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The purpose of this article is to examine the situation where trading results declared by the assessee in the books of accounts is not accepted by the Income Tax department for defects in the books of accounts and when there is low Gross Profit Rate as compared to previous year.��

Gross profit rate is a very important aspect of any scrutiny assessment u/s 143(3) of the Income Tax Act. Whenever any case is taken up for scrutiny the first question arises about the trading result of the assessee as compared to the preceding years.

Before I proceed about taxation issues let us first understand the components of Gross profit::

Components of Gross Profit:

A. Selling Price:

Before comparing and working out Gross profit following requires to be looked into

a. Vat on sale

b. Discount on cash sales to customers

c. Discount on credit sales

Vat on sales is charged from customers. But is observed that In many cases goods are sold on MRP. It means MRP includes VAT also. By applying backward calculation VAT is worked out and paid to the department. In this situation it is quite possible that VAT paid is shown as an expense in Profit & Loss Account. In other cases VAT paid is deducted from Gross Sales Figure and NET figure is shown in Trading Account.�� So while comparing gross profit ratio adjustment of VAT may be required to give a comparative figure.

Cash Discount to customers Generally cash memo is raised on MRP. But discount is requested by the customers and keeping in mind the factors like how old is the customer, volume of purchases, frequency of purchases, minor defects in product etc discount is allowed sometimes in lump sum and sometimes in % terms. These are cash discounts and sales are entered in cash memo on net figure realized from customers. If we compare MRP with cost it will not give a correct figure unless adjustment for discount is also made.

Discount on credit sales is another very important factor. There may be a situation where Gross Profit is higher but huge discount is allowed at the time of payment. So while comparing Gross profit ratio discount allowed to customers shown in profit and loss account should also be kept in mind,.

B. Cost of goods

Apart from purchase price of the goods, assessee may be required to pay freight, Insurance, CST, other octroi and taxes. These should also be kept in mind while working out GP and comparing it with previous year of the assessee or other assessee in the same trade.

C. If the assessee is dealing with more than one item, the gross profit ratio for each item should be separately worked out. Otherwise it will give misleading information every year depending upon the sale volume of a particular product,


The problem arises as soon as it is noticed that GP ratio is lower than ratio shown by the assessee in previous year. The assessee is generally asked to explain the reasons for fall in GP Rate. Now the onus is on assessee to prove that gross profit ratio shown in the books is correct and there is no defect in the books of the assessee.

Now the assessee is to examine the following:

a. Whether there is substantial increase in turnover. At many occasions the assessee is to reduce its profit margin to gain extra turnover.

B. assessee should prepare a chart covering all the twelve months and select a reasonable no of sales vouchers to show the selling price and related cost price. It means Gross profit for selected sales vouchers is separately shown and average of the total samples taken comes to margin shown in trading account. This way the assessee may be in a position to verify the GP rate and also verify how lower GP has come.


Section 145(3) of Act provides for assessment in the manner prescribed in Section 144 of the Act where the Assessing Officer is not satisfied about the correctness or completeness of the accounts of the assessee or where either the method of accounting provided in sub-Section (1) or the accounting standards as notified under sub-Section (2) having been regularly followed by the assessee.

If the assessing officer is not satisfied with the book result i.e. gross profit shown by the assessee, he may reject the books u/s 145(3) and estimate gross profit ratio. But before doing that he has to give finding that the there are DEFECTS IN BOOKS OF ACCOUNTS e.g.

a. purchase, sales, direct expenses, valuation of stock etc shown in the books is not correct.

b. accounts written are not full and complete and do not reflect the actual receipts on sales.

c. Actual quantity of finished product produced by the assessee is more than what it has shown in the accounts books.

d.. The assessee had made any sale of the finished product which is not been reflected in the accounts books.

e. The finished product has been sold by the assessee at a price higher than what is declared in the accounts books.

f. Assessee not maintaining any stock register and adopting closing stock without any supporting documents to enable verification

g. the Central Government had notified any particular accounting standards to be followed by the assessee and the assessee has not followed it.

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h. The rate of Gross Profit declared by the assessee is low as compared to other assessee�s in the same line of business.

If the rate of gross profit declared by the assessee in a particular period is lower as compared to the gross profit declared by him in the preceding year, that may alert the Assessing Officer and serve as a warning to him, to look into the accounts more carefully and to look for some material which could lead to the conclusion that the accounts maintained by the assessee is not correct. But, a low rate of gross profit, in the absence of any material pointing towards falsehood of the accounts books, cannot by itself be a ground to reject the account books under Section 145(3) of the Act.

It is well known that in case of transactions in cash, the purchaser and the seller often do not bother to keep details of their identity. So the name of the customer if not mentioned on cash memo cannot be treated as defect in the books of the assessee.

Maintenance of Stock Register

Non maintenance of stock register on day to day basis by itself does not lead to inference that it is not possible to deduce the true income of the assessee from the accounts maintained by assessee, nor can the accounts be said to be defective or incomplete for this reason alone. If stock register is not maintained by the assessees that may put the Assessing Officer on guard against the falsity of the return made by the assessee and persuade him to carefully scrutinize the account books of the assessee. But the absence of one register alone does not amount to such a material as would lead to the conclusion that the account books are incomplete or inaccurate.

If the assessee is dealing in such items where maintenance of stock register is not possible i.e. keeping in mind the quantity, size, varieties, processes involved in production etc it can�t be treated as defect for application of section 145(3) of the Act.��

Rate of profit cannot be assumed merely on assumptions, surmises and conjecturesIn case the books of account are rejected, onus lies on the AO to determine the rate of profit on consideration of material which may be brought before him.


The procedure for making assessment in a matter where voluntary return submitted by the assessee under s. 139(1) is not accepted by the AO has been given under s. 143(3). Whereas procedure for giving best judgment assessment is given under s. 144. Merely because the procedures for such assessment have been separately provided in the aforesaid two sections relating to an assessee where the voluntary return has not been found as acceptable by the AO and where the books of account have been rejected and best judgment assessment has been made. It would not in itself be sufficient to hold that the statutory deductions which are otherwise available to the assessee, would not be available to the assessee who has been assessed under best judgment assessment by the AO, unless, of course, any rule or provision of the Act expressly excludes the benefit of statutory deductions to such an assessee,.

By Deepak k Gujrati FCA

Cases Referred: The High Court of Delhi at New Delhi, Commissioner of Income Tax v. Smt Poonam Rani ITA 406/2009 judgement delivered on 07-05-2010;

Madnani Construction Corporation P Ltd. vs Commissioner Of Income-Tax on 5 December, 2006;

Commissioner of Income Tax v. M/s Jas Jack Elegance Exports, High Court of Delhi at new Delhi ITA 681/2010;

ASSISTANT COMMISSIONER OF INCOME TAX vs. JAGAT SINGH & SONS* ITAT, CHANDIGARH 'A' BENCH ITA Nos. 1257 & 1258/Chd/2004 and C.O. Nos. 30 & 31/Chd/2005 16th June, 2006 (2007) 11 SOT 147 (Chd);


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Category Income Tax, Other Articles by - deepak K Gujrati