MUSHTAK Ali KAZI, J. -These are five connected applications under section 66 (2) of the Income- tax Act, 1922 which have been treated as direct references by the assessee, company manufacturing cotton yarn. The references pertain to the assessment years 1958-59, 1959-60, 1960-61, 1961-62 and 1962-63. These references arise under the following circumstances.
2. The assessee-Company is a limited company carrying on the business of manufacturing of cotton yarn of course counts only the machinery of the company comprises of 10,000 spindles. The company filed its return of income for the assessment year 18-59 showing a gross profit of Rs.
32,639 only on total sales of Rs. 16,16,626 the rate of gross profit being slightly over 2 %. The total cotton consumed in that year was 12,26,270 lbs. The yarn produced was ,63,230 lbs. Giving a yield of 78.5 %. The visible wastage was shown as 14 % and invisible wastage 7.44 %-total wastage be--ing 21.44 %.The total cost of production according to Books of Account was unusually high.
3. A notice was accordingly issued to the assessee under section 23(2) of the Income-tax Act and in response to this notice the company produced particulars of production and clarifications. They explained that the mills were uneconomic and incomplete unit with only 10,000 spindles. The machinery was of 1932 having been reconditioned. There was therefore, low turnover. The machinery being incomplete the operation involved more of manual labour resulting in higher expenses. The quality of cotton was supplied to the trill as N. T. But it turned out to be desi and it was purchased at higher rate due to inexperience. The finished product was sold at rates lower by Rs. 2 per lb. On account of inferior quality turn out as compared to the other mills.
4. The Income-tax Officer found the above explanation to be unsatis--factory. For the reason that the gross profit declared was negligible he rejected the accounts and that the results declared by the assessee and fixed the gross profits at 20 % on the estimated sales. He accordingly added Rs.
2,17,361 to the amount of Rs. 32,639 already declared and assessed the company accordingly, under section 2313) of Income-tax Act.
5. The assessm ent for the remaining four years was also affected in the same manner by the Income-tax Officer' -himself after rejecting the accounts on account of excessive cost of production, low yield of yarn and abnormal wastage, both visible and invisible.
6. The assessee preferred appeals before the Appellate Assistant Com--missioner of Income-tax (B Range) Karachi. Objection was taken in them appeals to the rejection of properly, maintained accounts declared by the assessee and the assessment done in arbitrary manner by adding up the sums bring the gross profit to the rate of 20 %. It was argued before the Appellate Assistant Commissioner that the low rate of gross profit should not be a criteria for the rejection of accounts specially when complete records had been maintained of day to day production and both the pur- -chases and sales were vouched alongwith the quantitative and qualitative details. The Assistant Commissioner found that the lower selling rate per bundle of 10 lbs. By Rs. 2 got support from the market reports and all that could be said was that the invisible wastage declared was rather exces--sive. The excessive shortage of invisible wastage was, therefore, added up as being visible wastage sold at the rate of 60 per lb. The total addition during the first year worked out at Rs.
69,000 only. In the remaining assessment years it was found that the results declared by the appellant company were much better than those in the case cited of some other mills which had been accepted. The appellate Assistant Commissioner also found that the I: T. O. Could not point out any superfluous item to suggest that the expenses inflated nor could he show any inflation or bogus payments in the accounts. That the low rate of profit declared by the company had been sufficiently explained. Thus no defect, whatsoever, had been pointed out in the account books. The accounts were fully vouched and verifiable ; that under these circumstances the Income-tax Officer was not justified in rejecting the account books without pointing out any flaw. That the gross profits appeared to be reasonable as compared to other parallel cases of similarly placed companies. The Assistant Income-tax Commissioner accordingly fixed the yield at 82 % and assessed the gross profits accordingly, giving relief to the assessee-Company of more than Rs.
2,00,000 in some of the years.
7. The Income-tax Officer being dissatisfied with the order of the Appellate Assistant Commissioner preferred 5 departmental appeals against these orders to the Income-tax Appellate Tribunal, Karachi Bench. In reply to the objection taken it was contended by the representative of the assessee company that even if on account of excessive invisible wastage shown the accounts could not be rejected but all the assessing officer could do was to add-back the price of the excessive invisible wastages.
8. The Tribunal found that there were two uncontroverted defects in the books of accounts viz. (i) yield of yarn produced was abnormally low and (ii) the invisible wastages were abnormally high. In addition the pro--duction expenses were excessive but no inflated or bogus payments could be found and the accounts were fully verifiable. Thus the accounts though verifiable were not dependable. It was contended before the Tribunal by the counsel for the assessee that in the absence of any finding that regular accounts had not been maintained or that the method of accounting in the opinion of the I.-T. O. As such that profits and gains could not properly be deduced therefrom, the authorities concerned could not reject the account and make an assessm ent by pure guess or conjecture without refer--ence to any evidence or material. To this the finding of the Tribunal was that the Income-tax Authorities had denounced the books of accounts for the defects that there was low yield, excessive invisible wastage and high cost of production ; that the Income-tax Officer bad not made guess work but had worked out the profits on reasonable basis and standards. On the face of the defects, namely, low production of yarn and excessive visible and invisible wastages the Income-tax Authorities could have re-sport to the proviso to section 13 of the Income-tax Act. Reliance was placed on the case of Punjab Trading Co.
Limited v. Commissioner of Income-tax (1965) 2 Taxation 81 that if the method employed by the assessee does not show the true income, profits and gains then the Income-tax Authority is not bound to compute the same in accordance with the method of accounting employed by the assessee.
9. The Tribunal accordingly held in all these cases that the Appellate Assistant Commissioner went completely wrong in reducing the income added up by the Income-tax Officer. The orders of the Appellate Assistant Commissioner were accordingly set aside and those of the Income-tax Officer were restored.
10. The assessee then filed Reference Applications before the Tribunal under section 66 (1) of the Income-tax Act for referring 8 common questions of law involved in the five cases. For the sake of brevity all these 8 ques--tions of law are not being reproduced here in extenso. The Tribunal rejected the Reference Applications and held that there was no controversy regarding certain defects in the accounts and application of proviso to section 13 could not therefore, be challenged, that the legal questions sought to be referred were merely of academic nature. The applications for reference were, therefore, refused.
11. Mr. Ali Athar in, course of these arguments one these direct references has pressed only two out of 8 questions to be answered. These questions are as under:
(a) Whether the Income tax Officer was entitled to reject the book results without finding any flaw, defect, discrepancy or irregularity in the account books maintained, or in the method of accounting employed by the applicant?
(b) Whether in the facts and circumstances of the case the order of the Income-tax Officer and the Income-tax Appellate Tribunal is not arbitrary based on mere suspicion, surmises, conjectures and prejudiced?
In order to consider these questions sections 23 and 13 of the Income tax Act, 1922 may be referred to. Under section 23, the Income-tax Officer is required to determine the total income of the assessee on the basis of the return filed by him and the accompanied documents. If he is not satisfied with the return as being complete he has to serve a notice on the assessee to produce evidence on which he may rely in support of the return. After hearing such evidence which the assessee may produce and such other evidence as the Income-tax Officer may require on specific points the Income-tax Officer shall then pass an order of assessment determining the amount payable on the basis of such assessment. Under section 13, income, profits and gains shall be computed in accordance with the method of accounting regularly employed by the assessee provided that if no method of accounting has been regularly employed or if the method employed is such that in the opinion of the Income-tax Officer the income, profits and gains cannot properly be deduced therefrom, then the computation shall be made upon such basis and in such manner as the Income-tax Officer may determine. The above two sections of the Income-tax Act have been inter--preted in various cases explaining as to how for the Income-tax Officer is entitled to reject the accounts or the method of accounting as defective and substitute or add up the income declared in the results according to his own computation. The assessee is required to maintain his accounts on the basis of the recognised methods of accounting sack as (i) cash system, (ii) mercantile system and (iii) Hybrid system. If the Assessing Officer finds that no regular method of accounting has been employed or the method in which accounts have been kept, no true profits could be deduced therefrom he will compute the profits keeping in view the profits declared by other dealers of the line under similar cases. Section 13 refers to method of accounting regularly employed by the assessee. By method of accounting is meant the basis upon which profits are computed. Under the cash basis record is kept of actual receipts and actual payments and the profits of the business are then calculated. Under the mercantile system the assets and liabilities are valued and from the difference the profit is worked out. The assessee is at liberty to choose the method that suits him best. The accounts may not be accepted by the Income-tax Department, if the stock register or manufacturing register have not been kept. The inventory of the stocks lacks quantitative date and the :ate of gross profit disclosed is low and is not in conformity with the rate shown in other identical cases. These are considered as defects for which the department could reject the assessee's account version. Great stress is laid on the point of the gross profit revealed by the tax payer then support is found from non-availability of purchase vouchers, stock registers etc. The trend of decisions of the Indian Supreme Court is that assessing authorities could reject the account version for non-maintenance of stock register if after taking into account of the materials it is found that from the method of accounting the correct pro--fit of the business is not deducible and only then operation of Proviso to section 13 would be attracted and not otherwise.
The method adopted by the assessee must prima facie prevail where it is regularly employed and the power under the proviso to section 13 is to be reasonable and judicially exercised which excludes any objection or arbitrary decision by the Income--tax Authorities. The principle was also recognised that before drawing the adverse inference against an assessee he must be confronted with all the material which is going to be utilised against him. In the case of Seth Gurmuk Singh v.
Commissioner Income-tax Punjab (1944) 12 I T R 393 it was observed: "In making an assessm ent under section 13 (3) of the Indian Income-tax Act the Income-tax Officer is not fettered by technical rules of evidence and pleadings and he is entitled to act on material which may not be accepted as evidence in a Court of law, but the Income-tax Officer, is not entitled to make a pure guess and make an assess--ment without reference to any evidence or any material at all. There must be something more than bare suspicion to support the assessment under section 23 (2)."
This view was reiterated in the case of Dhiraj Lal Girdhari Gal v. Commissioner of Income-tax (1954)
26 I T R 736 and Nagulakonda Venkata Subba Rao v. C. I. T., Hyderabad Deccan (1937) 31 I T R 781. It is duty of Income-tax officer to disclose all that material to the assessee which the Assessing Officer wants to utilise against him so that he may have a chance of rebutting the same. It was likewise held in a Dacca case by the High Court that authorities cannot rely on materials which are not disclosed or kept known to the assessee without giving him a hearing in respect of the same. In Swami Brothers v. C. I. T., Mysore and Travancore Cochin (1958) 34 I T R 133 it was held that where the Income-tax Officer rejects the amounts of the assessee and makes an assessment to the best of his knowledge by adopting a percentage on the turnover of the assessee and taking into account material from comparative cases of other assessee, the material on which the officer intends to found him estimate must be disclosed to the asses who must first be extended an apportunity to explain. Where the goods are sold below the market rate and department doubts the genuineness of the sale price they must place some material to show that the market prices were in fact paid by the purchaser or that the prices in the account books of the assessee were under-rated. In R. M. P. Perianna Pilli & Co. v. C.I.T. ((1961) 4 Taxation 230) it was held that the system of accounting adopted by an assessee cannot be rejected under the proviso to section. 13 of the Income-tax Act on the only ground that the gross profits disclosed by his books were low and com- -pared un-favourably those of others, in the line of business.
12. Even in cases where no method of accounting has been regularly employed by the assessee or where the assessee's method of accounting or books of accounts are rejected, the I.-T. O. May, exercising his judgment, reasonably and judicially, compute the profits by applying a flat rate of certain percentage by admitted or estimated turnover or gross receipts but in determining the flat rate I.-T. O. May have regard to the rate of profits made by the assessee in the past years, the average rate of profits made by other traders in the line and other circumstances. But all this must be done on evidence. A question will always arise for a judicial determination whether there was any evidence before the department upon which it could rind necessity for inclusion in his account of certain amount of income. The Court will set aside the computation of income made by the authorities if it is arbitrary or the basis on which the computation is made is not disclosed in the order. In M/s. Rajput Metal Works Limited v. Commissioner of Income---tax, Rawalpindi (1976 P T D119) it was held by Muhammad Akram, J that officer rejecting account version of assessee for the reasons assigned by him a further a much onerous duty was cast upon him to make him computation, of the income upon such "basis" and in such manner as he may "determine". His judgment must be based on reason. He cannot just take a leap in the dark and indulge in a pure guess by snaking contrary, capricious and ad hoe addition without laying down the basis for it. He should en--deavour to the best of his ability to ascertain the income, profits and gains of the assessee nearest to his true income, profits and gains as far as possible, under the circumstances of the case. In Seth Nathuram Munnalal v. Commissioner of Income-tax C. P: & Berar ((1954) 25 1 T R 216) under same provisions of law it was held that it after rejecting the method of accounting employed by the assessee the Income-tax Officer were simply to add a particular amount to the income return or disallow a part of the business expenses properly incurred by the assessee, he would not be acting under the proviso to section 13, and that he must disclose the basis and the manner of computation 'and make his order a `speaking order'. In the case of S. M. Yousuf and Brothers v. Commissioner of Income-tax ((1974) 29 Taxation 120) It was held by Noorul Arfin, J. That the account books could not be rejected merely because some . Of the case sales and expenses were, No 1 vouched and were not verifiable. Low figure of profits or even failure to maintain stock register were held not be sufficient ground for rejec--tion of book version. In Pandit Brothers v.
Commissioner of Income---tax ((1954) 26 1 T R 159), it was held that in all cases which fell under section 13 of the Indian Income-tax Act, 1932 there must be material before the Income-tax Officer to lead him to the conclusion that the method employed is defective or that the case requires reconsideration and a new computation must be made. In that case the Income-tax Officer added a certain sum to the profit as given by ' the assessee on the ground that the profit disclosed by him was low and there was no stock register. The assessee maintained regular accounts of his purchases and sales and Income-tax Officer did not show that the method employee by the assessee was such that in his opinion the income, profits an gains could not properly be deduced therefrom. Held There was n definite finding by the Income-tax Officer that the case, fell within the proviso to section 23. Even if such findings were to be implied from hi order it could cot be said that there was material before him which would enable him to come to such a finding. The fact that the profits appear to him to be insufficient and the fact that no stock register was maintained by the assessee were not materials upon which such a finding ca be given. But they were circumstances which might provoke an enquiry The Income-tax Officer must discover evidence or material aliunde before he can arrive at such a finding. In increasing the taxable income the Income-tax Officer did not adopt any method or basis and he was no acting according to the provisions of the statute.
13. The ratio in all these decisions is that if the assessee had employed regular method of accounting and the accounts were maintained regularly the Income-tax Officer was not entitled to reject the book results without finding any flaw, defect or discrepancy in the accounts and even in cases where the accounts or the method employed was rejected as being such that true income could not be deduced from it the Income-tax Offer could not merely adopt a flat rate or make addition in the income arbitrarily. Ha is required to base such additions on material or evidence of which due notice must be given to the assessee.
14.In the present case no irregularity was found in the method accounting employed by the assessee-Company. The accounts had been regularly kept, they were vouched and were verifiable. The Income-tax Officer could not point out a single discrepancy nor did he have any ma--terial to suggest that the sale price etc. Were not according to the reports. The Income-tax officer found the yield too low and the tage of wastage to be high, as compared to the other mills similarly glad. But he gave no names of such mills, nor did he give any figures vela to yield and wastage given by such mills. The report of the Textile Enquiry Commission published in March, 1980 at page 18 in this respect is as under: "The mills in reply to the questionaire issued to them gave figures of waste losses varying from 14 % to 30 % irrespective of the variety of cotton or counts upon therefrom. From these figures it was very difficult to come to any definite conclusion. Eliminating the extremes, whether the Commission observed that the figures either were exaggerated or a mistake had been made in making a reply, the waste losses averaged to 18%."
The Commission report also showed that most of the mills did no maintain a complete record of the wastage in spinning. The Commission came to the conclusion that a net wastage of 15 % could be allowed where, visible wastage would be 12 % and invisible wastage 3 %. Thus, in the p sent case any excess in invisible wastage would not warrant wholesale rejection of accounts and substitution of a flat rate of 20% as gross profits irk the absence of any evidence or material in support. The additions thus made b the Income-tax Officer and the Tribunal over and above the income are with out any basis and cannot be sustained under the proviso to section 13 of the Act. A fresh computation has accordingly to be made on the basis of evidence as to the wastage visible and invisible that could be allowed.
15. We would accordingly answer the first question in the negative and the second question in the affirmative.
16. The reference is answered accordingly, but there shall be no order a' to costs in the circumstances of the case.