ITAT Mumbai: AO Can't Reject Consistently Followed Stock Valuation Method (ICDS-II) U/S 145(3) Without Pointing Out Specific Defects - 2025-08-04

Mumbai ITAT Upholds Principle of Consistency in Stock Valuation, Rejects Revenue's Appeal

Mumbai, India – The Income Tax Appellate Tribunal (ITAT), Mumbai Bench, has delivered a significant ruling in favour of Blue Star Diamonds Pvt. Ltd., dismissing an appeal by the Deputy Commissioner of Income Tax (DCIT). The Tribunal, comprising Accountant Member Shri Narendra Kumar Billaiya and Judicial Member Shri Anikesh Banerjee, affirmed that the Assessing Officer (AO) cannot arbitrarily reject a consistently followed method of stock valuation without pointing out specific defects, especially when the method complies with mandated accounting standards.

The ruling reinforces the "principle of consistency" and sets a clear precedent on the powers of the AO under Section 145(3) of the Income-tax Act, 1961, concerning the rejection of books of account.

Brief Overview of the Case

The case, DCIT vs. Blue Star Diamonds Pvt. Ltd. (ITA No.1375/Mum/2024), centered on the assessment for the year 2018-19. Blue Star Diamonds, a trader and manufacturer of diamonds, had its books of account rejected by the AO under Section 145(3). The AO, dissatisfied with the company's valuation of its closing stock, made a substantial addition of ₹92.80 crore to its income by revaluing the stock based on a simple average of purchase prices from the last two months of the financial year.

Additionally, the AO made a disallowance of ₹39.97 lakh under Section 14A, which deals with expenditure incurred in relation to income not includible in total income. The assessee successfully challenged these additions before the Commissioner of Income-tax (Appeals) [CIT(A)], leading the Revenue to appeal to the ITAT.

Arguments of the Parties

The Revenue's Position: The DCIT argued that the assessee had significantly undervalued its closing stock of rough and polished diamonds. It was contended that the weighted average cost of ₹10,577 per carat for rough diamonds was indefensible when the lowest purchase price in the final two months was ₹14,441 per carat. The Revenue asserted this was a clear attempt to suppress profits and that the AO was justified in rejecting the books and re-calculating the stock value based on available data. They also argued for the disallowance under Section 14A, citing a 2022 amendment and a CBDT circular to justify making the disallowance even in the absence of exempt income.

The Assessee's Defence: Blue Star Diamonds, represented by Shri Nitesh Joshi, countered that its valuation method—"cost or net realizable value (NRV), whichever is lower"—was consistently applied, compliant with both ICDS-II and Ind AS-2, and had been accepted by the department in scrutiny assessments for the preceding four years and the subsequent year. They maintained a day-to-day, lot-wise stock register and provided a valuation report from a government-approved valuer, which the AO had dismissed without identifying any specific flaws. The assessee highlighted the unique nature of each diamond (based on the 4Cs: cut, colour, carat, clarity), making the AO's simple averaging method inappropriate.

Tribunal's Analysis and Key Findings

The ITAT conducted a thorough review of the facts and legal precedents, leading to several key observations.

On Rejection of Books and Stock Valuation: The Tribunal found the AO's actions to be legally and factually unjustifiable. The judgment highlighted the following pivotal points:

"...it is evident from the record that the assessee has consistently followed the method of valuation prescribed under ICDS-II and Ind AS-2, i.e., “cost or net realisable value, whichever is lower”, and the same has been accepted by the department in preceding as well as subsequent assessment years."

The bench noted that the AO had failed to find any specific defect in the stock register or the valuation report provided by the assessee. Furthermore, the AO's approach was inconsistent as he revalued the closing stock but did not make any corresponding adjustment to the opening stock, a move contrary to settled accounting principles.

Citing the Supreme Court in Radhasoami Satsang v. CIT and United Commercial Bank v. CIT , the Tribunal reiterated that a consistently applied accounting method cannot be disturbed without cogent reasons. The CIT(A) had correctly observed that the AO ignored crucial evidence, including sample invoices and stock registers that corroborated the assessee's valuation method.

On Disallowance under Section 14A: Regarding the disallowance under Section 14A, the Tribunal upheld the CIT(A)'s decision to remand the issue back to the AO. The direction was to verify the actual exempt income earned and compute the disallowance accordingly. The bench noted this was in line with binding Supreme Court precedents.

"The direction is in consonance with the binding precedents of the Hon’ble Supreme Court in Chettinad Logistics (P.) Ltd. (supra) and Delhi International Airport (P.) Ltd. (supra), wherein it has been held that no disallowance under section 14A of the Act can be made in the absence of exempt income."

Final Decision

The ITAT concluded that the CIT(A)'s order was well-reasoned and did not suffer from any legal or factual infirmity. It dismissed all grounds of the Revenue's appeal.

The final order stated:

"In view of the foregoing analysis, we find that the order passed by the Ld. CIT(A) does not suffer from any legal or factual infirmity. All grounds raised by the revenue are devoid of merit and accordingly, the appeal of the revenue is dismissed."

This judgment provides crucial clarity for businesses, particularly those with complex inventories like the diamond industry, affirming that adherence to established accounting standards and consistent application of valuation methods provide a strong defence against arbitrary rejections by tax authorities.