Period of Holding on Conversion of Leasehold Property into Ownership

The complication
arises when the immovable property that is being transferred was to
begin with taken on lease by the assessee, and the leasehold rights
therein were thereafter converted into ownership rights within a period
of 36 months prior to the date of transfer of the immovable property,
with the combined total period of lease and ownership put together
exceeding 36 months. In such cases, the question that has arisen for
consideration is whether the property that is under transfer can be said
to have been held for more than 36 months or not, and accordingly
whether it will be regarded as a long-term capital asset or whether it
would be treated as a short term capital asset.

While the
Karnataka and the Bombay High Courts have taken the view that the gains
arising on sale of the property under such circumstances would be a
short term capital gains, the Allahabad High Court has taken a contrary
view and held that the gains would be classified as longterm capital
gains .

Dr. V. V. Mody’s case
The issue first came up before the Karnataka High Court in the case of CIT vs. Dr. V. V. Mody 218 ITR 1.

In
this case, the assessee was allotted a site by the development
authority in 1972 on lease with a stipulation that the asset in question
would be sold after a period of 10 years to the assesse. A
lease-cum-sale agreement was executed at that point of time, providing
for payment of certain amount by the assessee, and that on payment of
the entire sale consideration, conveyance was agreed to be executed in
favour of the assessee at the end of the 10th year. Subsequently, in
pursuance of the said agreement, a sale deed was executed in favour of
the assessee in March 1982, which was registered in May 1982. The
assessee sold the site in November 1982, and claimed that the capital
gains arising on sale was a long term capital gain, since he held the
site since 1972.

The assessing officer treated the gains as a
short term capital gain, holding that the assessee acquired the site
only in March 1982, when the conveyance was executed in his favour and
the asset that was transferred was a short term capital asset in the
hands of the assessee. The Commissioner(Appeals) allowed the assessee’s
appeal, agreeing with the view of the assessee that the site had been
held by him since 1972. On appeal by the revenue, the tribunal held that
the rights acquired under the lease-cum-sale agreement were also
capital assets. It held that on transfer of the site, the assessee had
in fact transferred a bundle of rights, a part of which (half) were held
as a long term capital asset. It accordingly directed that 50% of the
sale consideration should be regarded as received pertaining to the
transfer of the short term capital asset , with 50% of the consideration
being regarded as pertaining to the transfer of the long term capital
asset, with 50% of the cost of the asset being attributed to each of the
components.

Before the Karnataka High Court, on behalf of the
assessee, it was argued that the lease rights held by the assessee was a
capital asset, since the expression “property of any kind” in the
definition of capital asset in section 2(14) was wide enough to include
rights enjoyed by an assessee in respect of immovable property, even
though such rights were inferior to the rights of ownership of the
property. It was argued that transfer of such lights would legitimately
give rise to capital gains, and since these rights were held for more
than 36 months, the gains was to be treated as a long-term capital gain.

The Karnataka High Court noted that there were two questions
which arose for consideration before it – what was the capital asset
that had been transferred by the assessee giving rise to the capital
gains, and since when was that capital asset held by the assessee.
According to the High Court, the answers to these questions were
straight and simple. The asset transferred was title to the site, which
the assessee held on the basis of the conveyance in his favour since
March 1982. The gain was therefore a short term capital gain.

The
High Court noted that the approach adopted by the tribunal implied that
the transfer made by the assessee pertained to both the lease rights as
well as title to the property, which in turn meant that as on the date
of the transfer in favour of the purchaser, the assessee combined in
himself the dual capacity of being not only the owner of the property,
but also the lessee thereof. According to the High Court, this approach
was not legally sound and ignored the legal effect of the transfer of
absolute title in favour of the assessee, who was holding the site in
question till March 1982, only on the basis of the leasecum- sale
agreement.

The significance of the transfer was that it brought
about a merger of the lesser interest held by the assessee in the bigger
estate acquired by him under the sale deed in his favour. Merger
implied the vesting of lesser rights held by an individual in the larger
estate that he may acquire qua the property in question. It postulated
the extinction of the lesser estate, whenever the person holding any
such estate acquired a greater estate in respect of the same property.
In the event of the lesser and the greater estate is coinciding in the
same individual, the lesser got annihilated, ground or sunk in the
larger. The doctrine owed its origin to the English common law, but with
equity intervening, the position in England was that merger would be
deemed to take place only in case the party acquiring the larger estate
intended so. The High Court noted that this position was accepted, even
in India except to the extent that the statutory provisions like the
Transfer of Property Act, 1882 mandated otherwise. The High Court noted
the observations made by the Supreme Court in Jyotish Thakur vs.
Tarakant Jha AIR 1963 SC 605 in this regard.

The Karnataka High
Court noted that the assessee held the site in question under an
agreement of lease cum sale, and that it was not in dispute that in so
far as an agreement to sell was concerned, it did not create any right
in the property agreed to be sold. The assessee had valuable interest in
the site in his capacity as a lessee, which leasehold rights was a
capital asset. These rights, being a lesser estate in comparison to the
larger one representing the title or the property, merged with the
larger estate upon the assessee acquiring the title to the property
under the sale deed.

The  Karnataka  high  Court  noted  that  there  were  two questions which arose for consideration before it – what was the capital asset that had been transferred by the assessee giving rise to the capital gains, and since when was that capital asset held by the assessee. According to the high Court, the answers to these questions were straight  and  simple.  The  asset  transferred  was  title  to the site, which the assessee held on the basis of the conveyance in his favour since march 1982. the gain was therefore a short term capital gain.

The high Court noted that the approach adopted by the tribunal implied that the transfer made by the assessee pertained to both the lease rights as well as title to the property, which in turn meant that as on the date of the transfer in favour of the purchaser, the assessee combined in himself the dual capacity of being not only the owner of the property, but also the lessee thereof. According to the high Court, this approach was not legally sound and ignored the legal effect of the transfer of absolute title    in favour of the assessee, who was holding the site in question till march 1982, only on the basis of the lease- cum-sale agreement.

The significance of the transfer was that it brought about a merger of the lesser interest held by the assessee in the bigger estate acquired by him under the sale deed in his favour. Merger implied the vesting of lesser rights held by an individual in the larger estate that he may acquire qua the property in question. It postulated the extinction of the lesser estate, whenever the person holding any such estate acquired a greater estate in respect of the same property. in the event of the lesser and the greater estate is coinciding in the same individual, the lesser got annihilated,  ground  or  sunk  in  the  larger.  The  doctrine owed its origin to the english common law, but with equity intervening, the position in england was that merger would be deemed to take place only in case the party acquiring the larger estate intended so. the high Court noted that this position was accepted, even in india except to the extent that the statutory provisions like the transfer of Property act, 1882 mandated otherwise. The high Court noted the observations made by the Supreme Court in jyotish  Thakur  vs. Tarakant  Jha AIR  1963  SC 605 in this regard.

The Karnataka high Court noted that the assessee held the site in question under an agreement of lease cum sale, and that it was not in dispute that in so far as an agreement to sell was concerned, it did not create any right in the property agreed to be sold. The assessee had valuable interest in the site in his capacity as a lessee, which leasehold rights was a capital asset. these rights, being a lesser estate in comparison to the larger one representing the title or the property, merged with the larger estate upon the assessee acquiring the title to the property under the sale deed.

The Karnataka high Court noted the provisions of section 111(d) of the transfer of Property act, which provided that a lease of immovable property determined in case the interests of the lessee and the lessor in the whole of the property became vested at the same time in one person in the same right. According to the high Court, this provision recognised what was true even on first principles, i.e., a person cannot be a tenant and landlord qua the same property at the same time. In the opinion of the high Court, the question of the assessee intending to keep the two capacities or estates, namely one of leasehold rights and the other of ownership, separately from each other or any such separation of the interests held by him being beneficial to the assessee, did not arise. The question of intention of the assessee or his interest would arise only if the situation was not covered by the provisions of section 111 (d).

The  Karnataka  high  Court  noted  that  from  the  date of sale in favour of the assessee, the assessee  had  only one capacity to describe himself qua the land in question, and that was the capacity of being the absolute owner of the same. it was in that capacity alone that the assessee transferred his title over the site in favour of the purchaser. the sale did not describe the transfer made in favour of the purchaser to be one of the rights which the assessee held in respect of the site prior to the sale deed. All such rights had sunk or drowned in the larger estate and therefore stood extinguished. The legal effect of the transfer made in favour of the assessee was that he had become the absolute owner of the property and therefore all that he could convey and did actually convey to the transferee was the absolute title in the property without any reference to any inferior rights that the assessee had held prior to his becoming owner.

Viewed from that angle, according to the Karnataka high Court, it was apparent that what the assessee transferred had been held by him only from the date of the sale deed in his favour and not earlier to that. Therefore, in the view of the high Court, the question of splitting up the sale price or the cost of acquisition of the asset separately for the purposes of short-term and long-term capital gains did not arise.

The  high  Court  rejected  the  argument  of  the  assessee regarding the transfer of leasehold rights by the assessee, which were long-term capital assets.  according  to  it, the issue was not whether such leasehold rights were    a property or a capital asset, but  whether  any  such right existed and could be transferred by the assessee after it had merged in the larger estate acquired by the assessee.  This  was  so  because  what  was  transferred by the assessee was not the lesser  interest  held  by him prior to becoming the absolute owner, but the total interest acquired by him in the form of absolute title to the property. Unless it was possible for the assessee to hold the two estates simultaneous and independent of each other, the transfer of the title in the property could not be deemed to be a transfer of both the larger and the lesser estates, so as to make them amenable to the process of splitting into long term and short term capital gains.

The   Karnataka   high   Court   therefore   held   that   as from march 1982, the assessee had only one estate representing the title to the property, and the capital gain arising from the transfer of this estate gave rise to a short term gain.

A similar view was taken by the Bombay high Court in the case of CIT vs. Dr. D. A. Irani 234 ITR 850, where it dealt with a case of an assessee having tenancy right over a flat, who acquired the ownership rights to the flat and sold the flat within 5 months of acquisition. In that case as well, the Bombay high Court applied the provisions of section 111(d) of the transfer of Property act, to hold that the gain on sale of the flat was a short term capital gain.

Rama rani kalia’s case
the issue again came up recently before the allahabad high Court in the case of CIT vs. Smt. Rama Rani Kalia 358 ITR 499. in this case, the assessee acquired a property on leasehold basis in 1984. She applied for freehold rights, which were granted by the collector in march 2004. Within 3 days thereafter, the property was sold. the assessee claimed the capital gains on sale of the property to be long term capital gains.

The assessing officer took the view that since the property was sold within 3 days of conversion of the leasehold rights into freehold rights, the capital gains was a short term  capital  gains.  The  Commissioner(appeals)  held that the conversion of leasehold property into freehold property was an improvement of title over the property, since the assessee was the owner of the property even prior to conversion. He therefore held that the gain was a long term capital gains. The Tribunal confirmed the order of the Commissioner(appeals).

The  allahabad  high  Court  noted  that  the  difference between a short term capital asset and a long-term capital asset was the period for which the property had been held by the assessee, and not the  nature of title  or the property. according to the high Court, the lessee  of the property had rights as owner of the property for all  purposes,  subject  to  covenants  of  the  lease.  The lessee may transfer the leasehold rights of the property with the consent of the lessor, subject to covenants of the lease deed. The conversion of the rights of the lessee in the property from leasehold right into freehold was only by way of improvement of rights over the property, which she enjoyed.

According to the allahabad high Court, the conversion would not have any effect on the taxability of gains from such property, which was related to the period over which the property was held. Since the property was held by the assessee as a lessee since 1984, and was transferred  in march 2004, after the leasehold rights were converted into freehold rights of the same property, which was in her possession, the conversion was by way of improvement of title, which, according to the high Court, would not have any effect on the taxability of profits .

The allahabad high Court therefore held that the gains arising on sale of property was long term capital gains.

The  allahabad  high  Court,  in  yet  another  decision, delivered in ita no. 134 of 2007 dated 22-11-2007, in the case of Dhiraj Shyamji Chauhan has confirmed that the period of holding in such cases should commence from the date of acquiring leasehold rights.

Observations
The Supreme Court, in the case of A.R. Krishnamurthy vs. CIT 176 ITR 417, held that a land is a bundle of rights. the issue is whether these rights are separable, whether they can be separately transferred, and if transferred together, whether it is possible to bifurcate the rights between those held for more than 36 months and those held for a shorter period. in the case of A R Krishnamurthy, the Supreme Court considered a situation of grant of mining rights, which was one of the bundle of rights acquired on acquisition of the land. in that case, the Supreme Court directed bifurcation of the cost of acquisition to compute the capital gains. In that case, of course, it was the assessee himself who separated the rights, and transferred one of the rights. The court found that each of the rights comprised in the bundle was capable of being separately transferred for a valuable consideration. Conversely, the different rights in an asset can be acquired at different point of time, acquisition     of each of which has the effect of improving the title of the acquirer over the property.   The doctrine of merger, embodied in the transfer of Property act, provides that on acquisition, by the lessee, of the freehold rights in a property, the lesser estate of the lessee i.e., his leasehold rights merge into a larger estate of the lessee i.e., his freehold rights. . .

Section 111 (d) of the transfer of Property act provides as under:

111. A lease of immovable property determines – (a)…..
(b)…..
(c)    ….
(d)    in case the interests of the lessee and the lessor in the whole of the property become vested at the same time in one person in the same right.

From the statutory provision, it is clear that a lease comes to an end when the same person is both the owner as well as the lessee of the property, and therefore the subject matter of transfer is the ownership rights in the property, which remain on merger, to the buyer of the property. To that extent, the views of the Karnataka high Court and the Bombay High Court at first seem to be justified when the courts dealt with the nature of rights or the title that the buyer acquired. What perhaps, was overlooked, with respect, and had remained unaddressed, was the issue whether the asset in question was held for a longer period that began with the date of acquiring the leasehold rights in the property. This issue was specifically dealt with by the allahabad high court in the later decision which after considering the ratio of the decision of the Karnataka high court chose to take a contrary view.

The issue in question, as identified by the Allahabad High Court, is about the period of holding of a capital asset which is determined with reference to the period for which an asset is ‘held by an assessee’. the property all along remained the same i.e., an immovable property. What was changed was the rights over the property – from leasehold  to  ownership.  the  assessee  remained  the same. Holding a property under a leasehold right as a lessee, is also a recognised mode of holding the property. It is only when the property in question is changed, that the period of holding is shortened, for e.g., warrants to shares. When the property remains the same, the change in the title to the property is not a relevant factor for the purposes of the income-tax act.

It is a settled position that lease is one of the modes of acquisition of an immovable property and that leasehold rights are a capital asset capable of being transferred. Applying the law of section 2(47) to the case of a purchase or acquisition, it is possible to hold that an asset is acquired on execution of a lease deed. It is also clear that an immovable property comprises of a bundle of rights and grant of lease is one such right.

In the case of R. K. Palshikar HUF vs. CIT 172 ITR 311, the Supreme Court held that grant of a lease of a property for 99 years amounts to transfer of the property, giving rise to capital gains. if that is the position, and under tax laws, the owner is regarded as having transferred the property, the logical consequence should be that the lessee is then regarded as the deemed owner, a position that is acknowledged by section 27 of the act. Even A.
R. Krishnamurthy’s case (supra) was a case of grant of a mining lease for 10 years, where the Supreme Court followed r. K. Palshikar huf’s decision (supra), taking a view that transfer of capital asset in section 45 includes grant of mining lease for any period.

In fact, section 27 of the income-tax act provides that a person who acquires any rights (excluding any rights by way of a lease from month to month or for a period not exceeding one year) in or with respect to any building or part thereof, by virtue of any such transaction referred to in section 269UA(F), is deemed to be the owner of that building or part thereof. Section 269UA(F), which dealt with acquisition proceedings, refers to, inter alia, a lease for a period exceeding 12 years. Therefore, for all practical purposes, the income-tax act regards the property as having been transferred to the lessee if the lease is for a period exceeding 12 years.

Under such circumstances, is it appropriate to say that the lessee was really not the owner, for the period that he was a lessee, when it comes to payment of capital gains taxes, even if he was a lessee for more than 12 years?

The cost of acquisition is a significant factor in computation of the capital gains. The cost in certain specified cases remains the historical cost, and, in those cases, the courts have taken a consistent view that the period of holding should also be so taken, by relating it back, in the interest of the harmonious construction of the provisions of the act, [h.f.Craig harvey  244 itr 578 (mad.), and manjula j. Shah, 355 itr 474(Bom)].

Alternatively, the cost would have to be taken as the market value as on the date of conversion where a view is taken that the period of holding should be determined with reference to the date of acquisition of the new asset. The law on this aspect is very clear that the cost should be the market value.

In case of an asset held under a deed of conveyance executed in pursuance of an agreement for sale, the period of holding should commence from the date of agreement and not of the deed, though on execution of the deed, the rights under the agreement are extinguished and absolute rights are acquired in the asset.

It may not be possible to separate the gains in two parts nor may it be possible to divide the consideration, but the period of holding can surely be said to have begun from the date of the lease, particularly in a case where the lessee has acquired a dominion over the property with   a right to transfer the same in lieu of consideration paid by him. In fact, in dr. V. V. mody’s case, the lease was coupled with the right to acquire ownership after a period of ten years, which right itself was a capital asset. The definition of the term ‘capital asset’ u/s. 2(14) includes a ‘property of any kind’ and is wide enough to cover the case of a leasehold right. Having acquired a capital asset, it does not vanish in thin air, unless it is lawfully transferred or is improved upon.

The issue therefore is not whether there were two estates or one but is all about the period of holding of the property. It may be that the latest rights that are transferred may not be old, but the property that is transferred is certainly old. Even the pedigree of the new rights is ancestral.

Various explanations contained in ssection  2(42a)  of the Act, precisely confirm the theory of harmonious construction by extending the period of holding in cases of various financial assets referred to therein. This principle also is approved by section 55 of the act. in all cases, where the historical cost is frozen in time, the period of holding of the new asset is extended to cover the period of holding of the old asset as well. this is, otherwise, also true on first principles of taxation.

One strong view is that the issue cannot be determined with reference to the provisions of section 111 of the transfer  of  Property  act.  These  provisions  have  the limited impact of explaining the title of a person over a property.  they  simply  explain  that  the  inferior  rights  of a  person  are  transformed  into  the  superior  rights.  this does not affect the period of holding of the property at all. It only improves the legal title to the property. Tax laws clearly recognise the concept of holding of an asset other than by way of legal title – leasehold rights in a property is one such form of ownership.

In fact, the delhi high Court, in a recent decision in the case of CIT vs. Frick India Ltd. 369 ITR 328, has analysed the meaning of the term “held by the assessee” u/s. 2(42A) as under:

“We would like to elucidate and explain the expression, “held by the assessee” in some detail. General words should normally receive plain and ordinary construction but this principle is subject to the context in which the words are used as the words  reflect  the  intention  of the Legislature. The words have to be construed and interpreted to effectuate the object and purpose of the provision, when they are capable of multiple meanings or are ambiguous. Isolated reading of words can on occasions negate the very purpose. Lord Diplock had referred to the term, “business” as an ‘etymological chameleon’, which suits its meaning to the context in which it is found. The background, therefore, has to be given due regard and not to be ignored, to avoid absurdities. This principle is applicable when we interpret the word, “held” in section 2(42A) of the Act, for the said word is capable of divergent and different connotations and understanding.

The word, ‘held’ as used in section 2(42A) of the Act is with reference to a capital asset and the term, ‘capital asset’ is not confined and restricted to ownership of a property or an asset. Capital assets can consist of rights other than ownership right in an asset, like leasehold rights, allotment rights, etc. The sequitur, therefore, is that the word ‘held’ or ‘hold’ is not synonymous with right over the asset as an owner and has to be given a broader and wider meaning. In Black’s Law Dictionary, Sixth Edition, the word ‘hold’ has been given a variety of meanings under nine different headings. Four of them, i.e, 1, 4, 8 and 9 read as under:

‘1. To possess in virtue of a lawful title; as in the expression, common in grants, “to have and to hold,” or in that applied to notes, “the owner and holder.”
** ** **
4. To maintain or sustain; to be under the necessity or duty of sustaining or proving; as when it is said that a party “holds the affirmative” or negative of an issue in a cause.
** ** **
8.    To possess; to occupy; to be in possession and administration of; as to hold office.

The word ‘held’ was interpreted to mean “lawfully held, to possess by legal title”. The term ‘legal title’ here not only includes ownership, but also title or right of a tenant, which will mean actual possession of the land and a  right to hold the same and claim possession thereof as a tenant (we are not examining rights of a rank trespasser in the  present  decision  and  we  express  no  opinion  in that regard).”

From  this,  it  is  clear  that  the  term  “held”  need  not necessarily refer to only the period of holding as an owner.

Under the law contained in the income-tax act, 1961, in the context, there are only two possibilities:

a.    a transfer arises on conversion of leasehold rights into ownership rights in which case;
i.    liability to capital gains is attracted on such conversion, and
ii.    the fair market value becomes the cost of acquisition of the new asset,
 
9.    To keep; to retain; to maintain possession of or authority over.’

or

b.    there is no transfer on such conversion and the period of holding is extended to include the period during which the asset was held on lease.

The latter view seems to be the more equitable view of the matter, but given the views of the Karnataka and Bombay high Courts, the debate will ultimately be settled only by a decision of the Supreme Court.