According to a recent Supreme Court ruling, it is settled law that the true profit of a business for an accounting period cannot be ascertained without taking into account the value of the stock in trade at the end of the period and that such valuation is a necessary element in the process of determining the trading profit of the period.
H. P. Ranina
According to the Court, the recognised and settled accounting practice is that the closing stock has to be valued on cost basis or on the market value basis, only if the market value of the stock is less than the cost value.
The apex Court laid down the principle that if the market value of stock is taken into consideration while arriving at chargeable income, where such value of the stock is more than the cost of the stock, the profit earned would be notional. This is because there is no transfer of goods and the closing stock remains the opening stock of the next accounting year. Thus, the income which has not been earned by the assessee cannot be said to be income chargeable to tax.
The Court referred to the provisions of Section 145 of the Act, which lays down the method of accounting to be adopted for determining an assessee's income. Under this provision it is necessary that the assessee has computed the income in accordance with the method of accounting regularly employed by him, provided the accounts are correct and complete to the satisfaction of the Assessing Officer.
If 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 income as he may determine.
The assessee is free to employ whichever basis of valuation of stock he opts for in the first year of business but he must adhere to that method consistently year after year. Casual valuation of trading stock in hand at cost or market value is not permissible. The choice of a 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 that method the true income, profit or gains cannot be arrived at.
If the method adopted does not show the true profit, it should be rejected but then such rejection should be based on cogent evidence and should be done with caution. The power can be exercised by the assessing authority to choose the basis and manner of computation of income but he must exercise his discretion and judgment judiciously and reasonably.
In Sanjeev Woollen Mills v. C.I.T. ( 149 Taxman 431 (SC)), where this principle was laid down, the assessee was engaged in the export of woollen blankets.
Since the accounting year 1986-87, the assessee followed the method of accounting under which the stock of raw-material/semi-finished goods was valued at cost price and finished goods at the market price.
For the assessment year 1992-93, the assessee valued the opening stock at the rate of Rs 90 per kg and it valued the closing stock at the higher market-rate of Rs 130 per kg and claimed deduction under section 80-HHC. In the subsequent assessment year 1993-94, the assessee valued the opening stock at Rs 130 per kg for the finished goods and there was no closing stock. For the assessment year 1993-94, the assessee returned a loss.
The Assessing Officer found that this method of valuation for the assessment year 1992-93 resulted in abnormal gross profit ratio of 2,054.60 per cent, which stood in stark contrast to 119.18 per cent for the accounting year 1991-92. Accordingly, he concluded that by valuing the closing stock at market rate, the assessee had artificially inflated profits in order to get benefit under Section 80-HHC in the first year and to suppress the profits of the second year, which resulted in defrauding the revenue. The Assessing Officer, invoking Section 145, adopted the method of valuing closing stock at cost or market price, whichever was lower, and made an addition to the assessable income.
On appeal, the Commissioner (Appeals) upheld the order of the Assessing Officer that the valuation of the closing stock required valuing of closing stock either at cost or at market price, whichever was lower.
On second appeal, the Tribunal allowed the assessee's claim, holding that if an assessee had been employing the market value method for a long time consistently, it could not be considered as against the principles of accountancy nor can the method adopted be said to be for defrauding the revenue. Accordingly, it directed that the valuation of finished goods as made by the assessee be accepted.
Regarding the opening stock of the second year, the Tribunal allowed the assessee to value it as the closing stock of the first year. On appeal, the High Court while setting aside the order of the Tribunal, upheld that of the Assessing Officer.
The Supreme Court held that the assessee throughout had computed the income and maintained accounts on the basis of valuation of opening stock of raw material and semi-finished goods at cost price and finished goods at the market price. The assessee had adopted this method of accounting, whereby closing stock of the year was the opening stock of the next year, and the valuation placed by the assessee upon its closing stock of the year as the valuation of the opening stock of the next year.
The apex Court observed that the High Court had arrived at the conclusion that inflated profits were made merely to get the benefit of Section 80-HHC for the first year and suppress the profit in the second year.
Thus, it was apparent that the Assessing Officer as well as the High Court were of the view that the method adopted by the assessee in computing the income resulted in showing an abnormally high gross profit ratio and that was done for the purpose of taking benefit under Section 80-HHC 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 at the beginning of the second year.
The Supreme Court laid down that it is settled law that the true profit of a business for an accounting period cannot be ascertained without taking into account the value of the stock in trade at the end of the period and that such valuation is a necessary element in the process of determining the trading profit of the period. The principle on which the method of valuation of closing stock is done is also well settled.
In the Sanjeev Woollen Mill's case, by showing the market value of the closing stock, the assessee had earned potential profit out of itself inasmuch as the stock-in-trade remained with the assessee at the close of the accounting year.
Second, valuing the stock at market price did not bring in any real profit which was necessary for taxing the income under the Act. Third, it is a settled principle of the Income-tax Law that it is the real income that is taxable under the Act.
The method adopted by the assessee was to value the closing stock at the market price, irrespective of the fact that the market value of the stock at the relevant time was more than the cost of the stock, which necessarily resulted in an imaginary or notional profit to the assessee which it had not actually received.
In fact, such a notional imaginary profit could not be taxed.
It is well-settled principle that a firm cannot make a profit out of itself. A transaction that is not a business transaction and does not derive immediate pecuniary gain is not subjected to tax.
The Supreme Court, therefore, concluded that the rejection of the accounts maintained by the assessee for the valuation of closing stock by the Assessing Officer and confirmed by the High Court was in accordance with law.
The power exercised by the Assessing Officer under Section 145 was in conformity with principles enunciated by different Courts.
The aforesaid decision would apply equally to cases where businessmen inflate their stocks simply to secure higher amount of cash credit or overdraft facilities from banks.
In such cases as well, the Assessing Officer may be justified in re-computing the profits by valuing the stock at cost or market price, whichever is lower.
(The author, a Mumbai-based advocate specialising in tax laws, can be contacted at firstname.lastname@example.org)