NAYAN T. SHAH,MUMBAI vs. DCIT CIR 23(3), MUMBAI

During hearing, the ld. counsel for the assessee, Shri Paresh Shaparia, contended that the assessee declared income of Rs.60,91,425/- and offered the income as business income on presumptive basis under section 44AD of the Act declaring profit @ 8% of the gross receipt basis and paid taxes for Assessment Years 2003-04 to 2006-07, where it was accepted, therefore, section 41(1) is not applicable to the case of the assessee. It was claimed that the issue in hand is covered by the decision from the Mumbai Bench of the Tribunal in the case of Income Tax Officer vs Shri Jaikishan Arjun Singh (ITA No.229/Mum/2010) order dated 04/02/2011 and also the Ltd. (2016) 71 taxmann.com 184(Bangalore), order dated 13/04/2016. On the other hand, the Ld. DR, Shri T.A.

Khan, claimed that the addition was rightly made for which reliance was placed upon the decision in the case of Trinuelveli Motor Bus Service Company P. Ltd. vs CIT 178 ITR 55(Supreme Court). In reply, the Ld. counsel for the assessee claimed that no allowance or deduction have been claimed/allowed in respect of loss, expenditure or trading liability in determining the taxable income, therefore, the abovestated case, relied upon by Ld. DR, is not applicable to the facts of the present appeal.

Ground No.2 assails invocation of section 144 of the Income-tax Act, 1961 [in short "the Act"] and passing of a best judgment assessment on the assessee, which was confirmed by the CIT(Appeals).

Facts apropos are that assessee engaged in the business of construction of roads and contracts had filed return of income for the A.Y. 2007-08 at Rs.1,45,72,139. In the course of assessment proceedings, the assessee was required to give break-up of the inventory of Rs.36.04 crores shown by it in its accounts, details of contract receipts, operating expenditure and current liabilities. Assessing Officer also required the assessee to produce books of accounts. In reply, assessee furnished copies of inventory and break-up of unsecured loans along with statement of sundry creditors as on 31.3.2007 and 31.3.2008. Nevertheless, it seems books of account and other records were not produced. AO put the assessee on notice as to why section 144 should not be invoked. It seems assessee could not justify its inability to produce the books of accounts. Since assessee did not produce books of account nor furnish the specific information called by the AO, he proceeded to make an assessment u/s. 144 of the Act. The action of the AO in invoking section 144 of the Act was confirmed by the CIT(Appeals) considering the non-compliance with the requirement of production of books of account and evidence in respect of its claim of expenditure.

Now before us, the ld. AR strongly submitted that invocation of section 144 of the Act was not warranted under the facts and circumstances of the case. Per contra, the ld. DR supported the orders of authorities below.

We have perused the records and heard the rival contentions. It is not disputed that assessee failed to produce books of account. It could not furnish various details called for by the AO. Assessee had filed its balance sheet and profit & loss account along with the return of income. Once the assessee, despite notices, failed to produce books of account for verification, AO is left with no choice but to proceed with a best judgment assessment. We cannot find any fault with the AO in this regard. Ground No.2 of the assessee stands dismissed.

Vide ground No. 4, grievance raised by the assessee is on the disallowance of Rs.55,95,000. AO during the course of assessment proceedings found that assessee had in its profit & loss account debited a sum of Rs.4,49,07,419 as finance charges. Out of this, sum of Rs.62,97,421 was bank charges and commission, whereas the balance represented interest paid to various banks on loans taken by the assessee. AO noted that majority of the loans taken were for the working capital needs of the assessee. However, according to the AO, assessee had advanced a sum of Rs.4.45 crores as on 31.3.2007 and Rs.3 crores as on 31.3.2008 to various parties without charging interest. As per AO, the average advances sans interest came to Rs.3.73 crores. He applied a rate of 15% on such amount and held that Rs.55,95,000 out of the total claim of interest expenditure was not allowable. Addition was accordingly made.

In its appeal before the CIT(Appeals), argument of the assessee was that advances given by it was out of interest free funds available. However, ld. CIT(A) was of the opinion that assessee could not substantiate this argument. According to him, assessee had given a loan of Rs.5,66,26,900 to one Shri J. Srinivasulu Reddy, Rs. 87,51,304 to Smt. J. Sowadhamini and Rs.62,58,275 to one Shri R. Ramachandra Reddy, who were all directors of the assessee. As per ld. CIT(A), no interest was charged by the assessee on the above loans and he held that disallowance of pro rata interest at 15% was justified since assessee had paid substantial interest during the relevant previous year. He thus confirmed the addition.

Ad interim reply of the ld. AR was that the decision of Hon'ble Punjab & Haryana High Court in the case of Abhishek Industries Ltd. (supra) was considered by the Hon'ble Apex Court in the case of Munjal Sales Corpn. v. CIT [2008] 298 ITR 298/168 Taxman 43 (SC) and the said decision stood overturned.

We have perused the orders and heard the rival contentions. Interest free funds available with assessee as on 31.3.2007 and 31.3.2008 were as under:- Particulars 31.03.2008 31.03.2007 Share Capital 60,62,000 60,62,000 Reserves & Surplus 16,93,24,161 15,32,96,877 Loans from Directors & 8,94,00,827 1,96,83,046 Shareholders Total 26,47,86,988 17,90,41,923 13. Obviously the loans given by the assessee coming to Rs.4.45 crores as on 31.3.2007 and Rs.3 crores as on 31.3.2008 were more than covered by interest free funds available with it. The observation of the Hon'ble Bombay High Court in the case of Reliance Utilities and Power Ltd. (supra) is very relevant. It was held by the Hon'ble Bombay High Court as under:— "if there were funds available both interest-free and overdraft and/or loans taken, then a presumption would arise that investments would be out of the interest-free funds generated or available with the company, if the interest- free funds were sufficient to meet the investments. In this case, this presumption was established considering the finding the fact both by the Commissioner (Appeals) and the Tribunal. The interest was deductible."

As for the contention of ld. DR that Hon'ble Punjab & Haryana High Court had accepted the principle of proportionate funding for calculation of interest in the case of Abhishek Industries Ltd.(supra), we find that the Hon'ble Apex Court had considered the said decision in the case of Munjal Sales Corporation, 298 ITR 298 (SC) and held against the Revenue. We are therefore of the opinion that disallowance of interest was not warranted in the facts and circumstances of the case. Such disallowance stands deleted. Ground No.4 is allowed.

Vide ground No.5, grievance raised by the assessee is that interest expenditure of Rs.1,78,91,526 was disallowed for the reason that it was expenditure pertaining to work-in-progress and had to be capitalized.

Facts apropos are that during the course of assessment proceedings, it was noted by AO that assessee was holding inventory of more than Rs.34 crores as on 31.3.2008. The average work-in-progress of the assessee for the year came to Rs.23,85,53,685. AO was of the opinion that assessee should have capitalized the interest attributable to work-in-progress. As per AO, Section 145 of the Act required computing cost of stock including all expenditure. As per ld. AO, once the work-in-progress was completed and taken to the revenue account, corresponding material and interest costs could be allowed as expenditure. He considered 50% of the average work- in-progress of Rs.23,85,53,685 as funded through interest bearing loans. According to ld. AO, interest ascribable to the sum of Rs.11,92,76,842 at 15% p.a. came to Rs.1,78,91,526. He disallowed the claim of interest to this extent and made an addition.

In appeal before the CIT(Appeals), argument of the assessee was that none of the work-in-progress was capital work-in-progress. As per assessee, it was undertaking road contract works. The work-in-progress and closing stock of Rs.14,63,91,113, as per assessee, were held as part of its business. Argument of the assessee was that working capital loans taken and interest paid thereon could not be capitalized. Further contention of assessee was that closing stock of work-in-progress could not include interest cost, since work-in-progress represented its trading assets and not capital assets. However, the ld. CIT(Appeals) was not impressed. According to him, assessee was following percentage completion method. A part of the increase in work-in-progress pertaining to one work called Nandyal Division Work, as per ld. CIT(A), came due to cost arising from accrued interest charged by assessee on its clients. Again, as per ld. CIT(A), in another project called Nagpur Project, work-in-progress was calculated considering the entire value of the work. Thus, as per the ld. CIT(A), the addition made by the AO considering 50% of work-in-progress to have been financed out of interest bearing funds was justified. He confirmed the addition.

Now before us, ld. AR submitted that section 145 which was relied on by the AO for making this disallowance did not require interest on loans raised for financing working capital to be charged to the closing inventory.

Per contra, ld. DR strongly supported the orders of authorities below.

We have perused the record and heard the rival contentions. There is no dispute that work-in-progress shown by the assessee was a part of its current assets. Such work-in-progress and inventory did not represent any capital item or capital asset being constructed or acquired by the assessee for its own use. Assessee was doing road work based on contracts awarded to it. Interest cost attributed to loans taken for financing its normal trading activity is, in our opinion, a period cost that has to be charged to profit & loss account. Such interest cannot go into the cost of inventories. Accounting Standards AS-2 which deals with valuation of inventories states as under:— "Cost of Inventories 6. The cost of inventories should comprise all costs of purchase, costs of conversion and other costs incurred in bringing the inventories to Valuation of Inventories to their present location and condition. Costs of Purchase 7. The costs of purchase consist of the purchase price including duties and taxes (other than those subsequently recoverable by the enterprise from the taxing authorities), freight inwards and other expenditure directly attributable to the acquisition. Trade discounts, rebates, duty drawbacks and other similar items are deducted in determining the costs of purchase. Costs of Conversion 8. The costs of conversion of inventories include costs directly related to the units of production, such as direct labour. They also include a systematic allocation of fixed and variable production overheads that are incurred in converting materials into finished goods. Fixed production overheads are those indirect costs of production that remain relatively constant regardless of the volume of production, such as depreciation and maintenance of factory buildings and the cost of factory management and administration. Variable production overheads are those indirect costs of production that vary directly, or nearly directly, with the volume of production, such as indirect materials and indirect labour.

The allocation of fixed production overheads for the purpose of their inclusion in the costs of conversion is based on the normal capacity of the production facilities. Normal capacity is the production expected to be achieved on an average over a number of periods or seasons under normal circumstances, taking into account the loss of capacity resulting from planned maintenance. The actual level of production may be used if it approximates normal capacity. The amount of fixed production overheads allocated to each unit of production is not increased as a consequence of low production or idle plant. Unallocated overheads are recognised as an expense in the period in which they are incurred. In periods of abnormally high production, the amount of fixed production overheads allocated to each unit of production is decreased so that inventories are not measured above cost. Variable production overheads are assigned to each unit of production on the basis of the actual use of the production facilities.

A production process may result in more than one product being produced simultaneously. This is the case, for example, when joint products are produced or when there is a main product and a by-product. When the costs of conversion of each product are not separately identifiable, they are allocated between the products on a rational and consistent basis. The allocation may be based, for example, on the relative sales value of each product either at the stage in the production process when the products become separately identifiable, or at the completion of production. Most by- products as well as scrap or waste materials, by their nature, are immaterial. When this is the case, they are often measured at net realisable value and this value is deducted from the cost of the main product. As a result, the carrying amount of the main product is not materially different from its cost. Other Costs 11. Other costs are included in the cost of inventories only to the extent that they are incurred in bringing the inventories to their present location and condition. For example, it may be appropriate to include overheads other than production overheads or the costs of designing products for specific customers in the cost of inventories.

It is clear from clause 12 of the Accounting Standards 2 that normal interest and borrowing costs cannot form part of cost of inventory. When an assessee is following method of valuation of inventory which is in accordance with the Accounting Standards prescribed by ICAI, in our opinion, Revenue cannot step into the shoes of assessee and foist on it a different method, unless there is a clear statutory edict allowing a departure from such accepted standards. We cannot say that assessee had understated its work-in-progress or inventory by not charging interest relating to working capital loan to its valuation. Assessee was well justified in considering interest as a period cost and debiting in its profit & loss account. We do not find any merit in the additions made by the AO. As such, these additions are deleted and ground No.5 is allowed.

Vide its ground Nos.6 to 8, assessee is aggrieved on rejection of books of account and estimation of business income at 8% which was confirmed by the ld. CIT(Appeals).

AO, finding that assessee could not produce books of account and evidence in support of claim of expenditure, had held that the only option available was to estimate the income. As per AO, assessee who was a civil contractor building roads and bridges, had claimed many expenditure which could not be verified in the absence of books of account and non-production of vouchers and bills. As per AO, it could not also be verified whether expenditure incurred by the assessee were through cash or through account payee cheques. Thus, according to AO, it was not possible to make the verifications required under the Act. He therefore rejected the book results of the assessee and estimated net profit at 8% of the total contract receipts. The total receipts came to Rs.65,28,61,901 and applying 8%, AO arrived at a business income of Rs.5,22,28,952. On the said amount, he allowed telescoping interest disallowances of Rs.55,95,000 and Rs.1,78,91,526. Since assessee himself had declared a business income of Rs.1,45,72,139, AO made an addition of balance which as per AO's working came to Rs.1,40,23,483. In other words, AO allowed telescoping of interest disallowance against the 8% net profit estimated.

In its appeal before CIT(Appeals), argument of assessee was that estimation of income was done at an excessive rate. As per assessee, books of account were audited and audit reports were filed along with return of income. Contention of assessee was that estimation of profit at 8% was not warranted. However, the ld. CIT(Appeals) did not agree with the above arguments. According to him, there was possibility of large number of violations with regard to rules on cash payments. Further, as per ld. CIT(A), AO could also show that there were number of discrepancies in the statement of accounts filed by the assessee. Thus, as per ld. CIT(A), totality of the circumstances justified the action of the AO in estimating net profit at 8% of total contract receipts. He confirmed the addition. 25. Now before us, ld. AR strongly assailed the order of CIT(A) and submitted that assessee had no grievance against rejection of books of account or estimation of net profit. However, according to ld. AR, net profit estimation @ 8% was very much on higher side when considering the normal standards. As per ld. AR, 8% was fixed by the ld. AO relying on section 44AD of the Act, but such section applied only to contractors having turnover below 40 lakhs. Further, as per ld. AR, in assessee's own case for preceding assessment years 2006-07 and 2007-08 where assessments were done u/s. 143(3), net profits were accepted at 1.7% and 2.21% on the contract receipts. Even if average of above was taken, as per ld. AR, it would much less than 8%. Thus, according to him, estimation of profit at 8% was not justified and it had to be scaled down. Reliance was placed on the judgment of jurisdictional High Court in the case of Deluxe Roadlines (P.) Ltd. v. Dy. CIT [IT Appeal No.213 of 2014, dated 14.10.2014]. 26. Per contra, ld. DR submitted that AO had taken guidance from section 44AD for estimating profit at 8% of gross contract receipts. According to him, assessee had not brought out any details regarding its own income for earlier years neither raised any argument for accepting the rates of profits for earlier years before the lower authorities. Thus, according to him, estimation done by the AO was justified.

We have perused the record and heard the rival contentions. It has been not disputed by the Revenue that assessee's own assessments for the AYs 2006-07 and 2007-08 were completed u/s. 143(3) of the Act after scrutiny. As per assessee, the net profit rate for AY 2006-07 and worked out to 2.2% and for AY 2007-08 it came to 1.7%. In the case of M/s. Deluxe Roadlines Pvt. Ltd.(supra) relied on by the ld. AR, where assessee was engaged in transportation business, Their Lordships of the jurisdictional High Court had held as under:— "6. The Apex Court in the case of RAGHUBAR MANDAL HARIHAR MANDAL vs THE STATE OF BIHAR (1957 Vo.VIII STC 770) has held when the returns and the books of account are rejected, the assessing officer must make an estimate, and to that extent he must make a guess; but the estimate must be related to some evidence of material and it must be something more than mere suspicion. The assessing officer must make what he honestly believes to be a fair estimate of the proper figure of assessment and for this purpose he must take into consideration such materials as the assessing officer has before him, including the assessee's circumstances, knowledge of previous returns and all other matters which the assessing officer thinks will assist him in arriving at a fair and proper estimate. 7. Therefore, in the instant case, when the assessee did not produce the books of accounts, the assessing officer was not helpless. The assessee has been filing returns every year. In fact, he has produced five years returns. It is from that they took the turnover because the turnover offered by the assessee for the year 2009-10 was comparable with the past five years turnover as reflected in the returns filed. They acted on that. However, he refused to act on the profits shown in the said returns. No reasons are given for not relying on the said profits at the same time, he has also not taken into consideration the comparable cases in similar business to come to the conclusion. Without any basis, the assessing authority determined the profit at 8%, the first appellate authority reduced it to 3% and the tribunal has reduced it to 2.5%. In coming to the said finding, all the three authorities have declined to take note off the evidence by way of earlier returns. In that view of the matter, what the authorities have done is a mere guess work and without any basis. That is not permissible in law as held by the Apex Court in the aforesaid judgment. 8. In that view of the matter, the impugned orders are unsustainable. Hence, the order passed by the tribunal is hereby set-aside. Matter is remitted back to the tribunal for fresh consideration in the light of the observations made above. In that view of the matter, the substantial question of law is answered in favour of the assessee and against the revenue and appeal is partly allowed."

What we find from the above judgment is that in the said case, assessment was completed u/s. 144 of the Act estimating the income of assessee at 8% as done here. The concerned assessee had failed to produce books of account. The CIT(A), on assessee's appeal, had reduced the net profit to 3% of the total turnover. This was reduced by the Tribunal to 2.5%. Their Lordships had held that such adhoc estimate was not warranted, when evidence in the nature of earlier returns filed by the assessee was available.

Now we take up the appeal of the Revenue. Revenue in its appeal is aggrieved that CIT(A) had deleted the addition of Rs.1,14,31,582 made by the assessee u/s 41(1) of the Act.

During the course of assessment proceedings, it was noted by the AO that assessee had shown sundry creditors of Rs.21.62 crores on 31.3.2007 and Rs.23.59 crores as on 31.3.2008. As per ld. AO, assessee could not furnish any explanation as to why the outstanding creditors who were remaining so for more than one year should not be added u/s. 41(1) of the Act. Though assessee gave break-up of sundry creditors, ld. AO was of the opinion that there was no change in the outstanding amount between 31.3.2007 and 31.3.2008, insofar as credits which were more than one year old were concerned. As per ld. AO, such creditors had ceased to exist. He held that section 41(1) was attracted. An addition of Rs.1,14,31,582 was made.

In its appeal before the CIT(A), argument of the assessee was that many of the creditors had transactions in subsequent and earlier year which would show that there was no cessation of liability. As per assessee, the balances were genuine and just because there were no repayments during the relevant previous year would not mean that the liabilities had ceased to exist. The CIT(A) sought a remand report from the AO. In such remand report, AO stated that except ledger extract of the concerned creditors appearing in the books of account of such creditors, assessee could not furnish any further evidence.

Ld. CIT(A), after going through arguments of assessee and remand report of AO, was of the opinion that conditions required to attract section 41(1) of the Act was not satisfied. As per ld. CIT(A), loan had not ceased to exist just because the claim by the creditors would be barred by law of limitation. As per ld. CIT(A), unless AO could show that there was a remission or cessation of trading liability, section 41(1) could not be applied. He deleted the addition.

Now before us, the ld. DR strongly assailing the order of CIT(A) submitted that AO in the remand report clearly brought out the failure of assessee to prove the credits. According to him, it was clearly proved that credits did not exist. Hence as per ld. DR, section 41(1) was correctly applied by AO.

Per contra, ld. AR submitted that liability remained in the books and had not ceased to exist. Further, as per ld. AR, Hon'ble Allahabad High Court in the case of CIT v. Modern Rubber Industries [2013] 37 taxmann.com 394/218 Taxman 70 (Mag.) had held that once profits were estimated and assessment completed u/s. 144 of the Act, there was no question of making any addition on the ground of sundry creditors.

We have perused the orders and heard the rival contentions. AO in his remand report has stated that assessee was unable to give ledger extracts from the books of creditors for proving the credit. But this by itself would not show that liabilities had ceased to exist; when the liabilities were appearing in the books of account. AO had not issued any summons on the creditors or obtained any statements from them which would show that liabilities were not existing and had ceased. In any case, we find that assessment was completed u/s. 144 of the Act. When an assessment is completed u/s. 144 of the Act by applying the net profit rate on the turnover, addition u/s. 41(1) of the Act, in our opinion, cannot be made. When books of account as such are rejected, the question whether creditors appear in such books were there or had ceased to exist, would become irrelevant. We are of the opinion that ld. CIT(Appeals) was justified in deleting such addition.

To summarise, appeal of assessee is partly allowed, whereas that of Revenue is dismissed.” 2.2. We find that in the aforesaid case, it has been not disputed by the revenue that assessee's own assessments for the assessment years 2006-07 and 2007- 08 were completed under section 143(3) after scrutiny. As