- (1.) In order to appreciate the question involved in this reference it would be necessary to narrate briefly the facts leading up to the making of this reference. The assessee is a company engaged in the business of manufacture and also of paints. This reference arises in the business of manufacture and also of paints. This reference arises out of assessment order for the years 1963-64 and 1964-65 for which the relevant accounting years were the calendar years 1962 and 1963, respectively. The assessee had valued raw materials at cost in the closing stock inventory. However, the goods in process and the finished products had been valued at the cost of raw materials only, which according to the assessee, formed 84.49% representing overheads. The assessee had contended that it had been the practice to uniformly value the goods in process and the finished products at the cost of raw materials only. It was submitted that the paints had a limited storage life and if these were not sold within a certain period these lost their market value. The Income-tax Officer did not accept the said reasoning or the contention. He was of the opinion that the basis of valuation of stocks. According to the well-known principles of accountancy, should have been either cost or market price, which ever was lower. The Income-tax Officer, therefore, valued such stock of goods in process and finished products at 100% of cost including the overheads as against 84.49% as shown in the books of account of the assessee. On the aforesaid basis the Income-tax Officer re-valued the closing stocks and also the opening stocks and made an addition of Rs.1,04,417/- in the assessment year 1963-64 and allowed a deduction of Rs.3,338/- in the assessment year 1964-65 by adjustment of valuation of stocks. There was an appeal before the Appellate Assistant Commissioner. The appellate assistant commissioner for the reasons mentioned in his order upheld the Income-tax Officer's Order.
(2.) There was a further appeal before the Tribunal. It was urged before the tribunal-1 that the basis of valuation adopted by the assessee was in accordance with the recognized system of accounting. It was urged that the practice of valuing the closing stocks at only the value of raw material had been followed consistently over the years and therefore the same should not be disturbed by the departmental authority. Reliance was placed on certain books of accountancy in support of the method followed by the assessee. It was reiterated that depending upon the life of a particular kind of paint which was described as 'shell-life' that is to say, the period during which the paint could reasonably be stored without loosing its quality, and experience had shown that irrespective of the actual cost the writing down of it in the manner it was done was necessary for the purpose of balancing the profits on sale of such products. The tribunal was of the opinion that the goods in process as well as the finished products had been arbitrarily taken below the costs that is the cost of raw materials and others overheads. The Tribunal was of the opinion that in this case there was no evidence that the stocks had either become obsolete or slow-moving. In the premises there was, according to the tribunal, no justification for writing down the value of the stocks. It was noted by the Tribunal that in none of these years the assessee had claimed deduction for depreciation of stocks remaining unsold over a stated period. The tribunal therefore, came to the conclusion that apart from a mere possibility of the paint losing its quality there was nothing to show that the goods in stock had actually deteriorated in value. The tribunal noted that in this case it was not merely the cost of raw material that was debited in the account but the cost of overheads had also been debited in the account. The tribunal though if the entire revenue expenditure was to be claimed as deduction, then, it could only be on the basis that either the sales were accounted for or the closing stock accounted for the full value, that is the cost and over-heads. The tribunal, therefore, was of the opinion the assessee's method of accounting was such from which true profits could not be deduced. In the premises, the tribunal up held the order of the Income-tax Officer. The tribunal in the aforesaid facts and circumstances of the case has referred to this court the following question under section 256(1) of the Income-tax Act, 1961 - ?Whether, on the facts and circumstances of the case, the tribunal was justified in rejecting the method of valuation of the goods in process and the finished products on the basis of cost of raw material adopted by assessee, and taking their valuation on the basis of the finished goods??
(3.) It is, therefore, necessary in order to determine the question before us to examine the purpose of valuation of stocks in computing the tax liability of an assessee. In the case of (1) Chainrup Sampatram v. Commissioner of Income-tax, West Bengal 24 ITR Page 481 the Supreme Court observed that it was a misconception to think that any profit arose out of the valuation of the closing stock, valuation of unsold stock at the close of an accounting period was a necessary part of the process of determining the trading result of that period, and cold in no sense be regarded as the source of such profit. At page 485 of the report the Supreme Court observed as follows: - ?It is wrong to assume that the valuation of the closing stock at market rate has, for its object, the bringing into charge any depreciation in the value of such stock. The true purpose of creating the value of unsold stock is to balance the costs of these goods entered on the other side of the account at the time of their purchase, so that the canceling out of the entire, relating to the same stock from both side of the account would leave only the transactions on which there have been actual sales in the course of the year showing profit or loss actually realized on the year's trading.? In this connection the Supreme Court referred to the extract from the report of the Committee on Taxation and Trading profits presented to the British Parliament in 1951. At page 281 of the said report the committee observed as follows: - ?As the entry for stock which appears in the trading accounts is merely intended to cancel the charge for the goods purchased which had not been sold, it should necessarily represent the costs of these goods. If it is more or less than the cost, then the effect is to state the profits on the goods which actually have been sold at the incorrect figure . . . . . . . . from this rigid doctrine one exception is generally recognized on prudential grounds and is now fully sanctioned by custom that is to say, the adoption of market value at the date of making up of accounts if that value is less then the cost. It is of course an anticipation of the loss that may be made on these goods in the following year, and may even have the effect, if the prices rise again, on attributing to the following year's result a greater amount of profit than the difference between the actual sale price and the actual cost price of the goods in question?. In the case of (2) Indo Commercial Bank Ltd. v. Commissioner of Income-tax 44 ITR page 22, at pages 37 and 38 of the report the Madras High Court had dealt with certain examples which might demonstrate that if a method of accounting recognized by accounting principle is regularly adopted over a course of year then true profits and true loss for income-tax purposes could always be determined though in a particular year it might not be the reflection of the actual trading profits. It is for this purpose that in the case of (3) Commissioner of Income-tax, Madras v. Krishnaswami Mudalliar and others 53 ITR 122 the Supreme Court observed that the Income-tax Officer was entitled to apply the proviso to section 13 of the Indian Income-tax Act 1922 which is similar to section 145(1) of the Income-tax Act 1961 with which we are concerned in this case, not arbitrarily but only within the limitations enjoined by the statute, i.e. after examination of the method of accounting employed by the assessee to come to the conclusion that either the method had not been regularly employed or that the income, profits and gains of the assessee under the Income-tax Act could not be properly deducted therefrom. In the case of (4) India Motor Part and Accessories (P) Ltd. v. Commissioner of Income-tax Madras 60 ITR page 531 the Supreme Court held that if the method of valuation adopted by the assessee was a recognized method and had normally been regularly followed by the assessee, then the fact that occasionally solitary items might be sold for higher prices than the cost price would not detract from the nature and the system followed to be rejected it must be shown that the method was improper or the same did not lead to the determination of the true profits for the income tax purposes or was patently irregular and unless these conditions were fulfilled revenue authorities were not entitled to resort to the provisions of the proviso to section 13 of the Indian Income-tax Act, 1922. The same principles were reiterated by the Supreme Court in the case of (5) P. M. Mahammad Meerakhan v. Commissioner of Income-tax, Kerala, 73 ITR page 735. In this connection reference is necessary to a decision of the Judicial committee in the case of (6) Commissioner of Income-tax Bombay v. Sarangpur Cotton Company 6 ITR page 36. There the judicial committee observed, in the facts of that case, that the view that an Income-tax Officer was prima facie entitled to accept the profit shown by the assessee's account where there was a method of accounting regularly employed by the assessee was not a correct view. It was the duty of the Income-tax Officer where there was such a method of accounting was followed to consider whether the income, profits and gains could be properly deducted there from and to proceed according to his judgment on the question. In that case the assessee had employed a regular method of accounting but had for some years past adopted a method of valuation of stock by taking some price below both cost and market price with the object of creating a secret reserve which involved the retention of 'secret profits' as not be included in the profit shown to the shareholders. For the accounting year 1930 the assessee had submitted their profit and loss account showing a profit of Rs.2,64,086/- and a return of the total income of the company showing an income of Rs.1,99,086/- which was arrived at by taking into account the result of under valuation of stock which the company had adopted in the previous year. The Income-tax Officer without considering whether the true income could be arrived at from the method of accounting employed by the assessee held that the assessee was bound by the profits shown in the balance-sheet. It was held by the judicial committee that the Income-tax Officer was not entitled to take profits shown in the balance sheet as the real income of the assessee but was bound to consider whether the true income could be determined from the account of the assessee and to proceed according to his judgment on this question. In the case of (7) Sun Insurance Office v. Clark 1912 AC page 443 at page 445 viscount Haldane observed in his speech: - It is plain that the question of what is and what is not profit or gain must primarily be one of fact, and of fact to be ascertained by tests applied in ordinary business.? In the case of (8) Duple Motor Bodies Ltd v. Inland Revenue Commissioner (1961) IWLR. 739 at page 755 of the report in his speech Lord Reid observed: It appears to me that we must begin tat the other end and simply ask what, in all circumstances of a particular business is a figure which fairly represents the costs of stock in trade and work in progress. One thing clearly emerges as approved by accountancy profession whatever method is followed it must be applied consistently I accept that. So the real question is what method best fits the circumstances of a particular business. And if a method has been applied consistently in the past, then it seems to follow that it should not be changed unless there is good reason for the change sufficient to outweigh any difficulties in the transitional year.;