1. This is an appeal filed by the assessee and the main dispute relates to the order of the CIT (Appeals) upholding an addition of Rs. 80,89,150 on account of valuation of closing stock.
2. The Assessing Officer has stated that the assessee was dealing in equity shares of Reliance Industries Ltd. only. The method of valuation of stock according to the Audit Report was at cost or market value, whichever was lower. The Assessing Officer observed that in such a system of valuation, normally FIFO system was followed which meant "first in first out". He noticed that the closing stock included the entire opening stock and certain current purchases and according to him this was neither in conformity with the FIFO system (first in first out) nor the LIFO system (last in first out). He came to the conclusion that it was nothing but a deliberate device to reduce the profits illegitimately and thereafter he proceeded to value the closing stock according to the FIFO system. This resulted in enhancement of the value of the closing stock by Rs. 80,89,150 which was added by him as concealed income of the assessee-company.
3. The matter was examined further by the CIT (Appeals). He observed that the first year of assessment of the assessee-company was assessment year 1988-89 and in the Audit Report attached with the return, the method of valuation of stock was shown as "at cost". On the other hand the method adopted in the year under consideration was "at cost or market value, whichever was lower". He mentioned that the assessee had differed with the earlier method of accounting in this year.
4. It was submitted before the CIT (Appeals) on behalf of the assessee that the closing stock had been valued at cost and each share was identifiable by its distinctive number. The assessee was stated to be following the specific identification method for working out the cost.
The shares which remained in the closing stock were valued at their actual cost and the assessee was therefore following neither the FIFO (first in first out) method nor the LIFO (last in first out) method.
The method followed by the assessee was claimed to be recognised by the Institute of Chartered Accountants and relevant part of the publication of Institute of Chartered Accountants titled "Accounting Standard (AS2)" were brought to the notice of the CIT (Appeals). Reliance was placed on the decision of the Supreme Court in Challapalli Sugars Ltd. v. CIT [1975] 98 ITR 167 for the assessee's claim that in the absence of statutory definition, the accountancy rules laid down by the Institute of Chartered Accountants should be followed. Support was also sought from some other decisions noted in the order of the CIT (Appeals). In the end it was clarified that each lot of shares purchased by the assessee was identifiable by its distinctive number and the assessee was having complete record, including distinctive numbers of shares held in the opening stock, purchases and the closing stock.
5. The submissions did not find favour with the CIT (Appeals). He took a view that the method of accounting followed by the assessee for the purpose of valuation of opening and closing stocks was such that it did not give true results. He recalled that the assessee was not following the same method of accounting consistently, inasmuch as in one year it was "at cost" whereas in the other year it was "at cost or market value, whichever is lower". As far as the publication of Institute of Chartered Accountants of India was concerned, he pointed out that according to para 11 thereof the specific identification formula attributed specific costs to identify goods that have been brought or manufactured and are segregated for a specific purpose. No such specific purpose for segregation was available in the present case, as all the shares were similar except for specific identification mark and carried the same uniform price in the market. Further, he could not see any logic of choosing a particular lot of shares for sale which had cost higher as compared to various other lots lying with it, which had been purchased at a lesser price. According to the CIT (Appeals), the assessee alone had a choice of declaring whatever income it liked, if this system was accepted. Accordingly, the method of accounting was stated to be defective and therefore proviso to Section 145(1) would apply in this case. He also made a reference to the decision of the Supreme Court in the case of McDowell & Co. Ltd. v. CTO [1985] 154 ITR 148, where it was held that colourable devices cannot be part of tax planning. In the end the addition of Rs. 80,89,150 was upheld by him.
The assessee is aggrieved by this decision and is now in appeal before us.
6. The learned counsel for the assessee submitted that the assessee was a dealer in shares of Reliance industries Ltd. only and the shares had been purchased in different years. The method of valuation of closing stock in this year was at cost or market value, whichever was lower.
The cost was lower than the market value and therefore the shares had been valued at cost. The shares were fully identifiable because of their distinctive numbers and therefore the actual cost was known and had been adopted, whereas the Assessing Officer had adopted the FIFO method (first in first out) of valuing the shares at cost. There was therefore an assumption by the Assessing Officer that the sales had been made in the same order in which the shares had been purchased, which was contrary to fact. Our attention was invited to page 37 of the paper book showing valuation of closing stock at cost on specific identification method, from which it could be easily seen that the entire opening stock remained unsold and was available in the closing stock and the sales during the year had been made out of a part of the purchases during the current year.
7. In this connection a reference was invited to the decision of the Supreme Court in CIT v. Dalmia Investment Co. Ltd. [1964] 52 ITR 567.
In a case where bonus shares are issued in respect of ordinary shares held in a company by an assessee who is a dealer in shares, the real cost to the assessee has to be as certained by spreading the cost of the old shares over the old shares and the new bonus shares taken together if they rank part passu and if they do not, some adjustments may be necessary. The learned counsel contended that the decision had been rendered in the case of a dealer in shares and the assessee was also a dealer in shares. However, it made no difference whether the assessee was a dealer in shares or an investor, where the question of computation of capital gains would be involved. Reliance was placed on the decision of the Bombay High Court in D.M. Dahanukar v. CIT [1973] 88 ITR 454. The learned counsel for the assessee emphasised that the entire scheme approved by the Courts was that the actual cost of that particular scrip should be taken, whether it was for the purpose of calculating profit on sale in the case of a dealer in shares or it was for the purpose of ascertaining capital gains in the case of an investor in shares.
8. The learned counsel submitted further that in the case of an investor, there was an additional factor to be considered for ascertaining capital gains. The actual cost had to be compared with the fair market value as on 1-1-1954 (or subsequent dates as amended later) and now there was a scheme of indexing of cost. For these purposes it was necessary to pinpoint a particular share so that these provisions could be made effective. Thus the actual cost method was stated to be the only acceptable and workable method in the circumstances.
9. A reference was also invited to the decision of the Bombay High Court in W.H. Brady & Co. Ltd. v. CIT [1979] 119 ITR 359. The principles enunciated by the Supreme Court in Dalmia Investment Co.
Ltd.'s case (supra) for valuation of bonus shares were followed therein in respect of each stream of shares purchased on various dates.
10. The learned counsel submitted further that the method of accounting followed by the assessee disclosed the true picture of profits and gains and therefore the facts were distinguishable from the facts in the case of CIT v. British Paints India Ltd. [1991] 188 ITR 44 (SC) where the method of accounting did not disclose true and proper income and therefore the Supreme Court held that the Assessing Officer was entitled and had a duty to adopt appropriate computation to determine the true income by applying the proviso to Section 145(1) of the Income-tax Act.
11. The learned counsel stated in the end that the action of the Assessing Officer was not only not justifiable but also inconsistent.
In this regard our attention was invited to the Profit and Loss account and Balance Sheet of the assessee company at pages 7 and 8 of the paper book, where the profit disclosed was Rs. 9,72,122. The Assessing Officer had started the computation of total income with some figure and made an addition of Rs. 80,89,150 for undervaluation of closing stock, apart from one more disallowable which was not in dispute. It was explained that the profit had been worked out in the Profit and loss account by adopting the cost price of the shares sold during the year by the specific identification method and the A.O. had not thought it fit to alter the cost of these shares to a value computed by the FIFO (first in first out) method.
12. For these reasons it was submitted by the learned counsel that the addition was unjustified and should be deleted.
13. The learned departmental representative supported the order of the CIT (Appeals) strongly. He emphasised further that the Audit Report for assessment year 1988-89 had disclosed that the method of valuation of closing stock in that year was "at cost" whereas for the present year i.e., assessment year 1989-90 the method was stated to be "cost or market value, whichever was lower". Thus the principle on which valuation was to be done had undergone a change and it was not possible to ascertain true profits because of the change. It was therefore necessary to take the recourse to proviso to Section 145(1), as held by the Supreme Court in the case of British Paints India Ltd. (supra). He therefore submitted that the addition was fully justified and should be confirmed.
14. The learned counsel for the assessee stated in reply that although there was a change in the method of valuation of stock compared to last year, in practice there was no difference since the cost price was lower than the market value and the entire dispute centred round valuation at cost only. He submitted further that the assessee was entitled to change the method of valuation of stock as long as the new method was an acceptable method and the assessee was consistent in following it. Reliance was placed on the decision of the Kerala High Court in Forest Industries Travancore Ltd. v. CIT [1964] 51 ITR 329, the Bombay High Court in Sarupchand v. CIT [1936] 4 ITR 420 and the Madras High Court in Indo-Commercial Bank Ltd. v. CIT [1962] 44 ITR 22.
It was further submitted alternatively and without prejudice that even if the last year's method was to be applied, the valuation would still have to be made at cost and that is what the assessee had done in practice. He therefore reiterated that there was no justification to invoke the proviso to Section 145(1) of the IT Act, 1961.
15. We have considered the rival submissions carefully. The IT Act does not contain any specific provision for the valuation of stock. The object of stock valuation is the correct determination of the profits and losses resulting from a year's trading and the generally accepted principles of commercial accounting allow an assessee to value the opening and closing stocks either (i) at cost or (ii) at market value or (iii) at cost or market value, whichever is lower. The Assessing Officer has not raised any controversy which of these methods should be followed. He has accepted that the closing stock has been rightly valued "at cost" but the dispute has arisen how the cost should be ascertained in the case of shares which have been purchased at different dates at different actual cost.
The CIT (Appeals) has tried to bring in another dimension to the dispute by saying that in the preceding year i.e., the assessment year 1988-89 the method of valuation of closing stock was "at cost" whereas in the year under consideration i.e., assessment year 1989-90, the method has been changed to "at cost or market value, whichever is lower" and has invoked proviso to Section 45(1) of the IT Act on the ground that true profits cannot be ascertained due to the change in the method of accounting. The learned departmental representative has also argued on the same lines. However, we do not propose to enlarge the area of dispute in this manner. It has been clarified by the learned counsel for the assessee that although the method of valuation of closing stock was changed in this year as noted by the CIT (Appeals), in practice the cost was lower than the market value and therefore the valuation has been done at cost only. There is nothing contrary to this submission on record and it is not the case of the Assessing Officer that any share included in the closing stock has been valued at market value. We therefore express no opinion on the question whether the assessee was entitled to change its method of valuation of closing stock for this year, since in any case it has no impact as far as this year is concerned. We will confine ourselves to the question of valuation of closing stock at cost only and whether the cost should be ascertained by the specific identification method, as has been done by the assessee, or by the FIFO method (first in first out) as has been done by the Assessing Officer and confirmed by the CIT (Appeals).
16. Reliance was placed on behalf of the assessee before the CIT (Appeals) on Accounting Standard (AS2) issued by the Council of the Institute of Chartered Accountants of India on "Valuation of Inventories" and the CIT (Appeals) declined to apply the same to the present case on the ground that the specific identification formula attributes specific cost to identify goods that have been bought or manufactured and are segregated for a specific purpose. According to him no such specific purpose could be pointed out in the present case.
We have examined the matter further and find that in the very introduction to the above statement, it has been clarified that the statement applies to valuation of all inventories except six commodities listed therein, one of which is shares held as stock-in-trade. The following extract from the statement makes the above point clear : 5. This statement applies to valuation of all inventories except inventories of the following to which special considerations apply: 17. We also find that the learned counsel for the assessee has not referred to the above Accounting Standard in the arguments before us, with foresight, if we may say so, since the particular Accounting Standard is clearly not applicable to shares held as stock-in-trade. We do not propose to go further, but only note that the assessee does not derive any support from it.
18. We now come to the real dispute before us i.e. whether the cost of the shares should be determined by the specific identification method as was done by the assessee or by the FIFO method (first in first out) as was done by the Assessing Officer. In this connection it will be useful to refer to Clause (1) of Section 145 of the Income-tax Act, 1961, according to which the income from business shall be computed in accordance with the method of accounting regularly employed by the assessee. It is laid down in the first proviso that where the method employed is such that the income cannot properly be deduced therefrom, then the computation shall be made upon such basis and in such manner as the Assessing Officer may determine. We have therefore to examine whether the income can or cannot be properly deduced from the method of valuation of stocks adopted by the assessee. Some assistance is available from the decision of the Bombay High Court in W.H. Brady & Co. Ltd.'s case (supra). The assessee was an investor in shares and bonus shares were issued of the same value as the equity shares held by it. All the shares were sold. The question arose about the method of valuation of the bonus shares. The assessee took a stand that the value was nil and therefore it was entitled to opt for the fair market value as on 1-1-1954 under the provisions of Sections 48 and 55(2)(i) of the Income-tax Act, 1961 in respect of the bonus shares, in place of their cost of acquisition. However, it was held that the proper method of valuation of bonus shares was to take the amount spent by the shareholder in acquiring his original shares and to spread it towards the new and old shares and treat the cost of the original shares as the cost price of the old shares and bonus shares taken together. The decision of the Supreme Court in the case of Dalmia Investment Co. Ltd. (supra) was followed in this regard and it was also held that the case of an investor in shares was not different from that of a dealer in shares in this regard. Although the direct issue before the Hon'ble High Court was not the same as the issue before us, it is seen that there was some similarity, inasmuch as the shares had been purchased in different lots over a period of time and spreading over of the original cost of shares over the old shares and bonus shares was done separately in respect of different lots of shares. The option to adopt fair market value on 1-1-1954 was also given in respect of separate lots. This working had found favour with the Hon'ble High Court.
19. Looking at it from another angle, it may be seen what is the object of valuation of closing stock. In the case of British Paints India Ltd. [supra) the Supreme Court has extracted the following passage from the judgment in Chainrup Sampatram v. CIT [1953] 24 ITR 481, 485:- 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 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....
20. In the case of Chainrup Sampatram, the Hon'ble Supreme Court went on to say that the entry for stock which appears in a trading account is merely intended to cancel the charge for the goods purchased, which have not been sold and would normally represent the cost of goods, but adoption of market value is permissible, if that value is less than cost. While anticipated loss is thus taken into account, anticipated profit in the shape of appreciated value of the closing stock is not brought into account as no prudent trader would care to show increased profit before its actual realisation. On applying this test, we are of the opinion that the FIFO method followed by the Assessing Officer brings into account anticipated profit on shares which are still held in the closing stock. Thus the method does not compute the income properly and cannot be accepted.
21. We are not saying that the FIFO method cannot be an acceptable method for valuation of stock under any circumstances. The proposition we are stating is not so wide at all. There may be cases where specific identification of the stock is not possible, such as a petrol station where the earlier liquid stock gets merged with the later liquid stock and in such cases it may be argued that the FIFO method should be applied. However, where specific identification is possible and has been actually maintained, we see no reason why the specific identification method should be departed from in the case of a dealer or investor in shares. We are thus of the opinion that the income can be properly deduced from the method of accounting followed by the assessee and the proviso to Section 145(1) is not applicable.
22. For the above reasons we reverse the order of the CIT (Appeals) and delete the addition of Rs. 80,89,150. The assessee's ground of appeal is allowed.
23. The next ground relates to the direction of the CIT (Appeals) estimating the expenditure for earning dividend income at Rs. 13,624 as against Rs. 400 estimated by the assessee. In the return of income the assessee claimed that dividend income fell under the head "Other sources" and consequently the deduction under Section 80M was claimed in respect of the dividend income. However, the Assessing Officer took a view that dividend income should be taxed under the head "Business" in light of the decision of the Supreme Court in the case of Bengal & AssamInvestors Ltd. v. CIT [1966] 59 ITR 547 and therefore denied the claim for deduction under Section 80M. The CIT (Appeals) noticed that the gross dividend income was Rs. 13,62,499 out of which the assessee had claimed deduction under Section 80M at 60% after reducing the dividend income by Rs. 400 as expenses for earning the dividend income.
He agreed with the assessee's contention that the Assessing Officer was not justified in denying deduction under Section 80M by treating the income from dividend as business income, inter alia, because of the amendment in the Act w.e.f. 1-4-1955. He also accepted that the assessee was entitled for deduction under Section 80M to the extent of 60%. However, he took a view that the net dividend income should be worked out by deducting estimated expenditure of Rs. 13,624 for earning the dividend income as against Rs. 400 shown by the assessee. The assessee is aggrieved by this finding and is now in appeal before us.
24. We have heard the rival submissions and find that expenses directly relatable to the earning of dividend income are not available separately. Therefore, an estimate is necessary. Sales of shares were Rs. 2,02,61,700 and dividend income was Rs. 13,62,499. The main expenditure was salaries Rs. 11,564 and payment to auditors Rs. 5000.
The total expenditure was of the order of Rs. 20,000. We would estimate that Rs. 5,000 can be related to earning of dividend income as against Rs. 13,625 adopted by the CIT (Appeals). This ground is partly allowed.