The conversion is itself a transfer, but the charge is held back. Section 45(2) computes the capital gain by treating the fair market value of the asset on the date of conversion as the full value of the consideration, and charges it only in the previous year in which the stock is actually sold or otherwise transferred. Everything the asset earns after conversion is business profit, not capital gain. Section 28(via) does the reverse for stock converted into a capital asset.
Start with the fact that conversion is a transfer. Section 2(47) clause (iv) includes, in the definition of transfer, "in a case where the asset is converted by the owner thereof into, or is treated by him as, stock-in-trade of a business carried on by him, such conversion or treatment". So the moment the land moves from the investment column to the stock column, a transfer has happened.
What s.45(2) then does is separate the event from the year of charge. It reads: "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."
Two things follow, and they are the two things practitioners miss. First, the quantum is fixed on the date of conversion and never moves again - the fair market value on that date is the deemed consideration, so a later rise or fall in the price of the land changes the business profit and not the capital gain. Second, the year of charge is the year of sale of the stock, not the year of conversion. If the stock is sold in tranches over four years, the capital gain is brought to charge in the same proportions, because only so much of the stock as has been sold has triggered the charge.
The practical consequence is that one sale produces two heads of income. Suppose land bought in 2005 is converted to stock on 1 July 2020 at a fair market value of 3 crore and sold from stock on 1 September 2023 for 4 crore. The capital gain is 3 crore less the cost of acquisition, and it is charged in the year ended 31 March 2024. The business profit is 4 crore less 3 crore, and it is charged in the same year under s.28. The fair market value at conversion is the hinge: it is the sale price for the capital gains computation and the cost for the business computation.
Indexation is where the treatment is less settled than it looks. The Explanation to s.48 defines "indexed cost of acquisition" as "an amount which bears to the cost of acquisition the same proportion as Cost Inflation Index for the year in which the asset is transferred bears to the Cost Inflation Index for the first year in which the asset was held by the assessee or for the year beginning on the 1st day of April, 2001, whichever is later". Since the transfer is the conversion, the natural reading is that the index for the year of conversion is used and indexation stops there - the asset is not held as a capital asset after that date, and the post-conversion appreciation is being taxed as business profit anyway. I have not found a source that settles the point. The itatonline analysis of s.28(via) discusses CIT v. Jannhavi Investment Pvt. Ltd. [2008] 304 ITR 276, but on the opposite conversion - stock-in-trade into a capital asset, before s.28(via) existed - where the Court held that "The cost of acquisition can only be the cost on the date of the actual acquisition" and that "There was no acquisition of the shares when the same were converted from stock-in-trade to a capital asset", so that indexation ran from the base year rather than from the date of conversion. That is not authority on a s.45(2) computation, and I have not read the judgment. Take the year-of-conversion reading as the working position and check the authority before you rely on it in a contested case. Note also that for transfers on or after 23 July 2024 indexation has gone for most assets, so the question now arises only within the resident individual and HUF land-and-building comparison described at cost-of-acquisition-and-indexation.
The mirror provision runs the other way. Section 28(via) charges as business income "the fair market value of inventory as on the date on which it is converted into, or treated as, a capital asset determined in the prescribed manner". The valuation is made under Rule 11UAB, which for land or building takes the value assessed or assessable by the State Government for stamp duty purposes on the date of conversion, and for other assets an open-market value. That fair market value then becomes the cost on the capital gains side: s.49(9) provides that "Where the capital gain arises from the transfer of a capital asset referred to in clause (via) of section 28, the cost of acquisition of such asset shall be deemed to be the fair market value which has been taken into account for the purposes of the said clause." And the clock restarts - Explanation 1 to s.2(42A) provides that in the case of such an asset "the period shall be reckoned from the date of its conversion or treatment".
So the two directions are not symmetrical. Converting a capital asset into stock defers the charge; converting stock into a capital asset accelerates it, because s.28(via) taxes the business profit in the year of conversion and does not wait for the eventual sale.
The corpus already covers the timing side of transfer generally at what-is-a-transfer-and-when, which mentions s.45(2) in one sentence; this page is the computation.
Builders and land aggregators convert investment land into stock as a matter of course, and the conversion is usually recorded in the books with a journal entry and no tax computation at all. The exposure is that the department picks it up years later, fixes the fair market value at conversion on its own evidence, and charges the capital gain in the year the flats were sold with interest running from that year. Doing it properly the first time also locks in a cost base for the business computation, which is worth having when the project margin is examined.
I handed over possession of my factory and the buyer credited me with the price, but the sale deed came much later. In which year did I make the capital gain?
The company redeemed my preference shares and paid me the face value. Is that a transfer, or just a repayment?
My mortgaged property was auctioned and the department kept what I owed it out of the proceeds. Do I pay capital gains on the whole price or only on what reached me?
We sold the goodwill our own firm built up over the years. It cost us nothing to acquire. Is the price taxable as a capital gain?
I held shares as an investment for years and then started dealing in them. When I sell, is my profit measured from what I originally paid or from the market value on the day I began trading?
Our JDA was never registered and the project collapsed. Am I still taxed on capital gains?
The landlord paid my company to give up its tenancy. Is that taxable, and if it cannot be computed as a capital gain can the officer tax it as a casual receipt instead?
I received bonus shares and later sold my holding. What is the cost of the bonus shares: face value, nil, or something else?
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