The main objective of the tax audit is to compute the taxable income according to the law and for maintaining transparency in the financial statements filed by the assessees with the Income-tax department.

The tax audit u/s. 44AB of the Income-tax Act 1961 is significant practice area for Chartered Accountants. Since the introduction of tax audit, we have been given responsibilities to discharge the duties as tax auditors for the proper compliance of tax law by the assessees.


The Institute of Chartered Accountants of India has defined auditing as follows –

“A systematic and independent examination of data, statements, records, operations and performances (financial or otherwise) of an enterprise for a stated purpose. In any auditing situation, the auditor perceives and recognises the propositions before him for examination, collects evidence, evaluates the same and on this basis formulates his judgment which is communicated through his audit report”.


The auditor should document the matters, which are important in providing audit evidence that the audit was carried out in accordance with the basic principles, which are governing audit.

audit evidence

The auditor should obtain sufficient and appropriate audit evidence, which will enable him to draw reasonable conclusions there from on which base his opinion on the financial information.


The auditor should respect the confidentiality of information acquired in the course of his work and should not disclose any such information to a third party without specific authority or unless there is a legal or professional duty to disclose.

skills and competence

The audit should be performed and the report has to be prepared with due professional care by persons who have adequate training, experience and competence in auditing.

section 2(12a)-books of accounts

“Books or books of account” include ledgers, day-books, cash books, account-books and other books, whether kept in the written form or as print-outs of data stored in a floppy, disc, tape or any other form of electro-magnetic data storage device. – Is it necessary to take printouts?

If the assessee has maintained proper books of account, the provisions of Sec 145(1) shall apply and the Income has to be assessed on the basis of the books of account.  Thus, unless, the books of account are rejected, or no books of account are maintained, the Income disclosed cannot be disturbed as held in ITO Vs Amar Singh Jain (1992) 43 TTJ   (Jp Trib) 11.

Non maintenance of stock register & non recording of sales with identifiable details was held to be good ground for rejection of account books in Kishan Chand Chella Vs CIT (1978-114 ITR 671)

System of Accounting cannot be rejected merely because the disclosed gross profit was low.  (Chandra timber traders Vs CIT 1996 54 TTJ 544 Del Tri).


The Institute has issued a statement on Peer Review.  The basic objectives of peer review is to enhance the quality of the professional work by adopting technical standards which  includes the following:

  • Accounting standards issued by the Institute of Chartered Accountants of India.
  • Auditing and assurance standards issued by the Institute of chartered accountants of India.
  • Framework for the preparation and presentation of financial statement
  • Frame work of statements on standard auditing practices
  • Guidance notes on related services issued by the Institute of Chartered Accountants of India.
  • Compliance of the Guidance Notes issued by the Institute of Chartered Accountants of India.
  • Notification/Directions issued by the Institute of Chartered Accountants of India including those of a self-regulatory nature. And
  • Compliance of the provisions of the various relevant Statutes and/or Regulations, which are applicable in the context of the specific engagements being reviewed.

Can the  tax auditor revise his tax audit report?

Guidance notes on Revision / Rectification of Financial statement, state that the auditor may revise the audit report provided; he gives it in the manner suggested by the institute.  But normally the report u/s 44AB should not be revised.  However, it may be revised on the following grounds.

Revision of accounts of company after its adoption in the annual general meeting.

Changes in law (eg) retrospective amendment

Change in interpretation (eg) CBDT circular, judgment etc.,

Change of tax auditor and code of ethics

A chartered accountant in practice cannot accept a position as auditor previously held by another chartered accountant without first communicating with him in writing. It will be in violation of clause(8) of Part I of First Schedule to the chartered accountants Act 1949.

Even though there is proper communication the incoming auditor should before acceptance must ensure all the undisputed fees must have been paid as per notification no 1CA(70/46/99dated28/10/99of ICAI.

The communication must be effective one, hence it should be by registered acknowledgement due or by hand delivery with written acknowledgement.


“While discharging their attest function it will be the duty of the members of the Institute to ensure that the Accounting Standards are implemented in the presentation of financial statements covered by the Audit Reports. In the event of any deviation from the standards, it will be also their duty to make adequate disclosures in their reports, so that the users of such statements  may be aware of such deviation “.

Mandatory accounting standards are also applicable in respect of financial statements audited under Section 44 AB of the Income-tax Act, 1961.  The ICAI has issued various accounting standards to harmonize the diverse accounting polices and practices in consonance with the International Accounting policies and statements. The corporate and non-corporate entities are subject to these mandatory regulations

accounting standard 2: – Valuation of Closing Stock

As per the AS2, stock has to be valued at cost or net realisable value whichever is less. Section 145 of the Income-tax Act, provides that valuation of inventory shall be made on the basis of the method of accounting, regularly employed by the assessee but subject to certain adjustments. The method of valuation of stock must be consistently followed from year to year and the method followed must be brought out clearly.

Ref: CIT Vs British Paints Ltd., (1991) 188 ITR 44(SC)

Corborundum Universal Ltd., 173 ITR 759 (Mad)

The Calcutta High Court has held in the case of CIT Vs UCO Bank (1993) 200 ITR 68 (Cal), that an assessee cannot adopt a system of stock valuation notionally for Income-tax purpose, which is different from the one which has been consistently followed by the assessee.

As per the AS2, for determining the cost of inventories, loose tools, abnormal waste of materials, labour or other production costs are to be eliminated.  The storage cost other than direct production process cost, administration overhead, interest and finance charges, selling and distribution cost are to be excluded.  In case of any deviation, the tax auditor has  to disclose all the deviations and its impact on the financial statement. The closing stock has to be valued either at FIFO or Weighted Average method.  This method will reflect the fairest possible approximation of the cost incurred in bringing the inventories to the present location and condition.

The closing stock has to be valued at cost or market value whichever is less, but in the following circumstances the valuation of closing stock has to be made as stated below.

Valuation of stock in certain circumstances.

A proprietor wants to contribute his closing stock to a firm as a capital contribution for which he adopted cost of the closing stock as his contribution.  The assessing officer cannot compel the market value as the contribution.  If the partners agreed for the particular value there is nothing in law, which would compel them to adopt a method of valuation of stock different from the one that they had chosen to adopt. Refer: CIT Vs R.Venkatachariee (1999) 107 TAXMAN 438 (Mad)

Where in the case of dissolution of the partnership firm by mutual consent or on the death of the partner the closing stock has to be valued on the basis of market price only.  Refer: CIT Vs Paranjothi Nadar (1999) 240 ITR 713 (Mad)

When a new firm is formed after dissolution and the opening stock of the new firm has to be valued at market price Refer: V Chandraprakasa Nadar & Co., Vs CIT (1999) 107 Taxman 31 (Mad).

Where in the case of dissolution of the firm on the death of one of the partner and the firm is reconstituted with the remaining partner and the business is continued the closing stock has to be valued at cost or market value whichever is less. Refer: Sakthi Trading Co., Vs CIT (2001) 250 ITR  871 (SC)

Where in the case of a dissolved firm, which discontinued the business, the closing stock has to be valued at market rate and higher income has to be offered. Refer: ALA Firm Vs CIT (1991) 189 ITR 285 (SC), CIT Vs Popular Automobiles (2001) 119 Taxman 633 (Ker),      CIT Vs Diza Electricals (1999) 238 ITR 924/(1998) 101Taxman 464 (Ker).

Stock valuation difference between bank statement and register maintained or stock value adopted

The stock valuation discrepancies between stock records and one given to the bankers for obtaining the over draft facilities can be considered as income. However the tax auditor must satisfy himself by making proper reconciliation of the two stock figures.

Ref: CIT Vs Rudarappan & Co., (1984) 147 ITR 204 (MAD), CIT Vs Bharat Mineral Sales Corporation (2002) 253 ITR 419 (Cal)

Whether stock register forms part of books of account or not?

It is clear from the definition for books of accounts the stock record also forms part of the books of account to be maintained by the assessee.    The method of maintenance, test checks, periodical physical verification conducted by the assessee and other rectifications are to be verified during the tax audit.  Our Institute is also discouraging the method of disclosure of the value closing of stock as certified by the management in the audit report.  However, it is advisable to get the management representation in this regard.

Guidance notes on audit of inventories, stipulates that the tax auditor should obtain management representation from the client, description in detail of location, methods & procedures of physical verification and valuation of inventories. The tax auditor shall exercise his professional judgment as to whether the absence of such records would affect his reporting requirements.


Measurement of Inventory – costs or net realisable value

Cost formula used – FIFO or weighted average.

accounting standard – 9  – revenue recognition

The “Revenue Recognition” deals with the bases for recognition of revenue arising in the course of the ordinary activities of the enterprise from:

The sale of goods

The rendering of services and

The use by others of enterprise resources yielding interest, royalties and dividends

“Revenue” is the gross inflow of cash, receivables or other consideration arising in the course of the ordinary activities of an enterprise from the sale of goods, from the rendering of services, and from the use by others of enterprise resources yielding interest, royalties and dividends.

“Revenue” is measured by the charges made to customers or clients for goods supplied and services rendered to them and by the charges and rewards arising from the use of resources by them.  In an agency relationship, the revenue is the amount of commission and not the gross inflow of cash, receivables or other consideration.

Revenue recognition is mainly concerned with the timing of recognition of revenue in the statement of profit and loss of an enterprise.  Normally the revenue recognition is determined by agreement between the parties involved in the transaction. When uncertainties exist regarding the determination of the amount, or its associated costs, these uncertainties may influence the timing of revenue recognition.

Basis for recognizing revenue:

Sale of Goods.

The following are the key criteria for determination for recognize the revenue:

Sale of goods between the seller and buyer,

The goods must be sold for a consideration, and

the risk and reward must be transferred

The transfer of property in goods, in most cases, results in or coincides with the transfer of significant risks and rewards of ownership to the buyer.

If the transfer of property in goods does not coincide with the transfer of significant risks and rewards of ownership, Revenue in such situations is recognised at the time of transfer of significant risks and rewards of ownership to the buyer.

At certain stages in specific industries, such as when agricultural crops have been harvested or mineral ores have been extracted, performance may be substantially complete prior to the execution of the transaction generating revenue.  In such cases when sale is assured under a forward contract or a Government Guarantee of where market exists and there is a negligible risk of failure to sell the goods involved are often valued at net realisable value.  Such amounts while not revenue as defined in this Statement, are sometimes recognised in the statement of profit and loss and appropriately described.

accounting standard 1: – cbdt as-i

– Disclosure of accounting policies –       AS-1

Accounting standard 1 of the Institute deals with disclosure of significant accounting policies adopted by the entity. The accounting policies adopted by the entity will have a bearing on its taxable income. Thus, while verifying the disclosure of accounting policies, the auditor will have to bear in his mind the implications in audit report u/s.44AB. The accounting standard 1 issued under the Income-tax Act, 1961 is similar to the one issued by the Institute.

According to Accounting Standard 1, Disclosure of Accounting Policies, “accrual” is one of the fundamental accounting assumptions.  The Standard requires that if any fundamental accounting assumption is not followed in the preparation and in the presentation of financial statements, the fact should be disclosed.

All significant accounting policies should be disclosed as part of the financial statements in one place and any change there of which has a material effect should be disclosed.  If fundamental accounting assumptions viz., going concern, consistency and accrual are not followed, it should be disclosed.


All significant accounting policies should form part of Financial Statements.

If there is a Change in policies with material impact, it should be disclosed.

If Fundamental assumptions are not followed, the fact has to be disclosed.

accounting standard 5: – cbdt – as 2

AS-5 deals with prior period items and changes in accounting policies. The Auditor has to decide whether an item is in the nature of prior period after considering the facts of the case. Accounting Standard  – 2 has been issued under Income-tax Act, which also deals with prior period items. If there is a conflict between the notified accounting standards of the Income-tax Act and accounting standard of the Institute, the notified accounting standard of the Income-tax Act shall prevail for tax audit purpose.

The changes in the accounting estimates is not required for the purpose of treating an item as a prior period item in the tax audit report, though it is a relevant issue in AS-5.

As a tax auditor, one has to report on the prior period items debited to profit & loss account.  In the computation statement, many of the auditors disallow the same, while some allow. This is always a debatable area.  The prior period items are mainly because of omissions or errors of previous years.  The expenses relating to earlier years cristalised during the year need not be a prior period item.


Any material effect should be disclosed

Where it is not ascertainable, the fact should be indicated

method of accounting

The accounting standard of The Institute of Chartered Accountants of India and Accounting Standard of CBDT are applicable.

The assessee must disclose the following information:

Method of computation of stock:

Disclosure in financial statements:

First time tax audit

No tax audit was made in the previous assessment year, the tax auditor of current assessment year must verify previous year methods followed by the assessee.

The tax auditor should report the method of accounting followed and if there is any change, it may not be difficult to verify the method of accounting followed in the earlier previous year.  He should apply his professional experience and satisfy that there is no change in the method of accounting employed during the previous year.  Hence it is not necessary for him to verify the previous year accounts.

Whether addition can be made due to change in the method of accounts?

The Gujarat High Court observed that the change in the method of accounting was a bonafide and consistently followed in the subsequent years.  It was held that no addition was warranted as no substantial question of law was involved. There is no question of invoking Mc. Dowels decision 154 ITR. Ref :  CIT Vs Soma Textiles & Industries Ltd., (253 ITR 137 Guj), Special leave petition dismissed by the SC 252 ITR ST 60.


The auditing and assurance standards are our basic tools to conduct any audit and it has to be followed with out any reservation.

Basic principles governing an audit                            -AAS 1

Compliance with the standards to be ensured whenever an audit including a tax audit is carried out.

Application of auditing procedures and reporting practices appropriate to the particular situation.

Auditor should show integrity, objectivity and independence.

Audit should be performed and report prepared with due professional care by persons having training, experience and competence in auditing.

Auditor should have specialized skills and competence to carry out audit.

Auditor should ensure that all accounting information that should be recorded has in fact been recorded.

Auditor should review and assess the conclusions drawn from audit evidences to arrive at an overall conclusion with regard to the following.

(a)Financial statements have been prepared  using acceptable accounting policies.

(b)Such policies are consistently applied.

Financial information ensure compliance with the relevant provisions of the Income Tax Act, 1961 and other circulars, notifications, Income Tax Rules and the principles laid down in various judgments.

Documentation                                          –        AAS3

The auditor to   document matters important in providing evidence that the audit was carried out in accordance with the basic principles of audit.

Documentation refers to the working papers prepared/ obtained and retained by the auditor.

Audit planning                                            –        AAS 8

Auditor to plan his work with a view to conduct

(a) An effective audit

(b) In a timely and efficient manner

Plan to be based on the knowledge of the client’s business.

Plan to cover following

(a) Acquiring knowledge of the client’s accounting system, policies and internal control procedures

(b) Establishing degree of reliance on the internal control.

(c) Determination and scheduling the nature, timing and extent of audit procedures to be performed. Audit plan to be developed accordingly

Nature of Income-assessabilty.

agricultural income vs- business income

Any person who is performing basic agricultural operation and who sells his products, the income earned there from is an agricultural income.  If any person, who has done basic agricultural operation and later on transfers it into saleable conditions like transferring into pots etc., sold in his nursery, is also an agricultural income.

The Madras High Court in the case of CIT Vs Soundarya Nursery held this view 160 CTR 319 (MAD)

assessability of income u/s. 28-business income vs other heads

At certain times it will be difficult to ascertain under which head the income has to be computed. There are number of cases where the business was leased out to outsiders or properties may be let out by the promoters of the building or there may be no revival of the business but there may be chances for getting only the lease income.   The assessability as business income or income from house property or  income from other sources depend   upon the lease agreements, facts and circumstances of  each  case.

In the case of  Sri. Hanuman Sugar and Industries Ltd vs CIT [2004] 266 ITR 106 [Cal], it was held that the reason for leasing out the asset was due to financial difficulties faced by the company.  The director’s report also showed that the directors of the assessee company would continue to be associated with the management of the factory in advisory capacity and maintain day to day contacts with the activity of the factory. Ref:[1994] 205 ITR 88 [Cal] Lakshmi Narayan Board Mills vs CIT, exploit the asset short tenure.           Ref: ACIT  vs. Dilnavaz.S. Variva [2003] 877 Itd 113 [Mum]

In the case of CIT vs Gambhir Mal Pandey P. Ltd [2004] 266 ITR 274 [RAJ] held, AO revealed that Mill had been given for lease and not for manufacturing during the year 1973-74 & 1976-77, since no business activities had been carried over by the assessee pertaining to manufacturing and till date the assessee had never taken back the Mill for same purpose, amount received from lease was treated as income from other sources. Ref: Universal Plastics vs CIT [1999] 237 ITR 454 [SC] factory let out – earning income treated as income from other sources. Also Ref: Sri Indramani Bai vs ACIT [1993] 200 ITR 594

Income earned from the business center is assessable as business income.  The assessee constructs a business complex and leases it to various parties and provides secretarial and other facilities.  The department treats it as “income from house property” – ACIT vs Saptharishi Services Ltd [2004] 265 ITR 379 [Guj]

Letting out furnished office premises to various parties and recovering the interest on security  advances and collection  of amount every month by month itself proves that the assessee is not exploiting the commercial asset, so that the income has to be assessed as” Income From House Property”- Hela holdings [P] Ltd vs CIT [2003] 263 ITR 129 [Cal]

income from letting out buildings belonging to promoters & developers.

In the case of CIT vs Chennai Properties & Investments Ltd [2004] 266 ITR [ST] 685 [MAD] it was held that income from letting out buildings belonging to Property Developers has to be assessed as income from house property.  The fact of the case was that no precise test could be laid down to ascertain whether income received by an assessee from leasing and letting out of assets would fall under the head ‘profit and gains’ of business or profession.   If only  few of the business assets are let out temporarily while the assessee is carrying out other business activity then it is a case of exploiting the business assets otherwise than employing them for its own use for making profit for that business.

In case the assessee as owner of building was only exploiting the property as owner by leasing out the same and realizing income by way of rent, such rental income was liable to be assessed under the head “Income from house property”.  Please refer CIT vs Karnani Properties Ltd [1971] 82 ITR 547 [SC], CIT vs Indian Overseas Bank Ltd [2000] 246 ITR 206 [MAD].

In Rampur Industries Limited vs CIT [1971] 82 ITR 23 [All], rental income from certain unused godowns derived by a company doing rice milling business has been held to be income from property.

In the case of Delhi Cloth & General Mills Company Limited [1966] 59 ITR 152 [Punj] – residential quarters to employees- Income from residential quarters is income from business.  Sec. 22 does not apply to rent, if any charged for such property.

In the case of CIT vs. Vikram cotton Mills ltd.(1977) 106 ITR 829(All) there was a temporary suspension of business for a short period with the object of tiding over the crisis condition. There was never any act indicating that the company never intended to carry on the business in  future. The High court was right in its view that the income derived by the respondent company by way of lease rent from  letting out of its assets was assessable to tax under the head “profits and gains.

Income from Advertisement hoardings

The above income is treated as income from other sources not as income from property. Ref in the case of Mukherjee Estate [P] Ltd vs CIT [200] 244 ITR [Cal].

profession of information technology

A Chartered Accountant after passing ISA or CISA surrendered his certificate of practice and started his own software consultancy, development and system audit and earned Rs.15Lakh as gross receipt – Is he liable for tax audit?

Yes.  Even though he has not been pursuing the profession of accountancy but he can be considered as a professional of information technology if his gross receipts exceeds Rs.10 lakhs attracts tax audit u/s 44AB. Ref : Profession of Information Technology notification No.50385 (E) dt.04-05-2001.

Information technology is a vast area we have to analyse from case to case basis with reference to the nature of service rendered by each person like software consultancy, developer, Hardware Engineer etc.,

writeback of amount

Though there is a write back of liability amounts to gross receipt and if the gross receipt exceeded Rs.40Lakhs, will the assessee be liable for tax audit?

Guidance note on tax audit clarifies that writing back of liability may be deemed to be the income u/s 41(1) of the Act.  The amount written back is a part of gross receipts for determining the tax audit u/s 44AB.



The amount paid by way of salary, bonus, commission or remuneration by a firm to a working partner is not deductable in the computation of income of the firm unless the following conditions are fulfilled:

The  partnership,  is authenticated by an instrument in writing,

Individual shares of the partners should be specified in the deed of partnership.

A certified copy of the partnership deed signed by all partners should be filed along with the return of income.

In case,  there is any change in the constitution, sharing ratio or any other substantial changes effected during the year, a copy of deed of reconstitution should be filed along with the return for the relevant assessment year.

There should be an authorisation in the partnership deed,  in the  case of payment of remuneration, commission and interest to the partners.

If the firm has not filed any of the above documents along with the return on  income, it has to be assessed only as AOP up to the assessment year 2003-2004

The Finance Act 2003,  has modified the assessment of firms,  by altering  Section 184 and 185.  Hence, with effect from the assessment year 2004-05,  for non-filing of the above documents,  the firm will be treated as a firm and assessed at the tax rate of 35% after disallowing the partner’s remuneration, bonus, commission and interest.

huf as a partner

The remuneration paid to a partner who represents, as an HUF has to be considered in accordance to the definition given for “WORKING PARTNER”.

As per the Explanation 4 to Section 40(b) “Working partner” means an individual who is actively engaged in conducting the affairs of the business or profession of the firm, in which he is a partner. Since the HUF cannot be treated as an individual for this explanation, the department may disallow the remuneration paid to the representative.

In the view of the legislature, HUF, not being a person, is not entitled to enter into contract. Hence HUF cannot be a partner as was decided in the case CIT Vs Kalu Babulalchand (1959) 37 ITR 123 (SC)

Such partnership cannot exist even under the rules of Hindu law, as was the case in Ramlaxman Sugar Mills Vs CIT (1967) 66 ITR 613 (SC)

Further, as held in the case of Rashik Lal & Co., Vs Commissioner of Income-tax (1998) 96 Taxman 16 (SC), in the judgment, the Supreme Court has considered the firm, as an Association of individuals.  It also considered that partnership with HUF is equal to partnership with other firms.  It has been held that,  in both the cases the person entered as a partner on behalf of HUF or another firm will not be considered as a partner.

This decision was given with respect to the payment of Commission made under section 40(b) of the Income-Tax Act, 1961.  Before the new system of assessment of firms, came into, the payments made to a partner were not allowed as deduction.

Salary paid to a partner who is representing his HUF in the firm, in his individual capacity, is disallowable u/s 40(b) – HUF directly or indirectly cannot become a Partnership of a Firm.

CIT Vs Manalal N. Chokshi (2002) 125 Taxmann 460 (Guj)

Whether HUF can be a partner?

What should be recitals in the partnership deed with respect to the HUF partner?

In case of payment of salary or interest (as per the partnership deed) made to the Partner representing the HUF, in whose hands should it be assessed?  In  the hands of the individual or HUF?

1. HUF can be a partner.  Any member of the HUF can represent it as    partner.

2. The recitals in the deed should only be the name of a person.  It should     not be as X (HUF) or X represents HUF.

3. It should be treated as individual, as HUF cannot be a working partner. Salary paid should be allowed as regular one.  The individual can offer the same as HUF income.  In that case the income will be treated as income from other sources in the hands of the HUF.

In various judicial decisions relating to law, prior to 01-04-93, it was held that the remuneration paid to a partner, because of HUF funds being invested in the firm has been treated as HUF income.  If the amount was paid with respect to the skill, experience etc., have the partner, it will be treated as individual income.

In a recent decision of the ITAT in the case of ITO vs Vegunda Surya Prakasha Rao Sons & co [2004] 88 ITD 322 [vizag]] [SMC],  the tribunal  has analysed,  the various Supreme Court decisions,  about the impact of remuneration,  paid to a partner representing the HUF and concluded that the remuneration can be allowable as deduction.

The ITAT has considered Supreme court’s decision in the case of Rashiklal & Co Vs CIT [1998] 229 ITR 458, to support  the remuneration claim as allowable  u/s. 40[b] of IT Act.  However, it is left with the assessing  officer to assess the remuneration either in the hands of the individual or in the hands of HUF.  Ref  :  Vanson Kids Stuff Vs ACIT, 79 TTJ 155

Other cases for reference:

1. CIT Vs KALU BABULALCHAND (1959) 37 ITR 123 (SC)

2. Mathura Prasad Vs CIT (1966) 60 ITR 428 (SC)

3. M.Dhanwatey Vs CIT (1968) 68 ITR 385

4. Tolaram Brij Buwar Vs CIT (1978) 112 ITR 750 (SC)

5. T.L.Agarwalla Vs CIT (1978) 114 ITR 471 (SC).

6. Smruthi Trading Co., Vs ITO (2001) 118 Taxman 151.

remuneration vs cash system:

Assessee is a firm following cash system of accounting.  At the end of the year, it earns profit of Rs.5 lakhs and debit Rs.1,80,000/- by way of journal entry to partners’ remuneration.  Partners do not withdraw the amount.

In the second year also it earns a profit of Rs.5 Lakhs and debit Rs.1,80,000/- by journal entry to partners’ remuneration.  In the same year, there are withdrawals by partners of Rs.2 Lakhs.  What will be the amount of remuneration allowable in the second year?  Whether Rs.1,80,000/- or Rs.3,60,000/-.  There are strong points even in the cash  system,  if the partners account credited with remuneration, it can be considered as payment.  Hence each year  remuneration can be claimed as expenditure in the hands of the firm.

partners remuneration vs claims:

An assessee has borrowed money from outsider for investing in a firm in which he is getting remuneration as a working partner.  He has paid interest towards the borrowing and claimed it as expenses against the remuneration received.  Can it be allowed?

In the case of Santhosh Kumar Agarwal Vs ACIT 78 ITD 394 (SMC) the Mumbai Tribunal allowed the above claim on the basis of Supreme Court ruling in CIT Vs R.M.Chidambaram Pillai 106 ITR 292.

terms of the partnership deed vs remuneration

A partnership firm consisting of 4 partners in which each partner is entitled to claim Rs. 20000/- as remuneration.  Due to non availability of profit,  the partners have claimed Rs.17000/- per partner as remuneration,  in the books.  The AO has taken the view that remuneration   paid is less than the amount specified in the partnership Deed.  Hence it is not in accordance with the Deed and is not allowable in computing the income of the firm.  The firm was able to demonstrate, though there is a clause in the partnership Deed for higher remuneration, but the allowability under the Act is less than the amounts specified in the Deed due to over all ceiling specified u/s. 40[b] [v].

The Tribunal has considered and held that since the overall remuneration paid is within the limits specified under 40[b] [v] the remuneration paid by the firm was allowable.  Ref : Gopal Dass Kulwant Rai Vs ITO (2004) 88 ITD 445 (Chand)

Allowability of remuneration on returned income and assessed income:

We have seen in number of cases that in the assessment,  the returned income is increased by the assessing officer.  A partnership firm would have filed its return of income, where it may not be possible to allow the full remuneration as per deed.  But the assessing officer may determine higher income or would not allow loss after disallowing certain deduction. Whether the partner can get full deduction of remuneration based on the assessed income?

Though the income determined by the assessing officer is subject to test before the appellate authorities, which  has legal sanctity. More over he has to compute the income as per chapter IV D,  hence the assessee is entitled to claim allowable remuneration as per law. Consequently it has to be assessed in the hands of the partner as per proviso to section 28(v) and section 2(24)(ve) of the Income-tax Act.  The assessing officer may option to rectify the partners’ assessments.  But, in certain circumstances the assessing officer may not allow the remuneration on the assessed income as it results in revenue loss,  if it is distributed in the hands of partner.

death/retirement  of a partner during the financial year.

Death/retirement of a partner during the lifetime of the partnership firm is yet another clause in respect of dissolution/continuance of firm etc., in partnership deed in the event of the death of a partner amounts to change in constitution of firm and whether section 187/188 is attracted or not etc.,

The decision in CIT Vs Surya Bhagawan Vastralayam (AP) helps us to arrive at the following conclusions:

From a reading of section 187 & 188 it is clear that if there is a change in the constitution of the firm, Section 187 is attracted and single assessment has to be made on the firm as constituted at the time of making the assessment and the death of a partner is not treated as a fact for changing the constitution of the firm for purpose of the section.

Depending upon the clauses mentioned in the partnership deed,   we have to look into,  whether a firm stands to continue (or) be dissolved on death or retirement of a partner.  This question is squarely covered by a decision of the Supreme Court in the case of  CIT Vs Empire Estate (1996) 218 ITR 355 in which, the court held that “Section 188 states that where a firm carrying on a business is succeeded by another firm and the case is not covered by section 187, separate assessments have to be made on the predecessor firm & the successor firm.  “change in constitution of the firm is defined for the purpose.

Other cases ref:

CIT Vs T.Naggi Reddy (1993) 202 ITR 233 (SC)

Nava Jeevam Udyog Mandir (P) Ltd., Vs CIT (1994) 207 ITR 40 (Guj)

In case of death of one of the partner and where the deed is silent regarding the continuance of the firm then there will be two assessments on the firm. For the period upto the date of death and the period thereafter.

Wazir Ali Vs CIT (1988) 169 ITR 76 (SC).

application of sec. 45(4) – Dissolution  Vs reconstitution

The partnership firms with immovable properties are now vulnerable for tax litigation in case of retirement and dissolution in view of section 45(4). While considering applicability of section 45(4), on distribution of assets by firm to partners, it should be well analysed,  if such distribution of assets by the firm to the partners,  is a case of distribution of the capital asset of the firm by withdrawal by the partner or sale of the capital asset of the firm to the partner.  Here, distribution will have to be defined and further be understood that no consideration is involved in distribution as was held by the Bombay Tribunal in Burlington’s Exports Vs CIT (1993) 45 ITD 424.

For attracting the provisions of Section 45(4), mere dissolution alone is not sufficient but, there should be distribution of the assets also.

The decision rendered by the Madras High Court in CIT Vs Vijayalakshmi Metal Industries (2002) 256 ITR 540 (Mad), it was held that the dissolution may take place in one year and distribution may be in future.

In this case, if  two partners carried on the business and one of them expired.  Naturally, by the operation of law the firm was dissolved.  There is no distribution of assets though the business continued.  As per the wording in section 45(4) “the previous year in which the transfer takes place” the capital gain tax liability will arise.

The decision rendered in CIT Vs Thermoflics India ( 1997) 60 ITD 554 ( Jab-Tri) is important  as regards Sec 45(4).  As per this decision, even-though the tax liability under capital gain arising out of dissolution of firms,  is taxable,  since the word   “ Transfer “ as defined by Sec  2(47) of Income Tax Act 1961 is not amended,  the  asset distribution  and the dissolution will not attract the capital gains tax.

In another case,  it was held that, as per sec 45(4) which itself,   is a charging Section, so there is no need for a separate amendment in the definition of  capital asset. As per the decision rendered in  Swamy Studio Vs ITO 66 ITD 276 (Mad) the tribunal held that “ Section 45(4) is a separate code by itself,  providing for a levy of capital gain tax,  on distribution of assets among the partners on dissolution of the firm. Charge of tax and legislative intent cannot be defeated by referring to the definition “Transfer” given in section 2(47), which is a  restrictive definition and not applicable to the provisions of section 45(4) because it is a charging section”.

The core question is whether changes  resulted in the reconstitution,   will be considered as dissolution of the firm. In  CIT Vs Pigot Champan & Co. AIR 1982 SC. 1085,  it was held that “  It can not be disputed that dissolution and reconstitution are two distinct legal concepts, for, a dissolution brings the partnership while a reconstitution means the continuation of partnership under altered circumstances. i.e. Disappearance of the original firm and the birth of the new firm “.

In the case of Vishwanath Seth Vs CIT (1984) 146 ITR 249,held that “Reconstitution without dissolution does not bring into existence a new firm. In case of reconstitution, the same firm continues to exist”. The Calcutta and Madras High Courts expressed the same view.

Other cases ref:

Sohanlal Pachisia &  Co., Vs Bilasray Khemani  AIR (1954) Cal 179 and

Meenakshi Achi Vs P.S.M.Subramanian Chettiyar AIT(1957)Mad 8.

The Apex court affirmed the view in  CIT  Vs A.W.Figgies & Co., (1953) 24 ITR 405 and held that “…..The reconstituted firm can carry on its business in the same firm’s name till dissolution…” In  CIT Vs Sant Lal Arvind  Kumar (1982) 136 ITR 379, Delhi High Court expressed the view that “….If one can imagine a partnership as an association of persons bound by a legal type or vinculum juris, a change in the constitution of the firm reflects only an adjustment of this legal tie which binds the partners. It is as if there is a belt which encircles all these partners and the belt either shrinks or expands to accommodate or give effect to an incoming or out going partner. A dissolution, on the other hand, is a breaking or a disruption of this legal tie………..”

It is thus beyond doubt that under the Indian partnership Act, the same firm continues to exist in spite of change in its constitution and that it ceases to exist only on its dissolution that being so, there is no case of transfer.

As per the Tribunal decision Dy. CIT Vs G.K.Enterprises (2003) 79 TTJ 02 (Mad), there is no capital gain tax u/s 45(4) in the case of retirement of a partner from a firm.

The decision rendered by the Karnataka High Court in CIT Vs Manglore Ganesh Beedi Works (2004) 256 ITR 658 (Kar),  is an another view relating to the dissolution of a firm and its subsequent continuance of the business,  by the erstwhile partners as AOP, which will not attract Section 45(4) and no Capital gain tax will arise for the firm or AOP.

The Kerala High Court in the case of CIT Vs Kunnamkulam Mills Board (2002) 257 ITR 544 (Ker) held that,  the retirement of partner from the firm after receiving their credit balances will not be covered u/s 45(4) of the Income-tax Act.  In this case the assets have been revalued and the amounts were credited in the partners account.  The partners have received larger amounts on their retirement from the firm.

The decision rendered by the Bombay High Court in CIT Vs A.N. Naik Associates and another (2004) 265 ITR 346 (Bom), will create yet another confusion about the word “ otherwise” in Section 45(4). As per this decision, if the retiring partner receives any property during the subsistence of the firm even without dissolution, Section 45(4) will attract and the firm is liable to pay capital gain tax.

income accrued but waived after the previous year-ends.

Whether the partners,  can decide not to charge interest or waive the same?  What is the treatment in the hands of the partners?

It should be treated as income in the hands of the partner even though no charge of interest is made in the books of firm and It is only application of income as taxable .

Ref : CIT Vs KRMTT.  Thiagaraja Chetty & Co. (1953) 24 ITR 25, SBT Vs CIT  158 ITR 102, CIT Vs Shiva Prakash Janakraj & Co., (P) Ltd., 222 ITR 583 Ref : Saraswathi Insurance Co. Ltd., Vs CIT 116 Taxman 306 (Del)

book profit

The remuneration to partners depends upon the computation of book profit of the firm.  The allowability will vary with reference to this computation.  As per the explanation 3 to section 40 (b) the “book profit” means, the net profit as per profit and loss account which has to be arrived in the manner laid down under chapter IV – D of the Income-tax Act.  The firm has to compute the taxable income before claiming the remuneration to partners allowable as per section 40 (b).

computation of partners remuneration, carry forward losses & unabsorbed  depreciation:-

Is it necessary to consider,  the carry forward and set off of losses and unabsorbed depreciation,  to compute the book profit to arrive at the eligible remuneration allowable to the partners?

The carry forward  and set off of losses is governed by chapter VI hence it has no bearing on the book profit computation under chapter IVD. However the unabsorbed depreciation requires a different treatment.

The old section 32,  has been re-incorporated by the finance Act 2001.  The decision rendered by the Supreme Court in CIT Vs Viramani Industries (P) Ltd., (1995) 216 ITR 607 is applicable to the present section 32.  The independent operation of section 32(2) in chapter IVD has to be applied for purpose of computation of book profit.

The unabsorbed depreciation has to be considered as current depreciation. Hence for the purpose of arriving at the book profit u/s.40 (b) the unabsorbed depreciation has to be considered w.e.f. the Asst. year 2002-2003,   to  determine the allowable  remuneration.

Another view is that unabsorbed depreciation,  need not be treated as current year depreciation,  for arriving at the book profit  of the firm as the same was already adjusted in the earlier years.

The brought forward loss precedes unabsorbed depreciation even as specifically provided under section 72(2).  The Supreme Court has taken the same view in CIT Vs Mother India Refrigeration Industries [P] Ltd., (1985) 155 ITR 711(SC).  This conclusion may support the view that the unabsorbed depreciation need not be considered,  to arrive at book profit.

book profit vs income-tax liability

The remuneration fixed on the basis of percentage of net profit is  another area of controversy as to whether the net profit arrived for the purpose of business income as per the IT Act has to be taken or merely deduct all the expenses including the income-tax liabilities.  As per the decision rendered by the Kerala high court in the case of CIT Vs  Kajaha Co [2004] 266 ITR 122, the income tax liability need  not be deducted both under the general law and under the IT law to arrive at the allowable remuneration  on a certain percentage of net profit.  I would like to draw your attention to this decision with reference to deferred tax liability or asset as per AS 22 which is applicable for non-corporate entities for the assessment year 2004-2005.


Interest paid to partners on current account whether admissible?

The petitioner,  assessee claimed interest paid to partner both in respect of capital account and also in current account.  The assessing officer disallowed the claim of interest on current account on the ground that the partnership deed did not authorize payment of interest on current account.  In the case of Novel Distributing Enterprises Vs DCIT & Anr. 251 ITR 704 [Ker],  it was held that,  the disallowance was correct because there was no provision in the partnership deed enabling such payment for the partners’ current account.

interest paid to partners in different capacity

Whether interest paid to a partner for the amount deposited in different capacity allowable?

Even though the partner representing in different capacities either an individual or as partner, the interest paid will not be hit by section 40 (b).   Ref :  CIT Vs Heralal chagan lal (2002) 257 ITR 281 (Raj). In case,  the HUF is a partner the interest can be assessed in the hands of HUF.

interest to other firm

Interest paid by one firm to another firm could not be treated as interest paid to the partners of that firm within the meaning of sec.40 (b) even though the two firms have common partners. CIT V. Nagpur Golden Transport Co. (1998) 233 ITR 389 (Delhi)

interest paid out of borrowing in personal name of the partner

Partner borrowed loan in his Individual capacity from bank and advanced the same to the firm.  The firm repaid the loan and interest to bank directly.  This cannot be disallowed u/s 40(b) but allowable as interest paid. Dy. CIT Vs Kamala Shankar .P Joshi & Co., (2001) 79 ITD 229 (Mumb- Trib).

revaluation of the asset vs interest payments

A very interesting issue has been considered by the Chandigarh bench of ITAT in the case of ACIT Vs Sant Shoes Store [2004] 88 ITD 524 [CHD] [SMC]. In this case a firm,  has revalued their assets and the revalued amount has been credited in the accounts of the partners. The firm has paid interest on the revalued amount credited in the partners’ account.

The AO has taken the view that the credit entry represents only notional introduction  of capital and no actual contribution by the partners. Hence assessing officer,  recalculated the interest and disallowed the same to the extent of the revalued amount credited in the partners’ account.

The tribunal has taken the view that the appreciation in the value of the building which  belongs to the partners under general law cannot be ignored.  The accretion, increase, profit or gains in any shape and form accruing in the course of the business or during subsistence of the partnership belonging to the partners according to the share in the partnership. Hence the interest on the capital can be allowed as an  expenditure in the hands of the firm.

set off losses

As per sec. 78[1] while carrying forward the loss and subsequent by set off care should be taken with ref. to the change in constitution of the firm.  The change due to retirement or demise of a partner will affect the carry forward loss of the firm since the loss to the extent of the retired or deceased partner has to be reduced for carrying forward to the subsequent year.

illegal firm

Whether the assessing officer has power to disallow interest or remuneration or both?

A firm constituted with five partners on the basis of licence in the name of one of the partner.  The partners claimed interest and salary.  The assessing officer refused to allow the interest and salary and decided that the firm is not a valid firm since there is no licence in the name of the firm and there is a restriction in the licence for the usage other than the person in whose name the licence was approved.

In the case of Abkari Law, Arms Act the Supreme court held that if there is a specific prohibition in law for forming the partnership for the usage the licence the firm will be considered as illegal one.  Hence applying this analogy the firm cannot be considered as a valid one eligible to be treated as firm under Income-tax Act. Ref:  CIT Vs Ragila Ram (2002) 254 ITR 230 (SC, Bihari Lal Jaiswal Vs CIT (1996) 217 ITR 746 (SC).

A  question of allowability of the remuneration and interest paid to partners have to be considered in each case.

Partner of a professional firm received remuneration from firm exceeding Rs.10 Lakhs p.a- Whether Tax Audit u/s 44AB necessary?

Yes.  Ref Explanation 2 to section 15 and Section 28(1)

Whether material supplied by contractee is to be included in gross turnover of contractor?

In the case of Piyare Lal Hari Singh Vs CIT (2001) 117 Taxman 1/252 ITR 739 (Delhi) on the basis of the decision of the Supreme Court in Brij Bhushan Lal Parduman Kumar Vs CIT (1978) 115 ITR 524 (SC), value of materials supplied by contractee is not to be included in gross turnover of contractor-firm while estimating profits.  But in the case of a single contract consisting of supply of material and construction entered by the contractor with contractee exceeds Rs.40 lakhs,    he  has to maintain the books of accounts and subject to tax audit as per the institute’s guidance note.

However the different views are possible to apply sec.44AD and 44 AB.  The AS7 applicable for the construction contracts.  Since the percentage of completion contract method, has to be applied the question will arise whether the gross advance to be taken as gross receipt for the purpose of sec.44 AB or billed amount should be taken into consideration.

An assessee owns more than one business. The aggregate annual turnover of all business exceeds Rs.40 lakhs, but the turnover on individual item of business is less than Rs.40 lakhs.          Will tax audit u/s 44AB be applicable? If yes, how Form 3CB/3CD shall be furnished, as consolidated or not?

To examine whether an assessee attracts the provisions of  Sec 44AB.  We have to take into account the gross receipts/sales of all businesses carried on by him.  Hence the assessee should be considered as a unit for all his business receipts for determination of tax audit u/s 44AB.

An assessee carries on more than one business.  Report u/s 44AB has to be given only in respect of the assessee.


‘plant’ not to include buildings or furniture and fittings

Section 43(3) has amended expressly and  excluded buildings or furniture and fittings from the definition of the word ‘plant’. Section 43(3) defines the word ‘plant’ in an inclusive manner, i.e., plant includes vehicles, books, scientific apparatus and surgical instruments used for the purpose of business or profession but do not include tea bushes or livestock. The words ‘but does not include tea bushes or live stock’ are being extended by the addition of the words ‘building or furniture and fittings’. This amendment will overcome the difficulty arising because of the interpretation given in certain judgments of the courts relating to plant and machinery.

Whether building is treated as plant, when it can be considered as a means of carrying on business?

Where assessee with a definite purpose, considering the nature of business carried on by him, constructs a building with specific required design keeping in view specified technical requirement, without which assessee’s business cannot be carried out, the building in question would qualify as plant for the purpose of section 32 of IT Act. Ref: Nowrangroy Metals Pvt Ltd Vs. JCIT (2003) 262 ITR 231.

Supreme Court has held that Hotel Building is not a plant.  However the operation theatre of the hospital is a plant.  Ref : CIT Vs Anand Theatres (2000) 244 ITR (SC), CIT Vs Dr.B.V.Rao 243 ITR  (SC).  Now it is very clear that building etc., will not constitute as plant

Whether the depreciation has been claimed under the cash basis system of accounting?  If, yes on what amount?

Yes. Full value.

Is it optional?

The Supreme Court’s decision in Mahendra Mills’s case was nullified by the Finance Act 2001.  It is mandatory on the part of the Assessing Officer to allow the depreciation as per the section 32 in computing the income.

In the tax audit report in Form 3CD the auditor has to give details about the depreciation claim, addition and deletion of assets?

In case the assessee does not want to claim depreciation the fact should be mentioned in the report.

Is the concept of “used” in the business, shall hold good under law?

Depreciation can be allowed only on machinery or plant or other asset used in the business.  Now the block asset concept is in the statute. Even if any of the assets purchased during the year is not put into use but the existing asset in the same block is used in business it is enough to claim depreciation.  Because, once new plant or machinery is purchased it will be merged with the block.

Even in the earlier law if the assets are ready to use it is eligible for depreciation.

Whittle Anderson Ltd., Vs CIT (1971) 79 ITR 613 (Bom)

Capital Bus Servies (P) Ltd., Vs CIT (1980) 123 ITR 404 (Del).

Machineries not used because of labour unrest?

In CIT Vs Vayithri Plantations Ltd., (1981) 128 ITR 675 (Mad)

Where the machinery was not used because of labour unrest, even then the assessee was held entitled to depreciation because of passive user. Temporary Closure due to crop failure – eligible for depreciation. Ref CIT Vs Refrigerators & Allied Industries 163 ITR  498 (Del)


In Mysore Minerals Ltd V. CIT 239 ITR 775 (SC), the assessee is in possession of the building on payment of part of the sale consideration. Building not registered in the name of the assessee by the Housing Board. The assessee has dominion over the property and in its own right allotted the building as quarters to the staff. The staff is actually using the building. The assessee is held to be entitled to depreciation as a wide meaning  must be given to the term ‘owner ‘ used u/s 32.

Whether depreciation u/s 32(1) on building is allowable though  transfer is not effected by means of registered instrument?

The full bench of the Punjab & Haryana High Court in 251 ITR 830 held that the Tribunal was right in holding that the assessee was entitled to claim the depreciation on building although the transfer of the building was not effected by means of registered instrument. Mysore Minerals Ltd., Vs CIT (1999) 239 ITR 775 SC; Dalmia Cement (Bharath) Ltd., Vs CIT (2001) 247 ITR 267SC

full  amount claimed as revenue.

Depreciation u/s 32 for the assets purchased u/s 35 claimed full deduction – not permitted.  Escorts Ltd., Vs UOI 199 ITR 43 (SC), CIT Vs HICO Products (P) Ltd., 247 ITR 797 (SC)

Whether depreciation is allowable on spare engines kept by the assessee in store?

Yes. The Punjab & Haryana High Court held that there is a normal depreciation of value even when a machine or equipment is merely kept in storeroom.  Thus actual use of the asset may not be the relevant test in all cases.

CIT Vs Pepsu Road Transport Corpn. [2002] 121 Taxman 232.

Whether depreciation is admissible for trial run of machinery?

It was held in the case ACIT Vs Ashima Syntex Ltd., (251 ITR 133 Guj HC) that when there is commencement of business by way of production of articles it can be said that the assessee is entitled to depreciation.

Whether Vehicles registered in the name of the partners but firm is claiming depreciation?

In CIT Vs Mohd Bux Shokat Ali (1) (2002) 256 ITR 355 (Raj) the Rajasthan High court held that the Tribunal allowed the appeal of the assessee and  the department’s, reference application was rejected on the basis that no question of law was involved.  The High Court held it as a question of law.  But in the subsequent decision for the same assessee in CIT Vs Mohd Bux Shokat Ali (2) on the basis of Supreme Court decision in Mysore Minerals Ltd., Vs CIT (1999) 239 ITR 775 (SC) held no question of law involved. The above decision can be applied for claiming depreciation for the assets in the name of partners.

Can the rigs mounted on lorries eligible for higher depreciation?

No. The Madras High Court disallowed the assessee’s claim in CIT Vs Arihant Trust (2001) 251 ITR 149 (MAD)

Can the Air Conditioner fitted in the bus forms part of integral part and eligible for higher depreciation available for buses?

Yes. As per the decision rendered by the Delhi High Court in CIT Vs Delhi Airport Service (2002) 255 ITR 91 (Del)

What would be the duty of the tax auditor if the department disallows the claim of depreciation on fixed assets in the earlier year?

If there is any dispute regarding classification, rate of depreciation or etc., with the department the tax auditor should make suitable disclosure depending upon the fact and circumstance of the case.


The usage of the company vehicles by the Directors cannot be treated as personal use of the company vehicles and cannot be treated as personal expenses of the company. Ref : Sayaji Iron and Eng. Co. Vs CIT (2002) 253 ITR 749 (Guj)

The expenses incurred for the partners foreign tour expenses for higher studies was allowed as business expenditure.  The partners experience will be utilised for the firm in future.In CIT Vs Kohinoor Paper Products (1997) 226 ITR 220 (MP)

Whether expenditure on education abroad of son of partner who is also a partner of the firm is an allowable expenditure?

It was held in the case of M.Subramaniam Bros. Vs CIT (250 ITR 769 (2001) MDS HC) that the expenditure on the education of the partner of the firm was of personal nature and was not business expenditure.

Financial Directors and his wife travelling and medical expenses incurred allowed as business expenditure. Ref: CIT Vs Steel Ingot (P) Ltd., (1996) 220 ITR 552 (MP)

Foreign tour expenses incurred for the wife of the chief executive is considered as business expenditure. Ref: CIT Vs Aspinwall & Co., Ltd., (1953) 231 ITR 106 [Ker],  CIT Vs Appollot Tyre Ltd., (1999) 237 ITR 706 [Ker]

sec.36(1)(iii): interest on borrowed capital – personal nature

In the assessment proceedings the assessing officer may disallow the interest paid to bankers and others on account of the following reasons

1. Interest free advance made to subsidiary companies.

2. Interest free advance or loan to partners or sister concerns.

The assessing officer cannot make any addition merely because of interest free advance or loan.  He must prove the nexus of borrowing and lending otherwise this disallowance cannot be made. Ref : D & H Secheron Electrodes (P) Ltd., Vs CIT (1983) 142 ITR 528 (MP),     CIT Vs Coimbatore Salem Transport (P) Ltd., (1966) 61ITR 480 (Mad)

In Addl. CIT Vs Laxmi Agents (P) Ltd., (1980) 125 ITR 227 (Guj), applied in the present case, it was held that once it is established that the capital was borrowed for the purpose of business, it is immaterial as to how that borrowed capital was applied for the purpose of business, because all that Section 36(1) (iii) requires is that the borrowing on which the interest is paid should be used for the purpose of business.

In CIT Vs Sethani Indermani Jata (1978) 114 ITR 539 (All), not referred in the present case, it was held that the entire interest paid to a bank on loan taken for the business purpose is allowable as deduction though part of loan amount is utilised for advancing interest-free loan to various parties. Patel India (P)Ltd. Vs Deputy Commissioner of Income-tax (1999) 63 TTJ 19.

Interest on borrowed funds disallowed to the extent of diversion of funds to sister concerns as interest free advance. Interest disallowance same rate as applicable to the bank borrowings – Saraya Sugar Mills (P) Ltd., Vs CIT 120 Taxman 411 (All)

interest on borrowed capital

Interest  on borrowed capital u/s 36(1)(iii)-when machinery purchased and the machinery has not been put into use in the previous year.  Whether such interest is allowable?

Interest on Borrowings – section 36 (1) (iii)

For the assessment year 2004-2005 the investment made in plant or machinery or building out of borrowings,  require close scrutiny.  After the amendment in section 36 (1) (iii) if the machinery or plant or building etc., are not put into use for the current year the interest on borrowings cannot be allowed as deductions.

term loan interest

Whether the conversion of interest due into term loan can be considered as payment u/s 43B?

No. As per the decision rendered by the Madras High Court in Kalpana Lamp and Components Ltd., (2002) ITR 491 (MAD) can  not be allowed as payment.  It is also not part with the sales tax loan allowed by the state Government.

Statutory payments were made and the assessee issued a cheque towards statutory payment on 31st March 2004 but the realisation was made after 15 days.  Is it an allowable claim?

As per the second proviso of section 43B the cheque should be realised within 15 days.  It is not the fault of the assessee. Ref: CIT Vs Hindustan Wire Products Ltd., (2002)120 Taxman 744 (Pun & Har)

What is the duty of the tax auditor of subcontractor regarding the PF Payment made by the main contractor on behalf of him where the liability in this regard is on the main contractor?

The tax auditor certifies only in respect of his assessee accounts and need not report of other’s liabilities.

Has the tax auditor to report about the professional tax deducted from the employees but not paid to the concerned authorities?

The tax auditor need not report as to whether the professional tax deducted by employer from the salary paid to employee has been paid to the credit of the concerned authorities.

Capital or revenue

New Explanation – for the removal of doubts, it is hereby declared that the amount paid on account of the cost of repairs referred to in sub-clause (i) and the amount paid on account of current repairs referred to in sub-clause (ii), of clause (a), shall not include any expenditure in the nature of capital expenditure.

repairs to buildings (s.30):

By explanation added in S.30, it is now provided that cost of repairs and current repairs to building used for business or profession shall not include expenditure in the nature of capital expenditure. This amendment as well as amendments in S.31 and S.36 will invite litigation and will upset the well-settled law on the subject. In spite of this amendment, it will be possible to take the view that renovation of any part of building (S. 30) or replacement of any part of machinery or plant (S. 31) does not amount to expenditure in the nature of capital expenditure.

The Supreme court decision in Madras Auto Services (P) Ltd., clearly held that the building constructed on the leasehold land amount to revenue expenditure and will be applicable for the assessment year 2004-2005.

Replacing subsidiary parts of a whole asset is Revenue expenditure. Replacement of machines forming integrated plant will be allowable as deduction.

CIT Vs Sri Hari Mills [1999] 237 ITR 188 (Mad)

Section 31

New Explanation – for the removal of doubts, it is hereby declared that the amount paid on account of current repairs shall not include any expenditure in the nature of capital expenditure.

The above two sections deal with the deduction allowable under income from business or profession.

The word “current” referred in section 31 means expenditure incurred relating to that current accounting period or year.  The expenses incurred after such event  of repair occurred.

As per the Calcutta High Court’s decision, in Humayun Properties Ltd., Vs CIT (1962) 44 ITR 73 (Cal) the current repairs are necessary repairs to maintain the building plant etc., They are not luxury repairs, the element of need being implicit in the expression.

In the case of CIT Vs Chowgule & Co., (P) Ltd., (1995) 214 ITR 523 (Bom) certain, conditions have been fixed to allow deduction u/s 31 of the Income-tax Act.  As per the decision, the “current repair” means repairs undertaken in the normal course of user for the purpose of preservation, maintenance or proper utilization or for restoring plant and machinery to its original condition.

Current Repairs Vs Repairs:  –

The Madras High Court in CIT Vs Sriram Sugar Mills Ltd., 21 ITR 191 held that the meaning of the word “current” is not petty expenses but it means “belonging to the present time, prevailing”.  In this case the assessee incurred expenditure for replacement of an old boiler by a new one but exactly similar boiler.  The expenditure incurred was allowed as revenue expenditure.

In the case of Gridhari Dass & Sons Vs CIT (1976) 105 ITR (ALL) it was held that the “current repairs” means only such repairs as are necessitated by the day-to day wear and tear during the relevant previous year only, while “repairs” may mean accumulated repairs of several years.

On an analysis of Mysore High Court decision in the case of Hanuman Motor Services Vs CIT (1967) 66 ITR 88, it is seen that the result of the expenditure what is being done for the purpose of preserving and maintaining the existing asset is a repair.  But the object of the expenditure is to bring out a new asset as replacement renewal.

The replacement of petrol engine by Diesel engine in buses was held as revenue expenditure (CIT Vs Khalsa Mirbhai Transport Co. Ltd., (1971) 82 ITR 741 (P&H) Addl.  CIT Vs Desai Brows (1997) 108 ITR 14 Guj) CIT Vs Mohd. Ishaque Mohd. Gulam 210 ITR 817 MP.

The replacement of old engine by a new one in a motor vehicle was held as revenue expenditure Nathmal Bankatlal Patrik & Co., Vs CIT (1980) 122 ITR 168 (AP-FB) and CIT Vs Jaferbhai Akbharath & Brs. 211 ITR 496 (Bomb).

In the case of CIT Vs Co-op Sugars Ltd., (99 Taxman 93 KER) (1998) the Kerala High Court held on the basis of the observation of the Supreme Court in the case of Alembic Chemical Works Co. Ltd., Vs CIT (1989) (177 ITR 377/43 Taxman 312 SC) that the end product viz.  Sugar would be available only after the entire processing is complete and that would be complete only after the completion of the processing through all the machinery on which the assessee incurred the expenditure.  The High Court thus allowed the entire expenditure on the replacement of entire new machineries as revenue u/s. 37(1) of the IT Act 1961.

The Supreme Court’s decision rendered in the case of CIT Vs Alembic Chemicals Ltd., (1989) 177 ITR 377 (SC) wherein it was held that the expenditure incurred for advantage of business was a revenue nature.

The Kerala High Court in the Case of CIT Vs Steel Complex Ltd., (1999) 238 ITR 1054 held that expenditure incurred for water treatment plant and fume extraction plant without increasing the production capacity in allowable as revenue expenditure.

Ref: CIT Vs Madras Cements Ltd., (2002) 255 ITR 243., the decision rendered by the Madras High Court in the above case has distinguished the repairs, replacement and current repair.

“Repair” implies the existence of a thing which has malfunctioned and can be set right by effecting repairs which may involve replacement of some parts, thereby making the thing as efficient as it was before or as close to it as possible.

The Calcutta High Court has held in the case of CIT Vs Hindustan Pilkingston Glass Works Ltd., (1994) 673 Taxman 631 (Cal) that the assessee engaged in manufacturing rolled plate glass, demolished old furnace and reconstructed new one claimed as capital expenditure and subsequently in revised return claimed it as revenue expenditure under current repair.   High Court held that it was not a current repair.

In the case of CIT Vs Mahalakshmi Textiles Mills Ltd., (1967) 66 ITR 710, the Supreme Court held that the claim u/s 31 on the ground that the new system introduced is not new machinery or plant but amounted to improved version of certain parts.

In the case of Madras Spinners Ltd., Vs CIT 107 ITR (KER) the Kerala High Court has allowed the modernisation programme by the Mill by spending amount on replacing certain parts of the machinery as revenue expenditure.

The Kerala High Court has taken the same view in CIT Vs Sree Bhagavathi Textiles Ltd., 207 ITR826 (Ker) and also in Vanaja Textile Mills Ltd., Vs CIT 208 ITR (Ker). In both these cases the assessee incurred certain expenditure towards modernisation of machineries for replacing certain parts and converting certain part of plant and machineries to improve the efficiency of their units.  As there was no new plant or machinery, which came into existence, it was allowed as revenue expenditure.

The Supreme Court in Ballimal Nawal Kishore Vs CIT 224 ITR 414 held substantial amount  spent to convert the ginning factory as capital expenditure. The decision rendered by the Madras High Court in Sri Hari Mills Case is that the modernisation expenditure has been considered and allowed as current repairs.  But there is no reference about the Supreme Court’s decision in 224 ITR 414.

The Rajasthan High Court in CIT Vs Udaipur Distillary Co Ltd (2004) 134 Taxman 616 held that, the replacement cost of new transformer is a revenue expenditure even though the old transformer form part of the block assets and not sold or discarded by the assessee.

The Madras High Court in the case of CIT Vs Gitanjali Mills Ltd., (2004) 265 ITR 681, has allowed the expenditure incurred for the replacement of machineries at a cost of Rs.63,80,131 as revenue expenditure u/s 37.

Ref : Any expenditure incurred by assessee for improving the performance of its machines was to be allowed as revenue expenditure u/s 37. Hence the present amendment will not hold good for any expenditure covered u/s 37 of the IT Act 1961.

retrospective effect:

This amendment is not applicable for the pending assessments. This amendment though clarified one but in view of the decision rendered by the Kerala High court in CIT Vs Kerala Electric Lamp Works Ltd., (2003) 261 ITR 721 (Ker) with reference to Finance Act 2001 relating to mandatory requirement of claim of depreciation held that these amendments are to be clarified, which are prospective in nature.  Ref: Tuticorin Spinning Mills Ltd. Vs. (2003) 201 ITR 291 (Mad). Section 32 (1) (iia) inserted :

Whether the amount of liquidated damages received by the assessee for the delay in delivery of the capital asset, is capital or revenue?

It has been held in CIT Vs Surashtra Cement & Chemical Industries Ltd., (2002) 121 Taxman 223 (Guj) that the amount received,  was capital in nature since the amount of damages received had a direct nexus with the delay caused in the delivery of the capital asset.

The loan is taken at higher rate of interest by assessee company and given to director at lower rate of interest, whether the difference amount of interest can be disallowed?

Yes.  In a case H.R. Sugar Factory P ltd 187 ITR 363 the loan is not for the business purpose

Whether fees paid to Registrar of Companies for enhancement of capital, is an allowable expense u/s 37(1)?

The fees paid to ROC for enhancement of Capital is a capital Expenditure and not deductible u/s 37 (1), Punjab State Industrial Development Corporation Ltd Vs CIT (SC) 225 ITR 792. But the expenses incurred on raising finance through borrowers either by issue of debentures or otherwise is deductible as revenue expenditure as per decisions of India Cement ltd Vs CIT 60 ITR 52

Whether expenditure on issue of share capital is an allowable expenditure?

The expenditure on issue of share capital treated as capital expenditure and not allowable as business expenditure. Ref: Brooke Bond India Ltd VS CIT (SC) 225 ITR 798.

Interest on income during the construction period taxable as per the decision rendered in Tuticorin Alkali Chemicals & Fertilizers Ltd., Vs CIT (1997) 227 ITR 172 (SC).

Income from guesthouse rent,  plant hire charges are not taxable but deductible from the cost of the project. Ref: CIT Vs Bokaro Steels Ltd., (1999) 236 ITR 315, Bongagigaon Refinery of Petro Chemicals Ltd., Vs CIT 251 ITR 329 (SC).

269SS and share application money

The recent decision of Jharkhand High Court  in Bhalotia Engineering Works P ltd Vs CIT(2005) 275 ITR 399 held that the share application money will attract  Section 269SS.


When the credit will be given?

Majority of the assessees who are following cash system of accounting and those who are following mercantile system of accounting face the problem of getting credit for the tax deduction made on their payments. As per section 199 the TDS amount paid to the credit of Central Government shall be treated as a payment of tax on behalf of the person from whose income the deduction was made.  The credit will be given to him in the assessment on production of certificate furnished u/s 203.

TDS credit for tax paid shall be given for the assessment year for which the corresponding income is assessable.

There are number of instances when tax has been deducted but not remitted to the Government. account. The decision of Gauhati High Court in the case ACIT Vs Om Prakash Gattani (2000) 242 ITR 638 where in held that the payee will not have any control on the deductor for the proper remittance to the Government.  Hence the payee should not be penalised but the credit should be given to him.

Non-deduction of tax and section 40(a)(ia)

The Tax auditor has to take larger burden in discharging his duty in case if the taxpayer failed to deduct or after deduction failed to remit the government account. The new section is very clear that the above failure will render these expenditures as non-deductible.

filing of tax audit report and penalty u/s 271b

The tax audit report u/s. 44AB has to be filed along with the return of income of the assessee. However the audit report may be filed  first before the due date of  filing even if the return of income is not filed, so as to avoid the penal provisions of section 271B. If the tax audit report is not filed before the due date of filing of return, then penalty would be levied u/s.271B.

However penalty u/s.271B would not be levied if reasonable causes existed, that prevented the assessee from filing return of income and obtaining audit report u/s.44AB.

Penalty u/s.271B is discretionary and not mandatory. The use of word “may direct” in section 271-B indicates the power of the assessing officer. Ref: Indian Handloom Textiles  Vs ITO (1999) 68 ITD560, Asst. CIT Vs Gayatri Traders (1996) 58 ITD 121

Penalty u/s. 271-B is independent from assessment proceedings. It can be  initiated even before compliance of assessment. Asst. CIT Vs Madani Rotles Flour Milss (1997) 71 ITD 274 (Asr)

The counsel to whom the audit report u/s.44AB handed over could not file in  time is a reasonable cause for not filing the report in time. Ref: Lalla Prasad Chaurasia Vs (ITO) (1999) 104 Taxman  110 (Jab)

Completion of audit delayed due to statutory auditors is a reasonable cause for  not filing the report in time. Solapuri Zilla Vinkar Sahakali  federation Niyamat Vs. Dy.CIT (1999) 71 ITD 117.

Change of auditor not proved for tax audit purpose. Levy of penalty justified. C.Ramaswamy  Vs. ITJ (1999)63 TTJ (Mad)

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June 2021