Show cause notice issued before audit observations are finalised is not legally sustainable; proper officer must follow the procedure under Section 65 and Rule 101(4) before initiating recovery proceedings: Kerala High Court

The Court held that a show cause notice issued on the basis of draft audit observations — before providing the taxpayer an opportunity to reply and before the final audit report was issued — cannot be treated as a valid foundation for recovery proceedings.

The Kerala High Court has quashed a show cause notice and the final audit observations issued by the Central Tax authorities against a company, holding that the statutory procedure mandated under Section 65 of the CGST Act read with Rule 101(4) of the CGST Rules was not followed and that the taxpayer was deprived of the opportunity to respond to the discrepancies highlighted during audit before recovery proceedings were initiated [The Alleppey Company Ltd. v. Assistant Commissioner, Central Tax and Central Excise, Audit Circle III, Kottayam].

The petitioner was issued a draft audit observation on 4 July 2024 and sought additional time to respond, given that the observations were voluminous and covered several years. Without disposing of the extension requests, the Department issued what it styled as a final audit note on 16 July 2024, followed immediately by a show cause notice on 31 July 2024 relying on the discrepancies in the audit note. While the writ petition was pending, the Department issued a further audit report on 3 September 2024 which, according to the Revenue itself, constituted the actual final audit observations.

Justice Ziyad Rahman AA first addressed the limitation question and held that the three-month period under Section 65(4) must be computed from the date of commencement of audit as defined in the Explanation — being the later of the date on which records were made available or the actual institution of audit at the place of business. Since the audit was physically conducted in May-June 2024, the September 2024 report was within time. However, the Court found merit in the petitioner's second contention regarding the procedure. Section 65(6) requires that on conclusion of the audit, the proper officer shall inform the taxpayer of the findings and the reasons therefor. Rule 101(4) further requires that discrepancies observed during audit be communicated to the taxpayer, who must be given an opportunity to file a reply, and the proper officer shall finalise the findings only after due consideration of that reply.

The Court held that the show cause notice issued on 31 July 2024 was based on observations that had not attained finality — the Department's own position being that the final audit report was issued only on 3 September 2024. A show cause notice cannot rest on a foundation that is itself incomplete. Furthermore, even the final audit report of 3 September 2024 was issued without providing the petitioner the opportunity to submit objections to the discrepancies, as mandated under Rule 101(4). Both the show cause notice and the final audit observations were quashed, with a direction to permit the petitioner to submit objections and to finalise the audit proceedings only after considering the reply. The decision establishes that the audit procedure under Section 65 is a sequential, mandatory process — draft observations, opportunity to reply, consideration of reply, and then final report — and that any attempt to short-circuit this sequence by issuing a show cause notice before the audit has been properly finalised renders the notice legally unsustainable.

2026-juristway.com-2893-HC(Kerala)-GST  |  High Court of Kerala  |  WP(C) No. 30354 of 2024  |  30.09.2026