'Bogus Purchases': Understanding Its Implications In The Income Tax Regime

[Tejaswini Kaushal]

INTRODUCTION

Recent developments concerning the cancellation of Goods and Services Tax (“GST”) numbers by the GST department and their subsequent communication of this information to the Income Tax authorities have given rise to a complex issue involving questionable purchases. Different courts have not consistently approached these cases because the facts in each case vary. Presently, the Department is employing three distinct approaches when dealing with fraudulent purchases:

1. In some instances where the legitimacy of the seller's transactions is not in doubt and comprehensive documentation for the purchases is provided, these purchases are categorized as fraudulent.
2. In other cases, it has been uncovered that the sales transactions themselves were fabricated, and the documentation for the purchases is considered unreliable. As a result, the entirety of such purchases is treated as fictitious and added to the total.
3. In yet other situations where the genuineness of the seller's sales is not questioned, the Commissioner of Income Tax (Appeals) [CIT(A)], Income Tax Appellate Tribunal (ITAT), and High Courts have directed the taxation of only a specific percentage of the questionable purchases or the application of a higher gross profit rate to these purchases labeled as fraudulent.

It is crucial to consider the following:

1. The actions taken by the Department concerning the treatment of these bogus purchases.
2. Potential investigations that may be conducted by the Department in response to these cases.
3. The subsequent legal obligations that may arise following such investigations.
4. Variations in the treatment of bogus purchases due to discrepancies in the facts of each case.

UNDERSTANDING ‘BOGUS PURCHASES’

The term 'bogus' denotes something that lacks authenticity or genuineness. In the context of accounting records, it pertains to entries made in the books that inaccurately portray purchases, despite the absence of actual purchase transactions and the involvement of tangible goods at the time of recording.

Presently, the GST department supplies information regarding canceled GST numbers and sales details, which the income tax department leverages to investigate entities that have procured materials from these sources. Within this process, the concept of bogus purchases is intertwined with unverified purchases. Unverified purchases arise when a buyer does indeed acquire goods or services, but these are obtained from the grey market, with invoices originating from entities other than the actual seller.

It is paramount to distinguish between bogus purchases and unverified purchases, and decisions regarding additional assessments should be made based on this differentiation.

Bogus purchases or unverified purchases are tactics employed to reduce gross profit through two primary methods:

1. By fictitiously inflating purchases and manufacturing expenses without actual purchase transactions.
2. By substituting grey market purchases for genuine ones, incorporating them into manufacturing or sales processes, and then obtaining documentation for these purchases at higher rates from invoice providers.

SOURCE OF BOGUS INFORMATION FOR THE ASSESSING OFFICER

The Assessing Officer (“AO”) obtains information on these types of purchases from various sources, including:

1. Actions such as search, survey operations, and detailed scrutiny assessments conducted by the department on accommodation entry providers or any beneficiaries involved.
2. Data received from the GST department or other relevant authorities through information-sharing mechanisms.
3. Identification of discrepancies or mismatches during inquiries carried out through notices issued under section 133(6) of the Income Tax Act.

The department may develop suspicions of bogus or inflated purchases by examining the books of accounts and conducting investigations. Key indicators may include:

1. A significantly high turnover paired with relatively low profit margins, which is unusual for a business with such a large turnover.
2. Consistent turnover patterns from year to year, but a decreasing trend in profit margins.
3. Prolonged inclusion of creditors for purchases in the balance sheet.
4. Cash payments for purchases.
5. Purchase vouchers with scanty or doubtful details (e.g., outdated phone numbers) about the seller.
6. Sellers who are not regular dealers with the assessee.
7. Lack of confidence-inspiring details on purchase vouchers (e.g., sellers from the South not mentioning any regional language on their vouchers).
8. Unclear transportation details in vouchers or books.
9. Absence of bank details for payments made through RTGS or other banking channels on the vouchers.

To confirm these details, the Assessing Officer may undertake the following investigations:

1.  Verification of the seller's identity and existence by cross-referencing address, GST numbers, phone numbers, PAN, etc., through a notice under section 133(6).
2. Field inquiries conducted by an inspector if the dealer is a local entity.
3. Issuing summons or conducting operations under section 133A to record the statement of the seller and investigate whether sales to the assessee have indeed occurred.
4. Examining the reasons for prolonged pending payments.
5. Verifying the authenticity of transportation methods, as it has been observed that vehicle numbers mentioned do not match the transportation methods.

In recent times, the department's approach has evolved. The AO often completes the assessment by considering the entirety of the purchases as bogus. This results in additions being made under section 69A of the Act for unexplained investments or under section 69C for unexplained expenditures.

Alternatively, in some cases, the Assessing Officer may treat a lump sum of the purchase cost as unexplained investment or enhance the Gross Profit (“GP”) rate based on the assessee's regular books of account to estimate the income embedded in these transactions. This approach follows the precedent set by the Supreme Court in the case of Vijay Proteins Ltd. v. CIT (2014). The assessment is sometimes hurriedly completed without considering the documents presented, solely based on this decision.

It's worth noting that in cases where the income embedded in bogus purchases or untested purchases has been estimated as a percentage of such purchases without an independent inquiry by the AO, and the addition is based on third-party reports (e.g., from the GST department), judicial authorities have often ruled in favor of the taxpayer and deleted the total addition.

This discourse must be understood in light of previous cases on the matter:

1. YFC PROJECTS (P) LTD. VERSUS DCIT - 2010 (1) TMI 880 - ITAT, DELHI : The AO was unable to point out a single defect in the assessee's books of account. Mere non-filing of confirmations could not be a ground for addition.
2. THE COMMISSIONER OF INCOME TAX-I VERSUS M/S NIKUNJ EXIMP ENTERPRISES PVT LTD. - 2013 (1) TMI 88 - BOMBAY HIGH COURT: The entire addition related to Bogus Purchases was completely deleted. The assessee furnished comprehensive evidence, including confirmation letters from seven suppliers, bank statements reflecting payments via account payee cheques, purchase invoices, and details of stock inventory. Importantly, the authenticity of sales was not questioned, and the mere absence of supplier appearances did not provide sufficient grounds to negate the purchases.
3. DCIT 25 (3) , 308, C-11, MUMBAI VERSUS SHRI RAJEEV G. KALATHIL - 2014 (8) TMI 807 - ITAT MUMBAI: While the sales were accepted, the judgment in this case allowed only the addition of the profit element embedded in the purchases, typically ranging from 5% to 8%, based on the assessee's historical records. This balanced approach was upheld, with the High Court declining to interfere with the ITAT's decision to attribute a 5% profit to the alleged Bogus Purchases.
4. COMMISSIONER OF INCOME TAX-III VERSUS SUNRISE TOOLING SYSTEM PVT. LTD. - 2014 (1) TMI 1493 - DELHI HIGH COURT: Cross-examination was not provided in this case, but the books were not rejected, and sales were not doubted. Goods purchased were utilized, and the addition based on third-party statements was deemed unjustified.
5. CHEIL INDIA PVT LTD (FORMERLY KNOWN AS CHEIL COMMUNICATIONS INDIA PVT LTD) VERSUS INCOME-TAX OFFICER, WARD-3 (3) , NEW DELHI - 2015 (8) TMI 918 - ITAT DELHI : In this case, the AO did not examine the veracity of the documents filed by the assessee. The ITAT held that there could be several reasons for a party's non-appearance or non-compliance before the AO.
6. M/S CANNON INDUSTRIES PVT. LTD VERSUS DCIT 1 (1) MUMBAI. - 2015 (7) TMI 564 - ITAT MUMBAI : In this case, the sole basis for addition was a statement recorded during a survey. The AO did not provide an opportunity for cross-examination, and sales and quantitative tally were not disputed. Purchase bills matched with export sales, and therefore, the addition was deleted. Importantly, where books were accepted and trading results were accepted, with no discrepancies in books, no addition was made for Bogus Sales.
7. SMT. KIRAN NAVIN DOSHI VERSUS INCOME TAX OFFICER-23 (2) (4) MUMBAI - 2017 (1) TMI 1108 - ITAT MUMBAI: The tribunal upheld the CIT (Appeals) order in this case, which replaced the total disallowance of purchase expenditure under section 69C with an estimation of profit at 12.5% of the Bogus Purchase amount. This estimation was deemed justifiable as it represented the profit element embedded in these purchases.
8. THE PRINCIPAL COMMISSIONER OF INCOME TAX-17 VERSUS M/S MOHOMMAD HAJI ADAM & CO. - 2019 (2) TMI 1632 - BOMBAY HIGH COURT: It was established that the factum of Bogus Purchase was established, but sales were accepted, leaving no reason to reject the purchases. The CIT(A) added 10% of the purchase amount. However, the ITAT decided to tax only on the basis of the difference in GP rates, upholding the order of the ITAT.
9. PR. COMMISSIONER OF INCOME TAX-13, MUMBAI VERSUS RISHABHDEV TACHNOCABLE LTD. - 2020 (2) TMI 662 - BOMBAY HIGH COURT: In cases where the sales were genuine, the High Court held that only the profit margin embedded should be added. The profit margin was calculated by comparing the GP ratio of previous years and then adding the difference.
10. M/S. GEOLIFE ORGANICS, SHRI VIKRAM N. CHANDAN, SHRI JABARSINGH B DAIYA, AND SHRI RAJENDRA NEMICHANDJI VERSUS ACIT – 23 (2) , AND ITO – 19 (3) (5) , MUMBAI - 2017 (5) TMI 1101 - ITAT MUMBAI: In this case, information was received from the sales tax department indicating that the assessee was a beneficiary of bogus billing. The AO added the profit ratio embedded in the purchases, and the disallowance was due to the non-appearance of suppliers. The ITAT ruled that the AO made no further investigation to substantiate his allegation, and since the purchases were supported by sufficient documentary evidence, the information from the sales tax department or the non-production of party could not treat the purchases as bogus.
11. PRINCIPAL COMMISSIONER OF INCOME TAX, GANDHINAGAR VERSUS JAGDISH H PATEL - 2017 (8) TMI 194 - GUJARAT HIGH COURT : The High Court held that treating the entire purchases as bogus would result in a GP higher than the total turnover, leading to a distorted figure. Therefore, when additions were made based on GP rates, they constituted a limited amount of estimation, which was inherently present.
12. INCOME TAX OFFICER VERSUS SHRI DEEPAK KHUSALDAS MEHTA - 2016 (10) TMI 318 - ITAT MUMBAI: The ITAT ruled that the opportunity for cross-examination was not given, and the assessee was not asked to provide the whereabouts of the parties. Moreover, the quantitative reconciliation and one-to-one identification of sale and purchase led to stock reconciliation. As the books of accounts were not rejected, and sales were accepted, only the profit embedded in the Bogus Purchases could be added.
13. SURANA ENTERPRISES, SURANA JEWELERS VERSUS ITO, WARD-47 (3) NEW DELHI - 2020 (5) TMI 598 - ITAT DELHI : ITAT Delhi ruled that since the sale of goods was shown or found in the closing stock, the resultant gross profit disclosed should be the basis for estimation. The assessee argued that goods were not recorded in quantitative terms in the books, and therefore, only an estimation of profit was justified.
14. COMMISSIONER OF INCOME-TAX VERSUS HI LUX AUTOMOTIVE (P.) LTD. - 2009 (3) TMI 1003 - DELHI HIGH COURT: The reason for disallowance in this case was non-compliance/appearance by suppliers, who were found to be small dealers or job workers. An inquiry was conducted after six years, and it was not unusual for such small parties to have left the business. The assessee produced sufficient evidence, leading to no adverse inference, and the addition was deleted.
15. PR. COMMISSIONER OF INCOME TAX SURAT 1 SURAT VERSUS TEJUA ROHITKUMAR KAPADIA - 2018 (7) TMI 590 - SC ORDER: The Supreme Court held that third-party statements against the assessee were not sufficient to make additions. Sales confirmed by the seller and documentary evidence provided supported the assessee's case.
16. THE COMMISSIONER OF INCOME TAX-I VERSUS M/S NIKUNJ EXIMP ENTERPRISES PVT LTD. - 2013 (1) TMI 88 - BOMBAY HIGH COURT: The stock statement was reconciled, and the books were not rejected in this case. Substantial sales were made to government departments, and all documentary evidence was furnished. The non-appearance of suppliers was not considered a valid ground for addition, and the entire addition was deleted.
17. Commissioner of Income-tax Act v. Odeon Builders (P.) Ltd. (2019): In this instance, the entire additions linked to Bogus Purchases were deleted. The AO had based the disallowance solely on third-party information obtained from the Investigation Wing, without providing a copy of such statements to the assessee. This lack of independent inquiry was deemed unjustified.
18. COMMISSIONER OF INCOME TAX-7, NEW DELHI VERSUS M/S ODEON BUILDERS PVT. LTD. - 2019 (8) TMI 1072 - SUPREME COURT: The addition in this case was based on third-party information. However, the assessee produced all the documentary evidence and thus discharged their burden. Cross-examination was not provided for third-party statements, and they were not subjected to further verification, leading to the deletion of the addition.
19. POOJA PAPER TRADING CO. PVT. LTD. VERSUS INCOME TAX OFFICER-4 (3) (1) , MUMBAI - 2019 (3) TMI 62 - BOMBAY HIGH COURT: In this case, the assessee failed to produce evidence of the genuineness of the purchases. As a result, the disallowance was limited to the income/profit attributable to the bogus purchases, following a progressive GP ratio accepted by the AO. The sales were accepted, and no addition was made for Bogus Purchases.
20. PR. COMMISSIONER OF INCOME TAX-13, MUMBAI VERSUS VAMAN INTERNATIONAL PVT. LTD. - 2020 (2) TMI 464 - BOMBAY HIGH COURT: The entire addition associated with Bogus Purchases was expunged in this case. The AO had relied on statements made by two individuals before the sales tax department, yet the assessee was not afforded the opportunity to cross-examine these individuals. The onus was on the revenue to substantiate that the income belonged to the assessee, and the absence of cross-examination was deemed insufficient to support the addition.
21. PRINCIPAL COMMISSIONER OF INCOME TAX-3 VERSUS SHAPOORJI PALLONJI & CO. LTD. - 2020 (3) TMI 552 - BOMBAY HIGH COURT: In this case, additions were made based on third-party statements. However, the High Court observed that the cross-examination of these statements was not provided. The assessee had furnished all the necessary documentary evidence to substantiate their case. Notably, the Bogus Purchases constituted only a minor fraction of the total volume of the company's transactions. In light of these factors, the High Court ruled in favor of the assessee and deleted the addition. This judgment underscores the significance of allowing cross-examination and considering the overall context of the transactions when determining the legitimacy of Bogus Purchases.
22. PCIT v. Ui Packs India (2023): The High Court held that, in the absence of cross-examination, the department's reliance on third-party statements was unjustified. The department had accepted the sales, and it was not justified in invoking section 69C of the Income Tax Act. The High Court further noted that recasting the trading account based on disallowance of purchase would alter the GP rate, and without rejecting books and invoking section 145, the GP could not be changed.

ANALYSIS OF THE JUDICIAL DISCOURSE

The judicial precedents highlighted above emphasize that additions for Bogus Purchases or Untested Purchases should be limited to the income embedded in such transactions and should not be categorized as unexplained investment under section 69A or unexplained expenditure under section 69C of the Income Tax Act. However, when formulating a response, it's crucial to consider the presence of the GST Department's involvement in such cases.

In instances where an assessee is required to substantiate the genuineness of purchase transactions, the following documentary evidence can be submitted to the AO to establish the legitimacy of purchases:

1. Purchase Invoices, along with photographic evidence of the goods acquired.
2. An inward register maintained at registered premises, containing details such as dates, supplier names, GST numbers, taxable values, GST amounts, waybridge receipts, the time of goods receipt in the factory, signatures of transporters, vehicle numbers, and other pertinent information.
3. Confirmations from the sellers of goods, along with their income tax returns and income statements, affirming the sale of goods.
4. Bank account statements reflecting payments made to the seller.
5. Goods Receipt Notes issued by the transporting party for the goods.
6. Detailed Stock Registers displaying the quantities of materials purchased and subsequently sold.
7. For manufacturing entities, the provision of production records may be necessary to justify the utilization of raw materials and consumables for production purposes.
8. Ensuring alignment between purchase values and quantities recorded in the books of account and the information reported in GST returns, such as GSTR-1 and GSTR-3B, submitted to the tax authorities.
9. In the event of the seller's GST number being canceled or suspended, providing documentation of the seller's appeal or actions taken to reinstate the GST number.
10. Endeavoring to establish the movement of goods with substantial supporting evidence.
11. These measures can strengthen the assessee's position and demonstrate the authenticity of purchase transactions when faced with scrutiny by tax authorities, especially in cases where Bogus Purchases or Untested Purchases are being investigated.

CONCLUSION

In conclusion, a clear distinction can be made between Bogus Purchases and Untested Purchases as follows:

Bogus Purchase:

1. Actual purchases are nonexistent.
2. Bills are acquired solely from bill providers.
3. Purchases are inflated to artificially reduce taxable profits.
4. Payments are made, but the equivalent amount, minus a commission, is withdrawn in cash by the assessee.

In cases of Bogus Purchases, both the purchases and the suppliers are fictitious. Consequently, the AO is justified in adding the entire amount of Bogus Purchases as income.

Untested Purchase:

1. Genuine purchases have occurred.
2. These purchases are typically made from the grey market and involve cash transactions.
3. Bills and vouchers for purchases are obtained from bill providers.
4. Quantitative details and evidence of goods movement can be substantiated.

In Untested Purchase scenarios, reasonable estimation can be applied, taking into account the GP based on the assessee's historical records or the prevailing market conditions. This allows for a more measured approach to determining the income associated with such purchases.

By distinguishing between Bogus and Untested Purchases, tax authorities can apply appropriate evaluation methods to ensure the accuracy of income assessments, depending on the nature of the transactions involved.

This article is written by Tejaswini Kaushal. She is a B.A. LL.B. (Hons.) Student at Dr. Ram Manohar Lohiya National Law University and is pursuing her CS Professional Programme.