[Section 47(x) read with section 49(2A)] As per Section 47(x):- Nothing contained in section 45 shall apply on the following transfers:-
(x) any transfer by way of conversion of bonds or debentures, debenture-stock or deposit certificates in any form, of a company into shares or debentures of that company;
As per Section 49(2A) :- Where the capital asset, being a share or debenture in a company, became the property of the assessee in consideration of a transfer referred to in a clause (x) of section 47, the cost of acquisition of the asset to the assessee shall be deemed to be that part of the cost of debenture, debenture-stock or deposit certificates in relation to which such asset is acquired by the assessee.
When any debentures or part thereof of a company are converted into shares of that company, the transaction is not considered as a transfer and hence no capital gain is chargeable. However, when these shares are, thereafter, actually transferred, capital gain shall arise and be chargeable in the previous year in which the shares are transferred. The cost of acquisition of the shares shall be that part of the cost of debenture in relation to which share were acquired by the assessee.
Although the conversion of debentures into equity shares is not regarded as transfer but if the preference shares are converted into equity shares, it will be regarded as a transfer and there will be capital gain to the shareholder on the date of allotment of equity shares in exchange of preference shares and the full consideration in this case shall be fair market value of equity shares on the date of its allotment.
[Addl. CIT v. Trustee of HEH the Nizams Second Supplementary Family Trust (1976) 102 ITR 248 (AP)]
However, the Apex Court dismissed a special leave petition by the Department against the order dated 09.11.1981 of the Allahabad High Court in ITA No. 178 of 1981, rejecting a reference application on the question whether conversion of preference shares into equity shares was only exchange and not transfer within the meaning of section 2(47) of the Act and therefore no capital gain arose on such conversion [CIT v Goel Investment Pvt. Ltd. (1948) 148 ITR St. 90]