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January 19, 2021

Section 145 imposes duty upon AO to compute inventory in such manner as he determines for deducing the correct profits – SC

by CA Shivam Jaiswal in Income Tax

Section 145 imposes duty upon AO to compute inventory in such manner as he determines for deducing the correct profits – SC

Section 145 of the Income Tax Act pertains to method of accounting. According to the said section, income chargeable under the head” Profits and gains of business or profession” or” Income from other sources” shall be computed in accordance with the method of accounting regularly employed by the assessee.

In any case where the accounts are correct and complete to the satisfaction of the Assessing Officer but the method employed is such that, in the opinion of the Assessing Officer, the income cannot properly be deduced therefrom, then the computation shall be made upon such basis and in such manner as the Assessing Officer may determine

Where the Assessing Officer is not satisfied about the correctness or the completeness of the accounts of the assessee, or where no method of accounting, has been regularly employed by the assessee, the Assessing Officer may make an assessment in the manner provided in section 144.

The method of valuing stocks has a direct impact on taxable profits. The recognised and settled practice of accounting is that the closing stock of a business has to be valued on cost basis or on the market value basis, provided the market value of the stock is less than its cost. Let us refer to the case of CIT v. British Paints India Ltd. (1991), where the issue under consideration was whether the Assessing Officer was justified in rejecting the method of valuation of inventories or not.

Facts of the Case:

  • The assessee was a limited liability company engaged in the business of manufacture and sale of paints.
  • Assessee contended before the authorities that it was its consistent practice to value the goods in process and finished products exclusively at cost of raw materials and totally exclude overhead expenditure.
  • The justification for this practice, according to the assessee, was that the goods being paints had limited storage life and, if not quickly disposed of, they were liable to lose their market value.
  • This contention of the assessee was rejected by the ITO observing that at no time had the assessee claimed any deduction on account of deterioration or damage to goods.
  • The officer held that there was no justification to recognize a practice, as claimed by the assessee, of valuing its stock otherwise than in accordance with the well-recognized principle of accounting which required the stock to be valued at either cost (raw material + overhead expenditure) or market price, whichever was the lower.
  • The Tribunal rejected the assessee’s submission. High Court (HC) accepted the contention of the assessee.
  • Aggrieved with the order of the HC, Department preferred an appeal before Supreme Court (SC)

Observations of the Supreme Court (SC)

  • Any system of accounting which excluded, for the valuation of the stock-in- trade, all costs other than the cost of raw material for the goods in process and finished products, was likely to result in a distorted picture of the true state of the business for the purpose of computing chargeable income.
  • Such a system may produce a comparatively lower valuation of the opening stock and the closing stock, thus, showing a comparatively low difference between the two.
  • In a period of rising turnover and rising prices, the system adopted by the assessee, as found by the Tribunal, was apt to diminish the assessment of the taxable profit of a year.
  • The profit of one year was likely to be shifted to another year which was an incorrect method of computing profits and gains for the purpose of assessment.
  • Each year being a self-contained unit, and the taxes of a particular year being payable with reference to the income of that year, as computed in terms of the Act, the method adopted by the assessee was found to be such that income could not properly be deduced therefrom.
  • It was, therefore, not only the right but the duty of the Assessing Officer (AO) to act in exercise of his statutory power, as he had done in the instant case, for determining what, in his opinion, was the correct taxable income.
  • Section 145 imposed a duty upon the AO to make such computation in such manner as he determines for deducing the correct profits and gains.
  • This meant that where accounts were prepared without disclosing the real cost of the stock-in-trade, albeit on sound expert advice in the interest of efficient administration of the company, it was the duty of the ITO to determine the taxable income by making such computation as he thinks fit.
  • Therefore, ITO was justified in rejecting assessee’s method of valuation and in holding that assessee’s products were liable to be valued at 100% of cost along with overhead expenditure.

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