Cessation of Liability Cannot Rest on Statistical Estimation: ITAT Delhi Strikes Down ₹5 Crore Addition Based on Sample Inquiry Under Section 41(1)
Introduction
The Income Tax Appellate Tribunal, Delhi Bench, delivered a significant ruling in Blaze Manufacturing Co Vs DCIT, striking down a substantial addition of ₹5.00 crore made under Section 41(1) of the Income Tax Act, 1961. The Tribunal categorically held that cessation or remission of trading liability cannot be presumed or calculated through percentage-based methodologies. This decision reinforces the settled legal position that actual benefit by way of cessation must be demonstrated before invoking Section 41(1), and that ad-hoc additions based on sampling have no statutory sanction.
The judgment addresses a critical issue: whether tax authorities can treat sundry creditors as ceased liabilities merely because a fraction of them could not be traced during inquiry, and whether a mathematical extrapolation of such findings to the entire creditor base is legally sustainable.
Factual Matrix of the Case
Business Profile and Return Filing
Blaze Manufacturing Co., constituted as a partnership firm, is engaged in exporting Indian handicraft items. For Assessment Year 2014-15, the assessee filed its return of income on 26th November 2014, declaring total income of ₹92,29,680.
The original assessment was completed under Section 143(3) on 12th July 2016, determining income at ₹93,74,390 after minor disallowances pertaining to miscellaneous expenses, staff welfare, telephone charges, and vehicle maintenance costs.
Order Under Section 263
Subsequently, the Principal Commissioner of Income Tax, Moradabad, invoked revisionary powers under Section 263 on 28th March 2019. The revisionary authority directed the Assessing Officer to conduct fresh assessment after making proper inquiries into sundry creditors amounting to ₹17,12,38,198 appearing in the assessee's balance sheet.
Methodology Adopted by Assessing Officer
In compliance with the Section 263 directions, the Assessing Officer undertook verification of sundry creditors. However, instead of examining all 680 creditor parties, the AO:
- Issued notices under Section 133(6) to only 168 parties
- Deputed an Inspector to physically verify 39 additional parties
- Thus made inquiries covering 207 creditors out of 680 total creditors
- Found that 63 parties were either non-traceable or did not respond, involving ₹1,46,72,415
- Calculated that these 63 parties represented 29.24% of the 207 parties examined (in value terms)
- Applied this 29.24% ratio mechanically to the entire creditor balance of ₹17,12,38,198
- Computed addition of ₹5,00,70,049 and treated it as cessation of liability under Section 41(1)
Pattern of Creditor Balances Over Years
The assessee demonstrated continuity of creditor balances across multiple years:
- As on 31.03.2012: ₹9,14,65,315
- As on 31.03.2013: ₹11,38,67,923
- As on 31.03.2014: ₹17,16,33,625
- As on 31.03.2015: ₹18,17,15,021
This progression reflected growing business operations, with turnover increasing from ₹15.52 crore in FY 2012-13 to ₹25.89 crore in the year under consideration.
First Appellate Proceedings
The Commissioner of Income Tax (Appeals) upheld the Assessing Officer's approach. The CIT(A) relied primarily on the decision of the Ahmedabad Bench of ITAT in ACIT vs Dattatray Poultry Breeding Farm Pvt. Ltd. [2018] 171 ITD 615 (Ahmedabad Tribunal), which had held that in absence of PAN details and confirmations, additions on account of cessation of liability could be sustained.
Contentions Before the Tribunal
Assessee's Arguments
The assessee challenged the addition on multiple grounds:
On Acknowledgment of Liabilities:
The assessee consistently acknowledged these liabilities in audited financial statements across successive years. No unilateral write-off or cessation was recorded in the books of account. The liabilities represented genuine business transactions with artisans and suppliers from whom handicraft items were purchased on credit.
On Acceptance of Trading Results:
In all preceding years (AY 2012-13 and 2013-14), assessments were completed under Section 143(3) wherein the sundry creditors were examined and accepted. Moreover, in the impugned year itself, the AO accepted the purchases, sales figures, gross profit margins, and overall trading results without any adverse findings.
On Payment in Subsequent Years:
The assessee demonstrated that many of these creditors were paid in subsequent assessment years, thereby proving that these were live, subsisting liabilities and not fictitious entries.
On Invalidity of Ad-hoc Methodology:
The assessee contended that Section 41(1) does not contemplate or permit estimation, sampling, or percentage-based additions. The provision requires actual remission or cessation to be established, not presumed through statistical extrapolation.
On Legal Precedents:
Extensive reliance was placed on:
- Supreme Court decisions in CIT v. Kesaria Tea Co. Ltd. [2002] 122 Taxman 91 (SC) and CIT v. Sugauli Sugar Works (P.) Ltd.
- Delhi High Court judgments in CIT v. Shri Vardhman Overseas Ltd. 2011 (12) TMI 77 and CIT v. Ritu Anurag Agarwal 2009 (7) TMI 1247
- Gujarat High Court's reversal in Dattatray Poultry Breeding Farm Pvt. Ltd. vs ACIT [2019] 415 ITR 407 (Gujarat)
Revenue's Position
The Departmental Representative supported the lower authorities' orders, submitting that:
- The AO conducted proper inquiries by issuing notices to 207 parties
- Out of these, 63 parties were found non-existent through spot verification or non-response to summons
- The conclusion that these were bogus creditors was reasonable
- Addition was made only in respect of those creditors who failed to respond
- The percentage-based extrapolation was a fair method given the large number of parties involved
Tribunal's Analysis and Findings
Fundamental Requirement of Section 41(1)
The Tribunal began by examining the statutory framework of Section 41(1) of the Income Tax Act, 1961. The provision requires that four essential conditions be cumulatively satisfied:
- An allowance or deduction must have been granted in an earlier assessment year
- Subsequently, the assessee must obtain some benefit
- This benefit must be by way of remission or cessation of trading liability
- Such benefit must be obtained in the previous year relevant to the assessment year under consideration
The Tribunal emphasized that the phrase "obtained, whether in cash or in any other manner whatsoever, any amount" or "benefit in respect of such trading liability by way of remission or cessation thereof" refers to actual receipt or accrual of benefit, not imaginary or presumed advantages.
Rejection of Estimation-Based Approach
The Tribunal categorically held that Section 41(1) admits of no estimation or ad-hoc calculation. The provision is triggered only when there is demonstrable, concrete evidence of cessation or remission. Statistical inference, sample-based projection, or percentage-wise disallowance—however administratively convenient—finds no sanction in the statutory language.
The Tribunal observed: "Section 41(1) taxes real remission, not imagined percentages—once purchases and trading results are accepted, sundry creditors cannot be knocked down by statistical guesswork."
Acknowledgment in Books of Account
The Tribunal noted that the assessee continuously acknowledged these liabilities in:
- Regular books of account maintained in accordance with Section 44AA
- Audited financial statements prepared by chartered accountants
- Balance sheets filed with income tax returns
- Reconciliations and ledger accounts
No entry of write-off, write-back, or cessation was made by the assessee. The liabilities showed organic growth corresponding to business expansion.
The Supreme Court precedent in CIT v. Kesaria Tea Co. Ltd. was applied, wherein it was held that even unilateral writing-off in books does not necessarily constitute cessation in the eyes of law. In the present case, not even such unilateral action was taken, making the case for the assessee stronger.
Acceptance of Purchases and Trading Results
A critical aspect highlighted by the Tribunal was that the Assessing Officer:
- Never doubted the purchases made by the assessee
- Accepted the sales figures and turnover
- Did not challenge the gross profit ratio
- Made no finding of suppression of income or inflation of expenses
This complete acceptance of trading results created a logical inconsistency. If the purchases were genuine and accepted, the corresponding creditor liabilities arising from those purchases could not be treated as non-existent.
The Tribunal relied on CIT v. Ritu Anurag Agarwal 2009 (7) TMI 1247 (Delhi High Court), where it was held:
"Once the sales, purchases as well as gross profits as disclosed by the assessee have been accepted by the Assessing Officer, no addition could be made under Section 68 in as much as it is not in dispute that the creditors outstanding related to purchases and the trading results were accepted by the AO."