Appeal No 250 of 1963
Appeal by special leave from the judgment and order dated February 2 1960 of the Madras High Court in Case Referred No 1 of 1955
R Ganapathy Iyer and R N Sachthey for the appellant
section Narayanaswamy and R Gopalakrishnan for respondent nos
I and 3 6
April 16 1964
SHAH J Respondents to this appeal are a firm constituted under a deed dated December 12 1947
The firm originally consisted of three partners K N Damodara Mudaliar A Krishnaswami Mudaliar and vs Thangaraja Mudaliar
KN Damodara Mudaliar acquired for the firm for Rs 100000 the exploitation rights which were to ensure for four years in a cinematograph film Apoorva Chinthamani for the North Arcot the South Arcot and the Chingleput districts and for Pondicherry
For the period December 25 1947 to August 2 1948 which was the previous year corresponding to the assessment year 1949 50the firm filed a voluntary return declaring that Rs 28643were earned by the exploitation of the film
In the statement submitted by the firm the total receipts credited in the firm s books were Rs 146849  and against that amount were debited Rs 13206 as expenses and Rs 100000 as the amount disbursed for acquiring the exploitation rights
Thereby in the computation of the profits of the business the firm debited the amount paid for acquiring the rights of exploitation of the film but did not take credit for the value of the unexpired exploitation rights at the end of the previous year
On August 15 1948 a deed of dissolution of the partnership was executed and Damodara Mudaliar sold with effect from August 6 1948 his half interest in the assets of the partnership to Krishnaswami Mudaliar for Rs 2000 and retired from the partnership
On August 27 1948 a trial balance sheet of the firm s books of account was prepared showing a cash balance of Rs 190124 a debit against Krishnaswami Mudatiar for Rs 264188 and credits in favour of Damodara Mudaliar and Thangaraja Mudaliar respectively for Rs 1888211 and Rs 94421
Thereafter Krishnaswami Mudaliar Thangaraja Muidaliar and V section Lakshmanan an outsider formed themselves into another partnership to exploit the film for the unexpired period
From this partnership Krishnaswami Mudaliar retired on February 22
1949 agreeing to receive Rs 12000 for his 778 six sixteenth share in the assets of the firm on the date of retirement
In the assessment of the respondent firm for the year 1949 50 the Second Additional  income tax Officer Vellore declined to accept the statement of account that the firm had earned till August 2 1948 a net profit of only Rs 28643 as truly representing the profits of the firm
Fie observed that no stock valuation of the picture has been taken but only the excess collection over purchase value has been returned indicating thereby that in his view from the statement of account which omitted to include at the close of the year the value of the rights in the film for the unexpired period the profits of the firm could not properly be deduced
The Income tax Officer estimated the value of the rights for the unexpired period of exploitation to which the firm was entitled on August 2 1948 at Rs 65000 and computed net profits of the firm as an unregistered firm at Rs 93642and assessed income tax and super tax payable by the firm on that footing
In appeal by the firm to the Appellate Assistant Com missioner the correctness of the estimated value of the ex ploitation rights of the film at Rs 65000 was alone chal lenged and it was submitted that the sum of Rs 4000 was the true value of the assets at the end of the previous year
Damodara Mudaliar the retiring partner having relinquished his rights representing half share for Rs 2000 only
The Appellate Assistant Commissioner rejected the contention holding that the valuation of the exploitation rights for the unexpired period in the deed of dissolution dated August 15 1948 was dictated by extra commercial considerations
and confirmed the valuation of Rs 65000 made by the Incometax Officer
Even in appeal to the Income tax Appellate Tribunal Madras the respondent firm merely contended that the valuation of the exploitation rights for the unexpired period was excessive
The Tribunal partially upheld the plea and reduced the valuation to Rs 40000 as on August 2 1948 and directed modification of the assessment on that footing
Pursuant to an order issued by the High Court of Madras in a petition under section 662 the Tribunal stated the case and referred the following question Whether on the facts and circumstances of this case the Tribunal was justified in applying the proviso to section 13 of the Income tax Act and in confirming the assessment on a mercantile basis of accounting
 779 The High Court held that it was open to the assessee to maintain accounts according to a recognised system of ac counting and the assessee having adopted the cash system of accounting and the Tribunal having assigned no reasons for discarding that system in the computation of the profits the Tribunal was in error in making the assessment on the basis of the mercantile system of accounting
The High Court observed When we reach the position that it was the cash system that the assessee had adopted in this case and that valuation of the closing stock was not an incident of that system for ascertaining the profits it should be obvious that the Income tax Officer had no power under the proviso to section 13 to force a different system on the assessee either the mercantile system or a hybrid system of cash plus valuation of closing stock
 The High Court accordingly answered the question referred in the negative
Against the order with special leave this appeal is preferred
The question to be determined in this appeal is whether in the computation of the income of the firm under the head Profits and gains of business the Income tax Officer was bound by the method of accounting in which the cost of acquisition of the film of which the exploitation rights were held was debited at the commencement of the year but the value of the film at the end of the year was ignored
Section 10 of the Indian Income tax Act 1922 provides that tax shall be payable by an assessee under the head Profits and gains of business profession or vocation in respect of the profits or gains of any business profession or vocation carried on by him
Such profits or gains have to be computed after making the allowances set out in sub section
Section 13 provides that the income profits and gains shall be computed for the purposes of sections 10 and 12 in accordance with the method of accounting regularly employed by the assessee provided that if no method of accounting has been regularly employed or if the method employed is such that in the opinion of the Income tax Officer the income profits and gains cannot properly be deduced therefrom then the computation shall be made upon such basis and in such manner as the Income tax Officer may determine
It may be recalled that the Income tax Officer had in the order of assessment observed that the firm had not made a stock valuation of the film and had merely taken the excess collection over the purchase value and had submitted its 780 return of income on that basis
No express order was re corded by the Income tax Officer that in his opinion the in come profits or gains of the business could not properly be deduced from the method of accounting employed by the firm but it is implicit in what is stated by him that without valuation of the unexpired exploitation rights the profits of the year of account could not be computed
With this view
it appears the Appellate Assistant Commissioner agreed
In appeal to the Appellate Tribunal the only plea raised was that the Income tax Officer had erred in estimating the value of the unexpired exploitation rights at Rs 65000 
That was partially accepted and the value was reduced to Rs 40000 
It is difficult to appreciate how any question about the regularity of the proceedings of the Income tax Officer by the adoption of the mercantile system of accounting and by the application of the proviso to section 13 of the Incometax Act arose from the order of the Tribunal
The High Court has under the Income tax Act power to call upon the Appellate Tribunal to state a case  only if the High Court is not satisfied about the correctness of the decision of the Tribunal that no question of law arises from the order of them Tribunal
The grounds of appeal filed before the Tribunal and before the Appellate Assistant Commissioner make it abundantly clear that the question as to the applicability of the proviso to section 13 to the profits disclosed by the respondent firm was never challenged
Nor can it be said that the Tribunal forced the x x x firm to adopt for the purpose of computation of its profits a system of accounting other than the one adopted by the firm
In the title of the order by the Income tax Officer it was recited that the method of accounting adopted by the firm was mercantile but that does not amount to saying that he proposed to compute the income on the basis that the accounts should be re written on the mercantile system
The question referred to the High Court asks for advice on the justification for applying the proviso to section 13 and computation of the income on the basis of the mercantile system of accounting
On neither of these two branches there was any argument raised by the firm before the Tribu nal
But we do not propose to dispose of this appeal on the limited ground that the question as framed did not arise out of the order of the Tribunal and need not be answered
The grounds given by the High Court in support of their answer to the question referred raise a matter of principle of some importance in the computation of income of an assessee carrying on a trading venture with the aid of a wasting asset and we have heard elaborate arguments advanced by counsel at the Bar and we deem it necessary to express our opinion on the questions debated
781 It is true that the Revenue authorities and the Tribunal did take into consideration the stock valuation at the end of the year of account but that was not because in their view the system of accounting adopted was or should be mercan tile the truth of the matter is that in their view profits of the firm for the year could not having regard to the nature of the business properly be deduced from the accounts unless the opening and closing stocks were brought into the picture
This is made clear by the observations of the Tribunal in paragraph 15 of the statement of the case x x x in all trading cases the true profits cannot be deduced from any system of maintaining accounts whether cash or mercantile unless the opening and closing stocks are brought into the picture at cost or market price whichever is lower it will not avail an assessee to say that in his cash system he had not made any profit on his cash sales till all his stock is disposed of
Income tax is an annual levy and the profits of each year require to be ascertained for that purpose as accurately as circumstances permit
It therefore in any system of accounting maintained by the assessee otherwise acceptable the stocks are left out of account the aforesaid proviso it is humbly submitted necessarily has to be invoked even if it were for the sole purpose of adjusting the book figures for the stock figures
 Correctness of this view especially in the context of a trading venture by the exploitation of a wasting asset but which is the assessee s stock in trade falls to be considered
Section 13 of the Indian Income tax Act was incorporated for the first time in the Income tax legislation in India by the Income tax Act II of 1922 because in a case decide  under the Income tax Act 1918 Wallis C J delivering the principal judgment of the Full Bench in Secretary Board of Revenue Madras vs Arunachalam Chettiar1 expressed the view that whatever may be the system of accounting adopted by an assessee income assessable to tax means the income actually or constructively received and that the words of the charging section placed limits upon the succeeding sections specifying the different classes of income liable to tax
To supersede this exposition of the law the Legislature while enacting Act 11 of 1922 found it necessary to enact section 13
The section leaves it to the assessee to adopt any compute of accounting and obliges the Income tax Officer to compute the income profits and gains for the purposes of sections 10 and 782 12 in accordance with such method of accounting regularly employed if profits of the business can properly be deduced therefrom
The Judicial Committee of the privy Council ob served in Commissioner of Income tax Bombay vs Sarangpur Cotton Manufacturing Company Ltd Ahmedabad2  x x x the section relates to a method of ac counting regularly employed by the assessee for his own purposes x x x and does not relate to a method of making up the statutory return for assessment to income tax
Secondly the section clearly makes such a method of ac counting a compulsory basis of computation unless in the opinion of the Income tax Officer the income profits and gains cannot properly be deduced therefrom
It may well be that although the profit brought out in the accounts is not the true figure for income tax purposes the true figure can be accurately deduced therefrom
The Board also observed It is the duty of the Income tax Officer where there is such a method of accounting to consider whether the income profits and gains can properly be deduced therefrom and to proceed according to his judgment on this question
 Again as observed by this Court in Commissioner of Income tax vs Mcmillan  Co2 the expression in the opinion of the Income tax Officer in the proviso to section 13 of the Indian Income tax Act 1922 does not confer a mere discretionary power in the context it imposes a statutory duty on the Income tax Officer to examine in every case the method of accounting employed by the assessee and to see whether or not it has been regularly employed and to determine whether the income profits and gains of the assesses could properly be deduced therefrom
But the section only deals with the computation of income profits and gains for the purposes of sections 10 and 12 and does not purport to enlarge or restrict the content of taxable income profit and gains under the Act
Section 215 of the Act defines total income as meaning total amount of in
come profits and gains referred to in sub section
1 of section 4 computed in the manner laid down in the Act
Section 41 lays down what income shall be included in the total income and sections 102 122 12B2 14 15A 15B 15C and 16 prescribe the manner of computation of income profits and gains in 1 LR 65 IA 1
2  783 different circumstances and also prescribe special excep tions
Section 13 does not directly impinge upon the application of these provisions it merely prescribes that the computation of taxable profits shall be made according to the method of accounting regularly employed
Where in the opinion of the Income tax Officer the income profits and gains cannot properly be deduced from the method of ac counting it is open to the Income tax Officer to compute the income upon such basis in such manner as he may determine
The section does not compel the Income tax Officer to accept a balance sheet of cash receipts and outgoings prepared from the books of account he has to compute the income in accordance with the method of accounting regularly employed by the assessee
The only departure made by section 13 of the Indian Incometax Act from the tax legislation in England is that whereas under the English legislation the Commissioner is not obliged to determine the profits of a business venture according to the method of accounting adopted by the assessee under the Indian Income tax Act prima facie the Income tax Officer has for the purpose of sections 10 and 12 to compute the income profits and gains in accordance with the method of account ing regularly employed by the assessee
If therefore there is a system of accounting regularly employed and by appropriate adjustments from the accounts maintained taxable profits may properly be deduced the Income tax Officer is bound to compute the profits in accordance with the method of accounting
But where in the opinion of the Income tax Officer the profits cannot properly be deduced from the system accounting adopted by the assessee it is open to him to adopt a more suitable basis for computation of the true profits
Among Indian businessmen as elsewhere there are current two principal systems of book keeping There is firstly the cash system in which a record is maintained of actual receipts and actual disbursements entries being posted when money or money s worth as actually received collected or disbursed
There is secondly the mercantile system in which entries are posted in the books of account on the date of the transaction ie on the date on which rights accrue or liabilities are incurred irrespective of the date of payment
For example when goods are sold on credit a receipt entry is posted as of the date of sale although no cash is received immediately in payment of such goods and a debit entry is similarly posted when a liability is incurred although payment on account of such liability is not made at the time
There may have to be appropriate variations when this system is adopted by an assessee who carries on a profession
Whereas 784 under the cash system no account of what are called the outstandings of the business either at the commencement or at the close of the year is taken according to the mercan tile method actual cash receipts during the year and the actual outlays during the year are treated in the same way as under the cash system but to the balance thus arising there is added the amount of the outstandings not collected at the end of the year and from this is deducted the liabilities incurred or accrued but not discharged at the end of the year
Both the methods are somewhat rough
In some cases these methods may not give a clear picture of the true profits earned and certainly not of taxable profits
The quantum of allowances permitted to be deducted under diverse heads under section 102 from the income profits and gains of a business would differ according to the system adopted
This is made clear by defining in sub section
5 the word paid which is used in several clauses of sub s 2 as meaning actually paid or incurred according to the method of accounting upon the basis of which the profits or gains are computed under section 10
Again where the cash system as adopted there is no question of bad debts or outstandings at all in the case of mercantile system against the book profits some of the bad debts may have to be set off when they are found to be mercantile system there are in numerable other systems of accounting which may be called hybrid or heterogeneous in which certain elements and inci dents of the cash and mercantile systems are combined
But whatever method of book keeping is adopted in the case of a trading venture for computing the true profits of the year the stock in trade must be taken into account
If the value of stock in trade is not taken into account in the ultimate result the profit or loss resulting from trading is bound to get absorbed or reflected in the stock in trade unless the value of the stock in trade remains unchanged at the commencement of the year and at the end of the year
It must be remembered that under the Income tax Act tax is levied on income profits and gains and not on receipts taxable profits therefore cannot ordinarily be deduced from cash receipts alone
If in the computation of profits of a trading venture only the cash receipts and outgoings are taken into account in substance emergence of profits would be deferred till the firm s capital outlay is completely recouped thereby transforming what in truth are profits of the business into capital by book keeping entries
In this case it is unnecessary to consider whether the method of accounting adopted of ignoring the value of the stock in trade may be regarded as regularly employed by the respondent firm when it is the first year of account
It is com 785 mon ground that the method of accounting was not mercantile
but was wholly or primarily cash
The Income tax Officer was of the view that in the absence of stock valuation of the film which was a wasting asset of the partnership and which was exploited for earning profits the income of the firm could not properly be deduced and with that view the Appellate Assistant Commissioner and the Tribunal have agreed
The High Court however held that the maintenance of account on cash basis being a recognised method of accounting the Income tax Officer was bound by the choice of the assessee who had adopted that system of accounting and to compute the income in accordance with that method unless the Income tax Officer was satisfied that the assessee had not regularly adopted that system
The High Court also observed that what the Department had done was to make the assessment on the basis that the system of accounting adopted by the assessee was mercantile a system which the assessee had never adopted and thereby computed the profits of the assessee by taking into consideration valuation of the closing stock which was not an incident of the cash system
The Income tax Officer had in the view of the High Court no power under the proviso to section 13 to force a different system on the assessee either the mercantile system or a hybrid system of cash plus valuation of closing stock
In coming to that conclusion in our judgment the High Court erred
Note the facts an amount of Rs 100000 was paid by the firm for acquiring a wasting asset which was to be exploited for the benefit of the partnership
The price paid for acquiring the asset was debited as an outgoing
At the end of the year there was a total collection of Rs 146849 by the exploitation of the asset
The expenses for carrying on the business amounted to Rs 18206  
The result according to the respondent firm was a net profit of Rs 28647 
This was arrived at by posting the outgoing for acquiring its stock in trade as a proper debit and ignoring the value of that asset at the end of the year altogether
Under the Income tax Act for the purpose of the assessment each year is a self contained unit and if out of the receipts the cost of the film was to be deducted in the absence of an entry crediting the value of the asset at the end of the year for arriving at the income of the profit of the firm would either wholly or substantially be absorbed in the amortization of the capital value of the asset
The result of the accounting would therefore give a false picture of the partnership however lucrative the business may in reality be
The methods of computation of taxable incomes prescribed by the Act of different kinds of income are undoubtedly highly artificial but the Act does not compel the Income tax Officer to accept a statement of account which is not prepared according to any recognised accounting practice
786 In Commissioner of Inland Revenue vs Cock Bussell and Co Ltd1
Croom Johnson J in dealing with valuation of  stock in trade for purposes of taxation observed there is no word in the statutes or rules which deals
with this question of valuing stock in trade
There is nothing in the relevant legislation which indicates that in computing the profits and gains of a commercial concern the stock in trade at the start of the accounting period should be taken in and that the amount of the stock in trade at the end of the period should also be taken in
It would be fantastic not to do it it would be utterly impossible accurately to assess profits and gains merely on a statement of receipts and payments or on the basis of turnover
It has long been recognised that the right method of assessing profits and gains is to take into account the value of the stock in trade at the beginning and the value of the stock in trade at the end as two of the items in the computation
I need not cite authority for the general proposition which is admitted at the Bar that for the purposes of ascertaining profits and gains the ordinary principles of commercial accounting should be applied so long as they do not conflict with any express provision of the relevant statutes 
 We have already said that in England there is no provision which compels the tax officer to adopt in the computation of income the system of accounting regularly employed by the assessee
But whatever may be the system whether it is cash or mercantile as observed by Croom Johnson J in a trading venture it would be impossible accurately to assess the true profits without taking into account the value of the stock in trade at the beginning and at the end of the year
Reference may also be made to Whimster  Co vs The Commissioner of Inland Revenue2 in which Lord President Clyde observed at p 823 In computing the balance of profits and gains for the purposes of Income Tax x x x two general and fundamental commonplaces have always to be kept in mind
In the first place the profits of any particular year or accounting period must be taken to consist of the difference between the receipts from the trade or business during such year or accounting period and the expenditure laid out to earn those receipts
In the second place the 1 2 TC 813
787 account of profit and loss to be made up for the purpose of ascertaining that difference must be framed consistently with the ordinary principles of commercial accounting so far as applicable and in conformity with the rules of the Income tax Act or of that Act as modified by the provisions  and schedules of the Acts regulating Excess Profits Duty as the case may be
For example the ordinary principles of commercial accounting require that in the profit and loss account a merchant s or manufacturer s business the values of the stock intrade at the beginning and at the end of the period covered by the account should be entered at cost or market price whichever is the lower
although there is nothing about this in the taxing statutes Similarly in Commissioner of Income tax and Excess Profits Tax Madras vs Messrs Chari and Ram Madura1 Rajamannar CJ observed that stock in trade in hand is an essential item in the computation of the profits for a period
Profits as observed by Fletcher Moulton LJ in the Spanish Prospecting Company Ltd in re2
implies a comparison between the state of a business at two specific dates usually separated by an interval of a year
The fundamental meaning is the amount of gains made by the business during the year
This can only be ascertained by a comparison of the assets of the business at the two dates
We start therefore with this fundamental definition of profits namely if the total assets of the business at the two dates be compared the increase which they show at the later date as compared with the earlier date x x x x represents in strictness the profits of the business during the period in question
 It is true that in that case Fletcher Moulton LJ made the observations not in dealing with a profit and loss account in a case relating to taxation but with a balance sheet of a company intended to show the actual financial condition of a business at the end of a year
The observations however do show that in ascertaining profits what may be regarded as normal book keeping practice has to be observed
Whether in the case of trading in special classes of assets appropriate adjustments may have to be made it beside the point
The Income tax Act makes no provision with regard to the valuation of stock
It charges for payment of tax the income 1 2 788 profits and gains which have to be computed in the manner provided by the Income tax Act
In the case of a trading venture these profits have to be adjusted in the light of the provisions of the Income tax Act permitting allowances prescribed thereby
For that purpose it is the duty of the Income tax Officer to find out what profits the business has made according to true Accountancy practise  in the system adopted and thereafter to make requiste adjustments and even appropriate modifications on the rule suggested by Fletcher Moulton LJ to ascertain the taxable profits
it is true as observed by Lord Buckmaster in The Naval Colliery Co Ltd vs The Commissioner of Inland Revenue1 that the principle of determining the profits of the trade by valuing everything at the beginning and the end of the accounting period and by finding the difference may not be universally applicable in all cases and needs material modification
The formula suggested in the Spanish Prospecting Company s case was sought to be applied to a case in which Excess Profits duty was assessed
The assessee a mining company was unable to work its colliery on account of a strike
The assessee sought to introduce into its account which normally ended on June 30 1921 the estimated expenses for repairing the damage which though arising in the account period was restored later on the plea that the expenses were in the nature of liability of business and properly debitable before they were actually incurred
The House of Lords rejected that contention
It was in this context that Lord Buckmaster observed that the accountancy rules applicable to wise and prudent trading could not be used in connection with the working of a mining lease
These observations do not affect the true character of the profits of a business
Adjustments may have to be made in the principle having regard to the special character of the assets the nature of the business and the appropriate allowances permitted in order to arrive at the taxable profits
They do not support the proposition that in the case of a trading venture
you can arrive at the true profits of a year by ignoring altogether the valuation of the stock in trade at the end of the year while debiting its value at the commencement of the year as an outgoing for determination of the profits by ignoring the valuation of the stock at the end of the year and debiting the value of the assets at the commencement of the year would not give a true picture of the profit for the year of account
There is no warrant in this case for assuming that the Re venue authorities and the Tribunal had sought to displace the method of accountancy adopted by the assessee
By applying the proviso to section 13 they made the computation upon the basis 1 2 789 and in the manner in which in their opinion profits would be properly deduced
That they were entitled to do
We are therefore of the view that the High Court was in error in holding that because the assessee had maintained his accounts in the cash system it was not open to the Income tax Officer to add to the receipts from the business the value of the stock in trade at the end of the year for the purpose of properly deducing the profits of the business for the year in question
The appeal therefore must be allowed and the answer to the question referred to the High Court will be in the affirma tive
The Commissioner will be entitled to his costs in this Court as well as in the High Court
Appeal allowed


Summary:
The assessee firm acquired for Rs 100000 the exploitation rights of a cinematograph film which were to enure for four years
For the period December 25 1947 to August 2 1948 which was the previous year corresponding to the assessment year 1949 50 the firm filed a voluntary return declaring that Rs 28643 were earned by the exploitation of the film
In the statement submitted by the firm the total receipts credited in the firm s books were Rs 146849 and against that amount were debited Rs 18206 as expenditure and Rs 100000 as the amount disbursed for acquiring the exploitation rights
The Income tax Officer was of the view that from the statement of account which omitted to include at the close of the account year the value of the right in the film for the unexpired period the profits of the firm could not properly be deduced
Accordingly he estimated the value of the rights for the unexpired period of exploitation to which the firm was entitled on August 2 1948 at Rs 65000 and computed the net profits of the firm as an unregistered firm at Rs 93642 and assessed income tax and super tax payable by the firm on that footing
In the appeals filed against the order or assessment only the correctness of the estimated value of the rights of the film at Rs 65000 was challenged and the Appellate Tribunal reduced the valuation to Rs 40000 
On reference the High Court of Madras took the view that it was the cash system that the assessee had adopted
that valuation of the closing stock was not an incident of that system for ascertaining the profits and that the Incometax Officer had no power under the proviso to section 13 of the Indian Income tax Act 1922 to force a different system on the assessee either the mercantile system or a hybrid system of cash plus valuation of closing stock
Held In a trading venture for computing the true profits of the year the stock in trade must be taken into account whatever method of book keeping was adopted and the High Court was in error in holding that because the assessee had maintained his accounts in the cash system it was not open to the Incometax Officer to add to the receipts from the business the value of the stock in trade at the end of the year for the purpose of properly deducing the profits of the business for the year in question
There was not warrant in the case of assuming that the income tax Officer sought to displace the method of accountancy adopted by the assessee it  as only by applying the proviso to section 13 of the Indian Income tax Act 1922 that the Income tax Officer made the computation upon the basis and in the manner in which in his opinion profits could be properly deduced 777