Case: The Commissioner Of Income-Tax, Madras Vs. A. Krishnaswami Mudaliar And Others

earn those receipts. In the second place the 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 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 of a merchants or manufacturers business the value of the stock-in-trade 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 v. M/s. Chari and Ram Madura, 1949-17 ITR 1 : (AIR 1949 Mad 580 ) Rajamannar C. J., observed that stock-in-trade in hand is an essential item in the computation of the profits for a period.18. "Profits" as observed by Fletcher Moultion, L. J., in the Spanish Prospecting Co. Ltd., In re 1911-1 Ch. 92"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 a 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 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, L. J., 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 is beside the point.19. The Income-tax Act makes no provision with regard to the valuation of stock. It charges for payment of tax the income, 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 practice, in the light of the system adopted, and thereafter to make the requisite adjustments, and even appropriate modification of the rule suggested by Fletcher-Moulton, L. J., to ascertain the taxable profits. It is true as observed by Lord Buckmaster in Naval Colliery Co. Ltd. v. Commissioner of Inland Revenue, (1928) 12 Tax Cas 1017 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 Co. case, 1911-1 Ch 92 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.20. 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.21. There is no warrant in this case for assuming that the Revenue authorities and the Tribunal had sought to displace the method of accountancy adopted by the assessee. By applying the proviso to S. 13 they made the computation upon the basis 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 account 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.22

Decision (1 = appeal accepted, 0 = rejected): 1

Explanation:
1[ds]15. In this case it is necessary 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 first year of account. It is common 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 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 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 S. 13 "to force a different system on the assessee either the mercantile system or a hybrid system of cash plus valuation of closing stock."16.In coming to that conclusion, in our judgment, the High Court erred. Note the facts: an amount of Rs. 1,00,000/- 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. 1,46,849/- by the exploitation of the asset. The expenses for carrying on the business amounted to Rs. 18,206/-. The result according to the respondent firm was a net profit of Rs.28,647/-. 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.The Income-tax Act makes no provision with regard to the valuation of stock. It charges for payment of tax the income, 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 practice, in the light of the system adopted, and thereafter to make the requisite adjustments, and even appropriate modification of the rule suggested by Fletcher-Moulton, L. J., to ascertain the taxable profits. It is true as observed by Lord Buckmaster in NavalColliery Co. Ltd. v. Commissioner of Inland Revenue, (1928) 12 Tax Cas 1017that 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 Co. case, 1911-1 Ch 92 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.20. 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.21. There is no warrant in this case for assuming that the Revenue authorities and the Tribunal had sought to displace the method of accountancy adopted by the assessee. By applying the proviso to S. 13 they made the computation upon the basis 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 account 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 inis difficult to appreciate how any question about the regularity of the proceedings of theOfficer by the adoption of the mercantile system of accounting and by the application of the proviso to S. 13 of theAct arose from the order of the Tribunal. The High Court has under theAct 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 the 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 S. 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 theOfficer 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 rewritten on the mercantilewe 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 questionsis true that in that case Fletcher Moulton, L. J., made the observations not in dealing with a profit and loss account in a case relating to taxation, but with aof 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 normalpractice has to be observed. Whether in the case of trading in special classes of assets appropriate adjustments may have to be made is beside the point.