Gujarat High Court
Raylon Silk Mills vs Commissioner Of Income Tax on 9 November, 1995
Equivalent citations: [1996]221ITR155(GUJ)
Author: S.K. Keshote
Bench: S.K. Keshote
ORDER--Basis thereof. Ratio & Held : It is an essential condition of exercise of the power under section 263 that the Commissioner must find that the error which is found in the order of the assessing officer is prejudicial to the interests of the revenue. The conclusion of the Commissioner that the order is prejudicial to the interests of the revenue is not a matter of subjective satisfaction of the Commissioner. That is to be founded on the objective material after assessing the contentions raised by the assessee on opportunity of hearing being afforded to him before passing the order. Application : Also to current assessment year. A. Y. : 1974-75 Income Tax Act 1961 s.263 Revision under s. 263--VALIDITY--Enquiry by assessing officer. Ratio : In the circumstances of the case the Commissioner was not justified in law in holding that the assessing officer concerned had not at all examined goodwill account and made no inquiry at the time of passing an assessment order and hence his order was erroneous and prejudicial to the interests of the revenue within the meaning of section 263. Held : The relevant period is the assessment year 1974-75. Law is settled on the subject that no capital gain can be charged in respect of self-created goodwill. It is not the case of the revenue that the goodwill account was credited in the books of account on purchase from the market. It is case of debiting goodwill account in the books of the firm for the estimated value of goodwill which was self-generated and its transfer even for consideration ultimately even to the company which had acquired the business of the firm could not have resulted in levy of any tax in respect thereof. Therefore, as a matter of law no profit or gain could arise to the firm by creation of a goodwill account in the firm or by crediting the partners' accounts in their profit-sharing ratio, the amount of such goodwill, which can be subjected to tax. In that view of the settled position of law, the assessment order could not have been said to be an order prejudicial to the interests of the revenue, qua the goodwill account. Therefore, the conclusion of the Tribunal in affirming the decision of the Commissioner that the order of the assessing officer for the assesment year 1974-75 was erroneous for want of making enquiry, and is otherwise prejudicial to the interests of the revenue is not well-founded in law. Application : Also to current assessment though not in relation to controversy as to changing of self generated goodwill, to capital gains tax. A. Y. : 1974-75 Income Tax Act 1961 s.263 Income Tax Act 1961 s.45 JUDGMENT Rajesh Balia, J.
1. The Tribunal, Ahmedabad Bench 'A' at the instance of the assessee has referred the following two questions of law arising out of its order in ITA No. 420/Ahd/79 relating to the asst. yr. 1974-75, for the decision of this Court :
"1. Whether, on the facts and in the circumstances of the case, the Tribunal was justified in law in holding that the ITO concerned had not at all examined goodwill account and made no inquiry at the time of passing assessment order and hence his order was erroneous and prejudicial to the interest of Revenue within the meaning of s. 263 of the Act ?
2. Whether, the order of the Tribunal justifying the order of the CIT under s. 263 of the Act is not against evidence on record and unsupported by any evidence and is reasonable ?"
2. The ITO had completed assessment under s. 143(3) of the Act for the asst. yr. 1974-75 in the case of the assessee, a registered firm on 25th Jan., 1977. On 15th Dec., 1978 the CIT, Rajkot issued notice under s. 263 of the IT Act stating that on going through the case records of the IT assessment proceedings of the assessee for the asst. yr. 1974-75 it was noticed that the assessment made by the ITO on 25th Jan., 1977 is erroneous and is prejudicial to the interests of the Revenue on the following grounds :
"(i) that the ITO has failed to tax the so called goodwill amounting to Rs. 10,75,000 credited to the accounts of the partners in their profit sharing ratio;
(ii) that the ITO has failed to pass an order under s. 185(1)(a) of the IT Act, 1961.
(iii) that the ITO has failed to add back the interest payments of Rs. 94,631 made to the partners."
3. The assessee replied. In respect of questions about taxing the goodwill amount, the assessee replied that the entire matter was scrutinised in detail and accepted while passing the assessment order and therefore no action under s. 263 can be taken in this regard merely on the basis of change of opinion or any audit objection or because of the change of ITO, there being no transfer much less transfer of capital asset and that too for the consideration at any stage during the assessment year in question, no question of making addition of value of goodwill for the purpose of taxing can arise. The CIT rejected the contention of the assessee vide his order dt. 23rd Jan., 1979 and directed the ITO to thoroughly examine all the relevant transactions and book entries concerning the goodwill amount and its final destination vis-a-vis the eventual take over of the assessee's business by the private limited company. For issuing this direction, the CIT reasoned that the assessee created an amount styled as 'goodwill account' which was debited by a sum of Rs. 10,75,000 and the said amount was transferred to the accounts of the partners of the assessee firm. After referring to the past record of the business results of the firm, and havala entries in the account of M/s Rayon Silk Mills Pvt. Ltd. From the assessment records, specially from the assessment order, it is evident that the ITO concerned has not at all examined the goodwill account. With the aforesaid reasoning, the CIT further concluded that it is in this context that the ITO's order of assessment is certainly erroneous in so far as prejudicial to the interests of Revenue which has suffered on account of ITO's omission to examine and visualise the tax implications of the creation of goodwill account and the business ultimately having been transferred in subsequent years. So far the order of ITO being erroneous and prejudicial to the interest of Revenue on other two counts concerned was not contested by the assessee and we are not referring to those controversies therein. On appeal the Tribunal affirmed the order of CIT. However, it was observed :
"The CIT has not gone into the fact whether the goodwill should be assessed as such. He has only directed the ITO to take all the material facts into consideration while determining the issue. In other words he has not gone into the merits of its assessability. We therefore do not propose to adjudicate upon the issue whether or not the goodwill of Rs. 10,75,000 debited in the books of account with corresponding credits in the accounts of the partners in their profit sharing ratios is taxable or not taking into consideration the havala entries and the ultimate transfer of the assets to a limited company which the ITO will no doubt consider while framing the assessment de novo."
4. We have heard learned counsel for the parties.
5. In the first instance it was contended by the learned counsel for the assessee that the very premise on which order under s. 263 was made against the assessee, namely, that the ITO has not at all examined the good will account is not existent. According to him, it is apparent from the record that the goodwill account was thoroughly examined by the ITO before making assessment and after examining when he accepted the contention of the assessee its discussion did not find place in the assessment order, as no additions were going to be made or no modifications in the return filed by the assessee was required to be made in that regard.
6. This contention of the assessee appears to be well founded. It is true that the assessment order does not speak about the examination of good will account as such. However, as we have noticed above, the assessee in his reply to show cause notice under s. 263 had specifically mentioned that the entire matter was scrutinised and accepted while passing the assessment order. Our attention was also drawn to Annexure D. A submission made by the assessee to ITO, Surat dt. 18th Oct., 1976 regarding asst. yr. 1974-75 giving detailed chronological data of the constitution of the firm on 11th Nov., 1968, induction of four more partners on 7th Nov., 1972, the creation of good will in the books of accounts of the firm by debiting the good will account and crediting old partner's capital accounts in their profit sharing ratio on that date, formation of a private limited company in the name of M/s Rayon Silk Mills Pvt. Ltd., and its induction into the firm as partner by the deed of partnership dt. 27th Oct., 1973 and the dissolution of the partnership firm on 23rd Feb., 1974 leaving the private limited company as a sole proprietor thereof and the valuation of the business at the book value as on that date. After giving chronological sequence of events the assessee also contended in his submission before the ITO that there was no actual transfer of any asset inasmuch as when a partner is admitted into the firm no transfer takes place. It was also contended that no cash transfer took place from person to person and the transfer and the dissolution of the firm also did not result in accrual of capital gains. In the face of this material on record it is difficult to explain that the assessment order was made without making any enquiry into the good will account of Rs. 10,75,000. On the contrary while the CIT in his order, which has been quoted by the Tribunal, took pains to refer to havala entries in the books of accounts of other concerns and the business results of the firm in the past years it is conspicuously silent about the relevant dates which had relevant bearing on coming to the conclusion whether the order of the ITO for the asst. yr. 1974-75 on the facts existing during the previous year relevant to asst. yr. 1974-75 could be said to be erroneous and prejudicial to the interests of Revenue. The accounting year of the assessee is Samvat year closing on Diwali year. Hence previous year relevant to asst. yr. 1974-75 in the case of assessee ended with Diwali 1973. It is fundamental that the assessment of each year is independent of the assessment of other years, the assessment being of a particular assessment year which is in respect of income which has been earned, accrued or received during twelve months comprising in previous year relevant to the assessment year, the assessment has to be framed on the basis of the existing material and which is then existing law applicable for that assessment. From the chain of events it is apparent that good will account was created on 7th Nov., 1982, that is to say at the beginning of the previous year relating to the asst. yr. 1974-75 and on the date when actual account was debited and the accounts of existing partners the induction of new partners were credited. It is also apparent that the business of the firm ultimately became the business of the company only on 23rd Feb., 1974 that is to say after about fifteen months of creation of good will account in the books of the firm and about five months after induction of private limited company as partner of the firm and about three months after the closure of the previous year. If any capital gain or profit arose to the firm as a result of transfer of business in February, 1974, the same could not be the subject matter of the scrutiny or enquiry for the asst. yr. 1974-75. Therefore it is apparent that the Tribunal and the CIT have not looked into the record before coming to the conclusion whether any enquiry into the creation of a good will account was made or not and have taken into consideration the materials which are irrelevant. We make it clear that the aforesaid observations we have not made to lay down that whenever any enquiry into any aspect of the assessment has been made that cannot be the subject matter of the proceedings under s. 263. Even in such cases, if the CIT finds the conclusion of the ITO to be erroneous and prejudicial to the interests of the Revenue it can certainly have recourse to powers under s. 263 subject to limitation appended thereto. However the power under s. 263 are not conferred on the CIT to direct for making an enquiry on mere suspicion to disturb a completed assessment.
7. In the present case the only ground on which the CIT has directed the ITO to hold an enquiry in the creation of 'good will account' is for the supposed reason that ITO has not examined the issue. It is not founded on the ground that the ITO has erroneously not taxed the good will amount for the asst. yr. 1974-75 while it was so taxable.
8. It is essential condition of exercise of power under s. 263 that a CIT must find that the error which is found in the order of ITO is prejudicial to the interest of Revenue. The prejudice which has been held to be contrary to interests of Revenue is stated to be the only one, namely, in not holding enquiry into the good will account by the ITO and not on any other grounds. The conclusion of the CIT that the order is prejudicial to the interest of Revenue is not a matter of subjective satisfaction of the CIT. That is to be founded on the objective material after assessing the contentions raised by the assessee on opportunity of hearing being afforded to him before passing the order.
9. Apart from the fact that the basic premise on which order under s. 263 has been made does not exist, there is no whisper in the order how on reaching any finding about creation and disbursement of good will account amongst the partners in their profit sharing ratio would be prejudicial to the interests of Revenue. The period with which we are concerned is the asst. yr. 1974-75. So far as the charge of any tax on transfer of good will is concerned, if creation of a capital asset in the nature of good will in the accounts of the firm and its crediting to the partner's capital accounts in the profit sharing ratios, is treated to be a transfer within the meaning of sub-s. (2) of s. 47 of the IT Act, law is settled on the subject that no capital gain can be charged in respect of self created good will. It is not the case of Revenue that good will account was credited in the books of account on purchase from market. It is a case of debiting good will account in the books of firm for the estimated value of good-will which was self-generating and its transfer even for consideration ultimately even to the company which had acquired the business of the firm could not have resulted in levy of any tax in respect thereof. A reference in this connection may be made to CIT vs. B. C. Srinivasa Setty reported in (1981) 128 ITR 294 (SC). The Court enunciated the principle that the charging section and the computation provisions together constitute an integrated code. When there is a case to which the computation provisions cannot apply at all, it is evident that such a case was not intended to fall within the charging section. For the purpose of levy of tax on capital gains, the Court said :
"All transactions encompassed by s. 45 must fall under the governance of its computation provisions. A transaction to which those provisions cannot be applied must be regarded as never intended by s. 45 to be the subject of the charge. What is contemplated by s. 48(ii) is an asset which possesses the inherent quality of being available on the expenditure of money to a person seeking to acquire it. None of the provisions pertaining to the head "Capital gains" suggests that they include an asset in the acquisition of which no cost at all can be conceived. When goodwill generated in a new business is sold and the consideration brought to tax, what is charged is the capital value of the asset and not any profit or gain. Further, the date of acquisition of the asset is a material factor in applying the computation provisions pertaining to capital gain; but in the case of goodwill generated in a new business it is not possible to determine the date when it comes into existence".
10. Discussing the nature of self generated good will, the Court propounded :
"Goodwill denotes the benefit arising from connection and reputation. A variety of elements goes into its making, and its composition varies in different trades and in different businesses in the same trade, and while one element may preponderate in one business, another may dominate in another business. Its value may fluctuate from one moment to another depending on changes in the reputation of the business. It is affected by everything relating to the business, the personality and business rectitude of the owners, the nature and character of the business, its name and reputation, its location, its impact on the contemporary market, the prevailing socioeconomic ecology, introduction to old customers and agreed absence of competition. There can be no account in value of the factors producing it. It is also impossible to predicate the moment of its birth. The benefit to the business varies with the nature of the business and also from one business to another. No business commenced for the first time possesses goodwill from the start. It is generated as the business is carried on and may be augmented with the passage of time."
The same view was taken by Gujarat High Court in the case of Jayantilal Bhogilal Dasai vs. CIT reported in (1981) 130 ITR 655 (Guj).
11. Therefore as a matter of law no profit or gain could arise to firm by creation of goodwill account in the firm or by crediting partners' accounts in their profit sharing ratio the amount of such goodwill, which can be subjected to tax. In that view of the settled position of law, the assessment order could not have been said to be an order prejudicial to the interest of Revenue, qua the goodwill account.
12. Law is also well settled that no capital gain or transaction resulting in creating a charge under IT Act arises on a partner contributing an asset as his capital to the firm of which he is a partner or an asset of firm being distributed amongst partners of which they are otherwise co-owners inasmuch as such transaction does not result in passing of any consideration which only can be foundation for charge of capital gains. The principle was firmly stated by the Supreme Court in the case of Sunil Siddharthbhai vs. CIT (1985) 156 ITR 509 (SC) wherein the Court opined that though contribution of a capital asset as capital by a partner who is the partner of the firm is transfer under s. 45 but the partner does not receive any consideration within the meaning of s. 48 and therefore no profit or gain accrue to him for the purpose of capital gains tax levy under s. 45. The principle equally applies when at the dissolution of the firm the assets are distributed amongst partners. Therefore even assuming that the creation of goodwill in the books of accounts of the firm and its distribution amongst the capital gains of the partners be treated as transfer of the capital asset of the firm still it could not have resulted in any revenue under the IT Act.
13. Much emphasis has been laid by the CIT as well as by the Tribunal to find out ultimately how the business has passed on to the company. Firstly it is an admitted fact and does not need any enquiry that the business of the firm was ultimately taken over by the company, which became its partner on 23rd Nov., 1973, on the dissolution of the firm on 27th Feb., 1974. This transaction also as per law applicable at the time could not have resulted in any tax liability against the firm, on transfer of goodwill.
As per law as existing prior to its amendment w.e.f. 1st April, 1987, conversion of partnership asset into personal assets on dissolution did not result in transfer of a capital asset for consideration for the purpose of levy of capital gains. Therefore when the business of the firm came to be vested in the company which was a partner of the dissolved firm on the dissolution of the firm as a result of settlement of accounts between the parties in February, 1974 it also did not give rise to any taxable event. Even if on such transfer of business to the company on dissolution of the firm would have attracted levy of tax, it would not have made order passed for the asst. yr. 1974-75 as prejudicial to the interest of the Revenue. The event on which much emphasis has been laid by the Tribunal and the CIT clearly happened beyond the period which was under consideration for the asst. yr. 1974-75. The Revenue authorities have fallen into error by not noticing the most relevant fact as to when the business of the firm became the business of the company and it consequently failed to appreciate that even that has no bearing as far as the asst. yrs. 1974-75 were concerned.
14. Therefore, in our opinion, the conclusion of the Tribunal in affirming the decision of the CIT that the order of the ITO for the asst. yr. 1974-75 was erroneous for want of making enquiry, and is otherwise prejudicial to the interest of Revenue is not well founded in law.
15. Accordingly, we answer both the questions referred to us in negative that is to say in favour of the assessee and against the Revenue. There shall be no order as to costs.