AO cannot reject entire books of accounts on insignificant defects having minuscule impact on profit

Brief of the Case

ITAT Ahmedabad held In the case of The ACIT vs. Garden Silk Mills Ltd. that rejection of books of accounts should not be in a mechanical manner. The AO has to come to a definite conclusion that the accounts are not correct or not complete; consequently, it has distorted the true picture of profit. The AO is required to make analysis of each item and factor which has impact on the profit of the assessee. If a particular item of account is found to be not correct or complete, the AO is required to find out its impact on the profit of the assessee, if it is found that there is no impact or very miniscule impact on profit, such defect becomes insignificant. In such a situation, there would be no need of rejection of entire books of accounts; the AO would be justified to make addition into the profit to the extent of such item.

Facts of the Case

The case of the assessee was picked up for scrutiny assessment and the assessment u/s.143 (3) was framed vide order dated 31/12/2007, thereby the AO made disallowance of commission paid to its Director of Rs.88,00,000/- and disallowance of expenditure by invoking provisions of section 14A of Rs.298/-. The AO after rejecting the books of accounts of the assessee made estimation of profit and, thereby made addition of Rs.31,31,87,129/- being 5% of net turnover considering the same as suppression of Gross Profit (GP). Further, the AO made disallowance of interest of Rs.1,88,84,000/- and made disallowance of depreciation of capital goods of Rs.62,23,134/- and computed the book profit at Rs.2,15,36,320/- as against the book profit declared by the assessee of Rs.2,02,69,269/-.

Contention of the Assessee

 The ld counsel of the assessee submitted that the submissions of CIT-DR are misplaced and ill-founded. He submitted that the CIT (A) has elaborately discussed the issue and rightly came to the conclusion that the AO was not justified in rejecting the books of accounts of the assessee. The ld.counsel for the assessee submitted that the reason for fall in gross profit was duly explained to the AO, but the AO on the basis of whims and fancies proceeded to reject the books of accounts. The ld.counsel for the assessee submitted that there is no dispute with regard to the fact that the AO has neither doubted the sales nor purchases. He submitted that the AO has not mentioned any instance

of any bogus purchases or inflated purchases. He submitted that the assessee is a public limited company and is subjected to audit by Statutory Auditor as well as the Auditor of the Company. The Auditors have not made any adverse remarks with regard to the accounts of the assessee-company.

The ld.counsel for the assessee submitted that the AO has not doubted the purchases and sales and has also not given reasoning as to how the basis taken for rejection of accounts would affect the profit. The ld.counsel for the assessee, in respect of the contention of the CIT-DR made on the issue of disclosure of stock to the bank and to the Revenue, relied upon the judgement of Hon’ble High Court of Gujarat rendered in the case of CIT Ahmedabad-III vs. Riddhi Steel and Tubes (P.) Ltd. reported at (2013) 40 taxmann.com 177 (Gujarat). The ld.counsel for the assessee submitted that the AO failed to appreciate the fact that fall in gross profit was due to steep rise into the cost of raw-material. He submitted that the assessee is engaged in the business of manufacturing and is substantially dependent on raw-material. He submitted that in the instant case, there is increase in raw-material price and decrease in sale price due to tough competition.

Contention of the Revenue

 The ld counsel of the revenue submitted that CIT (A) was not justified in holding that the books of accounts were not validly rejected by the AO. He submitted that the AO had pointed out various defects into the books of accounts of the assessee. He submitted that there was suppression of work-in-progress. He submitted that the books of accounts can be rejected if there is any suppression of work-in-progress and in support of this contention, he placed reliance on the decision of the Coordinate Bench (ITAT “D” Bench Ahmedabad) rendered in the case of Archna Dyeing & Printing Mills Pvt. Ltd. vs. ITO in ITA No.268/Ahd/2009 for AY 2005-06, dated 25/11/2011.

He further submitted that one of the reasons for rejecting the books of accounts was that the sundry debtors figure did not match with the corresponding company. He further submitted that the AO observed that there was a huge difference between the statement of stock furnished before the bank on 25/03/2009 and the closing stock as disclosed before the revenue authorities on 31/03/2009. He further submitted that the AO noted that the assessee has not provided the quantitative details of the ready-made garments to the auditors. The AO also observed that there were inter-group transactions, however, there was no statement to the effect is made in the balance-sheet. He further submitted that the assessee failed to furnish the separate trading accounts

He further relied on the judgement of Hon’ble Apex Court rendered in the case of Arisudana Spinning Mills Ltd. vs. CIT reported at (2012) 26 taxmann.com 39(SC) in support of the contention that the assessee is required to maintain separate trading accounts for the activities undertaken by the assessee. He also placed reliance on the judgement of Hon’ble High Court of Madras rendered in the case of Coimbatore Spinning & Weaving Co.Ltd. vs. CIT reported at (1974) 95 ITR 375 (Mad.) in support of the contention that heavy burden lies on assessee to prove that books of accounts alone give correct picture and not that declared to banks.

Finally he submitted that He submitted that there is no quarrel with regard to the fact that there is steep fall into gross profit in the year under appeal. He submitted that the assessee failed to give plausible explanation for such fall in gross profit. He submitted that the assessee was required to explain the reason for fall in G.P.

Held by CIT (A)

 CIT (A) after considering the submissions of the assessee deleted the addition made on account of estimation of GP. It was held that AO was not justified in rejecting the books of accounts. However, CIT (A) sustained the addition made on account of undervaluation of work-in-progress in the closing stock to the extent of Rs.1,15,63,596/-.

Held by ITAT

As per section 145(3), the books of accounts can be rejected where the AO is not satisfied about the correctness or completeness of the accounts of the assessee.   In that event, the AO is empowered to proceed for making an assessment in the manner provided u/s.144. The test of validity of action of the AO for rejecting the books of accounts and estimation of profit would be on touch stone of a conjoint reading of both the section 145 and 144. Any violation thereof would vitiate the action of AO. As per section 145, at the outset,   the AO has to satisfy himself about the correctness or completeness of the accounts or about the method of accounting applied by the Assessee. In the absence of such satisfaction, the powers so exercised would become illegal and unjustified. In the case in hand, the AO has stated about eight grounds for rejection of books of accounts. However, the CIT (A) dealt with each defect and rejected the reasons of AO. It is clear that the CIT(A) has considered all the defect as recorded by the AO and has given a finding that the AO was not justified in rejecting the books of accounts, consequently, estimating the profit.

It is a settled position of law that the AO is expected to make assessment on the basis of the material available on record and basis should be tenable in the eyes of law. In the present case, the AO after rejecting the books of accounts estimated the profit.  It was incumbent upon the AO when he rejected the books of accounts he had to make the assessment in the manner prescribed u/s.144 of the Act. As per this provision, the AO after taking into account all relevant material which he had gathered and was required to give the assessee an opportunity of being heard before making the assessment, of the total income or loss to the best of his judgement and determine the sum payable by the assessee on the basis of such assessment.

It is also settled position of law that the books of accounts cannot be rejected on insignificant grounds. The AO should point out the specific defects, whereby the accounts of the assessee cannot be treated as correct or complete giving rise to distorted figure of GP. The Hon’ble Apex Court in the case of Sanjeev Woolen Mills vs. CIT reported at [2005] 279 ITR 434 (SC) has held that the method of accounting cannot be substituted by the AO merely because it is unsatisfactory. What is material for the purpose of s. 145 is, the method to be such that the real income, profit and gain can be properly deduced there from. If the method adopted does not afford true picture of profit, it would be rejected, but then such rejection should be based on cogent evidence and would be done with caution. The power can be exercised by the assessing authority to choose the basis and manner in computation of income but he must exercise his discretion and judgment judicially and reasonably.

From the above, it is clear that the AO should have based his finding on the basis of the material available on record. The provision also envisages that opportunity of being heard to the assessee, meaning thereby before making assessment, the AO is required to take into account the submissions/explanations of the assessee with regard to the profit likely to be computed by the AO. The case of the assessee had been that the fall in Gross Profit was due to increase in the cost of raw material and decrease in sale realization. We find that the AO did not give any finding on this aspect. However, the CIT (A) accepted the contention of assessee after verifying the details furnished before him. The basic factor for fall in G.P. in the case of the assessee was found to be increase in crude oil price and decline in realization of POY Yarn sale as per CIT (A). This finding on fact is not rebutted by the Revenue.

In the case in hand, the assessee is a company subjected to internal audit as well as statutory audit. The auditors have not pointed out any defect and or there are no adverse remarks. The AO has not made any adverse comment upon sale & purchase. Undisputedly, no defect has been noticed by the Central Excise Department in the registers maintained under the Central Excise Act, regarding raw material and furnished goods, which is subjected to inspection and audit. In our considered view, the rejection of books of accounts should not be in a mechanical fashion, the AO has to come to a definite conclusion that the accounts so placed before him are not correct or not complete.

Taking a holistic view of the entire matter, we do not see any reason to disturb the finding of the CIT (A). Moreover, in our considered view, the AO has not given any basis for estimation of net profit @ 5% of turnover.

Accordingly, appeal of the revenue dismissed.