• Apr
  • 19
  • 2013

Rejection of books of Accounts – Section 145(3) – Issues & Case Laws

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Section 145 of the Income Tax Act 1961, lays down that income chargeable under the head “Profit and gains of business or profession” or “Income from other sources” shall, subject to the accounting standards notified by the Central Government in the Official Gazette, be computed in accordance with either cash or mercantile system of accounting regularly employed by the assessee. Subsection 3 of Section 145 lays down that where the Assessing Officer is not satisfied about the correctness or completeness of the accounts of the assessee, or where the method of accounting namely cash or mercantile systems or accounting standards as notified by the Central Government, have not been regularly followed by the assessee, the Assessing Officer may make an assessment in the manner provided in Section 144 of the Act.

2. It may be pointed out that Section 145 of the I.T Act 1961, prior to its substitution by the Finance Act 1995 effective from April 1, 1997, permitted an assessee having income from ‘business’, ‘profession’ or ‘other sources’ to follow either the cash or mercantile or the hybrid system of accounting to arrive at its profit but it also empowers the A.O to reject the accounts and estimate the assessed income if the sytem followed by the assessee was such that his true profits were not ascertainable from it. The present Section 145 restricts the choice of system to either the cash or mercantile system and also invests the Central Government with powers to lay down accounting standards to be followed by the assessee. In order to appreciate completely the intent and operation of Section 145 in the present form, it is necessary to have a cursory look on the provisions of Section 145 which were effective upto 31st March 1997. The understanding of old provision of Section 145 is also necessary for appreciating the various judgments of the Supreme Court which have been rendered on the basis of those provisions. A number of decisions have been discussed in the following paragraphs upholding the rejection of books of accounts or otherwise have been rendered keeping in view the provisions of old Section 145. Though these decisions have been rendered on the basis of old provisions yet they are relevant in sum and substance in respect of the provisions of Section 145(3).

2.1 It is relevant to quote from the Memorandum to the Finance Bill, 1995 through which Section 145 was amended which explained the provisions as under :-

“The existing section 145(1) of the Income-tax Act provides for computation of income from business or profession or income from other sources in accordance with the method of accounting regularly employed by the assessee. Income is generally computed by following one of the three methods of accounting, namely, (i) cash or receipts basis, (ii) accrual or mercantile basis, and (iii) mixed or hybrid method which has elements of both the aforesaid methods. It has been noticed that many assessees are following the hybrid method in a manner that does not reflect the correct income. It is proposed to amend Section 145 to provide that income chargeable under the head ‘Profits and gains of business or profession’ or ‘Income from other source’ shall be computed only in accordance with either the cash or the mercantile system of accounting, regularly employed by an assessee.

The Institute of Chartered Accountants of India (ICAI) have directed its members to ensure that the Accounting Standards formulared by it are followed in the presentation of financial statements covered by their audit reports. It is seen that there is a flexibility in the standards issued by ICAI which makes it possible for an assessee to avoid the payment of correct taxes by following a particular system. Therefore, there is an urgent need to standardize one or more or the alternatives in various standards so that the income for tax purposes can be computed precisely and objectively.

The Bill proposes to amend the Income-tax Act to empower the Central Government to prescribe by notification in the Official Gazette, the accounting standards which an assessee will have to follow in computing his income under the head ‘Profits and gains of business or profession’ or’ ‘Inocme from other sources’

The proposed amendements will take effect from April 1, 1997, and will, accordingly, apply in relation to assessment year 1997-98 and subsequent years.”

2.2 The new provisions were explained in the Board’s Circluar No.717 dated August 14, 1995. The relevant paras 44.1 to 44.3 of the circular are as under :

44.1 “Section 145(1) of the Income-tax Act prior to its amendment by the Finance Act, 1995, provided for computation of income from business or profession or income from other sources in accordance with the method of accounting regularly employed by the assessee. Income is generally computed by following one of the three methods of accounting namely, (i) cash or receipts basis, (ii) accrual or mercantile basis, and (iii) mixed or hybrid method which has elements of both the aforesaid methods. It was noticed that many assessees are following the hybrid method in a manner that does not reflect the correct income. The Finance Act, 1995, has amended Section 145 of the Income-tax Act to provide that income chargeable under the head ‘Profits and gains of business or profession’ or ‘Income from other sources’ shall be computed only in accordance with either the cash or the mercantile system of accounting, regularly employed by an assessee. The first proviso to sub-section (1) of section 145 has been deleted.”

44.2 The Finance Act, 1995, has empowered the Central Government to prescribe by notification in the Official Gazette, the accounting standards which an assessee will have to follow in computing his income under the head ‘Profits and gains of business or profession’ or ‘Income from other sources.’. These accounting standards will be laid down in consultation with expert bodies like the Institute of Chartered Accountants.

44.3 The amendement will take effect from April, 1 1997 and will, accordingly, apply in relation to assessment year 1997-98 and subsequent years.”

Old and new provisions

Old provisions. – The existing Section 145 had two sub­sections and three proviso to sub-section (1) of Section 145. Sub-section (1) provided that income from business or profession or income from other sources shall be computed in accordance with the method of accounting regularly employed by the assessee. The first proviso provided that where the accounts are correct and complete but the method of accounting is such from which income cannot be properly deduced, the computation of income shall be done by the Assessing Officer on such basis and in such manner as he may determine. The second proviso provided that where no method of accounting is regularly employed, any income by way of interest on securities shall be chargeable as the income of the previous year in which such interest is due to the assessee. The third proviso provided that nothing shall preclude an assessee from being charged to income-tax in respect of any interest on securities received by him in the previous year, if such interest had not been charged to income-tax for any earlier year. Sub-section (2) of section 145 provided that where the Assessing Officer is not satisfied about the correctness or completeness of the accounts or where no method of accounting has been regularly employed, the Assessing Officer may make an assessment in the manner provided in Section 144 of the Act.

New provisions The choice of selecting the method of accounting – cash, mercantile or hybrid – was with the assessee. The choice still remains with the assessee, but the new sub­section (1) of Section 145 restricts the choice to the cash system or the mercantile system. The concept of the hybrid system has been done away with. Sub-section (2) now authorizes the Central Government to notify from time to time accounting standards to be followed by any class of assessees or in respect of any class of income, while sub-section (3) authorizes the Assessing Officer to make an assessment in the manner provided in Section 144 in three contingencies – (i) where the Assessing Officer is not satisfied with the correctness or completeness of accounts, or (ii) where the cash or mercantile sytem of accounting has not been regularly followed; or (iii) where the accounting standards as notified have not been regularly followed.

3. Two methods of accounting, the cash system and the mercantile system

3.1 Cash system. Broadly, the cash system of accounting is that in which the receipts are accounted for as and when actually received and the debits are made when actual disbursement is made. In Morvi Industries Ltd. v. CIT [1971] 82 ITR 835, the Supreme Court said that under the cash system, it is only actual cash receipts and actual cash payments that are recorded. In CIT v . A. Krishnaswami Muda liar [1964] 53 ITR 122 , the Court observed that in the cash system record is maintained on actual cash receipts and actual disbursements, entries being posted when money or money’s worth is actually received, collected or disbursed. It was further stated that under the cash system, no account of what are called the outstandings of the business either at the commencement or at the close of the year is taken. It was further observed that where the cash system is adopted, there are no bad debts or outstandings. In CIT v. K.R.M.T.T. Thiagaraja Chetty & Co. [1953] 24 ITR 525 , the Supreme Court held that the fact that certain moneys were drawn in cash from time to time did not necessarily lead to the inference that the accounts were kept on cash basis. The cash system will cover cases where accounts are not maintained on the mercantile basis, as held by the Orissa High Court in CIT v. Bijoy Kumar Das [1972] 84 ITR 351 . It may even cover cases where no proper accounts are kept as per the decision of the Gauhati High Court in N.R. Sirker v. CIT [1978] 111 ITR 281. The cash system of accounting does not necessarily mean that income is assessable only when it is reduced to cash; where payment is received in kind, it is income even though it remains in kind and is not converted into cash. The cash system of accounting does not require that it will not be treated as income so long as it is in kind – Seth Kishorilal Babu lal v . CIT [1963] 49 ITR 502 (All). In Raja Mohan Raja Bahadur v. CIT [1967] 66 ITR 378, the Supreme Court held that where the accounts are kept on cash basis, receipt of money or money’s worth and not the accrual of the right to receive, is the determining factor. It was held that if commercial assets are received by a trader maintaining accounts on cash basis in satisfaction of an obligation, income which is embedded in the value of assets is deemed to be received : the receipt of income is not deferred till the asset is realized in terms of cash or money. In Raja Raghunandan Prasad Singh v. CIT [1933] 1 ITR 113 (PC), the Supreme Court held that where a property is purchased in the Court sale, the profits will be deemed to have arisen on the date of confirmation of sale.

The foregoing discussion explains, in brief, the salient features of cash system of accounting.

3.2 Mercantile system. The mercantile system of accounting or the double entry system is different in substance from the cash system of accounting. The basic features of the mercantile system of accounting were explained by the Supreme Court in Morer Industries Ltd. ‘s case ( supra ) as follows :

“… under the mercantile system, credit entries are made in respect of the amounts due immediately they become legally due and before they are actually received. Similarly, the expenditure items for which legal liability has been incurred are immediately debited even before the amounts in question are actually disbursed. Where accounts are kept on mercantile basis, the profits or gains are credited though they are not actually realized and the entries thus made really show nothing more than an accrual or arising of the said profits at the material time.” (p. 836)

Earlier in CIT v. A. Gajapathy Naidu [1964] 53 ITR 114, the Supreme Court observed that the mercantile system brings into credit what is due immediately it becomes legally due and before it is actually received; and it brings into debit expenditure the amount for which a legal liability has been incurred before it is actually disbursed. The mercantile system, thus, treats profits or gains as arising or accruing at the date of the transaction, notwithstanding the fact that they are not received or deemed to be received. It may, however, be noted that the right or liability must be legally enforceable and must have ripened. A contingent and conditional liability cannot be taken cognizance of, as held by the Allahabad High Court in Swadeshi Cotton Mill Co. Ltd. v. CIT [1980] 125 ITR 33 / 3 Taxman 280. The mercantile system cannot be used for provisional, contingent or notional payments. The mercantile system implies passing of entries on the date of transaction and that is the date on which rights accrue or liabilities are incurred irrespective of the date of payment. In the mercantile system, bad debts are allowable when they become irrecoverable.

3.3 Only two systems of accounting recognised now. Sub-section (1) of section 145 now recognizes only these two – cash or merchantile – systems of accounting. Besides these two well known systems of accountancy, there are several variations prevalent in the business community keeping in view the nature of particular transaction and commercial expediency. Even the Supreme Court felt in CIT v . A. Krishnaswami Mudaliar [1964] 53 ITR 122 that in some cases these methods may not give a clear picture of the true profits earned and certainly not of taxable profits.

3.4 All the assessees following the mercantile system of accounting are required to follow the Accounting Standards notified by the Central Government. The main features of these Accounting Standards are as under :-

(i) Significant policies adopted in the preparation and presentation of financial statements shall be disclosed at one place and shall form part of the finanacial statements.

(ii)        Any change in the accounting policy affecting the financial effect on the current year and subsequent years or in subsequent year and the impact of the adjustments resulting therefrom, should be stated in the financial statement of the year in which such change takes place.

(iii)      Accounting policies adopted should represent a true and fair view of the state of affairs and the major consideration in this respect shall be : (a) provision should be made for all known liabilities and losses, wherever necessary, on the basis of estimate in the light of available information; (b) the accounting standard should be governed by substance and not merely by legal form; and (c) the financial statements should disclose all material items which might influence the decision of the user.

(iv)      If any fundamental accounting assumptions relating to a going concern, consistency and accrual are not followed, the fact should be disclosed.

(v)           The prior period items should be separately disclosed in the profit and loss account with their nature and amount;

(vi)      Extraordinary items of the enterprise should be disclosed in the profit and loss account separately so that their effect on the operating results of the previous year can be perceived.

(vii)      A change in accounting policy shall be made only if it is required by statute or it will result in more appropriate presumptions of financial statements.

(viii)      Any change in accounting policy which has a material effect on the financial statements of the period in which such change occurs or if it has effect for the subsequent period, shall be disclosed, indicating its impact.

(ix)           A change in an accounting estimate that has a material effect in the previous year or the subsequent year shall be disclosed.

(x) If a question arises as to whether a change is a change in accounting policy or a change in accounting estimate, such a question shall be referred to the Board for decision.

3.5 Aim of notified standards – transparency in financial statements. The accounting standards laid down in the notification are not materially different from the principles of the mercanticle system of accounting except that these are aimed at making the financial statements more transparent and require certain vital information to be disclosed in the financial statements. The Department is accepting 97 per cent of the returns under section 143(1) of the Act (subject to prima facie admustments). The scrutiny is now confined to only random selection of 3 per cent cases and a few specified categories of companies. The transparency of the financial statements accompanying the returns of income will enable the Department to locate cases of fraudulent change of accounting policies.

4. The A.O may proceed under Section 145(3) under any of the following circumstances :

(a)         Where he is not satisfied about the correctness or completeness of the accounts; or

(b)         Where method of accounting cash or mercantile has not been regularly followed by the assessee ; or

(c) Accounting Standards as notified by the Central Government have not been regularly followed by the assessee.

4.1 Though the broad parameters have been laid down in the Section itself under which the provisions are required to be invoked for rejection of books of account in a particular case, yet, a definite ground work is sine-qua­non on part of the Assessing Officer before resorting to the provisions of section.

It is noted that in a large number of cases the provisions of Section are invoked on the pretext of fall in gross profit rate. Though the fall in G.P rate definitely provides a ground to the Assessing Officer for invocation of the provisions of Section 145(3) yet it is not a sufficient condition. The Assessing Officer is required to analyse various other parameters which have the effect on the gross profit rate of the assessee for the relevant period, before drawing any conclusion on the merit of such claim. The fall in G.P rate might be a symptom of malice with which the assessee’s account would be suffering. However, it is the duty of the Assessing Officer to pin point the malice and bring it out in the Assessment Order by marshelling the facts encompassing the same. In the case of low gross profit rate, there could be inflated purchases or unrecorded sales besides manipulation in the valuation of closing stock. Therefore, the Courts expect that the Assessing Officer shall bring on record specific defects in the books of account of the assessee before invoking the provisions of Section 145(3). The rejections of books of account simply on lower G.P rate in comparison to earlier years or with other assessees placed in similar circumstances would not suffice and will not stand the test of appeal.

4.2 Where the assessee is unable to reconcile the quantities handled by it as between purchases and sales, subject to adjustment as between opening and closing stocks or where no quantity accounts are kept, the accounts are to be taken as unproved, so that the income returned may well be rejected and income estimated, if the gross profit declared is low. But where quantities in purchases and sales are different in character of the stock, such reconciliation is not  possible in CIT v/s. Saatal Kattha and Chemicals P. Ltd. [2008] 296 ITR 197 (MP), where the assessee was purchasing timber on the basis of length, girth and weight, but converted them into logs and sold the same in different sizes. The High Court found, that the inference of shortage in the facts of the case was not a sound basis. All the same, the High Court found, that a reasonable addition sustained by the Tribunal, which reduced the additions made “capriciously” by the Assessing Officer, was held justified.

4.3 In a case, where accounts were rejected on the gound that purchases of raw materials were vouched only by internal debit vouchers, it was found that assessee had explained, that it was not possible to get third party vouchers for purchase of raw materials from sundry dealers in respect of a contract work in State of Assam in a disturbed situation. It was in this context, that the High Court in Madnani Construction Corporation P Ltd. v. CIT [2008] 296 ITR 45 (Gauhati) held, that the Tribunal was not justified in merely confirming the addition without considering assessee’s case for acceptance of return.

4.4 In yet another case decided by the Tribunal in ITO v. Girish M Mehta [2008] 296 ITR (AT) 125 (Rajkot), it was pointed out, that the pre-condition for estimating business income of the assessee, where an assessee keeps accounts is that the assessee’s books should have been found to be unreliable or otherwise not capable of proving the assessee’s income. Without this first step, the fact that the gross profit is low cannot by itself be a ground for taking a view that it is open to the Assessing Officer to make good the alleged deficiency in gross profit.

4.4 Merely because the value of goods by the customs authorities was higher than the invoice price, the accounts cannot be rejected as found in CIT v. Central Provinces Manganese Ore Co.Ltd. (2008) 296 ITR 217 I (Bom).

4.5 In the case of CIT v. Smt. M.Thankamma [2010] 326 ITR 249 (Ker), where an undisclosed income based upon a single document was deleted, the High Court felt that a remand is necessary because the Tribunal had merely confirmed the order of the first appellate authority by referring to the decision of the Supreme Court in CIT v. P.V Kalyansundaram [2007] 294 ITR 49 (SC), when according to the High Court there were several corroborative materials as alleged on behalf of revenue, which were not examined.

5. REJECTION OF BOOKS OF ACCOUNT IS JUSTIFIED

Hon’ble Allahabad High Court in the case of Awadhesh Pratap Singh Abdul Rehman & Bros v/s. CIT 201 ITR 406(All) held that “It is difficult to catalogue the various types of defects in the account books of an assessee which may render rejection of account books on the ground that the accounts are not complete or correct from which the correct profit cannot be deduced. Whether presence or absence of stock register is material or not, would depend upon the type of the business. It is true that absence of stock register or cash memos in a given situation may not per se lead to an inference that accounts are false or imcomplete. However, wher a stock register, cash memos, etc., coupled with other factors like vouchers in support of the expenses and purchases made are not forthcoming and the profits are low, it may give rise to a legitimate inference that all is not well with the books and the same cannot be relied upon to assess the income, profits or gains of an assessee. In such a situation the authorities would be justified to reject the account books under section 145(2) and to make the assessment in the manner contemplated in these provisions.

In this case, the Tribunal’s finding was held giving rise to no question of law and the said finding confirming rejection of books of accounts was held justified because no stock register was maintained nor were the sales found verifiable in the absence of cash memos. The vouchers of expenses were also not forthcoming and the income returned was ridiculously low as compared to the exorbitant turnover and the extent of the business carried on by the assessee.

5.1 Hon’ble Supreme Court in the case of Kachwala Gems V/s. JCIT, Jaipur 288 ITR 10 (SC) held the rejection of books of accounts under Section 145 justified and the best judgement assessment under Section 144 of the Act.

The facts of this case were that the assessee was dealing in precious and semi-precious stones. The Assessing Officer noticed certain defects in books of account of the assessee, viz, that it had not maintained any quantitative details/stock register for the goods traded in by it; that there was no evidence / document or record to verify the basis of the closing stock valuation shown by it; that GP rate declared by the assessee at 13.49 per cent during the assessment year did not match the result declared by the assessee itself in the previous assessment years; and that the gross profit declared by it was much below the rate declared voluntarily by another assessees engaged in similar business. Thereafter, the Assessing Officer rejected the books of account of the assessee and resorted to best judgment assessment under section 144 and estimated the gross profit rate at 40 per cent. The Assessing Officer, further held that the assessee had shown bogus purchases for reducing the gross profits. On appeal, the Commissioner (Appeals), though reduced the quantum of the gross profit, estimated by the Assessing Officer, yet upheld most of his impugned findings. On further appeal, the Tribunal had also given further relief to the assessee. On appeal to the Supreme Court : the assessee himself who is to blame as he did not submit proper accounts. There was no arbitrariness in the instant case on the part of the authorities. Thus, there was no force in the instant appeal and the same was to be dismissed accordingly.

5.2 In the case of Champa Lal Choudhary vs DCITCent. Cir. 2 ,Jaipur the ITAT Bench-

‘A’ 54 SOT398(JP) confirmed the rejection of books of account holding that the addition(s) being agitated would need to be examined, firstly, from the standpoint of the validity or otherwise of the invocation of Section 145(3) of the Act and the concomitant rejection of assessee’s book results, and then on the merits of the addition on quantum. The revenue’s action in invoking section 145(3) is confirmed. This is principally for the reason that the assessee’s books of account do not meet the test of deduction of true and correct profits therefrom in the absence of proper stock records, only whereupon can they be considered as correct and complete. The assessee’s case is that each piece of stone bears different characterstics and composition and, therefore, it is not possible to maintain the stock register quality-wise. Firstly, therefore, it admits to its books of account as not bearing the quality-wise details of the goods purchased and sold and, thus, in stock at any given point of time and, therefore, not complete. The same may yield or reflect its quantity but then that by itself is of little moment or value in the absence of any indication as to its value which is an essential ingredient in determining the cost of the goods sold and, thus, trading profit, and which, in turn, is necessary to work out the net profit. The value of the stock-in-trade as at the year­end or the year of account, thus, becomes an independent variable, which cannot even be approximated with reference to the books of account as maintained. It is not the assessee’s case that stock is valued at the average (weighted) cost of purchase, and which, though not a precise measure, evens out the profits when applied from year to year, so that it may be considered as a viable alternative, employed bona fide. The same, even otherwise, does not offer itself as an acceptable alternative in the facts and circumstances of the case. This as the average method would yield approximate and reasonably correct results only when the conditions for its application exist. That is, the prices of the various stone pieces vary over a given, small range, with a low co-efficient of standard variation. When the individual prices (or data points) vary considerably, which is admitted, employment of such a method would yield irregular and misleading results. Two stones of the same weight may have largely different values or (say value per unit (weight), where their weight differs. Further, how would the stock-in-trade as at the year end be valued? The same is to be at the actual cost of acquisition or production, and which again requires cost of bought out goods/raw material, i.e., not only would its characterstics and/ or composition be required to be assessed for the purpose, but also its cost ascertained with reference to the acquisition cost, identifying the relevant purchase bills, which do not bear any such details in respect of such characterstics or composition? [Para 5.1]

5.3 Similarly , the ITAT Chandigar Bench ‘A’ in the case of Pawan Kumar vs ITO, Range IV(4), Malerkotla, 137 ITD 85 confirmed the rejection of books of account under section 145(3) holding that the discrepancies pointed out by the Assessing Officer while rejecting the book results have not been satisfactorily explained by the assessee. The Assessing Officer has observed that although the quantity of cotton seed, mustard and groundnut crushed during the previous year were shown separately but the yield of oil and oil cakes have been given in consolidated form at 13.02 per cent and 83.91 per cent respectively. Further, the sales of oil and oil cakes have been shown in the manufacturing account in consolidated form although there was a wide variation in the market price of these products. It is also true that there is always a wide variation in the percentage of yield of oil and sale rates of oil and oil cakes in the market. However, the assessee has preferred to put up a consolidated account of different types of oil seeds for the reasons best known to him. The assessee was asked by the Assessing Officer to rework the yield of oil and oil cakes separately from different types of oil, oil seeds crushed by him. The assessee was also asked to explain the reasons for mixing up the cotton, mustard and groundnut oil seeds in the same category when there was vast variation in market price of these types of oil seeds and other products. When Assessing Officer asked the assessee to give the explanation, the assessee stated that there was not much difference in the market price of both these oils and, therefore, he has made the sales of khal and oil of both these varieties jointly. It is opined that the Assessing Officer has correctly rejected the above explanation of the assessee stating that assessee’s statement in this behalf is not correct, therefore, under no circumstances is acceptable. Unless the yield of oil obtained on the crushing of three types of oil seeds is separately given, the manufacturing results cannot be appreciated in their proper perspective. [Para 11]

There were sufficient reasons to hold that the books of account maintained by the assessee are unreliable, incorrect and incomplete. Therefore, the books of account of the assessee have correctly been rejected under section 145(3). The Commissioner (Appeals) has correctly upheld the action of the Assessing Officer in rejecting the books of account. [Para 13]

6. Rejection of Books of Account under Section 145(3) and Assessment in the manner under Section 144 Connotation thereof

In a case where the provisions of Section 145(3) are attracted, although the assessment is made in the manner provided in Section 144, nevertheless the assessment is made under Section 143(3) of the Act. A clearcut distinction between Best Judgement Assessment and in the manner provided under Section 144 is required to be understood while resorting to the provision of Section 145(3). Under Section 145(3) the assessment is required to be in the manner under Section 144 of the Act only. However, it is well known that in the case of Best Judgement where resort is taken to Section 144, the Assessing Officer excercising his jurisdiction cannot act arbitrarily or capriciously. The assessment must proceed on judicial considerations in the light of relevant material that may be brought on record. The Hon’ble Allahabad High Court in the case of CIT V/s. Surjeetsingh Maheshkumar (1994) 210 ITR 83 has held that in every case of Best Judgement, the element of guess work cannot be eliminated so long as Best judgement has a nexus with material on record and discretion in that behalf has not been exercised arbitrarily or capraciously.

6.1 Bombay High Court in the case of Bastiram Narayandas V/s. CIT (1994) 210 ITR 438 held the rejection of books of accounts justified under Section 145 and the Best Judgement assessment under Section 144 where the assessee had not produced relevant records relating to its day to day manufacture of ‘bidis’ including the quanitity of bidis manufactured daily, the figures of bidi leaves consumed per day in each factory and the records relating to the daily collection of CHAAT and MAPARI bidis, the Tribunal has been held correct in holding that the Income Tax Officer was not satisfied about the fairness or correctness of the accounts of the assessee.

6.2 Although the words “Best of the Judgement” are used in Section 144 alone, the only difference between the assessment under Section 143(3) where books are found to be unreliable and an assessment under Section 144 is that the Act has contemplated a more summary method when the Assessing Officer is acting under Section 144 and that on account of deliberate default of the assessee. [Gunda Subahiya v/s. CIT (1939) 7 ITR 21 Mad-FB.]

6.3 It may further be noted that the assessment that has to be made after rejection of books under Section 145(3), of the evidence or books produced is not an assessment under Section 144, but is only an assessment under Section 143(3) which is to be made “in the manner provided in Section 144”. In such cases, the Assessing Officer has to give an opportunity to the assessee to contradict the materials upon which the Assessing Officer wants to base his estimate. [Addl. ITO V/s. Ponkunnam Traders (1976) 102 ITR 366 (Ker)]

7.              POWER TO BE EXERCISED JUDICIALLYWhen the Assessing Officer does not accept the assessee’s method of accounting then he has to resort to the provisions of Section 145 to 145(2) {now 145(3) } for computation of income by adopting such other basis as determined by him. The Karnataka High Court in the case of Karnataka State Forest Industries Corporation Ltd., V/s. CIT (1993) 201 ITR 674 has held that the Assessing Officer’s powers under the Section are not arbitrary and he must exercise his discretion and judgment judicially.

A clear finding is necessary before invoking the Section 145(3) of the Act.

8. Hon’ble Supreme Court and the various High Courts in number of cases have held that before invoking the provisions of Section 145(3) of the Act [earlier Sections 145(1) and 145(2)]. The Assessing Officer has to bring on record material on the basis of which he has arrived at the conclusion with regard to correctness or completeness of the accounts of the assessee or the method of accounting employed by it.

9.               LOW GROSS PROFIT, WHETHER BOOK RESULTS CAN BE REJECTEDIn the business of definite finding that the case fall within the ambit of Section 145(3), the rejection of books of accounts cannot be sustained merely on the fact that the gross profit of the assessee is low during the relevant period as compared to book results of other years.

Similarly, the system of accounting adopted by the assessee cannot be rejected merely on the ground that the gross profits disclosed by his books were low as compared unfavourably with those of others in the same line of business.

10.           NON MAINTENANCE OF STOCK REGISTERThe fact that there is no stock register only cautions the Assessing Officer against the falsity of the returns made by the assessee. He cannot show that merely because there is no stock register the account books must be false “Pandit Brothers v/s. CIT (1954) 26 ITR 159”. In Chhabildas Tribhuvandas Shah V/s. CIT (1966) 59 ITR 733, the Supreme Court held that there was material to support the appellate Tribunals sustaining addition made on the ground that (i) the assessee’s business was on wholesale basis and in the absence of tally of quantities in respect of major items of the trading account, the fall in margin of profits could not be satisfactorily explained; and (ii) the fall was all the more difficult to explain in view of the fact that the assessee had a substantial import quota which could have been given him a handsome margin of profit. The Supreme Court, however, made it clear in the concluding portion of its judgment that it was not concerned with the correctness of the conclusion but was concerned only with the question whether there was any material in support of the Tribunal’s findings in the case of Bhundiram Dalichand v/s. CIT(1971 81 ITR 609 (Bombay). The Bombay High Court found the rejection of books of accounts under Section 145 justified in the absence of quantitative tally of purchases and sales besides unexplained lowness of gross profit rate. Similarly, in the case of CIT v/s. Pareck Brothers (1987) 167 ITR 344 (Patna) it has been held that invocation of Section 145 was justified as the assessee was not maintaining day to day stock account and did not furnish any distinctive numbers either of purchases or sales to the Income Tax Officer.

10.1 A number of High Courts have held that the keeping of stock register is of great importance because it is a means of verifying the assessees accounts by having a quantitative tally. If in any case, after taking into account the absence of a stock register coupled with other materials, it is felt that correct profits and gains cannot be deduced from the accounts, resort to the provisions of Section 145(3) can be taken (S N Namashivayam Chettiyar v/s. CIT (1960) 38 ITR 579 (SC); Bombay Cycle Stores Co. Ltd., v/s. CIT (1958) 33 ITR 13 (Bombay).

10.2 The Calcutta High Court in the case of Amiya Kumar Roy and Brothers v/s. CIT (1994) 206 ITR 306 held that failure to maintain stock accounts by the assessee was a substantial defect in the accounts. It upheld the decisions of Tribunal holding that the estimate which was made in the case and the addition made on such estimate was quite reasonable and fair taking cumulative view of all the factors present in the case.

10.3 In the context of Sales Tax legislation, it has been held that where the relevant statute mandates the dealer to maintain stock books in respect of raw materials as well as products obtained at every stage of production and the dealer does not maintain the stock of books, it leads to the conclusion that the account books are not reliable or that particulars are not properly verifiable. If the account books are rejected, the turnover has to be determined to the best of the Judgement of the assessing authority concerned. In such circumstances, it cannot be said that a defect in non maintenance of stock register is only technical and so the turnover disclosed in account books should be accepted. (CST v/s. Girija Shankar Awanish Kumar (1997) 104 STC 130 (SC).

11. STOCK REGISTER NOT VERIFIABLE AT THE TIME OF SURVEY – PRODUCED AT THE ASSESSMENT STAGE

Where at the time of survey, a stock register was not found at the business premises, that circumstances may create a suspicion about the genuineness of the stock register when it is produced during the assessment proceedings. But the assessing authority has to scrutinize the stock reigister so produced and it is only in case he finds it spurious that a conclusion can be drawn that the assessee had not maintained its accounts properly. (Delhi Iron Syndicate Pvt. Ltd., v/s. CIT (1979) Tax LR 775 (All).

12.        POWER OF THE FIRST APPELLATE AUTHORITY IN THE MATTER OF REJECTION OF BOOKS OF ACCOUNTSIt is well settled position of law that the CIT(A) during the appellate proceedings exercises all the powers vested with Assessing Officer to be exercised while framing the assessment order. Therefore the CIT(A) can reject the books of accounts of the assessee by invoking the provisions of Section 145(3) of the I.T.Act. For the first time, while framing the appellate order provided with all other conditions exist warranting rejection of such books of accounts. In this regard, the decision of Supreme Court in the case of CIT v/s. Mc Millan and Company (1958) 33 ITR 182 (SC) is quite relevant. The decision has been rendered in respect of the old provisions of Section 145 neverthless it is equally applicable to the present provisions of Section 145 also.

13.                   REJECTION OF ACCOUNTS IN EARLIER YEAR(S) CANNOT JUSTIFY REJECTIONFOR CURRENT YEARIt is a well settled position of law that while making the assessment, the account books for that year have alone to be considered, as each assessment year is independent. There is no scope of presumption that merely because for some reason the account books in earlier years were rejected, these stood condemned forever. In this regard the decision of Allahabad High Court in the case of Ram Avtar Ashokumar v/s. CST (1980) 45 STC 366 (All) is quite relevant.

14.                ESTIMATES AFTER REJECTION OF BOOKS OF ACCOUNTOnce the books of account of assessee are rejected, then, profit has to be estimated on the basis of proper material available. An Assessing Officer is not flattered by technical rules of evidence and pleadings, and he is entitled to act on material which may not be accepted as evidence in Court of law. Neverthless, the AO is not entitled to make a pure guess and make an assessment with reference to any evidence or any material at all. There must be something more than mere suspicion to support an assessment under Section 143(3) of the Act. The rule of law on this subject has been fairly and rightly stated by the Lahore High Court in the case of Sheth Gurmukh Singh v/s. CIT (1944) 12 ITR 393 and the Supreme Court in the case of Dhakeswari Cotton Mills Ltd., v/s. CIT (1954) 26 ITR 775.

15.                ESTIMATES BASED ON COMPARABLE CASESThe estimate of turnover and fixation of gross profit rate are two important parameters which affect the assessment. If these are fixed or calculated in such a way that they adversely affect the assessee’s case, then he is entitled to know the basis and to be given an opportunity to rebut the same. The rule of law on this subject has been well settled that estimates framed without giving the basis for their fixation or without furnishing to the assessee the material on which the rate of gross profit is arrived at or without giving an opportunity to the assessee to rebut it are bad. [Dhakeswari Cotton Mills Ltd., v/s. CIT (1954) 26 ITR 775]

No reliance can be placed on rejected account books for working out Peak Credit. Madras High Court in the case of CIT v/s. KMN Naidu (1996) 221 ITR 451 has held that where assessee’s business income is estimated after rejecting the account books produced by the assessee, it is not reasonable on the part of the ITO to work out the Peak Credit on the basis of such accounted books.

16. THE COMPARATIVE GP RATE OF EARLIER YEARS

The rate of gross profit in a particular year depends on many factors namely the general market conditions based on demand and supply position, the rise or fall in market rates, specially abrupt ones, the capital position viz-a-viz the turnover acheived and many others. It is for the assessee to explain the fall, if so happens and to substantiate the reasons. Even if, thereafter, the Assessing Officer considers the material placed before him by the assessee to be unreliable, keeping in view the comparative statement of accounts of the earlier years, he cannot proceed to make an arbitrary addition and base his conclusion purely on guess work. He can do so only if he relates to some evidence or material on the record. The Courts have held that if the profit shown by the assessee in his return is not accepted, it is for the taxing authorities to prove that the assessee made more profits. [ International Forest Company v/s. CIT (1975) 101 ITR 721 (J & K) ]

Further, once the books are properly rejected, the income has to be estimated and in making the estimate of such income, the best record alongwith other things will become the relevant material. [ Vrajlal Manilal & company v/s. CIT(1973) 92 ITR 287 (MP)]

17. MANDATORY REJECTION OF BOOKS OF ACCOUNTS UNDER SECTION 145(3) BEFORE REFERENCE UNDER SECTION 142A TO D.V.O.

Section 142A was inserted by the Finance (No.2) Act 2004 with retrospective effect from 15/11/1972, to confer power on the Assessing Officer to refer the matter to the Valuation Officer, which earlier had not been conferred. Earlier there was a provision being Section 55A to ascertain the fair market value of a capital asset for the purposes of Chapter-IV of the Income Tax Act. The Supreme Court after considering the scope and ambit of Section 55A in the case of Smt. Amiya Bala Paul v/s. CIT (2003) 263 ITR 407 held that it would not apply to proceedings under Section 69B. Apparently, Section 142A has been introduced to overcome such situations.

17.1 Supreme Court in the case of Sargam Cinema v/s. CIT (2010) 328 ITR 513 has held that the Assessing Officer cannot refer the matter to the DVO under Section 142A without rejecting the books of accounts under Section 145(3) of the Act. In this regard, reference can also be made to the other judgements e.g., CIT V/s. Lucknow Educational Society (2011) 339 ITR 588 (All) and CIT v/s. Hotel Joshi (2000) 242 ITR 478 (Raj)

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Author – Y K BATRA, CIT (Audit), Ahmedabad


2 Responses to “Rejection of books of Accounts – Section 145(3) – Issues & Case Laws”

  1. Yeturi Prabhakar says:

    can any other additions be made i.e.,like disallowance of expenditure u/s 40(a)(ia) or 40A(2) etc. of the Act, when the books of account of the assessee are rejected u/s 145(3) and the profit of the assessee is estimated.

  2. CA.Shakir V Chauhan says:

    Good and comprehensive material on S-145(3).

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