Commissioner Of Income-Tax vs Kikabhai Premchand

Rewritten Version Notice: This is a rewritten version of the original judgment.

Court: supreme-court

Case Number: Not extracted

Decision Date: 9 October, 1953

Coram: N.H. Bhagwati, Bose, J.

In this case, the Court noted that the proceeding was an appeal by a taxpayer against a judgment and order of the Bombay High Court that had been delivered on a reference made by the Income-Tax Appellate Tribunal. The High Court had refused the taxpayer’s request for leave to appeal, but the taxpayer subsequently secured special leave to appeal from this Court.

The appellant’s trade consisted of dealing in silver and in share certificates, and a substantial portion of his assets was held in the form of silver bullion and shares. The business was owned and managed solely by the appellant himself, and the accounts were kept in accordance with the mercantile system of accounting. The Court observed that, under the mercantile system, it is permissible for a taxpayer to value stock either at cost price or at market price, provided that the method chosen is applied consistently from year to year unless the Income-Tax authorities have authorised a change. The appellant had consistently employed the cost-price method, recording the cost price of the stock at the beginning of each financial year and again at the end of the year for any stock that remained undisposed. Consequently, the entries at the start of the year balanced those at the end of the year for those items, resulting in the books showing neither a profit nor a loss on them. The Court affirmed that this method was regularly used by the appellant and that it was permissible under the mercantile system of accounting.

The accounting year that was the subject of the dispute was the calendar year 1942. At the commencement of that year, the silver bars and share certificates that were in the appellant’s possession were valued in the books at their cost price. During the course of the year, the appellant withdrew a number of bars and shares from the business and transferred them to three separate trusts. In each of the trusts the appellant was named as a beneficiary, retaining a reversionary life interest that would vest after the death of his wife, who held the initial life interest. After the death-interest arrangements, the ultimate beneficiaries of the trusts were charitable entities. The appellant served as the managing trustee in two of the trusts and acted in a virtually identical capacity in the third trust. In the appellant’s books, the withdrawn bars and shares were credited back to the business at their original cost price, and the Court identified this accounting entry as the central issue to be resolved. The Court observed that there was no allegation that the appellant had removed the bars and shares from the business in anything other than good faith.

The appellant contended that the act of withdrawal did not generate any income, profit, or gain for either himself or his business, and that the transaction was not a business transaction at all; therefore, it should not be subject to taxation. The learned Attorney-General, for the Revenue, advanced two principal contentions. First, he argued that because the bars and shares had originally been brought into the business, any subsequent withdrawal must be treated in accordance with ordinary business principles, meaning that the value of the asset at the time of withdrawal should be measured at the prevailing market price. He further asserted that the fact that the appellant was the sole owner of the business could not alter the tax consequences, because income is assessed under distinct heads and the rules applicable to business income must be applied irrespective of ownership. Second, the Attorney-General maintained that when the market price at the time of withdrawal exceeded the cost price, the State was deprived of a potential profit, whereas, had the market price been lower, the appellant would have been entitled to set off the loss against his overall profit from other transactions.

The learned Attorney-General argued that because the bars of silver and the shares had originally been brought into the business, any withdrawal of those assets should be treated in the same manner as an ordinary business transaction. He maintained that when a person removes an asset from a business, the asset must be accounted for at the market price that prevailed on the date of the withdrawal. He further contended that the fact that the appellant was the sole proprietor of the business could not alter this rule, because under the Income-Tax Act income is assessed under distinct heads and, when the income of a business is being calculated, the rules that apply to business incomes must be applied regardless of who owns the business.

The Attorney-General’s second contention was that if the withdrawal took place at a time when the market price of the asset exceeded its cost price, the State would be deprived of a potential profit that could have been taxed. He conceded, however, that if the market price at the time of withdrawal had been lower than the cost price, the appellant would have been entitled to set off the resulting loss against his overall profit from other transactions, thereby obtaining a lower overall tax liability.

The Court expressed the view that the Attorney-General’s second contention was unsound. For purposes of income tax, each fiscal year is a self-contained accounting period, and only income, profits, and gains actually realized in that year may be taken into account. The Court explained that the tax authorities are not concerned with potential profits that might be realized in a future year, just as they are not concerned with losses that might occur in the future.

Regarding the first contention, the Court held that the appellant was correct in recording the cost value of the silver bars and the shares at the date of withdrawal. The Court observed that the withdrawal did not constitute a business transaction, and consequently the business neither earned a profit nor incurred a loss as a result of that act. Because the appellant obtained no immediate pecuniary gain, the State could not tax the withdrawal, since the Income-Tax Act provides the State with no power to tax a future or potential advantage. The only taxable items are income, profits, and gains that arise within the relevant accounting year.

The Court also noted that it had been conceded that if the assets had been sold at their cost price, the State could have claimed no tax, because a person cannot be compelled to make a profit on a particular transaction. It was further conceded that if the silver and the shares had remained where they were, the State would still have had no advantage, as the appellant would have been allowed to record their closing values at cost at the end of the year. The Attorney-General even acknowledged that if the assets had been sold at a loss, the appellant would have been entitled to set off that loss against his other gains, but he argued that this treatment applied only because such sales would be ordinary business transactions, and the law deals with them accordingly. However, the Court found this argument inapplicable to a mere withdrawal without a sale or its equivalent.

The learned counsel argued that when an asset is withdrawn from a business without being sold or without any equivalent transaction, the tax consequences differ from those applicable to a sale. He maintained that because the activity pertains to a commercial enterprise, any withdrawal of assets should be treated as a business transaction and that the appropriate method of accounting for such a withdrawal was to record the market price of the asset on the date of withdrawal, regardless of whether that valuation benefited the taxpayer or the revenue authority. The Court disagreed with this proposition. It observed that established revenue jurisprudence requires that the substance of a transaction be examined rather than its mere form. In the case before it, the Court noted that, setting aside technical formalities, the business was owned and operated directly by the appellant. Accordingly, the Court found it unrealistic and artificial to imagine the business and its owner as distinct parties engaged in a fictitious sale to one another, thereby generating a fictional profit that, in reality, did not exist. By stripping away such legal fictions, the situation reduced to a scenario in which the owner would be selling to himself and supposedly earning a profit from his own assets—a result that the Court described as not only absurd but also contrary to the fundamental principles of commercial law and the law of income tax. Moreover, the Court pointed out that the owner could simply retain the asset without realizing any profit, or could sell it to a third party at a loss, in which case no tax could be imposed because the law does not compel a taxpayer to sell at an imagined profit merely because market values have risen, nor can it impose a tax that is not grounded in an actual gain.

The Court then illustrated its reasoning with a simple example. It described a trader who dealt in rice and also used rice for his family's consumption. All the rice bags were stored in a single warehouse, and the trader withdrew rice from the warehouse whenever needed, either for his commercial operations or for personal use. The Court held that rice kept for personal consumption could not be taxed, even if market prices had increased, and that rice given away from the trader’s personal stock also could not be taxed. Similarly, the trader could not be forced to sell his personal rice at a profit for tax purposes. If the trader maintained two sets of accounts—one recording all rice placed in his personal store and another recording rice taken from the store and sold to customers—then the personal transactions recorded in the first set would not give rise to tax liability unless the rice was sold at a profit. The Court emphasized that the actions of the trader with respect to the rice stored in his private warehouse were outside the concern of the income-tax department, provided that the rice was not sold or otherwise yielded a profit. The trader was free to consume the rice, give it away, or simply retain it without any tax implication.

The Court examined the argument that it should matter whether the taxpayer keeps two separate sets of books or a single set of accounts. It questioned how any income could be said to arise in the taxpayer’s personal affairs or his business simply because he used ten bags of rice from his godown for a feast celebrating his daughter’s marriage. The Court further observed that the physical route taken by the bags – whether they are moved straight from the godown to the kitchen or first passed through the shop and then to the kitchen – should not alter the tax assessment. The Court noted that the learned Attorney-General, if his reasoning were pursued to its logical end, would treat the transaction as taxable or not based solely on the form the rice takes as it travels from the godown to the wedding feast. In the Court’s view, the result would be the same if, instead of arranging the feast himself, the taxpayer simply handed the rice to his daughter as a wedding gift for her son. The distinction between a feast and a gift, and the path the rice follows, does not create a taxable profit.

The Court then turned to the method of bookkeeping employed by the appellant. It held that his accounting practice accurately reflected the true state of his affairs. When the appellant purchased stock, he recorded the cost of the stock on one side of his ledger. At the close of the financial year he entered the value of any unsold stock, also at cost, on the opposite side of the ledger. This entry cancelled the earlier entry for the same unsold stock, and the net amount was carried forward as the opening balance for the next year. By cancelling the unsold stock on both sides, the accounts retained only those transactions that resulted in actual sales, thereby showing the genuine profit or loss for the year. In the same manner, the appellant recorded the withdrawal of bullion and silver for a purely non-business purpose at their original cost, because that withdrawal did not generate any income, profit or gain. This treatment, the Court said, presented a truthful picture of the appellant’s profit and loss.

The Court observed that there was no directly applicable precedent. The learned Attorney-General relied on the decision in Gold Coast Selection Trust Limited v. Humphrey (H. M. Inspector of Taxes) (1949) 30 Tax Cas. 209; 17 ITR Suppl. 19, where the assessee received a new valuable asset in exchange for another asset in the ordinary course of trade, and was therefore required to account for the receipt in monetary terms. The Court distinguished that case because, in the present matter, the assessee’s business received nothing in exchange for the withdrawal of the assets – no money, nor any equivalent value. Consequently, the Court held that the fair approach was exactly what the appellant had done: to enter the assets at the cost price at which they were valued at the beginning of the year, so that the corresponding entries cancelled each other out. This method left the business ledger neutral, showing neither a gain nor a loss on those particular assets.

The Attorney-General maintained that permitting the method adopted by the appellant would cause a substantial loss to the State, because a taxpayer could simply, at the end of the fiscal year, withdraw every asset that had appreciated in value and retain only those assets whose market price had fallen. By doing so the taxpayer could either record a loss or diminish his assessable profits. This line of argument, however, relies on the assumption that the State is entitled to tax profits that are merely potential. Apart from that assumption, the State would neither gain nor suffer a loss in a case of this kind. If the assets were left in the business, they would be valued at the end of the year at the same amount at which they were recorded at the beginning – namely their original cost. Any future gain would be uncertain and could as well turn into a loss. Moreover, the rule advocated by the Attorney-General is susceptible to abuse: a taxpayer could just as easily withdraw assets that had depreciated, record them in the books at their reduced market value, and keep at cost price the assets that had risen, thereby achieving a similar tax advantage.

Two earlier decisions were cited as bearing a superficial resemblance to the present matter. The first is the decision in In the matter of Messrs. Chouthmal Golapchand ([1938] 6 ITR 733). The second is In re Spanish Prospecting Company Limited ([1911] I Ch 92). The Court chose not to express any opinion on those cases because they reach different conclusions, involve facts that are not identical, and the specific questions arising from those facts were not presented for argument here. Those authorities raise broader issues that would need to be examined in a more suitable case. Importantly, both cases concerned enterprises that were not owned and operated by a single proprietor, so the artificial distinction of treating the business as a separate legal entity trading with its owner – the fiction that the present case seeks to invoke – does not arise. Additionally, the businesses in those cases were not continuing enterprises as in the present facts. In the Calcutta case, a partnership was being wound up and the issue concerned the valuation of stock-in-trade assets at dissolution. In the English case, a company without fixed capital was in liquidation and the question was whether the market value of certain debentures purchased by the company should be included in the profit-and-loss account to increase the profit shown in the balance sheet; the company wished to treat those debentures as having no value in order to display a smaller profit, which affected the remuneration of two employees whose salaries could be paid only out of profits. The Court found that neither of those decisions is applicable to the present matter.

In this case the Court was asked to consider two questions. The first question was whether, given the facts of the case, any income accrued to the appellant as a result of transferring shares and silver bars to trustees. The second question was, if the answer to the first question were affirmative, whether the method used by the Appellate Assistant Commissioner and confirmed by the Income-Tax Appellate Tribunal for computing the appellant’s income from that transfer was the correct method of computation. The Court answered the first question in the negative, holding that no income arose to the appellant from the transfer of the shares and silver bars to the trustees. Because the first proposition was answered in the negative, the second question did not arise. Accordingly, the appeal was allowed and costs were awarded, the order being pronounced by Justice Bhagwati.

The appeal was filed by special leave from a judgment of the High Court of Judicature at Bombay. The High Court judgment had been rendered on a reference made by the Income-Tax Appellate Tribunal under Section 66 (I) of the Indian Income-Tax Act of 1922. The reference raised the issue of how to value an asset that had been removed from the stock-in-trade of a business that was still operating. In the relevant year of account, namely the calendar year 1942, the assessee was engaged as a dealer in shares and in silver. On 21 January 1942 he removed from his business certain shares and silver bars and, in connection with that removal, executed two deeds of trust. Later, on 19 October 1942, he removed additional shares and silver bars and executed a third deed of trust. The Court noted that the specific terms and conditions of those deeds of trust were not material for the purpose of deciding the appeal.

The assessee maintained his books of account on a mercantile basis and, as had been his practice in earlier years, he valued his closing stock at its cost price. For the purpose of stamp duty, however, the deeds of trust were valued at the market value of the shares and silver bars prevailing on the dates on which the deeds were executed. Despite this, the assessee recorded the transfer of the shares and silver bars to the trustees in his books of account at their cost price, thereby setting off the debit that had appeared at the beginning of the year of account. He argued that the market value, which formed the basis of the stamp duty assessment, could not be used as the basis for computing his profit from the stock-in-trade that had been transferred.

The Income-Tax authorities disagreed with the assessee’s contention. They assessed his profit on the basis of the difference between the cost price of the shares and silver bars and their market value at the time they were withdrawn from the business. The Income-Tax Officer, the Appellate Assistant Commissioner and the Income-Tax Appellate Tribunal all rejected the assessee’s argument. The Tribunal, acting on the appellant’s request, referred the matter back to the High Court under Section 66 (I) of the Act, posing the following two questions for determination: (i) whether, in the circumstances of the case, any income arose to the petitioner as a result of the transfer of shares and silver bars to the trustees; and (ii) if the answer to the first question was affirmative, whether the method employed by the Appellate Assistant Commissioner and upheld by the Appellate Tribunal for computing the petitioner’s income from the transfer was the appropriate method for such computation.

The High Court was asked to consider two specific questions. The first question was whether any income arose to the petitioner as a result of transferring shares and silver bars to trustees. The second question was, assuming that income did arise, whether the method used by the Appellate Assistant Commissioner and subsequently upheld by the Appellate Tribunal was the appropriate method for computing that income. The Court answered both questions in the affirmative, holding that income did arise from the transfers and that the method adopted by the revenue authorities was the correct one for assessing the petitioner’s income.

The tribunal had not disputed that the shares transferred by the assessee formed part of the stock-in-trade of the business. Regarding the silver bars, the tribunal observed that the assessee engaged in frequent purchases and sales of silver, indicating that the silver also constituted stock-in-trade and was not a mere capital investment. Consequently, both the shares and the silver bars were treated as components of the business’s stock-in-trade. The assessee had acquired these assets periodically, and each time they were recorded in the books of account at their cost price. The cost price of the shares and silver bars was shown in the accounts for preceding years and also at the opening of the relevant year of account.

The issue that required determination was the effect of withdrawing these assets from the stock-in-trade at the close of the financial year. If the shares and silver bars were removed from the stock-in-trade at year-end, the assessee’s accounting system would still reflect their value at cost price, consistent with the method of valuation employed throughout the year. The critical question therefore concerned how such a withdrawal should be treated for tax purposes.

From the perspective of the business, an asset that is brought into the enterprise possesses a specific value on the date of acquisition, and it is initially recorded in the books at that cost. As the business operates, the market may cause the asset’s value to rise or fall. If the cost price basis is retained for valuing stock-in-trade at the end of the year, any appreciation or depreciation that occurred during the year will not be captured in the accounts. Conversely, if the market-value basis is adopted at year-end, the asset may be shown at a loss or gain reflecting current market conditions, and the Income-Tax authorities would permit that loss or gain in computing the business’s profit or loss.

Regardless of the valuation method chosen, the assessee is required to carry forward the asset into the next year’s books at the valuation determined at the close of the preceding year. The assessee is not permitted to alter that valuation basis during the intervening period, except when a new valuation is adopted at the end of a subsequent year, at which point the cost price realized at that later date may become the new basis for valuation.

In this case the Court observed that the profit or loss arising from a particular asset, whether a gain or a loss, would be taken into account by the Income-Tax authorities when they compute the taxable profit or loss of the business. The method of valuation, however, would not alter the ultimate result. When the cost-price basis of valuation is applied, every intermediate fluctuation in the market price of the asset that occurs between the time the asset is introduced into the business and the time it is sold is ignored. Only the difference between the price at which the asset was originally brought into the business and the price at which it stands at the close of each financial year is considered for accounting purposes. If, during the year, the assessee had adopted the market-value basis and therefore recorded the asset at the market price prevailing at the end of the preceding year, a correction would have to be made in the profit-and-loss account of the preceding year because the earlier account would not have reflected the true result of trading. Such rectifications would be required year after year until the asset is finally realized on sale, at which point the corrected amount would be recognised in the year of sale. The Court held that, as regards the asset itself, the cumulative effect of these adjustments does not change the final outcome. The only benefit that accrues to the assessee from using the market-value basis is the ability to anticipate a possible loss on the asset in a future year if market prices are expected to fall again.

The Court then considered whether any distinction arises when an asset is withdrawn from the stock-in-trade rather than being realized through sale. It concluded that, for the business, the asset ceases to be a part of the stock-in-trade in either circumstance. Once the asset has been taken into the business, its value will rise or fall in line with market fluctuations, and the asset remains recorded as part of the stock-in-trade until it is either sold or withdrawn. These fluctuations are not reflected in the valuation of stock-in-trade at the end of the accounting year, but they are captured in the books of account when the market-value basis is employed. In either case, the true profit or loss to the business, measured against the price at which the asset was originally acquired, is determined at the moment the asset is realized. That determination represents the measure of the appreciation or depreciation that the asset has experienced up to that point, regardless of whether it was ultimately sold or simply withdrawn from the stock-in-trade.

The Court observed that when an asset ceased to be part of the stock-in-trade of the business, the measurement of profit or loss related to that asset was exactly the same as when the asset was realised through a sale. Once the asset left the stock-in-trade, it no longer formed part of the business’s inventory, and the amount of profit or loss was determined by the price at which the asset was either sold or, if withdrawn without a sale, by the market value of the asset on the date of withdrawal. The Court held that the business was therefore entitled to credit its goods account with the amount actually received from the sale or, in the case of a withdrawal, with the market value of the asset at that moment. From the assessee’s viewpoint, the Court noted that it made no material difference whether the asset was sold in the ordinary course of business or simply withdrawn. The asset entered the business at a certain value, and when it was withdrawn it might have appreciated or depreciated in line with market fluctuations. The business was permitted to recognise that appreciation or depreciation because the asset had been part of the stock-in-trade. Upon withdrawal, the assessee obtained an asset whose value at that time reflected any such change, and the manner in which the assessee dealt with the asset thereafter was irrelevant. What mattered was the market value of the asset on the date of withdrawal, which determined the amount that could be credited to the stock-in-trade account.

The Court also rejected the submission that withdrawal of an asset from the stock-in-trade was not a business transaction and that a simple credit entry for the asset’s original cost price would suffice. That argument, the Court explained, ignored the effect of any appreciation or depreciation that had occurred between the time the asset was first brought into the business and the time it was withdrawn. Moreover, the argument failed to consider that the assessee might have adopted a market-value basis for valuing stock-in-trade at the close of the preceding financial year. In such a situation, the debit entry recorded at the beginning of the year would represent the market value of the asset at the end of the prior year rather than its historical cost. Consequently, the appropriate basis for the credit entry on withdrawal could not be the original cost price, which was not reflected in the accounts after the initial entry, but rather the market value of the asset at the date of withdrawal. The Court affirmed that the method of accounting could not alter the substantive economic position of the business, whether the asset had increased or decreased in value.

The Court observed that the argument presented failed to consider the change in the asset’s value on the date of its withdrawal compared with its value at the time it was originally introduced into the business. The Court further pointed out that the argument ignored the possibility that the assessee might have employed a market-value basis for valuing the stock-in-trade that was held at the close of the preceding financial year or years of account. Consequently, an entry recorded on the debit side at the beginning of the current year would not represent the original cost price of the asset; rather, it would embody the market value of that asset as determined at the close of the previous year’s accounts.

The Court then questioned what rational basis should govern the credit entry to be made on the date of withdrawal. It asked whether the credit should reflect the original cost price, which had not been shown in the accounts except at the initial stage when the asset entered the business, or whether it should reflect the market value of the asset at the moment of withdrawal. The Court emphasized that the method of accounting could not alter the factual situation of whether the asset had appreciated or depreciated, nor could it affect the profit or loss that accrued to the business when the asset was removed from the stock-in-trade.

The Court also noted an additional practical consideration: whenever an asset is withdrawn from the stock-in-trade, the withdrawing person’s account must necessarily be debited with the price of that asset. The Court asked whether, when the assessee withdraws an asset that has either appreciated or depreciated, there is any justification for debiting the account with the original cost price rather than with the asset’s market value on the date of withdrawal.

In the circumstance where the asset has appreciated, the Court held that the assessee should be debited with the higher, appreciated market value, because that reflects the true value of the asset withdrawn. Conversely, where the asset has depreciated, the Court stated that the assessee should not be charged a loss; he should certainly not be debited with an amount higher than the asset’s market value, even if the cost price recorded in the books under the particular accounting system is higher.

Accordingly, the Court expressed a firm opinion that, in cases of withdrawal just as in cases of realization of an asset, the business is entitled to credit the goods account with the market value of the asset on the date of its withdrawal, irrespective of the valuation method the business has adopted for its stock-in-trade at the close of any financial year. The Court further noted that counsel for the appellant, Shri R. J. Kolah, had specifically relied upon a decision of the Calcutta High Court.

In the matter of Messrs Chouthmal Golapchand, the firm was composed of four partners who each held an equal share. At the commencement of the accounting year 1935-36 the partners recorded an opening stock of shares that were valued at their cost price of Rs 85,331. On 8 January 1936 the partners passed a resolution to dissolve the firm, with the dissolution to take effect on 30 March 1936. In anticipation of the pending dissolution, the partners divided among themselves, on 9 March 1936, the shares of the firm. The division was carried out at the market rates prevailing on that date and the aggregate value assigned to the divided shares was Rs 51,966. The assessees claimed that the difference between the original cost price and the market valuation represented a loss, and they sought to set off that loss in the assessment for the year. The assessing authority rejected the claim on the ground that no loss had been demonstrated for the year of account. The assessees followed a system of accounting that valued the shares at cost price at the close of each year and used that cost price as the opening value for the next year. The partition of the shares was therefore treated not as a sale but as a mere internal reallocation, and consequently the authorities found no evidence of any loss incurred during the year.

The learned judges, however, expressed a respectful disagreement with the reasoning that had been applied. They observed that the assets brought into the business at earlier dates had depreciated by the time of the partition, and that those depreciated assets were the subject of the division among the partners. Even if the partition were not characterised as a sale, it amounted to a transfer of property: the firm’s shares were transferred to the individual partners, each of whom acquired an absolute interest in the shares he received. Accordingly, the transfer also represented a transfer of the partners’ inter-se interests in the shares, each interest being conveyed absolutely to the respective partner. The judges indicated that, were it necessary, they would hold that the earlier decision had been erroneous. They referred to the judgment of Fletcher Moulton L.J. in In re Spanish Prospecting Co., Ltd. ([1911] 1 Ch. 92 at p. 98). The Supreme Court concluded that the answers given by the High Court to both questions referred to it were correct, and therefore dismissed the appeal with costs. The appeal was ultimately allowed.