TMI Blog1974 (8) TMI 5X X X X Extracts X X X X X X X X Extracts X X X X ..... if these were not sold within a certain period these lost their market value. The Income-tax Officer did not accept the said reasoning and contention. He was of the opinion that the basis of valuation of stocks, according to the well-known principles of accountancy, should have been, either cost or market price, whichever was less. The Income-tax Officer, therefore, valued such stock of goods-in-process and finished products at 100% of cost including the overheads as against 84.49% as shown in the books of account of the assessee. On the aforesaid basis the Income-tax Officer revalued the closing stock and also the opening stock and made an addition of Rs. 1,04,417 in the assessment year 1963-64, and allowed a deduction of Rs. 3,338 in the assessment year 1964-65, by adjustment of valuation of stocks. There was an appeal before the Appellate Assistant Commissioner. The Appellate Assistant Commissioner, for the reasons mentioned in his order, upheld the Income-tax Officer's order. There was a further appeal before the Tribunal. It was urged before the Tribunal that the basis of valuation adopted by the assessee was in accordance with the recognised system of accounting. It was ur ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... bunal was justified in rejecting the method of valuation of the goods-in-process and the finished products on the basis of cost of raw material adopted by the assessee, and taking their valuation on the basis of cost of the finished goods ? " It is, therefore, necessary in order to determine the question before us, to examine the purpose of valuation of stocks in computing the tax liability of an assessee. In the case of Chainrup Sampatram v. Commissioner of Income-tax [1953] 24 ITR 481 (SC), the Supreme Court observed that it was a misconception to think that any profit arose out of the valuation of the closing stock ; valuation of unsold stock at the close of an accounting period was a necessary part of the process of determining the trading result of that period, and could in no sense be regarded as the source of such profit. At page 485 of the report the Supreme Court observed as follows : " 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 ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ed by the statute, i.e., after examination of the method of accounting employed by the assessee, to come to the conclusion that either the method had not been regularly employed or that the income, profits and gains of the assessee under the Income-tax Act could not be properly deduced therefrom. In the case of India Motor Parts and Accessories (P.) Ltd. v. Commissioner of Income-tax [1966] 60 ITR 531 (Mad), the Madras High Court held that if the method of valuation adopted by the assessee was a recognised method and had normally been regularly followed by the assessee, then the fact that occasionally solitary items might be sold for higher prices than the cost price would not detract from the nature of the system followed ; to be rejected it must be shown that the method was improper or the same did not lead to the determination of the true profits for income-tax purposes or was patently irregular and unless these conditions were fulfilled the revenue authorities were not entitled to resort to the provisions of the proviso to section 13 of the Indian Income-tax Act, 1922. The same principles were reiterated by the Supreme Court in the case of P. M. Mohammad Meerakhan v. Commission ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... d Reid observed : " It appears to me that we must begin at the other end and simply ask what, in all the circumstances of a particular business is, a figure which fairly represents the cost of stock-in-trade and work-in-progress. One thing clearly emerges as approved by accountancy profession--whatever method is followed it must be applied consistently. I accept that. So the real question is what method best fits the circumstances of a particular business. And if a method has been applied consistently in the past, then it seems to follow that it should not changed unless there is good reason for the change sufficient to outweigh any difficulties in the transitional year. " The purpose and object of valuing the stocks have been aptly described in the speech of Lord Reid in the case of B.S.C. Footwear Ltd. v. Ridgway [1972] 83 ITR 269, 272, 273 ; [1971] 2 WLR 1313, 1315 (HL) as follows : " It is a commonplace that a trader's profit for tax purposes must be determined by framing a profit and loss account in which there is set against his gross receipts all relevant expenditure. It has often been said that you set against the receipts all expenditure incurred in earning those rec ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ticipated loss in year two. It is only an anticipated loss because the market price may move upwards before he sells the stock so that when he does sell it he gets a price equal to or greater than the original cost and so never in fact suffers any loss. If that happens the matter is put right in the year two. The effect of carrying forward the stock at a valuation below cost is that in the account for year two that valuation and not the actual original cost is deemed to be the cost, and so the profit in year two is increased. That exception has been expressed by the phrase ' cost or market value, whichever is the lower '. But that is only a shorthand convenient form of expression. It is not contended by the Crown that it is a rule of law to be interpreted as if the words occurred in a statute. It is I think accurate and adequate where there is a market in the ordinary sense. " From the aforesaid judicial decisions it appears to us that the following principles emerge for application to the question with which we are concerned in this reference : (1) The true purpose of valuation of the unsold stock is to balance the costs of these goods entered on the other side of the accoun ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... Parts and Accessories (P.) Ltd. v. Commissioner of Income-tax [1966] 60 ITR 531 (Mad), observations of Viscount Haldane in Sun Insurance Office v. Clark [1912] AC 443, 455 (HL), observations of Lord Reid in Duple Motor Bodies Ltd. v. Inland Revenue Commissioners [1961] 1 WLR 739, 755 (HL), in B.S.C. Footwear Ltd. v. Ridgway [1971] 2 WLR 1313, 1315 ; [1972] 83 ITR 269, 272 (HL)]. (5) Whatever is the method it must be one recognised by accounting practice and sanctioned by commercial practice. The method adopted must be regularly followed over the periods. But the method adopted and regularly followed by the assessee and accepted by the revenue should not be departed from unless there is good reason for the same. If, however, the method adopted and regularly followed by the assessee does not result in the determination of the true profits for tax purposes, even for one particular year, or there is some other good reason, the revenue is entitled to reject the method followed and value the stocks upon basis as will result in the determination of true profits. (See the aforesaid decision of the Judicial Committee, the aforesaid decisions of the Supreme Court and the House of Lords). ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... let me correct any such impression by emphasizing that the treatment of fixed expenses is, in my opinion, the crux of the inventory valuation problem so far as overhead is concerned. Most of the really difficult problems of overhead application arise because of fixed expenses. Because these expenses do not vary as the volume of production changes, the cost of overhead per unit of product or per machine or direct labour hour tends to vary inversely with the volume of production. This results in low overhead costs per unit of product in periods of more than normal activity, when selling prices are likely to be low. Product costs obtained by including overhead on this basis are as unsatisfactory for inventory valuation purposes as they are for the determination of selling prices or the calculation of profits. " The Institute of Cost and Works Accountants, London, in its report on Marginal Costing (1961) at page 21 observed : " The inclusion of overhead cost in the valuation of work-in-progress and finished stock is a subject on which considerably divergent views are held. The extremes vary from the inclusion of total overhead to the inclusion of variable overheads only, or even th ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... x Officer's basis of valuing the stocks and goods-in-process at 100% of cost including the overheads. On behalf of the revenue great reliance was placed on the case of Freeman, Hardy Willis Ltd. (Now B.S.C. Footwear Ltd.) v. Ridgway [1969] 1 WLR 1488 ; [1970] 75 ITR 632 (Ch D). There what happened was that the taxpayer-company carried on business as shoe retailers through its 790 retail shops. In order to effect a large sale it had to keep large stocks and the number of shoes in stock at the end of its trading year which ended in December was generally equal to about one-third of the total annual sales. Some of the remaining stock used to be sold at reduced prices at the January sales, some at even lower prices in subsequent sales and some at less than cost. When making up its accounts the taxpayer-company had followed its practice of 30 years and valued two-thirds of the stock in hand at the end of the year at original cost and the remainder at a lower figure being replacement value, i.e., the price which according to it would be paid for it in the wholesale market. The Crown computed the taxpayer-company's income for income-tax purposes on the basis that stock was valued at cos ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... L. J. noted that the taxpayer had operated a system in valuing its stock which to some extent was a flexible one which was termed as " an average mark-up ". From the decision of the Court of Appeal there was a further appeal to the House of Lords and the said decision is reported in [1971] 2 WLR 1313 ; [1972] 83 ITR 269 (HL) (B.S.C. Footwear Ltd. v. Ridgway), and we have already referred to the said decision. The House of Lords by a majority judgment dismissed the appeal and held that in the phrase " cost or market value, whichever is the lower " market meant the price at which the stock could be expected to be sold in the market in which the trader sold, and in the case of retail trade, that market must be retail market. It was further held that if a method had been consistently applied in the past it should not be changed unless there were good reasons sufficient to outweigh any difficulties, but the House found that there was such a reason in that case, namely, that the method consistently applied prior to 1959, however commercially sensible, did not reproduce the profits and gains of a particular year taken in isolation. Viscount Dilhorne gave a dissenting judgment. Reliance wa ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... unt, as was observed by Lord Reid in the aforesaid decision at page 272 of the report, there are no statutory rules and the ordinary principles of commercial accounting must be used except in so far as any specific statutory provision requires otherwise. In this connection it is necessary also to remember the observations of Viscount Haldane that what is and what is not profit or gain must primarily be one of fact and of fact to be ascertained by test applied in ordinary business. Therefore, the valuation of unsold stock or work-in-progress by a process recognised in the trader's business and sanctioned by accounting practice should be applied and followed unless, as we mentioned before, there are very cogent reasons for departing from it in a particular year. Having regard to the principles that we have discussed above and in view of the facts and circumstances of this case, the question before us is whether the Tribunal was justified in its conclusion ? We have come to the conclusion that the Tribunal was not so justified. The Tribunal was wrong, in our opinion, in taking into consideration the fact that the assessee had not claimed any depreciation in respect of the stock. As ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... s disclosed by the accounts for the relevant year, in comparison with the earlier years, were too low, and that there were no day-to-day stock details for the purpose of verification. The Income-tax Officer rejected the trading accounts of the assessee and added the sum of Rs. 75,000 to the income returned by the assessee. The Tribunal in that case upheld the addition on the ground that the assessee was doing business in the main on wholesale basis and, in the absence of tally of quantities in respect of major items of the trading account, the fall in the margin of profits could not be satisfactorily explained and, further, that the fall in the margin of profits was all the more difficult to explain in view of the fact that the assessee had a quota of imports worth about Rs. 8 lakhs which could have given the assessee a handsome margin of profit. The Supreme Court held that there was material to support the finding of the Appellate Tribunal and no question of law arose out of its order. The Supreme Court further observed that in cases involving the applicability of the proviso to section 13 of the Indian Income-tax Act, 1922, the question to be determined by the Income-tax Officer ..... X X X X Extracts X X X X X X X X Extracts X X X X
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