REJECTION OF BOOKS OF ACCOUNT UNDER INCOME TAX ACT, 1961

[Mr. M. GOVINDARAJAN]

Method of Accounting

Section 145 of the Income Tax Act, 1961 (‘Act’ for short) provides the method of accounting by the assessee. Section 145(1) provides that income chargeable under the head "Profits and gains of business or profession" or "Income from other sources" shall be computed in accordance with either cash or mercantile system of accounting regularly employed by the assessee. Section 145(2) gives powers to the Central Government to notify in the Official Gazette from time to time income computation and disclosure standards to be followed by any class of assessees or in respect of any class of income.

The cash system of accounting is that in which the receipts are accounted for as and when actually received and the debits are made when actual disbursement is made. In ‘Morvi Industries Ltd. v. Commissioner of Income Tax’ - 1971 (10) TMI 5 - SUPREME Court, the Supreme Court said that under the cash system, it is only actual cash receipts and actual cash payments that are recorded. The cash system will cover cases where accounts are not maintained on the mercantile basis. The cash system of accounting also includes receipt of kind as revenue receipt of the year in which kind is received.

Under the mercantile system, credit entries are made in respect of the amounts due immediately they become legally due and before they are actually received. Similarly, the expenditure items for which legal liability has been incurred are immediately debited even before the amounts in question are actually disbursed. Where accounts are kept on mercantile basis, the profits or gains are credited though they are not actually realized and the entries thus made really show nothing more than an accrual or arising of the said profits at the material time.

Rejection of books of account

Section 145(3) provides that where the Assessing Officer is not satisfied-

• about the correctness or completeness of the accounts of the assessee; or
• where the method of accounting provided in has not been regularly followed by the assessee; or
• income has not been computed in accordance with the standards notified,

 the Assessing Officer may make an assessment in the manner provided in section 144. Section 144 provides for best judgment method of assessment by assessing Officer. Thus it is clear that before the Assessee goes for best judgment he is to reject the books of accounts maintained by the assessee.

Justification for rejection

In rejecting the books of accounts of the assessee there shall be justification for the same. In ‘Awadhesh Pratap Sing Abdul Rehman & Bros V. Commissioner of Income Tax’ – 1993 (12) TMI 28 - ALLAHABAD High Court the High Court held that it is difficult to catalogue the various types of defects in the account books which may render rejection on the ground that the accounts are not complete or correct from which the correct profit cannot be deduced. Absence of stock register or cash memos in a given situation may not per se lead to an inference that accounts are false or incomplete. However where a stock register, cash memos etc., coupled with other factors like vouchers in support of the expenses and purchases made are not forthcoming and the profits are low, it may give rise to a legitimate inference that all is not well with the books and the same cannot be relied upon to assess the income, profits or gains of an assessee. In such a situation the High Court held that the authorities would be justified to reject the account books under Section 145 and to make the assessment in the manner contemplated in these provisions.

In ‘Principal Commissioner of Income Tax V. Garden Silk Mills Limited’ – 2016 (7) TMI 915 - GUJARAT HIGH COURT the High Court held that the Commissioner and the Tribunal, after appreciating the material on record, recorded concurrent findings of fact and gave detailed, cogent and convincing reasons that the Assessing Officer was not justified in rejecting the books of Accounts of the assessee. The Department was not in a position to dislodge the findings of fact recorded by the Tribunal by providing out any material to the contrary, nor was it the case of the Department that the Tribunal had placed reliance upon any irrelevant material or that any relevant material had been ignored. Under the circumstances the accounts could not be rejected.

Accounting method

Books of account cannot be rejected while the assessee is following consistently following one method as held in ‘Commissioner of Income Tax V. Principal Officer, Hill View Infrastructure (P) Limited’ – 2015 (10) TMI 2059 - PUNJAB & HARYANA HIGH COURT In this case the Assessing Officer rejected the books of account of the assessee rejecting the contention of the assessee that they had been consistently following the Project Completion method i.e., the method of booking of the revenue on completion of the flat when full payment has been made to it by the persons concerned and possession was delivered to him. The Commissioner (Appeals) accepted the plea of the assessee and set aside the order of the Assessing Officer. The Tribunal confirmed the same. The High Court held that the assessee had been consistently following one of the recognized methods of accounting i.e., Project Completion Method. In the absence of any prohibition or restriction under the Act for doing so, it could not be held that the approach of the Commissioner (Appeals) and the Tribunal was erroneously or illegal.

Non production of accounts for verification

The rejection of books of accounts is justified under Section145 and the Best Judgment assessment under Section 144 where the assessee had not produced relevant records.

In ‘Ganesh Dass Piara Lal Jain V. Income Tax Officer’ – 2016 (7) TMI 686 - ITAT CHANDIGARH the Tribunal held that in the absence of purchases there could not be sales worth of ₹ 4.03 crores. Not only this, the Assessing Officer also accepted the opening and closing stock as shown by the assessee in the books of account which were never rejected by him. The Assessing Officer had not doubted the sales. If the Assessing Officer’s version was accepted then the gross profit works out 83% which was unbelievable. Non production of parties could not be a ground for disallowance of all the purchases because the parties from purchases were made could not always be in the control of the assessee especially when they were unrelated parties. The Tribunal held that there was no justification for making the addition of ₹ 3.07 crores on account bogus purchases.

In ‘Income Tax Officer V. Brij Fertilizers Limited’ – 2016 (5) TMI 1176 - ITAT AGRA the Assessing Officer made an addition of fertilizer subsidy received on the ground that the assessee was not found to have been engaged in the manufacturing of fertilizers, which was based on findings of a survey in the case of certain companies. The assessee did not produce books of account for verification. The Assessing Officer rejected the books of accounts. The Commissioner (Appeals) upheld the order of the Assessing Officer. The Assessing Officer was directed to estimate the net profit of the assessee at 10%. The Tribunal found that the Commissioner (Appeals) passed speaking order based on the evidence. The Tribunal upheld the order of Commissioner (Appeals).

In ‘Bastiram Narayandas V. Commissioner of Income Tax’ – 1993 (12) TMI 31 - BOMBAY High Court the High Court held that the rejection of books of accounts was justified under Section145 and the Best Judgment assessment under Section 144 where the assessee had not produced relevant records relating to its day to day manufacture of ‘bidis’ including the quantity of ‘bidis’ manufactured daily, the figures of ‘bidi’ leaves consumed per day in each factory and the records relating to the daily collection of CHAAT and MAPARI bidis the Tribunal has been held correct in holding that the Income Tax Officer was not satisfied about the fitness of correctness of the accounts of the assessee.

Failure to produce records

In ‘Samwon Precision Mould Manufacturing (India) Private Limited V. Income Tax Officer’ – 2016 (4) TMI 1094 - ITAT DELHI the Assessing Officer rejected the books of account of the assessee under Section 145 of the Act on the ground that the assessee had failed to produce any bills or vouchers in respect of various cash payments made by the assessee and there were mistakes and discrepancies in the books of account. The Assessing Officer applied the net profit @ 3% and computed the income. The Commissioner (Appeals) confirmed the order of Assessing Officer. The Tribunal held that the books of account were duly audited and no effects had been pointed out regarding the sales, purchase or profit. The purported defects were confined to cash book which had no nexus with the trading results. Instances of irregularities in cash payment could not warrant ipso facto rejecting books of account.

In ‘Commissioner of Income Tax V. Gupta, K.N. Construction Co’ – 2015 (5) TMI 315 - RAJASTHAN HIGH COURT the High Court held that where the provisions of Section 145(3) are invoked one has to consider either the past history of the assessee or history of similarly situated other businesses or trades. Out of the past five assessment years, the Tribunal had applied the rate of 5%. For the Assessment year in question though the contract receipts had sharply increased from ₹ 10.60 crores to ₹ 12.32 crores the net profit had increased from 5.02% to 5.38% or 5.78% with the addition of ₹ 5 lakhs. The Assessing Officer had merely disallowed 20% or 10% as the case may be, out the various expenses, was not proper and he had to bring on record justifiable basis or evidence for making an addition. As the Assessing Officer had failed to bring on record any comparable case so as to justify any estimation, addition, the addition had been rightly deleted by the Commissioner (Appeals) as well as the Tribunal.

Defective accounts

The Assessing Officer is having power to examine the books of accounts submitted by the assessee and also other supporting materials. If the account is found defective, then the Assessing Officer may reject the books of account and initiate action according to the provisions of the Act.

In ‘Chaturbhuj Major Kumar and others V. Commissioner of Income Tax and another’ – 2016 (7) TMI 1230 - RAJASTHAN HIGH COURT the Assessing Officer examined the books of account and other supporting materials produced by the assessee. The Assessing Officer found that the purchases could be said to be vouched as they were made from Government undertakings or/and other distilleries, the sales version has totally manipulated. The assessee did not maintain brand wise and size wise quantitative details of various bottles/pouches. Even registers were not maintained. The assessees admitted the defects. The Assessing Officer rejected the books of account. The Commissioner (Appeals), while granting partial relief, upheld the rejection of books of account. The Tribunal also upheld the order. The High Court held that admittedly the books of account had been found to be defective even on the admission of the assessee. The books of account were rightly rejected for the reasons assigned by the three authorities.

In ‘Kachwala Gems V. Joint Commissioner of Income Tax, Jaipur’ – 2006 (12) TMI 83 - SUPREME COURT the assessee was dealing in precious and semi precious stones. The Assessing Officer noticed certain defects in books of account of the assessee. The assessee had not maintained any quantitative details/stock register for the goods trade in by it. There was no evidence/document to verify the basis of closing stock valuation shown by it. The gross profit rate declared by the assessee at 13.49% during the assessment year did not match the result declared by the assessee itself in the previous assessment years and that the gross profit declared by it was much below the rate declared voluntarily by another assessee engaged in similar business. Therefore, the Assessing Officer rejected the books of account of the assessee and resorted to best judgment assessment under Section 144 and estimated the gross profit at 40%. The Assessing Officer further held that the assessee had shown bogus purchases for reducing the gross profits. On appeal, the Commissioner (Appeals) though reduced the quantum of the gross profit, estimated by the Assessing Officer, yet upheld most of his impugned findings. On further appeal, the Tribunal had also given further relief to the assessee. The Supreme Court, on appeal, held that the assessee himself who is to blame as he did not submit proper accounts. There was no arbitrariness in the instant case on the part of the authorities. Thus there was no force in the instant appeal and the same is liable.

In ‘Champa Lal Choudhary V. Deputy Commissioner of Income Tax’ – 2012 (7) TMI 761 - ITAT, Jaipur the Tribunal confirmed the rejection of books of account holding that the additions being agitated would need to be examined, from the standpoint of the validity or otherwise of the invocation of Section 145(3) of the Act and the concomitant rejection of assessee’s book/results and then on the merits of the addition on quantum. The revenue’s action in invoking Section 145(3) is confirmed. This is principally for the reason that the assessee’s books of account did not meet the test of deduction of true and correct profits there from in the absence of proper stock records, only whereupon can they be considered as correct and complete.

Maintenance of stock register

In case of the assessee is a manufacturer he is required to maintain stock register. Non maintenance of stock register would amount to defect in accounts.

In ‘Pandit Brothers V. Commissioner of Income Tax’ – 1954 (3) TMI 70 - PUNJAB HIGH COURT it was held that the fact that there is no stock register only cautions the Assessing Officer against the falsity of the returns made by the assessee. He cannot show that merely because there is no stock register the accounts books must be false.

In ‘Bhundiram Dalichand V. Commission of Income tax’ – 1970 (4) TMI 52 - BOMBAY High Court the High Court found the rejection of books of accounts under Section 145 justified in the absence of quantitative tally of purchases and sales besides unexplained lowness of gross profit.

In ‘Commissioner of Income Tax V. Pareck Brothers’ – 1987 (3) TMI 79 - PATNA High Court it has been that invocation of Section 145 was justified as the assessee was not maintaining day to day stock account and did not furnish any distinctive numbers either of purchases or sales to the Income tax officer.

In ‘Chhabildas Tirbhuvandas Shah V. Commissioner of Income Tax’ – 1964 (9) TMI 8 - SUPREME Court the Supreme Court held that there was material to support the appellate Tribunal’s sustaining addition made on the ground that-

• the assessee’s business was on wholesale basis and in the absence of tally of quantities in respect of major items of the trading account, the fall in margin of profits could not be satisfactorily explained; and
• the fall was all the more difficult to explain in view of the fact that the assessee had a substantial import quota which could have been given him a handsome margin or profit.

A number of High Courts have held that the keeping of stock register is of great importance because it is a means of verifying the assessee’s accounts by having a quantitative tally. In any case, after taking into account the absence of a stock registered coupled with other materials, it is felt that correct profits and gains cannot be deducted from the accounts, resort to the provisions of Section 145 (3) can be taken.

In ‘Amiya Kumar Roy and Brothers V. Commissioner of Income Tax’ – 1993 (3) TMI 26 - CALCUTTA High Court the Calcutta High Court held that failure to maintain stock accounts by the assessee was a substantial defect in the accounts. It upheld the decisions of the Tribunal holding that the estimate which was made in the case and the addition made on such estimate was quite reasonable and fair taking cumulative view of all the factors present in the case.

Resorting to Best Judgment – when?

Section 145 (3) of the Act lays down that the Assessing Officer can proceed to make assessment to the best of his judgment under Section 144 of the Act only in the event of not being satisfied with the correctness of the accounts produced by the assessee. In ‘Commissioner of Income Tax and another V. Anil Kumar & Co’ – 2016 (3) TMI 184 - KARNATAKA HIGH COURT the High Court held that the Tribunal has rightly held that when the books of account of the assessee had not been rejected and assessment having not been framed under Section 144 of the Act the said authorities were in error in resorting to an estimation of income and such exercise undertaken by them was not sustainable. In the instant case the Assessing Officer has not made out a case that conditions laid down in Section145 (3) of the Act are satisfied for rejection of books of account. As such the Tribunal has rightly rejected or set aside the partial addition made by the Assessing Officer for arriving at gross profit and sustained by Commissioner (Appeals). The High Court dismissed the appeal filed by the Revenue.

Best judgment to be judicial

In case where the provisions of Section 145(3) are attracted, although the assessment is made in the manner provided in Section 144, nevertheless the assessment is made under Section 143(3) of the Act. A clear cut distinction between best judgment assessment and in the manner provided under Section 144 is required to be understood while resorting to the provisions of Section 145(3). Under Section 145(3) the assessment is required to be in the manner under Section 144 of the Act only. However it is well known that in the case of best judgment where resort is taken to Section 144, the Assessing Officer exercising his jurisdiction cannot act arbitrarily or capriciously. The assessment must proceed on judicial considerations in the light of relevant material that may be brought on record. In ‘Commissioner of Income tax V. Surejeet Singh Maheskumar’ – 1993 (11) TMI 22 - ALLAHABAD High Court the Allahabad High Court has held that in every case of best judgment, the element of guess work cannot be eliminated so long as best judgment has a nexus with material on record and discretion in that behalf has not been exercised arbitrarily and capriciously.

Opportunity to the assessee

The assessment that has to be made after rejection of books of account under Section 145(3), of the evidence or books produced is not an assessment under Section144, but is only an assessment under Section 143 (3) which is to be made ‘in the manner provided in Section 144’. In such cases, the Assessing Officer has to give an opportunity to the assessee to contradict the materials upon which the Assessing Officer wants to base his estimate.

Estimation of profit

Once the books of account of assessee are rejected, profit has to be estimated on the basis of proper material available. An Assessing Officer is not flattered by technical rules of evidence and pleadings and he is entitled to act on material on which may not be accepted as evidence in Court of Law. Nevertheless the Assessing Officer is not entitled to make a pure guess and make an assessment with reference to any evidence or any material at all. There must be something more than mere suspicion to support an assessment under Section 143(3) of the Act.

The estimate of turnover and fixation of gross profit rate are two import parameters which affect the assessment. If these are fixed or calculated in such a way that they adversely affect the assessee’s case, then he is entitled to know the basis and to be given an opportunity to rebut the same.

Peak credit

No reliance can be placed on rejected account books for working out Peak Credit. In ‘Commissioner of Income Tax V. KMN Naidu’ – 1995 (10) TMI 16 - MADRAS High Court the Madras High Court has held that where assessee’s business income is estimated after rejecting the books of account produced by the assessee, it is not reasonable on the part of the Income Tax Officer to work out the Peak credit on the basis of such books of accounts.

Accounting of commission

In ‘Sajid Iqbal Qureshi V. Assistant Commissioner of Income Tax’ – 2016 (7) TMI 106 - ITAT MUMBAI the assessee was sole selling agent and power of attorney of film producer marketing, selling films to prospective distributors on behalf of principal. The assessee collected the amount on behalf of principal and remitted the same to the principal after deducting expenses and commission. The Assessing Officer has observed that the assessee only accounted for receipts of ₹ 22,04,265/- whereas according to the certificate of tax deduction at source the total receipts were ₹ 82,38,000/- and therefore he rejected the books of account and added the difference of ₹ 60,33,735/- to the total income. The Tribunal allowed the appeal holding that the assessee had rightly accounted for the commission on the gross value instead of accounting for payment from the parties on which tax was deducted. Since the assessee was working as the sole selling agent the provisions of Section 194J or 194C and Section 40(a)(ia) were not attracted. The Tribunal directed the Assessing Officer to delete the addition made of ₹ 60,33,736/-.

Reference to Valuation Officer

Section 142A (1) of the Act provides that the Assessing Officer may, for the purposes of assessment or reassessment, make a reference to a Valuation Officer to estimate the value, including fair market value, of any asset, property or investment and submit a copy of report to him. In ‘Sargam Cinema V. Commissioner of Income Tax’ – 2009 (10) TMI 569 - Supreme Court of India  the Supreme Court held that the Assessing Officer cannot refer the matter to the District Valuation Officer under Section 142A of the Act without rejecting the books of accounts under Section 145(3) of the Act.

Comparing gross profit of earlier years

In ‘International Forest Company V. Commissioner of Income Tax’ – 1974 (12) TMI 33 - JAMMU AND KASHMIR High Court the High Court held that the rate of gross profit in a particular year depends on many factors such as general market conditions based on demand and supply position, the rise or fall in market rates, specially abrupt ones, the capital position and the turnover achieved etc., It is for the assessee to explain the fall, if so happens and to substantiate the reasons. Even if, thereafter, the Assessing Officer considers the material placed before him by the assessee to be unreliable keeping in view the comparative statement of accounts of the earlier years, he cannot proceeded to make an arbitrary addition and base his conclusion purely on guess work. He can do only if he relates to some evidence or material on the records. If the profit shown by the assessee in his return is not accepted, it is for the taxing authorities to prove that the assessee made more profits.

The rejection of books of accounts under Section 145(3) cannot be sustained merely on the fact that the gross profit of the assessee is low during the relevant period as compared to the book results of other years. Similarly the system of accounting adopted by the assessee cannot be rejected merely on the ground that the gross profits disclosed by his books were low as compared with those of others in the same line of business.

Comparison of earlier accounts

It is well settled position that while making the assessment, the account books for that year have alone to be considered, as each assessment year is independent. In ‘Ram Avtar Ashokumar V. CIT’ – 1979 (7) TMI 227 - ALLAHABAD HIGH COURT it is held that there is no scope of presumption that merely because for some reason the account books in earlier years were rejected, these stood condemned for ever.

Estimation of income/profit

In ‘Vrailal Manilal & Company V. Commissioner of Income Tax’ – 1972 (11) TMI 9 - MADHYA PRADESH High Court the High Court held that once the books are properly rejected, the income has to be estimated and in making the estimate of such income, the best record along with other things will become the relevant material.

In ‘Commissioner of Income Tax V. Nuchem Limited’ – 2015 (5) TMI 259 - PUNJAB & HARYANA HIGH COURT the Assessing Officer made an application of ₹ 30.26 lakhs on account of trading addition by applying the gross profit rate of 52% instead of 51.27% shown by assessee after rejecting the book results in the MDF division. The Commissioner (Appeals) deleted the addition and confirmed by the Tribunal. The High Court held that in deleting the addition by rejecting the accounts, the Commissioner (Appeals) and the Tribunal had followed the earlier decision in the case of the assessee for the financial year 1993-94 which was not shown to have been upset by any higher court. The deletion of the addition was justified.

Power to be exercised judicially

The power to reject the books of accounts by the Assessing Officer is to be exercised judicially. The Assessing Officer is to bring on record material on the basis of which he has arrived at the conclusion with regard to correctness or completeness of the accounts of the assessee or the method of accounting employed by it. In ‘Karnataka State Forest Industries Corporation Limited V. Commissioner of Income Tax’ – 1992 (10) TMI 65 - KARNATAKA High Court the High Court held that when the Assessing Officer does not accept the assessee’s method of accounting, then he has to resort to the provisions of Section 145(3) for computation of income by adopting such other basis as determined by him. The Assessing Officer’s powers under the Section are not arbitrary and he must exercise his discretion and judgment judicially.

Power of First Appellate Authority

It is well settled position of law that the Commissioner of Income Tax (Appeals) during the appellate proceedings exercises all the powers vested with Assessing Officer to be exercised while framing the assessment order. Therefore the Commissioner (Appeals) can reject the books of accounts of the assessee by invoking the provisions of Section 145(3) of the Act for the first time, while framing the appellate order provided with all other conditions exist warranting reject of such books of accounts.       

No presumption

In ‘Commissioner of Income Tax V. Kohinoor Foods Limited’ – 2015 (5) TMI 82 - DELHI HIGH COURT the Tribunal found that the assessee’s books of account were regularly maintained, audited and no discrepancies whatsoever had been indicated by the Assessing Officer in any material terms. All the books of account were found and seized and there was no quantitative tally in the account book. Therefore, the conclusion of the Assessing Officer in this behalf reject the books was purely based on surmises and conjectures, the ad hoc addition of 1% of sales had been made which was again guess work based again on conjectures. The High Court held that the Assessing Officer’s narrow basis for rejecting the books of account and addition of 1% of sales and bringing to it tax was legally untenable.

Explanation of the assessee

In ‘Pawan Kumar V. Income Tax Officer, Malerkotla’ – 2012 (11) TMI 3 - ITAT CHANDIGARH the Tribunal confirmed the rejection of books of account under Section 145(3) holding that the discrepancies pointed out by the Assessing Officer, while rejecting the book results have not been satisfactorily explained by the assessee. The Assessing Officer has observed that although the quantity of cotton seed, mustard and ground nut crushed during the previous year were shown separately but the yield of oil and oil cakes have been given in consolidated form at 13.02% and 83.91% respectively. Further the sales of oil and oil cakes have been shown in the manufacturing account in consolidated form although there was a wide variation in the market price of these products. It is also true that there is always a wide variation in the percentage of yield of oil and sale rates of oil and oil cakes in the market. However, the assessee has preferred to put up a consolidated account of difference types of oil seeds for the reasons best known to him. The assessee was asked by the Assessing Officer to rework the yield of oil and oil cakes separately from different types of oil, oil seeds crushed by him. The assessee was also asked to explain the reasons for mixing up the cotton, mustard and ground nut oil seeds in the same category when there was vast variation in market price of these types of oil seeds and other products. When Assessing Officer asked the assessee to give the explanation, the assessee stated that there was not much difference in the market price of both these oils and, therefore, he has made the sales of Khal and oil of both these varieties jointly. It is opined that the Assessing Officer has correctly rejected the above explanation of the assessee stating that assessee’s statement in this behalf if not correct, therefore, under no circumstances is acceptable. Unless the yield of oil obtained on the crushing of three types of oil seeds is separately given, the manufacturing results cannot be appreciated in their proper prospective. There were sufficient reasons to hold that the books of account maintained by the assessee are unreliable, incorrect and incomplete. Therefore, the books of account of the assessee have correctly been rejected under Section 145 (3). The Commissioner (Appeals) has correctly upheld the action of the Assessing Officer in rejecting the books of account.

Conclusion

The Assessing Officer, before rejecting the books of account, has to bring on record material on the basis of which he has arrived at the conclusion with regard to correctness or completeness of the accounts of the assessee or the method of accounting employed by it. The obligation on the part of the assessee is to bring the accounts/documents before the Assessing Officer whenever it is required. The Assessing Officer may resort to best assessment, the power of which shall be exercised judicially and not violating the principles of natural justice.