Tax Audit u/s. 44AB of the Income-tax Act, 1961

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1 Special Story Tax Audit u/s. 44AB of the Income-tax Act, 1961 Preamble The article that I have been requested to contribute was simply titled Tax Audit u/s 44AB. This topic is extremely vast and has been the subject matter of numerous books. It is also topic which every year sees fresh controversies. Therefore, there is no dearth of material already written on the subject, and no end to the number of issues that one can raise under this broad title. To make this article meaningful, and capable of being part of the issue of IT Review, I have restricted myself to the broad topics suggested by the editorial board in formulating the outline of the issue. It is entirely possible that subjects that some readers may consider important may not have been addressed, but I trust you will appreciate the limitations of time and space within which one must operate. 1. Tax audit Is it still relevant and useful to the Income-tax Department 1.1 In the numerous areas of professional work performed by a chartered accountant, tax audit conducted under the provisions of section 44AB of the Income-tax Act, 1961 has come to occupy an important role, especially for small and medium sized practitioners. The introduction of this audit u/s Section 44AB in 1984 was however with the purpose that Tax Audit Report would assist in the process of better assessment. It is at times felt by professionals, that this whole exercise is a formality which yeilds very little productive information to 1.2 Such a narrow view ignores the historical perspective and the subsequent developments that have taken place. Those who have been in practice for more than a couple of decades would recall that virtually every income tax return was the subject matter of assessment under section certainly conclude that an approach of undertaking only selective scrutiny, and acceptance of even high income returned u/s 143(1) was a step possible only once there was a basic level of confidence that assessees in the higher tax bracket (who had business income) had complied with the minimum requirements of maintenance of books of account and that the same had been subjected to a scrutiny by a professional. One can therefore say that in a larger perspective, the object of introduction of a certain amount of discipline in maintenance of books and records has certainly been achieved. Secondly, since C.As. are following up with their clients in regard to tax audits, there is a definite trend towards better and more timely compliance with the provisions of the Act. 1.3 However, the issue remains that with submission of so much of data, has the quality of assessment improved? With the increase in amount 19

2 of data provided by the revised Form 3CD, the process of assessment should really be speeded up since the A.O. can focus on more important areas rather than grinding the assessee through an various expenses. 1.4 The introduction of e-filing whereby no return has given a new twist to the situation. It has audit report along with the acknowledgement to be filed in physical form may be permitted. This has been suggested because making a selection for scrutiny without reference to a tax audit report may render the process of selection truly random (beyond what is intended). For example a tax auditor may have stated that the financial of inventory valuation standard not having been accounting practices. Under the procedure presently prescribed, the tax authorities would not have the benefit of such inputs since the tax audit report itself is not available at the time of selection of the sample. 1.5 On the other hand, once a particular return to go for verification of facts which have already been reported in excruciating detail. Since number of cases selected for scrutiny is much smaller, the assessing officers have developed a mindset whereby even in cases where there is an absolutely clean report, a detailed exercise of verification is carried out in the belief that almost every case selected for scrutiny warrants some addition or the other to be made. Such a detailed enquiry is not only troublesome to the assessee but sets at nought the effort taken by the auditor. I therefore, feel that there is need for some sort of instruction/ procedure to be prescribed by the CBDT whereby normally, data which has been stated to be correct as per the audit report should not be subjected to detailed scrutiny unless there is some reason to believe that the data furnished is erroneous. At times, the data often subjected to a re-checking at the time of assessment, but it is almost as if a super-audit of the auditors performance is also undertaken. 1.6 In balance I would however believe that while the efficacy of tax audit as a tool for improving assessment can be significantly enhanced, the tax audit provisions have certainly contributed positively in the task of compliance and revenue collection. Thus while there is always scope for improvement, one can only conclude that tax as originally contemplated. 2. Is the information reported in the tax audit format useful in assessment 2.1 One of the criticisms of the entire tax audit exercise (as mentioned in an earlier paragraph above) is that the information generated in the tax audit report is not of any practical use to the of the facts would indicate that the lack of utility arises from various factors which inter alia include :- a) Questions included in Form 3CD becoming is relevant or otiose due to subsequent changes in law, judicial decisions or even as a result of circulars and clarifications issued by the CBDT. b) A lack of understanding of the manner in which the information can be suitably used or simply a lack of attention to detail in perusing the audit reports along with its annexures. 2.2 There could be other case specific factors that could arise in certain unique circumstances as a result of which the necessary information may not provide the requisite value addition. Without getting into those specific circumstances (for example, in regard to share trading or speculation business situations), we can consider the above broad propositions in slightly greater detail. 2.3 The basic proposition that needs to be accepted is that the assessees covered under the provisions of tax audit cover the entire gamut 20

3 Special Story of those having business income. The same questionaire is therefore applicable to every business ranging from retailers, consultants, brokers to those undertaking complex industrial activities such as mining, petrochemicals or aeronautics. Where a one resulting in non-applicable queries is bound to arise. For example, Ss. 35, 35ABB, etc. dealt within Cl. 15 would invariably result in a Not Applicable answer for assessees engaged in consultancy or brokerage business. Similarly in most such cases the answer to Cl. 22(a) dealing with MVAT credits would also evoke a similar response. 2.4 Some of the questions asked are relevant only to certain types of assessees for example, Cl. 17(g) - relates to expenses disallowable in the hands clause would not apply. Similarly, Cl. 17(b) dealing with personal expenses can never apply in the case of corporate assessees and would thus evoke a similar response in case of all companies. 2.5 These difficulties are inherent in framing such a widely applicable form. They should not be construed as a negative feature because having a universally applicable form has its own advantages and therefore some extent of non-applicability which seems inherent in devising a format should not be considered a negative feature. 2.6 On the other hand, the frequency of changes in legislation render some of the data sought irrelevant or infructuous. Though many of the situations have been remedied periodically, the bigger problem arises due to the fact that what seems to be the intent of the query does not necessarily match the interpretation that arises from a plain reading of the question. For example, Sec 145(1) prescribes that only cash or mercantile system of accounting may be followed by the assessees. Cl. 11(b) asks whether there has been a change in the method of accounting employed. Experience shows that changeover from cash system of accounting to mercantile system or vice versa is extremely rare. On the other hand, the possibility of change in application of certain policies, and the impact of such changes in accounting policies on the taxable income is more likely to be relevant in the process of assessment. However, since the question consistently deals with change in method of accounting and not with change in accounting policies; the chartered accountant conducting the audit would perforce have to respond in the in policy. Undoubtedly, as prescribed by the ICAI, changes in policy would be reflected in the notes under section 145(2)]. However the manner in which the query is framed seems to defeat the intent. 2.7 In a similar manner, certain questions such as requirement of disclosure of commission received and commission paid, which were relevant when these matters were the criteria on the basis of which scrutiny cases were selected have now lost relevance but continue to be part of the data sought under 2.8 Once again, despite criticism in regard to some of the mismatches referred to above and other similar difficulties, I would believe that such deficiencies do not detract from the larger picture -viz., that some critical information does undoubtedly flow from the data authenticated by the tax auditor. Such data can certainly assist in the assessment and therefore inadequacy of results should not be confused with lack of results in totality. Efforts to make the data and content of Form 3CD more relevant and useful can be a continuing process, and should not be taken as an argument that the entire exercise is futile. 2.9 On the other hand, I strongly believe that the end-users of the data furnished by Form 3CD are very often not adequately trained / or mentally attuned to use the information so available. It is human nature to focus on things which one is familiar with and to avoid the unfamiliar. It has been my experience that most assessing officers would readily seize upon the slightest hint of a default in complying with the tax deduction provisions (mainly because most of them are more familiar with these provisions). However, only the more knowledgeable assessing officers 21

4 would tend to deal with issues relating to matters referred to in the notes to accounts, dealing with issues such as valuation policies in regard to investments, quantification of deferred tax assets or liabilities or even qualifications in regard to contingent incomes. Dealing with such items which are reported by diligent auditors requires a better understanding of accounting theory which many of the assessing officers are not updated with. I focused purely on the contents of Form 3CD which ignored a qualification on the face of Form 3CB which mentioned that the accounts of a certain branch of the business have not been incorporated into the accounts due to a lockout at the given premises. Such information could have the potential for significant addition in terms of inventory at that site but was possibly overlooked because of the excessive focus on form 3CD coupled with a lack of awareness about the significance of report. 3. Applicability of tax audit provisions 3.1 The threshold limits for application of tax audits u/s 44AB have been revised w.e.f. AY Thus for those engaged in business, the threshold has now been raised from ` 40 lakhs to ` 60 lakhs. For those carrying on a profession, tax audit would become applicable if the gross receipts in the profession exceed ` 15 lakhs. For business or professional income of that size, this would be merely an incident of carrying on business or profession and cannot really be considered as a hardship to such assessees. 3.2 Another significant requirement mandates an audit u/s 44AB in the case of assessees carrying on business to which the provisions of S. 44AD Reading the sections together it would be clear that in the case of any "eligible assessee" i.e. resident claiming deduction under Ss. 10A. 10AA, 10B, 10BA, Ch. VI-A (C) etc. who is carrying on an eligible business (viz. any business other than transporters covered u/s. 44AE) and who does not have a minimum income of 8% of total turnover would be covered by requirement of tax audit. Thus in the initial years numerous businesses which have a lower net profit ratio, businesses where margins are much lower (e.g. textile trading, selling and commission agents, petty traders, etc.] and businesses which for circumstances beyond their control are in loss due to factors such as higher borrowing costs, cyclical slumps or adverse business conditions would all be covered by these provisions. In all such cases, if the net income of such business is less than 8% of their turnover or gross receipts; then such assessee will have to mandatorily obtain and furnish a tax audit report u/s 44AB. The sweeping impact of this provision and the possible consequence of inability to carry forward losses unless such a report is obtained and referred to appreciated. 3.3 The burden cast on a widespread spectrum assessees who are at the lower end of the tax pyramid was possibly not fully appreciated when introducing this amendment. It would be advisable for all chartered accountants to check in all cases of persons having business income, particularly those having losses and whose turnover / gross receipts do not exceed ` 60 lakhs whether the stringent provisions of S. 44AD have been complied with. In the case of firms, the salary and interest payable to partners within the limits prescribed u/s 40(b) is permitted to be adjusted in computing the prescribed 8%. S. 44AD does not apply to persons carrying on profession. 3.4 In the case of Trusts and Societies, which have part of their income arising from business, a question arises whether such other collections / gross receipts should also be included in computing the threshold limit of ` 60 Lakhs. Thus, a members club that provides services to its members and has gross collection exceeding ` 60 lakhs (which includes a part which is claimed is not taxable on grounds of mutuality) needs to decide its position vis-à-vis S. 44AB. To me 22

5 Special Story it would appear that the concept of turnover would include the gross receipts, irrespective of whether such gross receipts would eventually enter the computation of taxable income. However, it would be equally clear that this leads to a highly anomalous situation that an entity which has 90% of its receipts from members and a mere 10% (say ` 10 Lakhs) from non-members would also have to undergo a tax audit. 3.5 Numerous other issues have often been raised in regard to what constitutes turnover for the purpose of determination of applicability of S. 44AB. Audit deals with certain related issues. Despite this, litigation and practical issues relating to concepts of turnover, gross receipts etc. continue to arise. Since the meaning of Turnover etc., has been I have not dealt with some vexatious issues arising in context of these phrases. I may only mention the situation where an assessee (who follows exclusive method regularly) has a sales turnover of ` 56 lakhs. The amount of Excise Duty on sales is ` 8.4 lakhs 15%). In such borderline cases, the question that would arise is whether the assessee would be governed by provisions such as Section 145A even for determination of what constitutes turnover? I believe that the basic principle is that turnover for the purpose of S. 44AB has to be determined as per the method of accounting regularly followed by the assessee. For example, a person who is speculating in shares without actually taking delivery thereof is merely dealing in the margins earned on the shares. Therefore in such a case the gross value of purchase transactions and sale transactions entered into by such a speculator should not be considered. This view has found favour with the Bombay Tribunal in Growmore Exports Ltd. & Others vs. ACIT 78 ITD 95 (Mumbai). 4. Manner of reporting and furnishing of data 4.1 The role of the tax auditor is primarily to compile "true and correct" information and to furnish it in the format prescribed. The tax auditor is not a quasi-judicial authority, and is not expected to sit in judgment about complex issues of interpretation. He cannot step into the shoes of the data in order to assist the assessment process. For example, Clause 27 requires the auditor to report on the compliance in regard to deduction and payment. The emphasis is more on whether the amount is deducted and thereafter paid. Accordingly, it is not expected of the auditor to adjudicate upon complex issues about which provision of Chapter XVII-B would apply to particular facts. Thus, if certain payments are being considered as falling u/s 194C but an interpretation treating the said payments as professional fees is also possible; the auditor is not expected to report a case of non-compliance. This would apply in cases where bona fide both views are possible. However if the auditor is himself convinced that the applicable provision is s.194j and tax is short deducted, he should indicate so in the remarks column. Similarly, even though an assessee may have a certain view, if in the preceding years the Department has consistently been taking a view that the said payments are subject to deduction u/s 194J, this fact may be noted in the remarks column. However, care may be taken not to report this as a default, since this could otherwise lead to an automatic disallowance in the hands of the assessee. In all such cases, the auditor will have to exercise care in the manner in which his views are without unduly prejudicing the legal stand of the assessee. limited role that he has to play, an auditor may come across situations which could result in tax impact. In absence of any specific requirement to report such item, he may only advise / alert the assessee about possible disallowance, and advise him to consider a unilateral addition to income when filing the return of income. However, he would have no duty beyond this in situations such as when interest is not charged on loans to relatives, 23

6 to determine any admissible or inadmissible amount(s). except where specifically asked as in Clauses 14 and 15 of Form 3CD which deal with reporting of allowable depreciation and admissible deductions. to be stated is voluminous the tax auditor may exercise his professional judgment and state only those cases where actual date of payment is beyond the due date of payment and indicate this by way of a suitable note. 4.4 While conducting a tax audit, the auditor must keep in mind the object for which certain data is required to be furnished in Form 3CD. This would enable the data furnished to be more relevant and also more focused. Where there exists a genuine ambiguity about what is required to be furnished, the auditor should state clearly the approach adopted by him (citing any case law if relied upon by him) and accordingly furnish the data. For example, in response to the query :-Amounts not credited to profit & loss account [clauses 13(a) to (e) ], one would have to keep in mind the context of clause 13 which covers a whole spectrum of transactions. The sweeping requirements of this clause if literally interpreted would require reporting of all sorts of transactions which would make a mockery of the requirements of law. Some extreme examples of capital receipts, one may consider are: 10,000 shareholders. of meaningless data. Logically, the reporting requirement has to be read in conjunction with the intent of tax audit. I would thus consider it logical that reporting under this clause would be restricted to items which may be considered to be taxable receipts irrespective of whether they are considered to be of revenue or capital nature. This required to be stated under this sub-clause. 4.6 I may also add that reporting of data in 3CD is and relates to the business under audit. Thus, if the during the year and in the course of audit, the auditor incidentally comes to know that the source of capital is from some income which may be taxable as the sale of some jewellery, he is not required to make any reference to this in his report in Form 3CD. This of capital from a partner is not income in the hands of the firm. What is the taxability in the hands of the partner cannot be within the scope of audit of the firm. Thus, I believe that reporting is required in respect of amounts entered in the books but not the opinion of the auditor require to be so credited. Reporting would also be required in respect of items that may constitute taxable receipts under any head Loss Account. 5. Role of auditor Who can perform of return Before concluding this article I must bring out two important features, one which needs attention before commencement of audit and the other upon completion of audit. 5.1 Members must keep in mind the limits that have been prescribed for undertaking tax audits, the register required to be maintained by persons carrying out tax audits and other similar regulatory requirements imposed by ICAI from time to time. a broad framework about responsibility of auditor in undertaking various audits under the tax laws, I have not dealt with the general provisions relating to application of Institute standards and guidance notes to chartered accountants undertaking tax audit. I may 24

7 Special Story however draw attention to a specific clarification concerning tax audit. The ICAI has clarified that in accordance with the overall framework, only an independent auditor can carry out a tax audit. In effect this means that a person carrying out an internal audit of an assessee is not competent to carry out in the same year, a tax audit for the same assessee. I may clarify that a statutory auditor appointed under any other statute would be an independent auditor and therefore a statutory auditor can certainly carry out a tax audit. An internal auditor however cannot do so. 5.2 Certain other situations that arise particularly in the case of co-operative societies and government companies are also relevant. For example, where for some reason, the statutory auditor has not completed the audit of the accounts by the due date to furnish his report independently. In para 9.4 of may do so and that he should furnish his report in Form 3CB. 5.3 A question may arise where statutory auditor has also been asked to carry out tax audit, but he has failed to do so. Can the C.A. who is regularly representing the Company in tax proceedings undertake the tax audit. There appears to be no conceptual bar to this being done, subject to necessary ethical guidelines being complied with. 5.4 Upon completion of the tax audit, the tax auditor must take care to complete necessary audit reports in the prescribed forms along with the annexures & sign and seal them appropriately. Although not mandatory, it is my personal view that it is desirable that the assessee should sign a copy of Annexures. This is because the information contained in the form is very often within the knowledge and control of the assessee and not directly in the knowledge of the auditor. The assessee must therefore be asked to take responsibility for the accuracy and completeness of the date made available. 5.5 Having signed the reports, the same shall be handed over to the assessee and acknowledgement of the same should be kept on the auditors record. This is because although in small and medium enterprises it is most often the tax auditor who is the assessee the two roles are distinct. It is for the tax auditor would do well to have proof that he has completed and handed over the audit report in time so that in case the assessee fails to comply with his obligation, the responsibility should not be passed on to the tax auditor if the assessee takes a stand that he was unable to do so because of nonavailability of the tax audit report The problem is further compounded by the fact that in the case of e-filing of returns, the tax audit report is not actually uploaded to the servers of the IT department. The ICAI has been continually representing to the revenue authorities that the law and procedure should be amended so as to prevent misuse and eliminate irregular practices such as backdating of the reports. Numerous cases of assessees or other interested persons fraudulently citing the membership number of some chartered accountant as the tax auditor have come to light. The ICAI has initiated a process where one can voluntarily upload the particulars of reports signed so as to prevent such misuse and details in this regard are available on the ICAI website. Considering the potential for such misuse, tax auditors would do well to keep their documentation in regard to audits performed, date of report, date and evidence/ acknowledgement of handover of the tax audit report to the client so as to avoid 6. Conclusion As mentioned at the commencement of the article, the issues that one can deal with are innumerable. A clause by clause analysis would take too much space and is probably not needed by readers. I have therefore attempted to touch upon only the hopefully the issues dealt with would facilitate readers to undertake tax audit with the necessary 25

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