Sakthi
Trading Co. Vs. Commissioner of Income-Tax, Coimbatore [2001] Insc 362 (2 August 2001)
Y.K.
Sabharwal & Brijesh Kumar Y.K.Sabharwal,J.
At the
instance of the Revenue the question, in respect of the assessment year
1984-85, that was referred for the opinion of the High Court was :
"Whether
on the facts and in the circumstances of the case where on the dissolution of
the firm the business is taken over by a partner without discontinuance and the
value of the closing stock determined under the regular method of accounting is
accepted by the partners in the settlement of accounts for dissolution
purposes, the Income-tax Officer can substitute the market value in respect of
the closing stock alone for the purpose of determining the income of the firm upto
the date of dissolution?" Briefly, the facts are as follows :
The assessee
is a registered firm. As a result of the death of one out of its six partners,
on February 6, 1984, the firm was dissolved. It was,
however, reconstituted with effect from the next day, that is, 7th February, 1984 with the remaining five partners.
Two orders of assessments were made : one for the period upto February 6, 1984 and the other for the period from 7th February, 1984 to 31st March, 1984. The Commissioner of Income Tax made an order under Section
263 of the Income Tax Act, 1961 as according to him the assessment order made
by the Income Tax Officer was erroneous and prejudicial to the interest of the
Revenue in valuing the stock in trade as on 6th February, 1984 on the basis of
cost or market rate, whichever is lower as that was the usual method the assessee
used to adopt in valuing its stock. The Commissioner of Income Tax relying upon
the decision of the Madras High Court in A.L.A Firm v. Commissioner of
Income-tax [(1991) 189 ITR 285] came to the conclusion that the Income Tax
Officer ought to have valued the closing stock at its market rate as on 6th
February, 1984. Thus, setting aside the assessment order dated 30th May, 1984, the Income Tax Officer was
directed to pass a fresh order.
The
order of the Commissioner of Income Tax was challenged by the assessee in
appeal before the Income Tax Appellate Tribunal. The contention of the assessee
before the Tribunal was that the question of valuing the closing stock at the
market value can arise only on discontinuance of the business and as the
business of the firm was never discontinued but was taken over on succession by
another firm, the closing stock was not required to be revalued at the market
value. The Tribunal found that the firm was reconstituted with the remaining
five partners under the partnership deed dated 6th March, 1984 w.e.f. 7th February, 1984. The new deed recited that :
"Whereas
the above said parties were carrying on business in Erode in the name "Sakthi
Trading Company" along with one Shri P. Chenniappan S/o late Sri Palanippa
Gounder, Erode and whereas the above said P. Chenniappan died on 6.2.1984, the
parties hereto having decided to continue the business with all assets and
liabilities in partnership from 7.2.1984 as orally agreed, this deed is drawn
up reducing the oral agreement between the parties hereto taking effect from
7.2.1984, to carry on business in partnership upon the following terms and
conditions." The Tribunal came to the conclusion that if the business
itself is discontinued and the stocks are realised then the value realised
would have to be substituted for the value given in the accounts but where the
business was not discontinued though the firm was dissolved, the question of realising
the value of the goods does not arise and there was no necessity for revaluing
the closing stock. According to the Tribunal, there was no warrant for
revaluation of stock in a continuing business and the order of the Income Tax
Officer accepting the profit shown by the assessee, on the method of accounting
regularly followed, was not in any way erroneous and did not require to be
revised under Section 263. In respect of the decision of the Madras High Court
in A.L.A. Firm's case (supra), the Tribunal noticed that the firm in the said
case had closed its accounts on 13th March, 1961, the date of dissolution and
profit was arrived at by crediting to the profit and loss account the
difference on revaluation of stock as on that date, but for income-tax
purposes, the firm claimed that difference should be written back and the
profit adjusted. The High Court did not countenance such a claim and following
its earlier decision in G.R. Ramachari & Co. v. Commissioner of Income-tax,
Madras [(1961) 41 ITR 142 (Mad)] held that when there is a dissolution, the
stock in trade should be valued at market value. In these cases, the Tribunal
noticed that the question posed was that where the value of the stock had been
accepted by the partners upon dissolution, it could not be varied by the
Income-tax Officer. The Tribunal was of the view that if on the dissolution of
a firm, the business is also discontinued and the value of the stock realised,
it may be possible for the Income-tax Officer to insist that the value realised
shall be taken as the value of the closing stock instead of any notional value
on the regular principle of cost or market value, whichever is less. But where
the business is not discontinued, the question of revaluing the stock cannot
arise at all.
The
Tribunal held that the valuation of the closing stock of a continued business
on the principle of cost or market value whichever is less cannot be
substituted with the market value only because the firm carrying on that
business is dissolved and the business is taken over by another firm consisting
of the remaining partners. In respect of A.L.A. Firm's case (supra), it was
noticed that that was a case where partners had agreed to substitute the market
value and wanted to retract from it. Both in the case of Ramachari and A.L.A.
Firm, there was discontinuance of the business which was not so in assessee's
case and, therefore, there was no warrant for revaluation as directed by the
Commissioner of Income-tax whose order under Section 263 was set aside and
appeal of the assessee was allowed.
The
High Court by judgment under challenge has answered the question in favour of
the Revenue and, therefore, the assessee is in appeal before us.
In
this appeal the question is not whether two assessment orders were required to
be passed or not but is as to whether the value of the closing stock was
required to be determined on the market value for dissolution purposes upto the
date of dissolution when the business has been taken over by remaining parties
without discontinuance. The question itself suggests that the business was not
discontinued. As noticed above, on the dissolution of the firm on 6th February, 1984 as a result of the death of one of
the partner, the remaining partners continued the business w.e.f. 7th February, 1984. The question of valuing the
closing stock on market value is required to be answered where business is not
discontinued on the dissolution of the firm.
The
Tribunal has recorded a finding that the business was not discontinued and this
was the ground on which the decisions of Madras High Court in the case of G.R. Ramachari
& Co. and A.L.A. Firm were distinguished stating that "moreover in
both of those cases there was a discontinuance of the business itself which is
not the case in the present case". In A.L.A. Firm's case, the appeal filed
by the assessee has been dismissed by this Court.
According
to the contention urged on behalf of the Revenue, the question in the present
case is squarely covered by the decision in the case of A.L.A. Firm. Refuting
this contention, learned counsel for the appellant contends that the facts of
said case are clearly distinguishable and, in fact, the principles laid therein
support the assessee. The decision in A.L.A. Firm's case deserves to be
examined in some detail.
In
that case three questions of law were referred for the opinion of the High
Court but we are concerned with the second question which was as under :
"Whether,
on the facts and circumstances of the case, the assessment of the sum of $
101,248 as revenue profit of the assessee-firm chargeable to tax for the
assessment year 1961-62 is justified in law?" The facts under which this
question arose were that the assessee, a partnership firm, was carrying money
lending business in Malaya and as part of and incidental to the said business,
it was also carrying on the business of the purchase and sale of house
properties, gardens and estates.
The assessee
firm was reconstituted under a deed dated 26th March, 1960.
The
firm's accounts for the year 1960-61, which commenced on 13th April, 1960 would normally have come to close
on or about 13th April,
1961.
However,
the firm closed its accounts as on 13th March, 1961, with effect from which date it was
dissolved. Along with its income-tax return for the assessment year 1961-62 filed
on 10th April, 1962, the assessee filed a profit and
loss account and certain other statements. In the profit and loss account, a
sum of $ 101,248 was shown as "difference on revaluation of estates,
gardens and house properties" on the dissolution of the firm on 13th March, 1961, such difference being $ 70,500 in
respect of "house properties" and $ 30,748 in respect of estates and
gardens. In the memo of adjustment for income-tax purposes, however, the above
sum was deducted on the ground that it was not assessable either as revenue or
capital. A statement was also made before the officer that partner Ramanathan Chettiar
forming one group and the other partners forming another group were carrying on
business separately with the assets and liabilities that fell to their shares
on the dissolution of the firm. For the subsequent assessment year 1962-63, the
assessee filed a return showing nil income along with a letter pointing out
that the firm had been dissolved on 13th March, 1961. Thereafter, on 3rd September, 1963, the Income-tax Officer wrote a
letter to the assessee to the effect that the revaluation difference of $
101,248 should have been brought to tax in the assessment year 1961-62 in view
of the decision of Madras High Court in G.R. Ramachari & Co. v. CIT. He
called for the basis for the valuation and also for the assessee's objections.
The assessee sent a reply stating that no profit or loss could be assessed on
revaluation of assets.
Relying
on a circular of the Central Board of Revenue dated 21st June, 1956, it was urged that the assessee was gradually winding up
its business in Malaya and that, therefore, the surplus
would only be capital gains. It was urged that the revaluation had been at the
market price prevalent since 1st January, 1954
and that, therefore, no capital gains were chargeable to tax.
The
Income-tax Officer completed the reassessment on the firm after adding back a
sum of Rs.1,58,057/- (equivalent to $ 101,248) to the previously assessed
income. The assessee having failed upto the High Court in reference was in
appeal before this Court. This Court held that the question is squarely covered
by the decision of Madras High Court in Ramachari's case wherein it had been
held that principle of valuing the closing stock of a business at cost or
market price at the option of the assessee is a principle that would hold good
only so long as there is a continuing business and that where a business is
discontinued, whether on account of dissolution or closure or otherwise by the assessee,
then the profits cannot be ascertained except by taking a closing stock at
market value. The contention of the assessee was that while it is true that the
closing stock has to be valued, the well settled principle is that it should be
valued at cost or market price, whichever is lower, and there is no
justification for laying down a different principle for valuation of the
closing stock at the point of discontinuance of business unless the goods are
actually sold by the assessee at the time of discontinuance. Reliance was also
placed on a series of decisions holding that when a firm is dissolved and
assets are distributed among the partners, there is no sale or transfer of the
assets of the firm to the various partners.
The
submission was that revaluation of the assets of a firm which is only for the
division of assets among the partners on a real and not a notional basis is
part of the division of the assets and, therefore, logically, in point of time,
subsequent to the dissolution of the firm and since the revaluation takes place
after the dissolution, no profits can be said to have accrued to the firm by
the process of revaluation. It was urged that there is no principle by which
the stock-in-trade can be valued at market price so as to bring to tax the notional
profits which might in future be realised as a result of the sale of the
stock-in-trade. This Court rejected the contention that Ramachari's case does
not lay down the correct law and held that the High Court was right in pointing
out that the several decisions relied upon for the assessee as to the nature of
the transaction by which a firm, on dissolution, distributes its assets amongst
its partners, have no relevance in the case since those cases relate to what
happens after or in consequence of the dissolution of a firm whereas in that
case the Court was concerned with a question that arose before or at the time
of dissolution.
Dealing
with the principle that permits the assessee to value the stock at cost, in Kikabhai
Premchand v. CIT [(1953) 24 ITR 506 (SC)] Bose, J. said that :
"The
appellant's method of book-keeping reflects the true position. As he makes his
purchases he enters his stock at the cost price on one side of the accounts. At
the close of the year he enters the value of any unsold stock at cost on the
other side of the accounts thus cancelling out the entries relating to the same
unsold stock earlier in the accounts; and then that is carried forward as the
opening balance in the next year's account. This cancelling out of the unsold
stock from both sides of the accounts leaves only the transactions on which
there have been actual sales and gives a true and actual profit or loss on his
year's dealings".
In
A.L.A. Firm's case, the observations of Bose, J. were noticed and it was
pointed out that the valuation of the closing stock at market value would
invariably create a problem. For, if the market value is higher than cost, the
accounts will reflect notional profits not actually realised. On the other
hand, if the market value is less, the assessee will get the benefit of a
notional loss he has not incurred. Nevertheless, the ordinary principle of
commercial accounting permits valuation "at cost or market, whichever is
the lower". The rationale behind it was explained by Patanjali Sastri, C.J.
in Chainrup Sampatram v. CIT [(1953) 24 ITR 481 (SC)] wherein it was observed that
:
"It
is wrong to assume that the valuation of the closing stock at market rate has,
for its object, the bringing into charge any appreciation in the value of such
stock. The true purpose of crediting the value of unsold stock is to balance
the cost of those goods entered on the other side of the account at the time of
their purchase, so that the cancelling out of the entries relating to the same
stock from both sides of the account would leave only the transactions on which
there have been actual sales in the course of the year showing the profit or
loss actually realised on the year's trading. As pointed out in paragraph 8 of
the Report of the Committee on Financial Risks attaching to the holding of
Trading Stocks, 1919, `As the entry for stock which appears in a trading
account is merely intended to cancel the charge for the goods purchased which
have not been sold, it should necessarily represent the cost of the goods. If
it is more or less than the cost, then the effect is to state the profit on the
goods which actually have been sold at the incorrect figure . . . . From this
rigid doctrine one exception is very generally recognised on prudential grounds
and is now fully sanctioned by custom, viz., the adoption of market value at
the date of making up accounts, if that value is less, than cost. It is of
course an anticipation of the loss that may be made on those goods in the
following year, and may even have the effect, if prices rise again, of
attributing to the following year's results a greater amount of profit than the
difference between the actual sale price and the actual cost price of the goods
in question' (extracted in paragraph 281 of the Report of the Committee on the
Taxation of Trading Profits presented to British Parliament in April 1951).
While anticipated loss is thus taken into account, anticipated profit in the
shape of appreciated value of the closing stock is not brought into account, as
no prudent trader would care to show increased profit before its actual
realization. This is the theory underlying the rule that the closing stock is
to be valued at cost or market price whichever is the lower, and it is now
generally accepted as an established rule of commercial practice and
accountancy." This Court thus held that the proper practice is to value
the closing stock at cost. That will eliminate entries relating to the same
stock from both sides of the account. To this rule, custom recognises only one
exception and that is to value the stock at market value if that is lower. But
on no principle can one justify the valuation of the closing stock at a market
value higher than cost as that will result in the taxation of notional profits
the assessee has not realised.
The
consideration which prevailed with the High Court in A.L.A. Firm's case is
reflected in the following passage of the High Court's judgment :
"It
seems to us that none of these cases has any application to the facts of the
present case. There is no authority directly in point dealing with this
question, where a partnership concern dissolves its business in the course of
the accounting year, what is the basis on which the stock-in-trade has to be
valued as on the date of dissolution. We have accordingly to deal with the
matter on first principles." This Court while dismissing the appeal of the
assessee found substance in this consideration that prevailed with the High
Court.
From
the above, it is evident that in A.L.A. Firm's case this Court was considering
the question of valuation of closing stock at market value in a case where
there was dissolution and also discontinuance of the business of the firm. In
that case after dissolution, two groups were carrying on separate business with
the assets and liabilities which fell to their shares from the dissolution of
the firm. In the present case, however, though there was dissolution on account
of the death of one of the partner, but there was no discontinuance of the
business. The unchallenged finding recorded by the Tribunal is that there was
no discontinuance of business. Even as per principles laid down in A.L.A.
Firm's case in such a case the closing stock is to be valued at the cost or
market price, whichever is lower. That is an established rule of commercial
practice and accountancy. The High Court was clearly in error in relying upon
the decision of the Madras High Court in the cases of Ramachari and A.L.A. Firm
for coming to the conclusion that assets had to be valued at market value. As
already noticed, in the present case, there has no cessation of business and,
therefore, the closing stock could not be directed to be valued at the market
rate.
For
the aforesaid reasons, we answer the question in negative, i.e., in favour of
the assessee and against the Revenue.
The
appeal is accordingly allowed. The appellant will also be entitled to costs.
.............J.
[Y.K.Sabharwal]
.............J.
Back
Pages: 1 2
