular brand. Suppose, X.Y. Motors who is a dealer of Tata motors for cars purchases cars from Tata Motors, these cars will be their stock-in-trade, in natural way and usual course of business. If they want to use a car for office purposes, the same will be converted into capital asset by transfer from stock-in-trade account. Now suppose X.Y. Motors purchase a Jaguar Land Rover car for business use. The Jaguar Land Rover car will not be their stock-in-trade in natural way or usual course of business. That car will be their 'capital asset' in natural way.

Suppose, later on they sell the Jaguar Land Rover car from their block of assets, then, the gains will be computed as capital gains.

Alternatively suppose they transfer or treat the Jaguar Land Rover car also to their stock-in-trade, then the sale after such transfer or treatment will be considered a sale of stock-in-trade resulting business income and also capital gains in terms of Section 45(2).

It is worth to mention that under section 45(2) an assessee has an option to treat or convert a capital asset into stock-in-trade and the A.O. has no such option.    

Capacity of trader vis-a-vis stock-in-trade :

As discussed above a person who is known as trader of item or items in which he usually deals or act as a supplier/ distributor/ dealer/ whole seller/ retailer  etc. is a trader of such items. The items held by such businessman in the course of such business shall be considered as his stock-in-trade. The trader cannot, usually treat such items as his capital assets. However, in exceptional circumstances like closure of business or particular asset assuming character of 'capital asset', such items may be converted to investment. For example, a car dealer may use some cars out of his stock-in-trade for business use or personal use or in business of running such cars on hire. In such events the car shall assume character of 'capital asset' and may also become a part of block of asset for depreciation claim.

  A professional person, a salaried person, a trader in other goods say motor cars or petroleum products or cloth merchant or , a retired person who was employed earlier or engaged in some other business earlier, cannot be called as a share trader, merely because his investment portfolio is large and due to large portfolio, naturally frequency of transactions and volume is increased.-newly added, after sending the article.

Non-trade items are generally capital asset :

In view of above discussions it can be said that an items held a as a trader of particular item is his stock-in-trade and non-trade items are generally capital assets in case of any person who does not trade in such items or who does not require them as raw material or consumables. Investment in any article or thing is therefore holding of such things as capital assets and cannot be assumed as stock-in-trade. Thus gold, silver, jewellery, land and buildings, shares , securities, units, bonds other saving instruments etc. are to be considered as 'capital assets', unless they have been converted or treated as stock-in-trade by the assessee. The A.O. has no right to treat a capital asset into stock-in-trade.

Gain on sale of a non trade/ non consumable item is capital gain :

Therefore, it can be said that any gain on sale of an item of asset that is not 'stock-in-trade' of the assessee will result into income or loss under the head' capital gains' and it cannot be considered as business income.

Accounting entries and disclosures may not be conclusive :

It is well known that accounting red with tax laws is quite complex. Many times proper classification in account may not be made. This also happen because in case of small organization accounts are prepared by junior persons or the businessman himself. In case of self employed persons, salaried persons, a balance sheet may be prepared by himself or by a part time accountant in a very general manner without applying all technical and commercial aspects. Therefore, depending on the facts and circumstances of a case the accounting entries or disclosure in annual accounts may not be fully conclusive. 

A case before Delhi High Court :

In COMMISSIONER OF INCOME-TAX Versus HITASHI ESTATES LTD. [2009 -TMI - 34038 - DELHI HIGH COURT]. The assessee had taken a property on tenancy basis. The expenses of improvement were by mistake shown as stock-in-trade. The assessee was not a trader in tenancy rights. The tenancy was transferred. The revenue contended that the gain was taxable as business income because expenses for improvement were shown as stock-in-trade by assessee. The court held that the tenancy rights were a capital asset. Wrong entry will not make it stock-in-trade, because assessee is not a trader in tenancies.

For details the facts and decision are analyzed below :

Assessee took on rent the property No. 7, KG Marg, New Delhi many years ago.

The assessee made improvements in the said rented premises and retained the same for more than five years. ( the asset was however, used for business)

The assessee had shown the said property as inventory in its balance-sheets for several years.

 On April 4, 2001, the assessee surrendered the tenancy rights in the said property to the owner for a consideration.

The assessee showed the said property as a capital asset and the loss incurred on surrender of the tenancy rights in the said property was claimed at Rs. 14,10,737 after claiming the benefit of indexation.

The Assessing Officer and the CIT(A) did not allow the claim of assessee.

Before the Tribunal relying on ruling of the Supreme Court in the case of Commissioner of Income-Tax Versus D. P. Sandu Bros. Chembur P. Ltd. [2008 -TMI - 6153 - SUPREME Court]. assessee claimed that the said tenancy was a capital asset and that the profit or loss on transfer of the said asset would be computed under the head "Capital gains". It was contended that the cost of acquisition of the said capital asset (the tenancy right) in the hands of the assessee was nil. However, substantial improvements to the extent of Rs. 33,37,847 were made in respect of the said capital asset in different years. Upon indexation, the same came to Rs. 56,10,337. It was contended that the cost of improvement incurred by the assessee had been wrongly shown as stock-in-trade in its books of account and it is on the basis of such wrong treatment that the tenancy right was held to be stock-in-trade by the Assessing Officer. It was contended that since the accounting treatment given by the assessee was patently wrong, the Assessing Officer as well as the Commissioner of Income-tax (Appeals) were not justified in deciding the nature of the tenancy right as being stock-in-trade of the assessee's business relying on such wrong accounting treatment.

 The assessee contended that its business was purchase and sale of properties and not to acquire tenancy rights and sell the same so as to construe tenancy rights as its stock-in-trade.

By counsel of revenue it was contended that the assessee itself had shown the said property in all earlier years as its stock-in-trade and it is only in the year in question that it has been shown as a capital asset. It was contended that this cannot be permitted and, therefore, the capital loss claimed by the assessee could not be allowed.

Finding of Tribunal :

 The Tribunal noted that except the reason of treatment in earlier years as stock-in-trade there was no finding given by the authority below to the effect that the purchase and sale of tenancy rights was the business of the assessee company.

 The Tribunal observed that on examination of the copies of the balance-sheets and profit and loss accounts filed by the assessee for the year under consideration as well as for the earlier years showed that the assessee was engaged in the business of purchase and sale of property on ownership basis and that there was no transaction involving the purchase or sale of tenancy rights except the one in question.

 The Tribunal also observed that the present case was one where property was taken by the assessee on rent and after making substantial improvement therein, the same was occupied by it for a considerable length of time before finally surrendering the tenancy right in the said property to the owners thereof for consideration.

According to the Tribunal, this was not a part of the business of the assessee and that it was a solitary transaction of surrender of the tenancy right by the assessee in respect of the premises occupied by it and that too in favor of the owner.

Consequently, the Tribunal returned the finding that the tenancy rights were not acquired by the assessee for the purposes of sale in the normal course of business.

 The Tribunal also returned a finding that the tenancy right did not represent the assessee's stock-in-trade as alleged by the Revenue.

The Tribunal observed that the treatment given by the assessee in its books of account for the earlier years was patently wrong. Consequently, such wrong treatment could not be held against the assessee when the clear finding was that the said tenancy right was a capital asset in the hands of the assessee. Therefore in view of these circumstances the Tribunal set aside the order passed by the Commissioner of Income-tax (Appeals) on this issue and directed the Assessing Officer to assess the profit/loss arising from the surrender of tenancy rights under the head "Capital gains" as claimed by the assessee.

Supreme Court's ruling relied on and applied by the High Court :

In the case of Commissioner of Income-Tax Versus D. P. Sandu Bros. Chembur P. Ltd. [2008 -TMI - 6153 - SUPREME Court]. it was clearly held that a "tenancy right" is a capital asset.

A transaction of the kind involving the acquisition and surrender of a tenancy right, cannot in law acquire a different character because of the treatment accorded to it in the books of account of the assessee. This is trite law as laid down in Kedarnath Jute Manufacturing Company Limited Versus Commissioner of Income-Tax Central), Calcutta [2008 -TMI - 6262 - SUPREME Court]

There may be transactions, in respect of which, while determining their true nature, the treatment accorded to them by the assessee in the books of account may be one of the factors relevant in coming to a conclusion one way or the other. This is not such a transaction.

The only issue raised by the Revenue is that, given the fact, that the assessee treated the "tenancy right" as stock-in-trade, even though erroneously, the assessee ought not to be allowed to treat the same as a capital asset. The court held that such a submission is completely untenable.

No fault can be found with the reasoning of the Tribunal. No perversity in its findings has been pointed out.

Therefore the court dismissed the appeal as no substantial question of law arose for courts consideration.

The court however, also made clear that in case the cost of improvement has been treated as business expenditure in the earlier years then the Assessing Officer would be within his rights to withdraw the same.

The learned counsel for the respondent did not make any objection to this direction.

Authors view :

Trader; The court found that the assessee was not a trader of tenancy rights, therefore, tenancy right was in fact not an item in which assessee traded so it was not an item of stock-in-trade therefore it was a capital asset of assessee, the treatment given in books was wrong and could not make an item of 'capital asset' as a stock-in-trade.

Therefore, author feels that his view that first of all it is necessary to examine whether assessee is a trader of any items or whether he hold such item as stock-in-trade for selling to his customers or for being used as raw material or consumable items in manufacturing or other business of assessee. If it is not so then such item cannot be regarded as stock-in-trade.

About Cost of improvement :

The court held that the A.O. will have right to withdraw deduction of cost of improvement in earlier years, if it was allowed as business expenditure. There is principally no mistake , because if a wrong deduction has been allowed, it can be withdrawn. However, on consideration of the 'meaning of cost of improvement' as given in section 55, any expenditure which has been allowed under any other head of income like business or profession or other sources, cannot be considered as cost of improvement. For ready reference the meaning of cost of improvement as given in section 55 is reproduced below:

 [(b)     "cost of any improvement",—

XXX

 (2) in relation to any other capital asset,—]

             (i) where the capital asset became the property of the previous owner or the assessee before the 1st day of April, 1981 means all expenditure of a capital nature incurred in making any additions or alterations to the capital asset on or after the said date by the previous owner or the assessee, and

             (ii) in any other case, means all expenditure of a capital nature incurred in making any additions or alterations to the capital asset by the assessee after it became his property, and, where the capital asset became the property of the assessee by any of the modes specified in sub-section (1) of] section 49, by the previous owner,

but does not include any expenditure which is deductible in computing the income chargeable under the head "Interest on securities", "Income from house property", "Profits and gains of business or profession", or "Income from other sources", and the expression "improvement" shall be construed accordingly.

Therefore, on the part of the counsel of assessee it would have been better to clarify whether such expenses were actually allowed in earlier years, if so the same could be reduced from cost of improvement claimed by assessee in the year under consideration.

Applying the rule in relation to share investment:

Who is share trader :

A share broker as such is not a share trader. He acts on instructions of his client and purchase and sell securities on behalf of client. A share broker is not called a share trader.

Now -a-days we hardly can find a share trader in its true sense. The people transact there transactions through stock brokers. Many large brokers have provided facility of placing orders directly by the client on line. The transactions are routed through the website of the stock broker to the stock exchange. The bid or offer is placed on online trading system of the stock exchange, when a matching offer comes the transaction is placed. The clients can also place orders by phone calls or personal visit to broker. The broker while providing services act as an agent and not as a principal. The broker charges his services charges called as brokerage.

Share brokers advertise themselves as share broker being members of one or more stock exchanges. They do not advertise themselves as a trader in shares.

In commercial world a share broker is not known as a share trader.

Therefore, a share broker is not a share trader.

Purchase on own account by share broker is his investment :

A share broker can purchase and hold shares and units on his own account. These shares or units will be his capital assets because share or unit is a property which falls in the meaning of 'capital asset'. Therefore they will be his 'capital asset'. Therefore, if the share broker sells his shares or units held as 'capital asset', he will earn capital gains and not business profit.

Share traders of odd lots, physical share etc :

We find a class of share trader who specializes in trading of certain type of shares. For example, a share trader who deals in physical shares, odd lot of shares, suspended shares etc. These type of traders are known as share trader. They operate a share shop or trading office where one can contact them to purchase and sell shares of such type. These people also send emails, letters and place advertisements for buying and selling such shares. Therefore, these types of people can be called a trader of such type of shares. Therefore, in their case the shares which they deal in as share traders can be considered as stock-in-trade in a natural way.

However, when a person purchases odd or small lot of shares to hold several shares with small investment, to get company information and some benefits associated with concerned group, or shares then such shares will be on investment account and not stock-in-trade, because the buyer is not purchasing them in capacity as share trader.

Stock-in-trade is either a natural fact or a man made fact :

A person who is a trader or dealer, in a commercial manner of any article or thing is called a trader or dealer of that commodity , article or thing. For example a grains trader, a sugar trader, a paper trader, a machine trader or a car trader etc. Such persons are known for such business and people go t them to purchase or sell such article or thing. For example, no one will go to a sugar trader to purchase paper or to a paper dealer to purchase sugar. If a person trade in more than one commodity he is accordingly recognized. For example a trader who deal in sugar and grains both will be known as trader of sugar and grains. A person who deals in several thing of a particular branch is recognized as a trader of such things for example a 'general provision store', or ' grocery shop' , 'stationery shop', medicine shop etc. Therefore, such shops or trading offices or places are known as trader of such things or group of things in which they deal and people go to them knowing that they are trader in such things. Stock held by such traders of such things is his stock-in-trade as a natural fact.

Consumable items required for business purpose or personal use are kept for use and consumption. Therefore, such things are purchased for use and not for trading. For example spare parts of a machine in a factory are not stock-in-trade but are part of inventory for use and are considered as stock and not capital assets. A motor car for business use is a capital asset but its spare parts may not considered as capital asset, unless they form part of car and are sold with car.

 An article or thing or property which is not a trading item or a consumable in business of any person or as a consumable for personal need is a capital asset. The owner has option to convert or treat such things as stock-in-trade. Therefore, unless the owner has treated them as stock-in-trade or converted into stock-in-trade, such items will be his capital asset. 

Accordingly, it can be said that any property is a capital asset, unless it is a stock-in-trade of owner or a consumable item.

Stock-in-trade can also assume character of 'capital asset' :

In some circumstances stock-in-trade can also assume character of 'capital asset'. For example, a car dealer may take few cars from his stock for purpose of his personal use or use in business by employees or for running them on hire. In such cases cars earlier held as stock-in-trade, and now put to business or personal use assumes character of capital asset.

Similarly shares purchased as stock-in-trade can be considered as capital asset by treating them as investment in books of account.

Assessee has option to convert an item of asset in which he is not a trader or which he does not hold for consumption as a capital asset.

Business assets are capital assets :

All business assets are also capital asset, unless they are considered as stock-in-trade in natural way in capacity of trader of such asset or by way of conversion of capital asset to stock-in-trade.

Capital asset vis-a-vis stock-in-trade :

The term stock-in-trade is not defined in the Income-tax Act. Therefore, this expression shall have to be understood in its general meaning as understood in trade or commerce in which a person is engaged. According to the same we have to ascertain the nature of trade, industry or business in which any person is engaged and the items required in such business for the purpose of business of supplying goods whether manufactured by him or not. 

In the exception clause (i) in section 2 (14) as reproduced above we find that the expression stock-in-trade is used, therefore the stock must have linking with the trade and other items excluded in the same context are  consumable stores or raw materials held for the purposes of business or profession.

Therefore we can say and analyze that the following items are excluded from the meaning of capital assets in the context of this article:

Description	Examples and remarks
Stock-in-trade	These items are held as a trader in item for example a sugar dealer or a book dealer, held sugar, or books respectively as stock-in-trade. The people knows that he deals in sugar or books and approaches him to purchase sugar or books as the case may be.
Consumables stores required for business or profession,	In a factory lubricants, cleaning material, oils and fuels are used as consumables. In an office stationary items are used as consumables. A doctor uses items like syringes, testing material etc. as consumables in his profession. Coal will be raw material in a power generating organization whereas coal will be consumable in case of other manufacturer.
Raw material required for business or profession	Raw material required to manufacture goods or rendering services falls in this category. For example steel sheets in a machinery manufacturing facility, or coal in power generating organization or raw films in a doctors chamber who also take X-ray.

Common features :

The items like stock-in-trade, consumables and raw material have a common feature- they are related with a trade or industry which supply certain products or items which may be manufactured by him or not. Or these items may be held to render certain services. Thus, the holding of such items is for specific purpose of supplying some things or rendering some services as business or profession. In view of the expressions used in the exclusion clause, it is necessary that the items to be excluded from the definition of capital asset should have connection with the business in nature or trade, or industry or the profession carried by the assessee. If there is no connection with the trade or industry or commerce in which assessee is engaged, then similar items held by assessee cannot be considered as stock-in-trade.

The assessee has option to treat an item as stock-in-trade or not :

It can be said that except the items like raw material, consumables, and items used for supplying to others (that is trading items) other items of assets are generally capital asset. It is at option of the assessee to treat them as stock-in-trade or as capital asset. We find the provision in section 45 (2) which indicates existence of such an option to the assessee. The said provision reads as follows:

"(2) Notwithstanding anything contained in sub-section (1), the profits or gains arising from the transfer by way of conversion by the owner of a capital asset into, or its treatment by him as stock-in-trade of a business carried on by him shall be chargeable to income-tax as his income of the previous year in which such stock-in-trade is sold or otherwise transferred by him and, for the purposes of section 48, the fair market value of the asset on the date of such conversion or treatment shall be deemed to be the full value of the consideration received or accruing as a result of the transfer of the capital asset."

Thus, it can be said that except in case of items which are normally held as stock-in-trade, consumables, or raw material in the business or profession of the assessee ,all other assets are to be regarded as property of nay kind and capital assets of the assessee.

 However, the assessee has option to treat any property as stock-in-trade from the time of acquisition or to convert a  'capital assets' in to  stock-in-trade by proper book entries. Unless such items are considered in books of account originally or on conversion or treatment as stock-in-trade, all such items of properties shall be 'capital asset' as known in commercial world.

It can also be said that the option is only with the assessee to treat any capital asset or any property as stock-in-trade and the Assessing Officer has no option to treat an item as stock-in-trade which is held and disclosed as capital asset by the assessee. The A.O. also cannot force the assessee to treat or convert a capital asset as stock-in-trade.

Not a share trader- gain will be capital gains :

A company or an individual who does not have a share shop or who is not known as a share trader holds shares as his investment. Volume or frequency will make no difference s far head of income is concerned. In case share is held as investment, the gains will be under the head 'capital gains'.

A person who has purchased shares on stock-exchange and sells shares on stock exchange cannot be called as share trader.

Changes in pursuance of STT :

In view of levy of STT and corresponding changes in tax rates and rules, the assesses had an option to change their policies so as to suit them best and that minimizes tax burden. With exemption of LTCG and lower rate of tax in case of STCG, it is quite natural that it may be more advantageous to hold shares as capital asset. Therefore, even if stock-in-trade is converted into 'capital asset', it should not be viewed as tax avoidance. Because on change in law, one has to change his methods.

A FII who has no permanent establishment, or an assessee who had brought forward business losses, 

may find it more advantageous to hold shares as stock-in-trade so that business income is not taxable or it is reduced on set off of losses.

Volume and frequency should not be a criterion :

Volume will depend on various factors like:

            a. Capital invested,

            b. Price fluctuations- its range and frequency.

A person who has invested say Rs. one crore, will naturally and definitely will have higher volume and higher frequency of activity of buying and selling shares. With larger amount invested, one will need an organization to carry out various related activities.

Scrip in which range of fluctuation is low, will have lower frequency of deals then those having high range of fluctuations. Therefore, even when there is high volume and frequency, the transfer of capital asset will result into capital gain.

High volume and high frequency is not without payment of tax:

High the volume and frequency of buying and selling, there will be higher amount of STT paid. Therefore, these should not be criterion to consider the capital gain as business income.

Two view-then view favorable to assessee should be adopted:

Where two views are possible, the view that reduces tax burden of assessee should be adopted.

Conclusion :

If any asset e.g. shares or units are held as investment and they are sold, the gain will be capital gain irrespective of volume and frequency of activity of buying and selling of shares unless the assessee is known as a share trader in his circle. If the assessee has treated shares or converted them into stock-in-trade, then only they can be considered as stock-in-trade, and income can be computed under the head 'business'.