1. These two appeals filed by the assessee firm are directed against the common order dt.27.10.2006 passed by the Commissioner of Income Tax (Appeals), Rajahmundry, and they pertain to the assessment years 2003-2004 and 2004-2005. As the issue involved in both the appeals is common, I proceed to dispose of these appeals by a combined order for the sake of convenience.
2. The assessee firm is engaged in the business of running a Nursing Home in the name and style of M/s. Arthi Nursing Home. In respect of previous years relevant to assessment years under consideration the assessee declared taxable income of Rs. 45,540/- and Rs. 42,800/- respectively net of partners remuneration and interest on capital and depreciation. Though the returns were originally processed under Section 143(1) of the Income Tax Act, consequent to survey operations conducted on 20.12.2002 notices were issued under Section 142 of the Act and cases were taken up for scrutiny. During the course of assessment proceedings, the Assessing Officer noticed that in respect of assessment year 2003-2004 the capitals of the partners were taken at Rs. 2,58,387/- and Rs. 4,08,881/- respectively of Smt. Dr. K. Jyothi and Sri Dr. K. Chidambar. Similarly, for the next assessment year, the capitals of the partners were shown at Rs. 2,40,626/- and Rs. 4,09,179/- respectively and interest was paid to the partners on such capital balance. As could be noticed from the computation of income of the firm, the assessee was not urging depreciation to the profit and loss account, but claimed the same in the computation of total income, thereby creating an artificial increase in the apportioned capitals of the partners.
3. Under the circumstances, the Assessing Officer was of the view that the capitals of the partners have to be apportioned after reducing the depreciation claimed in the computation of income and by so re-computing, it was noticed that instead of credit balances in the capital accounts, it resulted in debit balances implying thereby that there were withdrawals from the capitals on which the assessee has to charge interest at the rate of 18% per annum. He accordingly disallowed the claim of payment of interest and added back the interest receivable from the partners as per the adjusted capital accounts.
4. Aggrieved, the assessee contended before the first appellate authority that the revenue authorities are not entitled to re-write the books of account and since the assessee has not debited the depreciation to the capital accounts, the balances reflected in the capital accounts as per the assessee ought to have been taken into consideration. In this regard, the learned Counsel placed reliance upon the decision of I.T.A.T., Visakhapatnam Bench in the case of Ambica Chemical Products v. D.C.I.T., Circle-1, Eluru in I.T.A. No.612/Vizag/1999 and I.T.A. No. 9/Vizag/1999, dt.31.5.2005, wherein the Bench followed the decision of I.T.A.T., Chandigarh Bench, in the case of A.C.I.T., v. SantShoe Store  88 ITD 524 (CHD.).
5. The learned CIT(A) was not convinced with the submissions of the assessee. He observed that the assessee admittedly claimed benefit of depreciation under Income Tax Rules for the purpose of getting benefit of reduced taxable income, but at the same time, the same was not taken into consideration for the limited purpose of showing higher amount of profit which can be carried forward to the capital accounts of the partners. The scheme of depreciation under the Income Tax Rules pre-supposes an essential condition that in accordance with the established principles of accountancy, depreciation, like any other head of expenditure, is required to be debited to the profit and loss account to arrive at the real profits of the business. The profit so arrived would then be apportioned for allocating among the partners.
Hence, debiting of depreciation is a cardinal principle of mercantile system of accounting, otherwise, the figure of the net profit would be reflected at an unrealistic and falsely higher figure. If this is the real state of affairs, then the question of charging of interest on the profit/capital accretion element embedded in the depreciation not charged to the profit and loss account does not arise at all. The figures of accretion to the capital year after year can be said to be exaggerated and fictitious and not in accordance with the cardinal principles of accountancy. For the purpose of completing the assessment, correct determination of the capital balances based on proper method of accounting is essential. The capital balances reflected in the books of the assessee are not in accordance with any standard accountancy principles and therefore the Assessing Officer was held to be justified in correcting such error and in recomputing the capitals. Thus, the disallowance of claim of interest payment to partners and the charge of interest on the overdrawals was held to be in accordance with law.
6. With regard to the observations of the I.T.A.T., Chandigarh Bench in Sant Shoe Store (supra), upon which the I.T.A.T., Visakhapatnam Bench had relied in Ambica Chemical Products (supra), the Commissioner observed that the case-law is distinguishable en facts inasmuch as in the instant case there is no question of re-writing of books of account. The books of account have already been written for all the years. What has been done by the Assessing Officer is verification of the correctness of the various heads of account, including that of capital balances of partners. In other words, the Assessing Officer has undertaken an exercise of discovery of the correctness, and on such discovery, gave a finding of fact to the effect that the capital balances of the partners had been artificially inflated so as to claim unwarranted invest expenditure under Section 40(b) which had the result of reducing the taxable incomes for the relevant assessment years. The learned Commissioner thus upheld the orders passed by the Assessing Officer for both the assessment years.
7. Further aggrieved, the assessee is in appeal before the Tribunal.
The learned Counsel appealing on behalf of the assessee submitted that in order to claim deduction of interest paid to partners, there is a statutory prescription under Section 40(b) of the Act, which has nothing to do with the profits and it is based on the books of account maintained by the assessee. In the instant case, the assessee having consistently followed a particular method of not charging depreciation to the profit and loss account, though for the purpose of computation of income under the Income Tax Act depreciation was claimed as deduction, the balances shown in the capital accounts reflected the true and correct figure and the same cannot be re-written by the Assessing Officer in the light of the decisions of the I.T.A.T., referred to before the first appellate authority.
8. On the other hand, the learned DR submitted that the case law relied upon by the learned Counsel are distinguishable on facts. He further contended that Section 32 of the Income Tax Act has undergone a change with effect from 1.4.2002 whereby depreciation has to be mandatorily claimed as deduction in which event, the same has to be taken into consideration by debiting it to the profit and loss account so as to reflect true and correct profit which is also in tune with the accountancy standards prescribed by the Institute of Chartered Accountants of India (AS.20). Since depreciation is a necessary charge to the profits, in order to arrive at the true and correct profit, assessee cannot artificially inflate the profit and apportion such profit to capitals of the partners as it is contrary to the mandatory provisions of the Income Tax Act as applicable with effect from 1.4.2002. The Assessing Officer was justified in re-computing the income to work out the re-adjusted capitals and consequently, he was justified in disallowing the claim of payment of interest as well as making an addition towards interest payable by the partners as per the partnership deed dt.1.4.2002. The learned DR further submitted that even as per explanation (3) to Clause (b) of Section 40 'book profit' has to be computed in the manner laid down in Chapter IV-D of the Act.
Explanation (5) to Section 32 which is a part of Chapter IV-D states that insofar as depreciation is concerned, it has to be reduced from the profits of the business whether or not the assessee has claimed said deduction in computing its total income. Therefore, the assessee is not permitted to show book profit without claiming depreciation. In other words, the case of the Revenue is that the assessee is not entitled to artificially boost his profits.
9. The learned DR has also relied upon the decision of the Hon'ble Supreme Court in the case of C.I.T. v. British Paints India Ltd. wherein the Court observed as under.
It is not only the right but the duty of the Assessing Officer to consider whether or not the books disclose the true state of accounts and the correct income can be deduced therefrom. It is incorrect to say, as contended on behalf of the assessee, that the officer is bound to accept the system of accounting regularly employed by the assessee the correctness of which had not been questioned in the past. There is no estoppel in these matters and the officer is not bound by the method followed in the earlier years.
10. He further contended that in the case of Sant Shoe Store (supra), a sum was credited to capital account of partners on account of revaluation of building owned by assessee - firm. The Assessing Officer took the view that the credit entries only represented notional introduction of capital. Therefore, he disallowed the interest payable on such notional capital. Under the given facts, the Tribunal took the view that it is not correct on the part of Revenue to show that the share of accretion was wrongly credited to the accounts of the partners and accordingly held that as the entry was legally made and effective, it has to be adopted and not treated as notional or inconsequential and further held that the assessee is entitled to interest on such coital reflected in the books of account. In other words, the emphasis was on the fact that the re-valuation is legally permissible and in such circumstances, it cannot be interfered with. The accounting standards also permit revaluation of asset, however, in the instant case, the procedure followed by the assessee is contrary to the accountancy standards, i.e., A.S.20. It is well-settled that depreciation is an automatic charge to the profits of the firm and as such arriving at the profits without reducing the depreciation component thereby showing a higher credit balance to the capital accounts of the partners is not legally permissible and therefore the Assessing Officer was justified in correcting such error.
11. Similarly, in the case of Ambica Chemical Products (supra), the Visakhapatnam Bench merely followed the decision of I.T.A.T., Chandigarh Bench in Sant Shoe Store (supra) and even otherwise, the case pertains to 1994-95 and 1995-96 which falls before the introduction of explanation (5) to Section 32 of the Act, whereby the claim of depreciation has become mandatory under the Income Tax Act.
12. It may be noticed that the learned Counsel for the assessee has placed a copy of the decision of I.T.A.T., Hyderabad Bench in the case of Prasad & Co. v. D.C.I.T. 43 ITD 93 (Hyd.) in support of his contention that where an identical issue has already been decided by the Tribunal such decision is binding on the Commissioner. It may be noticed that the case of the learned DR is that the decision was rendered on a different set of facts whereas, in the instant case, the case-law relied upon by the assessee are not applicable for the assessment years under consideration.
13. Joining the issue, the learned Counsel appearing on behalf of the assessee submitted that explanation (5) to Section 32 of the Act was followed by the assessee since depreciation was already claimed for the purpose of arriving at the taxable profit for income tax purposes.
However, consistently, the assessee followed the method of not incorporating the same for the purpose of apportionment of profit to the capitals of the partners. He also submitted that accounting standards reed not be followed by the firms and if contrary view has to be taken on the issue, the matter requires to be referred to Special Bench in the light of the Division Ger.ch decision of the I.T.A.T., Visakhapatnam, in the case of Ambica Chemical Products (supra) and therefore, he made an alternative request to refer the matter to Special Bench.
14. I have carefully considered the rival submissions and perused the record. The assessee mainly relies upon the decision of I.T.A.T., Visakhapatnam Bench in the case of Ambica Chemical Products (supra), which in turn is solely based upon the decision of I.T.A.T., Chandigarh Bench in Sant Shoe Store (supra) and therefore, in order to appreciate the contention of the assessee, the decision in the case of Sant Shoe Store requires to be analysed. In paragraph-12 of the reported decision, the Bench observed as under: ...When capital is brought to the partnership by a partner in a form other than cash, its market value is credited to the capital account of the partner, it may be a notional entry. The true value of all the entries can be determined only at the time of dissolution of the partnership when all the assets and liabilities are taken into account to find out the net wealth of the partnership. The value of share of a partner thus determined is real. Everything till that date is notional only. Yet for the sake of convenience and for practical purposes, entries are made having regard to the market value of items and transactions involved. Till the actual value is determined, the partnership acts on the above notional entries. For all practical purposes, these notional entries are as good as real.
These are binding on partners and partnership.
15. As per the accounting standards, depreciation has to be charged to the profit and loss account as otherwise, true and correct profits of an entity cannot be deduced therefrom. Even under the Income Tax Act, by virtue of explanation (5) to Section 32 of the Act, depreciation has to be charged to arrive at the correct profits. In fact, the assessee has claimed depreciation for the purpose of arriving at the taxable income. Such being the case, as observed by I.T.A.T., Chandigarh Bench in the case of Sant Shoe Store (supra), the notional entry of depreciation has to be treated as real and the same has to be incorporated for the purpose of arriving at the correct profit and only the balance amount has to be taken to the capital accounts of the partners. Any deviation from the said method can be corrected by the Asserting Officer. In the instant case, the Assessing Officer having precisely corrected the obvious omission of the assessee, in not reducing the depreciation from the profit arrived at by the assessee, the action of the assessee is contrary to the decision of the I.T.A.T., Chandigarh Bench. Thus, the evasion of I.T.A.T., Chandigarh Bench, fully supports the stand of Revenue. If it is treated as a notional entry, the same has to be treated as real for all practical purposes and it would be binding on the partners as well as on the partnership firm. Such being the case, the action of the assessee in not charging to the profit and loss account the depreciation element would amount to artificially inflating the capital balance of the partners. Therefore, the Assessing Officer, in the instant case, was justified in correcting the said error. The decision in the case of I.T.A.T., Visakhapatnam Bench in Ambica Chemical Products (supra), was rendered without reference to the accountancy standards and it was for the assessment year 1999-95 and 1995-96, which is prior to the introduction of explanation (5) to Section 32 of the Act and thus the decision of I.T.A.T., Visakhapatnam Bench, is distinguishable on facts. At any rate, the Hon'ble Supreme Court in the case of British Paints India Ltd. (supra) categorically observed that unless a correct method of accounting is followed by the assessee, the Assessing Officer is duty bound to consider whether or not the books disclose true state of accounts and correct the mistakes in conformity with the standard method of accounting. At the cost of repetition, it requires to be noticed that the system adopted by the assessee does not disclose true and proper income and therefore, the Assessing Officer was entitled to adopt proper computation to determine true income which in turn would affect the amount to be apportioned to the capital accounts of the partners.
16. In the light of the Apex Court decision in British Paints India Ltd. (supra) and provisions of explanation (5) to Section 32 of the Act as well as accounting standards prescribed by the Institute of Chartered Accountants and also in view of the fact that the method of not charging depreciation to the profit and loss account would not depict the true and correct state of affairs of the partnership firm, I am of the considered opinion that the Assessing Officer was justified in correcting the error thereby disallowing the interest claimed by the assessee under Section 40(b) of the Act and he is also justified in making addition towards the interest receivable from the partners.