The Commissioner Of Income-Tax, Madras vs A. Krishnaswami Mudaliar And Others

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

Court: supreme-court

Case Number: Civil Appeal No. 250 of 1963

Decision Date: 16 April 1964

Coram: J.C. Shah, S.M. Sikri

In this case the petitioner was the Commissioner of Income‑Tax for Madras and the respondents were A Krishnaswami Mudaliar together with other persons; the judgment was delivered on 16 April 1964 by a Bench composed of Justice J C Shah and Justice S M Sikri, and the decision is reported in 1964 AIR 1843 and 1964 SCR (7) 776, with subsequent citations in later law reports. The dispute arose from the manner in which the profits of a trading venture were to be computed under the Indian Income‑Tax Act, 1922, section 13 and its proviso. The assessee firm had purchased, for a cash outlay of one hundred thousand rupees, the exploitation rights to a cinematograph film, a right that was to remain effective for a period of four years. For the period extending from 25 December 1947 to 2 August 1948—the year that corresponded to the assessment year 1949‑50—the firm filed a voluntary return indicating that it had earned twenty‑eight thousand six hundred forty‑three rupees from exploiting the film. In the statement of accounts submitted by the firm the total receipts recorded in its books amounted to one hundred forty‑six thousand eight hundred forty‑nine rupees; from this sum the firm deducted eighteen thousand two hundred six rupees as expenditure and one hundred thousand rupees as the amount paid to acquire the exploitation rights. The Income‑Tax Officer held that the firm’s statement of accounts omitted the valuation of the unexpired portion of the film rights at the close of the accounting year, and consequently the officer concluded that the true profits could not be properly ascertained. The officer therefore estimated the value of the remaining film rights as of 2 August 1948 at sixty‑five thousand rupees, computed the net profits of the unregistered firm as ninety‑three thousand six hundred forty‑two rupees, and assessed income‑tax and super‑tax on that basis. The appeals filed against the assessment challenged only the correctness of the officer’s valuation of the film rights; the Appellate Tribunal reduced the valuation to forty thousand rupees. On further reference, the Madras High Court held that the firm had adopted a cash system of accounting, that valuation of closing stock was not a necessary incident of that system for ascertaining profits, and that the Income‑Tax Officer possessed no authority under the proviso to section 13 of the 1922 Act to compel the assessee to adopt a different system, whether a mercantile system or a hybrid of cash plus stock valuation. The Court ultimately held that in a trading venture the value of stock‑in‑trade must be taken into account for computing true profits of the year, irrespective of the bookkeeping method adopted, and therefore the High Court’s view that the officer could not add the value of closing stock to the receipts was erroneous.

In this case the Court held that the income‑tax officer was not authorised to augment the business receipts by adding the value of the stock‑in‑trade that remained at the end of the accounting year for the purpose of arriving at the correct profit of that year. The Court explained that there was no basis for presuming that the officer intended to override the method of accountancy adopted by the assessee, unless the officer relied on the proviso to section 13 of the Indian Income‑Tax Act, 1922, and performed the computation in the manner that, in his view, would properly disclose the profit. The judgment was delivered in Civil Appeal No. 250 of 1963, taken on special leave from the judgment and order dated 2 February 1960 of the Madras High Court in Case Referred No. 1 of 1955. Counsel for the appellant appeared for the appellant and counsel for the respondents appeared for respondents numbered 1 and 3‑6. The judgment was pronounced on 16 April 1964 by Justice Shah.

The respondents were a partnership firm created under a deed dated 12 December 1947 and originally comprising three partners: K. N. Damodara Mudaliar, A. Krishnaswami Mudaliar and V. Thangaraja Mudaliar. K. N. Damodara Mudaliar acquired for the firm exploitation rights to the cinematograph film “Apoorva Chinthamani” for a period of four years, covering the North Arcot, South Arcot, Chingleput districts and Pondicherry, at a cost of Rs 1,00,000. For the period from 25 December 1947 to 2 August 1948, which constituted the “previous year” corresponding to assessment year 1949‑50, the firm filed a voluntary return stating that it had earned Rs 28,643 from exploiting the film. In the statement of accounts the firm recorded total receipts of Rs 1,46,849, against which it debited Rs 13,206 as expenses and Rs 1,00,000 as the amount paid for acquiring the exploitation rights. Consequently, in computing the profit of the business the firm deducted the amount paid for the rights but did not credit the value of the unexpired exploitation rights that remained at the end of the previous year.

On 15 August 1948 the partners executed a deed of dissolution, and Damodara Mudaliar sold, with effect from 6 August 1948, his half interest in the partnership assets to Krishnaswami Mudaliar for Rs 2,000 and retired from the partnership. A trial balance prepared on 27 August 1948 showed a cash balance of Rs 190 12 4, a debit against Krishnaswami Mudaliar of Rs 2,641 8 8, and credits in favour of Damodara Mudaliar and Thangaraja Mudaliar of Rs 1,888 2 11 and Rs 944 2 1 respectively. Subsequently, Krishnaswami Mudaliar, Thangaraja Mudaliar and an outsider, V. S. Lakshmanan, formed a new partnership to continue exploiting the film for the remaining period. From that partnership Krishnaswami Mudaliar retired on 22 February 1949, agreeing to receive Rs 12,000 for his one‑sixteenth share in the partnership assets at the time of his retirement.

In the case, the retiring partner received his one‑sixteenth share in the assets of the firm on the date of his retirement. When the firm’s assessment for the year 1949‑50 was prepared, the Second Additional Income‑Tax Officer in Vellore refused to accept the firm’s statement of account that the firm had earned a net profit of only Rs 28,643 up to 2 August 1948 as an accurate reflection of its profit. The officer observed that the firm’s statement had omitted any valuation of the picture’s stock and had merely shown the excess of collections over purchase cost, thereby indicating that, in his view, the profit could not be properly determined from an account that did not include the value of the unexpired exploitation rights at the end of the year. The officer estimated the value of those unexpired rights on 2 August 1948 at Rs 65,000 and consequently calculated the firm’s net profit, as an unregistered firm, to be Rs 93,642. On that basis, he assessed income‑tax and super‑tax on the higher profit figure. The firm appealed to the Appellate Assistant Commissioner, challenging only the officer’s estimate of Rs 65,000 for the exploitation rights and contending that the true value of the assets at the close of the previous year was Rs 4,000, noting that the retiring partner, Damodara Mudaliar, had relinquished his half‑share for Rs 2,000. The Appellate Assistant Commissioner rejected this contention, holding that the valuation of the exploitation rights in the dissolution deed dated 15 August 1948 had been influenced by extracommercial considerations, and affirmed the officer’s valuation of Rs 65,000. The firm then appealed to the Income‑Tax Appellate Tribunal, Madras, again arguing that the valuation was excessive. The Tribunal partially accepted the appeal, reducing the valuation of the exploitation rights on 2 August 1948 to Rs 40,000 and directing that the assessment be modified accordingly. Following an order from the Madras High Court in a petition under section 66(2), the Tribunal stated the case and was asked to consider whether, given the facts and circumstances, it was justified in applying the proviso to section 13 of the Income‑Tax Act and confirming the assessment on a mercantile basis of accounting. The High Court ruled that a taxpayer was free to keep accounts according to a recognised accounting system and, having adopted a cash system, the Tribunal had not provided reasons for abandoning that system in computing profits. Consequently, the High Court found that the Tribunal erred in making the assessment on a mercantile basis. The Court further observed that, once it was established that the cash system was the one adopted by the assessee and that valuation of closing stock was not part of that system for profit determination, the Income‑Tax Officer possessed no authority under the proviso to section 13 to compel the assessee to adopt a different accounting system, whether mercantile or a hybrid of cash plus stock valuation. The High Court therefore answered the referred question in the negative.

The Court observed that the assessee had chosen a cash accounting system for the present case and that the valuation of the closing stock was not a component of that system for determining profits. Consequently, the Court held that the Income‑tax Officer possessed no authority under the proviso to section 13 to compel the assessee to adopt a different accounting method, whether a mercantile system or a hybrid arrangement combining cash accounting with a valuation of closing stock. On this basis, the High Court answered the referred question in the negative, concluding that the officer could not impose an alternative system. The appeal against the High Court order was filed with special leave, and the central issue for determination in this appeal concerned whether, in computing the income of the firm under the head “Profits and gains of business,” the Income‑tax Officer was bound by the accounting method in which the cost of acquiring the film for which exploitation rights were held was debited at the beginning of the fiscal year while the film’s value at year‑end was disregarded.

Section 10 of the Indian Income‑tax Act, 1922, mandates that an assessee must pay tax on profits and gains arising from any business, profession, or vocation, subject to the allowances specified in subsection (2). Section 13 further requires that income, profits, and gains be computed in accordance with the method of accounting regularly employed by the assessee, unless no regular method exists or the officer, in his opinion, cannot properly deduce the income, profits, or gains from the method used; in such cases, the officer may determine the basis and manner of computation. The Income‑tax Officer, in his assessment order, noted that the firm had not performed a stock valuation of the film and had merely taken the excess of collections over the purchase price, filing its return on that basis. Although no explicit order stated that, in the officer’s view, the income could not be properly deduced from the firm’s accounting method, his remarks implicitly indicated that without valuing the unexpired exploitation rights the year’s profits could not be ascertained. The Appellate Assistant Commissioner concurred with this implication. On appeal to the Appellate Tribunal, the sole contention raised was that the officer had erred in estimating the value of the unexpired exploitation rights at Rs 65,000; the Tribunal partially accepted this argument and reduced the valuation to Rs 40,000. It is therefore difficult to comprehend how any issue regarding the regularity of the Income‑tax Officer’s proceedings, arising from the adoption of a mercantile accounting system and the application of the proviso to section 13, could have originated from the Tribunal’s order.

The Court observed that the question regarding the use of a mercantile system of accounting and the application of the proviso to section 13 of the Income‑tax Act arose from the order issued by the Tribunal. It pointed out that, under the Income‑tax Act, the High Court possesses the authority to request the Appellate Tribunal to state a case only when the High Court is not convinced that the Tribunal’s decision is correct and that no legal question emerges from the Tribunal’s order. The Court examined the grounds of appeal that had been presented before both the Tribunal and the Appellate Assistant Commissioner and found that these grounds clearly indicated that the issue of whether the proviso to section 13 applied to the profits reported by the respondent firm had never been contested. Furthermore, the Court held that it could not be said that the Tribunal had compelled the firm to adopt any accounting system for the purpose of computing its profits that differed from the system actually used by the firm. Although the title of the order issued by the Income‑tax Officer described the method of accounting employed by the firm as “mercantile,” the Court explained that this description did not amount to a directive that the income should be computed on the basis of accounts rewritten according to the mercantile system. The matter referred to the High Court, the Court noted, sought advice on two separate points: first, the justification for applying the proviso to section 13; and second, the computation of income on the basis of a mercantile system of accounting. The Court observed that the firm had raised no argument on either of these two points before the Tribunal. Nevertheless, the Court declined to dispose of the appeal merely on the narrow ground that the framed question did not arise from the Tribunal’s order and therefore need not be answered. It emphasized that the reasons presented by the High Court in support of its answer to the referred question raised a principle of some importance in the computation of income for a taxpayer engaged in a trading venture involving a wasting asset. The Court further noted that elaborate arguments had been advanced by counsel at the Bar, and that, in view of those arguments, it was necessary to express an opinion on the debated questions. While acknowledging that the Revenue authorities and the Tribunal had indeed considered the valuation of stock at the end of the accounting year, the Court clarified that this consideration was not based on a view that the accounting system adopted was—or should be—mercantile. Rather, the Court explained, the authorities believed that, given the nature of the business, the firm’s profits for the year could not be accurately determined from the accounts unless the opening and closing stocks were brought into the calculation. This view was reflected in paragraph 15 of the Tribunal’s statement of the case, which observed that in all trading matters the true profits cannot be deduced from any system of maintaining accounts—whether cash or mercantile—unless the opening and closing stocks are taken into account at cost or market price, whichever is lower.

In this case the Court explained that the rule requiring valuation of stock at the lower of cost or market price prevented a taxpayer from claiming that, because he used a cash accounting system, he had not earned any profit from cash sales until all of his stock was sold. The Court noted that income tax is imposed annually and that the profit for each year must be determined as accurately as possible under the circumstances. Consequently, even when a taxpayer employed an otherwise acceptable system of accounting but omitted stock from the accounts, the proviso to Section 13 of the Income‑Tax Act necessarily had to be applied, even if the only purpose of the provision was to adjust the book figures for the stock values. The Court then examined the correctness of this view, particularly where a trading venture exploited a wasting asset that formed the taxpayer’s stock‑in‑trade. The Court traced the origin of Section 13 to the Income‑Tax Act II of 1922, noting that the provision was introduced because, in an earlier case decided under the Income‑Tax Act 1918, Justice Wallis, delivering the leading judgment of the Full Bench in Secretary, Board of Revenue, Madras v. Arunachalam Chettiar, held that irrespective of the accounting system adopted, assessable income meant income actually or constructively received and that the language of the charging section limited the subsequent sections that specified the various classes of taxable income. To replace this earlier exposition, the Legislature enacted Section 13, which permitted a taxpayer to adopt any method of accounting and required the Income‑Tax Officer to compute income, profit and gains for the purposes of sections 10 and 12 according to that method, provided that the business profit could be properly deduced from it. The Court cited the Judicial Committee of the Privy Council in Commissioner of Income‑Tax, Bombay v. Sarangpur Cotton Manufacturing Company Ltd, Ahmedabad, which observed that the section concerned a method of accounting regularly used by the taxpayer for his own purposes and did not prescribe a method for preparing the statutory return. The Privy Council further held that the method became compulsory for computation unless, in the officer’s opinion, the income, profit and gains could not be properly deduced. The Court added that even if the profit shown in the accounts was not the true taxable profit, the correct figure could still be accurately derived from those accounts. The Board of Revenue was also quoted as stating that the Income‑Tax Officer had a duty, where a method of accounting existed, to consider whether income, profit and gains could be properly deduced from it and to act according to his judgment on that question. Finally, the Court referred to its own earlier observation in Commissioner of Income‑Tax v. McMillan, emphasizing that the expression “in the opinion of the Income‑Tax Officer” in the proviso to Section 13 imposed a statutory duty, not merely a discretionary power, on the officer to examine the taxpayer’s accounting method in each case and to determine whether the income, profit and gains could be properly deduced therefrom.

In the proviso to section 13 of the Indian Income‑tax Act, 1922, the phrase “in the opinion of the Income‑tax Officer” does not grant the officer a simple discretionary power; rather, it creates a statutory duty for the officer to examine, in each case, the accounting method used by the assessee, to verify whether that method has been applied consistently, and to decide whether the income, profits and gains of the assessee can be properly derived from it. The provision, however, is limited to the computation of income, profits and gains for the purposes of sections 10 and 12 and does not intend to broaden or narrow the definition of taxable income, profit or gains under the Act. Section 2(15) of the Act defines “total income” as the aggregate amount of income, profits and gains referred to in sub‑section (1) of section 4, computed in the manner prescribed by the statute. Section 4(1) specifies which items must be included in total income, and sections 10(2), 12(2), 12B(2), 14, 15A, 15B, 15C and 16 lay down the methods of computing income, profits and gains in various situations, also providing special exceptions, as reflected in authorities such as L.R. 65 I.A. 1 and 33 I.T.R. 182. Section 13 itself does not directly affect the operation of those provisions; it merely states that taxable profits shall be computed according to the accounting method regularly employed by the assessee. If, in the opinion of the Income‑tax Officer, the income, profits and gains cannot be properly deduced from that accounting method, the officer is authorised to determine the income on any basis and in any manner he deems appropriate. The provision does not oblige the officer to accept a balance‑sheet of cash receipts and outgoings prepared from the books of account; instead, the officer must compute income following the accounting method that the assessee habitually uses. The only significant departure of section 13 of the Indian Income‑tax Act from English tax legislation is that, under English law, the Commissioner is not required to compute business profits according to the assessee’s chosen accounting method, whereas under the Indian Act, prima facie, the officer must compute income, profits and gains for the purposes of sections 10 and 12 in accordance with the regularly employed method. Consequently, when a regular accounting system exists and, after appropriate adjustments, taxable profits can be correctly derived from the maintained accounts, the officer is bound to compute the profits using that method. Conversely, if, in the officer’s view, profits cannot be properly deduced from the system adopted by the assessee, the officer may adopt a more suitable basis to compute the true profits. Among Indian businessmen, as

In this case the Court observed that Indian business practice employs two principal systems of bookkeeping. The first system is the cash method, under which a record is kept of actual receipts and actual disbursements, and entries are posted only when money or an equivalent of money is actually received, collected, or paid out. The second system is the mercantile method, in which entries are recorded on the date of the transaction, that is, on the date on which rights accrue or liabilities arise, regardless of when payment is actually made. For instance, when goods are sold on credit, the receipt is recorded on the sale date even though cash has not yet been received; similarly, a debit entry is made when a liability is incurred, even though payment may be deferred. The Court noted that a professional assessee who adopts the mercantile method may have to make appropriate variations to suit the nature of the profession. Under the cash system, the accountant does not keep an account of the outstanding receivables or payables either at the beginning or at the end of the year. By contrast, the mercantile method treats actual cash receipts and cash outlays during the year in the same way as the cash system, but then adds to the resulting balance the amount of receivables that remain uncollected at year‑end and subtracts the liabilities that have been incurred or accrued but not discharged at year‑end. The Court described both methods as somewhat rough in their application.

The Court further explained that because of this roughness, either method may fail to present a clear picture of the true profits earned, and certainly may not reflect the taxable profits accurately. The quantum of deductions permitted under section 10(2) of the Act, which relate to various heads of allowance, will differ depending on which system the assessee adopts. This distinction is clarified by the definition in sub‑section (5), where the word “paid” is interpreted to mean actually paid or actually incurred according to the accounting method on which the profits or gains are computed under section 10. The Court pointed out that when the cash system is used, the concept of bad debts or outstanding amounts does not arise at all. In the mercantile system, however, some bad debts may need to be written off against the book profits when they are identified. The Court also mentioned that a great many other accounting systems exist, often referred to as hybrid or heterogeneous systems, which combine elements of both cash and mercantile approaches. Nevertheless, the Court stressed that regardless of the bookkeeping method adopted, a trading enterprise must always take the stock‑in‑trade into account when computing the true profit for the year. If the value of stock‑in‑trade is ignored, the profit or loss from trading will ultimately be absorbed into or reflected by the stock‑in‑trade value, unless the stock’s value remains unchanged at both the beginning and the end of the year.

The Court observed that if the value of the stock‑in‑trade does not change between the beginning and the end of the accounting year, the stock‑in‑trade must still be taken into account when computing the true profit of a trading venture. It emphasized that under the Income‑tax Act tax is imposed on income, profits and gains, not on receipts; therefore taxable profit cannot ordinarily be inferred merely from cash receipts. The Court explained that if, in computing the profit of a trading business, only cash receipts and cash outgoings are considered, the emergence of profit is effectively postponed until the capital outlay of the firm has been fully recovered. In such a case the real profit of the business is transformed into capital by means of bookkeeping entries. The Court held that it was unnecessary to examine whether the accounting method that ignored the value of the stock‑in‑trade was regularly employed by the respondent firm, because the year in question was the first year of account. Both parties agreed that the method of accounting was not mercantile but was wholly or primarily a cash system. The Income‑tax Officer opined that, in the absence of a valuation of the film stock—a wasting asset used by the partnership to earn profits—the firm’s income could not be properly ascertained, and on that basis the Appellate Assistant Commissioner and the Tribunal concurred. The High Court, however, ruled that maintaining accounts on a cash basis is a recognised method of accounting and that the Income‑tax Officer was bound by the assessee’s choice of that system, unless the Officer was satisfied that the assessee had not regularly adopted it. The High Court further observed that the Department had assessed the firm as if it had used a mercantile system, which the firm never adopted, by including a valuation of closing stock—an element not part of the cash system. Accordingly, the High Court held that the Income‑tax Officer had no authority under the proviso to section 13 to compel the assessee to adopt a different system, whether mercantile or a hybrid of cash plus stock valuation. The Court found that the High Court erred in reaching that conclusion. The factual background disclosed that the firm paid Rs 1,00,000 to acquire a wasting asset intended for the partnership’s benefit, recording the purchase price as an expense. By the end of the year the partnership had collected Rs 1,46,849 from exploiting the asset, incurred business expenses of Rs 18,206, and reported a net profit of Rs 28,647. This profit figure was derived by debiting the purchase of the stock‑in‑trade as a proper expense and by ignoring the asset’s residual value at year‑end.

In this case the Court explained that, for the purposes of assessment under the Income‑tax Act, each fiscal year is a self‑contained unit. Consequently, if the cost of the film were to be deducted from the receipts without a corresponding entry that credits the asset’s value at year‑end, the deduction would either wholly or substantially be absorbed in the amortisation of the capital value of the asset. The Court observed that such accounting would present a false picture of the partnership’s financial position, irrespective of how lucrative the business might actually be. While acknowledging that the statutory methods of computing taxable income for various kinds of income are highly artificial, the Court stressed that the Act does not oblige the Income‑tax Officer to accept a statement of account that is not prepared in accordance with any recognised accounting practice. The Court then referred to the decision in Commissioner of Inland Revenue v. Cock Bussell and Co. Ltd. (1), where Croom‑Johnson J. observed that there is no specific word in statutes or rules dealing with the valuation of stock‑in‑trade for taxation purposes. He further noted that the legislation contains nothing indicating that, in computing the profits and gains of a commercial concern, the opening stock‑in‑trade and the closing stock‑in‑trade must be taken into account. The Court quoted Croom‑Johnson J.’s statement that it would be “fantastic not to do it” and “utterly impossible” to assess profits accurately on the basis of receipts and payments alone or merely on turnover. It has long been recognised, the Court said, that the correct method of assessing profits and gains is to include the value of stock‑in‑trade at both the beginning and the end of the accounting period as two of the items in the computation. The Court added that it need not cite authority for the general proposition, which is admitted at the Bar, that the ordinary principles of commercial accounting should be applied in ascertaining profits and gains, provided they do not conflict with any express statutory provision. The Court reiterated that, although English law contains no provision compelling the tax officer to adopt the taxpayer’s regular system of accounting, whether cash or mercantile, Croom‑Johnson J. correctly observed that in a trading venture it would be impossible to assess true profits without considering the value of stock‑in‑trade at the start and at the end of the year. The Court also referred to Whimster & Co. v. The Commissioner of Inland Revenue (2), where Lord President Clyde, at page 823, identified two fundamental commonplaces in computing the balance of profits and gains for income‑tax purposes.

In the judgment, the Court explained that two fundamental principles must always be remembered when determining profits for a particular year or accounting period. First, the profit for any specific year had to be understood as the difference between the receipts obtained from the trade or business during that year and the expenditures incurred to earn those receipts. Second, the account of profit and loss that was prepared in order to calculate that difference had to be framed in a manner consistent with the ordinary principles of commercial accounting, to the extent that they were applicable, and also in conformity with the rules laid down in the Income‑Tax Act, or with the provisions and schedules of that Act as they were altered by the regulations governing Excess Profits Duty, depending on the circumstances. The Court illustrated this point by noting that ordinary commercial accounting required that, in the profit and loss account of a merchant’s or manufacturer’s business, the values of the stock‑in‑trade at both the beginning and the end of the period covered by the account should be entered at either cost or market price, whichever was lower, even though the taxing statutes themselves contained no explicit provision on this matter. The Court also referred to the earlier decision of the Commissioner of Income‑Tax and Excess Profits Tax, Madras v. Messrs. Chari and Ram, Madura, where Justice Rajamannar C.J. had observed that stock‑in‑trade held at the end of the period was an essential element in computing the profits for that period. Further, the Court quoted the observations of Fletcher‑Moulton, L.J. in the Spanish Prospecting Company Ltd. case, which described profit as “a comparison between the state of a business at two specific dates usually separated by an interval of a year,” explaining that the fundamental meaning of profit was the amount of gains made by the business during the year, and that this could be ascertained only by comparing the assets of the business on the two dates. The Court acknowledged that Fletcher‑Moulton’s remarks were originally made in the context of a balance‑sheet rather than a tax‑related profit and loss account, yet emphasized that the observations demonstrated that normal bookkeeping practice must be observed when ascertaining profits. The Court added that, although special classes of assets might require appropriate adjustments, the Income‑Tax Act itself made no provision regarding the valuation of stock and imposed tax on the income, profits and gains computed in the manner prescribed by the Act. Consequently, for a trading venture, the profits had to be determined in accordance with the method laid down in the Income‑Tax Act.

The Court explained that, in accordance with the Income‑Tax Act, the profits of a trading business must be computed after making the adjustments that the statute itself permits. Accordingly, the Income‑Tax Officer is required to determine the amount of profit that the business has actually earned by applying proper accounting practice as adopted by the taxpayer. After that initial determination, the officer must then make the necessary adjustments and, where appropriate, apply the modifications suggested by Fletcher‑Moulton, L.J. for ascertaining the taxable profit. Lord Buckmaster, in The Naval Colliery Co. Ltd. v. The Commissioner of Inland Revenue(1), observed that the general rule of valuing the entire stock at the beginning and at the end of an accounting period and taking the difference does not suit every circumstance and may require material modification. The Court noted that the formula promoted in the Spanish Prospecting Company case was later attempted to be applied in a matter involving Excess Profits duty. In that case a mining company, unable to work its colliery because of a strike, sought to include in its accounts—normally closed on 30 June 1921—estimated expenses for repairing damage that, although incurred during the period, would be restored later. The company argued that these estimated expenses represented a genuine business liability and should be debited before actual payment. The House of Lords rejected this contention, and Lord Buckmaster observed that the accounting rules suitable for prudent trading could not be applied to the operation of a mining lease.

The Court held that such observations do not alter the essential character of a business’s profits. While adjustments may be necessary to reflect the special nature of the assets, the character of the trade, and the specific allowances authorized by law, those adjustments cannot support a proposition that, for a trading venture, the true profit of a year can be derived by ignoring the valuation of stock‑in‑trade at the end of the year and by treating the opening stock value merely as an expense. Ignoring the closing stock valuation and debiting the opening stock value would not present a true picture of profit for the relevant accounting year. The Court further observed that there was no justification to assume that the Revenue authorities or the Tribunal had attempted to displace the accounting method employed by the assessee. By applying the proviso to s. 13, the authorities computed the profit in the manner they considered proper and were entitled to do so. Consequently, the Court concluded that the High Court had erred in holding that, because the assessee used a cash accounting system, the Income‑Tax Officer could not add the value of the closing stock‑in‑trade to the receipts for the purpose of correctly determining the profit for the year in question.

The Court observed that the taxpayer had kept his books of account on a cash basis, and therefore it was not within the authority of the Income‑tax Officer to increase the amount of business receipts by incorporating the monetary value of the stock‑in‑trade that existed at the end of the financial year. By reason of the cash‑accounting method, the officer could not lawfully adjust the receipts for the purpose of arriving at a correct deduction of the profit earned by the business during the year that was under consideration. On this basis, the Court concluded that the appeal filed by the taxpayer must be allowed. Accordingly, the Court answered the question that had been referred to the High Court in the affirmative, confirming that the High Court’s view was erroneous. The Court further directed that the Commissioner of Income‑tax should be awarded his costs incurred not only in these proceedings before the Supreme Court but also for the expenses that were incurred in the earlier proceedings before the High Court. In sum, the Court allowed the appeal and granted the Commissioner his costs in both Courts.