SAKTHI TRADING CO.versusCOMMISSIONER OF INCOME TAX, COIMBATORE

A                             SAKTHI TRADING CO.
                                          v.
              COMMISSIONER OF INCOME TAX, COIMBATORE
                                                                                      ...
                                  AUGUST 2, 2001

B               [Y.K. SABHARWAL AND BRIJESH KUMAR, JJ.]


          Income Tax:

          Income Tax Act, 1961-Partnershipfirm-Dissolution offirm on death
C   of partner-Reconstitution of firm with remaining partners without
    discontinuance of business-Valuation ofclosing stock on dissolution offirm-
    Revenue valuing ii at market value-Maintainability of-Held, valuation of
    closing stock should be valued at cost or market value, whichever is lower as
    there is no discontinuance of business.
D         Appellant-assessee firm was dissolved due to the death of one of the
    partners. The firm was reconstituted with the remaining partners from next
    day itself without discontinuance of business. Assessments were made by the
    Income Tax Officer for the two periods of the assessment year-one for the
    period ending the date of dissolution and other for the period from the date
E   of reconstitution to the end of the previous year. The closing stock for the
    period ending the date of dissolution was valued at cost or market value,
    whichever was lower. Commissioner of Income Tax, utilising the powers under
    Section 263 of the Act, set aside the assessments and directed the Income Tax
    Officer to make fresh assessments by valuing the closing stock at market value.
F   The assessee-firm challenged the order of the Commissioner before Income
    Tax Appellate Tribunal. The tribunal allowed the appeal of the assessee
    holding that the valuation of the closing stock at market value cannot be
    adopted since. the assessee-firm continued to carry on its business with the
    remaining partners. In appeal, High Court held in favour of the Revenue.

G         In appeal to this Court, Revenue contended that the closing stock has
    to be valued at market value on the basis of the decision in A.LA Firm v.
    Commissioner of Income Tax, (1991) 189 ITR 285 SC.

         Allowing the appeal, the Court

H                                        214
                SAKTHI TRADING CO. v. C.l.T. [Y.K. SABHARWAL, l.]               215

          HELD 1.1. In A.l.A Firm v. Commissioner of Income Tax, (1991) 189 ITR         A

-
    285 SC this Court was considering the question of valuation of closing stock
    at market value where there was dissolution and also discontinuance of the
    business of the firm. In the present case, though there was dissolution on
    account of the death of one of the partners, there was no discontinuance of
    the business, which was the unchallenged finding of the tribunal. Even as per       B
    the principles laid down in A.l.A. Firm's case, the closing stock is to be valued
    at cost or market value, whichever is lower, which is the established rule of
    commercial practice and accountancy. The High Court was in error in coming
    to the conclusion that the assets had to be valued at market value. In the
    present case, there has been no cessation of business and, therefore, the closing
    stock could not be valued at the market rate. (222-F-H; 223-A(                      C
         A.l.A Firm v. Commissioner of Income Tax, (1991) 189 ITR 285 SC G.R.
    Ramchari and Co. v. Commissioner of Income Tax, Madras (1961) 41 ITR 142
    (Mad), distinguished.

         Kikabhai Premchand v. CIT, (1953) 24 ITR 506 (SC) and Chainrup                 D
    Sampatram v. CIT (1953) 24 ITR 481 (SC), referred to.

            CIVIL APPELLATE JURISDICTION : Civil Appeal No. 3818 of
    1999.

          From the Judgment and Order dated 1.12.98 of the Madras High Court            E
    in T.C. No. 954 of 1992.

         R. Venkataraman, V. Prabhakar and Reva thy Raghavan for the
    Appellant.

         Dr. V. Gauri Shankar, Neera Gupta and Ms. Sushma Suri for the                  F
    Respondent.

         The Judgment of the Court was delivered by

          Y. K. SABHARW AL, J. At the instance of the Revenue the question,
    in respect of the assessment year 1984-85, that was referred for the opinion        G
    of the High Court was :

            "Whether on the facts and in the circumstances of the case where on
            the dissolution of the firm the business is taken over by a partner
            without discontinuance and the value of the closing stock determined
            under the regular method of accounting is accepted by the partners in       H
    216                      SUPREME COURT REPORTS [2001] SUPP. 1 S.C.R.

A           the settlement of accounts for dissolution purposes, the Income-tax
            Officer can substitute the market value in respect of the closing stock
            alone for the purpose of determining the income of the firm upto the
            date of dissolution?"

            Briefly; the facts are as follows :
B
            The assessee is a registered firm. As a result of the death of one out of
     its six partners, on February 6, 1984, the firm was dissolved. It was, however,
     reconstituted with effect from the next day, that is, 7th February, 1984 with
     the remaining five partners. Two orders of assessments were made; one for
    the period upto February 6, 1984 and the other for the period from 7th
C    February, 1984 to 31st March, 1984. The Commissioner of Income Tax
    made an order under Section 263 of the Income Tax Act, 1961 as according
    to him the assessment order made by the Income Tax Officer was erroneous
    and prejudicial to the interest of the Revenue in valuing the stock in trade as
    on 6th February, 1984 on the basis of cost or market rate, whichever is lower
D   as that was the usual method the assessee used to adopt in valuing its stock.
    The Commissioner of Income Tax relying upon the decision of the Madras
    High Court in A.l.A Firm v. Commissioner of Income-tax, (1991) 189 ITR
    285 came to the conclusion that the Income Tax Officer ought to have valued
    the closing stock at its market rate as on 6th February, 1984. Thus, setting
    aside the assessment order dated 30th May, 1984, the Income Tax Officer
E   was directed to pass a fresh order.

          The order of the Commissioner of Income Tax was challenged by the
    assessee in appeal before the Income Tax Appellate Tribunal. The contention
    of the assessee before the Tribunal was that the question of valuing the
    closing stock at the market value can arise only on discontinuance of the
F   business and as the business of the firm was never discontinued but was
    taken over on succession by another firm, the closing stock was not required
    to be revalued at the market value. The Tribunal found that the firm was
    reconstituted with the remaining five partners under the partnership deed
    dated 6th March, 1984 w.e.f. 7th February, 1984. The new deed recited that:
G          "Whereas the above said parties were carrying on business in Erode
           in the name "Sakthi Trading Company" along with one Shri P.
           Chenniappan S/o late Sri Palanippa Gounder, Erode and whereas the
           above said P. Chenniappan died on 6.2. I 984, the parties hereto having
           decided to continue the business with all assets and liabilities in
H          partnership from 7.2.1984 as orally agreed, this deed is drawn up
                 SAK THI TRADING CO. v. C.l.T. (Y.K. SABHARWAL, J.]             217

             reducing the oral agreement between the parties hereto taking effect     A
             from 7.2.1984, to carry on business in partnership upon the following
             terms and conditions."

              The Tribunal came to the conclusion that if the business itself is
    . discontinued and the stocks are realised then the value realised would have
       to be substituted for the value given in the accounts but where the business B
       was not discontinued though the firm was dissolved, the question of realising
      .the value of the goods does not arise and there was no necessity for revaluing
       fhe closing stock. According to the Tribunal, there was no warrant for
       revaluation of stock in a continuing business and the order of the Income Tax
       Officer accepting the profit shown by the assessee, on the method of accounting C
       regularly followed, was not in any way erroneous and did not require to be
       revised under Section 263. In respect of the decision of the Madras High
       Court in A.L.A. Firm's case (supra), the Tribunal noticed that the firm in the
       said case had closed its accounts on 13th March, 1961, the date of dissolution
       and profit was arrived at by crediting to the profit and loss account the
       difference on revaluation of stock as on that date, but for income-tax purposes, D
       the firm claimed that difference should be written back and the profit adjusted.
       The High Court did not countenance such a claim and following its earlier
       decision in G.R. Ramachari & Co. v. Commissioner of Income-tax, Madras,
      (1961) 41 !TR 142 (Mad)] held that when there is a dissolution, the stock in
      trade should be valued at market value. In this case, the Tribunal noticed that E
      the question posed was that where the value of the stock had been accepted
       by the partners upon dissolution; it could not be varied by the Income-tax
      Officer. The Tribunal was of the view that if on the dissolution of a firm, the
      business is also discontinued and the value of the. stock realised, it may be
      possible for the Income-tax. Officer to insist that the value realised shall be
      taken as the value of the c!Osing stock instead of any notional value on the F
      regular principle of cost or market value, whichever is less. But where the
      business is not discontinued, the question of revaluing the stock cannot arise
      at all. The Tribunal held that the valuation of the closing stock of a continued
      business on the principle of cost or market value whichever is less cannot be
•    substituted with the market value only because the firm carrying on that
     business is dissolved and the business is taken over by another firm consisting G
     of the remaining partners. In respect of A.LA. Firm's case (supra), it was
     noticed that that was a case where partners had agreed to. substitute the
     market value and wanted to retract from it. Both in the case of Ramachari
     and A.LA. Firm, there was discontinuance of the business which was not so
     in assessee 's case and, therefore, there was no warrant for revaluation ·as H
    218                       SUPREME COURT REPORTS [2001] SUPP. I S.C.R.

A directed by the Commissioner of Income-tax whose order under Section 263
    was set aside and appeal of the assessee was allowed.

           The High Court by judgment under challenge has answered the question
     in favour of the Revenue and, therefore, the assessee is in appeal before us.

B          In this appeal, the question is not whether two assessment orders were
    required to be passed or not but is as to whether the value of the closing stock
    was required to be determined on the market value for dissolution purposes
    upto the date of dissolution when the business has been taken over by
    remaining parties without discontinuance. The question itself suggests that
C   the business was not discontinued. As noticed above, on the dissolution of
    the firm on 6th February, 1984 as a result of the death of one of the partner,
    the remaining partners continued the business w.e. f. 7th February, 1984. The
    question of valuing the closing stock on market value is required to be
    answered where business is not discontinued on the dissolution of the firm.

D         The Tribunal has recorded a finding that the business was not
    discontinued and this was the ground on which the decisions of Madras High
    Court in the case ofG.R. Ramachari & Co. and A.LA. Firm were distinguished
    stating that "moreover in both of those cases there was a discontinuance of
    the business itself which is not the case in the present case". In A.l.A. Firm's
E   case, the appeal filed by the assessee has been dismissed by this Court.

            According to the contention urged on behalf of the Revenue, the question
    in the present case is squarely covered by the decision in the case of A.l.A.
    Firm. Refuting this contention, learned counsel for the appellant contends
    that the facts of said case are clearly distinguishable and, in fact, the principles
F   l:iid therein support the assessee. The decision in A.l.A. Firm's case deserves
    to be examined in some detail.

         In that case three questions of law were referred for the opinion of the
    High Court but we are concerned with the second question which was as
    under :
G
            "Whether, on the facts and circumstances of the case, the assessment
            of the sum of $ I 01,248 as revenue profit of the assessee-firm
            chargeable to tax for the assessment year 1961-62 is justified in law?"

          The facts under which this question arose were that the assessee, a
H   partnership firm, was carrying money lending business in Malaya and as part
             SAKTHI TRADING CO. v. C.I.T. (Y.K. SABHARWAL. J.)                 219

  of and incidental to the said business, it was also carrying on the business of A
· the purchase and sale of house properties, gardens and estates. The assessee
  firm was reconstituted under a deed dated 26th March, 1960. The firm's
  accounts for the year 1960-61, which commenced on 13th April, 1960 would
  normally have come to close on or about 13th April, 1961. However, the firm
  closed its accounts as on 13th March, 1961, with effect from which date it E
  was dissolved. Along with its income-tax return for the assessment year
   1961-62 filed on I 0th April, 1962, the assessee filed a profit and loss account
  and certain other statements. In the profit and loss account, a sum of $
   IO 1,248 was shown as "difference on revaluation of estates, gardens and
   house properties" on the dissolution of the firm on 13th March, 1961, such
   difference being $ 70,500 in respect of "house properties" and $ 30, 748 in (
   respect of estates and gardens. In the memo of adjustment for income-tax
   purposes, however, the above sum was deducted on the ground that it was
   not assessable either as revenue or capital. A statement was also made before
   the officer that partner Ramanathan Chettiar forming one group and the other
   partners forming another group were carrying on business separately with the
   assets and liabilities that fell to their shares on the dissolution of the firm. For D
   the subsequent assessment year 1962-63, the assessee filed a return showing
   nil income along with a letter pointing out that the firm had been dissolved
   on 13th March, 1961. Thereafter, on 3rd September, 1963, the Income-tax
   Officer wrote a letter to the assessee to the effect that the revaluation difference
   of$ 101,248 should hav.e been brought to tax in the assessment year 1961- E
   62 in view of the decision of Ma4ras High Court in G.R. Ramachari & Co.
  v. CIT. He called for the. basis for the valuation and also for the assessee's
  objections. The assessee sent a reply stating that no profit or loss could be
  assessed on revaluation of assets. Relying on a circular of the Central Board
  of Revenue dated.21st June, 195.6, it was urged that the assessee was gradually
  winding up its business in Malaya and that, therefore, the surplus would only F
  be capital gains. It was urged that the revaluation had been at the market
  price prevalent since !st January, 1954 and that, therefore, no capital gains
  were chargeable to tax. The Income-tax Officer completed the reassessment
  on the firm after adding back a sum of Rs. 1,58,057 (equivalent to$ 101,248)
  to the previously assessed income. The assessee having failed upto the High G
  Court in reference was in appeal before this Court. This Court held that the
  question is squarely covered by the decision of Madras High Court in
  Ramachari's case wherein it had been held that principle of valuing the
  closing stock of a business at cost or market price at the option of the
  assessee is a principle that would hold good only so long as there is a
 .continuing business and that where a business is discontinued, whether on H
    220                      SUPREME COURT REPORTS [2001] SUPP. I S.C.R.

A   account of dissolution or closure or otherwise by the assessee, then the profits
    cannot be ascertained except by taking a closing stock at market value. The
    contention of the assessee was that while it is true that the closing stock has
    to be valued, the well settled principle is that it should be valued at cost or
    market price, whichever is lower, and there is no justification for laying
B   down a different principle for valuation of the closing stock at the point of
    discontinuance of business unless the goods are actually sold by the assessee
    at the time of discontinuance. Reliance was also placed on a series of decisions
    holding that when a firm is dissolved and assets are distributed among the
    partners, there is no sale or transfer of the assets of the firm to the various
    partners.
c          The submission was that revaluation of the assets of a firm which is
     only for the division of assets among the partners on a real and not a notional
     basis is part of the division of the assets and, therefore, logically, in point of
     time, subsequent to the dissolution of the firm and since the revaluation takes
     place after the dissolution, no profits can be said to have accrued to the firm
D    by the process of revaluation. It was urged that there is no principle by which
     the stock-in-trade can be valued at market price so as to bring to tax the
     notional profits which might in future be realised as a result of the sale of the
    stock-in-trade. This Court rejected the contention that Ramachari's case does
    not lay down the correct law and held that the High Court was right in
    pointing out that the several decisions relied upon for the assessee as to the
E   nature of the transaction by which a firm, on dissolution, distributes its assets
    amongst its partners, have no relevance in the case since those cases relate
    to what happens after or in consequence of the dissolution of a firm whereas
    in that case the Court was concerned with a question that arose before or at ,
    the time of dissolution.
F
           Dealing with the principle that permits the assessee to value the stock
    at cost, in Kikabhai Premchandv. CIT, (1953) 24 ITR 506 SC Bose, J. said
    that :



G
            "The appellant's method of book-keeping reflects the true position.
            As he makes his purchases he enters his stock at the cost price on one
            side of the accounts. At the close of the year he enters the value of
                                                                                          -
            any unsold stock at cost on the other side of the accounts thus
            cancelling out the entries relating to the same unsold stock earlier in
            the accounts; and then that is carried forward as the opening balance
            in the next year's account This cancelling out of the unsold stock
H           from both sides of the accounts leaves only the transactions on which
             SAKTHITRADINGCO. v. C.l.T. [Y.K. SABHARWAL,J.]                   221

          there have been actual sales and gives a true and actual profit or loss     A
          on his year's dealings".

         In A.l.A. Firm's case, the observations of Bose, J. were noticed and it
  was pointed out that the valuation of the closing stock at market value would
  invariably create a problem. For, if the market value is higher than cost, the
  accounts will reflect notional profits not actually realised. On the other hand,    B
  if th~ market value is less, the assessee will get the benefit of a notional loss
· he has not incurred. Nevertheless, the ordinary principle of commercial
  accounting permits valuation "at cost or market, whichever is the lower". The
  rationale behind it was explained by Patanjali Sastri, C.J. in Chainrup
  Sampatram v. CIT, (1953) 24 !TR 481 SC wherein it was observed that:                C
           "It is wrong to assume that the valuation of the closing stock at
           market rate has, for its object, the bringing into charge any appreciation
           in the value of such stock. The true purpose of crediting the value of
           unsold stock is to balance the cost of those goods entered on the other
          side of the account at the time of their purchase, so that the cancelling D
          out of the entries relating to the same siock from both sides of the
           account would leave only the transactions on which there have been
          actual sales in the course of the year showing the profit or loss actually
           realised on the year's trading. As pointed out in paragraph 8 of the
          Report of the Committee on Financial Risks attaching to the holding E
          of Trading Stocks, 1919, ·As the entry for stock which appears in a
          trading account is merely intended to cancel the charge for the goods
          purchased which have not been sold, it should necessarily represent
          the cost of the goods. If it is more or less than the cost, then the effect
          is to state the profit on the goods which actually have been sold at
          the incorrect figure . . . . From this rigid doctrine one exception is F
          very generally recognised on prudential. grounds and is now fully
         sanctioned by custom, viz., the adoption of market value at the date
         of making up accounts, if that value is less, than cost. It is of course
         an anticipation of the loss that may be made on those goods in the
         following year, and may even have the effect, if prices rise again, of
         attributing to the following year's results a greater amount cif profit G
         than the difference between the actual sale. price and the actual cost
         price of the goods in question' (extracted in paragraph 281 of the
         Report of the Committee on the Taxation of Trading Profits presented
         to British Parliament in April 1951). While anticipated loss is thus
         taken into account, anticipated profit in the shape of appreciated value H
     222                      SUPRE;v!E COURT REPORTS [2001] SUPP. I S.C.R.

 A           of the closing stock is not brought into account, as no prudent trader
             wou Id care to show increased profit before its actual realization. Th is
             is the theory underlying the rule that the closing stock is to be valued
             at cost or market price whichever is the lower, and it is now generally
             accepted as an established rule of commercial practice and
             accountancy."
 B
            This Court thus held that the proper practice is to value the closing
     stock at cost. That will eliminate entries relating to the same stock from both
     sides of the account. To this rule, custom recognises only one exception and
     that is to value the stock at market value if that is lower. But on no principle
     can one justify the valuation of the closing stock at a market value higher
 C   than cost as that will result in the taxation of notional profits the assessee has
     not realised.

           The consideration which prevailed with the High Court in A.L.A. Firm's
     case is reflected in the following passage of the High Court's judgment:

D            "It seems to us that none of these cases has any application to the
             fads of the present case. There is no authority directly in point dealing
             with this question, where a partnership concern dissolves its business
             in the course of the accounting year, what is the basis on which the
             stock-in-trade has to be valued as on the date of dissolution. We have
             accordingly to deai with the matter on first principles."
E
           This Court wh_ile dismissing the appeal of the assessee found substance
     in this consideration that prevailed with the High Court.

          From the above, it is evident that in A.L.A. Firm's case this Court was
   considering the question of valuation of closing stock at market value in a
F case where there was dissolution and also discontinuance of the business of
   the firm. In that case after dissolution, two groups were carrying on separate
   business with the assets and liabilities which fell to their shares from the           ..
   dissolution of the firm. In the present case, however, though there was
   dissolution on account of the death of one of the partners, but there was no
G discontinuance of the business. The unchallenged finding recorded by the
   Tribunal is that there was no discontinuance of business. Even as per principles
   laid down in A.L.A. Firm's case in such a case the closing stock is to be
   valued at the cost or market price, whichever is lower. That is an established
   rule of commercial practice and accountancy. The High Court was clearly in
   error in relying upon the decision of the Madras High Court in the cases of
H ·Ramachari and A.L.A. Firm for coming to the conclusion that assets had to
           SAKTHITRADING CO. v. C.I:T. [Y.K. SABHARWAL,J.]                 223
be valued at market value. As already noticed, in the present case, there has      A
no cessation of business and, therefore, the closing stock could not be directed
to be valued at the market rate.

     For the aforesaid reasons, we answer the question in negative, i.e., in
favour of the assessee and against the Revenue.
                                                                                   B
      The appeal is accordingly allowed. The appellant will also be entitled
to costs.

B.S.                                                          Appeal allowed.