Calcutta: There are two golden rules in the arena of taxation: first, that income should be chargeable to tax only in the year when there is a sale or a transfer of an asset. And second, that income can be recognised only when there is a profit or gain from a transaction.

Both these principles appear to have been turned on their head in Finance Bill 2018.

Businesses will be spooked by the implications of two changes proposed in the bill: the insertion of a sub-clause in section 2(24)(xiia) and the new section 28 (vi a) which, in effect, raise the prospect of tax trauma for firms that decide to convert inventory into a capital asset.

The big worry is that such conversions will become taxable as business income in the year in which the inventory is reclassified as capital asset, rather than in the year of the sale.

But that is not all. Under the amended section 28 (vi a), the fair market value of the inventory on the date of conversion shall be deemed to be the full value of the consideration received as a result of such conversion. It needs to be clarified that the cost of purchase will be debited in trading or profit and loss account as part of purchases.

Moreover, the definition of income in section 2 (24) has been amended to include fair market value of the inventory on the date of conversion.

This is apparently unfair.

Logically, only the profit arising from such a conversion should be treated as income after deducting the cost of inventory from the fair market value of the inventory on the date of its conversion into a capital asset.

The fair market value cannot be treated as income. Therefore the amendment of the definition of income under section 2 (24) needs to be revisited to make it logical and impervious to legal challenge which might otherwise ensue.

Let us look at the law as it stands today on the conversion in the opposite direction - from a capital asset to a stock in trade.

Under section 45 (2) of the income tax act, capital gains arising from the conversion of a capital asset into a stock in trade is chargeable to tax as income from the conversion only in the year of sale or transfer of such stock in trade. In such cases, income is calculated as capital gains after deducting the cost of the capital asset from the fair market value of such asset on the date of conversion, and then as business profit which is computed on the basis of the actual consideration on the sale or transfer by deducting the fair market value on the date of the conversion. But in such cases, the tax is chargeable only in the year of sale or transfer and not in the year of conversion.

At present, there is no specific taxing provision governing the conversion of inventory or stock in trade into a capital asset, a lacuna that gave rise to a rash of litigation.

The amendments to the income tax act have been made to plug this loophole. But in its overzealous attempt to cover a lacuna, the government has apparently transgressed logical reasoning.

Moreover, section 49 is also proposed to be amended to provide that for computing capital gains arising from the transfer of such a capital asset (which is converted from stock in trade or inventory), the fair market value on the date of conversion shall be treated as the cost of conversion, which is logical.

Further, the period of holding of such capital asset shall be reckoned from the date of its conversion from stock in trade and not from the date of actual acquisition, according to the amendment proposed in section 2(42A).

An interesting point to note is that as a result of the amendment, a taxpayer will be required to pay tax as business income in the year in which the stock in trade is converted into capital asset.

In contrast, when a capital asset is converted into a stock in trade, tax will be payable under section 45 (2) in the year of actual sale or transfer of such stock in trade (which has been converted as such from a capital asset).

The amendments will apply from assessment year 2019-20.

Narayan Jain is a tax advocate and author