Supplementary Guidance Note on Tax Audit under section 44AB of the Income-tax Act, 1961

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Supplementary Guidance Note on Tax Audit under section 44AB of the Income-tax Act, 1961

The Institute of Chartered Accountants of India
New Delhi.

Introduction

The Central Board of Direct Taxes has issued Notification No.208/2006 dated 10

th August, 2006 containing the Income-tax (9th Amendment) Rules, 2006. These rules incorporate several significant amendments in Form No.3CD relating to tax audit. The Fifth Edition of the Guidance Note on Tax Audit under section 44AB of the Income-tax Act, 1961 incorporating the law as amended by the Finance Act, 2005 was published in September, 2005. This supplementary Guidance Note gives guidance on the amendments made by the above-mentioned Notification in Form No.3CD.

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Furnishing of Form No.3CA/3CB with Form No.3CD

Every person who is required to get his accounts audited under section 44AB has to furnish the audit report along with the required particulars by the specified date mentioned in section 44AB namely 31

st day of October of the Assessment Year (A.Y.) For the A.Y. 2006-2007 the tax audit report is to be furnished latest by 31st October, 2006. The Notification No.208/ 2006 has been issued on 10th August, 2006. All tax audit reports signed on or after 10th August, 2006 whether in respect of A.Y . 2006-07 or the earlier assessment years should be in the revised format. The
tax auditor cannot use the old format merely because the tax audit is in respect of accounts for the financial years corresponding to the A.Y. 2006-07 and/or any of the earlier years. The relevant date is the date of signing of the tax audit report and not the financial year in respect of which such audit report is furnished. However, in respect of assessment years preceding A.Y. 2006-07 the tax auditor while giving his tax audit report in the revised format on or after 10th August, 2006 should indicate only those particulars as per the requirement based upon the relevant law applicable to the assessment year in relation to the financial year for which the report is being
furnished. Further, the tax auditor need not give information, which is not relevant for the concerned earlier assessment year. This is necessary having regard to the fact that the tax audit report is to be used by the Assessing Officer for the purpose of completing the assessment of the concerned assessee for the relevant assessment year in accordance with the law applicable to that assessment year.

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Tax audit report furnished prior to 10

th August, 2006

If any person who is required to get his accounts audited in terms of section 44AB has got the audit done and furnished the audit report prior to 10

th August, 2006 in the earlier Form No.3CD, he need not submit a revised audit report furnishing the particulars in the revised Form No.3CD. However, if such a person after getting the tax audit report prior to 10 th August, 2006 approaches the tax auditor for a revised tax audit report along with the revised Form No.3CD with Annexure II, the tax auditor may furnish a revised report. Attention is invited to the following extracts from para

13.9 of the Guidance Note on Tax Audit.
"It may be pointed out that report under section 44AB should not normally be revised. However, sometimes a member may be required to revise his tax audit report on grounds such as:

(i) revision of accounts of a company after its adoption in annual general meeting.
(ii) change of law e.g., retrospective amendment.
(iii) change in interpretation, e.g. CBDT Circular, judgements, etc.

In case where a member is called upon to report on the revised accounts, then he must mention in the revised report that the said report is a revised report and a reference should be made to the earlier report also. In the revised report, reasons for revising the report should also be mentioned. [Reference may also be made to Guidance Note on Revision of the Audit Report (Handbook of Auditing Pronouncement Volume II, page 472)

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Amendments made by Notification No.208/2006

Notification No.208/2006 dated 10

th August, 2006 has made significant amendments in Form No.3CD. It has also inserted Annexure – II for the computation of the value of fringe benefits in terms of section 115WC read with section 115WB. In the following pages the amendments made in various clauses of Form No.3CD, other than annexure II have been explained. Also the consequential impact of the Finance Act, 2006 and the Taxation Laws (Amendment) Act, 2006 have been discussed. This guidance note is a supplementary to and should therefore be read along with the Guidance Note on Tax Audit under section 44AB of the Income-tax Act, 1961
(September, 2005 Edition). The amendments made in different clauses of Form No.3CD have been given. The portions deleted are shown in a strikethrough form. The new insertions are given in bold.

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Clause 7

7. (a) If firm or Association of Persons, indicate names of partners/members and their profit sharing ratios.

b) If there is any change in the partners/ members or their profit sharing ratios, the particulars of such change

(b) If there is any change in the partners or members or in their profit sharing ratio since the last date of the preceding year, the particulars of such change

There is no change in clause 7(a). The amendment in clause 7(b) is clarificatory that the change since the last date of the preceding year is required to be reported. If there is any change in the partners of the firm or members of the association of persons or their profit sharing ratio since the last date of the preceding year, the particulars of such change must be stated. All the changes occurring during the entire previous year must be stated. Normally under the General Clauses Act, the word "year" refers to the calendar year. However, in this clause "preceding year" may be reckoned as the previous year ending before the commencement of the previous year for which tax audit is being conducted. Thus, for the audit of the year ended on 31

st march, 2006, any change after 31st March, 2005 will have to be reported.

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8. (a) Nature of business or profession

(a) Nature of business or profession (if more than one business or profession is carried on during the previous year, nature of every business or profession)

(b) If there is any change in the nature of business or profession, the particulars of such change.

The amendment made in clause 8(a) is clarificatory in nature. In regard to the nature of business, the principal line of each business such as manufacturing of electronic goods, trading in chemicals, wholesale trade in foodgrains or a retail trade in grocery should be stated. In case of a person rendering services, the nature of each type of service should be broadly stated.

In regard to the nature of business or profession, Part 'B' of the annexure – I to Form 3CD needs to be referred to, which also requires to give nature of business. This Annexure provides details of various sector and sub-sector in which an assessee could be engaged. Information has to be furnished in respect of each business. An amendment similar to the one in sub-clause (b) of clause 8 has been carried out in Part B of Annexure I. Information provided under this clause should be in consonance with the information provided in Part B of Annexure – I.

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12A. Give the following particulars of the capital asset converted into stockin-
trade: -

(a) Description of capital asset;
(b) Date of acquisition;
(c) Cost of acquisition;
(d) Amount at which the asset is converted into stock-in-trade.

This is a new clause inserted by the notification. For furnishing the particulars required by clause 12A, the provisions of section 2(47), 45(2), 47(iv) and (v) and 47A have to be kept in mind.

From the A.Y. 1985-86 onwards the conversion by the owner of an asset into or treatment of such asset as stock-in-trade of a business carried on by him is treated as a 'transfer' within the meaning of section 2(47). Under section 45(2) such a conversion or treatment of capital asset into stock-in-trade will be deemed to be a transfer of the previous year in which the asset is so converted or treated as stockin- trade. However, the capital gains arising from such a transfer will become chargeable in the previous year in which such converted asset is sold or otherwise
transferred. In the case of long-term capital asset, indexation of cost of acquisition and cost of improvement, if any, will be with respect to the previous year in which such conversion took place. The fair market value of the asset, as on the date of such conversion or treatment as stock-in trade, shall be deemed to be the full value of the consideration of the asset. The excess of the sale price over the fair market value as on the date of conversion would be treated as business income and taxed under the head 'profits and gains of business or profession'. The capital gains being the difference between the cost of acquisition and the fair market value on the date of the conversion or treatment as stock-in-trade will be chargeable to tax in the year in which the asset is sold.

Section 47 of the Act enumerates the transactions which will not be regarded as transfer. Under sub-clause (iv) any transfer of a capital asset by a company to its subsidiary company if the parent company or its nominees hold the whole of the share capital of the subsidiary company and the subsidiary company is an Indian company will not be treated as a transfer. Under clause (v) any transfer of a capital asset by a subsidiary company to the holding company if the whole of the share capital of the subsidiary company is held by the holding company and the holding
company is an Indian company will not be considered as a transfer.

The capital gains exempted by virtue of clause (iv) or clause (v) of section 47 may become chargeable under certain circumstances. The provisions of section 47A are relevant here. Accordingly, where at any time before the expiry of a period of 8 years from the date of transfer of a capital asset referred to in clause (iv) or clause (v) of section 47, such capital asset is converted by the transferee company into, or is treated by it as, stock-in-trade of its business or the parent company or its nominees or, as the case may be, the holding company ceases to hold the whole of the share capital of the subsidiary company, the amount of profits or gains arising
from the transfer of such capital assets not charged under section 45 by virtue of the provisions contained in clause (iv) or clause (v) of section 47 shall be deemed to beincome chargeable under the head "capital gains" of the previous year in which such transfer took place.

The particulars to be stated under new clause 12A should be furnished with respect to the previous year in which the asset has been converted into stock-in-trade. The clause does not require details regarding the taxability of capital gains or business income arising from such deemed transfer.

Under clause (a) description of the capital asset is required to be mentioned for example shares, security, land, building, plant, machinery etc.

Under Clause (b) the date of acquisition is to be reported. For ascertaining the correct date the tax auditor will have to refer the accounts of the financial year in which such capital asset is acquired. The date assumes importance for the purpose of determining whether the asset is long-term or short-term in nature.

Under clause (c) the cost of acquisition is required to be reported. Here the cost of acquisition as per the books of account is to be mentioned. In case of depreciable assets, the carrying cost appearing in the books will be the written down value. But the value to be reported will be the original cost of acquisition. Even in case of an asset acquired prior to the 1st day of April, 1981 the value to be reported will be the original cost of acquisition. The assessee may exercise the option of considering the fair market value of the asset as on 1st April, 1981 for assets acquired prior to that date for the purpose of computation of capital gains as provided under section
55(2)(b)(i).

Under clause (d) the amount at which the asset converted into stock-in-trade should be stated. Such an amount may not be the fair market value on the date of conversion or treatment as stock-in-trade. If a value other than carrying cost is recorded then the auditor has to examine the basis of arriving such a value. The valuation of stock-in-trade is to be examined with reference to AS-2 – Valuation of Inventories. Non-compliance of AS-2 is to be properly qualified in the main audit
report.

It is desirable that necessary accounting entry is passed in the books of account at the time of conversion of the asset into or treatment of the same as stock-in-trade.

In the case of assessees like a proprietorship concern, prior to the conversion of the asset into stock-in-trade, the details regarding the date of acquisition and cost of acquisition may not be recorded in the books of account. It is also possible that the year in which the capital asset is acquired, the accounts of the assessee may not have been subjected to audit. Also an assessee can acquire a capital asset through various modes such as discussed under section 49 of the Act. Under such circumstances the auditor may have to verify the cost of acquisition. The following
broad principles need to be kept in mind.

While verifying the cost of acquisition of the fixed asset, the auditor should bear in mind the principles enunciated in Accounting Standard (AS) 10, Accounting for Fixed Assets. As per paragraph 20 of the said Accounting Standard, the cost of a fixed asset comprises of its purchase price and any attributable cost of bringing the asset to its working condition for its intended use. Thus, in case of capital assets purchased by the assessee, it would relatively be easy for the auditor to verify the cost of acquisition, the evidence being provided by the supporting purchase invoices from the supplier, entries appearing in the bank statements in respect of payment to
the supplier, entries appearing in the cash book/ bank statement for payment of cartage installment etc. In case of self-constructed capital assets, the cost would comprise those costs that relate directly to the specific capital asset and those that are attributable to the construction activity in general and can be allocated to the specific asset. Thus, in this case, the evidence would be provided by documents such as board resolutions and minutes. In case of a company, engineer's certificate on stages of completion, communication with the regulating agency, if any, payment made to the contractor, payments made for purchase of raw materials etc. and entries recorded in the fixed assets register may be verified. In the case of Capital assets acquired in exchange or in part exchange for another asset, the cost of the asset acquired is either the fair market value or the net book value of the asset given up, whichever is more clearly evident, adjusted for any balancing payment or receipt of cash or other consideration. In case the capital asset is recorded at the net book value of the asset, the fixed asset register would provide the prime evidence of the value. If, however the capital asset so acquired is recorded at the market value the auditor would need to examine the basis for arriving at the fair market value, for example, the valuer's report, market quotes (in case of listed securities). While relying upon the valuer's report, the auditor should also bear in mind the principles outlined in Auditing and Assurance Standard (AAS) 9 - Using the Work of an Expert.

In any case the auditor would also need to look into how the assessee has decided the value at which the asset is recorded in the books of account is more clearly evident than the other value.
In case of a capital asset acquired by way of inheritance, the auditor may find it difficult to verify the cost of acquisition to the original owner. In case there does not exist any documentary evidence as to the cost of acquisition of the asset to the original owner, say the sale/purchase
agreement the auditor may need to rely upon the reports of the experts such as valuers. In addition to the above, the auditor should also refer to the guidance contained in the Guidance Note on Audit of Fixed Assets issued by the Institute.

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13. Amounts not credited to the profit and loss account, being,-

(b) the proforma credits, drawbacks,­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­ refund of duty of customs or excise, or refund of sales tax,

refund of duty of customs or excise or service-tax or refund of sales-tax or value added tax where such credits, drawbacks or refunds are admitted as due by the authorities concerned

The two items included by the amendment in sub-clause (b) of clause 13 are refund of service-tax and refund of value added tax. All the observations made in paragraph 24.3 are mutatis mutandis applicable in respect of refund of service tax and refund of value added tax.

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15. Amounts admissible under section 33AB, 33ABA, 33AC, 35, 35ABB, 35AC, 35CCA, 35CCB, 35D, 35E :-

Amounts admissible under sections –

(a) 33AB
(b) 33ABA
(c) 33AC (wherever applicable)
(d) 35
(e) 35ABB
(f) 35AC
(g) 35CCA
(h) 35CCB
(i) 35D
(j) 35DD
(k) 35DDA
(l) 35E

(a) debited to the profit and loss account (showing the amount debited and deduction allowable under each section separately);

(b) not debited to the profit and loss account.

This is an amendment to the existing clause 15. References to sections 35DD being amortisation of expenditure in case of amalgamation or demerger and section 35DDA being amortisation of expenditure incurred under voluntary retirement scheme have been added by the amendment.

All the observations made in paragraph 26.1 are mutatis mutandis applicable in respect of sections 35DD and 35DDA.

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17(f) amounts inadmissible under section 40(a)

Notification No.208/2006 has not made any amendments to clause 17(f). However, the Taxation Laws (Amendment) Act, 2006 has come into force on 13

th July, 2006 made amendment in sections 40(a) and section 194J which have a bearing on the responsibilities of a tax auditor. Therefore, the following additional guidance has been given to guide the tax auditor to discharge his responsibility in the context of the above mentioned amendments.

The Taxation Laws (Amendment) Act, 2006 has amended sub-clause (ia) of clause (a) of section 40 w.e.f. the 1st day of April, 2006. The scope of inadmissible amounts mentioned in the sub-clause has been expanded to include rent and royalty. Accordingly, where tax has not been deducted in respect of rent and royalty or after deduction has not been paid during the previous year or in the subsequent year before the expiry of the time prescribed under sub-section (1) of section 200, the same shall not be deducted in computing the income chargeable under the head
"profits and gains or business or profession".

It may be noted that section 194-I has also amended by Taxation Laws (Amendment) Act, 2006. However, this amendment is with effect from 13

th July, 2006. Therefore, for the purpose of computing the inadmissible amount under section 40(a)(ia) for the assessment year 2006-07 rent will have the meaning as per the Explanation (1) under section 194-I prior to its substitution by the Taxation Laws (Amendment) Act, 2006.

It is possible that an assessee may contend that the inadmissibility under section 40(a)(ia) with respect to the amended definition of rent and royalty does not apply in relation to assessment year 2006-07. In such a case the tax auditor should state the view point of the assessee and also provide the relevant information as mentioned above in order to enable the tax authority to take a decision in the matter.