Full Judgment Text
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CASE NO.:
Appeal (civil) 3818 of 1999
PETITIONER:
SAKTHI TRADING CO.
Vs.
RESPONDENT:
COMMISSIONER OF INCOME-TAX, COIMBATORE
DATE OF JUDGMENT: 02/08/2001
BENCH:
Y.K. Sabharwal & Brijesh Kumar
JUDGMENT:
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
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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
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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
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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
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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
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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.
[Brijesh Kumar]
August 2, 2001