Books Rejection and Section 40(a)(ia) limits: decline in gross profit and capitalised software cost did not justify additions

Books of account cannot be rejected under section 145(3) merely because gross profit has declined; absent specific defects, discrepancies, suppression of sales, or inflation of expenditure, the accounts remain acceptable and income cannot be estimated on conjectural gross profit differences. The article also states that section 40(a)(ia) does not extend to software expenditure capitalised in the books where no revenue deduction is claimed and only depreciation is sought under section 32, because the provision targets expenditure payments liable to TDS, not statutory depreciation allowances. On that reasoning, the gross profit addition and the capitalised software disallowance were found unsustainable.

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Issues: (i) Whether the books of account could be rejected under section 145(3) of the Income-tax Act, 1961 and income estimated by applying a higher gross profit rate; (ii) Whether disallowance under section 40(a)(ia) of the Income-tax Act, 1961 could be sustained in respect of software expenditure capitalised in the books and yielding only depreciation claim.

Issue (i): Whether the books of account could be rejected under section 145(3) of the Income-tax Act, 1961 and income estimated by applying a higher gross profit rate.

Analysis: The assessee maintained audited accounts and stock records, and the only basis for rejection was a fall in gross profit rate and the absence of product-wise correlation of raw material consumption and output. The material on record did not show any specific defect, discrepancy, suppression of sales, or inflation of expenditure. A mere decline in gross profit rate, without more, could justify further enquiry but not rejection of accounts unless the Assessing Officer was not satisfied about the correctness or completeness of the accounts.

Conclusion: Rejection of the books of account and the consequential gross profit addition were not justified, and the finding was in favour of the assessee.

Issue (ii): Whether disallowance under section 40(a)(ia) of the Income-tax Act, 1961 could be sustained in respect of software expenditure capitalised in the books and yielding only depreciation claim.

Analysis: The software payment was capitalised and no revenue deduction was claimed for the amount paid. The provision in section 40(a)(ia) operates on outgoing expenditure liable for tax deduction at source, whereas depreciation under section 32 is a statutory allowance on an eligible asset and not an expenditure payment. On that basis, the disallowance could not be extended to the capitalised software cost merely because tax was not deducted at source.

Conclusion: Disallowance under section 40(a)(ia) was not sustainable, and the finding was in favour of the assessee.

Final Conclusion: The revenue's challenge to the gross profit addition failed, and the assessee succeeded on the disallowance relating to capitalised software expenditure, resulting in disposal of the cross appeals with relief to the assessee on the latter issue.

Ratio Decidendi: Books of account cannot be rejected, and income cannot be estimated on conjectural gross profit differences, unless the accounts are shown to be incorrect or incomplete; further, section 40(a)(ia) does not apply to capitalised expenditure for which only depreciation is claimed as a statutory allowance.

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