From Inventory to Fixed Asset – Will changes to key sections of the Income Tax Act impact the real estate industry?

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In accordance with the existing provisions of Article 45 (2), gains accrued from the conversion of fixed assets into inventory must be taxed in the year that such inventory is sold / transferred.

By Rajesh Narain Gupta

The 2018 finance law made crucial changes to key articles of the income tax law, which are expected to have a significant impact on taxpayers. The changes specifically need to be considered in more detail in light of their impact on the developer fraternity in the country. These changes will come into effect on April 1, 2019 and will therefore apply to the 2019-2020 contribution year and subsequent contribution years.

With the new provisions introduced by law, the rental of any part of a property that is part of the inventory at the date by a promoter converts its status from “inventory” to “fixed asset”. The profits from the rental will be taxable as income of the entrepreneur. The value to be included under section 28 of the Income Tax Act would be the fair market value (FMV) of the asset at the date of its conversion. If the asset is sold or if its ownership is transferred, the gains from the transaction will be taxed as capital gains under section 45 (1) of the Act.

The date to be considered for converting inventories to capital would be the held date under section 2 (42A) for the purposes of determining the holding period of the asset. The cost of the converted asset would be determined on the basis of its acquisition cost under Article 49 of the Income Tax Act determined on the conversion date considered under Article 28. By being part of the inventory, the annual rental value of an unoccupied property, dating more than one year from the date of completion of the certificate issued by a competent authority, would be taxed as property income real estate.

In accordance with the existing provisions of Article 45 (2), gains accrued from the conversion of fixed assets into inventory must be taxed in the year that such inventory is sold / transferred. The FMV on the conversion date would be the value of the total consideration received in such a case. However, there was no provision for tax conversion of inventory to fixed assets prior to the amendment of the Income Tax Act. The amendment to Article 28 of the Law brought into conformity the provision relating to taxation when categorizing inventories as fixed assets.

These changes streamlined the provision for converting trading shares into fixed assets. Article 45 of the law provides in particular that capital gains resulting from the conversion of fixed assets into commercial shares are taxable. However, in cases where shares are converted into, or treated as, fixed assets, applicable law does not provide for taxation.

In order to provide symmetrical treatment and to discourage the practice of deferring the payment of tax by converting inventory into fixed assets, certain changes have been made to several provisions of the Income Tax Act:

  • Amendments to section 28 to provide that any profit or gain resulting from the conversion of inventory to capital property or its treatment as capital property must be charged to tax as business income. It is proposed to provide that the FMV of the inventory on the conversion or treatment date determined in the prescribed manner will be deemed to be the total value of the consideration received or accrued as a result of such conversion or treatment;
  • Amendments to clause (24) of section 2 to include this FMV in the definition of income;
  • Amendments to section 49 to provide that for the purposes of calculating capital gains arising from the transfer of such fixed assets, the FMV on the date of the conversion will be the acquisition cost;
  • Amendments to clause (42A) of section 2 to provide that the holding period of such fixed asset shall be counted from the date of conversion or treatment.

The changes do not specifically target real estate developers. The use of a fleet of vehicles for the operation of a taxi service will be subject to tax under the amendments made to section 28. It will apply when converting a business asset into fixed asset and of its operation as an asset. The government, banks and entities providing financial support to the real estate industry remain concerned that developers are treating stocks as an investment or a long-term asset rather than as movable property.

The author is Managing Partner, SNG & Partners

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