Background
This writ petition was filed under Article 226 of the Constitution of India, 1950 seeking quashing of the four notices issued to the petitioner under Section 148 of the Income Tax Act, 1961 for reassessment of the income of the petitioner for the four assessment years 1992-93, 1993-94, 1994-95, 1995-96.
Material Facts
The petitioner is involved in the business of construction and building development. On November 8, 1977, the petitioner, bought a property worth Rs. 3,00,000 and spent an additional amount of Rs. 44,087 on stamp duty and registration charges. All the tenements were put on lease. For the next ten years, the petitioner tried to get the tenants to vacate the property and incurred an additional cost of Rs. 9,92,427 in this regard. As on October 30, 1987, the property was shown on the balance sheet of the petitioner as a fixed asset with a value of Rs. 13,36,514. On November 1, 1987, the petitioner converted the vacated portion of the premises into stock-in-trade and retained the tenanted portion as a fixed asset. Petitioner thereafter demolished the vacant structures and commenced construction of a multi-storied building. In the balance sheet as on 31.03.1989, petitioner reflected the tenanted property as a fixed asset at a cost of Rs. 2,86,740.00 and the stock-in-trade at a value of Rs. 66,29,365.00.
From the assessment year 1992-93, the flats completed construction and the assessee began selling them. For the assessment years 1992-93. 1993-94, 1994-95, 1995-96, the petitioner filed his tax returns accompanied by his profit and loss account, his balance sheet, a tax audit report and detailed explanation letter about the method of computation of income and the nature of activity being carried on.
On March 08, 2000, the petitioner received a notice from the respondent under Section 148 with respect to assessment of income for the above mentioned four assessment years as the Assessing officer believed that the previous returns filed by the assessee had escaped assessment under Section 147 of the Act. On March 31, 2000, the petitioner through his CA wrote to the AO asking for reasons for the said notices and later on in October 17, 2000 the respondent furnished the petitioner with the reasons for having issued those notices. The petitioner then filed this petition before the Bombay High Court pleading for the aforesaid notices to be quashed.
Issues
- What constitutes ‘reason to believe’ under section 147 of the Act?
- Whether capital gains’ tax return on sale of flats in a building is to be filed as and when the individual flats are sold or when all the flats are sold and the co-operative society has been formed?
- Whether expenses incurred on eviction of tenants are deductible under Section 48 of the Income Tax Act, 1961?
- Whether market value of the stock-in-trade on the date of closing of accounts was lower than the cost of acquisition of the stock-in-trade?
- Whether the Assessing Officer was right is assuming jurisdiction under section 147?
- Whether there was sufficient cause for initiating re-assessment proceedings against the assessee?
- Whether closing stock of the land is to be valued at the market price as on the date of closing of accounts for the year concerned or as on the date on which portion of the property was converted into stock-in-trade?
Contentions of the Parties
Arguments of the Petitioner
Senior Advocate Mr. Pardiwala, who was counsel on behalf of the petitioner submitted that the Assessing Officer was wrong to issue notices under section 148 as the requirement of ‘reason to believe’ under Section 147 remained unfulfilled. The main contentions were as under:
Duty of the assessee does not extend to beyond making a true and full disclosure of primary facts. It is for the Assessing Officer to draw correct inference from the primary facts. Once an inference is drawn which may subsequently appear to be erroneous, that would amount to mere change of opinion with regard to that inference and would not justify re-opening of assessment. In other words, there should be live link or close nexus between the materials before the Assessing Officer and the belief formed by him regarding escapement of income from assessment.[1]
Arguments of the Respondent
The respondent had not appointed any counsel to represent itself. However, an affidavit was filed accompanied by the document which mentioned the reasons for issuing the notice. These have been considered by the court as the contentions of the respondent. The respondent specified four grounds for initiating the reassessment proceedings against the petitioner.
- The first and foremost objection of the respondent was with respect to the computation of the value of capital gains. When the assessee began constructing and selling the flats, it reduced the market value of the land in the same ratio as the flat’s area bore to the entire piece of land. However, the assessee considered the closing stock of the land based on its market value as it stood on October 1, 1987, that is on the day when the property was converted into stock-in-trade. This according to the A.O. reduced the profits of the assessee and resulted in escapement of tax. The Assessing Officer submitted that instead the assessee should have calculated the closing stock based on what its market value stood on every accounting year.
- According to the respondent, the ownership of land and the flats being constructed was different. As and when the flats were sold, the assessee proportionately also reduced the value of the property. This should not have been done according to the A.O. as the entire land still vested in the assessee till all the flats were sold and the cost of flats sold could not be deducted.
- The respondent also opposed to deduction of stamp duty, registration charges and costs incurred for eviction of tenants from the market value of the property by the petitioner. Moreover, according to the respondent, these expenses should have been deducted from the market value of only a portion of the property and not the whole property as a portion of the property had been converted into stock-in-trade.
- The fourth and the most far reaching contention of the respondent was that even after construction of building and sale of flat, the land was still under the ownership of the assessee. According to the A.O., the ownership of land was not transferred. As the land continued under the ownership of the assessee, its value could not be reduced on the plea that flat was sold. The whole of the land under ownership of the assessee constituted its stock-in-trade and it should have been valued at the market price as on the date of closing of the accounts for the year under consideration.
Reasoning of the Court
Provisions of the Constitution
This writ petition was under Article 226 of the Constitution which vests powers in a High Court to exert in its territorial jurisdiction the power to issue writs to any person, authority (including the Government) for the purpose of protection of rights guaranteed under Part III or for any other purpose.[2]
Statutory Provisions
While deliberating upon the issues enunciated above, the Bombay High Court referred to the following statutory provisions of the Income Tax Act, 1961:
The first and foremost section relating to tax on capital gains is Section 45 (2) which provides that, “Notwithstanding anything contained in sub-section (1), the profits or gains arising from the transfer by way of conversion by the owner of a capital asset into, or its treatment by him as stock-in-trade of a business carried on by him shall be chargeable to income-tax as his income of the previous year in which such stock-in-trade is sold or otherwise transferred by him and, for the purposes of section 48, the fair market value of the asset on the date of such conversion or treatment shall be deemed to be the full value of the consideration received or accruing as a result of the transfer of the capital asset.”[3]
The third contention of the respondent was rejected by the Bombay High Court as Section 48 squarely deals with the situation and expressly provides that “The income chargeable under the head “Capital gains” shall be computed, by deducting from the full value of the consideration received or accruing as a result of the transfer of the capital asset the following amounts, namely:—
(i) expenditure incurred wholly and exclusively in connection with such transfer;
(ii) the cost of acquisition of the asset and the cost of any improvement thereto…”[4]
The section which authorizes the Assessing Officer to reassess the income of any assessee is section 147. It provides that: “If the Assessing Officer has reason to believe that any income chargeable to tax has escaped assessment for any assessment year, he may, subject to the provisions of sections 148 to 153, assess or reassess such income and also any other income chargeable to tax which has escaped assessment and which comes to his notice subsequently in the course of the proceedings under this section.”[5]
Proviso to Section 147 also sets a time limit of four years for issuing the notice. However, three exceptions have been provided for when the notices may be issued even after four years. They are:
- any income chargeable to tax has escaped assessment for such assessment year by reason of the failure on the part of the assessee to make a return under section 139
- or in response to a notice issued under sub-section (1) of section 142 or section 148
- or to disclose fully and truly all material facts necessary for his assessment, for that assessment year.”[6]
As the A.O had issued the notices in 2000 for assessment years 1992-93, 1993-94 and 1994-95 after the period of four years, the proviso of Section 147 becomes important as the burden lies on the A.O. to prove that the case of the assessee fell under one of the three exceptions mentioned thereunder.
Finally, Section 148 is the provisions which enables an A.O. to issue notice before re-opening re-assessment proceedings against an assessee who the A.O. has reason to believe has escaped tax. Therefore, this provision may be considered as condition precedent before Section 147 can be invoked. It reads ass under:
“Before making the assessment, reassessment or re-computation under section 147, the Assessing Officer shall serve on the assessee a notice requiring him to furnish within such period, as may be specified in the notice, a return of his income or the income of any other person in respect of which he is assessable under this Act during the previous year corresponding to the relevant assessment year.”[7]
Judicial Precedents
The first and foremost issue before the Court was the challenge to the notices issued by the A.O. in the first place. As Section 148 expressly authorizes the A.O. to issue these notices, the authority of the A.O. to issue them is not in question. The only thing that must be looked at is whether the condition precedents specified under Section 147 were complied with. As the notices were issued four years after the concerned assessment years, it was necessary to prove that the matter fell within one of the three situations mentioned under the proviso of Section 147 (1). That burden lay upon the A.O. Moreover, it was to be established that the A.O. had ‘reason to believe’ that the assessee had escaped assessment before sending those notices. In order to construe the meaning of the phrase, the Bombay High Court placed reliance on its decision in the matter of Prashant S. Joshi v. ITO. In that case, a partner of a firm had upon retirement received a sum to the tune of INR 50 lakhs in lieu of settlement of dues. The partner did not add the amount to his income for charging income tax as he claimed the same was a capital receipt and not chargeable to tax. The revenue thought otherwise and issued a notice under Section 148 for reopening of assessment proceedings. The court was faced with the issue whether the revenue authority had ‘reason to believe’ while issuing the said notice.
The claim of the revenue that the said amount was a consideration for the transfer of the partner’s interests to the other partners was rejected by the Court as it cited the ratio of CIT, Gujarat v. Mohanbhai Pamabhai, which held that the amount given to a partner upon termination of partnership is actually his share in partnership assets after adjusting his debts and liabilities.[8]
Once this conclusion was arrived at, the Bombay High Court held that it being established law, no prudent person would have in the given circumstances suspected that the assessee had escaped tax. The principle as laid down by the Bombay High Court in that case is as under:
For issuance of notice, the Assessing Officer must be satisfied that the assessee has understated his income or has claimed excessive loss, deduction, allowance or relief in the return. The taking of such notice must be consistent with the provisions of the applicable law. The act of taking notice cannot be at the arbitrary whim or caprice of the Assessing Officer and must be based on a reasonable foundation.[9]
The Bombay High Court placed reliance on one of the prior decisions of the Supreme Court in which it was held that:
The word “reason” in the phrase “reason to believe” would mean cause or justification. If the Assessing Officer has cause or justification to know or suppose that income had escaped assessment, it can be said to have reason to believe that an income had escaped assessment.[10]
Another judgement that was referred to by the counsel for the petitioner and accepted by the Court was that of Income Tax Officer v. Lakhmani Mewal Das.
The counsel for the Income Tax officer, in that case tried to bring to the notice of the court the change in phraseology between the Acts of 1922 and the Act of 1961. While the former Income Tax Act, 1922 used the phrase, ‘definite information’, the same was lacking in the current Income Tax Act, 1961. Based on this difference, the counsel on behalf of the revenue tried to argue that under the current law in force, reassessment proceedings under Section 147 could be initiated even with information that was vague and remote, that is not definite. The court rejected this submission by opining that though the phrase, ‘definite information’ has not been used, the provisions does use the term, ‘reason to believe’, which implies that there should be existence of some objective parameters. The court backed this up by the opinion that there must be finality to judicial and even quasi-judicial proceedings.
The facts of tis case were that the assessee had taken a loan and was interest on the same. He continued to deduct the amount from his income. While the assessee approved of his assessment at the first instance, later on he felt that some of disclosures made by the assessee with respect to taking of the loan by the assessee were not true. The Income Tax Officer therefore approached the Commissioner for permission to issue notice under Section 148. The permission was given. The ITO, before the High Court cited judgements wherein it had been held that the duty of the assessee is not limited merely to making full disclosures, but the disclosure must also be true.[11]
The Supreme Court however observed that there was no reasonable ground to believe that the assessee had not borrowed those loans or that he was not paying the said amounts in interest as claimed. The following observations were made by the Court with respect to ‘reason to believe’ to be possessed by the Commissioner:
Rational connection postulates that there must be a direct nexus or live link between the material coming to the notice of the Income Tax Officer and the formation of his belief that there had been escapement of income of the assessee from assessment in the particular year. The grounds or reasons leading to the formation of the belief under s. 147(a) must have a material bearing on the question of escapement of income. The Commissioner cannot act mechanically while granting permission to issue notice under Section 147. The grounds or reasons which lead to the formation of belief that income chargeable to tax has escaped assessment must have a material bearing on the question of escapement of income from assessment. The reason must be held in good faith and cannot be a mere pretense. It is open to a court to examine whether the reasons for the formation of the belief have a rational connection with or a relevant bearing on the formation of the belief and are not extraneous or irrelevant. the powers of the Income Tax Officer to re-open assessment though wide, are not plenary; the words of the statute are ‘reason to believe’ and not ‘reason to suspect’.[12]
As far as the issue of valuation of the long-term capital gains is concerned, the Bombay High Court referred to the case of Chainrup Samptaram v. CIT. The Supreme Court, in that case was concerned primarily with two issues. First, relating to place of accrual of profits from stock-in-trade and second, with the method for valuation of closing stock of the assessee. We are only concerned with court’s ratio with respect to the second issue in the instance case. A partnership firm led by two brothers was engaged in the business of trading in bullions. The firm bought 582 bars of silver. Though the brothers claimed that the purchase was for their domestic use, the revenue did not buy and said the transaction was not a genuine one. They therefore directed for those silver bars to be treated as a stock-in-trade of the assessee firm. They were valued by the A.O as per their market value on the closing stock he same method which was used for valuation of the rest of the stock of the assessee. On appeal by the assessee against this, the Hon’ble High Court rejected it citing that the reason why the market rate of the stock on the closing day of the stock was considered was to account for any notional profit that might accrue to the assessee due to increase in the value of the product. When the same issue was discussed by the Supreme Court, it disagreed by the High Court. It said that the general rule was that the closing stock must be valued as per the cost price on which the same was purchased by the assessee. This amount is then entered on the credit side of the account’s book in order to cancel the same against the parallel entry in the ‘debit side’ when the good was bought. The court referred to the Report of the Committee on Financial Risks attaching to the holding of Trading Stocks, 1919 in order to explain the concept in detail. However, then citing the Report of the Committee on the Taxation of Trading Profits presented to British Parliament in April, 1951, the Court also acknowledged that there is but one exception to the above-mentioned general rule. This exception is for when the market value at the end of the accounting year is less than the cost at which it was purchased by the assessee. The reason for permitting taking into account only anticipated losses and not notional or expected profits is common prudence. As cited in paragraph 281 of the 1951 report, no prudent trader would report profits before actually having earned them. However taking consideration of anticipated losses has generally come to be accepted in the general principles of accounting. This is the theory underlying the rule that the closing stock has to be valued at cost or market price whichever is lower, and it is now generally accepted as an established rule of commercial practice and accountancy.[13]
Next, the Court dealt with the contention of the respondent that the petitioner was wrong to deduct the expenses incurred on vacating the tenants from the cost of whole of the property instead of from the cost of the property which remained proportionately after having converted part of it to stock-in-trade.
For this the Bombay High Court relied upon the ratio in the case of CIT v. Piroja C. Patel. The facts of the case were similar to the matter in hand. The assessee’s land had been acquired by the municipal corporation by negotiation-cum-acquisition. One of the terms of the acquisition was that the assessee would have to evict the tenants from the property. This also increased the value of the property and entitled the assessee to increased compensation from the acquirers. Giving a judgement in favour of the assessee, the Supreme Court laid down the principle that in order to determine whether a particular expenditure was deductible under Section 45 of the Income Tax Act, 1961 we only need to ask one question and that is whether the said expenditure will increase the value of the property. If the answer is in the affirmative, then the said expenditure is an improvement and hence a deductible expenditure. The expenditure incurred for having the land vacated would certainly amount to cost of improvement which is an allowable expenditure.[14]
Lastly, the Court dealt with the contention of the respondent pertaining to separation of ownership of land and flats and payment of capital gains tax only after all the flats were sold. According to the respondent, ‘capital gains’ would be chargeable to tax only in the year when the land is sold or otherwise transferred to the co-operative society formed by owners of the flats and not in the year when individual flats are sold. With respect to this, the Court observed as under:
If what the Assessing Officer says is correct, then there could not be any escapement of income chargeable to tax for the assessment years under consideration; rather excess income has been offered to tax.
That apart, the flat purchasers by purchasing the flats had certainly acquired a right or interest in the proportionate share of the land but its realization is deferred till formation of the co-operative society by the owners of the flats and eventual transfer of the entire property to the co-operative society.
Judgement in Rem/Ratio Decidendi
The following principles of law were laid down by the Court in this judgement:
- that capital gains tax for flats sold by a builder needs to be filed as and when the flats are and sold and not when all the flats have been sold and the ownership has been handed over to the co-operative housing society.
- that the phrase, ‘reason to believe’ under Section 147 means that the A.O should be satisfied of a link between the assessee’s actions and escaping of tax.
- that principles of accounting commonly accepted in the business would be the norm for computation so long as they are superseded by a legislative requirement.
- The Court also reiterated what has been expressly provided for under section 45 of the Income tax Act, 1961 and that is that the expenses incurred by the assessee in improvement of the property can be deducted from the cost of acquisition.
Judgement in Personam/Obiter Dictum
The writ petition was allowed, and the notices dated February 25, 2000 were quashed. The Bombay High Court neither overruled any judgement of any lower court neither did it reverse any of its previous rulings either partially or fully.
Critical Analysis of the Judgement
The author agrees with the decision of the Bombay High Court. The decision of the Court was in line with both statutory requirements and judicial precedents. The author would like to supplement the ratio of the Court by discussing some aspects which weren’t discussed in that detail in the judgement.
Capital gains tax accrues only when there is a capital asset. For that, the assessee’s property must be a capital asset under the eyes of law. The building that the assessee was constructing does fulfill this qualification as per Section 2(14) of the Income Tax Act, 1961, “a capital asset is property of any kind held by assessee”.[15] Next, there must be transfer of a capital asset. Section 2(47)(iv) of the Act provides that where the asset is converted by the owner thereof into, or is treated by him as, stock-in-trade of a business carried on by him, such conversion or treatment shall amount to transfer of capital asset.”[16]
On October 1, 1987 the property converted the untenanted portion of the building to stock-in-trade. Though the term ‘stock-in-trade’ has not been defined under the Income Tax Act, 1961, courts have many a time explanation. Almost in all decisions, including in Deputy Commissioner of Income Tax v. Nedungadi Bank, the Courts opined that “the term stock-in-trade should be understood according to its meaning in common parlance. The dictionary meaning of stock-in-trade is all the goods that a shopkeeper has for sale.”[17]
It is clear from the facts that the building flats were being constructed by the assessee with the intention of selling them. Therefore, they amounted to stock-in-trade. Once the assessee converted the property to stock-in-trade and began selling those flats, Section 45 (2) begins to start having an application. The section is the charging section for tax on capital gains and Section 45 (2) provides for capital gains tax earned from conversion of property into stock-in-trade. It reads as under:
Notwithstanding anything contained in sub- section (1), the profits or gains arising from the transfer by way of conversion by the owner of a capital asset into stock- in- trade of a business carried on by him shall be chargeable to income tax as his income of the previous year in which such stock- in- trade is sold or otherwise transferred by him and, for the purposes of section 48, the fair market value of the asset on the date of such conversion or treatment shall be deemed to be the full value of the consideration received or accruing as a result of the transfer of the capital asset.[18]
This section squarely covers two of the respondent’s contentions. First, relating to calculation of the value of the closing stock of the building and secondly, the contention relating to filing of income tax returns as and when the flats are sold.
Calculation of Value of Closing Stock
Section 45 (2) clearly specifies that, ‘for the purposes of Section 48, the fair market value of the property shall be the value of the asset as on the date of its conversion. The assessee converted his property into stock-in-trade on October 1, 1987 and rightfully computed its closing as its market value stood on that particular date. The contention of the respondent that the assessee should have valued it as per its market value in the assessment year when it was sold therefore does not hold water.
Section 45 (2) provides for two time-lines. While the income tax becomes chargeable in the year when the stock-in-trade is sold, its market value is computed based on the fair market value as it stood on the date of conversion.
The Court was also apt enough to point out that had the fair market value of the property during the relevant assessment year in which it was sold were to be considered, the assessee’s profits would have come to an even lesser amount considering that the fair market value of the property was more in 1992-93 as compared to its value in 1987. Therefore, by considering the fair market value of the property in the year 1987, the assessee actually paid more tax and question of escapement of tax does not arise in the first place. However, that is not the reason, why the statute mandates calculation of stock value as on its date of conversion.
Filing of Income Tax for the Assessment Year in Which the Flats Were Sold
With respect to this issue, the following observation of the Supreme Court in the case of CIT v. Bai Shirinbai K.Kooka becomes relevant:
There will be capital gains liability in respect of the conversion of capital asset into stock-in-trade, at market value thereof. Thus, the capital gains will be computed as a difference between the cost of capital asset to the assessee and the market value of such capital asset on the date of its conversion into stock-in-trade.
However, the tax on such capital gains will be payable only on realization of such converted stock in the year of sale thereof, though the capital gain is determined on the date of conversion.[19]
Secondly, the assessee was right in filing his income tax returns as and when the flats were sold because Section 45 (2) clearly mentions that, ‘income shall be chargeable to income tax as his income of the previous year in which such stock- in- trade is sold’. The respondent’s submission that income tax returns should have been filed only after all the flats were sold has no statutory or judicial backing.
Moreover, no assessee can be guaranteed of assured sale of all his flats. If the respondent’s contention were to be accepted, the revenue would face a severe loss as in cases where all of the units of the assessee’s property are not sold, the liability with respect to the units that have already been sold also would never arise.
Reduction of Expenditure Incurred on Eviction of Tenants
Even the third contention of the respondent pertaining to reduction of expenses incurred on eviction of tenants does not stand as Section 48 expressly allows, ‘cost of improvements’ to be deducted. Judicial precedents like CIT v. Piroja Patel have also settled that eviction of tenants does amount to improvement of the property.
Three of the respondent’s contentions can be rejected prima facie as they statutory requirements provide otherwise. As for the fourth contention with respect to separation of ownership and land, it related to the separation of land and ownership.
Separation of Land and Ownership
The respondent had also contended that there is separation of ownership of land and property. According to the respondent, the purchasers of the flats own only the flat and not the corresponding proportion of land. Based on this submission, the respondent further argued as ownership of the entire land continued to remain with the assessee, they were wrong to exclude from the land’s valuation, the cost of the land that had proportionately been already sold to the flat purchasers.
The Court rejected this argument to hold that there existed no such dichotomy between ownership of land and property. It observed that the purchasers got a right in proportionate share of land however, it was only the realization of this right that was deferred till the time the co-operative society was formed.
Though the Court did not dwell upon this issue at length, it is noteworthy to know that the concept of ownership of flat buyers, proportionally on the land over which the building has been constructed well established and widely accepted concept. It is called the right of the flat owner in the Undivided Share of Land (UDS).
Undivided Share of Land or UDS is a part of the plot given to the owner of the flat in an apartment complex on which the entire structure is built. This share of land has no defined boundaries and each and every flat built on that particular plot will have associated UDS.[20]
Even the Supreme Court explained the concept in the case of Faqir Chand Gulati v. Uppal Agencies as under:
“As a result, each Apartment owner becomes the owner of the Apartment with corresponding undivided share in the land and an undivided share in the common areas of the building.”[21]
The concept has been in place since the 19th century when in the case of Jardine, Skinner & Co. v. Rani Surut Soondari it was observed by the Judicial Committee in 1878 that a right of occupancy might be acquired in respect of an undivided share of land.[22]
Conclusion
The following conclusions can be drawn from the discussion above:
- That income tax returns for capital gains on sale of flats by a builder needs to filed as and when the flats get sold and not when the all the flats are sold and the building gets transferred to the co-operative society.
- That expenses incurred by a construction company to evict the pre-existing occupants shall be deductible under section 45 of the Income Tax Act, 1961 as they help in increasing the market value of the property and hence an improvement.
- Closing stock of stock-in-trade needs to be computed based on its fair market as on the date of conversion of the property into stock-in-trade.
- A developer who constructs building on his piece of land owns both the land as well as the building. There is no dichotomy between the ownership of land and the building.
- On purchase of flats, the buyers acquire proportionate share in the land where the building stands. However, the right to enjoy this pre-existing right is deferred until the time the co-operative society is formed.
Suggestions For Future Course of Action
A major confusion arose in the instant case with respect to computation of the closing stock of the property. Neither the Income Tax Act, 1961, nor the Indian Accounting Standards prescribe any method for valuation of closing stock by the assessee. Although a general custom that is prevailing in this regard is that it shall be the cost of acquisition of that stock or its market as on the date of closing of accounts, whichever is lower. Even the Bombay High Court in the instant case also gave judicial recognition to this principle by citing the case of Chainrup Sampatram.
Had there been no ambiguity in this regard, the question of valuation of closing stock wouldn’t have arisen only in the first place and the doubts in the minds of the assessing officer leading to reopening of assessment proceedings would have been dealt with squarely by the word of law.
Moreover, it is a settled principle of law that tax statutes should not leave any ambiguity. Also, there cannot be any presumption as to tax.[23] Therefore, in order to remedy the source of confusion in this case law, it is necessary that the principle relating to valuation of closing stock be given legislative recognition. The Lower of Cost or Market (LCM) method is also prescribed as the method for valuation of investments under Indian Accounting Standards 13.[24] Though the standard does not directly deal with valuation of closing stock, it impliedly refers to the same as stock-in-trade is nothing but a type of investment of the assessee.
Finally, there exists another compelling reason for bringing out the above amendment. The author would also like to bring to the notice of our readers that with respect to valuation of closing stock, there also exists an alternative opinion, which is contrary to the opinion of the Bombay High Court in the instant case. In the case of CIT v. Bharat Commerce and Industries, the Delhi High Court took the view that an assessee is free to choose any method for valuation of closing stock so long as the method is adhered to in a consistent manner over different financial years. The Court also opined that a bona fide change in the method of computation was also permissible. The Court observed as under:
“An assessee is free to adopt a particular method of valuation of its closing stock which it has to follow regularly from year to year. At the same time, it is well settled that irrespective of the basis adopted for valuation for earlier years, the assessee has an option to change the method of valuation of closing stock, provided the change is bona fide and followed regularly thereafter.”[25]
This observation of the Delhi High that the assessee can choose any method for valuation of closing is in direct contradiction of the observation of the Bombay High Court in the instant case wherein it specifically recognized that closing stock shall be valued at the lower of cost or value, as that was the generally prevalent principle in accountancy.
Fortunately, the ratio of the Bombay High Court is good in law and in conformity with the stand of the Supreme Court.
This is because the decision of a single judge of the Delhi High Court was rendered in 1999. The decision of the SC in the matter of Chainrup Sampatram v. CIT is however a decision of a constitution bench of the Supreme Court delivered much earlier in the year 1953. Clearly, the conflict if any between the ratios of these two decisions, shall be resolved in favour of the decision of the constitution bench of the Supreme Court. Therefore, the ratio of the Delhi High Court, insofar as it held that the assessee is free to adopt any method for valuation of closing stock is inconsistent with the LCM method recognized by the Supreme Court is bad in law. However, since the decision has not been expressly over-ruled in any judgement as yet, it may create ambiguity and uncertainty in this regard. Therefore, in order to avoid such a confusion from arising in future, it is recommended that the LCM method for valuation of closing stock as recognized by the Supreme Court, and reiterated by the Bombay HC, be given statutory recognition. Moreover, as will be discussed below, the LCM method is also in line with global practices with respect to valuation of closing stock, as will be discussed below.
United States of America
The Generally Accepted Accounting Principles (GAAP), which are (a set of rules which apply to all public listed companies in the United States of America) also provides that valuation of inventory (Indian equivalent of stock-in-trade) must be done using the lower of cost or value method as allows declines in inventory value to be offset against income of the period.[26]
Canada
Even in Canada, Section 10 of the Income tax Act, read with Section 1801 of the Income Tax regulations provide that “Value each item in inventory at the lower of original acquisition cost or its fair market value at the end of the year”.[27]
As it is evident that the LCM method is widely accepted globally for valuation of closing stock, it is time that the same also be given statutory recognition even in India. It is, therefore the suggestion of the author that an explanation be added after Section 45(2). The provision be therefore amended to provide as under:
“Notwithstanding anything contained in sub- section (1), the profits or gains arising from the transfer by way of conversion by the owner of a capital asset into, or its treatment by him as, stock- in- trade of a business carried on by him shall be chargeable to income- tax as his income of the previous year in which such stock- in- trade is sold or otherwise transferred by him and, for the purposes of Section 48, the fair market value of the asset on the date of such conversion or its treatment shall be deemed to be the full value of the consideration received or accruing as a result of the transfer of the capital asset.
Explanation- For the purposes of valuation of the stock-in-trade the lower of its cost or market value as on the day of closing of accounts shall be taken.”
If this is done, then not only will the ambiguity with respect to valuation of closing stock in the Indian legal regime be clarified, but Indian law will also be in conformity with the method followed by other common law jurisdictions for valuation of closing stock. In light of the same, it is therefore incumbent that by way of the Finance Act, 2021, Section 45(2) of the Income tax Act, 1961 be amended accordingly and an explanation be inserted in the manner suggested above so that it be conclusively settled that only the LCM method be adopted for valuation of closing stock.
[1] M.S. and J.F. Builders v. A.K. Chauhan, [2020] 272 TAXMANN 359 (Bom).
[2] Indian Const. art. 226.
[3] Income Tax Act, 1961, § 45 (2).
[4] Income Tax Act, 1961, § 48.
[5] Income Tax Act, 1961, § 147.
[6] Income Tax Act, 1961, § 141 (1).
[7] Income Tax Act, 1961, § 148.
[8] Commissioner of Income Tax, Gujarat v. Mohanbhai Pamabhai, (2007) 291 ITR 500 (SC).
[9] Prashant S. Joshi v. ITO, 324 ITR 154.
[10] ITO v. Rajesh Jhaveri, (2007) 291 ITR 500 (SC).
[11] Chhugamal Rajpal v. S.P. Chaliha, 1971 SCR (3) 342.
[12] Income Tax Officer v. Lakhmani Mewal Das, 103 ITR 437.
[13] Chainrup Sampatram v. CIT, 24 ITR 481.
[14] CIT v. Piroja C. Patel, 242 ITR 582.
[15] Income Tax Act, 1961, § 2 (14).
[16] Income Tax Act, 1961, § 2 (47) (iv).
[17] Deputy Commissioner of Income Tax v. Nedungadi Bank, 2003 85 ITD 1 Coch.
[18] Income Tax Act, 1961, § 45 (2).
[19] CIT v. Bai Shirinbai K.Kooka, [1962] 46 ITR 86 (SC).
[20] Aditya Pratap, Undivided Share of Land and Rights of Apartment Owners, Lawzilla (Oct. 23, 2020, 7:30 AM IST), http://lawzilla.in/world-of-law/real-estate-property/undivided-share-of-land-and-rights-of-apartment-owners/.
[21] Faqir Chand Gulati v. Uppal Agencies, (2008) 10 SCC 345.
[22] Jardine, Skinner & Co. v. Rani Surut Soondari, (1878) C. L. R. 140.
[23] Prince Azam Jah v. Expenditure Tax Officer, 1970 78 ITR 364 AP.
[24] Indian Accounting Standards, Ind. A.S. 13, Ministry of Corporate Affairs (Oct. 21, 2020, 2:30 PM IST), https://www.mca.gov.in/Ministry/notification/pdf/AS_13.pdf.
[25] CIT v. Bharat Commerce and Industries, (1999) 157 CTR Del 53.
[26] Generally Accepted Principles of Accounting, (Oct. 18, 2020, 8:52 AM IST), http://diversionservices.dsd.gov.za/FORMS/download/gaap_info%20(1).pdf.
[27] Income Tax Act, R.S.C. 1985, § 10 (Can.).
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