Income Tax Appellate Tribunal - Ahmedabad
D.C. Gandhi Associates vs Income-Tax Officer on 12 August, 1988
Equivalent citations: [1990]32ITD285(AHD)
ORDER
R.M. Mehta, Accountant Member
1. This appeal is preferred against the order of the CIT(A) for which purpose as many as 20 grounds are raised. The issues for our consideration however are two viz. the addition of Rs.10 lacs made under Section 28(iv) of the I.T. Act, 1961 and the disallowance out of rent by invoking the provisions of Section 40A(2) of the Act.
2. Taking up the first issue we reproduce here with the undisputed facts as stated in the order of the CIT(A). These are as under:
The appellant is a firm of professionals viz. Advocates practising mainly labour law. There are six partners in the firm.
Share
1. Shri D.C. Gandhi 30 %
2. Shri NJ. Sheth 23 %
3. Shri S.E. Rangwala 19.25%
4. Shri B.B. Vakil 10%
5. Shri P.N. Sheth 9.5%
6. Shri U.C. Gandhi 8.25% There was a dissolution on the last day of the previous year i.e. on 4-11-33 whereby the last three partners retired and the first three partners carried on the business with all the assets and liabilities. On that day of dissolution the following assets were revalued:
(1) Office Furniture & Equipments Rs. 4,50,000
(2) Library books Rs. 3,50,000
(3) Tenancy rights and Goodwill Rs. 2,00,000
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Rs. l0,00,000
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The appreciated value of the assets were distributed among the partners as follows:
D.C. Gandhi Rs. 3,00,000
M.J. Sheth Rs. 2,30,000
S.E. Rangwala Rs. 1,92,500
B.B. Vakil Rs. 1,00,000
P.N. Sheth Rs. 95,000
U.C. Gandhi Rs. 82,500
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Rs. 10,00,000
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3. The ITO in the course of the assessment proceedings issued a show-cause notice to the assessee whereby he proposed to bring to tax the aforesaid sum of Rs.10,00,000 resulting out of the appreciation in the value of the various assets. It was however claimed by the assessee that the revaluation of the assets did not give rise to any income. For this proposition reliance was placed on the unreported decision of the Gujarat High Court in the case of Jayantilal Laxmichand [IT Reference No. Ill of 1974 dated 4-9-1975].
4. The ITO first of all considered whether there was a dissolution of the firm or a change in the constitution. He opined that there was no dissolution of the firm but merely a change in the constitution. He did so by interpreting the terms of the dissolution deed dt. 4-11-1983.
5. As regards the appreciation in the value of the assets the ITO was of the opinion that the sum of Rs.10 lacs was taxable under Section 28(iv) of the Act. The relevant observations in this connection are as under:
Now, coming to the point of appreciation of assets, it may be seen that the book value of the furniture, A.Cs. etc. was only Rs.96,898 which is further appreciated by Rs.4,50,000. This sum of Rs.4,50,000 is separately credited to a new account. There is no basis with the assessee to appreciate their value at such an abnormal higher amount. Regarding goodwill it may be stated that the assessee is a firm of professionals. Goodwill is future earning capacity on the basis of past standing. In the case of professionals the future earning depends upon the skill of professionals and it cannot be self-generating asset. In the case of professionals, the earning capacity goes away along with the professionals. Therefore the valuation of goodwill at such a high figure cannot be accepted as such for payment of outgoing partner's share. In fact, as per the clause 8 of partnership deed dt.9-12-1980 the outgoing three partners were not eligible for the goodwill of the firm. Even then, they are paid goodwill. The law books are also valued at Rs. 3,50,000 without any basis.
By revaluation of the assets the partners are benefited to the extent of Rs.10,00,000 which is the benefit arising out of the business transaction and hence it is taxable under Section 28(iv). But by way of so called dissolution the assessee has resorted to dubious methods inasmuch as it has adopted colourable device of revaluation of its assets which had no value or nominal value in the assessee's book of accounts with a view to mitigating the tax liability of the firm and the partners.
It would not be out of place to cite the ratio of the decisions of Hon'ble Supreme Court in the following cases: -
(1) McDowell & Co. v. Commercial Tax Officer reported in [1985] 154ITR 148. In this case, their Lordships of the Supreme Court have observed as under: -
Page 159:
The Courts are now concerning themselves not merely with the genuineness of a transaction but with the intended effect of it on fiscal purposes. No one can now get away with a tax avoidance project with the mere statement that there is nothing illegal about it.
Page 111 Tax planning may be legitimate provided it is within the framework of law. Colourable devices cannot be part of tax planning and it is wrong to encourage or entertain the belief that it is honourable to avoid the payment of tax by resorting to dubious methods. It is the obligation of every citizen to pay the taxes, honestly without resorting to subterfuges.
(2) Workmen of Associated Rubber Industry Ltd. v. Associated Rubber Industries Ltd. and Another reported in [1986] 157 ITR 77.
In this case, their Lordships of the Supreme Court have followed the ratio laid down in McDowell & Co.'s case noted supra.
Their Lordships of the Supreme Court have held in the above cited case, that colourable devices to avoid the tax liability cannot be encouraged or entertained. In the present case, with the discussion the foregoing paragraphs it is evident that the act of dissolution and paying Rs. 10,00,000 to partners under the shadow of revaluation is a colourable device to avoid taxation and the ratio of Supreme Court's above mentioned decisions apply.
It is already held by me that Rs. 10,00,000 is benefit Under Section 28(iv) of the I.T. Act and therefore same is brought to tax as the income of the assessee firm. Since factually there was no dissolution the decision of Hon'ble Gujarat High Court in the case of Jayantilal Laxmichand quoted by the assessee does not apply to this case. Even otherwise the facts of that case are different than that of assessee.
6. Before the CIT(A) it was argued on behalf of the assessee that the revaluation of assets cannot be an income at all. Reliance was placed on the dissolution deed dt.4-11-83 for the submission that the amount received by the partners as a result of the revaluation was on a dissolution of the firm and there could not be any taxable income in the hands of the partners. The decision of the Gujarat High Court supra was once again referred to. It was further submitted that the firm was perfectly justified in revaluing its assets at the time of dissolution since the fair market value of these assets had to be ascertained for working out the necessary distribution to the partners. It was also submitted that even a firm of professionals had goodwill and its revaluation was fully justified. An objection was also raised against the action of the ITO in applying the decision of the Supreme Court in the case of McDowell & Co. Ltd. v. CTO [1985] 154 ITR 148/22 Taxman 11. It was finally submitted that there had been a dissolution of the firm and not a change in the constitution.
7. The CIT(A) after considering these arguments agreed with the ITO to the effect that the firm had not undergone a dissolution but there had been change in the constitution.
8. As regards the taxability of the sum of Rs.1,00,000 Under Section 28(iv) the decision of the CIT(A) proceeded on the following lines:
The next important question in this case is the revaluation of assets made by the appellant firm and to find out whether this was an income of the firm or not. In this regard, I may point out that the revaluation made by the appellant firm is totally unjustified, and fictitious. Regarding the assets the balance-sheet of the appellant company do pot show the goodwill and the books and the only fixed assets shown in the balance sheet are furniture whose value is shown at Rs.96,898. These furnitures are very old and naturally their market value cannot appreciate but rather depreciate. Regarding the books, they can also have depreciated value and not appreciated value since these books and law journals become outdated with the passage of time and old books do not fetch the same price if sold after 20-30 years. Regarding the valuation of the goodwill, it may be pointed out that the goodwill in the case of firm consisting of professionals, is personality oriented. If the eminent person upon whose eminence the professional firm has been built up, retires then the goodwill declines substantially. Thus, the goodwill in the case of professional firm is not a self-generating asset in the sense it is so in case of any business producing goods under a brand name. Thus the valuation of the above three assets is artificial and fictitious in my opinion. Secondly as pointed out by the ITO the goodwill has been apportioned to the retiring partners in violation of the original partnership deed of 1980. The appellant has not given the exact working of the apportionment of the assets. If it is pleaded that no goodwill was apportioned what was the necessary in valuing goodwill then? The question became very important since continuing partners retained goodwill as per the so-called Dissolution Deed.
This brings us to the real issue in this case viz. whether this revaluation of the assets and crediting of the partners with that amount was a colourable device or not. In this regard, I have perused the assessment record of the appellant firm and the following facts are noted. The summarised balance sheet of the appellant company for the A.Ys.1983-84 and 1984-85 are shown herein as annexure 'A'. It will be seen that the only liability of the appellant is the "Advances received from clients" amounting to Rs.17.24 lakhs during the year. The appellant firm maintains books of accounts on cash basis. It receives huge amount of advances from the clients towards fees and expenses. Whenever the advances are received, the client's account is credited. The expenses incurred for the client's matter are debited to its account and the balance amount shown as liability in the balance sheet. When the client's matter is finally settled in the court, the balance of advance received is transferred to the fees receipt account which may take many years.
This huge advance received from the clients is utilised by way of personal withdrawals by partners and loans to relatives and friends and employees. Thus, the only source of all the assets shown in the balance sheet is the advance received from the clients and such advances are nothing but the income of the assessee firm which is not yet transferred to the fees account so far. By following this system of accounting, the firm is able to manipulate its income from year to year.
In this context, the revaluation of assets should be treated as nothing but ascertaining the unadjusted income of the firm and thereafter distributing it to the partners according to their profit sharing ratio. This is certainly a colourable device since, in reality, in the garb of revaluation of asset the appellant firm has actually distributed its unadjusted income and distributed it to the partners. It has already been pointed out that the asset revalued by the appellant firm are not worth of revaluation at all. By this device of revaluation of asset, the unadjusted income of the firm has been brought into the books of the firm and therefore this is definitely income of the appellant firm. The decision of the Supreme Court in the case of McDowell & Co. Ltd. v. CTO [1985] 154 ITR148/22 Taxman 11, that where a device has been adopted to evade tax the authority is entitled to unravel the device is definitely applicable in this case.
Further, it appears palpably absurd that the retiring partners would be interested in taking their share of some depreciation and obsolete assets like books and furniture while leaving the real asset viz. the advances received from clients (which is nothing but unadjusted income) to the existing partners. In my opinion their real claim pertained to this asset and the transaction of revaluation of other assets was only a garb and colourable device to cover it up.
Lastly, I may point out that the decision of the Gujarat High Court in the case of Jayantilal Laxmichand, relied on by the learned A.R. is not at all relevant. In my opinion since the question decided by the Gujarat High Court in that case was entirely different. In that case, the Hon'ble Gujarat High Court decided the question of taxability of the share received by the partners on dissolution of the firm in the hands of the partners. Since this is not the issue before us, the ratio of that case is of no use in the present case.
As a result, the addition in respect of Rs.10 lakhs is confirmed.
9. It is in the aforesaid circumstances that the assessee is presently in appeal before us. As no arguments have been advanced in the direction of whether there was a dissolution or a change in the constitution, we do not pronounce one way or the other on this aspect of the matter. The arguments advanced by the parties are entirely on the taxability of the sum of Rs.10 lakhs arising as a result of the revaluation of the assets.
10. The learned counsel for the assessee advanced detailed arguments before us but most of these were a repetition of the arguments advanced before the CIT(A). The following factual aspects were however highlighted:
(1) That the assessee firm was maintaining its accounts on the "cash basis". That the fees were to be accounted for only when the cases were concluded and till such time they were to be treated as a liability of the firm.
(2) That all the liabilities in respect of the pending cases in so far as their completion was concerned were to be discharged by the three remaining partners, namely, Shri D.C. Gandhi, Shri MJ. Sheth and Shri S.E. Rangwala and the outgoing partners, namely, Shri B.B. Vakil, Shri P.N. Sheth and Shri U.C. Gandhi were in no way responsible.
(3) That even the predecessor firm, namely, M/s. I. M. Nanavaty Associates from whom the present firm had taken over the business was maintaining its accounts on the cash basis. In other words the fees was being received in advance from the clients which included the expenses to be incurred on behalf of the client and the firm's professional fees being taken to income only after the case Was concluded.
(4) That the revaluation of assets was a recognised method even under the Partnership Act and specially when there was a change in the constitution of the firm vis-a-vis its partners. That the assessee had paid a sum of Rs.23,750. On account of goodwill to one of the retiring partners Shri Sudhir Nanavaty in A.Y. 1979-80 and although the ITO had disallowed the claim for deduction, the CIT(A) had accepted it. It was further pointed out that the decision of the CIT(A) had become final since there was no further challenge to it by the department.
(5) That the sum of Rs.17,20,285 reflected in the balance sheet of the firm for the year under appeal was a liability in so far as it reflected amounts received in advance from various clients. That the aforesaid sum was transferred to the income account in various subsequent years viz. S. Y.2040, S. Y.2041 and S.Y.2042 and that also after the cases had been concluded. That the expenditure incurred on behalf of the clients totalling Rs.1,00,362 had also been debited to this account.
(6) That whereas the ITO's case v/as that the provisions of Section 28(iv) were attracted the CIT(A) was of the view that this was a device to distribute the unadjusted income of the firm (Rs.17,20,285) to the partners in their profit sharing ratio.
(7) That the unreported decision of the Gujarat High Court supra squarely applied to the facts of the case specially when it followed another decision of the same High Court in the case of CIT v. Mohanbhai Pamabhai [1973] 91 ITR 393 subsequently confirmed by the Supreme Court in 165 ITR 116 (sic).
The learned counsel for the assessee finally made an impassioned plea for the addition in question to be deleted as according to him no benefit had resulted to the assessee firm. In support of his arguments he also cited the following authorities:
(i) CIT v. Dewas One Corporation [1968] 68 ITR 240 (SC)
(ii) CIT v. Bankey Lal Vaidya [1971] 79 ITR 594 (SC)
(iii) Devidas Vithaldas & Co. v. CIT [1972] 84 ITR 277 (SC)
(iv) CIT v. Hind Construction Ltd. [1972] 83 ITR 211 (SC) and
(v) Malabar Fisheries Co. v. CIT [1979] 120 ITR 49 (SC).
11. The learned DR on the other hand strongly supported the orders of the ITO and the CIT(A). His detailed arguments thereafter took into account the entire line of reasoning as had weighed with the ITO in making the addition and the CIT(A) in confirming it.
12. We have examined the rival submissions and have also perused the orders of the ITO and the CIT(A). The material on record to which our attention was drawn including the paper book furnished on behalf of the assessee as well as the authorities cited have been duly considered.
13. At the outset we are of the view that the exercise of revaluing the assets does not give rise to any taxable income in the hands of the assessee firm much less Under Section 28(iv). The benefit if any has gone to the partners existing as well as retiring since they have found themselves richer to the extent of Rs.10 lakhs, the ITO in fact stated so in the following terms:
By revaluation of the assets the partners are benefited to the extent of Rs. 10,00,000.
The assessee firm has ended up with the "enhanced" value of certain assets which according to the CIT(A) is a "fictitious" value but in the same process finds itself a loser to the same extent since there is a payment of Rs.10 lakhs to the 6 partners (although by crediting the respective accounts). In case the valuation is treated as "fictitious" then the firm has lost Rs.10 lakhs and if it is treated as genuine then the increase in the value of the assets is neutralised by the corresponding payment to the partners. There, is no benefit to the assessee firm whatsoever whichever angle the matter is examined from.
14. During the course of the hearing certain arguments were advanced in the direction of the merits and demerits of the valuation placed on the various assets. This aspect of the matter has also been echoed by the CIT(A). We however do not indicate our mind in this respect since we are not concerned with the same indisposing of the present appeal. All that we would like to mention is that revaluation of assets is a natural corollary to any change in a partnership whether it be on account of dissolution or otherwise. On every such occasion the accounts of the partners have to be settled and such settlement takes into account the market value of the various assets.
15. We would also like to mention that the case sought to be made out by the CIT(A) is far-fetched. The inference that the revaluation being undertaken for the purpose of "ascertaining the unadjusted income of the firm and thereafter distributing it to the partners", is not called for since it appears to be a figment of his imagination. The system of maintaining accounts adopted by the assessee is an accepted one and consistently followed all along in the past and in the future. There was even a suggestion aired by the assessee's counsel that if what had been brought to tax (Rs.10 lakhs) Was the unadjusted fees (as per the CIT(A), then the assessments of subsequent years be modified by excluding a similar sum since that would amount to "double taxation".
16. Before we part we would like to observe that the decision of the Supreme Court in the case of McDowell & Co. Ltd. (supra) would not apply since we do not find any device in so far as the firm is concerned vis-a-vis the revaluation of the assets. We would repeat that it has not gained anything out of the transaction.
17. In the final analysis, we delete the addition of Rs.10 lakhs since the same is not taxable within the meaning of Section 28(iv) of the Act.
18. The second issue in this appeal pertains to the disallowance made by the ITO Under Section 40A(2) in respect of the rent paid by the assessee. The relevant observations of the ITO in making the impugned disallowance are as under:
The rent paid includes Rs.17,500 paid to M/s. Gandhi Chambers @ Rs.3,500 p.m. for 5 months for office at Baroda rented during the year. The partners of M/s. Gandhi Chambers are wives of 4 partners and mother of the partner of the assessee firm. It is stated that the property under consideration is a flat admeasuring 105 sq.yd. purchased for Rs.1,16,000. There is debit balance of Rs.2,53,435 in the account of M/s. Gandhi Chambers in assessee's book. No interest is charged on such debit balance. The assessee has also given loans to the partners of M/s. Gandhi Chambers without interest.
Considering all the above facts, I am of the opinion that the rent paid for Baroda office @ Rs.3500 p.m. is excessive and unreasonable. After taking into consideration the area of the flat and also its purchase price the reasonable rent is estimated at Rs.1000 p.m. Therefore, as per the provisions of Section 40A(2), deduction of Rs.5000 i.e. Rs.1000 p.m. for 5 months is allowed as against Rs.17,'500 claimed and the remaining amount of Rs.12,500 is disallowed.
19. The CIT(A) confirmed the action of the ITO but without giving any independent reasoning of his own.
20. The learned counsel for the assessee strongly challenged the action of the ITO in making the disallowance. According to him no doubt the flat in question belonged to the wives of some of the partners and the mother of one of them, the rent being paid compared favourably with the rates prevailing for office premises in Baroda at that time. He also invited our attention to the fact that the disallowance had been made on an estimated basis and without bringing any supporting evidence on record in the form of cases of comparable properties situation-wise, It was accordingly argued that the addition made by the ITO be deleted.
21. The learned DR on the other hand strongly supported the orders of the lower authorities.
22. We have examined the rival submissions and have also perused the orders of the lower authorities. It appears that the ITO has been swayed by the fact that the flat in question belongs to the close relatives of the partners of the firm. He has also taken into account the fact that there is a debit balance outstanding against the owners of the flat in the books of the firm. And further no interest has been charged on such debit balance. He has also taken note of the fact that the flat admeasuring 105 sq.yds. had been purchased for Rs.1,16,000 and the rent of Rs.3500 p.m. was on the higher side. The assessee's case on the other hand is that the carpet area of the flat is 945 sq.ft. and in a commercial area a rate of Rs.4 per sq.ft. is not unreasonable. After examining the viewpoints of the parties before us we are of the view that as far as the present assessment year is concerned, there is no basis for making any disallowance/addition under Section 40A(2) since the ITO has proceeded merely on surmises and conjectures and has not cared to bring any contrary evidence on record. We do not find anything in the assessment order which could show that the I.T.O. made enquiries about the rates of commercial properties in the area concerned or even the adjoining area with a view to come to the conclusion that the rent being paid by the assessee was on the higher side. On the facts and circumstances as prevailing, we are not in a position to approve the addition in question. The same is directed to be deleted.
23. In the result the appeal is allowed.