2016 (2) TMI 1400 - AT - Income Tax

Apply 5.5% net profit on contract receipts; allow depreciation, partner salary, interest; s.40A(3), s.68 deleted; accrued FDR interest taxed

M/s. Udayveer Singh Bhadoria Versus J.C.I.T., Range-II, Gwalior AND A.C.I.T., Circle 2, Gwalior Versus M/s. Udayveer Singh Bhadoria

ITAT Agra (AT) set aside prior orders and directed the AO to apply a 5.5% net profit rate on contract receipts (replacing the 6% applied earlier) and to ... Addition applying the net profit rate of 6% on the contract receipts applying the net profit rate of 6% on the contract receipts without further allowing depreciation, salary and interest to the partners - CIT(A) in applying the net profit rate of 6% instead of 10% applied by the AO - HELD THAT:- The assessee has declared NP rate after salary and interest to the partners at 3.25% in the assessment year under appeal and declared net profit rate of 0.87% and 2.19% in preceding assessment years 2009-10 and 2008-09. The history of the assessee clearly suggests that even the net profit rate applied by the CIT(A) at 6% is excessive. Further the assessee claimed that the depreciation, interest and salary paid to the partners should be allowed separately. We accept the contention of the assessee because these are allowable deductions and depreciation is statutory deduction and shall have to be allowed to the assessee even if the books are rejected by the authorities below. Considering the history of the assessee and that the assessee has declared higher profit rate as compared to earlier assessment years, we set aside and modify the orders of the authorities below and direct the AO to apply the profit rate of 5.5% as against 6% applied by the ld. CIT(A) and the AO shall grant depreciation and salary and interest paid to the partners separately. Addition u/s. 40A(3) - AO disallowed the above amount because the assessee paid cash on fuel expenses in contravention of section 40A(3) - HELD THAT:- Hon’ble Allahabad High Court in the case of CIT vs. Banwari Lal Banshidhar [1997 (5) TMI 37 - ALLAHABAD HIGH COURT] and Purshottam Lal Tamrakar Uchehra [2003 (3) TMI 10 - MADHYA PRADESH HIGH COURT] have held that when application of net profit rate is applied, section 40A(3) is not applicable when the income is determined by the AO by applying profit rate. Since in this case, we have confirmed the rejection of books of account and net profit rate is applied for computing the business income of the assessee, therefore, no disallowance u/s. 40A(3) could be made. We accordingly set aside the orders of the authorities below and delete the addition. Addition on account of accrued interest on FDR - addition is made by the AO because the assessee has not offered the interest on fixed deposits for taxation because such interest accrued on security deposits and fixed deposits -CIT(A) found that the assessee is following mercantile system of accounting and therefore, interest accrued on FDR and security deposits is liable to be taxed - HELD THAT:- We do not find any merit in this ground of appeal of the assessee. The assessee is maintaining mercantile system of accounting, therefore, the interest accrued on FDR and security deposits, may be with the other department for getting the contract, is liable to be taxed in the hands of the assessee. No infirmity has been pointed out in the order of the CIT(A). We, therefore, confirm this addition and dismiss ground No. 3 of the appeal of the assessee. Addition u/s. 68 - AO made the above addition respect of funds introduced by the partners in the assessee firm because the assessee failed to prove the creditworthiness of the partners and genuineness of the transaction - HELD THAT:- The assessee explained before the authorities below that the partners have introduced the amounts in their capital account and they have admitted these amounts to be of their own. Therefore, the issue is squarely covered by the judgment of jurisdictional MP High Court in the case of Metachem Industries [1999 (9) TMI 21 - MADHYA PRADESH HIGH COURT] - CIT(A) on proper appreciation of facts and material on record correctly deleted the addition. Ground No. 2 & 3 of the appeal of Revenue are accordingly dismissed. ISSUES PRESENTED AND CONSIDERED 1. Whether, upon rejection of books of account under section 145(3), the Assessing Officer may apply a gross profit/net profit rate of 10% on contract receipts without allowing separate deductions for depreciation, partner's salary and interest. 2. Whether disallowance under section 40A(3) is maintainable where the assessing authority determines business income by applying a net profit rate after rejecting books of account. 3. Whether accrued but unpaid interest on fixed deposits and security deposits is taxable where the assessee follows the mercantile system of accounting. 4. Whether amounts introduced by partners into a firm (credited to partners' current/capital accounts and admitted by partners) can be treated as unexplained cash credit under section 68. ISSUE-WISE DETAILED ANALYSIS Issue 1 - Application of NP rate after rejection of books and allowance of depreciation, salary and interest Legal framework: Section 145(3) permits rejection of books if they are not properly maintained or verifiable; where books are rejected the AO may estimate income by applying an appropriate profit rate on gross receipts. Separately, statutory deductions such as depreciation and allowable payments (e.g., partner's salary and interest) are ordinarily allowable unless excluded by law. Precedent treatment: Authorities recognise that profit-rate estimation should be guided by the taxpayer's past declared profits and comparable cases; prior decisions have allowed application of a reduced standardized profit rate but also permitted separate allowance of statutory deductions where justified. Interpretation and reasoning: The AO rejected books due to insufficient vouchers and unverifiable entries and applied 10% NP without permitting depreciation or partner deductions. The Tribunal accepted rejection under section 145(3) but found the 10% rate excessive in light of the assessee's historical NP rates (substantially lower in preceding years) and comparable tribunal authority applying 6%. The Tribunal held that even where books are rejected and a profit rate is applied, statutory and admissible deductions (depreciation, partner salary, partner interest) remain allowable and must be separately granted if supported. Ratio vs. Obiter: Ratio - Where books are rejected and income is estimated by profit rate, the profit rate should be consistent with the assessee's historical profitability and comparable benchmarks; statutory deductions such as depreciation and allowable partner payments remain claimable and cannot be summarily denied solely because books are rejected. Obiter - The precise quantum adjustment (reduction to 5.5% in the case) is fact-specific. Conclusion: The Tribunal reduced the NP rate to 5.5% (from 6% applied by the lower appellate authority and 10% by AO) and directed allowance of depreciation and partner salary/interest separately. The assessee's ground was partly allowed; departmental ground on the rate was dismissed. Issue 2 - Applicability of section 40A(3) disallowance when profit rate is applied Legal framework: Section 40A(3) disallows expenditure where payment is made to a person in cash beyond prescribed limits, subject to exceptions and judicial interpretation. However, where the AO determines income by applying a net profit rate on receipts, the utility of section 40A(3) disallowance is contested. Precedent treatment: High Court and tribunal authorities have held that disallowance under section 40A(3) is not applicable where income is computed by application of a profit rate; estimation by profit rate subsumes unverified expenditure adjustments. Interpretation and reasoning: Since the AO rejected books and determined income by applying a NP rate, the Tribunal held that the statutory disallowance under section 40A(3) could not be separately imposed. The rationale is that when income is determined via a standardized profit rate due to unverifiable books, further disallowance for cash payments would amount to double penalisation and is inconsistent with the method adopted to estimate income. Ratio vs. Obiter: Ratio - Once income is estimated by application of a profit rate after rejection of books, disallowance under section 40A(3) cannot be imposed in addition. Obiter - The proper treatment where some payments are verified but others are not remains fact-specific. Conclusion: The Tribunal deleted the addition under section 40A(3) and allowed the assessee's ground on this issue. Issue 3 - Taxability of accrued interest on FDR/security deposits under mercantile system Legal framework: Under the mercantile system of accounting, income is recognized on accrual basis; thus, interest accruing during the year is taxable irrespective of actual receipt. Treatment depends on the accounting system consistently followed. Precedent treatment: Standard accounting and tax principles treat accrued income as taxable in the year of accrual where mercantile system is followed; tribunals have sustained assessments taxing accrued interest under such circumstances. Interpretation and reasoning: The assessee argued that fixed deposits and security deposits were mandatory for tendering and interest should not be taxed until realized. The Tribunal found the assessee maintained mercantile accounts; therefore, interest accrued on fixed deposits and security deposits during the year is includible in income. There was no infirmity in the lower authority's conclusion taxing the accrued interest. Ratio vs. Obiter: Ratio - Where a taxpayer follows mercantile accounting, accrued interest on FDRs and security deposits is taxable on accrual. Obiter - The commercial purpose of deposits (e.g., mandatory tender security) does not alter accrual-based recognition if the accounting system records accruals. Conclusion: The Tribunal confirmed the addition of accrued interest and dismissed the assessee's ground on this issue. Issue 4 - Treatment of amounts introduced by partners and applicability of section 68 Legal framework: Section 68 allows taxing of unexplained cash credits unless the taxpayer satisfactorily explains the nature and source of credited amounts. Where amounts are introduced by partners and recorded in the firm's books as capital/current account credits, the firm must demonstrate genuineness and the partners' ownership of funds. Precedent treatment: Jurisdictional authority holds that once a firm satisfactorily explains that credit entries in partners' accounts represent amounts invested by them and partners admit the amounts, the burden is discharged and section 68 cannot be invoked to treat those amounts as unexplained income of the firm. However, separate action may be open against the partners if needed. Interpretation and reasoning: The AO treated partner-introduced funds as unexplained cash credit under section 68 due to alleged lack of creditworthiness proof. The Tribunal found it an admitted fact that partners had introduced the funds and had their current/capital accounts reflecting the same; partners admitted ownership. On that basis, and following the settled approach that admissions and records showing partners' contributions discharge the firm's explanation requirement, the Tribunal held that the addition under section 68 was not sustainable. The Tribunal left open the AO's option to pursue appropriate proceedings against the partners themselves if warranted. Ratio vs. Obiter: Ratio - When partners' contributions are reflected in firm accounts and partners admit the amounts as their own, the firm is not liable to assessment under section 68 for those credits; the firm's burden is discharged. Obiter - Possible departmental remedies against partners (separate inquiry) remain open. Conclusion: The Tribunal deleted the addition under section 68; departmental appeal on these points was dismissed.