Rejection of Accounting Method followed by Assessee which was accepted in Assessment of earlier Year

Method of Accounting regularly followed by the taxpayer which was accepted by the Tax Officer in past cannot be rejected in future years without expressing the dissatisfaction about the correctness or completeness of the accounts of the taxpayer

Recently, the Madras High court in case of CIT Vs. SAS Hotels & Enterprises Limited [Appeal No. 1030 of 2010] (Madras High Court) held that the Assessing Officer (AO) should not reject the method of accounting which is in accordance with Section 145(1) (Refer Note-1) of the Income-tax Act, 1961 (the Act) and is regularly followed by the taxpayer.

Further the High Court held that before invoking Section 145(3) of the Act, the AO must necessarily express his dissatisfaction about the correctness or completeness of the accounts of the taxpayer and also note that such system of accounting was not regularly followed by the taxpayer. Also, the High Court distinguished the facts in the case of CIT vs. N.M. Associates [2002] 256 ITR 141 (Mad) relied upon by the tax department, where the taxpayer did not maintain proper accounts and where Section 145(3) was invoked.

Facts of the case

• The taxpayer was engaged the business of building construction apart from its other business activities. The taxpayer was following mercantile system of accounting and in respect of on-going projects and followed “Completed Contract Method” for accounting profits of construction work and thus the income was assessed in the relevant year in which the contract was completed.

• The Assessing Officer (AO) having regard to Section 5 of the Act took the view that the taxpayer ought to disclose the accrued profit in each year.

• The Commissioner of Income-tax (Appeals) [CIT(A)] confirmed the AO’s order while the Income-tax Appellate Tribunal (the Tribunal) reversed the orders of the AO as well as the CIT(A).

Taxpayer’s contentions

• The completed contract method of accounting was all along followed by the taxpayer for the construction business. Further, the said method was not challenged by the tax department in any of the earlier years.

• The AO did not observe that he is not satisfied about the correctness or completeness of the accounts or the method of accounting is not regularly followed by the taxpayer before making assessment under Section 144 of the Act by invoking Section 145(3) of the Act.

Tax department’s contentions

• The AO took the view that, the taxpayer ought to have disclosed the accrued profit earned even in respect of the on-going projects up to the point of the relevant assessment year as the taxpayer was following mercantile system of accounting. The AO relying on the decision of Madras High Court in case of N.M. Associates invoked Section 145(3) of the Act and proceeded to assess the deemed profit accrued to the taxpayer under Section 144 of the Act.

High Court’s ruling

• The High Court upheld the Tribunal’s decision and dismissed tax department’s appeal. The High Court held that the AO cannot invoke Section 145(3) of the Act and complete the assessment under Section 144 of the Act unless he has expressed his dissatisfaction about the correctness or completeness of the accounts of the taxpayer. Since there was no such noting of the AO and the method of accounting to determine the profits was regularly deployed by the taxpayer and the same being in accordance with the Section 145(1) of the Act, such method of accounting cannot be rejected by the AO.

Our Comments

This is a welcome decision emphasising the acceptance of the method of accounting regularly and consistently followed by a taxpayer. The Supreme Court in the cases of CIT v. M/s. Woodward Governor India P. Ltd. [2009] 312 ITR 254 (SC) and CIT v. Realest Builders & Services Ltd [2008] 170 TAXMAN 218 (SC) had emphasised the importance of method of accounting regularly employed by the taxpayer. The Supreme Court in the case of Realest Builders & Services Ltd. had held that the tax department needs to provide facts and figures that the impugned method of accounting adopted by the taxpayer results in underestimation of profits for changing the method of accounting under Section 145 of the Act. Otherwise, it will be presumed that the entire exercise is revenue neutral.

Note-1 As per Section 145(3) of the Act if the AO is not satisfied about the correctness or completeness of the accounts of the assessee or if method of accounting or accounting standards have not been regularly followed by the assessee, the AO may make a best judgment assessment.

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