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

1. The respondents are a firm constituted under a deed dated December 12, 1947. The firm originally consisted of three partners: K. N. Damodra Mudaliar, A. Krishnaswami Mudaliar and V. Thangaraja Mudaliar. K. N. Damodra Mudaliar acquired for the firm for Rs. 1,00,000/- the exploitation rights which were to ensure for four years in a cinematograph film "Apoorva Chinthameni" 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 1949-50 the firm filed a voluntary return declaring that Rs. 28,643/- were earned by the exploitation of the film. In the statement submitted by the firm the total receipts credited in the firms books were Rs. 1,46,849/-, and against that amount were debited Rs. 18,206/- as expenses and Rs. 1,00,000/- 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 Damodra Mudaliar sold with effect from August 6, 1948, his half interest in the assets of the partnership to Krishnaswami Mudaliar for Rs. 2,000/- and retired from the partnership. On August 27, 1948 a trial balance-sheet of the firms books of account was prepared showing a cash balance of Rs. 190/12/4, a debit against Krishnaswami Mudaliar for Rs. 2,641/8/8 and credits in favour of Damodra Mudaliar and Thangaraja Mudaliar respectively for Rs. 1,888/2/11 and Rs. 944-2-1. Thereafter Krishnaswami Mudaliar, Thangaraja Mudaliar and V. S. 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. 12,000/- for his sixteenth share in the assets of the firm on the date of retirement.2. 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. 28,643/- as truly representing the profits of the firm. He 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. 65,000/- and computed the net profits of the firm as an unregistered firm at Rs. 93,642/- and assessed Income-tax and super-tax payable by the firm on that footing.3. In appeal by the firm to the Appellate Assistant Commissioner, the correctness of the estimated value of the exploitation rights of the film at Rs. 65,000/- was alone challenged and it was submitted that the sum of Rs. 4,000/- was the true value of the assets at the end of the previous year, Damodra Mudaliar the retiring partner having relinquished his rights representing half share for Rs. 2,000/- 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 au 15, 1948 was "dictated by extra-commercial considerations, and confirmed the valuation of Rs. 65,000/- made by the Income-tax Officer. Even in appeal to the Income-tax Appellate Tribunal, Madras the respondent firm merely contended that the valuation of the exploitation right for the unexpired period was excessive. The Tribunal partially upheld the plea, and reduced the valuation to Rs. 40,000/- as on August 2, 1948, and directed modification of the assessment on that footing.4. Pursuant to an order issued by the High Court of Madras in a petition under Section 66(2) the Tribunal stated the case and referred the following questionon the facts and circumstances of this case the Tribunal was justified in applying the proviso to S. 13 of the Income-tax Act and in confirming the assessment on a mercantile basis ofHigh Court held that it was open to the assessee to maintain accounts according to a recognised system of accounting 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 observedwe 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 S. 13 to force a different system on the assessee either the mercantile system or a hybrid system of cash plus valuation of closingHigh Court accordingly answered the question referred in the negative. Against the order, with special leave, this appeal is preferred.

Court's reasoning:
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.