Principle of valuing inventory at lower of cost or market price is applicable only if the business is continuing.
JUDGMENT SRINIVASAN, J. – The assessee was a partnership concern consisting of two partners, Ramachari and Anantaram. It manufactured and sold textiles known as Bombay dhavanis. Its central office was at Madurai, and it had its branches at Bombay and Nagpur. In the course of the account year from April 13, 1944, to April 12, 1945, disputes arose between the partners which led to the dissolution of the partnership. It resulted in the accounts being taken in respect of the Madurai shop from April 13, 1944, to July 7, 1944, and the accounts of the Bombay and Nagpur shops up to September 11, 1944. It would also appear that Ramachari took over the entire stock. In the suit between the two parties in this connection, it was decided by the High Court that in order to settle the claims inter se the parties, the stock as on the final dates of accounting should be valued at the market price.
The original assessment for the assessment year 1945-46 had been completed on March 20, 1950. This was set aside on appeal by the Assistant Commissioner who directed that a fresh assessment should be made. It was found then that as against the value of stock which Ramachari took away relating to the Nagpur and Bombay branches which was shown in the books as Rs. 22,286, the valuation as fixed by the High Court for the settlement of the disputes among the partners was Rs. 31,001. The Department accordingly took the view that the difference represented the “realisable position” and that for the purpose of dissolution of a firm and consequent division of assets and liabilities the schedules that are prepared have to be on the basis of the ruling market price at the date of such dissolution as the valuation invokes adjustments of the rights and obligations of the partners inter se, the consequential profits pr loss requires to be ascertained and divided among the various partners. On this basis, the Department held that this difference of Rs. 8,715 represented the profits of the partnership and made the assessment accordingly. In appeal the Appellate Assistant Commissioner confirmed took over the stock in hand it was not equivalent to the taking over of stock from one accounting period to another but any profit arising from this sale even if it was only notional could be brought to tax. The further appeal to the Appellate Tribunal also failed. In the view of the Tribunal, notional stock valuation at the opening and the closing of the accounts every year was available only in respect of continuing businesses for unsold stock and that when a finality is reached in a business by the termination of the business as in this case, the necessity for such valuation disappears and the “actual realisation price of the stock by transfer to one of the partners at prices fixed by the decree has to take its place.”
Under section 66 (2) of the Act, the following question has been referred to us :
“Whether on the facts and in the circumstances of the case, the valuation of closing stock as on September 11, 1944, with reference of the branches at Bombay and Nagpur as adopted by the Tribunal was correct in law ?”
The facts are clear from what has been stated above, and the short question is whether, in a case where the business comes to an end, the assessee is entitled to value the closing stock in the same manner as he has been doing when he was continuing the business. It is not denied by the Department that the valuation of the stock both at the opening and the closing of any year was being made at cost price in earlier years when the business was continuing. The assessee claims that he is entitled to adopt the same method even when the business is closed and the assessable entity ceases to exist. A somewhat vague claim was put forward that in such an event what remains on hand as stock-in-trade loses its character as such and becomes capital assets. We are not prepared to accept this proposition. It is obvious that when a business ceases, all its stock-in-trade has to be disposed of and brought to account in order to balance the books. The goods of hand do not lose the character of stock-in-trade, and its proposition put forward by the assessee has no authority to sustain it.
On behalf of the assessee the decision in In re Chouthmal Golapchand has been relied upon. That was a business which was carried on by four partners, and in the relevant accounting year there was an opening stock of shares valued at the cost price of Rs. 85,331. During that accounting period the parties entered into an agreement to dissolve the firm on and from March 30, 1936, which was the last day of the accounting year. In pursuance of that agreement, even during the course of the accounting year and prior to the actual dissolution, they divided the stock on hand, which consisted of shares, in specie. They purported to value this stock at the prevailing market price at the date on which they divided it and claimed a loss of Rs. 33,365 in the business. This claim of the assessee was repelled, and the pertinent observation of Costello, J., was : “To state the matter succinctly, I agree that if these shares were put into the accounts at cost they ought to have been taken out of the accounts at cost.” It would be note-worthy that the division of the stock-in-trade was in specie and the loss was not incurred as the result of any sale transaction. It is also important to notice that the partnership continued to run till the closing of the accounting year. It was observed in this decision :
“Having put in the value of these shares as at cost and being in the position that they were not able, and in fact did not seek, to change the system of accounting in this particular case, we must take the cost price of these shares as the starting point. It seems to me, therefore, that if there had been any real sale of these shares in the course of the year 1922 (Ramanavami) it might have been open to the assesses to say that it was between the cost and the sale price that there was this difference of Rs. 33,365. But there never was a sale….. Therefore, I prefer to say that there was a division of these shares and that division took place, as the learned Commissioner states, on March 9, 1936. The partners for their own purposes chose to say that they would take over the shares or rather their portion of the shares. What they said as regards a loss seems or rather their portion of the shares. What they said as regards a loss seems to me to be definitely as ipse dixit….”
Derbyshire, C. J., quotes the observations of Lord Buckmaster in Commissioner of Income-tax v. Ahmedabad New Cotton Mills Co. Ltd. :
“The method of introducing stock into each side of a profit and loss account for the purpose of determining the annual profits is a method well understood in commercial circles and does not necessarily depend upon exact trade valuations being given to each article of stock that is so introduced. The one thing that is essential is that there should be a definite method of valuation adopted which should be carried through from year to year, so that in case of any deviation from strict market values in the entry of the stock at the close of one year it will be rectified by the accounts in the next year.”
It is obvious from the above that the privilege of valuing the opening and closing stocks in a consistent manner is available only to continuing businesses and that it cannot be adopted where the business comes to an end and the stock-in-trade has to be disposed of in order to determine the exact position of the business on the date of closure.
In Chainrup Sampatram v. Commissioner of Income-tax a firm carrying on business at Calcutta as bullion merchants transferred some part of the stock to Bikaner where the partners resided. Their value at cost was credited in the books of the firm. It was claimed by the Department that it amounted to a sale to the partners for their domestic use and the market value of bullion was taken to arrive at the taxable profits. The decision proceeded on a different point. The learned judges observed :
“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 the goods entered on the other side of the account at the time of their purchase, so that the canceling out of the entries relating to the same stock 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 years trading.”
Later on they observed :
“In the present case, although it would appear that the cost price of part of the silver dispatched to Bikaner was less than the market price at the end of the year, the reference did not raise any question regarding the basis on which the amount in dispute, viz., Rs. 2,20,887, was arrived at. On the other hand, the question referred assumed that the said sum was correctly computed and put in issue only its assess ability in law on a true construction of section 4 (1) (b) and section 14 (2) (c) of the Act.”
This decision is important for the purpose of showing the basis for the valuation of the opening and closing stocks in any year in a consistent manner.
In Kikabhai Premchand v. Commissioner of Income-tax a similar question arose. The assessee, who was a dealer in silver and shares and who was the sole owner of the business, maintained his accounts according to the mercantile system. During the relevant year of account, he withdrew some silver bars and shares from the business and settled them on certain trusts. In his books the assessee credited the business with the cost price of the bars and shares so withdrawn. The Department sought to bring to tax the difference between the cost price and the market value at the date of the withdrawal. This view was upheld by the Appellate Tribunal and the High Court. But on appeal to the Supreme Court it was decided that no income arose to the assessee as a result of such transfer. After observing that in revenue cases regard must be had to the substance of the transaction rather than to its mere form, their Lordships proceeded to state :
“In the present case disregarding technicalities it is impossible to get away from the fact that the business is owned and run by the assessee himself. In such circumstance, we are of opinion that it is wholly unreal and artificial to separate the business from its owner and treat them as if they were separate entities trading with each other and then by means of a fictional sale inroads a fictional profit which in truth and in fact is non-existent. Cut away the fiction and you reach the position that the man is supposed to be selling to himself and thereby making a profit out of himself which on the face of it is not only absurd but against all canons of mercantile and income-tax law. …. The appellant has reflected the true state of his finances and given a truthful picture of the profit and loss in his business by entering the bullion and silver at cost when he withdraw them for a purely non-business purpose and utilised them in a transaction which brought him neither income nor profit nor gain.”
It seems to us that none of these cases has any application to the facts of the present case. There is no authority directly in point dealing with this questions, 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 deal with the matter on first principles.
The case of a firm which goes into liquidation forms a close parallel to the present case. In such a case all the stock-in-trade and other assets of the business will have to be sold and their value realised. It cannot be controverted that it is only by doing so that the true state of the profits or losses of the business can be arrived at. The position is not very different when the partnership ceases to exist in the course of the accounting year. The fact the Ramachari, one of the ex-partners, took over the entire stock and continued to run the business on his own, is not relevant at all, when we consider the profits or losses of the partnership which has come to an end. It should, therefore, follows that in order to arrive at the correct picture of the function, the valuation of the stock in hand should be made on the basis of the prevailing market price.
It is contended on behalf of the assessee that, when the High Court adopted the market price of the goods as on September 11, 1944, it did so in order to adjust the claims between the partners, and that fact should have no bearing on the question of the valuation under the income-tax law. This is no doubt true. But in a case of this kind we are of the view that the market price alone should be taken in order to arrive at the trading results of the business. The judgment of the High Court and the report of the Commissioner in connection with the valuation of the stock would only serve as evidence of the market value of the goods on the date in question.
It is further claimed by the assessee that after taking over the goods he has valued them at cost price as was done by the partnership itself when the goods belonged to the partnership. We do not see how this fact can affect the position. It is true that because Ramachari as an individual carrying on business has taken over the goods of the partnership and has valued them at cost price, there would be a greater margin between that price and the eventual sale price leading to a larger profits in his hands being brought to tax. It was no doubt open to him to have valued the goods at the market price because on the dissolution of the partnership when accounts were settled between the parties he had to pay the difference to his partner. Anantharam, on the basis of the market price on the date of the dissolution. That he failed to record the value in his individual accounts at the price at which they had to be dealt with on the dissolution of the partnership is not a factor that can affect the conclusion as to the principle on which the closing stock has to be valued in the case of a dissolved partnership in order to arrive at the true position of the profits of the partnership.
We accordingly answer the question referred to us in the affirmative and against the assessee. The assessee will pay the costs of the Department; counsels fee Rs. 250.
Question answered in the affirmative.