Discrepancy shown in the tax audit report in respect of stock, which is duly explained by the assessee cannot be declared as unexplained investment

Prism Jewellery Vs ITO (ITAT Mumbai)- The question of unexplained investment outside the books of account does not arise when the books itself has accounts purchases and payment through cheques. Assessee record itself indicates the purchases at that quantity and the same values were carried to the P & L Account as per the grouping shown above. On these facts_‘ we are unable to confirm the action of the A.O. and CIT(A) in treating the unexplained investment of diamond jewellery_‘ just because the tax audit has shown lesser figure in quantitative details in the audit report. To that extent the statement from the auditor and the explanation for the figures were bonafide and reasonable. We are also unable to understand on what basis the CIT(A) rejected the books of account while confirming the addition. It may be another reason that the CIT(A) considered the profits disclosed by the assessee as inflated while considering the deduction under section 10A but that does not mean that there will be unaccounted purchases outside the books of account when assessee is eligible for deduction under section 10A.

The entire approach of the A.O. as well as the CIT(A) is not correct given the fact that the difference is arrived on the basis of the books account it self. Provisions of section 69 will apply only when the investments were not recorded in the books of account and assessee has not offered any explanation for the nature and source of investment. In this case_‘ assessee has recorded the transaction in the books of account and the mistake in representing the cartage by the Tax Auditor was also properly reconciled. Therefore_‘ in our view there is no scope for any addition of unexplained investment as made by the A.O. and confirmed by the CIT(A). Both on facts as well as on law there is any scope for treating unexplained investment out of accounted purchases.

Merely because the assessee has not reconciled the use of raw materials and the price at which its goods were sold, it cannot be held that the assessee has declared higher profits to claim the deduction under s 10A.

Arriving at the gross profit and working out the GP to compare with the profit earned on transactions by considering sales to group concerns and others as a basis and giving credit for only purchases from such group concerns and others, respectively, is not a scientific method of comparison

Prism Jewellery Vs Income Tax Officer 20(2)(1)

Decided by-  ITAT Mumbai

ITA No. 8709/Mum/2010

(Assessment Year: 2006- 07)

ORDER

Per B. Ramakotaiah, A.M

1. This appeal by the assessee is directed against the order of the CIT(A) XXXI_‘ Mumbai dated 27.10.20 10.

2. Assessee has raised two grounds_‘ which are elaborate having submissions also but in substance ground No. 1 pertains to the determination of profit under section 10A whereas ground No. 2 pertains to addition of unexplained investment in stock of diamonds. These two grounds are dealt with as under.

3. Briefly stated_‘ assessee is a partnership firm engaged in the business of trading_‘ cutting and polishing and export of diamonds and diamond studded jewellery. This is the second year of business and assessee filed return of income claiming an amount of 4_‘24_‘30_‘ 179/- as deduction under section 10A of the Act. In the course of assessment proceedings A.O. denied deduction under section 10A while elaborately discussing the reasons for denying the deduction. In doing so vide para 7.3 of the assessment order he also considered that assessee has shown profits in excess of about 25% as gross profit shown by the assessee at 20.96% is extremely high. He made the following observations on the issue of quantum of deduction under section 1oA:

“In the unlikely event of assessee succeeding in appeal, the profit of the unit will be reduced by 25%, keeping in view the facts stated above and the reasons mentioned, in view of the provisions of Section 1 0A(7) r. w. s. 801A(1

0) Penalty proceedings under section 271 (1)(c) read with Explanation 1 thereto are initiated for filing of inaccurate particulars of income.”

In arriving at the above conclusion_‘ the A.O. noticed that assessee has purchased and sold goods from group companies and sister concerns and assessee failed to reconcile the average selling rate and purchases and details of sales to other third parties. These matters were carried to the CIT(A). The CIT(A) allowed assessee the benefit of section 1 OA vide his order_‘ which the Revenue has not contested. Therefore_‘ the issue of allowance under section 1OA was not in question. However_‘ the CIT(A)_‘ while determining the quantum for deduction under section 1~A_‘ redetermined the profits after calling for explanation from the assessee. The three reasons made by the CIT(A) were:

(a) that the Gross Profit (GP) earned by assessee from the sales and purchases made to group concerns is more than the profit earned on the sales made to others

(b) the Net Profit (NP) shown by assessee in the earlier year was less compared to the NP shown in this year in assessee’s own case; and

(c) on the basis of the details filed by the assessee with reference to the G.P. in similar business before the Transfer

Pricing Officer the average profit declared was about 2.12% as against 20.59% shown by assessee. Therefore he was of the view that profits were inflated by assessee in order to claim excess deduction and vide para 3.3.11 redetermined the allowable deduction under section 1OA at 48_‘ 10_‘884/- as against 4_‘45_‘67_‘639/- shown by assessee. Assessee is contesting the above action of the CIT(A) in ground No. 1.

4. Drawing our attention to the statement filed before the A.O. and CIT(A) and details furnished to them_‘ the learned counsel contested the above three reasons given by the CIT(A) in restricting the deduction. It was his submission that the CIT(A) has wrongly calculated the G.P. considering the purchases and sales from group concerns for arriving at the G.P. and compared the sales and purchases of other concerns ignoring the fact that raw material has been purchased from different sources and manufacturing of ornaments/ diamond studded jewellery was made from common pool of raw material. Therefore only considering the sales to sister concerns with that of purchases from sister concerns while arriving the G.P. is not a correct procedure. It was submitted that the statements prepared in para 3.3 of the net profit arrived at by the CIT(A) was only Rs. 82.86 lakhs whereas the profit earned by assessee firm was 464.48 lakhs. Therefore the ratio adopted by the CIT(A) while comparing the figures was also not correct. It was further submitted that assessee business profile was manufacturing high value jewellery in specialised designs and therefore raw material utilised is not only from purchases from sister concerns but also from others and sales were also made to different persons. Therefore the exercise undertaken by the CIT(A) in taking the sales to sister concerns and purchases from sister concerns and arriving at the G.P. was not correct. With reference to the N.P. comparison of earlier year to this year it was the submission that earlier year was the first year of business and the turnover was also less whereas this year it is a full fledged business year and assessee has optimised its efficiency. It was further submitted that there was higher claim of depreciation in earlier year and less depreciation in this year. Therefore the CIT(A) erred in taking the net profit comparison for arriving at the finding that assessee has disclosed higher profit during the year is not correct. He filed the gross profit comparison over the two years as under: –

Working of Profitability

(figs in lakhs)

		F.Y	F.Y
		2005-06	2004-05
A	Sales	2’315.66	669.81
B	Cost of Manufacturing	1’714.551	515.25
C	Gross Profit A – B	601.10	154.56
	GPR        C/A	26%	23%
	Admin Overheads	96.84	48.91
	Depreciation	27.78	44.22
D	Operating Profit	476.48	61.43
	OPR        D/A	21%	9%
	Interest	9.19	1.48
	Other Income	(0.43)	(0.17)
E	NP	467.72	60.12
	NPR E/A	20%	9%

 5. Referring to the above table it was the submission that in the earlier year the turnover was only 6.69 crores whereas this year it was 23.15 crores. The G.P. is comparable at 23% to 26%. There is difference in operating expenses which resulted in higher profit during this year due to less expenses and lesser depreciation. These factors were not considered by the CIT(A) while comparing the net profit only leaving the G.P. comparison in this case. It was further submitted that the CIT(A) also has taken out only those items of the data submitted to the Transfer Pricing Officer where the operating profits was less and ignored the other data furnished before the Transfer Pricing Officer. Referring to page No. 56 of the paper book it was submitted that assessee has furnished the statement of Goldiam International where the operating profits was 12.40% on a turnover of 147. 13 crores and in the case of Vaibhav Gems the operating profits was 17.02% on the turnover of 219.47 crores_‘ the statements of which were totally ignored by the CIT(A). He adopted only other details as stated in para 3.3.3 to arrive at the average operating profit of 4.8% as against assessee’s 20.59%. He further submitted that the revised statement prepared by the CIT(A) in para 3.3.4 is also not correct as he followed the same pattern of adopting of profits from group concerns in arriving at the profit and further submitted that the total profit adopted by the CIT(A) was at 5.04 crores asagainst 4.67 crores arrived at by the assessee in the books of account. He then referred to another statement prepared by the CIT(A) in para 3.3.8 where the total profit was taken at 2.38 crores and further in para 3.39 at5.54 crores. It was submitted that the CIT(A) went on wrong presumptions in order to consider that assessee has disclosed higher profits for claiming deduction under section 10A_‘ without any basis. It was further submitted that the A.O. also did not give any reason while making an adhoc statement that 25% of the profits were excess. Learned counsel’s submission that assessee has maintained books of account and all purchases and sales were vouched and the assessment in the group concerns were made without making any additions or dis allowance in those cases and further the Transfer Pricing Officer has also examined the sale price to group concerns and gave a finding that that the sales are arms length transactions and this order of the TPO was also accepted. Therefore_‘ he submitted that there is no case for making restriction of the profit declared by assessee. He placed on record in the paper books the orders of the group concerns and order of the Transfer Pricing Officer and statements made before the CIT(A) with reference to various submissions.

6. The learned D.R._‘ however_‘ supported the order of the CIT(A) to state that assessee has inflated profits so as to claim hither deduction. It was his submission that assessee has not matched the items embedded in the jewellery while they were sourced from group concerns or others_‘ therefore the CIT(A) has taken a plausible segregation of the transactions. While admitting that different profit figures were arrived at by the CIT(A) depending on inclusion of receipts_‘ inclusion of closing stock_‘ etc. it was learned D.R.’s submission that even after considering the details filed before the Transfer Pricing Officer and his orders relating to average operating profit including the two concerns which assessee submitted was excluded_‘ the GP comes to only 7.10% (as against 4.09 considered by the CIT(A)) there is indication that assessee’s profits were inflated as the GP disclosed was20.59%. Therefore the A.O. and the CIT(A) were correct in reducing the profit for the purpose of section 10A.

7. We have considered the issue and also examined the documents placed on record. As already stated above there are three reasons taken by the CIT(A) in coming to the conclusion that there was excess profit. The A.O._‘ however_‘ has not done any exercise in determining the profit and just because assessee has not reconciled the use of raw material and the price at which these are sold_‘ he was of the opinion that 25% of the profit was excess declared. This statement of the A.O. was not substantiated by any data or basis but only made on estimate. Be that as it may_‘ the CIT(A) has taken up himself determination of profit taking cue from the observation of the A.O. However_‘ his methodology was not correct. As rightly submitted by the learned counsel_‘ taking sales to group concerns and others as a basis and giving credit for only purchases from the group concerns and others respectively and arriving at the gross profit and working out the G.P. to compare with profit earned on transactions is not a scientific method of comparison. There is no evidence that only purchases from sister concerns are utilised in making the jewellery items sold to the sister concerns. Unless the raw materials utilised for preparing the gold! jewellery ornaments are examined_‘ it cannot be stated that all the purchases from sister concerns were utilised exclusively for making sales to sister concerns. Since there is common pool of raw material which goes into the manufacturing of various value added jewellery_‘ the segregation of accounts on the basis of purchases and sales to sister concerns and others is not a correct method. Not only that it is noticed that while arriving at the G.P. figures the profits taken by the CIT(A) varies from 82.86 lakhs to a high of 5.64 cores (as in para 3.3.9). This indicates that the method adopted by the CIT(A) has no reasonable basis. As rightly pointed out_‘ the method adopted itself is faulty. With reference to the second aspect of comparison of net profit of earlier year with that of this year the learned counsel placed on record a comparative chart of earlier year with that of this year where the G.P. arrived at on a small turnover of 6.69 crores in earlier year at 23% is very much comparable with that of 26% on turnover of 23.5 crores. The net profit is varying due to reduction in administrative overheads and also lesser depreciation claim. Therefore_‘ comparison of net profit as done by the CIT(A) is also not correct. The third aspect that the CIT(A) has considered is the comparative operating profit of similarly placed jewellery concerns. This data was furnished by the assessee on the basis of the available data in different domains for the purpose of transfer pricing_‘ in which the operating profit of seven concerns were examined and the average operating profit was arrived at 7.0% and assessee was declared at 20.59%. On the basis of this comparative study_‘ the Transfer Pricing Officer accepted the sale price to sister concerns/associate concerns as arms length transactions vide his order dated 29.02.2008. Since the sales are accepted at arms length price and since there is no allegation that the purchases are made at a lesser price_‘ the comparison of data given to the Transfer Pricing Officer for observation that assessee’s operating profit was very high_‘ in our view is also not correct. Moreover_‘ the CIT(A)_‘ for the reasons not explained_‘ has excluded from the comparison the high profit data of Goldiam International where the operating profit on higher turnover was at 12.40% and in the case of Vaibhav Gems the operating profit was 17.02%. Therefore_‘ it cannot be stated that the operating profit cannot be more. Of various concerns shown in the statement the operating profit varies from 2% to 17%. Assessee’s explanation with reference to the operating profit was that they were having niche jewellery and was trying to prepare exclusive designs which fetches more profits. This aspect of the argument was not countered. The A.O. also has not examined whether the purchases and sales to the sister concerns were manipulated so as to make higher profit. He only observed that the profit is to be reduced by 25% without any basis. The CIT(A)’s exercise in comparing various data as stated above is also not correct. The reasons explained by assessee of higher operating profit is plausible given the fact that this is the second year of business and the A.O. has accepted the returns of the sister concerns from whom assessee purchased the goods and further the Transfer Pricing Officer has given a finding that the sales to the sister concerns are arms length transactions. We are of the opinion that there is no basis for coming to the conclusion that profits are abnormally inflated by the assessee. In view of this_‘ assessee’s ground No. 1 is allowed. The A.O. is directed to allow the deduction as claimed.

8. Ground No. 2 pertains to the issue of addition of unexplained investments in the stock of diamonds. This issue arose in the circumstances that the assessee has purchased 10616.34 carats of diamonds valued at  17_‘99_‘1 1_‘531/- in the books of account. In the tax audit report the Auditor has mentioned the purchases of 9573 carats only. The A.O. was of the opinion that the difference of carats purchased was outside the books of account and made an addition of 1 _‘96_‘07_‘488/- as unexplained investment by the assessee. Before the CIT(A) assessee contended that it has not only purchased the total diamonds from group concerns but also from outside which include some imports but also the entire value was accounted for in the books of account_‘ paid by way of cheques and the entire cost represents the cost of purchase of 10616.341 carats. Therefore the question of unaccounted purchases does not arise. With reference to the statement of purchases of 9573 carats shown by the Tax Auditor in the report_‘ assessee furnished the statement from the Tax Auditor how the figure has revised and gave following reconciliation:

“During the hearing_‘ it was suggested that a clarification be obtained from the tax auditors on how the said figure of 9_‘573 carats came to be entered I the tax audit report.

We have checked our working papers in this regard and we confirm as under:

178.67 cts.

Represent items which were sent to a customer as samples and they were duly returned. These were specifically excluded while reporting the quantity of diamonds consumed since there was no value associated with these. The same however are included in the total of 10616.341 cts. Given by the client to the Tax Department.

887.21 cts.

Represent imports of diamonds. The local purchase of diamonds and imports of diamonds were accounted for separately in the books of accounts – as is also evident from the grouping to the Profit and Loss Account, though they were grouped together ultimately. Due to inadvertence the quantity of imported diamonds was not included while mentioning the quantity of diamonds purchased and consumed in the Tax Audit Report.

 The purchase invoices were vouched and we have re-vouched them and we confirm that the purchase cost of 17.99 crores represents the purchase cost of 10437.67 1 carats and that 178.67 carats represent samples returned back thus aggregating to a purchase of 10_‘616.341 carats.”

9. The CIT(A)_‘ however_‘ did not agree with the above and observed as under: –

“5.2.2 I have carefully considered the assessment order and the submissions of the AR and the classification of the tax auditor on this issue as discussed above. From the same, as I find the appellant as per the details of purchases furnished has shown diamonds purchased of 10,616.341 carats valued at Rs.17,99,11,531.50 but the same is shown at 9,573 carats of purchased and consumption in Annexure -F to the tax audit report in form No. 3CD dated 30.10.2006. The difference is the quantity of diamonds purchased and consumed according to the AR as discussed above is on account of typographical mistake of the tax auditor. However, the appellant or the AR has failed to demonstrate the said explanation offered by the tax auditor as per his reply submitted vide letter dated 15.12.2009, discussed above. It has failed to furnish the names and addresses of the customers to whom these free samples were given which was not recorded in its books of account and accordingly not taken into consideration by the tax auditors. Even, the AR has failed to furnish the evidences regarding the separate details of diamonds purchased locally and imported with regard to the difference of 887.211 carats s explained by the tax auditors, as discussed above. In nutshell, no such evidences were produced to substantiate the claim of the tax auditor. However, from the reply or explanation as furnished by the tax auditor it is seen that the books of account maintained by the appellant are not proper so as to deduce the correct profitability of the appellant. The tax auditor has duly certified that free samples are being issued or given by the appellant to its various customers in respect of which no records are maintained by the appellant. Therefore, in the absence of such day to day complete records of the movement of goods, as certified by the tax auditor, to may consideredopinion the books of account maintained by the appellant are liable to be rejected by invoking the provisions of section 145(3) of the Act.”

Assessee is aggrieved on the above.

10. The learned counsel referring to the statement filed before the CIT(A) and the audited accounts placed on record submitted that assessee has purchased the total diamonds at 10616.341 valued at Rs. 17_‘99_‘11_‘531 which was accounted for in the books of account. It has furnished the complete details party-wise_‘ bill-wise and also furnished letter from the Auditor which were not considered by the CIT(A) properly. The summary of the submissions are as under: –

“1. The Appellant filed a letter of the Auditor explaining the difference in carats shown in the Audit Report and that in the submissions made. The CITA held that the appellant had failed to demonstrate the explanation offered by the Auditor. However, the CITA had never asked the Appellant to provide further evidence to demonstrate the same – notwithstanding that the auditors explanation was filed on 15^th October 2009 and various hearings were held thereafter.

4. The CITA alleges that the AR failed to furnish evidence regarding separate details of diamonds purchased locally and imported – we reiterate that the AR was never asked to furnish any such evidence. It is also relevant to note that the CITA in his letter dated 8^th February 2010 (page 27 of the paper book) – Para 4 asked the AR to furnish all copies of purchase invoices for verification. The same were carried for verification as is mentioned on page 32 of the paper book in the AR’s response.

5. The CITA says that the tax auditor has duly certified that free samples are issued or given by the appellant to its various customers in respect of which no records are maintained by the appellant – no such statement is made by the Tax Auditor. The Tax Auditors letter is at page 24 of the paper book.

A complete listing of what constitutes a purchase of Rs.17,99,11,531 – party wise bill wise details showing carats and amounts was furnished during the assessment (pages 12 – 15 of paper book). All the invoices which were produced for verification to the CITA as mentioned above. A verification of the invoices would clearly show that the purchase price of 10616.341 carats (including samples were the cost is Nil) is Rs.17,99,11,531 and that hence there is no unaccounted purchase of diamonds”.

Prism Jewellery
A.Y. 2006-07
Purchases
As per Groupings
Imports – Cut and Polished diamonds		16‘919‘980
Local – Cu8t and Polished diamonds		162‘981‘668
Local-pearls		9‘855
TOTAL		179,911,533	as per listing page 15
Add:
Gold mountings/purchases/silver/alloys	Import	6‘405‘689
Gold mountings/purchases/silver/alloys	Local	18‘211‘802
Precious Stones/CZ purchase/Models	Local	178‘172
Clearing and Forwarding		126‘181
Exchange Difference		2’262’200
Total Purchases		207,095,577	as per accounts’ page 7
Break up of Purchases (from listing at pages 12-15)
	Carats
Imported purchases
World Shiner	248.380
Prism Diam Inc	233.040
Daiminter BVBA	405.79 1	887.21
Samples IN where value is Nil
Prism Enterprises	32.84
Prism Enterprises	53.44
Prism Enterprises	92.39	178.67

13. Assessee also furnished statement from the Tax Auditor explaining that the samples were not considered at 178.69 carats and how the imported purchases amounting to 887.21 were excluded. Instead of reconciling and examining the above_‘ the A.O. and the CIT(A)_‘ in our view_‘ erred in treating it as unexplained investment outside the books of account. The question of unexplained investment outside the books of account does not arise when the books itself has accounts purchases and payment through cheques. Assessee record itself indicates the purchases at that quantity and the same values were carried to the P & L Account as per the grouping shown above. On these facts_‘ we are unable to confirm the action of the A.O. and CIT(A) in treating the unexplained investment of diamond jewellery_‘ just because the tax audit has shown lesser figure in quantitative details in the audit report. To that extent the statement from the auditor and the explanation for the figures were bonafide and reasonable. We are also unable to understand on what basis the CIT(A) rejected the books of account while confirming the addition. It may be another reason that the CIT(A) considered the profits disclosed by the assessee as inflated while considering the deduction under section 10A but that does not mean that there will be unaccounted purchases outside the books of account when assessee is eligible for deduction under section 10A. The entire approach of the A.O. as well as the CIT(A) is not correct given the fact that the difference is arrived on the basis of the books account it self. Provisions of section 69 will apply only when the investments were not recorded in the books of account and assessee has not offered any explanation for the nature and source of investment. In this case_‘ assessee has recorded the transaction in the books of account and the mistake in representing the caratage by the Tax Auditor was also properly reconciled. Therefore_‘ in our view there is no scope for any addition of unexplained investment as made by the A.O. and confirmed by the CIT(A). Both on facts as well as on law there is any scope for treating unexplained investment out of accounted purchases. In view of this_‘ we have no hesitation in deleting the addition. Ground No. 2 is accordingly allowed.