INTRICACIES OF MAKING ADDITION ON ACCOUNT OF LAW GP

S.C. Tiwari
Addl CIT (Int. Taxation), Ahmedabad

1. Power of the Assessing Officer to estimate profits

Comparison of gross and net margin shown by an assessee is a normal exercise during the course of assessment proceedings. While lower gross profit shown by the Assessee as compared to the preceding years is a red flag for investigation, mere existence of low margin cannot be a ground for addition. While the initial burden is on the assessee to justify the margin shown by it in its books of account, once the AO rejects the contention of the assessee, burden is on him to justify his rejection of the assessee’s margins and basis for estimation of a new gross margin. The primary requirement before the assessing officer arrives at the stage of estimation of profits, is to demonstrate the unreliability of the books and consequently, the profit margin shown by the assessee. If the books are found to be correct and no flaw has been detected, it would be incorrect on the part of the Officer to reject the margin computed on the basis of such accounts. The flaw in the accounts drawn by the assessee can be for a variety of reasons - detection of non-recording of sales, booking of fictitious purchases, booking of fictitious expenses, evidence of inflation in expenses, adoption of wrong method of accounting to reduce taxable profits etc. These deficiencies, coupled with a low gross margin shown by the assessee provide the perfect platform for rejection of the books maintained by the assessee and estimate a reasonable profit margin based on margins of similar other assessees.

2. Relevant Legal Provisions

Detection of deficiencies in accounts is primarily work of investigation. The Assessing Officer needs to make proper inquiries in respect of the business dealings of the assessee to find out the correctness of data supplied by the assessee. Once deficiencies are noted in respect of such data and the assessee is not able to explain them satisfactorily, legal provisions are available for rejection of books in such cases. These provisions are contained in Section 144 and 145 of the Income Tax Act.

3. AO's Power To Reject Accounts

It is the duty of the Assessing Officer to consider whether or not the books disclose the true state of accounts and the correct income can be deduced therefrom. The officer is not bound to accept the system of accounting regularly employed by the assessee, the correctness of which had not been questioned in the past. There is no estoppel in these matters, and the officer is not bound by the method followed in the earlier years. But it is also pertinent here to mention that the AO must refer to the inherent defect in the system followed by the assessee, demonstrate that the defect has led to clear mis-statement of its income and record a clear finding that the system of accounting followed by the assessee is such that correct profits cannot be deduced from the books of account maintained by the assessee. In this regard, a factual finding by the assessing officer that part of the receipts or expenses have either not been accounted or wrongly accounted in the books would constitute a clear evidence of such nature. In the following paragraphs some important observations noted by the Courts and Appellate authorities have been reproduced relevant to this section of the report:

3.1 After going through the provisions of the Act, background of the provisions as well as important case laws in this regards, following important areas emerge, which are to be kept in mind at the time of investigating such cases and rejecting the books of accounts of the assessee.

i. If the assessing officer is not satisfied with the book result i.e. gross profit shown by the assessee, he may reject the books under Section 145(3) and estimate gross profit ratio. But before doing that he has to give a clear finding that the there are defects in books of accounts and hence books of accounts are not acceptable. Such instances may be:

a. Purchase, sales, direct expenses, valuation of stock etc shown in the books are not correct.

b. Accounts written are not full and complete and do not reflect the actual receipts on sales.

c. Actual quantity of finished product produced by the assessee appear to be more than what it has shown in the accounts books.

d. The assessee had made any sale of finished product which has not been reflected in the accounts books.

e. The finished product has been sold by the assessee at a price higher than what is declared in the accounts books.

f. Assessee is not maintaining any stock register and adopting closing stock without any supporting documents to enable verification.

g. The Central Government had notified a particular accounting standards for a specific trade to be followed by the assessee and the assessee has not followed it.

h. The rate of Gross Profit declared by the assessee is low as compared to other assessee’s in the same line of business or with reference to assessee’s margins in earlier years.

ii. If the rate of gross profit declared by the assessee in a particular period is lower as compared to the gross profit declared by him in the preceding year that should alert the Assessing Officer and serve as a warning to him, to look into the accounts more carefully for verifying the correctness of accounts. But, a low rate of gross profit, in the absence of any material pointing towards falsehood of the accounts books, cannot by itself be a ground to reject the account books under Section 145(3) of the Act. For example, in case of transactions in cash, the purchaser and the seller often do not bother to keep details of their identity. So the name of the customer if not mentioned on cash memo cannot be treated as defect in the books of the assessee.

iii. Non maintenance of stock register on day to day basis by itself should not lead to inference that it is not possible to deduce the true income of the assessee from the accounts maintained by assessee, nor can the accounts be said to be defective or incomplete for this reason alone. If the assessee is dealing in such items where maintenance of stock register is not possible i.e. keeping in mind the quantity, size, varieties, processes involved in production etc it can’t be treated as defect for application of section 145(3) of the Act.

In the case of CIT vs M/s Jas Jack Elegance Exports, ITA 681/2010 dated 26/4/2010, Delhi High Court, the Court has dealt on this issue elaborately. Some of the observations are as reproduced below.

1. This is not the case of the Revenue that the assessee had not followed either cash or mercantile system of accounting stipulated in sub- Section (1) of Section 145 of the Act.

2. This is also not the case of the Revenue that the Central Government had notified any particular accounting standards to be followed by manufacturers and exporters of readymade garments.

3. Assessing Officer had not pointed out any defect in the Accounts Books maintained by the assessee, which, admittedly, were produced before the Assessing Officer for his consideration.

4. This is also not the finding of the Assessing Officer that the account of the assessee was not complete.

5. No provision either in the Act or in the rules requiring an assessee carrying business of this nature, to maintain a Stock Register, as a part of its accounts has been brought to our notice. As regards non-production of Stock Register, the assessee has given an explanation which has been accepted not only by the Commissioner of Income Tax(Appeals) but also by the Tribunal and both of them have given a concurrent finding of fact that maintaining Stock Register was not feasible considering the nature of the business being run by the assessee which was engaged in the business of manufacturing readymade garments by purchasing fabric which was then subjected to embroidery, dyeing and finishing and then converted into readymade garments by stitching.

6. Section 145(3) of the Act therefore could not have been applied by the Assessing Officer to the present case. The Assessing Officer did not point out any difference in the consumption of raw material and production of finished goods when compared to earlier years. The Assessing Officer did not say that after comparing the raw material consumed and finished goods produced in the previous years with the raw material consumed and the finished goods produced in the year in question, he had found that the number of finished goods pieces actually produced by the assessee should have been more than the number of pieces declared in the account books produced before him.

4. Estimation of Profits

The AO need not examine the gross margin of an assessee with respect to its earlier performance. There are cycles of ups and downs in various sectors of economy and it is important for the Officer to examine this issue. A fall in GP for the assessee may be coupled with a general recession in that sector and hence profits of all the peers may have dipped. Similarly, the year may represent an exceptional year wherein all the peers have made exceptional profits. Hence, while examining gross margins, the assessing officer should not only compare the past margins of the assessee but also the current year margins of other assesses engaged in similar business. This would give an insight into the actual profit margins during the year under reference and would be a correct guide for estimation of profits.

4.1 As discussed above, a low gross margin per se can neither constitute a valid ground for rejection of books nor for estimation of profit. However, once the Assessing Officer has demonstrated that the books of accounts of the assessee company are not reliable, he needs to proceed under Section 145 and reject the books. Thereafter, an estimation of profit becomes an essential step towards determining the correct margin earned by the assessee. Once the books of accounts of the assessee are rejected, profit needs to be estimated on the basis of the material available on record. Even in cases where accounts are not rejected profit claimed by the assessee may have to be readjusted on the basis of material made available by the assessee itself. Before arriving at a reasonable profit estimate the AO must understand the intricacy of the business of the assessee along with the profit earned by other comparable business of the same nature as of the assessee. There may be variation in the profit of the assessee alone or the variation may be seen in the all businesses of the same nature.

4.2 Estimation of profits on account of low GP has been dealt with mercilessly at the appellate level. The main reason for this is that while the officer works very hard in collecting evidences relating to error in accounts for rejection of books, he hardly collects any evidence relating to his estimation of gross margin for the assessee. Most of the time, such estimation is based on the past average GP rate. The assessee can easily demonstrate at the appellate level that the circumstances in the preceding years were different from the year under reference resulting in deletion of the addition. The most important issue which should be examined and arrived at by the officer is the reasonable profit margin for the year under reference based on circumstances prevailing in during the year and the performance of similarly placed assesses.

4.3 In the following paragraphs some important observations noted by the Courts and Appellate authorities have been reproduced relevant to this section of the report:

In case of Mysore Fertiliser Co. v. CIT [1966] 59 ITR 268 (Mad.) it was held that the ITO shall make the assessment to the best of his Judgement; it means that he must make it according to the rules of reason and justice, not according to private opinion, but according to law and not humour, and the assessment is to be not arbitrary, vague and fanciful, but legal and regular.

It was held in case of CIT v. Surjit Singh Mahesh Kumar [1994] 210 ITR 83 (All.) that so long as the Best Judgement has nexus to material on record and the discretion in that behalf has not been exercised arbitrarily or capriciously, it is not open to scrutiny in reference proceedings to give rise to a question of law or to a mixed question of law and fact.

In case of CIT v. Eastern Commercial Enterprises [1994] 210 ITR 103 (Cal.) it was held that where the assessee has given a comparative instance of gross profit rate, it is necessary for the department to come to a finding as to the norm of the gross profit on the basis of comparative cases.

Therefore, it is the duty of the Assessing Officer to counter the comparative statement cited by the assessee before he can have the option to estimate the gross profit.

It was observed by Hon’ble Court in case of Aluminium Industries (P.) Ltd. v. CIT [1995] 80 Taxman 184 (Gauhati) that additions to the profits of the assessee made solely on the ground that it was low without giving a specific finding that the accounts of the assessee were not correct and complete, or that the income could not be properly determined and deduced from the accounting method employed by the assessee, is not justified. The mere fact that there was a less rate of gross profit declared by an assessee as compared to the previous year would not by itself be sufficient to justify the addition. In a recent landmark decision, the Hon’ble Delhi High Court has dealt with the issue elaborately. In the case of CIT vs Smt Poonam Rani [2010] 192 TAXMAN 167 (DELHI), wherein the Officer had rejected the books because of the quantitative variation in the weight of the output products as against input items, the High Court rejected the addition made on estimate basis because no defect was pointed out in the accounts and there was no basis for estimation. The observations of the High Court are reproduced as below:

1. The Assessing Officer had not pointed out any particular defect or discrepancy in the account books maintained by the assessee. During the course of hearing before the Commissioner (Appeals), it was pointed out by the assessee that her account books were duly audited under Section 44AB of the Central Excise Act and the quantitative details as required by clause 28(b) of Form No. 3CD regarding raw material and finished products were prepared and audited by certified accountant and were enclosed with Form No. 3CD which had been placed on record.

2. As regards the marginal increase in the weight of the finished product, the explanation given by the assessee had been accepted not only by the Commissioner (Appeals) but also by the Tribunal. The Assessing Officer had no material before him on the basis of which it could be said that the weight of the wire did not increase even marginally during the process of enamelling.

3. The fall in the gross profit ratio could be for various reasons such as increase in the cost of raw material, decrease in the market price of finished product, increase in the cost of processing by the assessee, etc.

4. There was no finding that the actual cost of the raw material purchased by the assessee was less than what was declared in the account books.

5. There was no finding that the actual cost of processing carried out by the assessee was less than what had been declared in her account books.

6. No particular expenditure shown in the account books had been disallowed by the Assessing Officer.

7. There was no finding by the Assessing Officer that the actual quantity of finished products produced by the assessee was more than what was shown in the account books.

8. There was no finding that the assessee had made any such sale of the finished products which was not reflected in the account books.

9. There was no finding by the Assessing Officer that the finished products were sold by the assessee at a price higher than what was declared in the account books.

10. In those circumstances, the Commissioner (Appeals) and the Tribunal were justified in holding that the Assessing Officer could not have increased the gross profit ratio merely because it was low as compared to the gross profit ratio of the preceding year.

11. The revenue contended that the assessee was not maintaining the daily stock register. However, no such finding was found in the assessment order. On the other hand, the assessee had submitted before the Commissioner (Appeals) that Form No. 3CD containing all the quantitative details in respect of raw materials as well as the finished goods and duly audited by the certified accountant had been placed on record, but the Assessing Officer ignored those actual figures enclosed with the return. In any case, there is no statutory provision under the income-tax regime requiring the assessee to maintain the daily stock register.

12. Hence, even if no such register was being maintained by the assessee, that, by itself, would not lead to the inference that it was not possible to deduce the true income of the assessee from the accounts maintained by her, nor the accounts could be said to be defective or incomplete for that reason alone.

13. If the stock register is not maintained by the assessee, that may put the Assessing Officer on guard against the falsity of the return made by the assessee and persuade him to carefully scrutinize the account books of the assessee, but the absence of one register alone does not amount to such a material leading to the conclusion that the account books were incomplete or inaccurate.

14. Similarly, if the rate of gross profit declared by the assessee in a particular period is lower as compared to the gross profit declared by him in the preceding year, that may alert the Assessing Officer and serve as a warning to him to look into the accounts more carefully and to look for some material which could lead to the conclusion that the accounts maintained by the assessee were not correct, but a low rate of gross profit, in the absence of any material pointing towards falsehood of the account books, cannot, by itself, be a ground to reject the account books under section 145(3).

4.4 As clear from the above discussion, not only a proper reason for rejection of accounts is needed but it is equally important to base the estimation on solid facts. While low gross profit may prompt an investigation in respect of the assessee, it may not serve as a guide for estimation of gross margin in the current year. As mentioned above, peer or sectoral analysis is generally available in respect of most of the sectors on the internet. The AOs should make full use of such data. Further, to factor geographical and other differences, the assessing officers may resort to local comparables in the same trade. Databases like Prowess maintained by CMIE and Capitaline are important source of such data. These databases can be used to find out the normal margins earned by other assesses in the same trade. This would give a sound basis for the assessing officer to arrive at a reasonable gross margin for the purpose of estimation.