Taxation Law | Bogus Purchases Cannot Be Allowed Even Partially: Bombay High Court Overrules ITAT, Directs Full Disallowance of Unverified Expenses

Once Purchases Are Found to Be Unverified, There Is No Legal Justification for Partial Disallowance - In a significant ruling Bombay High Court set aside the Income Tax Appellate Tribunal's (ITAT) decision, holding that once purchases are found to be unverified, they must be fully disallowed and not merely restricted to a percentage estimate. The Court ruled in favor of the Income Tax Department in The Principal Commissioner of Income Tax-25 v. Shree Ganesh Developers, emphasizing that when an assessee fails to substantiate expenses with proper documentation, tax authorities cannot arbitrarily allow a portion of such expenses under the guise of estimated profit margin.

Rejecting the practice of applying a 12.5% disallowance instead of a complete rejection of bogus purchases, the Court held that "once it is established that purchases are unverified, allowing a partial deduction is contrary to the legislative intent of Section 69C of the Income Tax Act, 1961. If an assessee cannot prove that the expenditure is genuine, it must bear the full tax consequences of such failure."

"Unverified Purchases Cannot Be Treated as Genuine Even Partially" – High Court Criticizes ITAT's Approach

The case arose from an income tax assessment for the year 2010-11, in which Shree Ganesh Developers claimed purchases worth ₹14.30 crore from various suppliers, some of whom were flagged as bogus entities by the tax authorities. The Assessing Officer (AO) disallowed the entire purchase amount, leading to an upward revision of the firm’s taxable income.

The assessee appealed before the Commissioner of Income Tax (Appeals) [CIT(A)], which deleted the disallowance for most suppliers but upheld a 12.5% disallowance for purchases from M/s Neptune Trading Co. and M/s Hari Om Traders. The ITAT later confirmed this decision, applying an estimated profit margin instead of outright rejecting the purchases. The Income Tax Department challenged this ruling before the High Court, arguing that partial disallowance effectively legitimizes fraudulent transactions.

The High Court ruled that "if purchases are found to be unverified, the entire expense must be disallowed. By restricting the disallowance to 12.5%, the lower authorities have created an arbitrary and legally unsustainable mechanism that indirectly validates an unsubstantiated transaction."

The Court observed that "under the Income Tax Act, an assessee cannot claim deduction for expenses that it has failed to prove as genuine. If the purchase is unverified, the law does not permit an estimation of a lower taxable amount—it mandates a complete disallowance."

"Failure to Produce Bank Statements Weakens the Assessee’s Case" – High Court Rejects the Justification for Partial Disallowance

The Court took note of the fact that the assessee had failed to furnish bank statements for transactions with M/s Neptune Trading Co. and M/s Hari Om Traders, unlike other suppliers for whom financial details had been verified.

"The burden of proving the genuineness of transactions lies on the assessee. If an assessee cannot substantiate its purchases with documentary evidence such as bank statements or supplier records, then an adverse inference must be drawn. There is no justification for treating such transactions as genuine to any extent," the Court ruled.

Rejecting the argument that the tax authorities should estimate a reasonable taxable portion of the purchases instead of disallowing them entirely, the Court held that "when a transaction is unverified, there is no logical or legal basis to compute a reduced disallowance. Either a purchase is genuine, or it is not. There is no in-between."

"Bogus Purchases Cannot Be Allowed Under the Guise of Estimated Profit Margin" – High Court Says Partial Disallowance Undermines Section 69C

The Court expressed strong disapproval of the approach adopted by CIT(A) and ITAT, stating that "estimating a profit margin on bogus purchases contradicts Section 69C of the Income Tax Act, which explicitly states that unexplained expenses shall be treated as income of the assessee and not allowed as deductions under any head."

Observing that "taxation principles do not permit an assessee to partially benefit from an expenditure it cannot verify," the Court ruled that the entire amount of purchases from unverified suppliers must be added to the taxable income of the assessee.

"If an assessee fails to provide satisfactory evidence for an expenditure, the law does not allow any portion of it to be deducted. Accepting a 12.5% disallowance instead of rejecting the purchase entirely sets a dangerous precedent where tax evasion can be disguised as an allowable business expense," the Court ruled.

"Assessee’s Silence on Partial Disallowance is an Admission That Purchases Were Not Genuine" – High Court Rejects Attempts to Justify Transactions

The Court took note of the fact that the assessee had not challenged the 12.5% disallowance imposed by CIT(A), observing that such inaction was an implicit acceptance that the purchases were not genuine.

"If an assessee accepts a partial disallowance, it is an acknowledgment that the transactions in question are not fully verified. The natural consequence of such an admission should have been a complete disallowance, not a percentage-based estimate," the Court held.

Rejecting the assessee’s attempt to justify the transactions, the Court ruled that "where the genuineness of an expense remains unverified, it cannot be deemed to be partially valid. The law does not operate on assumptions—it requires conclusive proof, which the assessee has failed to provide."

High Court Directs Full Disallowance, Overrules ITAT and CIT(A) on Bogus Purchases

Setting aside the ITAT and CIT(A)’s order regarding M/s Neptune Trading Co. and M/s Hari Om Traders, the Bombay High Court directed that the full purchase amount from these suppliers be added to the taxable income of the assessee.

"The question is answered in favor of the Revenue and against the assessee. The order of the CIT(A) and the Tribunal is reversed to this extent. The total additions shall reflect the full amount of ₹1,00,10,773, which was claimed as purchases from these two parties," the Court ruled.

While upholding ITAT’s decision regarding other suppliers whose transactions were verified, the Court clarified that "partial disallowance of unverified purchases is legally impermissible, and the correct approach is to disallow them in full."

With this ruling, the Bombay High Court has reinforced that tax authorities cannot adopt an arbitrary percentage-based disallowance when purchases remain unverified. The judgment establishes that:

• Unverified purchases must be fully disallowed, as there is no legal basis for allowing even a portion of them as business expenses.

• The failure to provide financial records such as bank statements creates an adverse inference against the assessee, warranting full addition to taxable income.

• Estimating a profit margin on bogus purchases undermines the intent of Section 69C and weakens enforcement against tax evasion.

• If an assessee accepts a partial disallowance without challenge, it amounts to an implicit admission that the purchases were not genuine.

The High Court has made it clear that an assessee cannot claim partial relief once purchases are found to be bogus, and tax authorities must ensure that unverified transactions do not receive any legitimacy under the guise of estimated disallowance.

Date of decision: 05/03/2025