How to Handle Surrendered Income During a Tax Survey: A Practical Guide

Important challenges in tax compliance understands implication of income surrendered during tax surveys and searches. The treatment of such income, whether it should be classified as business income or undisclosed income, can extensively impact on assessee’s tax liability. This article wants to provide  detailed  clear-cut analysis of how surrendered income is treated under the I.T Act, particularly focusing on the applicability of Sections 68 to 69D and related provisions.

Income Surrendered During Survey

When  taxpayer surrenders income during  survey conducted by the I.T department, the first question  arises is how this income should be classified. The classification directly influences the tax rate applicable and  ability to claim deductions.

Tax Rate On Undisclosed Income:

Income that falls U/S. 68, 69, 69A, 69B, 69C, and 69D is subject to a special tax rate of 60%. But it does not stop there.  additional surcharge of 25% on this 60% tax, and on top of that, a health and education cess of 4% is levied. When all these are summed up,  total tax effect reaches 78%. This high tax rate underscores the harshness with which the law treats undisclosed income.

Illustrations:

XYZ Traders, a partnership firm engaged in the wholesale business of electronic goods, was subjected to a survey under Section 133A of the Income Tax Act. During the survey, the Income Tax Department discovered certain discrepancies in the stock records and unaccounted cash of ₹50 lakhs. The partners, in order to avoid further scrutiny, voluntarily declared this ₹50 lakhs as additional income.

Key Questions:

1. How should this surrendered income be treated?
2. What are the tax implications?

Analysis:

• Classification of Surrendered Income: The ₹50 lakhs surrendered by XYZ Traders could be classified either as business income or as undisclosed income under Sections 68 to 69D of the Income Tax Act, depending on the explanation provided by the firm.

If XYZ Traders can satisfactorily link the surrendered income to its regular business operations (e.g., unaccounted sales or excess stock), it may be treated as business income. This would allow XYZ Traders to pay tax at the normal business rate and claim deductions for related expenses.

However, if the firm fails to provide a satisfactory explanation for the source of this income, it would be classified as undisclosed income under Section 69A (Unexplained Money) and taxed at a higher rate with no deductions allowed.

• Tax Implications: Assuming the income is treated as undisclosed under Section 69A:
  • The ₹50 lakhs will be taxed at a flat rate of 60%.
  • An additional surcharge of 25% on the tax amount will be levied.
  • A health and education cess of 4% will also be applied on the tax and surcharge.

Total Tax Calculation:

• • Tax on ₹50 lakhs at 60%: ₹30 lakhs
  • Surcharge at 25% of ₹30 lakhs: ₹7.5 lakhs
  • Cess at 4% of (₹30 lakhs + ₹7.5 lakhs): ₹1.5 lakhs
  • Total Tax Payable: ₹39 lakhs

No Deduction or Set-Off  Loss Allowable:

Section 115BBE(2) is particularly strict as it disallows any deductions or set-offs against income assessed U/S 115BBE(1)(a) or 115BBE(1)(b). This means that if a taxpayer surrenders income that falls under these sections, they cannot reduce their tax liability by claiming business expenses, losses, or any other deductions. This provision has been applicable from the A.Y 2017-18.

Income (Except Cash) Surrendered During Survey:

There is a possibility for income (other than cash) surrendered during  survey to be treated as business income. This is important because business income is taxed at regular tax rates and allows  claiming of deductions, which can reduce the general tax liability. However, this classification is not automatic and depends on the specific circumstances of  case and taxpayer’s ability to justify the income as part of their regular business operations.

• Surrender During Search or Survey: Deeming Provisions

A common misconception is that surrendering income during a search or survey automatically triggers deeming provisions U/S. 69 or 69A of the I.T Act. However, the reality is difference.

• Deeming Provisions Applicability:

The deeming provisions U/S.68 to 69D are related to unexplained credits, investments, and expenditures as income. These sections applicable  when the source of the surrendered income is not satisfactorily explained. If the taxpayer cannot properly explain where the money came from, these provisions allow the I.T department  to treat the income as undisclosed and tax it at the highest rates. This is a key area where taxpayers need to be cautious, as any unexplained income can result in  significant tax burden.

• Not Automatic Upon Surrender :

However, it’s important to note that the mere act of surrendering income during a survey does not automatically invoke these deeming provisions. Several judicial precedents, such as in the cases of Pradeep Kumar Gupta v. CIT (2008) 303 ITR 95 (Delhi)have established that the assessing officer must conduct a thorough examination and provide proper reasoning before applying these provisions. This means that taxpayers have the opportunity to present their case and avoid the harsh consequences of these deeming provisions, provided they can satisfactorily explain the source of the surrendered income.

• Surrender of Excess Stock or Cash:

Another important aspect is the treatment of excess stock or cash discovered during a survey. If the excess stock or cash can be linked to regular business activities, it may be treated as business income. This is a more favorable outcome for the taxpayer, as business income is taxed at normal rates and allows for deductions. On the other hand, if the taxpayer cannot explain the source of the excess stock or cash, it may be taxed as undisclosed income under Sections 69 and 115BBE, resulting in a much higher tax liability.

• Relevant Decisions:

Recent case laws, such as Pramod Singla Pr. CIT v. Industrial Safety Products (P) Ltd., have emphasized the need for a detailed assessment of the source and nature of the surrendered income. These decisions reinforce the principle that deeming provisions should only be applied when the income is clearly unexplained and not recorded in the taxpayer’s books of accounts. If the taxpayer can explain the source of the income, these provisions do not apply, and the income may be taxed at normal rates under Section 115BBE.

 Income Tax–Partnership Firm

• Section 40(b):
  • This section restricts the allowance of certain payments when computing income under the head ‘profits and gains of business or profession.’
  • It sets limits on the payments that can be deducted and requires that they are based on book profits.
• Nature of Income Surrendered During Survey:
  • In cases like Gaurish Steels (P) Ltd. v. ACIT, income surrendered during a survey (excluding cash) was treated as business income.
  • The distinction between business income and deemed income under Sections 69, 69A, etc., depends on the explanation of the source and nature of the income.
• Deemed Income Provisions (Sections 69, 69A, 69B, 69C):
  • These sections deem unexplained investments, money, bullion, etc., as income if they are not recorded in the books of accounts and their source is not satisfactorily explained.

Judicial Precedents

1. Pr. CIT v. Shri Ganesh Rice Mills (P&H High Court) [2018] 93 taxmann.com 27

Facts:

• Issue: The assessee had substantial cash deposits during the demonetization period. The assessee claimed that the deposits were from regular business operations, primarily the sale of rice.
• Assessment: The Assessing Officer (AO) was skeptical of the assessee’s explanation and deemed the cash deposits as unexplained income, invoking Section 68 of the Income Tax Act.

Submissions by the Assessee:

• The assessee provided evidence to substantiate the claim that the cash deposits represented sales proceeds.
• Documents Provided:
  • Sales invoices corresponding to the deposits.
  • Entries in the books of accounts that matched the cash deposits.
  • Explanation of the business cycle and how cash sales were prevalent during the period in question.

Explanation by the Income Tax Officer :

• Initial Stance: The ITO did not accept the assessee’s explanation. The AO argued that the cash deposits were not satisfactorily explained and categorized them as unexplained income under Section 68.
• Rationale: The AO felt that the deposits were unusual and did not correlate with the regular business operations as claimed by the assessee, particularly during the demonetization period when cash handling was under scrutiny.

Explanation by the Commissioner of Income Tax :

• Reevaluation: While the document does not specify the Commissioner’s observations, it is implied that the Commissioner of Income Tax (Appeal) sided with the assessee, likely due to the lack of substantial evidence from the AO.
• Decision: The Commissioner might have found the assessee’s evidence (sales invoices and books of accounts) to be credible, thus rejecting the AO’s addition.

Judicial Judgment:

• Punjab & Haryana High Court Decision: The court ruled in favor of the assessee.
• Key Points:
  • The AO failed to present any cogent evidence proving that the cash deposits were unexplained.
  • The High Court emphasized that when an assessee provides a plausible explanation supported by documentary evidence, the burden shifts to the AO to disprove the claim.
  • The Court held that mere suspicion cannot lead to an addition under Section 68.
• Outcome: The addition made by the AO was deleted, reaffirming the principle that the burden of proof lies with the revenue authorities.

Relevance:

• Comparable Case: This case is similar to Gaurish Steels (P) Ltd., where the issue of unexplained cash deposits was scrutinized. Both cases highlight the necessity of substantive evidence when making additions under Section 68.
• Principle Reinforced: The importance of the AO’s duty to substantiate claims with concrete evidence rather than relying on assumptions.

2. ITO v. M/s Best Hosiery [2011] 45 SOT 31 (Amritsar-Trib.)

Facts: 

• Issue: The assessee, engaged in the manufacturing and trading of hosiery goods, faced discrepancies in their books of accounts. The discrepancies were particularly related to the valuation of closing stock and cash credits.

• Assessment: The AO noticed inconsistencies in the financial records and made additions under Section 68 for unexplained cash credits and Section 69 for undervaluation of closing stock.

Submissions by the Assessee:

• Explanation: The assessee attributed the discrepancies to clerical errors.
• Documents Provided:
  • Purchase invoices.
  • Stock registers.
  • Other supporting documents to justify the valuation of closing stock and the source of cash credits.
• The assessee contended that the discrepancies were not intentional and were minor in nature, arising from human error.

Explanation by the Income Tax Officer :

• Initial Stance: The AO was not convinced by the assessee’s explanation. The AO insisted that the discrepancies indicated the presence of unexplained cash credits and undervaluation of stock.
• Action Taken: Additions were made to the assessee’s income under Section 68 and Section 69, as the AO felt that the explanations provided were insufficient to justify the anomalies.

Explanation by the Commissioner of Income Tax :

• Reevaluation: The document does not specify the Commissioner’s observations, but the focus is on the Tribunal’s judgment.
• Decision: Likely sided with the AO initially, prompting the assessee to appeal further.

• ITAT Amritsar Bench Decision: The Tribunal ruled in favor of the assessee.
• Key Points:
  • The AO had not conducted any independent verification of the documents provided by the assessee.
  • The Tribunal noted that discrepancies in books of accounts, without corroborative evidence, cannot be the sole basis for making additions under Sections 68 and 69.
  • The Tribunal emphasized that the burden of proof lies with the revenue authorities to substantiate claims when the assessee provides a reasonable explanation.
• Outcome: The Tribunal deleted the additions made by the AO, underscoring the need for proper evidence before making any adverse inferences.

Relevance:

• Principle Reinforced: The case underscores the importance of due diligence and independent verification by the AO. It also reiterates that the burden of proof remains with the revenue authorities when challenging an assessee’s claims.

3. M/s. Sumangal Spinning Mills v. Assistant Commissioner of Income Tax

Facts:

• Issue: During a survey action under Section 133A of the Income Tax Act, discrepancies were found in the stock records and cash book. The firm declared additional income to cover these discrepancies.
• Assessment: The AO treated the entire declaration as undisclosed income and added it to the assessee’s taxable income without allowing for any deductions.

Submissions by the Assessee:

• Declaration: The assessee declared additional income during the survey, attributing it to unaccounted sales and excess stock.
• Argument: The assessee argued that the additional income declared should be treated as business income, allowing for deductions related to business expenses.
• Supporting Evidence: The assessee provided records showing how the discrepancies were linked to regular business activities rather than undisclosed income.

Explanation by the Income Tax Officer :

• Initial Stance: The AO treated the entire declaration as undisclosed income under Sections 68 and 69, without considering the possibility that it could be related to regular business operations.
• Rationale: The AO believed that the declaration indicated a clear case of undisclosed income and did not allow for any deductions or consideration of business expenses.

Explanation by the Commissioner of Income Tax :

• Reevaluation: The document does not provide specific details about the Commissioner’s observations, but it’s implied that the Commissioner agreed with the AO.
• Decision: The Commissioner likely upheld the AO’s decision, leading to the assessee’s appeal to the Tribunal.

• ITAT Mumbai Decision: The Tribunal partially ruled in favor of the assessee.
• Key Points:
  • The Tribunal acknowledged that while some of the declared income might indeed be undisclosed, it was essential to distinguish between genuinely undisclosed income and income from regular business activities.
  • The Tribunal held that income linked to the firm’s regular business activities should be treated as business income, thus allowing the assessee to claim deductions for business expenses.
• Outcome: The Tribunal partially deleted the additions made by the AO, allowing the assessee to claim deductions on the portion of income related to business activities.

Relevance:

• Principle Reinforced: This case highlights the importance of accurately categorizing income, distinguishing between genuinely undisclosed income and income arising from regular business operations.

4. Kim Pharma (P.) Ltd. v. CIT & Anr. [2013] TaxPub(DT) 1591 (P&H-HC)

Facts:

• Issue: During the search, unaccounted cash was found in the possession of the assessee. The assessee failed to provide a satisfactory explanation regarding the source of the cash.
• Assessment: The AO treated the unaccounted cash as income under Section 69A and added it to the assessee’s taxable income.

Submissions by the Assessee:

• Explanation Attempted: The assessee attempted to explain the source of the cash but could not provide satisfactory evidence.
• Argument: The assessee argued that the cash found was not undisclosed income and should not be taxed under Section 69A.

Explanation by the Income Tax Officer :

• Initial Stance: The AO treated the unaccounted cash as deemed income under Section 69A, which deals with unexplained money, bullion, or valuable articles found in possession during a search.
• Rationale: The AO argued that since the assessee could not provide a credible explanation for the source of the cash, it should be treated as undisclosed income.

Explanation by the Commissioner of Income Tax :

• Reevaluation: While the document does not detail the Commissioner’s observations, the judgment indicates that both the Commissioner (Appeal) and the Tribunal agreed with the AO’s decision.
• Decision: The Commissioner likely upheld the AO’s addition, leading to further appeals by the assessee.

Judicial Judgment:

• Supreme Court Decision: The Supreme Court upheld the decision of the lower authorities.
• Key Points:
  • The Court emphasized that Section 69A is a deeming provision that applies when an assessee fails to satisfactorily explain the source of money, bullion, or valuable articles found during a search.
  • The Court noted that the burden of proof lies with the assessee to provide a credible explanation for the possession of unaccounted cash.
• Outcome: The Supreme Court upheld the addition of the unaccounted cash as income under Section 69A.

Relevance:

• Comparable Case: This case is similar to Fakir Mohmed Haji Hasan v. Commissioner of Income Tax, where unexplained cash or assets found during a search were treated as income under Section 69A.
• Principle Reinforced: The case highlights the stringent application of Section 69A and the importance of providing a satisfactory explanation for assets found during tax department searches. 

In short, during income tax searches and surveys, taxpayers must provide clear, documented explanations for any unaccounted assets or discrepancies found. If they fail to do so, these amounts may be treated as undisclosed income and taxed. However, when explanations are reasonable and well-supported, courts often rule in favor of the taxpayer. Proper documentation is crucial in these situations.