Section 145(3) of the Income Tax Act, 1961 Understanding Best Judgment Assessment and the Assessing Officer’s Powers
Where It All Begins: An Introduction
Ask any practicing tax professional in India what keeps their clients up at night, and Section 145 of the Income Tax Act, 1961 will feature prominently in the answer. Not the entire section, mind you sub-sections (1) and (2) are relatively straightforward in their operation. It is sub-section (3) that packs the real punch. Short, almost understated in its drafting, Section 145(3) hands the Assessing Officer a weapon of considerable force: the power to discard an assessee’s books of account entirely and compute income on the basis of his own best judgment.
To appreciate why this matters, one must understand what Section 145 as a whole does. It governs the method of accounting that must be used when computing income under two specific heads ‘Profits and Gains of Business or Profession’ and ‘Income from Other Sources.’ Sub-section (1) says that income must be computed on the basis of either the cash or mercantile system, whichever the assessee regularly employs. Sub-section (2) empowers the Central Government to notify Income Computation and Disclosure Standards i.e. the ICDS that override accounting standards for the purpose of computing taxable income. Sub-section (3) then provides the consequence when things go wrong: if the Assessing Officer finds the accounts unreliable, the accounting method irregular, or the ICDS not followed, he can step in and make the assessment himself. The importance of Section 145(3) goes beyond its wide application; it significantly affects taxpayers. A best judgment assessment can lead to income estimates much higher than what’s in the financial records, which then results in tax, interest, and possible penalties.
The Legal Structure of Section 145
Before looking at sub-section (3), it’s helpful to understand Section 145 as a whole. The three sub-sections are logically connected:
Sub-section (1) establishes the main rule: income from business, profession, or other sources must be calculated using either the cash system or the mercantile system, depending on which method the taxpayer usually uses. The word ‘regularly’ is critical here, as we will see later. There is no third option; a hybrid approach is generally not recognised.
Sub-section (2) builds on this by authorising the Central Government to notify computation standards, the ICDS that every taxpayer must follow when computing income for tax purposes. Ten such standards have been notified, covering everything from revenue recognition and inventory valuation to government grants and borrowing costs. These standards sometimes depart from what accounting principles like Ind AS or AS require, and where they do, the ICDS prevails for tax computation.
Sub-section (3) is the enforcement mechanism. It essentially says: if you have not played by the rules under sub-sections (1) and (2), the Assessing Officer is entitled to throw out your accounts and make his own assessment under Section 144. That is the entire provision, in essence but courts have spent decades unpacking what it means in practice.
The Provision in Its Own Words
Given how much turns on the exact language of Section 145(3), it is worth setting it out in full before analysing it:
“Where the Assessing Officer is not satisfied about the correctness or completeness of the accounts of the assessee, or where the method of accounting provided in sub-section (1) has not been regularly followed by the assessee, or income has not been computed in accordance with the standards notified under sub-section (2), the Assessing Officer may make an assessment in the manner provided in section 144.”
Notice a few things. First, the provision sets out three separate grounds, connected by the word ‘or’. This means any one of them is enough, the AO does not need to establish all three. Second, the word used is ‘may’, not ‘shall’. The power to invoke Section 145(3) is therefore discretionary, and that discretion must be exercised judiciously. Third, the consequence is a reference back to Section 144, the best judgment assessment provision which sets out the manner in which the assessment is to be made once the AO decides the ordinary route of accepting the assessee’s books is not viable.
The Three Grounds That Trigger Section 145(3)
Ground One: The Accounts Are Incorrect or Incomplete
This is the most frequently invoked of the three grounds, and it covers a remarkable variety of situations. The dissatisfaction of the AO here must relate to the correctness of what the books show, or the completeness of the picture they present. The accuracy of the figures is in doubt, or some data is missing. This situation usually arises in these circumstances:
- Sales numbers that don’t match the information from the assessee’s bank statements or GST returns.
- Purchases recorded in the accounts that can’t be verified, either because the supplier doesn’t exist or denies the transaction.
- A stock check during a search or inspection showing a significant difference between the actual stock and what’s in the stock register.
- Cash entries in the accounts—money received that the assessee can’t explain.
- Inflated expenditure claims, such as salary payments to persons who turn out to be non-existent.
- Missing vouchers or supporting documentation for a significant portion of transactions.
What the courts have been very clear about is that dissatisfaction cannot be a vague, general feeling. The AO must put his finger on something specific. The argument that the accounts are unreliable, without specifying the exact problems, has been repeatedly rejected. The Bombay High Court, in a leading judgment, made it clear that the Assessing Officer (AO) must point to specific, identifiable flaws. Only then is there a legal reason to reject the accounts on this basis.There is a further nuance here worth noting. Not every defect in the accounts justifies throwing out the entire set of books. If the defect is limited in scope and quantifiable say, one category of purchases is unsupported the better course may be to make a specific addition for that amount, rather than wholesale rejection. The courts have consistently warned against using Section 145(3) as a blunt instrument when a scalpel is more appropriate.
Ground Two: The Accounting Method Has Not Been Followed Regularly
Section 145(1) permits the use of either the cash or the mercantile system of accounting. The key word is ‘regularly’; the system the assessee uses must be one that he follows consistently, not one he applies selectively when it suits him.The problem arises when assessees switch between the two systems from year to year, or apply one system for certain types of transactions while applying the other for the rest. This kind of hybrid or inconsistent approach makes the accounts unreliable as a basis for computing income, because the reported figures depend as much on the accounting treatment chosen as on actual economic activity.
The Supreme Court addressed this squarely in Morvi Industries Ltd. v. CIT. The Court’s position was unambiguous: an assessee may adopt whichever system of accounting he chooses, but once adopted, that system must be followed regularly and consistently. Selective application i.e. cherry-picking the system that produces a lower taxable income for any given item is not acceptable. In practice, this ground is sometimes harder to establish than the first ground, because the AO must show not just that the method changed, but that the change was irregular rather than a genuine, principled adoption of a new system. An assessee who properly notifies a change in accounting method and applies it consistently from a given year onwards is on safer ground than one who applies different treatments to different transactions within the same year.
Ground Three: Non-Compliance with ICDS
This is the newest of the three grounds in operational terms; the ICDS were notified and became effective from Assessment Year 2017-18. Since then, assessees have been required to compute income for tax purposes strictly in accordance with these standards, and departure from them brings the third limb of Section 145(3) into play.
The ten ICDS currently in force cover the following areas:
- ICDS I — Accounting Policies
- ICDS II — Valuation of Inventories
- ICDS III — Construction Contracts
- ICDS IV — Revenue Recognition
- ICDS V — Tangible Fixed Assets
- ICDS VI — Effects of Changes in Foreign Exchange Rates
- ICDS VII — Government Grants
- ICDS VIII — Securities
- ICDS IX — Borrowing Costs
- ICDS X — Provisions, Contingent Liabilities and Contingent Assets
Where there is a conflict between an ICDS and an accounting standard, the ICDS prevails for the purpose of computing income under the Act. This means, for instance, that even if an assessee’s audited financial statements prepared under Ind AS defer recognition of certain revenue, the ICDS may require that revenue to be recognised earlier for tax purposes. Failure to make the necessary adjustments and disclose them properly can trigger Section 145(3).
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