2008 (2) TMI 23 - SC - Income Tax

Chit Fund business - allowance of Discount as deductible amount from in the P & L Account in the year in which it accrued or to be spread over the balance period of chit on proportionate basis where the accounts are kept on mercantile basis, deduction is allowed on completion of contract basis

Issues Involved:
1. Validity of the Completed Contract Method versus Percentage of Completion Method for accounting in chit transactions.
2. Tax treatment of chit dividend and chit discount under the Income-tax Act, 1961.

Issue-wise Detailed Analysis:

1. Validity of the Completed Contract Method versus Percentage of Completion Method for accounting in chit transactions:

The primary controversy in these appeals is whether the Completed Contract Method (CCM) followed by the assessees should be substituted by the Percentage of Completion Method (PCM) as contended by the Assessing Officer (AO). The assessees, private limited companies involved in chit transactions, have been maintaining their accounts on a mercantile basis and computing profit/loss at the end of the chit period using the CCM, which had been accepted by the Department over several years.

The AO argued that the CCM was not accurate in recognizing/identifying "income" under the Income-tax Act, 1961, particularly concerning chit discounts, and suggested that the PCM should be used instead. The Department's stance was that chit dividends should be taxed on an accrual basis, and income accrued to the assessees in the form of chit dividends during the year, while liability arose in the form of chit discounts over the relevant period.

The High Court, however, held that the CCM adopted by the assessees was valid and that the Department had erred in spreading the discount over the remaining period of the chit on a proportionate basis. This judgment was challenged by the Department.

The Supreme Court noted that the recognition/identification of income under the 1961 Act could be achieved by several methods of accounting, including the CCM and PCM. The CCM determines results only when the contract is completed, leading to an objective assessment of the contract's results. In contrast, the PCM aims for periodic recognition of income to reflect current performance, with revenue recognized by reference to the stage of completion of the contract.

The Court emphasized that the burden of proof lies on the Department to show that the existing method distorts the profits of a particular year when substituting one method with another. In this case, the AO did not record any finding that the CCM distorted the profits of a particular year. Additionally, the Chit Scheme is considered an integrated scheme spread over time, making the exercise revenue-neutral. Therefore, the Court found no justification for deviating from the CCM accepted by the Department over the years.

2. Tax treatment of chit dividend and chit discount under the Income-tax Act, 1961:

The assessees accepted the Tribunal and High Court's view that the CCM was not correct for chit dividends, settling that part of the controversy. The limited issue remained whether the CCM for chit discounts should be substituted by the PCM.

The Supreme Court discussed the matching principle, which is an important component of the accrual basis of accounting. The principle requires that revenue and income earned during an accounting period be matched with expenses incurred during the same period. The Court referred to various judgments, including the Bombay High Court's judgment in Taparia Tools Ltd. v. Joint Commissioner of Income-tax and the Supreme Court's judgment in J.K. Industries Ltd. & Anr. v. Union of India & Ors., which recognized the matching concept and its relevance in computing taxable income.

The Court concluded that the Department had not invoked the new accounting standards and concepts in the present batch of civil appeals. Therefore, it saw no reason to interfere with the High Court's judgment, which upheld the validity of the CCM for chit discounts.

Conclusion:

The Supreme Court dismissed the civil appeals, affirming the High Court's judgment that the CCM adopted by the assessees for chit discounts was valid and that the Department had erred in attempting to substitute it with the PCM. The Court emphasized the revenue-neutral nature of the exercise and the lack of any finding by the AO that the CCM distorted the profits of a particular year. The appeals were dismissed with no order as to costs.

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