Even in the case of an illegal business, Section 40A(3) would come into play and the taxable total income has to be computed in accordance with the I-T Act.
T. C. A. Ramanujam
Income-tax law has a radical provision for disallowing cash expenses in excess of Rs 20,000 where payment is made otherwise than by an account-payee cheque or bank draft. What happens if the entire business is meant to be unaccounted or illegal? In other words, will the provision for disallowance of cash expenditure apply to transactions outside the book?
Hynoup Food case
The question was considered by the Gujarat High Court in CIT vs Hynoup Food & Oil India (P) Ltd (290 ITR 702). In this case, the firm was searched under Section 132 of the I-T Act. During the course of search, the assessee firm admitted that it was carrying on unaccounted business which was not reflected in the regular books of account maintained by the firm.
It was explained that such unaccounted transactions were always made in cash and, therefore, Section 40A(3) of the I-T Act providing for disallowance cannot apply. It was also pleaded that the case will fall under the exception carved out in Rule 6 DD(j) of the I-T Rules 1962 and Circular No. 22 of the Central Board of Direct Taxes (CBDT) dated May 31, 1977.
The Tribunal ruled in favour of the assessee firm. The Department took up the matter in reference before the Gujarat High Court. The question for consideration was whether transactions outside the books will be left uncovered by Section 40A(3).
Outside the books
The High Court held that even if business expediency gets established by virtue of the entire business being kept outside the purview of the books of account, an assessee cannot seek recourse to exemption from the operation of the section and the rules without showing the genuineness of the payment and identity of the payee. In the absence of the identity of the payee, it will not be possible for the Department to ascertain the destination of the payment.
The Revenue must be able to verify the genuineness of the transaction and identify the recipient of the cash payment. The firm had not established in any manner business expediency and the exceptional and unavoidable circumstances warranting payment in cash. It is for the assessee to show that payment by crossed cheque of draft would have caused genuine difficulty to the payee having regard to the nature of the transaction and the necessity for expeditious settlement. The onus is on the assessee to establish the genuineness of the payment and the identity of the payee.
The Gujarat High Court quoted with approval the ruling of the Andhra Pradesh High Court in the S. Venkata Subba Rao (173 ITR 340) case. The Andhra HC had held that once it is conceded that the profits and gains derived from the ill egal business are liable to be taxed, then all the provisions of the I-T Act must apply. It is not possible to hold that some of the provisions such as Section 40A(3) do not apply to the assessment of taxable income in the case of illegal business while some others do.
It is not possible to draw a distinction between several provisions of the Act, one set applying to the assessment of income arising from illegal business and the other set not applying thereto. Maybe, in an illegal business such as smuggling, it may not be practicable to comply with the requirements of Section 40A(3). But that only means that such illegal business ought not to be carried on.
The legal position that emerges from the Gujarat High Court ruling is that even in the case of an illegal business, Section 40A(3) would come into play and the taxable total income has to be computed in accordance with the provisions of the Act.
This ruling of the Gujarat High Court raises interesting questions about unaccounted business and transactions outside the book. When the whole business is outside the books, the normal procedure would have been to leave it to the ITO to make an estimate of the income. In such cases both the buyer and seller intend that the transactions should be left unaccounted. This itself can constitute an exceptional circumstance. In all such cases, the net result of the investigation will be that the accounts are not verifiable.
It will be interesting to note that other High Courts have chosen to take a different view in the matter. The Madhya Pradesh High Court, in CIT vs Purushottamlal Tamrakar (270 ITR 314), held that Section 40A(3) can have no applicat ion when net profit rate was adopted in the case of search and seizure. A similar view was taken by the Allahabad High Court in CIT vs Banwarilal Banshidhar (229 ITR 229).
The Finance Act, 2007 has amended Section 40A(3) enhancing the disallowance from 20 per cent to 100 per cent in the case of cash expenses. The CBDT will have to take into account this judicial controversy while framing Rules under the amended section.
(The author is a former Chief Commissioner of Income-Tax.)