Section 147 can be invoked only if AO has reason to believe that taxable income has escaped assessment

Brief of the case

In case of Oriental Insurance Company vs. CIT, Delhi High Court held that AO could not assume jurisdiction to reopen assessment u/s 147, until his reasons of belief have a ‘direct nexus’ and a ‘live link’ with the opinion formed by him, that Taxable Income of Assessee has escaped assessment.

Facts of the case

• The Appellant Company is a subsidiary of General Insurance Corporation of India and is engaged in the business of General Insurance comprising of Fire, Marine and Miscellaneous Insurance Business.It invests its policy holder’s funds as per the statutory guidelines provided under The Insurance Act, 1938 and IRDA Regulations, 2000.

• The Assessee claimed that the profits on sale/redemption of investments for the year ending 31.03.2004, were exempt from tax in view of the omission of clause (b) of Rule 5 of theFirst Schedule of Income Tax Act w.e.f. 01.04.1989 and in terms of the CBDT Circular No. 528 dated 16th December, 1988, providing explanatory notes to Finance Act, 1988. The Assessee also claimed deduction of 3,57,54,000/- on account of amount written off in respect of depreciated investments in support of which, it relied upon an order passed by the Tribunal in its own case for an earlier assessment year.
• The AO, however, disallowed the claim for “Investments WrittenOff”. He held that after the omission of clause (b) of Rule 5 of the First Schedule of the Act, neither the losses on depreciation of investments were allowable as a deduction nor were the profits on sale/redemption of investments taxable.
• Subsequently, the AO issued a under Section 148 with the view that income from sale/redemption of investments had escaped assessment and initiated proceedings under Section 147 .In response to the said notice, the Assessee stated that the return of income filed on 29th October, 2004 be treated as its return in compliance of the notice.
• The AO, however, was not satisfied with the said response and, accordingly, passed an order reassessing the income of the Assessee by including the sum of `505.33 crores in the total taxable income.

Held by CIT(A)

The CIT(A) held that: (i) in absence of a specific statutory provision, the Assessee could not be granted exemption merely on basis of the CBDT Circular No. 528 dated 16th December, 1988 explaining the provisions of the Finance Act 1988; (ii) CBDT Circular being contrary to the legal position is not binding; and (iii) once income is credited to the Profit and Loss Account no adjustment to the same was permitted as per Rule 5 of the First Schedule of the Income-Tax Act, and that the Tribunal had held so in the Assessee’s own case for AY 1990-91.

Contention of Assesse

• The AO had initiated the reassessment proceedings solely on the basis of a ‘change of opinion’ which was not permissible. The Assessee also urged that the reasons to believe recorded by the AO were based on erroneous factual assumptions that the assessee was carrying on business other than Non-Life Insurance business, and that the assessee had credited a sum of `505,33,63,209/- directly into the General Reserve Account in the Balance Sheet as “profit on sale of investment” without routing the same through the Profit and Loss Account for the Previous Year.
• In respect of the addition of profit on sale of investment, the Assessee reiterated that the provisions of clause (b) of Rule 5 were omitted by the Finance Act, 1988 and the legislative intention for such statutory amendment was explained vide CBDT Circular No. 528 dated 16th December, 1988. As per the said Circular, Rule 5 of the First Schedule of the Act was amended to provide tax exemption in respect of profits earned by General Insurance Companies on sale of investment.
• The Assessee urged that this amendment was not retrospective and, therefore, the income from sale/redemption of investments during the Previous Year 2003-04 was not taxable.

Contention of Revenue

It was conceded by the Revenue that the reasons recorded by the AO for issuing notice under Section 148 of the Act were erroneous. Concededly, the profit and loss on sale of investments had been credited to the Profit & Loss Account and not entered directly to the General Reserve Account as assumed by the AO. The second reason provided by the AO for reopening the assessment was that the Assessee was carrying on two streams of business; (1) non-life insurance business and (2) business in shares and securities as a public financial institution. Concededly, this assumption was also erroneous.

HELD by ITAT

However, the Tribunal upheld the reassessment on the ground that the Assessee had not brought the decision of the Tribunal in respect of Assessment Year 1991, which was against the Assessee, to the knowledge of the AO. The Tribunal was of the view that since relevant information had been withheld from the AO, it was within the powers of the AO to reopen the assessment.

HELD by HIGH COURT

• It is now well established that the powers under Section 147 of the Act of an AO can be invoked only in cases where the AO has reason to believe that the income chargeable to tax has escaped assessment. It has been held in several decisions that reason to believe must be based on tangible material and cogent facts; the powers under Section 147 of the Act cannot be exercised merely on suspicion or on an apprehension that the income of an Assessee has escaped assessment.

• A bona fide reason to believe that income has escaped assessment is a necessary pre-condition that clothes the AO with the power to reopen the  assessment, which has otherwise attained finality. The reasons to believe must have a ‘direct nexus’ and a ‘live link’ with the formation of an opinion by the AO that taxable income of an Assessee has escaped assessment. It is not disputed that the reasons that led the AO to reopen the assessment were factually incorrect. It is not disputed that the Assessee was carrying on only one business – General Insurance Business, which is regulated under The Insurance Act, 1938. Indisputably, the insurers cannot carry on any business other than the insurance business or any prescribed business. The business of General Insurance is regulated and there is no allegation that the regulatory authority has found the Assessee to be in default of any provisions of The Insurance Act, 1938.

• The Revenue did not dispute that the AO’s assumption that the Assessee was carrying on two streams of business was incorrect. Thus, this reason to believe that the Assessee’s income had escaped assessment is clearly without any factual basis. The assumption that the Assessee had not credited the profits in question to the Profit and Loss Account is also, admittedly, factually incorrect. Thus, the reasons which led the AO to form a belief that income of the Assessee had escaped assessment are admittedly based on palpably incorrect assumptions. It is well established that reasons to believe that income had escaped assessment is a necessary precondition for the AO to assume jurisdiction. Clearly, it would be difficult to sustain that this pre  condition is met if such reasons to believe that income of an Assessee has escaped assessment are based on palpably erroneous assumptions. The reason to believe must be predicated on tangible material or information. A reason to suspect cannot be a reason to believe; the belief must be rational  and bear a direct nexus to the material on which such a belief is based. In the present case, the very assumption on the basis of which the AO is stated to have formed his belief that the Assessee’s income had escaped assessment has been found to be erroneous. There was no basis for the AO  to assume that the Assessee had not credited the profits from the sale of investments, which are alleged to have escaped assessment in its Profit and Loss account.

• In view of court , this contention is without merit as reasons to believe that income had escaped assessment is a necessary pre-condition which enables the AO to assume jurisdiction to proceed further. In the event such reasons are found to be erroneous, the AO would not have the jurisdiction to make an assessment and any proceedings initiated on the basis of palpably erroneous reasons would be without authority of law. Therefore, even if it is assumed that, infact, the Assessee’s income has escaped assessment, the AO would have no jurisdiction to assess the same if his reasons to believe were not based on any cogent material. In absence of the jurisdictional pre-condition being met to reopen the assessment, the question of assessing or reassessing income under Section 147 of the Act would not arise.

• Thus, in our view, the proceedings under Section 147 are liable to be quashed as being without jurisdiction. It is at once clear from the above that the AO had expressed its firm opinion that profits and gains on realization of investments were exempt from taxation. Admittedly, such profits had been included by the Assessee in its Profit & Loss Account, which was subjected to scrutiny in the assessment proceedings.
• It cannot be disputed that the exemption claimed by the assessee in respect of the profit on sale/redemption of investments was duly disclosed and the AO had also opined on the merits of the taxability of profits on sale/redemption of investments. The income from profit on sale/redemption of investments is now sought to be taxed as income which had escaped assessment. This, in our view, clearly represents a change in the opinion with regard to the taxability of the income in question. It is well settled that the power under Section 147 of the Act is not a power of review but a power to reassess. Permitting reopening of assessment on a change of opinion as to the taxability of the income of the Assessee is, thus, outside the scope of Section 147.