THE issues before the Bench are - Whether valuation of closing stock at market price is permissible only in cases where the business is discontinued and not where the business carried on by the partnership firm was taken over by a successor company without any interruption on conversion of firm into company and Whether the provision of section 40A(3) is attracted only when there is actual payment of cash from one person to another and not where transaction takes place only as part of exchange. And the answers favour the assessee.
On further appeal by the Revenue, held that,
Facts of the case
The assessee is a partnership firm, carrying on jewellery and diamond business. The partnership firm M/s.Keertilal Kalidas & Co. was converted into a private limited company on 1st January, 2008. The incorporation of the company was made
The assessee is a partnership firm, carrying on jewellery and diamond business. The partnership firm M/s.Keertilal Kalidas & Co. was converted into a private limited company on 1st January, 2008. The incorporation of the company was made
under Part IX of the Companies Act, 1956. The conversion was made on a going concern basis, such that the business carried on by the erstwhile firm continued to be carried on by the company incorporated on 1-1-2008 without any interruption. The business continued as such, even though the nature of the business organization changed from that of partnership firm to that of a private limited company. All the assets, liabilities, etc. of the erstwhile firm vested with the company on incorporation, as provided u/s 575 of the Companies Act, 1956.
In the light of the above developments, the newly formed company M/s.Keertilal Kalidas Jewellers Pvt. Ltd. filed the return of income for the impugned assessment year 2008-09, for the entire period of the previous year consisting of twelve months from 1st April, 2007 to 31st March, 2008. The company, in its assessment proceedings, submitted before the AO that the company being the successor in business, the entire income is assessable in its hands for the first fraction of the previous year from 1st April, 2007 to 31-12-2007 as the successor in business and for the second fraction from 1st January, 2008 to 31st March, 2008 as its own business.
In the assessment of the company M/s.Keertilal Kalidas Jewellers Pvt. Ltd., the AO proceeded to assess the income for the period of three months from 1-1-2008 to 31-3-2008 in the hands of the said company. The AO having jurisdiction over the assessee firm, issued a notice u/s 142(1), requiring the firm to file its return of income for the assessment year 2007-08 comprising the period from 1-4-2007 to 31-12-2007. Thereafter, a notice u/s 148 was issued to the assessee firm. The assessee firm, in response to the notice, filed a letter before the AO stating that the firm M/s.Keertilal Kalidas & Co. has been converted into a company by name M/s.Keertilal Kalidas Jewellers Pvt. Ltd. with effect from 1-1-2008 and thus a consolidated balance sheet alone was required to be filed for the impugned assessment year 2008-09. However, the assessee firm, in response to the notice issued u/s 148, has also filed a return of income in the status of the firm for the previous period of 1st April, 2007 to 31st December, 2007.
In the course of the assessment, in pursuance of the return filed in response to the notice u/s 148, the AO made certain adjustments to the income returned by the assessee firm. The first adjustment by way of addition has its basis on the stock valuation. The AO held the view that on conversion of the firm into a company with effect from 1-1-2008, the business of the firm needs to be considered as dissolved. The AO accepted the business carried on by the assessee firm for the period from 1-4-2007 to 31-12-2007 and thereafter treated it as a dissolved business. As the firm was dissolved, it was the view of the AO that the closing stock of jewellery and diamond of the firm must be valued at market price and the profit of the firm has to be computed on the basis of that market value of jewellery. The AO relied on the judgment of the Supreme Court rendered in the case of A.L.A.Firm vs. CIT, wherein the Supreme Court has considered the issue of valuation of stock in the context of dissolution of a firm. The Supreme Court held that while the valuation of assets during the subsistence of the partnership would be immaterial and could even be notional, the position at the point of dissolution is totally different. In taking accounts for purposes of dissolution, the firm and the partners, being commercial men, would value the assets only on a real basis and not at cost or at their other value appearing in the books. The real rights of the partners cannot be mutually adjusted on any other basis. The surplus, if any, has to be considered as chargeable revenue profits of the firm. In addition to the above judgment of the apex court, the AO also relied on the judgment of the Madras High Court rendered in the case of CIT vs. India Reinforcing Co., 188 ITR 651. Accordingly, the AO replaced the stock value offered by the assessee firm and adopted the market value, as a result of which an addition has been made to the extent of Rs. 26,51,49,027/-.
The next adjustment of addition made by the AO is on the ground of violation of section 40A(3). The assessee in the course of carrying on of its business, was collecting old gold jewellery from its customers and in its place selling new ornaments. The differential amount alone is paid by the customers to the assessee firm. The AO bifurcated this transaction into two segments. According to the AO, the delivery of old ornaments by the customers to the assessee firm comprised of different set of transactions and those transactions amounted to purchase of old ornaments by the assessee firm from its customers. The AO treated the other segment of the transaction as sale of new gold ornaments to the customers of the assessee firm. Regarding the first set of transactions, i.e. purchase of old ornaments from the customers, the AO held that the assessee firm was making cash payments equivalent to the value of the old ornaments purchased and to that extent there is violation of section 40A(3). The AO held that in all such cases cash payments exceeded the limit of Rs. 20,000/- and such payments need to be disallowed. On verification of the accounts, the AO worked out the amount covered by such violation u/s 40A(3) to the extent of Rs. 11,37,78,775/-. The AO also found that no details in the form of bills or vouchers were available in respect of another sum of Rs. 13,11,390/-. These two amounts of Rs. 11,37,78,775/- and Rs. 13,11,390/- were added up and treated as the quantity of violation u/s 40A(3). The total of these amounts, amounting to Rs. 11,50,90,165/-, has also been added to the income of the firm.
The CIT(A) found that the purchase of old gold was only part of exchange of old jewellery against sale of new jewellery to the same person and there was no de facto payment of cash by the assessee to the customers. He observed that in order to attract the provisions of section 40A(3), there should be actual payment of cash from one person to another. He observed that on verification of some of the transactions it was clear that there were no such cash payments made by the assessee to the customers so as to attract the provisions of law stated in section 40A(3). He also observed that the AO has not brought on record the instances where the assessee had made actual payment of cash to the customers at the time of purchase of old jewellery. Therefore, he held that the AO has erred in invoking the provisions of section 40A(3) of the Act.
Regarding the question of adopting the market price of jewellery at the time of conversion of partnership firm into joint stock company, the CIT(A) found that valuation of closing stock at market price is applicable only in cases where the business is discontinued. He found that in the present case the business carried on by the firm was never discontinued, but, on the other hand, the business was taken over by a successor company without any interruption. He observed that all the assets and liabilities of the firm were vested with the company and as per section 575 of the Companies Act, 1956, all properties vest with the company at the time of registration pursuant to Part IX of the Companies Act and therefore there is no cessation or discontinuance of business. He accordingly held that the decision of the Supreme Court in the case of A.L.A.Firm vs. CIT, 189 ITR 285 is not applicable to the present case. He, on the other hand, relied on the judgment of the Kerala High Court in the case of CIT vs. S.Koder, 233 ITR 620, wherein the court has held that in the case of conversion of firm to private limited company, with erstwhile partners being the only shareholders and the business of the firm continued by the company, section 170 of the Income tax Act, 1961 applied and, therefore, stock of the firm could not be valued at market price. The CIT(A) also relied on the judgment of the Supreme Court in the case of Sakthi Trading Co. vs. CIT (2002-TIOL-569-SC-IT), wherein the apex court held that where a firm is reconstituted with the remaining partners on dissolution of firm on death of one of the partners and without discontinuance of business, the closing stock of the firm needs to be valued at cost or market price, whichever is lower. He also relied on the judgment of the Madras High Court in the case of CIT vs. Standard Printing Machinery, 260 ITR 268 in support of the above proposition. In the light of the facts and judicial pronouncements, the CIT(A) held that the AO has gone wrong in valuing the closing stock at market price and accordingly he deleted the corresponding addition of Rs. 26,51,49,027/-.
In the light of the above developments, the newly formed company M/s.Keertilal Kalidas Jewellers Pvt. Ltd. filed the return of income for the impugned assessment year 2008-09, for the entire period of the previous year consisting of twelve months from 1st April, 2007 to 31st March, 2008. The company, in its assessment proceedings, submitted before the AO that the company being the successor in business, the entire income is assessable in its hands for the first fraction of the previous year from 1st April, 2007 to 31-12-2007 as the successor in business and for the second fraction from 1st January, 2008 to 31st March, 2008 as its own business.
In the assessment of the company M/s.Keertilal Kalidas Jewellers Pvt. Ltd., the AO proceeded to assess the income for the period of three months from 1-1-2008 to 31-3-2008 in the hands of the said company. The AO having jurisdiction over the assessee firm, issued a notice u/s 142(1), requiring the firm to file its return of income for the assessment year 2007-08 comprising the period from 1-4-2007 to 31-12-2007. Thereafter, a notice u/s 148 was issued to the assessee firm. The assessee firm, in response to the notice, filed a letter before the AO stating that the firm M/s.Keertilal Kalidas & Co. has been converted into a company by name M/s.Keertilal Kalidas Jewellers Pvt. Ltd. with effect from 1-1-2008 and thus a consolidated balance sheet alone was required to be filed for the impugned assessment year 2008-09. However, the assessee firm, in response to the notice issued u/s 148, has also filed a return of income in the status of the firm for the previous period of 1st April, 2007 to 31st December, 2007.
In the course of the assessment, in pursuance of the return filed in response to the notice u/s 148, the AO made certain adjustments to the income returned by the assessee firm. The first adjustment by way of addition has its basis on the stock valuation. The AO held the view that on conversion of the firm into a company with effect from 1-1-2008, the business of the firm needs to be considered as dissolved. The AO accepted the business carried on by the assessee firm for the period from 1-4-2007 to 31-12-2007 and thereafter treated it as a dissolved business. As the firm was dissolved, it was the view of the AO that the closing stock of jewellery and diamond of the firm must be valued at market price and the profit of the firm has to be computed on the basis of that market value of jewellery. The AO relied on the judgment of the Supreme Court rendered in the case of A.L.A.Firm vs. CIT, wherein the Supreme Court has considered the issue of valuation of stock in the context of dissolution of a firm. The Supreme Court held that while the valuation of assets during the subsistence of the partnership would be immaterial and could even be notional, the position at the point of dissolution is totally different. In taking accounts for purposes of dissolution, the firm and the partners, being commercial men, would value the assets only on a real basis and not at cost or at their other value appearing in the books. The real rights of the partners cannot be mutually adjusted on any other basis. The surplus, if any, has to be considered as chargeable revenue profits of the firm. In addition to the above judgment of the apex court, the AO also relied on the judgment of the Madras High Court rendered in the case of CIT vs. India Reinforcing Co., 188 ITR 651. Accordingly, the AO replaced the stock value offered by the assessee firm and adopted the market value, as a result of which an addition has been made to the extent of Rs. 26,51,49,027/-.
The next adjustment of addition made by the AO is on the ground of violation of section 40A(3). The assessee in the course of carrying on of its business, was collecting old gold jewellery from its customers and in its place selling new ornaments. The differential amount alone is paid by the customers to the assessee firm. The AO bifurcated this transaction into two segments. According to the AO, the delivery of old ornaments by the customers to the assessee firm comprised of different set of transactions and those transactions amounted to purchase of old ornaments by the assessee firm from its customers. The AO treated the other segment of the transaction as sale of new gold ornaments to the customers of the assessee firm. Regarding the first set of transactions, i.e. purchase of old ornaments from the customers, the AO held that the assessee firm was making cash payments equivalent to the value of the old ornaments purchased and to that extent there is violation of section 40A(3). The AO held that in all such cases cash payments exceeded the limit of Rs. 20,000/- and such payments need to be disallowed. On verification of the accounts, the AO worked out the amount covered by such violation u/s 40A(3) to the extent of Rs. 11,37,78,775/-. The AO also found that no details in the form of bills or vouchers were available in respect of another sum of Rs. 13,11,390/-. These two amounts of Rs. 11,37,78,775/- and Rs. 13,11,390/- were added up and treated as the quantity of violation u/s 40A(3). The total of these amounts, amounting to Rs. 11,50,90,165/-, has also been added to the income of the firm.
The CIT(A) found that the purchase of old gold was only part of exchange of old jewellery against sale of new jewellery to the same person and there was no de facto payment of cash by the assessee to the customers. He observed that in order to attract the provisions of section 40A(3), there should be actual payment of cash from one person to another. He observed that on verification of some of the transactions it was clear that there were no such cash payments made by the assessee to the customers so as to attract the provisions of law stated in section 40A(3). He also observed that the AO has not brought on record the instances where the assessee had made actual payment of cash to the customers at the time of purchase of old jewellery. Therefore, he held that the AO has erred in invoking the provisions of section 40A(3) of the Act.
Regarding the question of adopting the market price of jewellery at the time of conversion of partnership firm into joint stock company, the CIT(A) found that valuation of closing stock at market price is applicable only in cases where the business is discontinued. He found that in the present case the business carried on by the firm was never discontinued, but, on the other hand, the business was taken over by a successor company without any interruption. He observed that all the assets and liabilities of the firm were vested with the company and as per section 575 of the Companies Act, 1956, all properties vest with the company at the time of registration pursuant to Part IX of the Companies Act and therefore there is no cessation or discontinuance of business. He accordingly held that the decision of the Supreme Court in the case of A.L.A.Firm vs. CIT, 189 ITR 285 is not applicable to the present case. He, on the other hand, relied on the judgment of the Kerala High Court in the case of CIT vs. S.Koder, 233 ITR 620, wherein the court has held that in the case of conversion of firm to private limited company, with erstwhile partners being the only shareholders and the business of the firm continued by the company, section 170 of the Income tax Act, 1961 applied and, therefore, stock of the firm could not be valued at market price. The CIT(A) also relied on the judgment of the Supreme Court in the case of Sakthi Trading Co. vs. CIT (2002-TIOL-569-SC-IT), wherein the apex court held that where a firm is reconstituted with the remaining partners on dissolution of firm on death of one of the partners and without discontinuance of business, the closing stock of the firm needs to be valued at cost or market price, whichever is lower. He also relied on the judgment of the Madras High Court in the case of CIT vs. Standard Printing Machinery, 260 ITR 268 in support of the above proposition. In the light of the facts and judicial pronouncements, the CIT(A) held that the AO has gone wrong in valuing the closing stock at market price and accordingly he deleted the corresponding addition of Rs. 26,51,49,027/-.
++ violation of section 40A(3) - the CIT(A) has come to a finding that the assessee company did not make any cash payment to its customers while purchasing old ornaments. As a matter of fact, this is an age-old practice in jewellery business. In majority of cases the customers carry old ornaments to the jewellery shop and get them converted into new jewellery and make payments for the differential amount. Here also the assessee has followed the same practice prevalent in the industry. Wherever customers are bringing old jewellery, the assessee firm is recording it as purchase of old gold in order to satisfy statute and rule regarding sales-tax. This is because the assessee has to pay purchase tax at the time of buying of old ornaments. The expression that ‘the assessee has purchased old ornaments' is only technical in nature and meant only to satisfy sales-tax law. This is necessary because the assessee is bound to pay purchase tax on the value of the old jewellery received from the customers. The sales-tax law treats it as a purchase. But for all practical purposes the customer is entrusting the old jewellery to the assessee firm for converting it into new jewellery and the actual sale and purchase transactions take place only in respect of the additional gold provided by the assessee firm. Where the surrender value of the old jewellery entrusted by the customers to the assessee firm is Rs. 100/- and the value of new jewellery returned by the assessee is Rs. 200/-, the differential amount of Rs. 100/- alone is paid by the customers to the assessee. The assessee is not making payment of Rs. 100/- to the customer at the time of accepting the old ornaments. That is why the CIT(A) has correctly appreciated that the entire transaction consisted of cash entries as well as journal entries. The cash entries related to the payment of the differential amount by the customers to the assessee firm. There is no payment of cash by the assessee firm to its customers at the time of receipt of old ornaments;
++ therefore, the CIT(A) has correctly appreciated the facts of the case and has rightly come to the conclusion that the assessee has not made payments to the customers at the time of purchase of old jewellery. Therefore, there is no question of the assessee violating the provisions of law stated in section 40A(3). The order of the CIT(A) deleting the addition of Rs. 11,37,78,775/- is upheld;
++ valuation of closing stock at the time of conversion of the partnership firm into a private limited company – The Kerala High Court in the case of CIT vs. S.Koder, had an occasion to consider a similar issue. A firm was converted into a private limited company, the erstwhile partners being the only shareholders. The business of the firm was continued by the company. The court held that section 170 of the Income-tax Act, 1961 applied and it was a case of succession of business. The court held that in such circumstances the stock of the firm could not be valued at market price. The Tribunal has observed in that case that the intention of the partners in transferring the business to a private limited company was to change the form of organization. The Tribunal had recorded a finding that the dissolution was consequential to the transfer of business to the company. It was in those circumstances that the Kerala High Court found that it was a clear case of succession of business, inasmuch as it was not a case where dissolution preceded the transfer. Therefore, the High Court held that there was no compulsion to value the closing stock at market price;
++ in a slightly different context, the very same issue was considered by the Supreme Court in the case of Sakthi Trading Co. vs. CIT (2002-TIOL-569-SC-IT). In that case the assessee was a registered firm. One of the partners expired. As a result of the death, the firm was dissolved. It was reconstituted the next day with the remaining partners. The Tribunal held that as the business of the firm was never discontinued, but was taken over on succession by another firm, the closing stock of the assessee firm on the date of dissolution was sought to be valued at cost or market price, whichever was lower. The Madras High Court held that the closing stock had to be valued at market price. The Supreme Court upheld the decision of the Tribunal holding that there was no cessation of business and therefore the closing stock had to be valued at cost or market price, whichever is lower. It is in this case that the Supreme Court has declared the relevant law that "it is an established rule of commercial practice and accountancy that where there is no discontinuance of business the closing stock is to be valued at cost or market price, whichever is lower";
++ the judgment of the Supreme Court in the case of A.L.A.Firm vs CIT, 189 ITR 285, relied on by the AO, provides rules for another set of circumstances. The rule of valuing the closing stock at market value was declared by the Supreme Court to be followed in a case where there is dissolution of the firm and discontinuance of business. In a case of succession of business the rule laid down by the Supreme Court in the case of A.L.A.Firm vs. CIT, 189 ITR 285, is not applicable;
++ therefore, the CIT(A) has rightly deleted the stock valuation addition of Rs. 26,51,49,027/-.
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