RAJAMANNAR, C.J. - The question of law referred by the Income-tax Appellate Tribunal in accordance with the direction of this Court in C.M.P.Nos. 5830 and 5831 of 1946 is as follows :-
'Whether on the facts and in the circumstances of this case while the opening stock had been valued on the average costs basis, in accordance X with the method of accounting regularly followed by the assessee in the past, the method of valuing some items of the closing stock on the average cost basis and others on the market basis for the relevant account year is in conformity with law and principle and whether the true profits of the year can be properly deducted from such basis of valuation.'
The assessees are dealer in dye-stuffs and chemicals comprising numerous items. In valuing their opening and closing stock, the method followed by them was to take the average cost or market value, whichever was lower, in respect of the each separate article of the stock. For the relevant period the average cost of the opening stock was in respect of all items lower than the market rate and so the assesses valued the opening stock (which was the closing stock of the next preceding year) on the average cost basis. At the time to valuing the closing stock, with regard to some of the other articles the market rate was lower, Whereas with regard the other articles the market rate was higher than the average cost. Therefore, the respondents took the average cost as the value of the closing stock for those articles of which the cost was lower than the market rate and adopted the market rate for other articles of which the market rate was found to be lower than the average cost. The Tribunal accepted the method adopted by the assessees.
The contention on behalf of the Commissioner of Income-tax and Excess Profits Tax is that this method is wrong and the correct method would be to arrive at two separate valuations of the closing stock, one the aggregate of the actual average for each of the actual average cost for each of the articles and the other the aggregate of the market value of the same articles and to adopt the lower of the two aggregates.
The question for decision lies within a very narrow compass, but no authority directly in point has been cited to us by either counsel. The question shortly is whether in arriving at a valuation of the stock an assessee is entitled to adopt the average cost or the market rate, which ever is lower, itemwise or only in the aggregate.
It is admitted by learned counsel for the department that if an assessee is doing business in one kind of merchandise, he is entitled to adopt for purpose of valuation of stock, either the average cost or the market rate, whichever is lower. He called this a concession, probably meaning thereby that there is nothing the Act which lays down such a rule of valuation. But the rule appears to be well established both in England and in India, and it had been contended by the Income-tax authorities that it is mere matter of concession ex gratia which they could refuse to grant in any particular case.
Stock-in-trade hand in an essential item in the computation of the profit for a period. The accepted basis of valuation of stock is cost or market value, whichever is lower, at the date to which the accounts for a period are made up. In Whimster & Co. v. Commissioners of Inland Revenue the Lord President of the Court of Session in Scotland enunciated two general fundamental principles which have always to be kept in mind in computing the balance of profit and gains for the purposes of income-tax or for the purpose of excess profits duty, thus :-
'In the first place, the profits of any particular year or accouning period must be taken to consist of the difference between the receipts form the trade or business during such year or accounting period and the expenditure laid out to earn those receipts. In the second place, the accounts of profits and loss to be made up for the purpose of ascertaining that difference must be framed consistently with the ordinary principles of commercial accounting, so far as applicable, and in conformity with the rules of the Income-tax Act, or of that Act as modified by the Provisions and schedules of the Acts regulating Excess Profits Duty, as the case may be. For example, the ordinary principles of commercial accounting require that in the profit and loss account of a merchant or manufacturers business the values of the stock-in-trade at he beginning and at the end of the period covered by the account should be entered at cost or market price, whichever is the lower; although there is nothing about this in the taxing statutes.'
Coutts-Trotter, C.J., states the rule as follows in Commissioner of Income-tax v. Chengalvaraya Chetti :-
'I should add that the accepted rule is that the assessee in crediting the closing stock figure is to take either the cost price or the market value whichever be the less-a provision obviously intended to be in favour of the trader and which enables him more evenly to distribute his loss.'
This rule has been sometimes described as in exception to the general rule, namely, the rule that a precautionary reserve for anticipated loss is not allowable and no unrealised loss could to be set off against the profits of the period. In Halsburys Laws of England (2nd edition), Vol. 17, Section 232 runs thus :-
'It is to be observed that the allowable by the Inland Revenue authorities of a writing down of stock when the market rate value is lower than the cost is in effect the allowance of a reserve for future unrealised loss and as such is an exception to the general rule that precautionary reserves are not allowable.'
In Whimster & Co. v. Commissioners of Inland Revenue, Lord Sands observed at page 827 :-
'The consideration of how it would be prudent for a trade to act does not solve the question here presented to us as one of Revenue law. Under this law the profit are the profit realised in the course of the year. What seems an exception is recognised where a trader purchased and still holds goods or stocks which have fallen in value. No loss has been realised. Loss may not occur. Nevertheless, at the c lose of the year he is permitted to treat these goods or stock as of their market value. This exception to the general rule has never, however, been extended to the case of probable or indeed apparently inevitable loss to be incurred in the execution of future contracts entered into during the year in question, and the authorities are against it.'
Mr. Rama Rao Sahib, learned counsel for the department, argued that the method adopted by the assessees in this case does not enable the profits and gains of the period to be properly deduced. He says that the profits of the business as a whole must be ascertained, and that means, with reference to the stock comprising several articles, the proper computation can be made only by ascertaining the aggregate of the market value of each of the articles. If the assessees are allowed to adopt the market value only when it is lower than cost with respect to a particular article on the theory of a notional loss, likewise, he contends, they must be compelled to adopt the market value even when it is higher than the cost because they would be making a notional profit. Calculating on this basis, so the argument ran, the true profits and gains can be ascertained as regards the stock. Though at first sight the argument loss plausible, we consider that there is a fallacy underlying it. In the illustrative case which we mentioned above, namely, where the business comprised only one kind of article of merchandise, supposing the market value at the closing date is higher than the cost, the Income-tax authorities cannot compel the assessee to value the stock on the basis of the market rate on the ground that the assessee had made a profit. If this is so in case where the business comprises one kind of article, we fail to see why there should be a different principle when there are several kinds of articles. The real point which cannot be overlooked is that as regards stock the Income-tax department does not assess the unrealised notional profit.
In dealing with the case of a company carrying on the business of speculative building and the method of making out an account of the profit for period of assessment, in respect of houses completed or partially completed, and unsold, in B.G. Utting & Co. Ltd. v. Hughes (H.M. Inspector of Taxes), Clauson L.J., observed thus :-
'In order to ascertain the profit of the period of assessment he must credit the account with an item to represent the assets completed or partially completed but unsold. The normal method of dealing with this item would be to make it up by calculating cost or market value, whichever is the lower, of the various assets represented. The one thing which it would obviously be wrong to do would be to make up the item by putting on the assets the market value if it exceeds cost; that would result in swelling the gross profit (the balancing items on the other side) by bringing an as part of the gross profit an unrealised profit, i.e., it would put into the profit of the period of the assessment the profit expected to be realised in the future.'
We, therefore, cannot accept the contention of the learned counsel for the department. If one can speculate on the rationale of the rule, which allows an assessee to adopt the market value when it is lower than the cost, it appear as to be this : If one were to imagine a sale taking place on the closing day of the entire stock, it is reasonable to expect that the articles of which the market value is lower would not fetch anything more than at those rates, and therefore loss would be certain. But there would be no assurance that there would be a market for the entire stock of articles of which the market value is higher and therefore it would be hazardous to assume that the entire stock could be sold at the prevailing market rate and necessarily bring in a profit. Be that as it may, there is no provision of law or principle according to which the assessee could be compelled to adopt either the average cost for all the items for the market rate for all the items.
We consider that the question must be decided on the provisions of Section 13 of the Income-tax Act. Under the section, the assessee is entitled to compute the income, profits and gains in accordance with the method of accounting regularly employed by him, and ordinarily this method must be accepted by the department. It is only if in the opinion of the Income-tax Officer the method employed is such that the income, profits and gains cannot properly be deduced therefrom that he can disregard it altogether. No doubt, in cases of gross under-valuation of stock, the Income-tax Officer may refuse to accept the valuation of the assessee. Equally, the assessee will not be allowed to arbitrarily the change the method accounting to suit his purposes (vide Commissioner of Income-tax v. Chengalvaraya Chetti). But if it is found as in this case that the method adopted by the assessee in the period of assessment is in accordance with the method accounting regularly followed by the assessee in the past then that method must be accepted in the absence of anything to suggest that it is improper or patently false. As the privy Council observed at page 244 in Commissioner of Income-tax, Bombay v. Sarangpur Cotton ., of Ahmedabad, the section 'clearly makes such a method of accounting a comprlsory basis of computation, unless, in the opinion of the Income-tax Officer, the income, profits and gains cannot properly be deduced therefrom.' It had not been established before us in this case that there was anything in law or principle which empowered the Income-tax Officer to reject the method of accounting adopted by the assessees.
The answer to the question must be in the affirmative. The respondents will have their costs, Rs. 250.
Reference answered in this affirmative.