BEFORE THE INCOME TAX APPELLATE TRIBUNAL
[Hypothetical Bench], [Hypothetical City]
In the matter of:
M/s. Arya Textiles Pvt. Ltd. (“the Appellant/Assessee”)
v.
The Income Tax Officer, Ward –[ ](“the Respondent/AO”)
Subject
Written Submissions on Behalf of the Appellant–Assesses In ITA No. [XXX]/[City]/20XX arising out of the order passed under section 143(3) read with section 250 of the Income-tax Act, 1961, for Assessment Year [20XX–XX].
(i) Name of the assesses ------------ and address---------------.
(ii) PAN----------------.
(iii) Ayr-----------------.
(iv) DIN of the order appealed------------------.
(v) Appeal No. --------------.
Reference
Show Cause notice dated ……………Din………………….
1. Issue Raised in this Appeal:
Whether the Assessing Officer was justified in making an addition of the entire closing balance of sundry creditors amounting to ₹ 5,20,00,000 under section 41(1) of the Income-tax Act, 1961, on the allegation of bogus/non-existent creditors; and whether the Ld. CIT(A) was correct in confirming the same, notwithstanding (i) that purchases were duly recorded; (ii) sales arising from those purchases stood accepted; (iii) indirect tax returns reflected input tax credits; and (iv) jurisprudence that, at most, only a reasonable estimated disallowance can be made in cases of unverifiable purchases rather than taxing the entire closing balance as a cessation of liability.
2. Facts of the Case:
(i) The Appellant is engaged in the business of trading in fabrics and readymade garments under the brand Arya Textiles, with principal place of business at [City]. For A.Y. [20XX–XX], it filed a return declaring total income of ₹ 4,80,000, processed under section 143(1).
(ii) During assessment under section 143(3), the AO observed sundry creditors of ₹ 5.20 crores in the balance sheet, representing payables to suppliers of fabrics.
(iii) The AO issued notices under section 133(6) to 30 creditors; 22 notices were returned unserved with remarks “wrong address/incomplete address/non-existent.” Field inquiries also indicated that several parties could not be traced.
(iv) The AO concluded that the said creditors were non-genuine and added the entire closing balance under section 41(1), while simultaneously accepting the sales and not rejecting the books under section 145(3).
(v) The Appellant’s stand: purchases were entered in regular course, supported by bills; corresponding sales were recorded and accepted; quantitative records reconciled with stock movements; payments were subsequently made (partly by account-payee cheques and partly by small cash outgoings under ₹ 20,000 per transaction, ostensibly due to trade practices and collection arrangements); and indirect tax returns reflected input tax on such purchases.
(vi) The Ld. CIT(A) upheld the addition on the ground that the Appellant failed to prove the identity and genuineness of several creditors and that cash payments in later years cast doubt on the reality of the liabilities.
3. Reasons of Decision by the AO:
(i) The AO treated the non-service of notices and adverse field inquiries as conclusive proof of non-existence of creditors, holding that the onus to prove identity, genuineness, and creditworthiness was not discharged.
(ii) He noted small cash payments in subsequent years and found them suspicious, positing that genuine trade creditors would be settled through verifiable banking channels.
(iii) He invoked section 41(1) on the premise that liabilities were fictitious or had effectively ceased, and added the entire closing balance of ₹ 5.20 crores.
4. Reasons of Decision by the CIT(A):
(i) The Ld. CIT(A) agreed that the primary onus lay on the Appellant to prove the creditors’ existence and that the Appellant did not furnish confirmations, current addresses, or third-party verifications.
(ii) The Ld. CIT(A) found the pattern of cash payments as corroborative of the AO’s suspicion.
(iii) He therefore confirmed the section 41(1) addition in full.
5. Grounds of Appeal:
(i) The authorities below erred in law and on facts in invoking section 41(1) to add the entire closing balance of creditors despite accepted sales and without any write-back or remission.
(ii) The authorities below failed to appreciate that purchases stand corroborated by quantitative records, sales realization, and indirect tax filings.
(iii) Without rejecting books under section 145(3), and without demonstrating inflation of purchases, the wholesale addition of closing balances is untenable.
(iv) At most, in cases of unverifiable purchases/creditors, only a reasonable percentage disallowance may be justified—not a section 41(1) addition of the entire balance.
(v) The orders are contrary to settled judicial principles and deserve to be set aside.
6. Submissions on Facts:
(i) The AO has accepted sales and not disturbed the trading results or stock tally. The natural corollary is that purchases did occur. Where goods inflow and outflow are reconciled, it is artificial to bifurcate the chain, accept output, and impugn the input in toto.
(ii) Non-service of notices is not conclusive of non-existence. In trading sectors where counterparties change premises frequently, postal returns are common. The legal test is not “everlasting traceability,” but whether the transactions actually occurred and are reflected in books with supporting material.
(iii) Section 41(1) presupposes a remission or cessation of a subsisting liability. The Appellant never wrote back these liabilities; the AO also does not point to any event of remission. If anything, subsequent payments (even if small and in cash) reflect continuing recognition of the liability, which defeats the very hypothesis of cessation.
7. Submissions on Law:
A. Section 41(1) is inapplicable in absence of remission/cessation; non-service of notices ≠ cessation: In this case, Section 41(1) is a deeming provision: it fastens tax when a trading liability allowed in an earlier year is remitted or ceases to exist in a subsequent year, resulting in a benefit to the assessee. The Legislature contemplates a positive event that extinguishes the obligation—e.g., a waiver, write-back, composition, limitation explicitly invoked by the debtor, or a court-sanctioned arrangement. In the present case, there is no write-back, no creditor communication evidencing a waiver, and no material showing that the assessee intended to treat the liability as non-existent. On the contrary, there are subsequent outflows, which only underscore subsistence rather than cessation. The Supreme Court in CIT v. Sugauli Sugar Works (P.) Ltd. held that a mere expiry of limitation or oldness of a liability does not ipso facto amount to cessation; there must be a conscious act or event extinguishing the liability, or evidence that the liability is no longer acknowledged (e.g., by a write-back).
The guards against speculative taxation based on conjectures about untraceable parties or time-lapse. It insists on an objective trigger of cessation. The AO’s foundation—non-service of notices and field reports—does not answer the statutory precondition of remission/cessation. The assessee’s books continue to carry the liabilities; there is no unilateral write-back; and subsequent payments (even if partly in cash) reflect continuing acknowledgment. Therefore, the jurisdictional fact for invoking section 41(1) is absent. If the AO’s real concern was unverifiable purchases, the correct legal route would have been a limited estimation (see Part C below), not a deeming fiction under section 41(1).
B. Accepted sales logically validate purchases; input cannot be doubted if output is admitted: In this case, The assessee operates a trading model: goods-in become goods-out with a margin. If sales are accepted and closing stock is not disturbed, the input stream must, as a matter of commercial logic, be accepted in substance. Any doubt over a part of the purchase stream can only lead to a calibrated estimation to plug possible inflation—not an assumption that purchases never occurred. In CIT v. President Industries (Guj.), the Court explained that once sales are accepted, the corresponding purchases are a necessary concomitant, and revenue should confine itself to profit element estimation where irregularities are found, rather than making wholesale disallowances. Several High Courts and Tribunals have consistently held that when output is accepted, the input cannot be discarded entirely; only the embedded profit on unverifiable purchases can be taxed to neutralize leakage.
The AO here has not rejected books, not disputed quantities, and not disturbed sales. In such a posture, law and logic converge toward limiting any adjustment to the profit element (if at all). The approach of adding the entire closing balance as a deemed income under section 41(1) is inconsistent with President Industries and the broader jurisprudence on embedded profit in unverifiable purchases.
C. In cases of unverifiable purchases/creditors, only a reasonable estimation is permissible—typically a percentage of the purchase value; not the entire balance: In this case, Courts have evolved a balanced remedy for situations where purchases appear unverifiable: disallow only the probable inflation or profit element—often a percentage based on facts, industry margins, and the assessee’s trading pattern.
This avoids punishing real turnover while protecting revenue against paper inflation. Notably, this is a trading account adjustment, distinct from a section 41(1) addition of liabilities. In Vijay Proteins Ltd. (ITAT Ahd.), a 25% disallowance of purchases from suspect parties was sustained, precisely to capture the profit embedded in alleged accommodation entries. Numerous cases since have calibrated the percentage with reference to industry GP/NP, consistency of trading results, and the taxpayer’s past assessments. The core ratio is that unverifiability justifies an estimate, not a legal fiction of cessation.
In this case, this Hon’ble Tribunal, notwithstanding the Appellant’s evidence, still harbours doubts about a subset of creditors, the proper course consistent with precedent is to estimate an appropriate disallowance—not to sustain a section 41(1) addition of the entire closing balance. Given accepted sales, stable gross profit history, and stock movement, any adjustment should be limited to a reasonable percentage of the purchases actually booked from the suspect parties, rather than the closing balances.
D. Books not rejected; therefore, wholesale reconstruction is impermissible: In this case, The AO has not invoked section 145(3) to reject the books. In the absence of such rejection, the starting presumption is that the accounts present a fair picture, subject to specific, reasonable adjustments where evidence warrants. Wholesale recasts, sweeping additions of balances, or imputing non-existent cessations do not comport with the statutory scheme. Courts have consistently held that unless books are rejected for inherent unreliability, assessments must proceed on the basis of the recorded results, with targeted adjustments only. Rejection is a serious step; without it, the AO cannot lawfully substitute the trading results with conjectural additions. Further, section 41(1) cannot be used as a surrogate for book rejection or for penalizing perceived verification gaps.
In this case, The AO accepted sales, stock figures, and margins. That stance is irreconcilable with the idea that purchases did not occur or that liabilities ceased. If the AO believed pervasive falsity existed, the books ought to have been rejected—they were not. This alone undermines the logic of a dramatic section 41(1) addition.
E. Pattern of cash settlements—without more—does not prove sham; it negates “cessation” and, at best, informs estimation: In this case, The AO has relied upon small cash payments in subsequent years to infer non-genuineness. In informal textile trade, small cash settlements against running balances are not uncommon—owing to credit cycles, delivery cash-flows, and counterparty convenience. These payments are entries of discharge, not of remission.
Jurisprudence distinguishes “mode of payment” issues from the “existence of liability.” Cash payments may attract other disallowance provisions in particular fact-sets (e.g., section 40A(3) subject to exceptions), but they do not, per se, convert a subsisting liability into a ceased one. Nor do they transform all purchases into a nullity when sales and stock stand.
The cash pattern here, even if viewed critically, defeats the AO’s reliance on section 41(1)—because payments signify existence and discharge, not cessation. At the very most, the pattern could motivate a limited estimation of unverifiable purchases; it cannot justify a deemed income under section 41(1).
F. Indirect tax trail (input tax) and quantitative records are corroborative indicators of real movement of goods: In this case, The Appellant’s indirect tax returns reflect input tax on purchases; quantitative reconciliations link purchases to sales/closing stock. While VAT/GST acceptance is not binding on income-tax authorities, it is a cogent, contemporaneous indicator that transactions were undertaken in the regular course.
Tribunals (e.g., ITO v. Permanand) have treated indirect-tax evidence and quantitative tallies as probative of actual movement of goods and commercial reality. In such settings, the proper response to verification gaps is estimation rather than wholesale disregard.
Application to facts. The AO’s approach overlooks these corroborations. If goods did move and sales transpired (as accepted), the substance of purchases is made out. Any residual doubt can be addressed through a calibrated percentage disallowance, not a section 41(1) fiction.
8. Case Laws in Support:
(i) CIT v. Sugauli Sugar Works (P.) Ltd. [1999] 102 Taxman 713 (SC): No section 41(1) without clear remission/cessation: In this case, the assessee carried forward certain liabilities in its books for several years. The revenue argued that the liabilities had become time-barred and therefore stood ceased, inviting section 41(1). There was no write-back by the assessee and no correspondence evidencing a waiver by creditors.
The Supreme Court held that mere lapse of time or oldness does not by itself effect a cessation. Section 41(1) requires a positive event—a remission by the creditor or a conscious cessation by the debtor (such as a write-back). The Court emphasized caution in applying deeming provisions.
The present addition rests on non-service and field reports, not on any remission or write-back. The Appellant continued to acknowledge liabilities and made payments thereafter. The Sugauli ratio squarely forbids the application of section 41(1) in such circumstances. The AO’s remedy—if any—lay in estimation, not in a “deemed cessation” fiction.
(ii) CIT v. President Industries [2002] 124 TAXMAN 654 (GUJ.) — Accepting sales implies purchases occurred; tax only the embedded profit where irregularities exist: In this case, The assessee’s sales were undisputed; the dispute centred on the quantum of purchases and possibility of inflation. The revenue sought to treat significant portions of purchases as bogus.
The Gujarat High Court held that where sales are accepted, it follows that purchases must have occurred. If some suppliers are unverifiable, revenue may estimate the profit element embedded in such purchases, but cannot treat the entire purchases as non-existent or make wholesale additions inconsistent with accepted turnover and margins.
The AO has accepted sales and stock. Under President Industries, the farthest permissible course—assuming doubt—would be a calibrated percentage disallowance to capture embedded profit. The AO’s choice of a section 41(1) addition of entire closing balances departs from this settled ratio and is legally unsustainable.
(iii) Vijay Proteins Ltd. v. CIT [2015] 58 taxmann.com 44 (Gujarat) — Estimation route: disallowance of a percentage (e.g., 25%) of purchases from suspect parties: In this case, The assessee claimed purchases from certain unverifiable suppliers. While rejecting the proposition that the purchases were entirely bogus (given that sales existed), the Tribunal faced the practical necessity to protect revenue against accommodation bills.
The Tribunal adopted a middle path: disallow a percentage (25%) of the value of purchases from suspect parties to capture the inflated component/profit element, without dismantling the entirety of the trading results. This approach has been followed and adapted in various cases, with the exact percentage tailored to the fact setting.
If, arguendo, this Hon’ble Tribunal finds verification gaps, the Vijay Proteins template should govern—percentage-based disallowance of the purchase value from suspect parties, grounded in the Appellant’s historical GP and industry margins. A section 41(1) addition of the entire closing balance remains unjustified.
(iv) ITO v. Permanand [2008] 25 SOT 11 (Jodhpur) (URO) — Indirect tax and quantitative evidence are corroborative of real transactions: In this case, The assessee faced additions on alleged bogus purchases. However, the assessee demonstrated that VAT returns, stock registers, and quantitative reconciliations dovetailed with the recorded purchases and accepted sales.
Ratio. The Tribunal treated VAT compliance and stock records as persuasive indicia of genuineness, cautioning against wholesale disallowances where commercial flow of goods is evident. In such cases, if any doubt persists, only the profit element should be brought to tax.
The Appellant’s indirect tax trail (input tax claims) and quantity movement corroborate real movement of goods. This supports either deletion of the addition or, at most, a limited estimation—certainly not a section 41(1) charge.
(v) ACIT v. Allied Leather Finishers (P.) Ltd. [2009] 32 SOT 549 (Lucknow) — When trading results are accepted, drastic disallowances of purchases are unwarranted: In this case the assessee’s accounts were accepted broadly, with no rejection of books; yet the AO sought to disallow material portions of purchases. The Tribunal held that where books are not rejected, trading results are broadly reliable, and sales are accepted, revenue cannot make drastic disallowances untethered to evidence. Any perceived gaps should be addressed through reasonable estimation proportionate to the doubt.
In the present case he AO’s action of adding entire closing balances under section 41(1) is the antithesis of Allied Leather’s guidance. Without rejecting books—and while accepting sales—the AO could not leap to a deemed cessation theory.
9. Prayer: In view of the foregoing submissions on facts and law, and the supporting authorities, it is most humbly prayed that this Hon’ble Tribunal may be pleased to:
(i) Delete the entire addition of ₹ 5,20,00,000 made under section 41(1), as the statutory precondition of remission/cessation is not satisfied;
(ii) Alternatively, and without prejudice, if any adverse inference is drawn regarding a subset of creditors or purchases, direct a limited, percentage-based estimation of the profit element (calibrated to the Appellant’s historical GP/industry norms) on the purchase value actually booked from the suspect parties, rather than sustaining any addition of closing balances under section 41(1);
(iii) Grant such other or further reliefs as this Hon’ble Tribunal may deem fit in the interest of justice and equity.
Place: [City]
Date: [●]
For the Appellant-Assessee
[Name], Advocate
Enrolment No.: [•]
Chambers: [Address]
Email: [•] | Phone: [•]
Notes for oral emphasis (if needed at hearing)
(i) Section 41(1) is a deeming fiction; strictly construed—no write-back, no waiver, no cessation.
(ii) Sales accepted → purchases occurred; if doubt, estimate profit element, don’t deem cessation of entire closing balances.
(iii) Books not rejected; stock quantitative tally coherent; indirect-tax trail corroborates commercial reality.
(iv) Cash pattern may inform estimation; it negates cessation, it does not prove remission.
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