AO Cannot Adopt Different Valuation Methods for Capital Gains and Business Income: ITAT Delhi Ruling

The Income Tax Appellate Tribunal (ITAT) Delhi has ruled that the Assessing Officer (AO) cannot apply Fair Market Value (FMV) for computing capital gains and book value for business income on the same asset converted from capital asset to stock-in-trade. This decision emphasizes the mandatory consistent valuation under Section 45(2) of the Income Tax Act to prevent artificial inflation of taxable income.[1]

Understanding Section 45(2) and Conversion of Assets

Section 45(2) of the Income Tax Act addresses the taxation of profits arising from the conversion of a capital asset into stock-in-trade. When a taxpayer converts a capital asset, such as land or property, into business stock, it is deemed a transfer, triggering capital gains computation.[1][6]

The provision stipulates that the fair market value (FMV) of the asset on the date of conversion shall be taken as the full value of consideration for capital gains purposes. This FMV also becomes the cost of acquisition for the asset when treated as stock-in-trade and subsequently sold as part of business operations.[1][6]

• Capital gains are computed as FMV at conversion minus the original cost of the capital asset.
• Business income from sale is sale proceeds minus the FMV (as cost of stock-in-trade).

This symmetrical approach ensures that the overall tax liability remains neutral, as higher capital gains are offset by lower business profits, and vice versa.[1]

The Case Facts and AO’s Hybrid Approach

In the case before ITAT Delhi, the assessee converted certain assets from capital assets to stock-in-trade. The AO computed long-term capital gains by adopting FMV at the time of conversion, which increased the capital gains amount.[1]

However, for computing business income upon sale of these assets as stock-in-trade, the AO retained the original book value as the cost of acquisition instead of the FMV. This selective application resulted in higher business profits, leading to an inflated total taxable income.[1]

Key Issues Raised

• Whether the AO can adopt FMV for capital gains but book value for business income.
• Impact of such hybrid valuation on the legislative intent of Section 45(2).

The assessee challenged this before the Commissioner of Income Tax (Appeals) (CIT(A)), who ruled in favor of the assessee, deleting the addition made by the AO.[1]

ITAT Delhi’s Analysis and Ruling

The ITAT upheld the CIT(A)’s decision, emphasizing that Section 45(2) is a self-contained provision mandating consistent use of FMV.[1]

The Tribunal observed that adopting FMV for capital gains increases that component, but the same FMV must reduce the business income by serving as the cost base. Using book value for business income defeats this balance and artificially boosts total income.[1]

• CIT(A) findings: Hybrid approach is impermissible and contravenes Section 45(2).
• ITAT ratio: FMV at conversion must be used symmetrically for both heads of income.
• Revenue’s appeal dismissed, addition deleted.

The bench clarified: “The provisions of Section 45(2) are very clear which provide that when the fair market value is taken for the purpose of conversion of capital asset into stock in trade then that fair market value, having been deemed as value of consideration by that section becomes the cost of purchase for the purpose of calculation of business profit.”[1]

Implications for Taxpayers and AOs

This ruling provides clarity for taxpayers dealing with asset conversions, particularly in real estate and trading businesses where land or property is shifted from investment to stock.[1][4]

Key Takeaways for Compliance:

• Ensure consistent valuation across capital gains and business income computations.
• Avoid hybrid methods to prevent disputes and additions during assessments.
• Document FMV determination properly, as it forms the pivot for both calculations.

For Assessing Officers, the decision serves as a precedent against selective valuation, reinforcing the integrated nature of Section 45(2). Taxpayers can rely on this to defend against similar AO actions.[1][7]

In scenarios where book value is lower than FMV, the AO’s approach would always inflate income, which the Tribunal deemed contrary to law. This promotes fairness and aligns with the principle that tax is on real income, not manipulated figures.[1]

Real estate firms and businesses frequently face such conversions, making this ruling highly relevant. It resolves potential conflicts in valuation, similar to issues under Section 45(3) or 50C, by prioritizing statutory consistency.[4]

As a Chartered Accountant, advising clients on timely FMV adoption and integrated tax planning is crucial to leverage such judicial precedents effectively.