M J SOLANKI ,BHAVNAGAR vs. NFAC,DELHI, PRESENT JURISDICTION -DCIT ,CIRCLE-1, BHAVNAGAR

The brief facts of the case are that the assessee had filed its return of income for A.Y. 2020-21 on 20.03.2021 declaring income of Rs.9,38,04,290/-. The assessee is a partnership firm and engaged in the business of supply of manpower to Government departments, semi- government departments and Institutes. The case was selected for scrutiny under CASS to examine substantial increase in capital during the year. The assessee had disclosed opening capital of Rs. 3,44,48,545/-, introduced capital of Rs. 30,10,48,704/- during the year and reflected closing capital of Rs. 28,81,43,600/- at the end of the year. According to the AO, the source of capital of Rs. 29,75,48,704/- introduced during the year was not explained and, therefore the same was treated as unexplained credit u/s. 68 of the Act and added to income. Further, 20% of the salary paid to relatives of the partners was held as excessive and accordingly disallowance of Rs. 18,60,000/- was made u/s 40A(2)(b) of the Act. The assessment was completed u/s. 143(3) r.w.s 144B of the Act on 28.9.2022 after making these two additions.

Aggrieved with the order of the Assessing Officer [hereinafter referred as the “AO”], the assessee had filed an appeal before the First Appellate Authority which was decided by the Ld. CIT(A) vide the impugned order and the appeal of the assessee was partly allowed.

The Grounds taken by the Assessee and the Revenue are as under:

We have heard both Shri Biren Shah, the Ld. AR of the assessee and Shri R P Rastogi, the Ld. CIT-DR. The assessee had explained before the AO that out of total addition of Rs. 30,10,48,704/- to the capital account of four partners, a sum of Rs. 25 crores represented the year-end notional journal entry, transferring outstanding salary and wages liability to the partner's capital accounts. It was explained that the partners were contemplating reconstitution of the firm and the accountant had passed certain entries to get a picture of the actual standing of the firm for negotiations. Accordingly, the liability as well as the assets were divided in the capital accounts of the partners’ in their profit-sharing ratio. This was an internal exercise of the partners for limited purpose of evaluating the proposed reconstitution of the partnership and the notional journal entry was to be deleted at the time of finalization of accounts. According to the assessee, due to mistake of the accountant and the lockdown period, this entry was inadvertently not reversed before the finalization of the accounts and was subsequently rectified by passing a reverse entry on 01.04.2020. The AO had rejected this explanation of the assessee on the ground that no convincing documentary evidence was produced to establish the existence of out-standing salary liability of Rs. 25 crores. According to the AO, the salary payable was Rs. 10,97,27,169/- only in the audited balance-sheet as on 31.03.2020, whereas the assessee had shown total out-standing salary liability of Rs. 16,04,27,135/- at previous year-end. The AO had also rejected the assessee's contention that the impugned notional entry affected only the liability side of the balance-sheet. Further,

The Ld. CIT(A) had held that under the principles of double-entry accounting, any increase in capital must have a corresponding accounting effect on the asset side. According to him, while the liability side reflected increase in partner’s capital, there was no corresponding increase in the asset side of the balance sheet. Therefore, the Ld. CIT(A) held that the alleged notional entry was inconsistent with the accepted accounting principle. Further, that the tax audit report did not contain any qualification or disclosure regarding any notional entry or accounting mistake. The Ld. CIT(A) had rejected the assessee's contention regarding rectification made on 01.04.2020 in the immediately succeeding financial year on the ground that each assessment year is an independent unit of assessment and the correctness of books have to be examined with reference to the financial year under consideration. According to Ld. CIT(A), the rectification in the subsequent year cannot nullify the unexplained credit

We have carefully considered the rival submissions, perused the assessment order, the order of Ld. CIT(A) and the materials available on record. According to the assessee, the credit of Rs. 25 crores to the partner’s capital account was an year-end notional journal entry transferring the outstanding salary and wages liability to the partner’s capital account. The fact that this was a notional entry has not been disputed by the Revenue. There was no actual credit of Rs. 25 crores coming in the bank account of the assessee's firm from the four partners. The partners had also admitted that they did not contribute the capital of Rs. 25 crores but it was only a notional accounting adjustment. The AO had treated this notional entry as unexplained cash credit. The provision of section 68 is attracted when a sum is found credited in the books of accounts of the assessee and the assessee fails to explain the nature and source of such credit. This provision can be attracted only where there is

The explanation of the assessee throughout has been consistent that the accountant, while working out the financial position of each partner for the purpose of the proposed restructuring, passed journal entries allocating certain assets and liabilities amongst the partners. The assessee had explained that although other provisional entries were reversed, the impugned entry to capital account escaped reversal due to inadvertent error of the accountant. The explanation of the assessee has to be considered in right context and perspective. When all the businesses were closed during Covid period for a considerable period of time, the accountant having made this inadvertent mistake, due to time lag, was not ruled out. Further the explanation has to be judged in the context of subsequent action taken by the assessee. According to the assessee, the mistake was rectified and a reverse journal entry was passed on the first

The AO and the Ld. CIT(A) have laid much emphasis on the fact that the salary liability continued to appear in the balance-sheet and, therefore, the explanation of the assessee regarding credit of outstanding salary to partner’s capital account cannot be accepted. As per the finding given by the AO the salary payable as on 31st March, 2019 was Rs.16,04,27,135/- whereas the salary payable as on 31st March, 2020 was Rs.10,97,27,169/-. Considering this status of the salary payable, the AO had held it was not possible to transfer outstanding salary of Rs.25 crores to partner’s capital account. However, the AO had failed to consider that the assessee had debited a sum of Rs.62,50,000/- as remuneration to partners in the P&L account for the current year and certain amount being outstanding out of current year’s salary to partners, was not ruled out. The assessee had never submitted that the entire outstanding salary was credited to partner's capital account. Only a lump sum outstanding salary of Rs. 25 crores was transferred to partner's capital account and the balance outstanding salary continued to appear in the balance-sheet as salary payable. The observation of Ld. CIT(A) that any increase in capital must have a corresponding accounting effect on the asset side, is

The Revenue has not disputed the fact that the outstanding salary of Rs. 25 crores credited to partner’s capital accounts was reversed on the first day of the next financial year. The Revenue has merely proceeded on the assumption that increase in partner’s capital necessarily implies introduction of fresh funds into the firm. Such an assumption overlooks the distinction between an accounting entry and actual financial transaction. Accounting entries are intended to reflect commercial realities. They do not themselves create commercial realities. Tax liabilities has to arise from the substance of the transaction and not merely from an erroneous book entry. The Assessing Officer has not brought any material on record to establish that the partners had actually contributed Rs. 25 crores and that money, assets or benefit equivalent thereto had reached the assessee firm. No bank transaction evidencing receipt of such amount has been brought on record. No asset corresponding to the alleged introduction of capital was identified. As already discussed earlier, the assessee had explained that by transfer of salary payable of Rs. 25 crores to the capital account, the current liability was reduced by Rs. 25 crores and capital was increased by Rs. 25 crores and this adjustment

The contention of the Revenue that the assessee had failed to establish the credit worthiness of the partners, is otiose. The consistent stand of the assessee as well as the partners, was that no money was ever introduced. When the assessee denies the existence of any actual capital contribution, the question of proving the financial capacity of the partners does not arise. The Ld. CIT(A) has placed much emphasis on the fact that this notional entry was not qualified by the tax auditor. In our considered opinion, the absence of qualification in the tax audit report cannot convert an erroneous accounting entry into taxable income. The liability of tax can be determined on the basis of true nature of the transaction and not merely on the basis in which it is represented in the books of accounts. And considering the true nature of the transaction, no addition was called for in the present case.

The Ld. CIT(A) has relied upon the principle that every assessment year is an independent unit of assessment and the rectification carried out in the succeeding year cannot alter the position in the current year. There can be no quarrel with this settled proposition. However, the rectification done in the next financial year has not been relied upon by the assessee to alter the tax consequence in the current year. The assessee has merely relied upon it as corroborative evidence, demonstrating the error in the

The Assessing Officer had proceeded on the premise that because the accounting treatment was defective, the amount must necessarily represent unexplained income. Such an inference is not found to be logical. An erroneous entry may warrant correction in the books of accounts, but taxation u/s. 68 of the Act requires positive evidence of an unexplained credit representing real income. Suspicion, however strong, cannot substitute the statutory requirement of establishing that an unexplained credit actually represents income of the assessee. It is a settled principle that income-tax proceedings are concerned with taxing real income and not hypothetical income arising merely from book entries. Likewise, it is well settled that book entries by themselves are not conclusive and the real nature of the transaction has to be ascertained from the surrounding circumstances. Considering the facts as discussed above, we are of the considered opinion that the assessee had discharged the burden of offering a plausible and satisfactory explanation regarding the nature of the impugned entry and the Revenue has not brought any cogent material on record to dislodge the explanation of the assessee or to establish that the impugned credit represented unexplained money of the assessee. Since the conditions as stipulated u/s 68 of the Act are not found satisfied, the addition made by the Assessing Officer and sustained by the Ld. CIT(A), is directed to be deleted. The ground taken by the assessee is allowed.

We have heard the Ld. AR and the Ld. CIT-DR on this issue. We do not find any reasonable basis to treat the salary paid to the relative of the partners as excessive. The assessee had explained that it was operating from multiple locations of India viz. Bangalore, Delhi, Baroda, Ahmedabad, Rajkot, Junagadh, etc. from where affairs of various sites / locations were coordinated. Each of the specified employees were entrusted with the responsibility of managing the affairs of these offices. They played key role in evaluating and recruiting the manpower and overseeing the entire recruitment process of the firm for specified location. Further, they were also overseeing the administration of the specified office and controlled day-to-day activities at the given location. They were personally supervising the employees on regular basis. Considering the responsibilities given to them, the salary paid to them cannot be held as excessive. The assessee was engaged in the business of supply of manpower to various government agencies, companies and institutions and had rendered uninterrupted services to the hospitals across India during COVID pandemic. The AO has not brought on record any evidence to establish that the salary paid to these employees were excessive. Neither the basis for making the disallowance of 20% of the salary has been spelled out. We do not find any reason to conclude that the salary

In the result, the appeal of the assessee is allowed.

The ground taken by the Revenue pertains to deletion of Rs. 4,75,48,704/- out of total addition of Rs. 29,75,48,704/- on account of increase in partner’s capital. We have heard the Ld. CIT-DR and the Ld. AR. The Ld. CIT(A) has held that the capital contribution made by the four partners was explained to the extent of Rs. 4,75,48,704/-. On the other hand, the Revenue has contended that the assessee could not substantiate the application of the maturity proceeds of FDRs to the capital account with cogent and reliable documentary evidence. It is found from the assessment order that the AO did not give any reason as to how the capital contribution of Rs. 4,75,48,704/- made by the four partners was unsubstantiated. The partners had duly admitted having made the said capital contribution. There is no dispute to the fact that the capital to this extent was introduced by the four partners. It is a settled principle that if the identity of the contributor is established, the Department is free to