SUPREME COURT OF INDIA
Messrs Sanjeev Woolen Mills
Vs
Commissioner of Income Tax, Mumbai
Appeal (Civil) 6735-6736 of 2003
(Dr. A.R.Lakshmanan and P.P.Naolekar)
24/11/2005
P. P. NAOLEKAR, J.
The appellant, (hereinafter to be referred to as an 'assessee') is a firm
engaged in the imports of synthetic waste and manufacture and export of woolen
blankets. Since the assessee had been in export, the economy of the business of
the assessee worked out on the basis of U.S. $ price and for the purpose of
stock valuation, the same was recorded in Rupees for which the prevailing
exchange rate was applied. The assessee was maintaining books of accounts on a
consistent method on mercantile basis right from the insertion of its business
and Department has accepted the same for the purpose of income-tax except in
the years in question. Since the Account Year, 1986-87, the assessee followed
the method of accounting, and for which the stock of raw-material/semi- finished
goods were valued at cost price and finished goods at the market price.
For the Assessment Year 1992-93 (hereinafter to be referred to as the 'First
year'), the assessee valued the closing stock at the rate of Rs.130/- per kg.
whereas the opening stock were shown at Rs.90/- per kg. In the subsequent year
1993-94, the assessee valued the opening stock at Rs.130 per kg. for the
finished goods and there was no closing stock. The assessee returned a loss of
Rs.54, 420/- for the second year. For the First year, the assessee claimed
benefit under Section 80 HHC of the Income-tax Act 1961
(hereinafter to be referred to as an 'Act'). It is the case of the assessee
that during the Financial year 1991-92, the Rupee had undergone de-valuation
against U.S. $. The price of the U.S. $ as on 1.4.1991 was Rs.18/- per Dollar
and at the time of the closing as on 31.3.1992, it was Rs.31/- per U.S. Dollar.
As per the evidence, the assessee's case is that at the relevant time the
market price of the blanket in the international market was U.S.$ 4.59 per kg.
and the rate of U.S. Dollar in Rupees 18.20 per Dollar. As such, the market
price was Rs.90/- per kg. as on 31.3.1991/1.4.1991 (closing stock of the
previous year/opening stock valuation for the year 1992-93). At the end of the
year 1992-93, on 31.3.1992, the market price of the blanket in the
international market was U.S. $5.35 per kg. and the rate of U.S. $ in Rupee was
Rs.31/- per Dollar and the market price worked out to be Rs.165.85 per kg. and
on 31.3.1992 after deducting the transport charges, freight, commission and
other incidental charges to the tune of Rs.35.85, price of the blanket at
market value was fixed at Rs.130 per kg. which was shown as closing stock value
of the Assessment Year 1992-93. The assessee has taken the value of the closing
stock as on 31st of March as the opening stock on 1st of April to be the same
in every year for the finished product at market value and the raw material at
cost price. The assessee also valued the market price of the finished product
at the rate of Rs.98/- as on 1.4.1991 as the actual market price of Rs.130/-per
kg. as on 31.3.1992 and also on 1.4.1992 the price of the finished product as
opening stock value for the Second Year.
The Assessing Officer has found that on adoption of the aforesaid method, there
is a stark contrast in the gross profit ratio for the accounting year 1990-91,
1991-92 and 1992- 93. He concluded that the method of valuing the closing stock
at market value resulted in a distorted picture and assessee had artificially
inflated the profits in order to get benefit under Section 80 HHC of the Act,
which amounted to tax planning with intent to defraud the Revenue. The
Assessing Officer ruled that by following the aforementioned method, the
assessee effectively showed to earn income out of itself, which was totally
against the basic principles of accountancy and law. He further observed that
by proper application of the provisions of the Act and principles of
accountancy, the assessee had to value its closing stock at cost or market
price whichever was lower but that was not done. He further found that in the
Second Year, the assessee had valued opening stock at Rs.130 per kg. in place
of Rs.90 per kg. which had suppressed the factum of profits. He applied the
standard prescribed for "Valuation of Inventory" at the cost price
and added an amount of Rs.2, 67, 38.280.00 to the total income of the assessee
for the second year.
The assessee preferred an appeal for the First Year and also for the Second
Year before the C.I.T. (Appeals). Both the appeals were dismissed by C.I.T.
(Appeals) by observing that by merely following a particular system of
accounting regularly in the past would not entitle the assessee to follow the
same system of accounting which was not in accordance with the standard
principles of accountancy and placed reliance on the judgment of this Court in
British Paints vs. C.I.T. (referred). It was held that the Assessing
Officer had rightly interfered, as duty bound under provisions of Section 145
of the Act to conclude the correct taxable income of each year and for that
purpose, there was need to change the system of accounting regularly followed
by the assessee, that must be done. As per the appellate authority, no person
could earn profit from his own pocket. The valuation of the closing stock
required valuing of closing stock either at cost or at market price, whichever
was lower.
The assessee, aggrieved by the orders passed by C.I.T. (Appeals), further filed
appeals before the I.T.A.T. The Income-tax Appellate Tribunal allowed the
appeals of the assessee taking the view that the application on the principle
of lower cost or market value was pre-dominantly wrong because there had been
several accepted method of accounting such as pure cost method, LIFO, FIFO etc.
and observation of the Assessing Officer and the first appellate authority
regarding a particular method is the only correct method, was held to be
totally absurd. It was observed that lower of the cost or market value method
might certainly be considered to be a prudent method of accounting and might be
followed by the vast majority of business enterprises but what might not be
considered prudent did not necessarily incorrect or against the principles of
accounting and hence if any firm has been employing the market value method for
a long time consistently, it could not be considered as against the principles
of accountancy nor the method adopted for defrauding the Revenue. The Tribunal
has directed that valuation of the finished goods as made by the assessee be
accepted. Regarding opening stock of the Second Year, the Tribunal has allowed
the assessee to value it as the closing stock of the First year. The Revenue
challenged this order of the Tribunal in the High Court of Bombay by filing an
Income-tax Appeal.
The Division Bench of the High Court by its judgment dated 11.12.2002 allowed
both the appeals and held that the method of valuation of closing stock adopted
by the assessee was not correct and that the entire device was to inflate
deduction under Section 80 HHC and to suppress the profits in the Second Year
because the correct taxable income could never be computed on the basis of the
system of relief provided under Section 80 HHC and that under the different
assessment year constituting separate unit and the principle of 'lower of the
cost or market value' had been fully satisfying the mandatory touchstone of
"no escapement of tax" rule. Against this order of the High Court,
the assessee has came before this Court.
Shri B.V. Desai, learned counsel for the appellant has urged that in the facts
and circumstances of the case where in the First Year, the valuation of the
stock increased pre- dominantly because of the market factor and also the
sudden spurt and increase in the exchange rate of U.S. $, it could not have
been said that the appellant has adopted a method of accounting to defraud the
Revenue particularly so when the accounting method chosen by the assessee is
not for a particular year and is being adopted consistently from the year
1985-86. It is further urged that it is a well-settled principle of income- tax
law that the assessee is free to adopt any system of accounting and the
valuation chosen at the market rate has been a well settled principle of
accounting and therefore simply because the assessee has claimed benefit under
Section 80 HHC, in a particular year the method of accounting could not have
been found fault with. It was further urged that the provisions of Section 145
(1) of the Act are not attracted as the assessee had adopted the valuation of
the finished goods on market price and consistently followed the same. The
contention of the counsel proceeded on the exercise of jurisdiction and he
urged that the power under Section 145 of the Act could only be exercised if
there is material to prove that the method in question is such that in the
opinion of the Assessing Officer, the income cannot be properly deducted. The
sine qua non for enforcing the provisions of Section 145 of the Act is that the
Assessing Officer should be of the opinion that from the method of accounting
the income cannot be properly deducted and this opinion should be based on
sound and reasonable footing. On the other hand, Shri Rajiv Dutt, Sr. Advocate
for the respondent has urged that the established and consistent practice of
accounting which is accepted by Courts is valuation of the closing stock either
at the cost or at market price, whichever was lower. If the established
practice of accounting is not adopted, the Assessing Officer was justified in
invoking Section 145 of the Act. The method of accounting chosen by the
assessee was merely to claim maximum deduction under Section 80 HHC in the
First Year and suppression of the profit in the Second year. It is further
urged that each accounting year being a separate unit in itself, merely because
in the past Department accepted a method, would be no ground to prohibit the
assessing officer from exercising his discretion and powers under Section 145
of the Act.
To appreciate and to deal with the rival contentions put forward by the learned
counsel in the facts of the present case, it would be appropriate to re-produce
the relevant provisions of Section 145 (1) of the Income-tax Act as was
applicable at the relevant time. Section 145 (1) of Income-tax Act reads as
under:
145. (1) Income-chargeable under the head "Profits and gains of business
or profession" or "Income from other sources" shall be computed
in accordance with the method of accounting regularly employed by the assessee:
Provided that in any case where the accounts are correct and complete to the
satisfaction of the Assessing Officer but the method employed is such that, in
the opinion of the Assessing Officer, the income cannot be properly deduced
therefrom, then the computation shall be made upon such basis and in such
manner as the Assessing Officer may determine:
Provided further that where no method of accounting is regularly employed by
the assessee, any income by way of interest on securities shall be chargeable
to tax as the income of the previous year in which such interest is due to the
assessee:
Provided also that nothing contained in this sub- section shall preclude an
assessee from being charged to income-tax in respect of any interest on
securities received by him in a previous year if such interest had not been
charged to income-tax for any earlier previous year.
Where the Assessing Officer is not satisfied about the correctness or the
completeness of the accounts of the assessee, the Assessing Officer may make an
assessment in the manner provided in Section 144.
Section 145 provides that in case assessing officer is of the view that the
assessee's accounts are incomplete or incorrect or method of accounting has not
been regularly followed by the assessee, the Assessing Officer may resort to
make best judgment assessment in the manner provided under Section 144 of the
Act instead of making assessment under Section 145 of the Act. To attract
Section 145 of the Act, it is necessary that:
a) the assessee has computed the income in accordance with the method of
accounting regularly employed by the assessee ; and
b) provided where the accounts are correct and complete to the satisfaction of
the assessing officer; but
c) the method employed is such that in the opinion of the assessing officer,
the income cannot be deduced therefrom then the assessing officer may adopt a
different method of computation of the income as he may determine.
The assessee may employ whichever basis of valuation of stock in hand, but it
must adhere to that consistently year after year. Casual departure of valuation
of trading stock in hand at cost or market value is not permissible. The method
adopted of maintaining the accounts should be definite method of valuation
which is carried by the assessee from year to year. To attract the provision of
Section 145 of the Act the consistent method of maintaining accounts books is a
first condition thereafter the assessing officer should be of the view that the
accounts are correct and complete but the method employed is such that in the
opinion of the assessing officer the income cannot properly be deduced
therefrom. The choice of method of accounting regularly employed by the
assessee lies with the assessee but the assessee would be required to show that
he has followed the chosen method regularly. The Department is bound by the
assessee's choice of method regularly employed unless by this method the true
income, profit of accounts cannot be arrived at. The assessee's regular method
would not be rejected as improper merely because it gives him the benefit in
certain years or that as per the assessing officer the other method would have
been more preferable. The method of accounting cannot be substituted by the
assessing officer merely because it is unsatisfactory. What is material for the
purpose of Section 145 is, the method to be such that the real income, profit
and gain can be properly deduced therefrom. If the method adopted does not
afford true picture of profit, it would be rejected, but then such rejection
should be based on cogent evidence and would be done with caution. The power
can be exercised by the assessing authority to choose the basis and manner in
computation of income but he must exercise his discretion and judgement
judicially and reasonably. In the present case the assessee through out has
computed the income and maintained accounts on the basis of valuation of
opening stock of raw material and semi finished goods at stock price and finished
goods at the market price. The assessee has adopted method of accounting
whereby closing stock of the year is the opening stock of the next year, and
the valuation placed by the assessee upon his closing stock of the year as the
valuation of the opening stock of the next year. As per the assessing officer
by virtue of this method in the assessment year 1992-93 the gross profit ratio
was Rs.2054.60% for the first year which stood in stark contrast to 119.18% for
the accounting year 1991-92 and 64.85% for accounting year 1991 and, therefore,
the method adopted shows artificially inflated profit in order to get the
deduction benefit under Section 80HH (C) of the Income Tax Act. While framing
the question of law the High Court has also framed a question whether in the
facts and circumstances of the case and in law, the ITAT was justified in
holding that the higher market rate of valuation of closing stock adopted by
the assessee was correct, without appreciating that acceptance of said method
had resulted in doctored abnormal gross profit ratio of 2054.60%, which by no
yardstick of basic principle of accountancy could be held as proper reflection
of income. The High Court has arrived at the conclusion that this gross
inflation in the profit was made merely to get the benefit of Section 80HH(C)
for the first year and suppress the profit in the second year. Thus it is
apparent that the assessing officer as well as the High Court were impressed by
the factor that the method adopted by the assessee in computing the income
results in showing of abnormally gross profit ratio and that was done for the
purposes of taking benefit under Section 80HH(C) for the first year and for
reducing the profit in the second year by showing the value of the finished
products at the market rate at the end of the first year and in the beginning
of the second year. Although it is correct to say that regular method of
accounting adopted cannot be rejected by the assessing officer merely on the
basis of profit earned or loss suffered by the assessee in particular year but
that can be certainly a reason for an assessing officer to make deeper probe of
the account to find and whether the accounts reflects real income, profit and
gains of the assessee.
It is settled law that the true trading result of business for an accounting
period cannot be ascertained without taking into account the stock in trade at
the end of the accounting period. While considering the method of accounting in
C.I.T. vs. A. Krishnaswami Mudaliar (referred), this Court pointed out
that in the event where the assessee is following the cash system of
accounting, the valuation of the closing stock cannot be dispensed with. The
Court quoted with approval the following observations in Commissioner of the
Inland Revenue vs. Cock, Russell and Co. Ltd. 1949 (29) TaxCases 387 =
1949 AllER 889 (referred):
"There is no word in the statutes or rules which deals with this
question of valuing stock-in-trade. There is nothing in the relevant
legislation which indicates that in computing the profits and gains of a
commercial concern the stock-in-trade at the start of the accounting period
should be taken in and that the amount of the stock-in-trade at the end of the
period should also be taken in. It would be fantastic not to do it : it would
be utterly impossible accurately to assess profits and gains merely on a
statement or receipts and payments or on the basis of turnover. It has long
been recognized that the right method of assessing profits and gains is to take
into account the value of the stock-in-trade at the beginning and the value of
the stock-in-trade at the end as two of the items in the computation. I need
not cite for the general proposition, which is admitted at the Bar, that for
the purposes of ascertaining profits and gains the ordinary principles of
commercial accounting should be applied, so long as they do not conflict with
any express provision of the relevant statutes" *
The Court further observed:
"We have already said that in England there is no provision which
compels the tax officer to adopt in the computation of income the system of
accounting regularly employed by the assessee. But whatever may be the system,
whether it is case or mercantile, as observed by Croom-Johnson J. in a trading
venture it would be impossible accurately to assess the true profits without
taking into account the value of the stock-in-trade at the beginning and at the
end of the year." *
From the above it is clear that it is settled law that true profit of
business for an accounting period cannot be ascertained without taking into
account the value of the stock in trade remaining at the end of the period and
that such valuation is a necessary element in the process of determining the
trade result of the period. The principles on which the method of valuation of
closing stock is done is also well settled. # They have been set out in
Whimster and Co. vs. C.I.R. 1925 (12) TaxCases 813 (relied) in the
following words :-
"In computing the balance of profits and gains for the purposes of income
tax, two general and fundamental commonplaces have always to be kept in mind.
In the first place, the profits of any particular year or accounting period
must be taken to consist of the difference between the receipts from the trade
or business during such year or accounting period and the expenditure laid out
to earn those receipts. In the second place, the account of profit and loss to
be made up for the purpose of ascertaining the difference must be framed
consistently with the ordinary principles of commercial accounting, so far as
applicable, and in conformity with the rules of the Income-tax Act, or of that
Act as modified by the provisions and schedules of the Acts regulating excess
profits duty, as the case may be. For example, the ordinary principles of
commercial accounting require that in the profit and loss account of a
merchant's or manufacturer's business the values of the stock-in-trade at the
beginning and at the end of the period covered by the account should be entered
at cost or market price, whichever is lower; although there is nothing about
this in the taxing statutes." *
In the words of Bose, J. in Kikabhai Premchand vs. CIT (SC) (referred) at
page 510 :-
"The appellants's method of book- keeping reflects the true position.
As he makes his purchases he enters his stock at the cost price on one side of
the accounts. At the close of the year he enters the value of any unsold stock
at cost on the other side of the accounts thus canceling out entries relating
to the same unsold stock earlier in the accounts ; and then that is carried
forward as the opening balance in the next year's account. This canceling out
of the unsold stock from both sides of the accounts leaves only the
transactions on which there have been actual sales and gives a true and actual
profit or loss on his year's dealings." *
The rationale behind valuation of the stock at "cost" or
"market", whichever is lower is explained by Patanjali Sastri, CJ in
Chainrup Sampatram vs. C.I.T. (S.C.) at Page 485 (referred):-
"Mt is wrong to assume that the valuation of the closing stock at
market rate has, for its object, the bringing into charge any appreciation in
the value of such stock. The true purpose of crediting the value of unsold
stock is to balance the cost of those goods entered on the other side of the
account at the time of their purchase, so that the canceling out of the entries
relating to the same stock from both sides of the account would leave only the
transactions on which there have been actual sales in the course of the year
showing the profit or loss actually realized on the year's trading. As pointed
out in paragraph 8 of the Report of the Committee on Financial Risks attaching
to the holding of Trading Stocks, 1919, "As the entry for stock which appears
in the trading account is merely intended to cancel the charge for the goods
purchased which have not been sold, it should necessarily represent the cost of
the goods. If it is more or less than the cost, then the effect is to state the
profit on the goods which actually have been sold at the incorrect figure. From
this rigid doctrine one exception is very generally recognized on prudential
grounds and is now fully sanctioned by custom, viz., the adoption of market
value at the date of making up accounts, if that value is less, than cost. It
is of course an anticipation of the loss that may be made on those goods in the
following year, and may even have the effect, if prices rise again, of
attributing to the following year's results a greater amount of profit than the
difference between the actual sale price and the actual cost price of the goods
in question" (extracted in paragraph 281 of the Report of the Committee on
the Taxation of Trading Profits presented to British Parliament in April 1951).
While anticipated loss is thus taken into account, anticipated profits in the
shape of appreciated value of the closing stock is not brought into account, as
no prudent trader would care to show increased profit before its actual
realization. This is the theory underlying the rule that the closing stock is
to be valued at cost or market price whichever is the lower, and it is now
generally accepted as an established rule of commercial practice and
accountancy." *
In A.L.A. Firm vs. C.I.T. [1991] Vol.189 I.T.R. (S.C.) page 285 (referred), the
Court said that as against the valuation of the stock at cost or market
whichever is lower, valuation of the closing stock at the market value will
invariably create problem. For, if the market value is higher than the cost then
the accounts will reflect notional profits not actually realized. On the other
hand, if the market value is less, the assessee will get the benefit of the
notional loss which he has not incurred. Nevertheless, as mentioned earlier,
the ordinary principle of commercial accounting permit valuation at cost or
market whichever is lower. The proper practice is to value the closing stock at
cost. That will eliminate entries relating to the same stock from both sides of
the account. To this Rule, custom recognized only one exception and that is to
value the stock at market value that is lower. But on no principle can one
justify the valuation of the closing stock at a market value higher than the
cost as that will result in taxation of the notional profits the assessee has
not realized. In Shakti Trading Co. vs. C.I.T., Coimbatore , (referred),
this Court had held that the proper practice is to value the closing stock at
cost. To this Rule, the custom recognized only one exception and that is to
value the stock at market value if it is lower. But on no principle can one
justify the valuation of the closing stock at market value higher than the cost
as that will result in taxation of notional profits which the assessee has not
realized. The aforesaid catena of decision recognized in the accounting
practice, of valuation of closing stock and permissible limit thereof of
showing the stock at cost or at market value whichever is lower. Permissibility
of value of the stock at a market value would be only if the valuation of the
market value of the stock is lower than the cost of the stock. In C.I.T. vs.
A.Krishnaswami Mudaliar , at page 128(referred):-
"Again as observed by this Court in C.I.T. vs. McMillan and Co.
(referred), the expression 'in the opinion of the Income- tax Officer' in
the proviso to Section 13 of the Indian Income-tax Act, 1922 does not confer a
mere discretionary power ; in the context it imposes a statutory duty on the
Income-tax Officer to examine in every case the method of accounting employed by
the assessee and to see whether or not it has been regularly employed and to
determine whether the income, profits and gains of the assessee could properly
be deduced therefrom." *
It is said in S.N. Namasivayam Chettiar vs. C.I.T. (S.C.) (Referred), it
is for the officer to consider the material placed before him and, if, upon
such consideration, he is of the opinion that correct profits and gains could
not be deduced from the accounts, he would then be obliged to have recourse to
the proviso to section 13 of 1922 Act which corresponds to Section 145 of the
Act
In C.I.T. vs. Sarangpur Cotton Mfg. Ltd. , 1937
Indlaw PC 1 (referred), Lord Thankerton stated that section 13 of the
Indian Income-tax Act, 1922, related to a method of accounting regularly employed
by the assessee. The section postulated that such a method of accounting was
the necessary basis of computation, unless in the opinion of the Income-tax
Officer, the income, profits and gains could not properly be deduced from such
method. But it could very well be that, "though the profit brought out in
the accounts is not the true figure for income-tax purposes the true figure can
be accurately deduced therefrom . . ." But it was not a correct view that
the Income- tax Officer was "prima facie entitled" to accept the
profits mentioned in the accounts where there was a method of accounting
regularly employed by the assessee. "It is the duty of the Income-tax
Officer, where there is such a method of accounting to consider whether income,
profits and gains can properly be deduced therefrom, and the proceed according
to his judgment on this question. From the aforesaid decision one can easily
deduce the principle that it is the duty of the assessing officer to examine in
every case the method of accounting adopted by the assessee and to see whether
the income, profit and gains of the assessee could properly be assessed
therefrom. If the assessing officer is of the view that the profit could not be
properly deduced from the accounts maintained he can apply the provisions of
Section 145 of the Act. In the present case, the method adopted by the assessee
is to value the closing stock at the market value irrespective of the fact
whether the market value of the stock at the relevant time is more than the cost
value of the stock, which necessarily results in an imaginary or notional
profits to the assessee which he has not actually received. In fact such a
notional imaginary profit cannot be taxed. It is well settled principle as held
in Kikabhai Premchand vs. C.I.T. (S.C.) (referred) Constitution Bench
judgment that the firm cannot make profit out of itself. The transaction which
is not business transaction and does not derive immediate pecuniary gain is not
subjected to tax In the present case by showing the market value of the closing
stock the assessee has earned potential profit out of itself in as much as the
stock in trade remained with the assessee at the closing of the accounting
year. Secondly, putting the stock at the market value does not and cannot bring
in any real profit which is necessary for taxing the income under the Act as is
held in Chainrup Sampatram vs. C.I.T. (S.C.) (referred) and CIT vs. Hind
Construction Ltd.. (referred). Thirdly, it is settled principle of
Income-tax Law that it is the real income, which is taxable under the Act. This
proposition was enunciated in C.I.T. vs. Birla Gwalior (P.) Ltd., (S.C.)
(referred), which was pronounced in C.I.T., Bombay City I vs. Messrs. Shoorji
Vallabhdas and Co. (S.C.) (Referred).
Under Section 145 of the Act chargeable income has to be deduced from the
accounts regularly employed by the assessee, if in the opinion of the assessing
officer the accounts are correct and complete. The assessing officer can apply
a different method of accounts to deduce the income chargeable if in his
opinion the method employed by the assessee the chargeable income cannot
properly be deduced. The recognized and settled accounting practice of
accounting with the closing stock in the accounts has to be valued on the cost
basis or at the market value basis if the market value of the stock is less
than the cost value. In the present case the assessee has not adopted the
established and settled practice. The market value of the stock has been taken
into consideration while arriving at chargeable income although the market
value of the stock is more than the cost value of the stock. The profit earned
is only notional. There is no transfer of the goods and the closing stock
remains the opening stock of the next accounting year. The income which has not
been derived at by the assessee cannot be said to be the income chargeable for
income and, therefore, the rejection of the accounts maintained by the assessee
for the valuation of the closing stock by the assessing officer and confirmed
by the High Court is in accordance with law. The power exercised by the
assessing officer under Section 145 is as per the principles enunciated by
various authorities and the courts. # We do not find any good or sufficient
reason to interfere with the order passed by the High Court. The appeal is
dismissed with no order as to costs.