Civil Appeal Nos 1701 1703 of 1974
Appeal by Special Leave from the Judgment and order dated 26 9 73 of the Punjab  Haryana High Court in Income Tax Reference Nos 3872 273 373
section T Desai and Ramesh Chand for the Appellant
P G Gokhale and Miss A Subhashini for the Respondent
The Judgment of the Court was delivered by TULZAPURKAR J
The short question raised in these appeals by special leave is whether the cost of materials supplied by the Government MES Department for being used in the execution of works is liable to be taken into consideration while estimating the profits of a contractor and the question has assumed general importance as it affects the entire class of contractors who undertake works on behalf of the Government and in view of a conflict of decisions on the point among different High Courts
The facts in all the three appeals are substantially the same though the assessees are different
In Civil Appeal No 1701 of 1974 the material facts are these The assessee Ms Brij Bhushan Lal Praduman Kumar of Ambala Cantonment a registered firm is a Military Engineering Services MES contractor and as such carries on the business of executing contracts and works on behalf of the Government
For the execution of the works undertaken by the assessee certain material such as cement coal items of steel etc is supplied at the fixed rates specified in Schedule to the contract by the Government for being used in the works
Such material though in custody of the contractor always remains the property of the Government and if any surpluses is left at the completion of the contract the contractor assessee has to account for it at the same rates at which the supply was made to him wear and tear excepted and return the same to the Government
The assessment year involved was 1966 67 for which the accounting year commenced on 1 10 1964 and ended on September 19 30 1965
The assessee firm had taken two contracts one at Delhi A and the other at Ambala
For the said assessment year it filed its return of income declaring income of Rs 44462 being 10 of the total cash payments of Rs 444622 received from the military authorities
The assessee however did not furnish any figures about the stores material received by it from the MES The Income tax officer called upon the assessee to produce the relevant certificates in respect of such stores but the assessee failed to do so on the ground that the Departments were not cooperating with it
The Income tax officer therefore estimated the cost of such material at 50 of the cash payments namely at Rs 222311 and by adding this figure to the net cash receipts of Rs 444622 he arrived at total receipts including the cost of material of Rs 666933 and after rejecting the book results applied a flat rate of 10 and worked out net income or profits at Rs 66693 which was rounded upto Rs 66690 and on that basis the tax was levied after allocating the said profits among the three partners of the firm
The assessee preferred an appeal to the Appellate Assistant Commissioner contending that the addition of the cost of material supplied by the Government to the figure of cash receipts received by it during the year for applying the Hat rate of 10 was erroneous and in any case the estimate of the value of such stores at 50 of the cash payments was excessive
The Appellate Assistant Commissioner rejected the first contention but reduced the estimate of the value of the stores supplied by the Government to 25 and con fined the addition to Rs 111155
Aggrieved by that order the assessee preferred further appeal to the Income Tax Appellate Tribunal and the Tribunal accepted the contention of the assessee that the cost of the stores or material supplied by the Government to the assessee could not be added to the figure of cash payments received by the assessee on the ground that the stores material supplied by the Government F were never sold  to the contractor that the same always remained the property of the Government and that no profit could be said to have arisen to the assessee when such stores material was merely handled and manipulated by the assessee in the execution of the works under the contract
The Tribunal followed the decision of the Kerala High Court in MP Alexander  Co vs Commissioner of Income taxl where that Court has taken the view that the cost of such material supplied by the Government was not to be included while estimating the profits of a contractor
The Revenue sought a reference to the Punjab  Haryana High Court on the question whether on the facts and circumstances of the case the Tribunal was justified in holding that the cost of the material supplied by the Government was not to be 1 20 included while estimating the profits of a contractor and the High Court in Reference No 38 of 1972 answered the question against the assessee and in favour of the Department and restored the view of the taxing authorities by its order dated September 26 1973 and in doing so the yearly income tax paid by them is Rs 70 to Rs 80 only
There is Bhushan Lal vs Commissioner of Income Tax Delhil where it had held that the cost of the materials supplied by the military authorities was liable tc be included before applying the flat fate to the assessees rceipts
Civil Appeals Nos 1702  1703 of 1974 relate to the assessments of Ms Brij Bhushan Lal Ramesh Kumar for the assessment years 1965 66 and 1966 67 the relevant accounting years being the ones which ended on March 31 1965 and March 31 1966 respectively
The assessee firm a MES Contractor carried on the business of executing works on behalf of the Government under similar MES contracts wherein storesmaterials are supplied by the military authorities to the firm on identical terms
For the assessment year 1965 66 the assessee filed its return declaring an income of Rs 18684 and disclosing net cash receipts from the Government at Rs 263853
Though this income was based on books of accounts maintained by the firm the assessee during the course of assessment proceedings offered that a flat rate of 9 on the cash receipts of Rs 266853 may be applied
The Income Tax officer did not accept the offer but applied a flat rate of 10 on Rs 307605 which included the value of the stores supplied by the Department to the assessee with the
result that the profits were assessed at Rs 30760 and after allowing deprecation of Rs 5107 the net taxable income was determined at Rs 25653 which was rounded up to Rs 25650
For the assessment year 1966 67 the firm declared an income of Rs 62414 calculated by adopting the flat rate of 10 on the cash receipts of Rs 624144
The firm had received storesmaterial of the value of Rs 136520 from the military authorities and the Income Tax Officer after adding the value of the stores to the cash receipts arrived at a total receipt of Rs 760664 and by applying the flat rate of 10 determined the taxable income at Rs 76070
The assessee s appeals for both the years to the Appellate Assistant Commissioner were unsuccessful but in further appeals the Appellate Tribunal by its order dated October 31 1970 accepted the assessee s contention and held that the cost or the value of the storesmaterial supplied by Government to the contractor was not liable to he included while estimating the profits or income of the contractor
In coming to this conclusion as in the other case the Tribunal followed the Kerala High Court s decision in M P Alexander s case supra
1 21 At the instance of the Revenue two references being Income Tax References Nos 2 and 3 of 1973 were made to the Punjab  Haryana High Court and the High Court following its earlier decision in Brij Bhushan Lal s case supra answered the questions referred to it in the negative ie in favour of the Department and against the assessee
Both the assessees have come up to this Court by special leave challenging the view taken by the High Court
In support of these appeals counsel for the appellants has contended that it was well settled that even while making a best judgment assessment the Income Tax officer must make an honest and fair estimate of the income of the assessee and that having regard to the terms and conditions of the contract a specimen whereof was produced during the hearing before us and particularly the terms on which the storesmaterials were supplied by the military authorities to the assessee for being used in the works undertaken by the firm it was clear that no element of profit was embedded led in such storesmaterials that were made available to the contractor for being used in the works entrusted lo the contractor and as such the cost or value of such storesmaterial could not be added to the total cash payments received by the contractor from the Department under the contract for the purpose of estimating the income or profits derived by the contractor from such contract
He pointed out that under the terms and conditions of the contract such storesmaterial were never sold  by the Department to the contractor but the same always remained the property of the Department and the 15 contractor had merely handled manipulated or used the same in the works completed by him and the surplus of such storesmaterial if any that remained was required to be and was actually returned by the contractor to the Department and this being the true nature of the supply of such storesmaterial the cost or the value thereof could not be included or added to the total cash payment received by the contractor under the contract for computing his income or profits From the said contract
In support of his contention reliance was placed upon MPAlexander s case supra Madras High Court s decision in Commissioner of Income tax Madras vs K section Guruswami Gounder  K section Krishanarajul Gujarat High Court s decision in Trilokchand Chunilal vs Commissioner of Income Tax Gujarat2 and Full Bench decision of the Andhra Pradesh High Court in Additional Commissioner of Income tax vs Trikamji Punia  Sons2
on the other hand counsel for the Revenue contended that not only the cash payments received by the assessee under the contract but 1 2 3 22 also the cost of the store material supplied by the Department to the contractor both together represented the real value of the contract to the contractor and as such since the book results were rejected the Taxing Authorities and the High Court were right in coming to the conclusion that the income or profits derived by the contractor from such contracts was liable to be determined by applying the flat rate to the entire value of the contract
In other words it was contended by him that the cost of the storesmaterial supplied by the Government to the contractor was liable to be taken into account while estimating the income or profits of the contractor under such contract and in that behalf he pressed for our acceptance the view of the Punjab  Haryana High Court in Brij Bhushan Lal s case supra
At the out set it may be stated that in the case of both the assessees their returns and book results were rejected on the ground that proper and reliable books of account had not been maintained and the Income tax officer was required to make the assessments on best judgement basis
However the principles to be followed by the lncome tax officer while making a best judgment assessment have been clearly laid down by the Privy Council as also by this Court in a number of decisions
In commissioner of Income Tax vs Laxminarain Badri das1 their Lordships of the Privy Council observed as follows The officer is to make an assessment to the best of his judgment against a person who is in default as regards supplying information
He must not act dishonestly or vindictively or capriciously because he must exercise judgment in the matter
He must make what he honestly believes to be a fair estimate of the proper figure of assessment anl for this purpose he must their Lordships think be able lo take into consideration local knowledge and repute in regard to the assessee s circumstances and his own knowledge of previous returns by and assessments of the assessee and all other matters which he thinks will assist him in arriving at a fair and proper estimate and though there must necessarily be guesswork in the matter it must be honest guesswork
In that sense too the assessment must be to some extent arbitrary
Since the law relating to best judgment assessment is the same both in the case of income tax assessment and the sales tax assessment and the following observations of this Court in Raghubar Mandal Harinder Mandal vs State of Bihar2 a case under the Bihar Sales Tax Act would be material 1 1937 S ITR 170 PC
2 1957 7 STC 770 at p 778
23 No doubt it is true that when the returns and the books of account are rejected the assessing officer must make an estimate and to that extent he must make a guess but the estimate must be related to some evidence or material and it must be something more than mere suspicion Again in State of Kerala vs C Velukuttyl which was a case 1 under the Travancore Cochin General Sales Tax Act Subba Rao J as he then was speaking for this Court observed at page 244 of the report thus The limits of the power are implicit in the expression best of his judgment 
Judgment is a faculty to decide matters with wisdom truly and legally
Judgment does not depend upon the arbitrary caprice of a judge but on settled and invariable principle of justice
Though there is an element of guesswork in a best judgment assessment  it shall not be a wild one but shall have a reasonable nexus to the available material and the circumstances of each case
 It will appear clear from what has been said above that the authority making a best judgment assessment must make an honest and fair estimate of the income of the assessee and though arbitrariness cannot be avoided in such estimate the same must not be capricious but should have a reasonable nexus to the available material and the circumstances of the case
It is with reference to these principles that the question raised before us will have to be considered and looking at it from that point of view the real question is whether the turnover represented by the cost of the storesmaterial supplied by the MES Department involves any element of profit having regard to the terms and conditions on which such supply is made  If it does then cost of such storesmaterial will have to be taken into account but if it does not such cost will have to be excluded
In order to decide the aforesaid question it will be necessary to advert to the terms and condition of the works contracts undertaken by the two assessee firms which as stated earlier are common
The assessee firms in both the cases are MES Works Contractor tendering and obtaining from the MES Department what are known as  Lump sum contracts which arc governed by the General Conditions of contracts IAFW 2249 1963 print
In addition to the general conditions the particular work undertaken by the contractor is also governed by special terms contained in the Acceptance of Tender and the specification and Schedules annexed thereto  In Lump 1 24 Sum Contracts of MES Department two salient features are always present namely l there is a Schedule B  which specifies the items of storesmaterial to be supplied by the Department to he contractor solely for being used fixed or incorporated in the works together with the fixed rates at which the same will be supplied and such supply is governed by General Conditions Nos 10 and 33 apart from the storesmaterial specified in Schedule B  the contractor also brings his own storesmaterial on site for the purposes of the works which is also governed by some Paragraphs of General Conditions Nos 10 and 33 and 2 the final financial liability of the Government is fixed on completion of the contract on the basis of the actual measurements and on the basis of the rates which are already standardised a detailed measurement is undertaken at the end of the work at which the Garrison Engineer and the assessee s representative remain present and the measurements are entered in Measurement Books and after the measurements
final bills are prepared as per the MES Schedule and payments are made after making adjustments for the advances already made
With regard to storesmaterial Condition Nos 10 and 33 of the General Conditions are material
Condition No 10 so far as is material runs thus Condition 10 Stores and Materials The Contractor shall at his own expense supply all stores and materials required for the Contract other than those listed in Schedule B  which are to be provided by the Government by the rates detailed therein
            
All stores and materials to be supplied by the Contractor shall be the best of the respective kinds described in the Specifications and the Contractor shall upon the request of the Engineer in Charge furnish him with proof to his satisfaction that the stores and materials so comply         
In the case of stores provided under Schedule B  the Contractor shall bear the cost of loading transporting to site unloading storing under cover as required assembling and jointing the several parts together as necessary and incorporating and fixing these stores and materials in the Works including all preparatory work of whatever description as may 25 be required and of closing preparing loading and returning empty cases or containers to the place of issue without any extra charge condition No 33 SO far as is material runs thus Condition 33 Stores and Materials on site Stores and materials required for the Works are to be deposited by the Contractor only in places to be indicated by the Engineer in Charge
            
All stores and materials brought to the site shall become and remain the property of Government and shall not be removed off the site without the prior written approval of the GE
But whenever the Works are finally completed the Contractor shall at his own expense forthwith remove from the site all surplus stores and materials originally supplied by him and upon such removal the same shall revest in and become the property of the Contractor
All Government stores and materials Issued to the Contractor for incorporation or fixing in the Works and which making due allowance tor reasonable wear and tear and or waste have not on completion of the Works been so incorporated or fixed shall be returned by the Contractor at his own expenses to the place of issue
Surplus stores andor materials returned by the Contractor will be credited to him at a price not exceeding that at which the said stores and materials were originally issued to him but due consideration shall be given to and allowance claimed by Government in respect of ally depreciation or damage suffered by the Stores andor materials whilst in the custody of the Contractor  From the tender documents that are made available to contractor and the aforesaid terms and conditions of the Lump Sum Contracts two or three aspects emerge very clearly
In the first place the contractor becomes aware that certain specified storesmaterials will be supplied to him by the Department at fixed rates for being used in the works to be undertaken by him for which he has not to pay from his pocket and it is on that footing that he submits his tender quoting a particular figure for the entire work secondly such storesmaterial so supplied by the MES Department has to be used fixed or incorporat 3 817 SCI78 26 ed by the contractor in the works undertaken by him and the surplus if any that would remain after the completion of the work is to be returned to the Department thirdly since for accounting purposes the initial supply is debited to the contractor at the specified fixed rates credit for the balance of the storesmaterials so returned is also given at the same rates some adjustment being made in respect of the wear and tear of such storesmaterial but in regard to the storesmaterial out of such supply as is actually used fixed or incorporated in the works no accounting is done vis a vis the contract payment that is made to the contractor
In other words in substance and in reality such storesmaterial always remains the property of the Department and the contractor has merely the custody of it and he fixes or incorporates the same into the works
It seems to us clear that in such circumstances and having regard to the terms and conditions on which much supply of storematerials is made there is not even a theoretical possibility of any element of profit being involved in the turnover represented by the cost of such storesmaterial
It is conceiveable that when the contractor himself purchases materials in the open market and supplies the same to the Department by using fixing or incorporating the same in the works as in the case of materials other than specified in Schedule B  some profit element would be embedded in the turnover represented by the cost of such material but when storesmaterial is supplied by the Government Department at fixed rates for being used fixed or incorporated in the work on terms indicated above there would be no element of profit involved in the turnover represented by the cost of such material
It is true that ordinarily when a works contract is put through or completed by a contractor the income or profits derived by the contractor from such contract is determined on the value of the contract as a whole and cannot be determined by considering several items that go to form such value of the contract but in our view where certain storesmaterial is supplied at fixed rates by the Department to the Contractor solely for being used or fixed or incorporated in the works undertaken on terms and conditions mentioned above the real total value of the entire contract would be the value minus the cost of such storesmaterial so supplied
Therefore since no element of profit was involved in the turnover represented by the cost of storesmaterial supplied by the MES to the assessee firms the income or profits derived by the assessee firms from such contracts will have to be determined on the basis of the value of the contracts represented by the cash payments received by the assessee firms from the MES Department exclusive of the cost of the materialstores received for being used fixed or incorporated in the works undertaken by them
27 Having regard to our aforesaid conclusion the view taken by the Punjab and Haryana High Court in Brij Bhushan Lal s case supra must be regarded as erroneous and we approve the view taken by the Kerala High Court M P Alexander  Co case Madras High Court KS Guruswami Gounder case
Gujrat high Court Trilokchand Chunilal s case and Andhra Pradesh High Court Trikamji Punia s case
In the result the appeals are allowed the impugned orders of the High Court are set aside and those of the Appellate Tribunal are restored
The Revenue will pay the costs of the appeals to the assessee firms
SR Appeals allowed


Summary:
The appellant assessees are Military Engineering Services  contractors and as such carry on business of executing contracts and work on behalf of the Government
Their contracts are Lumpsum contracts where the department supplies the materials at fixed rates
The revenue was of the opinion that the cost of the materials supplied by the military authorities was liable to be included before applying the flat rate to the assessee s receipts and estimating the profits for the purposes of tax liability
The High Court of Punjab and Haryana on a reference at the instance of the Revenue confirmed it following its own earlier Judgments in the case of Brij Bhushan Lal vs CIT Delhi  1971  Allowing the appeals by special leave the Court  HELD l
The law relating to best judgment assessment  is same both in the case of income tax assessment and the sales tax assessment
The authority making a best judgment assessment must make an honest and fair estimate of the income of the assessee and though arbitrariness cannot be avoided in such estimate the same must not be capricious but should have a reasonable nexus to the available material and the circumstances of the case
22G H 23D E Commissioner of Income Tax vs Laxminarain Badridas 1937 S ITR 170 PC Raghubar Mandal Harihar Mandal vs State of Bihar 1957 7 STC 770 at p 778 and State of Kerala vs C Velukutty  referred to
Ordinarily when a works contract is put through or completed by a contractor the income or profits derived by the contractor from such contract is determined on the value of the contract as a whole and cannot be determined by considering several items that go to form such value of the contract but where certain storesmaterial is supplied at fixed rates by the Department to the Contractor solely for being used for fixed or incorporated in the works undertaken on terms and conditions mentioned in the contract the real total value of the entire contract would be the value minus the cost of such storesmatrial so supplied
Therefore since no element of profit was involved in the turnover represented by the cost of storesmaterial supplied by The MES to the assessee firms the income or profits derived by the assessee firms from such contracts will have to be determined on the basis of the value of the contracts represented by the cash payments received by the assessee 17 firms from the MES Department exclusive of the cost of the materialstores received for being used fixed or incorporated in the works undertaken by them
26E H In Lumpsum contracts of MES Department two salient features are always present namely  1  there is a Schedule B  which specifies the items of storesmaterial to be supplied by the Department to the contractor solely for being used fixed or incorporated in the works together with the fixed rates R at which the same will be supplied and such supply is governed by General Conditions Nos 10 and 33 apart from the storesmaterial specified in Schedule B  the contractor also brings his own storesmaterial on site for the purposes of the works which is also governed by some Paragraphs of General Conditions Nos 10 and 33 and 2 the final financial liability of the Government is fixed on completion of the contract on the basis of the actual measurements and on the basis of the rates which are already standardised a detailed measurement is undertaken at the end of the work at which the Garrison Engineer and the Assessee s representative remain present and the measurements are entered in Measurement Books and after the measurements final bills are prepared as per the MES Schedule and payments are made after making adjustments for the advances already made
24A D From the tender documents that are made available to contractor and the aforesaid terms and conditions of the Lump Sum Contracts two or three aspects emerge very clearly
In the first place the contractor becomes aware that certain specified storesmaterials will be supplied to him by the Department at fixed rates for being used in the works to be undertaken by him for which he has not to pay from his pocket and it is on that footing that he submits his tender quoting a particular figure for the entire work Secondly such storesmaterial so supplied by the MES Department has to be used fixed or incorporated by the contractor in the works undertaken by him and the surplus if any that would remain after the completion of the work is to be returned to the Department thirdly since for accounting purposes the initial supply is debited to the contractor at the specified fixed rates credit for the balance of tho storesmaterials so returned is also given at the same rates some adjustment being made in respect of the wear and tear of such storesmaterial but in regard to the stores material out of such supply as is actually used fixed or incorporated into the works no accounting is done viz a viz the contract payment that is made to the contractor
In other words in substance and in reality such storesmaterial always remains the property of the Department and the contractor has merely the custody of it and he files or incorporates the same into the works
In such circumstances having regard to the terms and conditions on which such supply of storesmaterials is made there is not even a theoretical possibility of any element of profit being involved in the turnover represented by the cost of such storesmaterials
It is conceivable that when the contractor himself purchases materials in the open market and supplies the same to the Department by using fixing or incorporating the same in the works
as in the case of materials other than specified in Schedule B  some profit element would be embedded in the turnover represented by the cost of such martial but when storesmaterial is supplied by the Government Department at fixed rates for being used fixed or incorporated in the work on terms indicated above there would be no element of profit involved in the turnover represented by the cost of such material
25G H 26A E 18 Brij Bhushan Lal vs Commissioner of Income Tax Delhi and Haryana overruled
M P Alexander and Co vs Commissioner of Income Tax  Commissioner of Income Tax Madras vs K section Guruswami Gounder and K section Krishnaraju  Trilokchand Chunilal vs Commissioner of Income Tax Gujarat  Additional Commissioner of Income Tax vs Trikamji Punia and Sons AP FB approved