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Case Number

Appeal No.77 of 1936

Advocates

Rogers and Nevill
Barrow
India Office
R.P. Hills
Hubert Hull
J. Millard Tucker

Judges

Sir George Rankin
Lord Wright
Justice Lord Thankerton

Acts

provisions of S. 13, Income-tax Act
S.66, Indian Income-tax Act, 1922.

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Smart Summary

Concise Analytical Summary of the Opinion (Lord Thankerton)

Factual and Procedural Background

This appeal arises from a judgment of the High Court of Judicature at Bombay dated 28 March 1935, on a question of law referred under S.66 of the Indian Income‑tax Act, 1922. The dispute concerns the assessment of the respondents (a limited liability company manufacturing cloth and yarn at Ahmedabad) to income‑tax for the financial year ending 31 March 1932 and, in particular, the computation of profits for the accounting year ending 31 December 1930 under S.10 of the Act.

On 18 July 1931 the respondents filed a return under S.22(1) including: (a) an audited balance sheet and profit & loss account for the year ending 31 December 1930 showing profit of Rs.2,64,086; (b) a return of total income for assessment showing income of Rs.1,99,086; and (c) a covering letter explaining adjustments made to the profit & loss account figures, notably additions and deductions to allow for alleged undervaluation of stock and a bond premium. The covering letter set out figures that illustrated adjustments for undervaluations of stock at the ends of 1929 and 1930.

The Income‑tax Officer issued a notice under S.23(2) requiring production of evidence; the company produced its closed accounts. The company contended that (i) the undervaluation of closing stock for 1929 (disallowed in the prior assessment) should be added to opening stock for 1930, and the undervaluation for 1930 added to closing stock for 1930; (ii) the office had previously adopted the method of accounting treating such undervaluations similarly and should not depart from that approach; and (iii) the Privy Council decision in Commr. of Income‑tax, Bombay v. Ahmedabad New Cotton Mills Co. Ltd. (1930) supported their method.

In his assessment order dated 26 February 1932 the Income‑tax Officer, relying on the cited Privy Council decision as he understood it, rejected the company's adjustments for undervaluation and accepted the profit as per the accounts (Rs.2,64,086), disallowing a claimed deduction of Rs.37,668. The Assistant Commissioner confirmed that assessment on appeal on 22 November 1932.

The assessees applied to the appellant (the Commissioner) for review under S.33 or, alternatively, for a reference of questions of law to the High Court under S.66(2). The appellant declined to review and, contending no legal point arose, declined to make a reference. The High Court, on the assessees' application under S.66(3), required the appellant to make the reference; the appellant did so. The High Court amended the referred question and answered it in the negative (holding that the covering letter formed part of the method of accounting under S.13 and that the Income‑tax Officer could not split the method). The case proceeded to the Judicial Committee (Their Lordships), who considered the meaning and application of S.13 and the conduct of the Income‑tax Officer and Assistant Commissioner in the assessment.

Legal Issues Presented

Whether in view of the provisions of S.13, Income‑tax Act, or otherwise, the Income‑tax Officer was right in computing for the purpose of S.10 income, profits and gains in accordance with the method of accounting regularly employed by the assessee, whether or not that method in fact shows the true income, profits and gains. (This was the original question formulated by the High Court and referred in the letter of reference.)
Whether, in the circumstances of the case, the Income‑tax Officer was entitled to compute the income, profits and gains of the assessees upon the basis of the printed copy of the profit and loss account sent with the letter of the assessees of 18th July 1931, without regard to any undervaluation of the stock which may have been or may be proved to have been made. (This was the amendment proposed by the High Court.)
The question rephrased by the Judicial Committee (Preferred formulation): Whether in view of the provisions of S.13, Income‑tax Act, or otherwise, the Income‑tax Officer was right in computing for the purpose of S.10 income, profits and gains in accordance with the method of accounting regularly employed by the assessee, when that method in fact does not show the true income, profits and gains. (This amended question was answered in the negative by Their Lordships.)

Arguments of the Parties

Assessees' Arguments

The undervaluation of closing stock in the prior assessment (end of 1929) which was disallowed then should be allowed as an addition to opening stock for the accounting year 1930.
The undervaluation of closing stock for 1930 (claimed at another figure in the return) should be added to the closing stock of the company for 1930, i.e., the method of accounting adopted should reflect those adjustments.
The office had in previous assessments adopted the method of treating such undervaluations in the same way (adding previous closing undervaluation to subsequent opening stock and recognising the undervaluation in closing stock), and the Income‑tax authorities should not depart from that consistent practice.
The Privy Council decision in Commr. of Income‑tax, Bombay v. Ahmedabad New Cotton Mills Co. Ltd. (1930) supported the method adopted by the company and the treatment of undervaluations in both opening and closing stock for computing taxable income.

Revenue / Income‑tax Officer and Assistant Commissioner — Positions

The Income‑tax Officer, as reflected in his assessment order, understood the Privy Council decision as indicating that if undervaluation of closing stock is considered in an assessment then undervaluation of opening stock should also be considered, but if closing stock undervaluation is not considered, opening undervaluation should be left out — and accordingly he accepted the profit shown in the accounts (Rs.2,64,086) and disallowed the claimed adjustments.
The Assistant Commissioner supported the acceptance of the profits as shown by the accounts, reasoning that where a method of accounting has been regularly and properly employed the Income‑tax Officer is prima facie entitled to accept the profits shown by the accounts; the Assistant Commissioner described the Income‑tax Officer's discretion as "absolute" in accepting the accounts where regularly employed.
The Revenue also noted that the company admitted not keeping proper cost accounts and that revalued stocks were approximate, arguing that revalued stocks did not show "real profits" and that the Income‑tax Officer had not put fictitious values of his own.

Table of Precedents Cited

Precedent	Rule or Principle Cited For	Application by the Court
Commr. of Income‑tax, Bombay v. Ahmedabad New Cotton Mills Co. Ltd. (1930) 17 AIR PC 56 = 121 IC 543 = 57 IA 21 = 54 Bom 213 (PC)	Relied on by the Income‑tax Officer (as he understood it) to support the proposition that if undervaluation of closing stock is considered in an assessment the undervaluation of opening stock should also be considered, and conversely that if closing undervaluation is not considered the opening undervaluation should be left out.	The Income‑tax Officer relied on this decision to justify accepting the accounts' profit and excluding the undervaluation adjustments. Their Lordships reviewed that reliance and stated that the cited case (referred to as 57 IA 21 in parts of the reference) was of no assistance on the present question; they did not accept that reliance as a proper justification for the failure by the Income‑tax Officer to exercise his duty under S.13's proviso.

Court's Reasoning and Analysis

(Step‑by‑step presentation of the Judicial Committee's analysis, based on the material in the opinion.)

Meaning of S.13: Their Lordships interpreted S.13 as relating to a method of accounting "regularly employed by the assessee for his own purposes" (that is, the commercial/business accounting method), and not to the method of preparing the statutory return alone. The section makes such a business method the compulsory basis of computation for S.10 unless, in the opinion of the Income‑tax Officer, income, profits and gains cannot properly be deduced from it (the proviso).
Nature of the Income‑tax Officer's duty: The Judicial Committee emphasized that the proviso requires the Income‑tax Officer to form a judgment whether the true taxable income can properly be deduced from the accounts. This is not a mere discretionary or absolute power to accept accounts; it is a judgmental duty that must be exercised properly and reasonably.
Failure to exercise the proviso judgment here: Their Lordships found from the statements in the reference and the assessment papers that the Income‑tax Officer had not in fact exercised his judgment under the proviso. The Income‑tax Officer and the Assistant Commissioner instead accepted the profit as shown by the accounts without the required consideration of whether the accounts, in view of systematic undervaluation, allowed deduction of the true taxable income.
Evidence of systematic undervaluation: The Committee noted factual findings showing that the respondents had regularly employed the same method of valuing stocks (taking some price under both cost and market price) and had been revaluing opening and closing stocks for several years because they were "grossly undervalued." The opinion sets out a sequence of undervaluation figures from earlier years' accounts (undervaluations asserted for years of account 1926, 1927, 1928, 1929 totaling Rs.3,86,642; Rs.4,15,208; Rs.3,15,127; Rs.3,97,634 respectively) to demonstrate the regularity and magnitude of the undervaluation practice.
Reasonableness of concluding true profits could be deduced: Given the magnitude and regularity of undervaluation (including the 1930 undervaluation on the same basis as previous years), Their Lordships concluded the Income‑tax Officer could not reasonably have arrived at the conclusion that the profit shown in the profit & loss account was the true taxable profit. In addition, the appellant's own statement that the undervaluation was intended to create a "secret" reserve confirmed that the accounts did not show true taxable profits.
Rejection of the Assistant Commissioner’s principled stance: The Committee rejected the Assistant Commissioner's view that the Income‑tax Officer is prima facie entitled to accept the accounts where a method is regularly employed; instead they clarified the correct duty: where a method is regularly employed, the Income‑tax Officer must consider whether taxable income can properly be deduced and then proceed according to his judgment.
Amendment of the referred question and negative answer: Their Lordships preferred the original question framed by the High Court but amended it to the specific formulation asking whether the Income‑tax Officer was right to compute in accordance with a method of accounting "when that method in fact does not show the true income, profits and gains." They answered that question in the negative and directed that the Income‑tax Officer should properly discharge his duty under S.13 in light of the opinion and the experience of preceding years' assessments.

Holding and Implications

Holding: Their Lordships answered the amended question in the negative — i.e., the Income‑tax Officer was not right to compute income, profits and gains in accordance with the method of accounting regularly employed by the assessee when that method in fact does not show the true income, profits and gains. The Judicial Committee advised that the High Court's order of 28 March 1935 be varied by substituting the amended question answered in the negative, and the appeal was dismissed with costs.

Immediate consequences and implications:

The Income‑tax Officer must properly apply S.13's proviso: where a regularly employed method of accounting is shown, he must decide whether true taxable income can properly be deduced from the accounts; if not, he must adopt such basis and manner of computation as he determines appropriate.
On the facts before the Court — evidence of systematic and substantial undervaluation (including a "secret" reserve) — the accounts did not show true taxable income, and the assessment based on the unadjusted profit in the profit & loss account could not stand without the Income‑tax Officer first exercising the required judgment under S.13.
The Judicial Committee directed that the Income‑tax Officer proceed to the proper discharge of his duty under S.13, informed by the findings and the history of prior assessments; the appeal was dismissed with costs — that is the immediate result for the parties.

Appeal dismissed. (This summary is strictly confined to the material contained in the provided opinion and does not add external information or inference beyond the text.)

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Commissioner Of Income-Tax, Bombay v. Sarangpur Cotton Manufacturing Co. Ltd., Ahmedabad

Lord Thankerton:-

This is an appeal from a judgment of the High Court of Judicature at Bombay, dated 28th March 1935 upon a question of law referred to the High Court by the present appellant under S.66, Indian Income-tax Act, 1922. The question arises out of the assessment of the respondents to income-tax for the financial year ending 31st March 1932 and concerns the computation of the profits or gains of their business for the year of account ending on 31st December 1980 under S.10 of the Act. The respondents are a limited liability company doing business at Ahmedabad as manufacturers of cloth and yarn. For the purpose of their assessment for the year ending 31st March 1932 they made a return under S. 22 (1) of the Act on 18th July 1931 to the Income-tax Officer, which consisted of (a) a copy of the audited balance sheet and profit and loss account of the Company for the accounting year ending on 31st December 1930 which showed the profit for the year as Rs.2,64,086, (b) a return of the total income of the Company for assessment, which included the income, profits and gains as per profit and loss account for the accounting year as Rupees 1,99,086 and (c) a covering letter which explained the adjustment of the figure in the profit and loss account so as to arrive at the figure of income in the return, and which was in the following terms :

We herewith beg to enclose the Income-tax Form No. 4449 for the year 1931-32 duly filled in showing therein the profits as per statement shown below, which please receive and pass the receipts for the same.

2,64,086 Profit-as per Balance Sheet for the year ending 31st December 1930.

3,43,353 Add-Difference for the undervaluation in stock at the end of 1930 (at market rate).

____________

6,07,439

3,97,634 Less-Difference for the undervaluation in stock at the end of 1929.

____________

2,09,805

10,719 Less-Premium received by sale of Government Bond of 1932.

____________

1,99,086

The printed copy of the Balance Sheet for the year 1930 is enclosed herewith which please note.

On receipt of the above return the Income-tax Officer issued a notice under S.23 (2) of the Act on the assesses to produce evidence in support thereof, and, in compliance, the assesses duly produced their closed accounts for the accounting year. The assesses contended, before the Income-tax Officer, (1) that the undervaluation of the closing stock of the assessee Company for the year 1929 disallowed by Rs.3,97,634 in the assessment year 1930-31, should be allowed as an addition in the opening stock of the current 1930, and that the undervaluation of the closing stock of the Company by Rs.3,59,966, should also be added in the closing stock of the Company in the current assessment; (2) that the method of adopting the undervaluations of the opening as well as closing stocks was adopted by this office in previous assessments and that it should not be departed from in the current year's assessment ; (3) that the ruling in Commr. of Income-tax, Bombay v. Ahmedabad New Cotton Mills Co. Ltd.,(1930) 17 AIR PC 56=121 IC 543=57 IA 21=54 Bom 213 (PC) is also in consonance with the method adopted by this office in considering the undervaluations of both the opening and closing stocks in computing the income of the Company for income-tax purposes. In his assessment order of 26th February 1932 the Income-tax Officer states :

As regards above contentions, according to the Privy Council's decision in Commr. of Income-tax, Bombay v. Ahmedabad New Cotton Mills Co. Ltd.,(1930) 17 AIR PC 56=121 IC 543=57 IA 21=54 Bom 213 (PC) I understand that, if the undervaluation of the closing stock of any assessee is considered in the assessment in any year, the undervaluation of the opening stock should also be considered in his assessment of that year; but if the undervaluation of the closing stock is not considered in the assessment, the undervaluation of the opening stock should also be left out of the same assessment. I accordingly set aside the question of the undervaluations of the opening as well as closing stocks of the assessee Company in the current year's assessment, and accept the profit of Rs.2,64,086, shown in the statement of the profit and loss account of the Company. Under the circumstances, the claim of the assessee Company for Rs. 37,668, as a deduction from the current year's assesment is rejected.

On an appeal by the assessees, the Assistant Commissioner of Income-tax confirmed the assessment by his order dated 22nd November 1932. The assessees then applied to the present appellant to review the above orders under S. 33 of the Act, or, alternatively, to make a reference of questions of law to the High Court under S. 66 (2) of the Act. The appellant declined to review the orders, and, on the ground that no legal point was involved, he also declined to make the reference. Thereafter the High Court, on an application by the assessees, under S.66 (3) of the Act, required the appellant to make a reference, and he made the present reference with the question of law as formulated by the High Court, viz.:

Whether in view of the provisions of S. 13, Income-tax Act or otherwise, the Income-tax Officer was right in computing for the purpose of S.10 of that Act income, profits and gains in accordance with the method of accounting regularly employed by the aseessee, whether or not that method in fact shows the true income, profits and gains.

The appellant suggested the substitution of another question, but his suggestion was not adopted by the High Court. The Court however without referring the case back, amended the question referred as follows :

Whether in the circumstances of the case the Income-tax Officer was entitled to compute the income, profits and gains of the assessees upon the basis of the printed copy of the profit and loss account sent with the letter of the assessees of 18th July 1931, without regard to any undervaluation of the stock which may have been or may be proved to have been made.

By their order, dated 28th March 1935, the High Court amended the question accordingly and answered the amended question in the negative. Their opinion was that the covering letter of 18th July 1931 formed part of the method of accounting employed by the assessees within the meaning of S.13 of the Act, and that the Income-tax Officer was not entitled to split up the method of accounting and to regard the profit and loss account apart from the covering letter; that the Income-tax Officer had only accepted a portion of the method, without taking the method as a whole, which he was not entitled to do. They therefore held that the matter was still at large for the proper decision of the Income-tax Officer. Their Lordships find themselves unable to agree with the view of the High Court as to the meaning of S. 13 of the Act, which provides as follows :

13. Income, profits and gains shall be computed for the purposes of Ss. 10, 11 and 12 in accordance with the method of accounting regularly employed by the assessee :

Provided that, if no method of accounting has been regularly employed, or if the method employed is such that, in the opinion of the Income-tax Officer, the income, profits and gains cannot properly be deduced therefrom, then the computation shall be made upon such basis and in such manner as the Income-tax Officer may determine.

Their Lordships are clearly of opinion that the section relates to a method of accounting regularly employed by the assessee for his own purposes-in this case for the purposes of the Company's business - and does not relate to a method of making up the statutory return for assessment to income-tax. Secondly, the section clearly makes such a method of accounting a compulsory basis of computation, unless, in the opinion of the Income-tax Officer, the income, profits and gains cannot properly be deduced therefrom. It may well be that, though the profit brought out in the accounts is not the true figure for income-tax purposes, the true figure can be accurately deduced therefrom. The simplest case would be where it appears on the face of the accounts that a stated deduction has been made for the purpose of a reserve. But there may well be more complicated cases in which, nevertheless, it is possible to deduce the true profit from the accounts, and the judgment of the Income-tax Officer under the proviso must be properly exercised. It is misleading to describe this duty of the Income-tax Officer as a discretionary power.

Despite some statements in the reference, which will be referred to later, their Lordships agree with the High Court that the facts stated make clear that here the Income-tax Officer has never exercised his judgment under the Proviso, and their Lordships are further of opinion that, if he had so exercised his judgment, the Income-tax Officer would not reasonably have come to any other opinion than that the profit shown in the profit and loss account could not be the true figure for income-tax purposes. It is necessary now to consider some of the statements to be found in the reference, in addition to the passage already cited from the assessment order of the Income-tax Officer. In the order of the Assistant Commissioner on the appeal the following passages occur :

It is only for the past five years that the opening and closing stocks have been revalued because they were found to be grossly undervalued, but the Income-tax Officer, now finding that the stocks (opening and closing) are being systematically and regularly valued at lower rates, he has deemed it fit to accept the profits as shown by accounts, as according to him the accounts do show real profits. Under S.13 of the Act, 'income, profits and gains shall be computed for the purposes of Ss.10 (business), 11 and 12, in accordance with the method of accounting regularly employed by the assessee'. In this case the method of accounting has been found to be regularly and properly employed, hence the Income-tax Officer was prima facie entitled to accept the profits shown by the accounts .... At any rate the Privy Council decision nowhere forbids the Income-tax Officer to accept the profits shown by the accounts in future; as a matter of fact, the decision relates to one year only, and If the Income tax Officer has now accepted the accounts, I think he was quite within his powers to do so for the discretion vests in him and it is absolute.

Perhaps, I should also remark here that the Income-tax Officer has not in this case put any fictitious values of stocks of goods of his own, nor has he thus taken any fictitious profits. As a matter of fact, the Company admits that they do not keep proper cost accounts and that the cost price worked out for revaluation of stocks is also approximate. Thus the revalued stocks also do not show real profits. What strikes me rather strange is that while the duly audited and certified balance sheet and profit and loss account according to the accounts of the Company is presented to the shareholders as representing the true state of affairs and real profits of the Company, the Company say to the Income-tax Department that the profits shown by them in their accounts and certified and duly audited balance sheet and profit and loss account is unreal.

Two important findings of fact are made in the letter of reference, viz. (1) the assessees have been found to have been regularly adopting all along the method of accounting which they followed for the year 1930, and (2) the method of valuation of stocks by taking some price under both cost and market price adopted for the year 1930 has been regularly employed by them for years past. This makes clear that the method of accounting regularly employed by the respondents comes within the meaning of S. 13, and it therefore became the duty of the Income-tax Officer to consider whether, in his judgment, the income, profits and gains for the purpose of S.10 could be properly deduced from the accounts. In their Lordships' opinion it is abundantly clear that he never applied his mind to this question, but held himself entitled to hold the respondents to the figures of profit brought out in these accounts. The Assistant Commissioner took the same view, although he recognized that these figures did not show real profits. The views expressed by these two officers make it impossible to accept three statements by the appellant in the letter of reference, viz. (a) in para. 4:

After examination of the accounts, the Income-tax Officer being satisfied that the accounts showed the true income, profits or gains, accepted them;

(b) in para.5 :

The Income-tax Officer however accepted as correct the profit of Rs.2,64,086 as shown in the assesses' profit and loss account and considered that there was no need to revalue the stocks ;

and (c) in para.8 :

The Income-tax Officer's finding was that the true income, profits and gains of the assessees could be properly deduced for the calendar year 1930 from the above method of accounts regularly employed by the assessees.

These statements are quite inconsistent with the statements already referred to, and further, the facts would seem to show that the Income-tax Officer could not reasonably have come to the conclusion that the profit shown in the profit and loss account was the true profit for income-tax purposes. It is found that the undervaluation in the 1930 accounts is of the same nature and on the same basis as that in previous accounts, which is referred to by the Assistant Commissioner as gross undervaluation. This is confirmed by the actual figures; taking the undervaluation of the closing stocks in the previous assessments, which, except in the present year, have been taken as the undervaluation of the opening stock in the succeeding assessment, the figures are as follows:

Year of Assessment. Year of Account. Undervaluation.

1927-28 1926 3,86,642

1928-29 1927 4,15,208

1929-30 1928 3,15,127

1930-31 1929 3,97,634

The last figure is that claimed by the assessees as the undervaluation of the opening stock in the accounting year of 1930, which is here in question. The Income-tax Officer could not reasonably conclude that the true profits could be properly deduced from a gross undervaluation. Lastly, if there were any doubt, the appellant himself has put the matter beyond possibility of doubt by the statement in his order of 16th April 1933, that the object of the undervaluation was the creation of a "secret" reserve, which involves the retention of profits so as not to be included in the profits shown to the shareholders by the profit and loss account and balance sheet, but which constitute part of the taxable profits. This negatives any suggestion that these accounts show the true profit for income-tax purposes.

Their Lordships desire to add that the view of the Assistant Commissioner that the Income-tax Officer is prima facie entitled to accept the profits shown by the accounts, where there is a method of accounting regularly employed by the assessee, is not a correct view. It is the duty of the Income-tax Officer, where there is such a method of accounting, to consider whether the income, profits and gains can properly be deduced therefrom, and to proceed according to his judgment on this question. It is clear that the Income-tax Officer acted on the same view as that expressed by the Assistant Commissioner, and did not perform the duty above stated. The case in 57 I A 211 is of no assistance on the present question. Their Lordships prefer the original question formulated by the High Court and embodied in the letter of reference, subject to the conclusion of their Lordships that the facts show that the method of accounting regularly employed by the assessees do not show the true income, profits or gains, and the question should therefore be amended as follows:

Whether in view of the provisions of S.13, Income-tax Act or otherwise, the Income-tax Officer was right in computing for the purpose of S.10 of that Act income, profits and gains in accordance with the method of accounting regularly employed by the assessee, when that method in fact does not show the true income, profits and gains.

This question falls to be answered in the negative. It will now be for the Income-tax Officer to proceed to the proper discharge of his duty under S.13, in light of the opinions above expressed, and, doubtless, his experience in the preceding years' asessments will assist him in reaching a proper decision. Their Lordships will therefore humbly advise His Majesty that the order of the High Court of 28th March 1935 should be varied by substitution of the amended question above set forth, which should be answered in the negative, and that the appeal should be dismissed with costs.

Appeal dismissed.

Commissioner Of Income-Tax, Bombay v. Sarangpur Cotton Manufacturing Co. Ltd., Ahmedabad

Concise Analytical Summary of the Opinion (Lord Thankerton)

Factual and Procedural Background

Legal Issues Presented

Arguments of the Parties

Assessees' Arguments

Revenue / Income‑tax Officer and Assistant Commissioner — Positions

Table of Precedents Cited

Court's Reasoning and Analysis

Holding and Implications

Commissioner Of Income-Tax, Bombay v. Sarangpur Cotton Manufacturing Co. Ltd., Ahmedabad

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