As assessees (i.e., taxpayers) are heading towards income-tax return filings (primarily for cases involving the statutory filing due dates, for non-tax audit cases) within 31 July, it may be imperative to note a few relevant provisions under the Income-tax Act, 1961 (“the IT Act” or “the Act”) in relation to books of account which may potentially impact the tax assessment (i.e., revenue audit) proceedings.

The Act provides for the method of accounting required to be adopted by taxpayers for purpose of reporting transactions related to “business income” and “income from other sources”.

To elaborate, the Act provides that the income from the aforesaid heads of income are required to be computed “in accordance with either cash or mercantile system of accounting regularly employed by the assesse”. The Central Government is also empowered to notify income computation & disclosure standards to be followed by any class of taxpayers or in respect of any class of income.

In the event the tax officer is not satisfied about the correctness or completeness of the accounts, or where the method of accounting cash or mercantile entries has not been regularly followed by the taxpayer, or where the accounting standards as notified by the Central Government have not been followed by the taxpayer, the tax officer is then empowered under law to make a “best judgement assessment”.

Historically, the Act empowered taxpayers to compute income either on cash / receipt basis, accrual / mercantile basis, or mixed / hybrid basis which had element of both cash and accrual basis of accounting. However, it was then noticed that many taxpayers followed a hybrid method which did not reflect true income earned (or loss incurred). Therefore, there was an amendment made in the provisions of Act in 1995 to provide for only the two methods of accounting (i.e., cash or mercantile) for income-tax reporting purposes.

On a practical / realistic level however, it may be noted that in case of certain taxpayers (especially companies), the method of accounting generally being followed is on mercantile basis (and not cash basis) in accordance with underlying accounting standards under applicable corporate laws (failing which there could be a reservation / qualification by the auditors in the financial statements, for financial reporting purposes).

The cash system is based on accounting for income on actual receipt basis (whether received in money or in money’s worth / in kind) and accounting for expense on actual spend / disbursement basis. Therefore, under the said system, taxpayers cannot take into account any outstandings and / or bad debts related the business (as the actual receipts / spends are itself intended to factor these into the results reported). Similarly, if anything (other than money itself) is received by taxpayers in exchange of satisfying a legal obligation by the payer, the relevant taxpayer should take in account the income embedded therein (i.e., money’s worth) and should generally not defer the said treatment until there is actual conversion into money / cash.

On the other hand, under the mercantile system, as held in various tax rulings / case laws, the principle of credit entries (for income recording purposes) are made in respect of the amounts due immediately when they become legally due to be receivable (and even before they are actually received or enforced for payment). Similarly, the principle of debit entries (for expense recording purposes) are made for expenditure items for which legal liability has been triggered / incurred (and even before the amounts in question are actually disbursed or paid out). In summary, where accounts are maintained on mercantile basis, the profits / gains are reflected although they are not actually realized and the books of accounts disclose the event of accrual of the said profits / gains for the relevant accounting period. A critical factor to note in such cases is that the right to receive or the liability to pay should be legally enforceable (which is generally determined based on contractual arrangement between the parties) and cannot merely represent a contingent or conditional liability (where the underlying event has itself not occurred).

As mentioned above, a tax officer can make a best judgment assessment only in specific cases. Having said this, it may also be noted that the tax officer should have definitive / specific defects as observed in the books of account of a taxpayer before invoking such as assessment.

For example, a mere fall in gross profit rate cannot by itself empower the tax officer to invoke a best judgment assessment under Section 144 unless the tax officer evaluates the underlying parameters / factual aspects and then leads to a conclusion that the books of account are inappropriate.

Even in the event a best judgment route is adopted for certain taxpayers, it is relevant to note (based on principles cited under various tax rulings / case laws) that the tax officer having jurisdiction over the matter cannot act arbitrarily or capriciously but is required to act based on relevant material brought on records. Tax tribunals and Courts have upheld the principle that the tax officer’s powers under section 145 are not arbitrary and that he / she must exercise his / her discretion and judgment judicially. In other words, a clear finding is necessary before invoking the provisions of section 145(3) of the Act and the tax officer should bring on record any material on the basis of which he / she has arrived at the conclusion with regard to rejecting the books of account &invoking the best judgement assessment provisions. The tax officer is also required to provide the taxpayer an opportunity to rebut (contradict) any materials upon which the tax officer wants to base his / her estimate under the best judgment assessment process.

Some of the key aspects therefore that may be relevant in the context of a potential rejection of books of account are given below.

1. Maintenance of stock register is sometimes not practically feasible in certain businesses on a day-wise or quantity-wise basis, but it may be extremely beneficial for taxpayers to have appropriate explanation/ business reasons to defend gross-profit rate reflected for the business.

2. While it is ideal to have vouchers / bills to support all underlying expenditures to substantiate entries in the books of account (except in cases where absence thereof could by itself trigger an expense limitation / restriction based on other provisions of the Act), one may also note that reasonableness of expenditure should also be judged from the view point of the business carried on by the taxpayer (and not solely from the view point of the taxing authorities).

Any rejection of books of account merely on account of a lower gross profit / net profit rate in comparison to earlier years or with other taxpayers in similar circumstances would not by itself be a tenable position for the taxing authorities to invoke a best judgement assessment.

Having said the above, where there is significant absence of registers and vouchers / bills and resultant profits are also low (and not explainable as compared to profit ranges earned and assessed as such during earlier years tax assessment), it may give a reasonable cause to the taxing authorities that the books of accounts cannot be completely be relied upon.

In such a situation, there could be consequentially be reasonable cause for the taxing authorities to reject the books of account and to proceed towards a best judgment assessment.

3. Any changes in the method of accounting should not be followed arbitrarily by taxpayers and it is ideal to follow a particular method consistently (although a justifiable change in a given year may be acceptable, provided that the same methodology is followed subsequently on a consistent basis). It may also be noted that any change in the accounting policy having a financial impact on the current year and / or subsequent years and the impact of the consequential adjustments should be disclosed appropriately in the financial statements of the year in which any such changes occur.

4. Books of accounts and the adequacy thereof for a given year have to be evaluated on a stand-alone basis as each tax assessment (i.e., revenue audit) is a separate and independent process. Further, there is no provision under the Act to enable the taxing authorities for any assumption / presumption that where books for accounts for any earlier year/s have been rejected that the same position as relates to rejection can by itself be followed for any subsequent year/s without an independent evaluation of the underlying facts.

5. Provisions of the Act generally prevail over the notified Income Computation & Disclosure Standards (“ICDS”) in the case of any conflict. However, as the ICDS are notified by the Central Government itself (through delegated powers to the Central Board of Direct Taxes or “the CBDT”), it may be prudent to follow such ICDS unless the taxpayer adopts a position that any part of the ICDS itself conflicts with the provisions under the Act (with the caution that the tax officers may not necessarily yield to such positions, particularly where there is no change in the law after the ICDS have been notified). Hence, adequate documentation are best maintained upfront to rebut any challenge by the taxing authorities during the course of tax assessment that the books of accounts are not prepared in accordance with section 145(2) of the Act.

6. Taxpayers should also note that account books cannot be rejected on mere suspicion or conjecture unless the accounts are kept in such a way that reliance cannot be placed upon them. However, if the method of accounting followed by taxpayers is by itself so defective that there is a possibility of suppression and leakage, the accounts can be rejected without any further material. On the other hand, if the accounts are properly maintained with all the relevant details, it is necessary for the taxing authority to place on record some material to show that the accounts are not reliable. It may also be mentioned  in this connection that reporting lower profits (whether at the gross level or the net level) cannot by itself represent the basis for rejecting the books of account (albeit it could be the basis for the taxing authorities to examine in more detail whether material exists to prove that accounts have been falsified).

7. Taxpayers are also required to be given an opportunity of being heard and / or to rebut the position being proposed by the taxing authorities in respect of estimating income by invoking the provisions of section 145(3) of the Act.However, note that it may be a relatively difficult proposition on this count where adequate opportunity has been provided to produce books of account under the provisions of section 142(1) of the Act.

8. Note that there is a relatively higher burden of proof on the taxing authorities to reject audited books of accounts, in the sense that the taxing authorities are required to point out how the method of accounting followed is itself defective failing which the books of accounts cannot be rejected.

9. Similarly, note that taxing authorities generally cannot reject books of account merely on account of a qualification by the auditors (unless the said qualification significantly creates a doubt on the books of account itself coupled with other evidences as well).

Taxpayers are therefore better placed to appropriately maintain books and records (with transactions for income-tax reporting purposes reflected under applicable ICDS) and to also have adequate documentation / explanation maintained upfront for underlying transactions (especially in cases where the profit ranges have dropped in the year of reporting, which could also be due to genuine business / commercial reasons) so it helps during the during the course of tax assessments.