The tax that no one saw coming: A rude shock builds up for builders across India
Builders across the country are in for a rude shock. They could be soon saddled with a tax burden that few, or probably none, of them have accounted for.
Developers, according to changes in the law that have gone unnoticed so far, will have to pay tax on the entire fair value — based on the ready reckoner rates — of all properties they lease out in 2018-19 and later. If a builder, for instance, leases out unsold properties having a combined fair market value of Rs 300 crore, the person may have to fork out more than Rs 90 crore as income tax. This is over and above the tax the builder has to pay tax on rent earned from the lease.
“The action of the developer to lease out unsold premises would tantamount, under the amended Income Tax Act, to a change in the character of the ‘inventory’ to ‘capital asset’. Perhaps unintended, this would severely impact many builders who should immediately pursue the matter with CBDT,” said senior chartered accountant Dilip Lakhani. Central Board of direct Taxes is the apex income tax authority under the finance ministry.
In the course of finalising the advance tax liability for financial year 2018-19, senior accountants have drawn the attention of some of the large real estate firms to the amendments (in the Income Tax Act) which are applicable from this year. While the amended law is not specific to any industry, the impact would be maximum on developers. According to the law, the ‘fair value’ of inventory’ (unsold properties) would be taxed because leasing them out amounts to conversion or treatment of the inventory as ‘capital assets’.
A CHANGE IN LAW
“Under Income Tax Act, only real income can be taxed. Profit from transaction with self cannot be taxed. The judicial pronouncements support the proposition that when a person deals with himself and no profit is deemed to be made, the same cannot be taxed,” said Lakhani. “Years ago, when Section 45(2) of the Act was introduced, it brought to tax the deemed profit on conversion of a capital asset into stock-in-trade when the stock was actually sold. Beginning this year, the reverse situation – thanks to Section 28 (via) dealing with conversion or treatment of inventory into capital asset has come under the tax net. The word inventory is not defined under I.T. Act but ICDS – II (Income Computation Disclosure Standards), prescribed u/s. 145 defines the word ‘inventory’ as ‘assets held for sale in the ordinary course of business’. The action of the developer to lease out the unsold premises might be viewed as conversion of inventory into a capital asset. The amendments in Sections 2(24) (xiia) (which deals with the definition of income) and 28(via) may cause considerable difficulty for many developers,” he said. Concurring with the possible view, chartered accountant Pradip Kapasi, who advises several developers, however emphasised that the onus shall be strictly on the tax authorities to establish the application of the tax u/s 28(via) by proving that the stock-in-trade was converted or was treated as capital asset.
Builders typically lease out properties either in the absence of buyers or to fetch a better price at a later stage — as large investors and funds betting on commercial real estate prefer rent generating properties.
TAX ON UNSOLD PROPERTIES
There are two parts to the recent changes in tax laws related to unsold inventories: first, which lie unoccupied; second which are leased out. Builders are well aware of the tax consequence of unsold properties which are not leased out. On such properties (that are lying vacant), builders have to pay tax on notional rental income based on the prevailing rent in a locality. This was brought about by inserting Section 23(5) in the Income Tax Act — probably to discourage hoarding of residential as well as commercial properties.
Here, the tax would be applicable after a certain period since the builder obtains certificate of completion of construction from the competent authority — there will be no tax on the notional rent on a property which had received ‘completion certificate’ in 2017-18, but tax on notional income on such unoccupied, unsold inventories will have to be paid while filing tax returns for financial year 2019-20.
However, there is no moratorium on tax on properties where builders have entered into actual rental agreements. Here, the provisions of Section 28(via) would kick in. Thus, if a property is leased out in April 2018, at least 30% tax on full fair value of the property will have to be paid in the I-T return for the assessment year 2019-2020 (corresponding to FY19).