TMI Blog2000 (8) TMI 69X X X X Extracts X X X X X X X X Extracts X X X X ..... of by the assessee during the year. In the assessee's profit and loss account, the opening and closing stock of raw material were shown net of Modvat credit. The purchases were shown net of Modvat credit. The assessee asserted that the method of accounting followed by it was in accordance with the guidance note of accounting treatment for Modvat issued by the Institute of Chartered Accountants of India (hereinafter referred to for the sake of brevity as the "ICAI"). The Assessing Officer held that the above method of accounting (briefly known as the net method) resulted in understatement of profits. He, therefore, invoked the proviso to section 145(1) of the Income-tax Act. In order to show that the above method resulted in understatement of profits, the Assessing Officer has worked out such understatement on the basis of an assumed data given at page 18 of the paper-book which shows that the gross profits worked out on the basis of net/exclusive method stood at Rs. 24,000, whereas gross profits worked out on the gross method (also known as inclusive method) worked out to Rs. 25,000. Therefore, he concluded that the method adopted by the assessee, viz., the net method, in which th ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... , he contended that the said credit was only on account and it could be availed of only at the time of clearance of the excisable final product. He, therefore, contended that the said credit cannot be utilised till the final product is manufactured. He contended that there was a vast difference between the accrual of credit and utilisation of credit. He urged that the meaning of modified value added tax (Modvat) itself indicates that the tax was levied at each stage in the production and distribution on the basis of the value added to the goods or services passing through that stage. He contended that the Modvat scheme laid down a procedure under which specified goods which are used in the manufacture of final products were eligible for credit of a specified duty on inputs. He contended that the scheme was to operate only when excise duty became payable on the final product. He contended that under the Income-tax Act each year was a self-contained unit and under the Income-tax Act, the profits could not be postponed to the next year. He contended that it was the duty of the Assessing Officer to deduce the profits. He relied upon the judgment of the Supreme Court in the case of CIT ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ccountants of India in the guidance note. He contended that the basic difference between the net and the gross method was that, in the net method, the rate per unit of the raw material did not include the element of Modvat credit whereas, in the gross method, the rate per unit included Modvat credit. He contended that under the above circumstances, the net method adopted by the assessee resulted in understatement of the profits. He contended that under the circumstances, the Assessing Officer was right in applying the gross method. He, however, contended that even the illustrations given in the guidance note of the Institute of Chartered Accountants of India did not depict the correct picture. He contended that under the gross method accepted by the Institute of Chartered Accountants of India, the Modvat credit which is taken into account is only to the extent of the raw materials consumed whereas, according to the Department, the Modvat credit is relatable to the full purchase cost and not only to the extent of raw materials consumed which has resulted in understatement of profits. He, therefore, contended that the Assessing Officer was right in rejecting the working of the gross ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... note of the Institute of Chartered Accountants of India show that under both the methods the gross profit remains at Rs. 120. Hence, even if the gross method is correctly applied, then there would be no revenue effect because the profit would remain the same, It was, however, contended that the Assessing Officer has not correctly applied the gross method and, therefore, in this matter, essentially, the point which arises for consideration is : whether the Modvat credit must be taken on the entire purchase cost or whether Modvat credit should be taken only in respect of the units consumed. It was urged that closing stock forms part of the purchases and, therefore, the element of Modvat benefit cannot be excluded therefrom. It was further contended that the valuation of inventory is not affected by Modvat credit. That the effect on the profit remains the same. It was contended that if the inventory is valued at gross rate then the purchases will also have to be recorded at the gross rate. In this connection, reliance was placed on the judgment of the Supreme Court in the case of CIT v. British Paints India Ltd. [1991] 188 ITR 44. It was contended that whatever component forms part of ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... and when Modvat credit is actually utilised against payment of excise duty of the final products, an appropriate accounting entry is made to adjust the excise duty paid out of the Modvat credit receivable account to the account maintained for payment of excise duty on the final product. Therefore, the purchase cost of the input is net of input duty. Therefore, the inputs consumed and the inventory of inputs are valued on the basis of purchase cost net of input duty. The debit balance in the Modvat credit receivable account is accordingly shown on the assets side of the balance-sheet under the head "Advances". Accordingly, under the net method on payment of excise duty on the final product, the entry, viz., "advances", would stand proportionately reduced. Reliance was also placed on the judgment of the Supreme Court in the case of Challapalli Sugars Ltd. v. CIT [1975] 98 ITR 167, in which it has been laid down that the meaning of the words "actual cost" should be as the common commercial man would understand. The court accepted the accountancy rules for deciding the cost of fixed assets so as to include all expenditure necessary to bring such assets into existence. Learned counsel f ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... t credit should be taken for the full amount irrespective of the units consumed. According to learned counsel, the Modvat credit must be restricted to the raw material consumed and if it is so restricted then whether one follows the net method or the gross method, there will be no effect on the profit. Accordingly, the valuation of inventory is not affected by Modvat credit. He contended that even in the gross method the Modvat credit availed account is a balance-sheet item. It can only be with reference to units consumed and not with reference to the entire purchase of raw materials, otherwise it would amount to double addition because in the closing stock of the raw material, the Modvat credit element is already embedded. He contended that if the Assessing Officer values the inventory of the assessee at gross then purchases will also have to be recorded at gross. In this connection, he relied upon the judgment of the Supreme Court in the case of CIT v. British Paints India Ltd. [1991] 188 ITR 44. He contended that even if there would have been no manufacture, the profit would have remained the same because the main dispute in the present case is as to what should be the Modvat cr ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ne the facts of the present case and in particular the method of accounting. At the outset, it may be mentioned that, according to the assessee, whether one adopts the net method or the gross method, it would have no effect on the gross profit. The department contends that the gross method alone should be applied whereas the assessee has adopted the net method. However, according to the assessee, even if the gross method is correctly applied the result would be the same as far as arriving at the gross profit is concerned. Therefore, we start with examination of the gross method which is as follows : Assumed data [see page 74 of Guidance Note of ICAI] The illustrations are based on the following assumptions : (i) There are no opening stocks; (ii) 100 units of raw materials are purchased at Rs. 10 per unit, plus Rs. 2 for excise duty, aggregating to Rs. 12 ; (iii) 60 units of raw material are consumed in a process involving manufacture of a component. All the 60 units are sold in the year. The balance 40 units are manufactured and sold in the subsequent year ; (iv) The manufactured components are sold at a price of Rs. 15 per unit (including excise duty Rs. 3 per unit) ; ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ts at the rate of Rs. 12 for Rs. 1,200. They are the 100 units of the raw material. Out of 100 units the assessee sold 60 at the rate of Rs. 15 for Rs. 900. The assumed data shows that the cost of the raw material has been taken at Rs. 12 which includes Rs. 2 per unit as excise duty on which the assessee got Modvat credit. On the other hand, in the cost of finished goods, the element of excise duty is Rs. 3 per unit. Having sold 60 units, the balance 40 units constitute closing stock. It is well settled that whatever is in purchase should also be in the closing stock. In order to arrive at the raw materials consumed the above chart shows deduction of the closing stock from the purchase. Therefore, out of 100 units the closing stock has been deducted which gives us the exact amount of raw materials consumed which is 60 x 12 = Rs. 720. Up to this stage, there is no dispute. Similarly, there is no dispute between the two charts as regards excise duty paid on sale of 60 units of finished goods. The only area of conflict arises because of the item in the above two charts under the caption "Less Modvat credit". Now, in the above illustration, the account is debited when 100 units were ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... of the inventory/closing stock, whereas in the gross method the raw materials are valued on the gross basis. The assessee has contended that the Modvat scheme under rules 57A to 57J provides for instant credit on purchase of the raw material by the assessee. They contend that Modvat credit is taken at the stage of the receipt of the raw materials and the same could be utilised at any stage thereafter. In other words, the credit can be availed of even before consumption of inputs. Therefore, according to the assessee, on the purchase of the raw material, the assessee does not only buy the raw material but he also buys a benefit in the form of Modvat credit to the extent of Rs. 2 in phe above example. Therefore, the assessee buys the raw material as also the Modvat benefit. Therefore, the cost of Rs. 12 consists of two components, viz., price of the raw materials and Modvat benefit. When the assessee purchases the raw material at Rs. 12 in the above example, the said rate includes excise duty of Rs. 2 and, accordingly, the assessee earns the Modvat credit to that extent. Therefore, an asset is created in favour of the assessee. Now, the assessee has bought 100 units of raw material. ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... d the intermediate product were liable to excise duty. At this stage, it may be mentioned that when an intermediate product is used for captive consumption for the next stage of production such intermediate product is nothing but the raw material. The assessable value of the intermediate product was determined on the basis of its cost. In determining the assessable value of the said product, the cost of the raw material was taken into account. According to the assessee, in that matter, since the manufacturer got Modvat credit for the amount of excise duty paid on the raw material, the amount of such excise duty cannot be said to form a part of the cost incurred by the manufacturer in procuring the raw materials. This view was accepted by the Tribunal. Ultimately, the matter came before the apex court. The apex court dismissed the appeal. The apex court held that excise duty paid on raw material, if modvated shall not be included in determining the cost of production of the excisable product. The Supreme Court held that when the word "cost" is not defined in the statute, it should be interpreted as it would be by a man of commerce. The Supreme Court gave an illustration in the said ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... tock (inventory) has to be on the basis of purchase cost. If the purchase cost includes the element of Modvat credit then the closing stock should also include such element, otherwise the profit and loss account will result in a distorted picture. In the case of Chainrup Sampatram v. CIT [1953] 24 ITR 481, the Supreme Court has discussed the above principle of balancing. It has laid down, firstly, that profits do not arise out of valuation of closing stock. Secondly, that valuation of unsold stock at the close of the accounting period is a necessary part of the process of determining the trading results and it cannot be regarded as source of such profits. The true purpose of crediting the value of unsold stock is to balance the cost of the 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. In short, this is the principle of balancing. The Supreme Court has further laid down that as the entry for ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... cluded from the valuation of stock-in-trade all costs other than the cost of raw materials for the goods-in-process and finished goods, was likely to result in a distorted picture of the true state of the business. Such a system might produce comparatively a lower valuation of the opening stock and the closing stock. In a period of rising turnover and rising prices such a system may diminish the assessment of taxable profits of a year and the profit of one year is likely to be shifted to another year which would be an incorrect method of computing the profits because each year was a self-contained unit. Accordingly, the Supreme Court held, applying the principle of balancing, that if the inventory is valued at gross then the purchases shall also have to be recorded at gross. Only then, the balancing of the entries could effectively take place. However, this judgment has been relied upon by the Department in support of their contention that by taking the Modvat credit as relatable only to raw materials consumed the assessee is likely to shift the profits of one year to another year which practice has been deprecated by the Supreme Court in the above judgment. We do not find any meri ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... of India on tax audit under section 44AB of the Income-tax Act. It was contended that even the Institute of Chartered Accountants of India has subsequently declared that the net/exclusive method adopted by various assessees should be applied with adjustments on account of any tax, duty, cess or fee actually paid or incurred on inputs which should be added to the cost of the inputs if not so added in the books of account. He contended that in the subsequent guidance note, the Institute of Chartered Accountants of India once again discussed the above two methods and, in the circumstances, it was urged that the net method followed by the assessee was wrong because the assessee has followed the net method without making any adjustments as required under section 145A. In this connection, we may point out that section 145A was introduced by the Finance (No. 2) Bill, 1998. Originally, the Bill contemplated the proposed amendment to apply from April 1, 1986, in relation to the assessment year 1986-87 and subsequent years. However, later on, when the said Bill was enacted into law, the provision was made applicable from April 1, 1999, i.e., assessment year 1999-2000. In this appeal, we are ..... X X X X Extracts X X X X X X X X Extracts X X X X
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