Section 145 of the Income Tax Act, 1961 (Act, for short) provides that income chargeable under the head “Profits and gains of business or profession” or “Income from other sources” is to be computed in accordance with the method of accounting regularly employed by the assesse. This leads to the decision as to what are the various method of accounting, which an assesse can adopt?
2. Two methods of accounting generally followed
There are two methods of accounting, which are generally prevalent mercantile and cash system. In order to further clarify the same principle, section 43(2) defines the word ‘paid’ to mean ‘actually paid or incurred’ according to the method of accounting upon the basis of which the profits or gains are computed under the head “Profits and gains of business or profession.” When books of account are maintained on the basis of mercantile system, income is taxable and expenditure is deductible on ‘due’ basis, whereas, if books of account are kept on the basis of cash system, income is taxable on ‘receipt’ basis and expenditure s deductible on payment basis. Earlier up to 31.3.1997, the assesses were permitted to follow ‘hybrid’ system of accounting, i.e. combination of both cash and mercantile system, but this is prohibited since 1.4.1997 when section 145 was substituted by new section 145 by the Finance Act, 1995.
3. Section 145 of the ACT-method of accounting
This section, for ready reference, is reproduced below:
(1)Income chargeable under the head “Profits and gains of business or profession’ or ‘Income from other sources’ shall, subject to the provision of sub-section (2) be computed in accordance with either cash or mercantile system of accounting regularly employed by the assesse.
(2) The Central Government may notify in the Official Gazette from time to time income computation and disclosure standards to be followed by any class of assesses or in respect of any class of income.
(3) Where the assessing officer is not satisfied about the correctness or completeness of the accounts of the assesse, or where the method of accounting provided in sub-section (1) has not been regularly followed by the assesse or income has not been computed in accordance with the standards notified under sub-section (2) the assessing officer may make an assessment in the manner provided in section 144.
4. When accounts of an assessee cab be rejected by the AO?
The circumstances in this regard have been stated in sub-section (3) (supra) and these are:
*When the assessing officer is not satisfied about the correctness or completeness of the accounts of the assessee; or
*Where the method of accounting provided in sub-section (1) has not been regularly followed by the asessee; or
*Income has not been computed in accordance with the Standards notified under sub-section (2)
In such circumstances, the assessing officer has been empowered to make an assessment in the manner prescribed under section 144 of the Act to the best of his assessment. In other words, he has to first record findings on the aforesaid aspects before rejecting the assessee’s method of accounting – cash or mercantile.
5. Method of accounting and computation of profit/Loss in the case of construction contracts.
The institute of Chartered Accountants of India (ICAI) has prescribed vide AS-7 two methods of revenue recognition in the case of construction contracts. These are:
If an assessee engaged in construction business follows any of the above methods for computation of his profit regularly, the same cannot be rejected by the assessing officer for making assessment of his income under the income Tax Act.
Now, the government has specified ICDS-III, which deals with construction contracts and recognises only the percentage completion method.
6. Tribunal’s decision in the case of Ashoka Hitech Builder (P) Ltd.v. DCIT (Central) –I, Indore (2018) 172 ITD (Ind-Trib)
In the background of legal position, as stated earlier the Tribunal’s decision can be examined to indicate how assessing officers, occasionally make assessments disregarding the legal position, as stated earlier, leading to proliferation of litigation unnecessary, putting the assessee to uncalled for hardship, expense and waste of time and energies, to no-one’s benefit. The facts and other relevant aspects emerging from this decision are analysed in later discussion.
The assessee, whose case was before the Tribunal, was engaged in the business of purchase/Sales/development of land, real, estate and infrastructure and construction and civil work. The issue linked to the grounds raised in this appeal related to agreement dt – 01.04.2009 entered into between the assessee and M/s.JSM Devcon (P) Ltd. The assessee is the owner of 2,039 hectare of land and the same was given for development to M/s. Devcon (P) Ltd. As per the terms and conditions of the development agreement, the developer will construct various high-rise buildings on the land and in consideration for allowing the development of land, the assessee company will be entitled to 32% of the total saleable constructed area, to be constructed by the developer. It was decided that entire revenue shall be shared in the ratio of 68:32 as decided in the development agreement. On examination of the audited accounts of the assessee, it was revealed that the assessee has not reflected any revenue from sale of units, however, it was getting advance against sale from the developer from 2010-11 onwards.
(ii)The assessee’s case and AO’s response
It was submitted by the assessee during the assessment proceedings that it is consistently following project completion method and has offered the revenue for tax in the year in which sales have been effected and the sale deeds, registered. However, the assessing officer was not convinced with the submission made by the assessee and he applied the method adopted by M/s.Devcon (P) Ltd, i.e. the percentage completion method on the assessee and calculated the income of the assessee applying the ratio of 68:32 as agreed in the agreement. The assessing officer took the basis of financial data of M/s.JSM Devcon (P) Ltd., which has accounted for the revenue on the basis of percentage completion method as per the guidelines prescribed by the ICAI.
(iii)Appeal before the CIT (A)
Aggrieved assessee filed appeal before the Commissioner (Appeals) against the method and Commissioner (Appeals) confirmed the action taken by assessing officer observing as follows:
“I have gone through the assessment order, the appellant’s contentions and the audited accounts of M/s.JSM Devcon (P) Ltd. In the assessment year under consideration, the appellant company has not reflected any revenue from the operations in the profit and loss account. During the course of assessment proceedings, the appellant company, in response to the query for not recognizing revenue in the books of account, had furnished the following reasons:
(i)The company has been recognizing revenue on the basis of sales deeds executed at the time of full payment coupled with possession of the apartment.
(ii)Advance have been received from various customers on the basis of schedule given in the allotment letter, which specifies that instalment shall be paid on completion of a particular level of activity. The amount so received is liable to refund and the possession shall be given at the time of execution of the sale deed.
(iii)In the transaction of advance received from customer, there is no transfer of property as envisaged in section 2(47) of the Income Tax Act, 1961 read with section 53A of the Transfer of Property Act, 1882.
(iv)Similar type of accounting method (mercantile) has been followed by the assessee from year-to-year.
The Tribunal posed the issue as to whether a person is mandatorily required to adopt percentage completion method or not and then, referring to section 145 of the Act and in the background of that and facts of the case, has decided that where project completion method had been consistently followed by assessee, land owner and it had been accepted by revenue authorities in case of assessee for previous year, assessing officer was not justified in applying percentage completion method on assessee for one year on selective basis merely because it had been followed by its developer.
7. Concluding comments
Such unfettered exercise of discretion by assessing officers, as has been done by the assessing officer in the case before the Tribunal, shows making assessment on the basis of whims and fancies of the assessing officers, who are quasi-judicial authorities without regard to legal provisions. If the assessing officer wants to alter the method of accounting consistently followed by an assessee, he can not do so arbitrarily on the ground that some other assessee follows a different method for computing profit from construction contracts. He has to give proper notice in regard to what he proposes to do, give adequate opportunity to the assessee to have his say and if he does not agree with the same, reject the assessee’s contentions by a speaking order. He cannot make assessment, deviating from the method of accounting followed by the assessee for two years 2012-13 & 2013-14 merely by observing that the assessee has entered into the agreement as a joint venture for development and the method of accounting followed by the assessee for two years 2012-13 & 2013-14 merely by observing that the development and the method of accounting applied by JSM DPL is binding on the assessee also. No such requirement is prescribed either under the Income Tax Act or by ICAI. He cannot function like an autocrat in the matter of making assessments unmindful of legal requirement and discard the method of accounting regularly followed by an assessee without giving any convincing justification merely on the ground that he must switch to the method to that of his co-developer merely because he feels that he should do so.
Such haphazard and arbitrary decisions by assessing officers need to be curbed by the CBDT by suitable instructions. Recently, the DG (Vig) with the concurrence of Chairman, CBDT, has issued instructions to CIT (Appeals) to regulate their way of functioning on the lines stated, which is, in a way, interference in the functioning of CsIT(A), which the CBDT is not authorized to do, there seems to be no reason why the malfunctioning of the ITOs indicated by the case before the Triunal (supra) cannot be regulated. Hence, immediate instructions to the assessing officers seem urgently called for.
1. Meaning of Prior Period Expenses
Prior period expense are generally those expenses which are relating to the current year in the sense they are crystalised during the year, though relating to activities of an earlier year.
For accounting purposes these are generally known as prior period items and required to be shown separately.
2. Allowability of expenditure in year of crystallization
Normally where mercantile system of accounting is followed, expenses relating to relevant year are accounted for in that year. However prior period expenses had to be allowed in subsequent years because the expenses were crystallized only in that year.
A liability though pertaining to earlier year, is said to accrue when it actually crystallises, is ascertainable and legally enforceable. Refer to, Wolkem (P) Ltd. v. CIT (1996) 54 TTJ (JP-Trib) 414, Kumar Aerosoles (P) Ltd. v.CIT (1996) 55 TTJ (Del-Trib) 385 and Sarvaraja Textiles Ltd.v. CIT (1995) 54 ITD 612 (Hyd-Trib).
In Bearingpoint Property Services (P) Ltd.v.Dy.CIT 2014 TaxPub (DT) 4064 (Bang ‘B’ – Trib) : (2014) 35 ITR (Trib) 177 (Bang ‘B’-Trib), it was held that in the light of the admitted position that the expenditure in question was wholly and exclusively for the purpose of business and that the same was genuine, the fact that the expenditure relates to an earlier period could not be a ground to deny the deduction, especially when factually crystalisation of liability during the previous year had not been disputed. Therefore, the expenses claimed by the assessee were directed to be allowed, as such these expenses were allowed though related to prior period.
Where prior period expenses on account of repair and maintenance were related to earlier years but crystallized when bills were received during current year, same were to be treated as current year’s expenses and hence allowable – Vide Dy.CIT.v.Enercon India Ltd. 2016 TaxPub (DT) 2867 (Mum ‘E’-Trib) : (2016) 48 ITR (Trib) 362 (Mum ‘E’ – Trib).
When the department was taxing prior period income, deduction of expenses, which had crystalized during the relevant previous year, should have also been allowed to the assesses. In a going concern, certain bills are received late and pertained to the business transaction and are crystalized during the relevant accounting period. These types of expenses are revenue in nature and are allowable in the previous year in which they are crystalized - Vide Dy.CIT v.Khurana Engineering Ltd. ITA No. 571 (Ahd) of 2010 (Ahd ‘D’ – Trib).
3. Expenditure incurred as continuous flow
It was a continuous process to incur expenditure and to account for in the books of account. Therefore, even though they were treated technically as prior period expenses, it related to a continuous flow of expenditure. Therefore, there was no justification in disallowing the expenditure, otherwise normally eligible for deduction – Vide Union Bank of India v. Asstt. CIT (2011) 49 SOT 32 (Mum ‘B’ – Trib) Also see, Bank of India v. Dy.CIT (2012) 139 ITD 493 (Mum ‘B’- Trib).
Where prior period expenses were debited on basis of receipts of bills and were in the nature of routine expenses duly authorized by company’s authorized body, the same could not be disallowed on the basis of tax audit report – Vide DCM Limited v. DY.CIT 2015 TaxPub (DT) 4649 (Del ‘B’ – Trib).
4. Expenditure to be disallowed where assessee failed to prove as to crystallization in current year
In Asstt.CIT v.Adani Wilmar Ltd.2014 TaxPub(DT) 3727 (Ahd ‘B’ – Trib): (2014) 64 SOT 122 (Ahd ‘B’- Trib), it was held that while upholding the disallowance of the expenses, the Commissioner (Appeals) has noted that the assessee had not submitted any evidence to prove that the expenses crystallized during the year either before assessing officer or before the Commissioner (Appeals). The statement of expenses very clearly indicated that the expenses were related to assessment year 2000-01. Therefore there was no reason to interfere with the order of the Commissioner (Appeals) disallowing the prior expenses, after offsetting the income of earlier year. Also see, Gujarat State Fertilizers and Chemicals Ltd.v.ACIT (2013) 1 ITR (Trib) – OL 540 (Ahd).
Assessee had failed to establish that the related expenses were actually crystallised during the year under consideration. Since assessee was following the mercantile system of accounting it has to establish that these liabilities pertaining to the previous year were actually crystallised during the year under consideration. Since the assessee had failed to do so the order of Commissioner (Appeals) was sustained – Vide Dy.CIT v.Cosmo Films Ltd & Ors. (2012) 13ITR (Trib) 340 (Del ‘B’-Trib): (2012) 139 ITD 628 (Del ‘B’- Trib).
Since assessee had failed in proving crystallization of prior period expenditure which included professional fee during the relevant year, assessing officer was justified in disallowing deduction claimed by assessee – Vide Adani Gas Ltd.v. ACIT 2016 TaxPub (DT) 843 (Ahd-Trib).
5. Information as regards expenses with evidence where received after closure of accounts
In State Bank of Bikaner * Jaipur v.Asstt.CIT 2014 TaxPub (DT) 4331 (Jp-Trib) : (2014) 166 TTJ (JP-Trib) 244, the assessing officer observed that as per audit report, prior period expenses had been debited to Profit and Loss Account. It was held that the genuineness of the expenses had not been doubted by the lower authorities. Thus, these expenses of previous year were allowable in respective year to which they pertained but information as regards such expenses with evidence was received by the assessee from the various branches after closing of books of account. Hence, these expenses are allowable during the year under consideration.
6. ICDS vis-à-vis prior period expenses
The notified ICDS does not provide anything on allowability of prior period expenditure. Hence, it can be presumed that the treatment of prior period expenditure shall be decided as per judicial precedents and the provisions of the Act.
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In CIT v. Canon India (P) Ltd. (ITA 137/2014, 138/2014, A.Y.2006-07, 2007-08 & 2008-09, decided on 03.08.2015), the assessee being a wholly owned subsidiary of Canon Singapore Pvt. Ltd. (hereafter ‘CSPL’) started its operations in India in 1996. During the course of its business, the assessee entered into various agreements/transactions with the Canon Group of Companies. These transactions pertained to purchase and resale of Canon products such as photocopiers, printers, scanners and cameras in India. The Assessee was also engaged in software development and as a part of its business, exports software and provides software related service to other Canon Group of Companies.
2. Canon India Appeals
One of the issue in the above appeals was relating to the adding by assessing officer unutilized subsidies, to the total income of the assessee received by the Assessee from its holding company – CSPL. The assessing officer observed that the subsidies received by the Assessee became its property notwithstanding that the same had not been spent for the purpose for which they were received. And, on the aforesaid basis, the assessing officer held that the subsidies received by the Assessee were required to be treated as its income for the relevant previous year.
3. Submission by assessee
The assessee had stated before the Tribunal that is had received sum of Rs.27,10,87,594 and Rs.50,16,13,022 from CSPL during the years relevant to assessment years 2007-08 and 2008-09 respectively. It was pleaded by the assessee that these subsidies were received for meeting specific advertisements and sales promotion expenditure that had been pre-approved by CSPL. During the period of the previous year ending 31.12.2007, the assessee had utilized a sum of Rs.19,48,29,160 for advertisements and sales promotion activities and this amount had been directly reduced from the relevant expenditure. The balance amount of Rs,7,62,58,434 remaining after incurring the expenditure was reflected as “Current Liabilities” by the Assessee in its books. Out of the said sum, a further amount of Rs.39,161,177 was utilized towards advertisements during the period from January to March 2007 and this amount had been directly debited to “Current Liabilities”. According to the Assessee, the remaining amount of Rs.37,097,257 continued to be reflected as “Current Liabilities” in its books as on 31.03.2007. In the subsequent year i.e. the Previous Year relevant to the assessment year 2008-09, the Assessee received an amount of Rs.50,16,13,022, which was directly credited to the account under the head “Current Liabilities”. All expenditure incurred against the aforesaid subsidy was directly debited to the said account. The unutilized part of the total subsidy as on 31.03.2008 amounted to Rs.10,54,11,660, which continued to be reflected as Current liabilities. The Assessee further pleaded that there were some inadvertent discrepancies in the amount of unutilised subsidy as recorded in the Assessment Order.
The procedure for receipt/reimbursement of subsidies against expenditure, as explained by the assessee, was recorded in the order of the Tribunal as under:
(a)Initially the assessee forwards a proposal to CSPL for reimbursement of expenditure to be incurred for specific purpose (eg display charges of neon sign fabrication charges of neon sign, advertisement in newspapers, etc.)
(b) Once the same is approved by CSPL, the assessee prepares debit notes from time to time for receiving the advance payment. This debit note contains the details of the particular relevant expenditure to be incurred.
© Thereafter, CSPL remits the advance in lump sum with a specific direction that such money is to be spent only for the specified purpose and any amount of subsidy remaining unspent/unutilised shall be held by the assessee in trust for and on behalf of CSPL and the same shall not utilized by the assessee for any other purpose.”
4. Decision by Delhi High Court in the appeal
The judges of the Delhi High Court observed that it is not disputed by the revenue that subsidies were received by the assessee from CSPL against specific obligation to incur expenditure on specific activities and it was not open for the assessee to divert the amount for any purpose other than for which it was remitted. It was also not disputed by the revenue that assessee was accountable to CSPL for the amount received. The Tribunal had examined the relevant facts and also concluded that the unspent amount is to be held in trust on behalf of CSPL and this was also confirmed by CSPL. The assessee rightly so – credited the subsidies received to its Profit & Loss Account but reflected the same as a current liability. In view of the Assessee’s obligation to utilize the same for the specific purposes, the revenue could be recognized only on the application of the subsidy for the specified purposes. In other words, the Assessee could credit the Profit & Loss Account with the quantum of subsidy only if the corresponding expenditure was also debited to the Profit and Loss Account maintained by the Assessee. The revenue’s contention that the unutilized subsidy is required to be recognized as income of the Assessee in the year of its receipt is contrary to the matching concept, which is the substratal principle for computing income during a relevant period. It is necessary that income be recognized along with the corresponding expenditure incurred for earning the income. Thus, where an assessee follows the Accrual/Mercantile system of Accounting – as in this case – income can be recognized only when the matching expenditure is also accounted for irrespective of the cash outflow/inflow during the year. It would thus, not be correct to recognize the subsidies received for incurring specific expenditure as income without accounting for the corresponding expenditure. In the circumstances, is was held that there was no infirmity with the Tribunal’s view on the issue in question.