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Category: Case Study

Addition to value of closing stock and MAT

1.0 Facts of the case :

    1.1 The following is the Profit and Loss account of ABC Ltd. for the year ended 31st March, 2006.

The company values its stock at lower of the cost or the net realisable value (NRV). The NRV in this case was lower than the cost.

1.2 The company filed the return of income for A.Y. 2006-07 as under:

1.3 The Profit and Loss account of the company for EY, 2006-07 relevant to A.Y. 2007-08 was as under:
1.4 The company declared income in its return for A.Y. 2007-08 as under:
1.5 Since there was no tax payable under the normal computation of income and since there was book profit as worked out u/s.115JB of the Act, the company paid MAT for A.Y. 2007-08 on the book profit of Rs.0.25 cr.

1.6 Thereafter, the AO completed assessment for A.Y. 2006-07 by adding Rs.0.25 cr. to the value of the closing stock on the ground that the company should have valued its stock at cost instead of at an amount being the lower of the cost or the NRV. Since the final tax still was nil the company did not opt to file an appeal. The assessed loss stood at Rs.0.25 cr. in place of the returned loss of Rs.0.50 cr.

1.7 The AO accepted the return for A.Y. 2007-08. Believing that the adjustment to the value of the closing stock would have a bearing on the taxable income of the succeeding year, the assessee contended in an application made u/ s.154 of the Act for A.Y. 2007-08 that the value of the opening stock should be adjusted by the amount of the adjustment made to the value of the closing of stock of the preceding year. It also contended that a similar adjustment should also be made to the book profit worked out u/s.115JB. According to the company, the revised book profit for A.Y. 2007-08 should appear as under:

It claimed  refund  of MAT paid.

1.8 The Aa rejected the application in so far as it concerned adjustment to the book profit, on the grounds that:

    i) the accounts of the assessee for the year relevant to AY. 2007-08 were prepared in accordance with the provisions of parts II and III of Schedule VI to the Companies Act, 1956; and

    ii) therefore, he had no power to make any adjustment to the book profit, as was held by the Honourable Supreme Court in Apollo Tyres Ltd. v. ClT, (2002) 255 ITR 273 and ClT v. Comnet Systems & Services Ltd., (2008) 305 ITR 409.

1.9 The company seeks your advice on whether an appeal should be filed against the stand of the AO.

2.0  Advice:

2.1 The company is advised to prefer an appeal for the reasons to be stated hereafter.

2.2 It is true that in the cases referred to by the AO, the SC held that the AO does not have power to make adjustment to the book profit other than the adjustments permitted in the provisions relating to MAT. The SC, however, did not say that no adjustment can ever be made by the AO to the book profit. The AO is empowered to make the permitted adjustments. Let us, therefore see the nature of the adjustment made by the AO in the form of addition to the value of closing stock for AY. 2006-07, and whether the adjustment sought by the assessee is a permitted one.

2.2.1 The assessee valued the closing stock at the lower of the cost or the NRV. Therefore, when the assessee found the NRV of the stock to be lower than the cost for AY. 2006-07, it scaled down the value of stock as at 31st March, 2006 in the books. Thus, the assessee effectively created a provision for eventual loss that might be incurred at the time of realisation of stock. When the AO did not allow the reduction in the value of stock for AY. 2006-07, what he was effectively doing was that he was disallowing the provision for loss, and he was permitted to make such adjustment to the ‘book profit’ for AY. 2006-07. (I leave aside for the present the ratio of decisions that hold that a provision in recognition of reduction in value of an asset is not it was not challenged in appeal). However, since the total book loss for A.Y. 2006-07 at Rs.0.50 cr. exceeded the disallowance of Rs.O.25cr., there was a negative ‘book profit’ after the said adjustment and there was no liability for AY. 2006-07 u/s.115JB of the Act.

2.2.2 It must be noted that though the Aa disallowed the hidden provision for loss in A.Y. 2006-07, the assessee had not made any corresponding changes in its books in the succeeding year. As a result, the assessee continued to carry the hidden provision in the books. In the next year relevant to AY. 2007-08, the profit and loss account of the assessee can be restated as under:

Based on the above, the assessee has the right to exclude the credit of Rs.0.25 cr. from the book profit since that figure represents provision recalled which was not allowed while computing the book profit for AY. 2006-07. S. 115JB, in clause (i) of Explanation (1) to S. 115JB, read with Proviso thereto, permits exclusion from the book profit of the amount withdrawn from reserve or provision (excluding a reserve created before 1-4-1997, otherwise than by way of a debit to the profit and loss account), if any such amount is credited to the profit and loss ac-count. The only issue that can survive is: whether the provision recalled at Rs.0.25 cr. as shown in the restated profit and loss account is an amount credited to the profit and loss account and thereby forming part of the book profit and therefore meriting exclusion from the book profit, for one may remember that this amount was not originally credited in the account and it appeared only in the rested profit and loss account. The author is of the view that though this amount did not appear in credit in the original profit and loss account, it was nevertheless de facto credited in the profit and loss account as is shown in the restated profit and loss account which is the same as the original profit and loss account except that it differs in presentation. It is submitted that the substance of a transaction rather than its presentation should decide taxability or otherwise.

2.2.3.1 There is one more aspect to be considered also. The assessee has prepared accounts for both the years following accounting standards in general and AS-2 relating to valuation of inventory in particular. Therefore, a question can arise whether there was any mistake committed by the AO in the next year as far as the working u/s.115JB is concerned. If there was no mistake, no rectification will lie u/s.154 of the Act.

2.2.3.2 In my view, it is true that AS-2 has been followed by the assessee for valuing inventory and therefore there is no mistake in the accounts which could be the subject matter of rectification u/s.154 of the Act. However, the AO, in my view, cannot take two different stands in two years in respect of one and the same issue. The AO holds the view for AY. 2006-07 that there is an uncalled for provision for loss in respect of closing stock, which should not be allowed. Here, for AY. 2006-07, I concede to the AO the right to make adjustment to the book profit of that year without providing justification to his right. However, as shown above, the book profit still would be a negative figure after such addition and the addition would have had no effect on the final tax. Now, when the AO comes to A.Y. 2007-08, he cannot hold the’ view that the addition to the closing stock for AY. 2006-07,which is also the opening stock for AY. 2007-08, did not represent addition on account of an uncalled for provision. If he could have made adjustment to the book profit for AY. 2006-07 on account of the addition, he should make adjustment to the book profit for AY. 2007-08. In other words, it is expected that the AO keeps his stand consistent for both the years.

3.0 Thus, in view of the above, the assessee is not liable to MAT for AY. 2007-08. MAT paid by it should be refunded.

Author’s Note:
There can be other angles to the issue. For example, it is a question whether the booking of reduction in value of stock in this case was a provision for a loss or was recognition of an actual loss. If it is a provision, the amended S. 115JB now may not permit reduction of the book profit by such amount, whereas if it is recognition of an actual loss, the provisions may permit reduction of the book profit. The issue discussed here also shows that it is advisable, in case the NRV of an inventory is less than the cost, that a separate provision is made by debiting the profit and loss account instead of reducing the closing value of the inventory in the trading account and recall such provision to the trading account in the next year and repeat the process every year. Thus, in case such a provision is disallowed u/s.115JB, its recall next year cannot form part of the book profit.

TDS and S. 40(a)(ia) of the Income-tax Act, 1961

1.0 Facts :

    1.1 ABC Ltd. credits on 1st October, 2009 the account of Mr. X, a resident, with Rs.55,000 being commission on sales payable to him. ABC Ltd. deducts tax at source @ 5% being oblivious of the actual rate applicable. This results in a short deduction of tax of Rs.2,750.

    1.2 ABC Ltd. also credits on the same day the account of Mr. Y, a resident, with Rs.55,000 being commission on sales payable to him. The company deducts tax at source @ 15%. This results in an excess deduction of tax of Rs.2,750.

    1.3 The company has made accounting entries in accordance with the above facts, and cleared the accounts of Mr. X and Mr. Y before 31st December, 2009. Thus, the balances in these accounts are reduced to nil. It is believed that in neither account any further credit will arise till 31st March, 2010.

    1.4 The company uploads its quarterly TDS statement with the above information.

    1.5 When the CFO of the company is informed that commission paid to Mr. X is likely to be disallowed u/s.40(a)(ia) on account of short deduction of tax thereon, he argues that there is no overall short deduction when payments to Mr. X and Mr. Y are considered together.

    1.6 The company seeks your opinion about the allowability of deduction in respect of commission paid to Mr. X. The company also seeks your views on whether the company is liable to pay interest u/s.201 in respect of this short deduction of tax.

2.0 Opinion :

    2.1 Let us first see how S. 40(a)(ia) when read with the substantive part S. 194A would work. For a better comprehension, substantive parts of S. 40(a)(ia) and S. 194A are reproduced below :

    40(a)(ia) : “any interest, commission or brokerage, rent, royalty, fees for professional services or fees for technical services payable to a resident, or amounts payable to a contractor or sub-contractor, being resident, for carrying out any work (including supply of labour for carrying out any work), on which tax is deductible at source under Chapter XVII-B and such tax has not been deducted or, after deduction, has not been paid”.

    194A : “(1) Any person, not being an individual or a Hindu undivided family, who is responsible for paying to a resident any income by way of interest other than income by way of interest on securities, shall, at the time of credit of such income to the account of the payee or at the time of payment thereof in cash or by issue of a cheque or draft or by any other mode, whichever is earlier, deduct income-tax thereon at the rates in force :

    2.1.1 The following features of S. 40(a)(ia) when r.w. the substantive part of S. 194A stand out in order that the provisions of S. 40(a)(ia) may apply.

    (i) Tax on interest is deductible in respect of every credit or payment of interest if the amount of credit or payment exceeds or is likely to exceed the specified amount in a financial year. Thus, the liability is fastened to credit or payment, as the case may be.

    (ii) Tax on specified incomes should be deductible under Chapter XVII-B.

    (iii) Such tax should not have been deducted;

    or

    (iii) after deduction, such tax should not have been paid before the specified dates.

    2.1.2 It is admitted that tax in this case is deductible since income is a specified income and that the full tax has not been deducted. Further, when taxes deducted from payments made to Mr. X and Mr. Y are taken together, there is no shortfall.

    2.2 The following issues arise out of the facts and the queries :

    (i) Whether full tax at source should be deducted and paid on a specified income in order that no disallowance u/s.40(a)(ia) may be made.

    (ii) Whether some tax deduced at source and paid to the Treasury on a specified income can make S. 40(a)(ia) inapplicable making thereby the entire underlying income eligible for deduction.

    (iii) Is it possible that the amount of disallowance u/s.40(a)(ia) is restricted to the amount which bears to the amount of expenditure the same proportion as the amount of tax not deducted bears to the amount of full tax ? In other words, can the amount of disallowance be decided by the formula :
   

    (iv) Whether an excess tax deduction in one case can be adjusted against shortfall arising in another case so as to avoid disallowance u/s.40(a)(ia) and interest.

    2.2.1.1 As regards the first issue, a view can be taken that a small shortfall may make the entire underlying expenditure disallowable u/s.40(a)(ia). The reason for holding this view is that S. 40(a)(ia) applies when a tax in respect of a specified income is deductible and such tax has been either not deducted or not paid. Therefore, in this case, Rs.5,500 was the tax deductible from the payment made to Mr. X, and therefore, such tax should have been deducted and paid if one wants to avoid disallowance under these provisions. Since such tax was not deducted and paid, S. 40(a)(ia), prima facie, becomes applicable making the entire underlying expenditure disallowable.

2.2.1.2 Another view can also be taken that if some as against the full tax is deducted from credits or payments of specified incomes, full allowance for the underlying expenditure should be made. The reason for holding this view is that, as seen above, S. 40(a)(ia) will primarily apply if there is a tax deductible in respect of a specified income and such tax has not been deducted, meaning thereby, that full of such tax should not have been deducted. In other words, in order that this case may fall in S. 40(a)(ia), the amount not deducted should be Rs.S,SOO,no more and no less. In case a part deduction of tax has been made, as in the case of payment to Mr. X, no disallowance u/s.40(a)(ia) can be made.

2.2.1.3 I must admit that the views expressed in paragraphs 2.2.1.1 and 2.2.1.2 are unreasonable and outrageously extreme. A person, who deducts some tax from a specified income and another person who does not deduct any tax at all from a similar income, cannot be treated on par. If the views expressed in paragraph 2.2.1.1 are accepted, both these persons suffer full disallowance whereas the offence of the first person is certainly mitigated by the fact he has made some deduction of tax at source. For similar reasons, the views expressed in paragraph 2.2.1.2 can also not be accepted as these views put on par persons who have fully complied with the law, with persons who have shown no compliance at all. It would be absurd to say that two persons, one of whom has made the full payment of tax at source of Rs.5500 and the other person who has made no payment at all, will both enjoy full allowance of the underlying expenditure.

2.2.2 Therefore, the better view is that disallowance of the expenditure is restricted to the amount which bears to the amount of expenditure the same prociate that any amount is mathematically a sum of several amounts and any amount can be broken up into several sub-amounts. For example, a thousand is also a summation of eight hundreds and two hundreds, and likewise. Thus, a view can be taken, when Rs.2,7S0 is deducted in the case of Mr.X, that the underlying expenditure in respect thereof is Rs.27,SOO. Viewed thus, there is full deduction of tax @ 10% from Rs.27,500. The remaining Rs.27,500 of the expenditure is the amount in respect of which the default has been committed. It is this last amount which will suffer disallowance.

2.3.1 We shall now deal with issue No. 4 : whether excess deduction in one case can be adjusted against the shortfall arising on account of short deduction in anether case. In this particular case, since the information with excess and short deduction of tax has been uploaded, inter account adjustment between the two accounts is not possible unless this information is revised and reuploaded. The obligation on a person is to deduct proper tax in respect of an expenditure. Though expenditures incurred in favour of Mr. X and Mr. Y have a similar nature, they represent different expenditures, and there is admittedly a default committed in respect of payment made to Mr. X. Therefore, the excess deduction of tax in the case of payment to Mr. Y will not be available for adjustment against the shortfall of tax in the case of Mr. X.

2.3.2 However, inter account adjustment between Mr. X and Mr. Y would have been possible before uploading the information in the quarterly statement by debiting Mr. X’s account in whose case short tax was deducted and crediting Mr. Y’s account in whose case an excess tax was deducted and thereby a net short payment of commission was made. The company would, thereafter, recover Rs.2,750 from Mr. X and pay it over to Mr. Y. Or else, if the company is unable to recover such amount from Mr. X, the company could write it off and claim it as a commercial loss. It should be remembered that such tax borne by the company is not ‘a tax levied on the profits or gains ,of any business or profession’, and therefore S. 40(a)(ii) operating as a disallowance of expenditure by way of income-tax, will not apply.

Needless to say that if inter account adjustment is carried out between the accounts of Mr. X and Mr. Y, the TDS certificates should be issued accordingly.

3.0 Conclusion:

The amount to be disallowed in this case should be Rs. 27,500, that is, on a proportionate basis. No inter account adjustment is possible once the information is uploaded; unless the information is revised. TDS certificates should be issued in accordance with the information uploaded.

Mens rea and penalty u/s.271(1)(c) of the Income-tax Act, 1961

Case Study

Case Study No. 1


1.0 Facts of the case :



1.1 Mr. Shivdasani, the assessee, filed his return of
income for A.Y.2006-07 declaring an income of Rs.5,00,000. Mr. Shivdasani
claimed a deduction u/s.35 in respect of a contribution of Rs.1,00,000 to an
institution approved for the purpose of S.35. The institution has issued a
receipt in acknowledgement of the contribution. The receipt bore the approval
number.

1.2 In the course of assessment, it is found that the
institution to which the contribution was made was not approved for the
purpose of S.35. The institution had forged the approval. The A.O. disallows
the claim and initiates proceedings for imposing penalty under S.271(1)(c) for
furnishing inaccurate particulars of income.

1.3 Mr. Shivdasani replies to the show-cause notice issued
for imposing penalty. One of the contentions of Mr. Shivdasani is that he
genuinely believed that the institution was approved for the purpose of S.35,
and that the claim was not mala fide.

1.4 The A.O. nevertheless imposes penalty on the ground
that the issue whether there was a bona fide belief or that the
intention was not mala fide in making a claim for a deduction, was
irrelevant particularly after the Honourable Supreme Court’s decision in the
case of UoI vs. Dharmendra Textiles Processors, 306 ITR 277. According
to the A.O. it is sufficient for imposing penalty that there results evasion
of tax on account of a claim made in the return which claim is found untenable
on assessment. The A.O. also highlights the fact that the assessee has
accepted the disallowance by not preferring an appeal against the assessment
order.

1.5 The assessee prefers an appeal against the penalty
order. Your views are solicited on the submissions to be made to the CIT(A) in
connection with the appeal filed against the penalty order.

2.0 Submissions :



2.1 It is true that it is irrelevant in penalty proceedings
under civil law whether there was guilty mind (mens rea) or not. In
other words, it is not necessary to prove presence of mens rea in
penalties imposable under civil law, more so after the decision of the SC in
the case of Dharmendra Textiles Processors (supra). However, this
decision should not be applied in a blanket manner to all penalty matters
under the Income-tax Act, for the reasons, one, that the SC decision does not
directly deal with a penalty imposable under S.271(1)(c), and two, the
decision does not make S.273 B otiose. That is, an assessee can always explain
the circumstances which led him to believe that his claim for a deduction was
made bona fide. S.273 B requires an A.O. to consider the reply
furnished by the assessee under S.273B, and it is only after the A.O. has come
to the conclusion that there was no reasonable cause for the assessee to make
the claim under S.35 that the A.O. can impose penalty. In this case, the
appellant did have a receipt issued by the donee institution indicating that
it was an approved institution under S.35, giving no reason to the assessee to
suspect its genuineness. Thus, the appellant had reason to believe that his
claim was legitimate.

2.2 The case of the appellant is also not governable by
Explanation 1 to S.271(1) to say that the assessee is deemed to have
concealed the particulars of his income. The Explanation is reproduced here :

Explanation 1 — Where in respect of any facts
material to the computation of the total income of any person under this
Act, —


(A) such person fails to offer an explanation or offers
an explanation which is found by the Assessing Officer or the Commissioner
(Appeals) or the Commissioner to be false, or

(B) such person offers an explanation which he is not
able to substantiate and fails to prove that such explanation is bona
fide and that all the facts relating to the same and material to the
computation of his total income have been disclosed by him,


then, the amount added or disallowed in computing the
total income of such person as a result thereof shall, for the purposes of
clause (c) of this sub-section, be deemed to represent the income in respect
of which particulars have been concealed.


2.3 One can see that this is not a case where the appellant
fails to offer an explanation. It is also not a case where the explanation as
offered by the appellant is found to be false. It must be remembered that what
is found to be false in this case is the ‘receipt’ issued by the donee
institution, not the explanation of the appellant. Therefore clause (A) of
Explanation 1 does not apply.

The appellant has shown that his explanation is made
bona fide which he is substantiating with the receipt issued by the
institution. It is also not a case where all the facts relating to the claim
and material to the computation of income have not been disclosed. Therefore,
clause (B) of Explanation 1 will also not apply. The A.O., therefore, cannot
hold any income in respect of which particulars have been, or deemed to have
been, concealed.

2.5 In view of the above submissions, the penalty as
imposed may be deleted.


Case Study No. 2

1.0 Facts of the case :


1.1 Mr. Haridasani was a resident of Dubai for a number of years. Later, he moved to India and started business.

1.2 For F.Y.2005-06, relevant to A.Y.2006-07, Mr. Haridasani had acquired the status of Resident and Ordinarily Resident. Since the business operations of Mr. Haridasani were low and since Mr. Haridasani had only the income from investments held abroad, he had not engaged services of any professional to assist him in preparation of his return of income.

1.3 Mr. Haridasani declared only his Indian income in the return for A.Y.2006-07. He filed his full personal accounts with the return of income showing all his investments in India and abroad and also filed full extracts of bank accounts showing credit in respect of all income including income earned abroad. He had filed his earlier returns similarly in respect of the preceding years. The case for A.Y. 2006-07 was for the first time selected for scrutiny under 5.143. The A.O., on finding his income abroad, brought it to tax and imposed penalty for concealment of income. Mr. Haridasani had pleaded innocence and lack of familiarity with the Indian laws since he had stayed abroad for a number of years and also for the fact that he had not engaged any professional to advise him. His pleas were turned down and penalty for concealment of income was imposed. The A.a. also mentioned in”his penalty order that innocence, or lack of mens rea, was no longer available as a defence since the promulgation of the SC decision in the case of UoI. vs. Dharmendra Textiles Processors, 306 ITR 277. Mr. Haridasani had preferred an appeal against the order imposing penalty and seeks your advice in preparing arguments to be made before CIT(A).

2.0 Submissions:

2.1 The penalty in this case is imposed for the act of ‘concealment of income’ as opposed to the act of ‘furnishing inaccurate particulars of income’. The two acts, namely, of ‘concealment of income’ and of ‘furnishing inaccurate particulars of income’ are two different circumstances both leading to penalty under S.271(1)(c) — Please refer to eIT vs. Indian Metal & Ferro Alloys Ltd., 117 CTR (Ori) 378, which succinctly draws distinction between the two circumstances and explains what they mean. The following passage from the said decision is self explanatory.

“The expressions ‘has concealed the particulars of income’ and ‘has furnished inaccurate particulars of income’ have not been defined either in Section 271(1)(c) or elsewhere in the Act. One thing is certain that these two circumstances are not identical in details although they may lead to the same effect, namely, keeping off a certain portion of income. The former is direct and the latter may be indirect in its execution. The word ‘conceal’ is derived from the Latin word ‘concolare’ which implies ‘to hide’. Webster’s New International Dictionary equates its meaning to ‘hide or withdraw from observation; to cover or keep from sight; to prevent the discovery of; to withhold knowledge of’. The offence of concealment is thus a direct attempt to hide an item of income or a portion thereof from the knowledge of the Income-tax authorities. In furnishing its return of income, an assessee is required to furnish particulars and accounts on which such returned income has been arrived at. These may be particulars as per its books of account if it has maintained them, or any other basis upon which it has arrived at the returned figure of income. Any inaccuracymade in such books of account or otherwise which results in keeping off or hiding a portion of its income is punishable as furnishing inaccurate particulars of its income.”

2.2 Once the position is admitted that the circumstance leading to penalty is ‘concealment of income’, one must proceed to find out the applicability of the ratio of the SC decision in the case of UoI. vs. Dharmendra Textiles Processors, 306 ITR 277.

2.3 It is true that the said decision does lay down the principle that the presence of mens rea need not be proved in civil matters before imposing penalty unlike in criminal matters. However, the said principle comes with a caveat. The caveat is that mens rea need not be proved only if the language of a provision imposing penalty does not require the presence of mens rea to be proved. In other words, if the language requires that a penalty cannot be imposed unless the assessee had a guilty mind before committing the act leading to the penalty, then the presence or absence of a guilty mind assumes importance. As per the decision in the case of Dharmendra Textiles Processors what is of paramount importance is the language of the provisions imposing penalty. The Honourable SC has also relied on the language of S.276C providing for prosecution in cases where a person wilfully attempts to evade tax, to make the point since this provision requires the element of mens rea to be proved before the person can be prosecuted because the language of the provision clearly requires so, the person cannot be prosecuted unless he had a guilty mind. Moreover, while deciding the case of Dharmendra Textiles Processors, the SC has approvingly quoted from its earlier decision in the case of Gujarat Travancore Agency vs. CIT, 177 ITR 455. According to the said decision which was rendered in the context of S.271(1)(a) of the Act, the SC confirmed penalty imposed under S.271(1)(a)where the appellant had no malafide in filing his return late because the Court did not find anything in the language of S.271(1)(a) which required the presence of mens rea to be established before a penalty could be imposed. Thus, what is important is not whether the presence of mens rea is essential or not before imposing penalty in civil matters, but the language of the particular provision under which the penalty is sought to be imposed.

2.4 With the above back ground let us see whether the language of S.271(1)(c) requires the presence of mens rea when the penalty is sought to be imposed on the ground that the assessee has concealed the particulars of his income.

2.5 The words used in these provisions are ‘the assessee has concealed … ‘. As per the standard dictionary the word ‘conceal’ in ordinary English means, ‘I. to hide; withdraw or remove from observation; cover or keep from sight: e.g., He concealed the gun under his coat. 2. to keep secret; to prevent or avoid disclosing or divulging: e.g., to conceal one’s identity by using a false name. In this regard, please also refer to the decision in CIT vs. Indian Metal & Ferro Alloys Ltd., 117 CTR (Ori.) 378 and particularly to the passage reproduced in paragraph 2.1 above which explains the meaning of the word ‘conceal’.

2.6 One may appreciate that the idea of deliberateness is implicit in the word ‘conceal’. Concealment is not accidental or involuntary, it is planned and voluntary. The following observations of the Honourable SC made in the case of T. Ashok Pai vs. CIT, 292 ITR 11 still hold good:

“concealment of income’ and ‘furnishing of inaccura te particulars’ carry different connotations. Concealment refers to a deliberate act on the part of the assessee. A mere omission or negligence would not constitute a deliberate act of suppressio veri or suggestio falsi”.

2.6 Therefore, it is submitted that if the charge on the assessee is of concealing particulars of his income, the assessee can rebut the charge by proving lack of mens rea. This construction of the provision is not inconsistent with the ratio of the Honourable SC’s decision in the case of Dharmendra Textiles Processors (supra) for the reason that the said decision also lays stress on the language of particular provision imposing penalty. The decision merely forbids the presumption of requirement of proving mens rea; it does not say that one should ignore such requirement if it is demanded by the very provision imposing penalty.

2.7 In view of the submissions and the facts of the case, penalty should be deleted.

Author’s Note:
The stand taken in these case studies seems to be vindicated by the recent decision of the Supreme Court in the case of Uol vs. Rajasthan Spinning & Weaving Mills – Civil Appeal No. 2523 of 2009, where the Supreme Court has explained its decision in Dharmendra Textile Processor’s case.

Amount of tax sought to be evaded

1.0 Facts :

    1.1 ABC Pvt. Ltd. filed its return of income for A.Y. 2005-06 showing the following position :

Statement of Loss to be carried forward u/s.72 of the Income-tax Act, 1961 (the Act) :
1.2 On assessment, the AO disallowed certain expenses and the assessed income and the revised Statement of Loss stood as under :
Revised Statement of Loss to be carried forward u/s.72 of the Act :
1.2 The AO worked out penalty u/s.271(1)(c) of the Act as under :

2.0 Assessee’s submission to the AO:

2.1 The company contended that the final tax payable as per the return of income and as per the assessment order was nil, and therefore, there was no ‘amount of tax sought to be evaded’ as the phrase was explained in Explanation 4 to S. 271(1) of the Act. The AO did not accept the argument and referred to the amendment made to clause (a) of Ex-planation 4 to S. 271(1) of the Act by the Finance Act, 2002, with effect from A.Y. 2003-04. According to the AO, the aforementioned amendment had put paid to all arguments in such cases made on the basis of the ratio of ClT v. Priihipal Singh & Co., 249 ITR 670 (SC) and Virtual Soft Systems Ltd. v. ClT,289 ITR 83 (SC). Moreover, the AO held that the ratio of Virtual Soft had no application after the amendment of 2002, as was observed in that case also.

2.2 The company tried to distinguish the facts in Virtual Soft’s case (supra) from its own facts by stating that in Virtual Soft the return was one of loss and the assessment was made at a reduced loss, whereas in its own case the return was one of nil income and the assessment was also one of nil income. Effectively, the company contended that as the term ‘the amount of tax sought to be evaded’ was explained in Explanation 4 to S. 271(1) of the Act there was no such amount. This argument was rejected.

3.0 The assessee seeks your advice on the above aspect with a view to deciding on the advisability of going  in appeal.

4.0 Opinion:

4.1 Before embarking upon giving opinion, one must admit that the issue involved here has a long history. The matter relates to penalty, and therefore, in construing penal provisions, as the Honourable SC said in Virtual Soft (supra), the statute creating penalty is the first and last consideration and must be construed within the term and language of the particular statute.

4.2 It is true that the ratio of Virtual Soft may not apply to cases post 1st April, 2003. However, what is necessary is to see whether the company’s case here solely rests on the ratio of Virtual Soft or it can stand on its own. The point involved in Virtual Soft is succinctly brought out by the Honourable SC in the following words at page 92 of the Report: “The point involved before the High Court was, as to whether penalty was leviable u/s.271(1)(c)(iii) read with Explanation 4 thereto which came on the statute book with effect from April 1,1976, in a case where the return filed was one of loss and the assessment made by the Assessing Officer was at a reduced amount of loss.”

Thus, one may see that there was a loss declared in the return of income which was reduced on assessment. This fact is material for later part of this opinion.

4.3 In order that penalty can be imposed u/s. 271(1)(c) of the Act, there must be an ‘amount of tax sought to be evaded’, because this amount forms the basis of quantum of penalty. If it is discovered in a given case that there is no such amount, or that such amount cannot be worked out, then one can say that though the substantive provisions may apply, the machinery provisions fail. If that is the case, one may infer that the substantive provisions are not intended to apply to a given case. Support for these propositions can be found in the Supreme Court decision in the case of Cl’T v. B. C. Srinivasa Setty, 128 ITR 294. In fact, this proposition is clearly accepted in Virtual Soft (supra) also.

4.4 Therefore, it is necessary for us to find out whether there is any ‘amount of tax sought to be evaded’ in terms of the language of Explanation 4 to S. 271(1) of the Act. Let us examine the individual clauses of the said Explanation.
 
4.4.1 Clause (a) of the said Explanation reads as under:

“(a) in any case where the amount of income in respect of which particulars have been concealed or inaccurate particulars have been furnished has the effect of reducing the loss declared in the return or converting that loss into income, means the tax that would have been chargeable on the income in respect of which particulars have been concealed or inaccurate particulars have been furnished had such income been the total income;”

4.4.1.1 As per this clause, it applies in a situation when the income alleged to be concealed has the effect of reducing the loss declared in the return of income or converting that loss into income. If this is not the case, one need not look beyond.

4.4.1.2 In the present case, there was no loss declared in the return, as the return declared nil income. Therefore, the question of the concealed income reducing that loss declared in the return of income does not arise. One may, here, argue that the balance of the carried forward loss of Rs.90,00,000 was a loss declared in the return of income (such losses have to be stated in the form of return of income) and since this loss got reduced from Rs.90,00,000to Rs.85,00,000, the condition of ‘the concealed income reducing the loss declared in the return of income’ is fulfilled. The question is : Is it to the brought forward loss or to the current year’s loss that the reference is made in the first limb of clause (a) of Explanation 4 ? The second limb of the sentence, which reads as, “…. or converting that loss into income” holds the key to that question. The word ‘that’ used in the second limb of the sentence explains, or rather qualifies, the term ‘loss’ referred to in the first limb of the sentence. It says that the ‘loss’ referred to in clause (a) is such loss as is also capable of being converted into income. Viewed thus, one may agree that brought forward losses can be reduced, but in any assessment, they cannot be converted into income. Such losses, can at best, be reduced to nil. Therefore, one may further argue that the reference to the word ‘loss’ in this clause is to the loss of the current year which alone is capable of being converted into income on additions or disallowances made in the assessment. Since there is no loss in the current year (there is income of Rs.10,00,000 from business), clause (a) of Explanation 4 to S. 271(1) of the Act does not apply to the facts of the case.

4.4.2 Clause (b) of Explanation 4 to S. 271(1)) of the Act, being applicable only in certain special cases of search and non-filing of returns, does not apply to the facts of this case.

4.4.3 Let us examine the applicability of the residuary clause (c) of the said Explanation to the facts of this case. Clause (c) reads as under:

“(c) in any other case, means the difference between the tax on the total income assessed and the tax that would have been chargeable had such total income been reduced by the amount of income in respect of which particulars have been concealed or inaccurate particulars have been furnished.”

4.4.3.1  In order to find out the quantum  of penalty under  this clause, one has to find out the difference between  the tax on the total  income  assessed  and the tax that would  have been chargeable  had such total income been reduced  by the amount  of income alleged  to be concealed  (Rs.5,00,000 in this case).

4.4.3.2 The tax on the total income as returned and assessed, both, in this case, is nil, and as such, there is no difference between the two. Thus, no amount of penalty can be worked out under this clause.

4.4.3.3 One may argue here that Rs.I0,00,000 and Rs.15,00,000 being the returned income and the assessed income from business, respectively, should be taken as ‘the total income’ and the difference between the notional tax on such total income, returned and assessed, should form the basis of quantum of penalty. In other words, what needs to be decided is: what is the meaning of ‘total Income’, the phrase used in clause (c) of Explanation 4 ? Does the term ‘total income’ here means the one as ar-rived at before setting off of brought forward losses or the one as arrived at after such set-off?

4.4.3.4 The ‘total income’ has been defined in S. 2(45) of the Act as, ” ‘Total Income’ means the total amount of income referred to in S. 5 computed in the manner laid down in this Act”. S. 5 of the Act lays down the scope of total income, but S. 15 to S.  59 lay down  provisions  relating  to computation  of income under  various  heads.  The question  is : Is S. 72 dealing  with  carry forward  and set-off of business losses part of computational  machinery?  The issue is addressed by the Supreme Court in Cambay Electric Supply Industrial Co. Ltd. v. CIT, 113 ITR 84.

At page 97 of the Report, Tulzapurkar T., speaking for the Court, said “that it was not possible to accept the view that S. 72 had no bearing on, or was unconnected with, the computation of the total income of the assessee under the head.” Following the decision in Cambay Electric, the Gujarat High Court has adopted a similar reason in Monogram Mills Co. Ltd. v. CIT, 135 ITR 122. In other words, the correct figure of total income cannot be arrived at without working out the net result of computation under the head ‘Profits and gains of business or profession’ and income under this head cannot be determined without taking into account S. 72 of the Act. Similar views are also expressed by the Supreme Court in CIT v. Shirke Construction Equipment Ltd., 291 ITR 380.

4.4.3.5 Therefore, it can be said that the term ‘total income’ used in clause (c) of Explanation 4 to S. 271(1) means the total income computed under the head ‘Profits and gains of business or profession’ taking into account the brought forward business losses. If this proposition is accepted, the total income, returned as well as assessed, in this case is nil, and the tax thereon is also nil. No amount of penalty can be worked out. It is true that the definition of the term ‘total income’ as contained in S. 2(45) is to not be followed if the context requires otherwise. However, it is submitted that there is nothing is clause (c) of Explanation 4 to S. 271(1) of the Act to suggest that the context requires a different meaning of the term ‘total income’, for any different meaning would be to stretch the language and, as the Supreme Court said in Virtual Soft (supra), it is not competent for the Court to stretch the meaning of an expression to carry out the intention of the Legislature.

In view of the above, it is submitted that though concealment might be established in the case, it is not possible to quantity the amount of penalty. The machinery provisions fail. Therefore, penalty is not leviable.

Author’s Note:

The author only expresses his views. Readers may write in to discuss a different viewpoint since the matter discussed here is controversial and may require one to act with caution.

Provision for Bad Debts — Explanation 1 to S. 115JB(2)

CASE STUDY

1.0 Facts :

1.1 X Ltd. provides for doubtful debts of Rs.10 crores in its
accounts for the year ended 31st March, 2010. The provision is based on a list
of debtors likely to turn bad. The company has reason to form such belief. After
making the provision, the company declares a ‘book profit’ of Rs.20 crores in
its profit and loss account. It has assessed brought forward unabsorbed business
losses of Rs.30 crores. Therefore, the company in its normal computation of
income, after adding back the provision for doubtful debts, declares nil income.

1.2 The question arises in computing the ‘book profit’
u/s.115JB : whether adjustment is required in respect of Rs.10 crores being
provision for doubtful debts. Your advice is sought in this regard.

2.0 Opinion :

2.1 Adjustments u/s.115JB to the book profits can be made if
the profit and loss account is not in conformity with Schedule VI to the
Companies Act, 1956, or such adjustments are necessitated by Explanation 1 to S.
115JB of the Income-tax Act, 1961. Therefore, the issue basically requires
consideration whether the debit entry in the income statement in respect of
provision for doubtful debts is hit by any requirement of the said Schedule VI
or by any clause of Explanation 1 to S. 115JB(2).

2.2.1 As far as the requirements of Schedule VI are
concerned, the profit and loss account is in conformity with the requirements of
Schedule VI. No adjustment is required on this account.

2.2.2 Let us turn to Explanation 1 to S. 115JB. There are two
clauses which may possibly apply to the creation of a reserve in respect of
doubtful debts. Clause (c) of the said Explanation reads as, “the amount or
amounts set aside to provisions made for meeting liabilities, other than
ascertained liabilities”. Thus, what is to be decided is whether such provision
is in respect of a liability or not, and if it is in respect of a liability,
whether the liability is an ascertained liability or not.

2.2.3 The issue whether a provision for doubtful debts is for
an ascertained liability or not has been setted by the Supreme Court in its
decision in the case of CIT v. HCL Conmet Systems and Services Ltd., (2007) 292
ITR 299. The Supreme Court held that the provision for doubtful debts and
advances could not be regarded as a provision for a liability other than an
ascertained liability. Thus, it is submitted that no adjustment is required in
respect of provision for doubtful debts under clause (c) of Explanation 1 to S.
115JB(2).

2.3.1 We must now consider clause (i) of Explanation 1 S.
115JB, introduced by the Finance (No. 2) Act, 2009, with retrospective effect
from 1st April, 2001. The new clause (i) reads as, “the amount or amounts
set aside as provision for diminution in the value
of any asset”.


2.3.2.1 The crucial terms of clause (i) to be considered are
: ‘amounts set aside’ and ‘diminution in the value of any asset’.

2.3.2.2 Before we proceed further, let us understand the
nature of provision for doubtful debts. The nature of provision for doubtful
debts is that the provision is recognition of the fact that certain debts are
unlikely to be recovered. The debts have not conclusively become bad. In
accordance with the conservative principle of accountancy, a charge is soon made
to the income statement in respect of the amounts of such debts without waiting
for the debts to actually turn bad.

2.3.2.3 Clause (i) speaks of amounts being set aside as
provision. Therefore, one of the questions that we need to ask ourselves is :
Are we setting aside any amount when we create a provision for a doubtful debt ?
The answer is no. When we create a provision for a doubtful debt, we do not set
apart or set aside any amount. An amount ‘set aside’ has the characteristic of
becoming available at a later time when required to recoup loss occasioned by
the eventuality. In fact, there is no such amount set aside when a provision for
a doubtful debt is made that it may be required later or that it may be
available. Such a provision is made in accounts to ascertain how much income
should be available for distribution to the stakeholders. Strictly interpreting,
when clause (i) speaks of amounts set aside, it may apply only to cases when an
amount on the asset side of the balance sheet corresponding to the amount of the
expected loss is earmarked for meeting an eventuality. We may remember that the
theory of depreciation discusses creation of an earmarked fund as an asset
corresponding in amount to the depreciation reserve, which can be used when the
asset concerned requires replacement. A mere debit in the profit and loss
statement may not amount to setting aside any amounts for a particular purpose.
A debit creating a provision for doubtful debts is nothing more than recognition
of the fact that certain debts may not be recovered. A provision of a revenue
nature is created through a debit in the income statement, but every debit in
the income statement is not creation of a provision. Many debits are in
recognition of losses or are a charge under the matching principle. When a
provision for doubtful debts is made no amount will be required to replenish
these debts when they actually become bad and therefore no amount is set aside
when such provision is made. Thus, we can say that there is no amount set aside
when a provision for doubtful debts is made. Thus, the first limb of clause (i)
of Explanation 1 to S. 115JB(2) does not apply.

2.3.2.4 If the first limb of clause (i) fails as shown above, the whole clause (i) should fail. However, one may argue that the debit entry in the income statement creating the provision restricts the distributable profits and thereby it can be said that it sets aside an amount. Thus, according to the advocate of this argument, the first limb of clause(i)    may be applicable to creation of a provision for doubtful debts. I must say that there is merit in this argument. Therefore, it will be interesting to examine whether the second limb, namely, that there is ‘diminution in the value of any asset’ applies or not. One may note the dictionary meaning of the word ‘diminution’ which is “the act, fact or process of diminishing, lessening, reduction”. The word ‘diminish’ means ‘to make or cause to seem smaller, less, less important, etc.; lessen; reduce.’ The words ‘lessen’ and ‘reduction’ have more or less the same meaning. Thus, the word basically means diminishing, reduction or lessening, as against complete annihilation or destruction. One generally will not associate the word ‘diminution’ with complete destruction or annihilation. Depreciation in respect of fixed assets is a classic example of diminution in the value of fixed assets. Provision for doubtful debts does not stand on par with provision for depreciation. Provision for depreciation is recognition of gradual fall in the value of the underlying asset, whereas the provision for doubtful debts is recognition of possible loss of an entire asset. There is no diminution, as the term is understood, of value of the debts; there is imminent complete loss of the asset. However, it may be noted that if a debt is valued (as it is valued for securitisation purpose) at a value less than the book value and a provision is made for the possible loss, such provision may be hit by clause (i) subject to consideration whether any amount can be said to have been set aside.

2.4 Conclusion:

Clause (i) of Explanation 1 to S. 115JB(2) should not apply to a bona fide provision for doubtful debts as there is neither setting aside of an amount, nor is there any recognition of diminution in the value of an asset. It is another matter that there may be a likelihood of a complete loss of value but then it is not diminution in value, it is loss of value. A question may arise : to which situation then the said clause (i) of Explanation 1 to S. 115JB(2) will apply? It will apply to a situation where the underlying asset is in existence and there is a fall in value which is recognised through the profit and loss account and a fund to recoup such loss is simultaneously created.

Note : The views are personal and expressed here to raise some arguments. The matter may be settled only through judicial intervention.
 

Editor’s Note: The Delhi Tribunal in the case of DCM Shriram Consolidated Ltd. vs DCIT (2010) 39 SOT 203 (Del) has taken a view contrary to the view expressed by the author in this Article.

Capital gains and S. 54EC of the Income-tax Act, 1961

Case Study

1.1
Mr. Atul Shah sold his land in Ahmedabad in F.Y. 2007-08. Mr. Shah also sold his
land in a small village in the same year. Mr. Shah earned a long-term capital
gain (LTCG) on transfer of the Ahmedabad land and incurred a lonwg-term
capital loss (LTCL) on transfer of the village land. Mr. Shah invested in
eligible bonds as per section 54EC of the Income-tax Act, 1961 in order to save
tax on LTCG. The working of the gain and the loss was done as follows :


1.3    Thus, the AO effectively exhausted the long-term capital loss, leaving nothing to be carried forward. The assessee argued that before the loss could be set off against the gain, effect should be given to S. 54EC. The assessee also relied on the decision in the case of ICICI Ltd. v. Dy. CIT, 70 ITD 55 (Mum.). The assessee argued that S. 70 or S. 71 should be applied only after giving effect to S. 54EC. The AO rejected this argument and distinguished the ICICI Ltd. case by stating that S. 54E, which was involved in the ICICI case, was one of the Sections named in S. 45(1) as having an overriding effect. S. 54EC, as applied by the assessee in the present case, was not named in S. 45(1). This can be seen from the language of the Section which is as under?:

“Any profits or gains arising from the transfer of a capital asset effected in the previous year shall, save as otherwise provided in S. 54, S. 54B, S. 54D, S. 54E, S. 54EA, S. 54EB, S. 54F, S. 54G and S. 54H, be chargeable to income-tax under the head ‘Capital gains’, and shall be deemed to be the income of the previous year in which the transfer took place.”

Thus, according to the AO, since there is no reference made to S. 54EC in S. 45(1), S. 54EC cannot have an overriding effect unlike S. 54, S. 54F, et al., named in S. 45(1). The AO was of the view that the net result under the head ‘Income from Capital Gain’ should be first found out after application of S. 70 and if there is any LTCG found taxable thereafter, it is in respect of such gain that the exemption mentioned in S. 54EC should be granted. In the result, the AO denied carry forward of the LTCL.

1.4    The assessee seeks your opinion.

2.0    Opinion:

2.1 It is true that S. 45(1) does not name S. 54EC like S. 54, S. 54F, et al. It is an admitted position that the Sections (S. 54, S. 54F, etc.) named in S. 45(1) have an overriding effect and capital gains u/s.45 have to be computed subject to those Sections. S. 45(1) does not name S. 54EC and, therefore, S. 45(1), apparently, is not subject to S. 54EC.

2.2 However, it must be remembered that capital gain or loss has to be worked out in respect of each capital asset separately. A useful reference may be made here to support this proposition to the case of Jt. CIT v. Montgomery Engineering Markets Fund, 100 ITD 217. The Mumbai Bench of the Tribunal upheld the plea that each capital asset is a separate source of capital gain or loss. Similar view is also taken by the Mumbai ITAT in the case of ACIT v. Nemish S. Shah, 36 BCAJ, P. 645, No. 29, March 2004 issue where the Tribunal held that each share in a company is a separate capital asset. Thus, transfer of each asset constitutes a source of capital gain. Once this position is conceded, the law does not provide about the specific gain against which exemption granted in S. 54EC should be claimed. In other words, it is left to the assessee to decide against which long-term capital gain or gains he wants to claim exemption. The aggregation of long-term capital gains in respect of each asset will be done only after the process of computation of capital gain, including granting exemption in respect of each individual capital asset, is completed, and it is the residue from each source that will be aggregated to arrive at the total figure of capital gain chargeable under the head ‘Income from Capital Gain’. It must be stated here that S. 70(3) states that when the result of computation made u/s.48 to u/s.55 is a loss arising from the transfer of a long-term capital asset the assessee shall be entitled to have the loss set off against any other gain arising from the transfer of a long-term capital asset. However, this provision talks of intra-head adjustment and for the purpose of this section, each capital asset constitutes a separate source of gain (or loss). It is only after the gain from a source is worked out in accordance with the provisions of S. 48 to S. 55 that one has to proceed further.

2.3 It is true that S. 45(1) does not explicitly mention S. 54EC as it mentions other Sections that have an overriding effect. Yet, one must not lose sight of the fact that S. 54EC grants exemption, and before the question of application of S. 70 and S. 71 would arise, net taxable capital gain from each source, i.e., transfer of each capital asset, should be worked out. Thus, omission of S. 54EC from being referred to in S. 45(1) is academic, without any significant effect as far as the present controversy is concerned.

2.4 Further, if the AO’s interpretation is accepted, it may frustrate S. 54EC. For example, a LTCG may arise to an assessee on 1st April of a financial year. As per S. 54EC he should make investment in an eligible instrument within six months form the date of transfer. Accordingly, he makes the investment. Now, the assessee incurs a long-term capital loss, say, in the month of December, that is, after making the investment. As per the AO’s interpretation, the investment made may become redundant as the long-term capital loss may take care of the long-term capital gain. However, this is a little absurd, as the assessee cannot wait till December to know whether he will have to make investment in the eligible instrument or not. If he does, and there is no loss incurred in December, unlike in the present case, he will have missed the bus of making investment. Though this logic is not entirely watertight, yet, we must try to give the provisions a meaningful purpose by resorting to purposive interpretation. On such an approach being adopted and on consideration of all the relevant provisions, one can say that S. 54EC operates in respect of capi-tal gain arising on transfer of each individual long-term capital asset and once an eligible investment is made it operates effectively so as to exclude the underlying gain from being considered for any purpose of taxation.

2.5 In ICICI Ltd.’s case (supra) the Tribunal interpreted S. 45(1) as being subservient to S. 54E. In order to make such interpretation, the Tribunal put weight on the language of S. 54E besides putting such weight on the language of S. 45(1) by ob-serving?: “In fact, the provision of S. 54E specifically states that, ‘the whole of such capital gain shall not be charged u/s.45’.” One may notice that S. 54EC also uses the same language. Thus, ICICI Ltd.’s case can be taken as an authority for the proposition that S. 54, S. 54F and other Sections referred to in S. 45(1) have an overriding effect on S. 45. But, the reverse may not necessarily be true. That is, the ICICI Ltd. case is not the authority for the proposition that if an exemption section is not mentioned is S. 45(1), it will not have an overriding effect.

3.0 To conclude, one can say that the exemption sections have an overriding effect on the main computational provisions as far as the charging S. 45 is concerned.