The Hindu Business Line : Thou owest the worm no silk, the beast no hide, the sheep no wool, the cat no perfume

"DOUBLE, double toil and trouble, fire burn, and cauldron bubble," chant the three witches in Macbeth. Thereafter, the second among them offers her recipe thus: "Fillet of a fenny snake, in the cauldron boil and bake; eye of newt and toe of frog, wool of bat and tongue of dog, adder's fork and blind-worm's sting, lizard's leg and owlet's wing, for a charm of powerful trouble, like a hell-broth boil and bubble."

You'd agree that accounting and tax computations are equally weird exercises, requiring at times a variety of ingredients to be thrown into the bookkeeping cauldron. One gets a glimpse of the ordeal through judgments that painstakingly describe the conflicting points of view held by the accountant and the taxman, in the context of what the law says, and then arrive at a reasoned conclusion to become a precedent for future such cases.

A recent example is Sanjeev Woollen Mills (SWM) vs Commissioner of Income Tax, Mumbai, that the Supreme Court decided on November 24. SWM imported synthetic waste, and manufactured and exported woollen blankets. The company worked out its economics on the basis of dollar price; for stock valuation, amount was recorded in rupees, applying the prevailing exchange rate. It maintained books of accounts consistently on mercantile basis, and the Department accepted the same, except in the case of years in question.

The assessing officer (AO) discovered "a stark contrast in the gross profit ratio for the accounting years 1990-91, 1991-92 and 1992-93." He concluded that the method of valuing the closing stock at market rate had resulted in a distorted picture, and that SWM had artificially inflated the profits in order to get benefit under Section 80HHC of the Income-Tax Act, as one learns from the text of the judgment.

Stock valuation

To the AO it appeared there was "tax planning with intent to defraud the Revenue," and so he said that SWM's method resulted in the company earning income out of itself, "which was totally against the basic principles of accountancy and law." Proper application of the provisions of law and accounting principles demanded that SWM value its closing stock at cost or market price, whichever was lower, but that had not been done. The AO noticed that in the second year, SWM had valued opening stock at Rs 130 per kg instead of Rs 90 per kg, suppressing `the factum of profits'. Therefore, the AO applied the standard prescribed for valuation of inventory; computed the value at cost price and added "an amount of Rs 2,67,38,280 to the total income of the assessee for the second year."

The company took up the issue before the Commissioner (Appeals), but he dismissed the application saying that merely following a particular system of accounting regularly in the past did not entitle SWM to follow the same, when it was not in accordance with the standard principles of accountancy. No person could earn profit from his own pocket, he reiterated, and reminded that the valuation of closing stock required valuing of closing stock either at the lower of cost or market price.

Aggrieved by the order, SWM approached the ITAT (Income-Tax Appellate Tribunal). Brace up, because this is something offbeat. ITAT said that the application of the principle of lower of cost or market value was pre-dominantly wrong because there are several accepted methods of accounting, such as pure cost method, LIFO, FIFO and so on. Therefore, the observation of the AO and the first appellate authority regarding a particular method was the only correct method, was totally absurd, said the Tribunal.

Lower of the cost or market value method might certainly be considered to be a prudent method of accounting, followed by the vast majority of business enterprises, conceded the Tribunal. What might not be considered prudent did not necessarily become incorrect or go against the principles of accounting, it was said. 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, is how the ITAT reasoned.

Accordingly, it directed that SWM's valuation of finished goods be accepted. The Revenue challenged this order of the Tribunal in the Bombay High Court, as the facts of the case inform. The High Court decided the case in December 2002, holding that the method of valuation of closing stock adopted by SWM was not correct. Also that "the entire device was to inflate deduction under Section 80HHC and to suppress the profits in the second year." Unhappy with the verdict, SWM approached the apex court.

In the apex court

SWM's counsel B. V. Desai submitted that the valuation of the stock increased predominantly because of market forces and due to the sudden spurt in the value of dollar. It could not be said that SWM had adopted a method of accounting to defraud the Revenue, he pointed out, because the accounting method chosen by the company was not for a particular year but adopted consistently from 1985-86.

Desai 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 that stock valuation at market rate has been a well-settled principle of accounting. Therefore, simply because SWM had claimed benefit under Section 80HHC in a particular year, the method of accounting could not be faulted, said Desai.

For the Department, it was Rajiv Dutta who argued that the established and consistent practice of accounting accepted by courts is that valuation of closing stock is at the lower of cost or market price. "The method of accounting chosen by the assessee was merely to claim maximum deduction under Section 80HHC in the first year and suppression of profit in the second year," he said. Each accounting year is a separate unit; and, therefore, merely because in the past the Department had accepted a method, there would be no ground to prohibit the AO from exercising his discretion and powers under Section 145 of the I-T Act.

Justices AR. Lakshmanan and P. P. Naolekar of the Supreme Court heard the case and looked at Section 145. It provides that if the AO is of the view that the assessee's accounts are incomplete or incorrect, or the method of accounting has not been regularly followed by the assessee, he may resort to make best judgment assessment in the manner provided under Section 144 instead of making assessment under Section 145.

To attract Section 145, the first condition is consistent method of maintaining account books, reasoned the apex court.

Thereafter, the AO should be of the view that the accounts are correct and complete, but the method employed is such that the income cannot properly be deduced therefrom. "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," reads the judgment.

Gross profit ratio 2054.60 per cent

The AO cannot reject the method of accounting merely because it is unsatisfactory. What is material is that the method should be such that the real income, profit and gain can be properly deduced. "If the method adopted does not afford a true picture of profit, it would be rejected, but then such rejection should be based on cogent evidence and would be done with caution," reminded the court.

In the case of SWM, gross profit ratio for assessment year 1992-93 was 2054.60 per cent, in stark contrast to 119.18 per cent and 64.85 per cent for the other years.

Acceptance of the company's method resulted in `doctored abnormal gross profit ratio... which by no yardstick of basic principle of accountancy could be held as proper reflection of income,' reads the text of judgment citing what the High Court had observed.

"Although it is correct to say that regular method of accounting adopted cannot be rejected by the AO merely on the basis of profit earned or loss suffered by the assessee in a particular year, but that can be certainly a reason for an AO to make deeper probe of the account to find and whether the accounts reflects real income, profit and gains of the assessee," said the court.

The recognised and settled accounting practice is that closing stock 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," observed the court. "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," pointed out the court.

Accordingly, the profit earned was only notional, because there was no transfer of 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; therefore, the rejection by the AO of SWM's accounts for the valuation of the closing stock, and confirmation by the High Court are in accordance with law, ruled the court. "Thou owest the worm no silk, the beast no hide, the sheep no wool, the cat no perfume," says King Lear. Problem comes when one extends the line to say, "The taxman no tax."

Tailpiece

"Will there be any tax relief for cyclone-braving expenses?"

"You should be lucky if there's no new surcharge to foot the massive cyclone relief expenses!"

Detaxification@TheHindu.co.in

D. Murali

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