M/S. ROTORK CONTROLA INDIA (P) LTD. Vs COMMNR. OF INCOME TAX, CHENNAI
Case number: C.A. No.-003506-003510 / 2009
Diary number: 18822 / 2007
Advocates: RADHA RANGASWAMY Vs
B. V. BALARAM DAS
REPORTABLE
IN THE SUPREME COURT OF INDIA
CIVIL APPELLATE JURISDICTION
CIVIL APPEAL NOS. 3506-3510 OF 2009 (Arising out of S.L.P.(C) Nos.14178-14182 of 2007)
M/s. Rotork Controls India (P) Ltd. … Appellant (s)
Versus
Commissioner of Income Tax, Chennai … Respondent(s)
WITH
Civil Appeal No. 3511 of 2009 – Arising out of S.L.P. (C) No.7490 of 2009 Civil Appeal No. 3512 of 2009 – Arising out of S.L.P. (C) No.5616 of 2009 Civil Appeal No. 3513 of 2009 – Arising out of S.L.P. (C) No. 12063 of 2009 (SLP(C) ………CC No.4633 of 2009) Civil Appeal No. 3514 of 2009 – Arising out of S.L.P. (C) No.722 of 2009 Civil Appeal No. 3515 of 2009 – Arising out of S.L.P. (C) No.723 of 2009 Civil Appeal No. 3516 of 2009 – Arising out of S.L.P. (C) No.4776 of 2009 Civil Appeal No. 3517 of 2009 – Arising out of S.L.P. (C) No.3440 of 2009 Civil Appeal No. 3518 of 2009 – Arising out of S.L.P. (C) No.4182 of 2009 Civil Appeal No. 3519 of 2009 – Arising out of S.L.P. (C) No.4183 of 2009 Civil Appeal No. 3520 of 2009 – Arising out of S.L.P. (C) No.4184 of 2009 Civil Appeal No. 3521 of 2009 – Arising out of S.L.P. (C) No.8983 of 2009 Civil Appeal No. 3522 of 2009 – Arising out of S.L.P. (C) No.8982 of 2009 Civil Appeal No. 3523 of 2009 – Arising out of S.L.P. (C) No.8311 of 2009 Civil Appeal No. 3524 of 2009 – Arising out of S.L.P. (C) No. 12064 of 2009 (SLP(C) ………CC No.5279 of 2009)
J U D G M E N T
S. H. KAPADIA, J.
1. Delay condoned.
2. Leave granted.
FACTS IN THE LEAD MATTER
Civil Appeal Nos. of 2009 – Arising out of S.L.P.(C) Nos.14178-14182 of 2007 – M/s. Rotork Controls India (P) Ltd. v. Commissioner of Income Tax, Chennai .
3. In these civil appeals filed by the assessee we are concerned
with the assessment years 1991-92, 1992-93, 1993-94 and 1994-
95. For the sake of convenience we hereby refer to the facts
concerning assessment year 1991-92.
4. Appellant-company sells Valve Actuators. Bulk of the sales is
to BHEL. At the time of sale appellant (assessee) provides a
Standard Warranty whereby in the event of any Beacon Rotork
Actuator or part thereof becoming defective within 12 months from
the date of commissioning or 18 months from the date of despatch
whichever is earlier, the company undertakes to rectify or replace
the defective part free of charge. This warranty is given under
certain conditions stipulated in the warranty clause. For the
assessment year 1991-92, the assessee made a provision for
warranty at Rs.10,18,800/- at the rate of 1.5% of the turnover.
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This provision was made by the assessee on account of warranty
claims likely to arise on the sales effected by the appellant and to
cover up that expenditure. It may be noted that since the provision
made was for Rs.10,18,800/- which exceeded the actual
expenditure, the appellant reversed Rs.5,00,246 as Reversal of
Excess Provision. Consequently, the assessee claimed deduction in
respect of the net provision of Rs.5,18,554/- which was disallowed
by the A.O. on the ground that the liability was merely a contingent
liability not allowable as a deduction under Section 37 of the
Income-tax Act, 1961 (“the 1961 Act”, for short). This decision was
upheld by CIT (A). The matter was carried in appeal to the
Tribunal by the appellant. It was held by the Tribunal that right
from the assessment year 1983-84 the CIT (A) as well as the
Tribunal had allowed the warranty claim(s) on the ground that
Valve Actuators are sophisticated equipments; that in the course of
manufacture and sale of Valve Actuators a reasonable warranty
was given to the purchasers; that every item of sale was covered by
the warranty scheme; that no purchaser was ready and willing to
buy Valve Actuators without warranty and consequently every item
sold had a corresponding obligation under the warranty clause(s)
attached to such sales. This has been the view of the Department
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and the Tribunal right from assessment year 1983-84. In fact the
Department allowed deduction on the above facts constituting
normal trading practice. For example, during the assessment year
1983-84 the total sales during the year was Rs.1,45,36,599/- and
in that year the appellant had earmarked 1% of the total sales
towards the warranty claims which it would have to meet. This
amount provided for was held to be reasonable having regard to the
anticipated liability which was discharged in the subsequent year.
From that year onwards it has been consistently held that looking
to the nature of the business and the nature of the product
manufactured and sold it was necessary for warranty clause to be
attached to the sales effected by the appellant and that the
warranty obligations constituted an integral part of the sales
effected during the year. All throughout this period between
assessment year 1983-84 and assessment year 1991-92, the
Tribunal took the view that the provision made by the appellant
was realistic. Applying the Rule of Consistency, the Tribunal held
that the assessee on the facts and circumstances of the case was
entitled to deduction under Section 37 of the 1961 Act in respect of
provision for warranty amounting to Rs.5,18,554. At this stage one
point needs to be emphasized. During the assessment year 1983-
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84 to assessment year 1991-92 there was one instance when the
Tribunal disallowed the warranty claim that was in the assessment
year 1985-86. The reason was in that year the assessee had not
adjusted the excess out of the provision to the expense of the
immediate following year and as a result the Closing Balance of the
Provision Account was found to be swelling up from year to year.
In other words, during that year reversal was not effected. That is
not the position during the assessment years 1991-92, 1992-93,
1993-94 and 1994-95. Accordingly, for the assessment year 1991-
92, the appellant herein succeeded before the Tribunal. Aggrieved
by the decision of the Tribunal, the Department carried the matter
in appeal to the Madras High Court vide Tax Case Appeal No.163 of
2003 etc. Those appeals were for all the assessment years 1991-
92, 1992-93, 1993-94 and 1994-95. By common judgment dated
5.2.07, the High Court held that the assessee was not entitled to
deduction in respect of the provision made for warranty claims. It
was held that no obligation was ever cast on the date of the sale
and consequently there was no accrued liability. According to the
impugned judgment, the liability had not crystalised on the date of
the sale and, therefore, appellant was not entitled to deduction in
respect of the provision made for warranty charges payable under
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the terms of sale. According to the impugned judgment, warranty
provision was made against the liability which had not crystalised
against the appellant and consequently it was a provision made for
an unascertained liability and, therefore, the appellant was not
entitled to claim deduction under Section 37 of the 1961 Act. The
case of the Department was accepted by the High Court, hence
these civil appeals are filed by the assessee.
CONTENTIONS
5. On behalf of the Department Mr. V. Shekhar, learned senior
counsel, submitted that provision for warranty is towards
unforeseen liability, which is not certain nor it could be foreseen
with precision in the relevant year, hence, claim of warranty as well
as liability in respect thereof was contingent. Being contingent,
deduction as expense(s) was not available. According to learned
counsel, Section 37 of the 1961 Act does not refer to “making of
provision” it only refers to “deduction permissible on account of
actual expenditure incurred”. In other words, according to learned
counsel, Section 37 does not refer to anticipated claims. According
to learned counsel, in this case the liability is contingent. The
goods sold may be defective or they may not be defective and,
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therefore, warranty provision was made only to earn goodwill and
stay in business. According to learned counsel, warranty is only an
assurance about the quality of the product sold. The obligation to
satisfy the claim in the warranty clause would depend upon
factors, namely, whether the product was used in the manner
required or whether the buyer was responsible for causing defect.
In the alternative, learned counsel submitted that whether the
liability for which provision is made was based on any scientific
study is required to be examined before allowing deduction under
Section 37 of the 1961 Act. Lastly, learned counsel urged that the
amount which is provided for or kept apart cannot be held to be
expenditure, actually incurred and consequently deduction is not
admissible. Learned counsel submitted that in each case one has
to find out whether there is an element of certainty that the liability
would occur. In each case one has to ascertain whether there is
any scientific data or material produced by the assessee about the
liability incurred in the past and in the absence of such a data
assessee was not entitled to deduction for warranty provision in its
books of accounts. According to learned counsel, merely because
the assessee is maintaining its account on mercantile basis, it
cannot claim that the provision made towards warranty is an
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accrued liability. According to learned counsel, accounting
treatment will not decide whether the warranty claim is actual
liability, accrued liability or contingent liability. Since in the
relevant year there was no claim for replacement of the defective
pieces, the assessee could not have claimed deduction by merely
making an entry in its books of accounts or by making a mere
provision in its books of accounts. In this connection, learned
counsel placed reliance on the judgment of the Madras High Court
in the case of Commissioner of Income-tax, Madras v. Indian
Metal and Metallurgical Corporation – (1964) 51 ITR 240.
Learned counsel also placed reliance on the judgments of the
Supreme Court in the case of Indian Molasses Co. (Private) Ltd.
v. Commissioner of Income-tax , West Bengal – (1959) 37 ITR 66
(SC) and Shree Sajjan Mills Ltd. v. Commissioner of Income-tax,
M.P., and Anr. – (1985) 156 ITR 585 (SC).
6. Mr. S. Ganesh, learned senior counsel, appearing on behalf of
the assessee, submitted that in this case the High Court had erred
in not following the Rule of Consistency. In this connection, it was
urged that right from assessment year 1983-84 upto assessment
year 1991-92, the Tribunal had come to the conclusion that Valve
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Actuators were sophisticated items; that, the appellant has been
following scientific method of accounting which included the
concept of “reversal”; that looking to the nature of business and the
nature of the product the appellant was entitled under the
Commercial Accounting Principles to create provisions for warranty
and accordingly the appellant was entitled to deduction under
Section 37 of the 1961 Act. According to learned counsel, for the
assessment years in question, the Tribunal has accordingly
followed its earlier view which has prevailed right from assessment
year 1983-84 and it has, therefore, directed deletion of the
disallowance of Rs.5,18,554/- for the assessment year 1991-92.
While explaining the concept of “reversal”, learned counsel pointed
out that 1.5% of total sales of Rs.1 crore (amounting to Rs.1.50
lakhs) was taken by the appellant as a provision for warranty
claims in its balance-sheet by debiting its profit and loss account
and by crediting the provision for warranty claims in the balance-
sheet. This is in the first year. In the second year Rs.1.50 lakhs
which was the provision for first year was brought forward by way
of Opening Balance of the Provision Account in the Ledger Account.
If expenditure incurred in the second year was not Rs.1.50 lakhs
but only Rs.1 lakh then such actual expenditure of Rs.1 lakh alone
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was debited to the Provision Account which, as stated above, had
the Opening Balance of Rs.1.5 lakhs and accordingly in the second
year Rs.50,000/- was taken to the credit of profit and loss account
and offered for tax. In other words, in the year in which the
provision made by the appellant exceeded actual expenditure by
Rs.50,000/- the same was offered for tax as income. In other
words, there was reversal to the extent of Rs.50,000/- in the
second year. This is the example of reversal. According to learned
counsel, the concept of “reversal” forms part of scientific method of
accounting which is being followed by the assessee from the
assessment year 1983-84 onwards right upto assessment year
1991-92, 1992-93, 1993-94 and 1994-95. While overruling the
judgment of the Tribunal, the High Court has failed to notice this
important aspect of reversal. According to learned counsel, if one
applies the concept of “reversal” which has been applied in the
present case, there is no escapement of income from assessment
and the entire exercise would be revenue neutral. Learned counsel
placed reliance on the judgment of the Privy Council in the case of
Commissioner of Inland Revenue v. Mitsubishi Motors New
Zealand Ltd. - (1996) 222 ITR 697 (PC). Learned counsel also
placed reliance on the judgments of the Supreme Court in the case
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of Bharat Earth Movers v. Commissioner of Income-tax – (2000)
245 ITR 428 (SC) and Metal Box Company of India Ltd. v. Their
Workmen – (1969) 73 ITR 53 (SC).
7. Learned counsel next submitted that assuming for the sake of
argument that the liability for warranty claim is a contingent
liability, the amount claimed by the appellant as deduction was still
allowable if deduction claimed is equal to the warranty expenses
actually incurred and the deductibility of such expenses viewed
over a number of years is beyond doubt. In this connection,
learned counsel urged that if having regard to surrounding
circumstances of the appellant’s business as a whole, a certain
item of expenditure is bound to incur year after year in different
degrees then the business liability has definitely arisen and such
liability cannot be considered as contingent liability.
8. It was next urged that under Section 145 of the 1961 Act, as
it stood prior to 1997, the income of the appellant had to be
determined on the basis of method of accounting followed by the
appellant year to year and that method could be departed from by
the A.O. only if it was in a position to give a finding that the correct
income was incapable of being determined on the basis of the
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assessee’s impugned method of accounting. As stated above, from
assessment year 1983-84 the appellant, according to learned
counsel, has been making provision for warranty claims
consistently at the rate of 1.5% of its total sales turnover and from
1987 appellant has introduced in its accounts the concept of
“reversal” of excess provision which has been accepted by the
Department right upto assessment years in question. According to
learned counsel, there is no finding in the order of the A.O. for the
assessment years in question saying that the method of accounting
of the appellant was incapable of income determination. In the
circumstances, learned counsel submitted that the High Court had
erred in reversing the decision of the Tribunal.
Relevant Provisions of Law:
9. We quote herinbelow relevant provisions of the Income-tax
Act, 1961 as it stood at the material time:
“General
37. (1) Any expenditure (not being expenditure of the nature described in Section 30 to 36 [***] and not being in the nature of capital expenditure or personal expenses of the assessee), laid out or expended wholly and exclusively for the purposes of the business or profession shall be allowed in computing the income chargeable under the head “Profits and gains of business or profession”.
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Expenses or payments not deductible in certain circumstances 40A.(7)(a) Subject to the provisions of Clause (b), no deduction shall be allowed in respect of any provision (whether called as such or by any other name) made by the assessee for the payment of gratuity to his employees on their retirement or on termination of their employment for any reason
(b) Nothing in Clause (a) shall apply in relation to:
(i) any provision made by the assessee for the purpose of payment of a sum by way of any contribution towards an approved gratuity fund, or for the purpose of payment of any gratuity, that has become payable during the previous year;
(ii) any provision made by the assessee for the previous year relevant to any assessment year commencing on or after the 1st day of April, 1973, but before the 1st day of April, 1976, to the extent the amount of such provision does not exceed the admissible amount, if the following conditions are fulfilled, namely:
(1) the provision is made in accordance with an actuarial valuation of the ascertainable liability of the assessee for payment of gratuity to his employees on their retirement or on termination of their employment for any reason;
(2) the assessee creates an approved gratuity fund for the exclusive benefit of his employees under an irrevocable trust, the application for the approval of the fund having been made before the 1st day of January, 1976; and
(3) a sum equal to at least fifty per cent of the admissible amount, or where any amount has been utilised out of such provision for the purpose of payment of any gratuity before the creation of the approved gratuity fund, a sum equal to at least fifty per cent of the admissible amount as reduced by the amount so utilised, is paid by the assessee by way of contribution to the approved gratuity fund before the 1st day of April, 1976, and the balance of the admissible amount or, as the case may be, the balance
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of the admissible amount as reduced by the amount so utilised, is paid by the assessee by way of such contribution before the 1st day of April, 1977.
Explanation 1.-For the purposes of sub-clause (ii) of clause (b) of this sub-section, "admissible amount" means the amount of the provision made by the assessee for the payment of gratuity to his employees on their retirement or on termination of their employment for any reason, to the extent such amount does not exceed an amount calculated at the rate of eight and one-third per cent of the salary [as defined in clause (h) of rule 2 of Part A of the Fourth Schedule] of each employee entitled to the payment of such gratuity for each year of his service in respect of which such provision is made.
Explanation 2.-For the removal of doubts, it is hereby declared that where any provision made by the assessee for the payment of gratuity to his employees on their retirement or on termination of their employment for any reason has been allowed as a deduction in computing the income of the assessee for any assessment year, any sum paid out of such provision by way of contribution towards an approved gratuity fund or by way of gratuity to any employee shall not be allowed as a deduction in computing the income of the assessee of the previous year in which the sum is so paid.”
FINDINGS:
10. What is a provision? This is the question which needs to be
answered. A provision is a liability which can be measured only by
using a substantial degree of estimation. A provision is recognized
when: (a) an enterprise has a present obligation as a result of a
past event; (b) it is probable that an outflow of resources will be
required to settle the obligation; and (c) a reliable estimate can be
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made of the amount of the obligation. If these conditions are not
met, no provision can be recognized.
11. Liability is defined as a present obligation arising from past
events, the settlement of which is expected to result in an outflow
from the enterprise of resources embodying economic benefits.
12. A past event that leads to a present obligation is called as an
obligating event. The obligating event is an event that creates an
obligation which results in an outflow of resources. It is only those
obligations arising from past events existing independently of the
future conduct of the business of the enterprise that is recognized
as provision. For a liability to qualify for recognition there must be
not only present obligation but also the probability of an outflow of
resources to settle that obligation. Where there are a number of
obligations (e.g. product warranties or similar contracts) the
probability that an outflow will be required in settlement, is
determined by considering the said obligations as a whole. In this
connection, it may be noted that in the case of a manufacture and
sale of one single item the provision for warranty could constitute a
contingent liability not entitled to deduction under Section 37 of
the said Act. However, when there is manufacture and sale of an
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army of items running into thousands of units of sophisticated
goods, the past event of defects being detected in some of such
items leads to a present obligation which results in an enterprise
having no alternative to settling that obligation. In the present
case, the appellant has been manufacturing and selling Valve
Actuators. They are in the business from assessment years 1983-
84 onwards. Valve Actuators are sophisticated goods. Over the
years appellant has been manufacturing Valve Actuators in large
numbers. The statistical data indicates that every year some of
these manufactured Actuators are found to be defective. The
statistical data over the years also indicates that being
sophisticated item no customer is prepared to buy Valve Actuator
without a warranty. Therefore, warranty became integral part of
the sale price of the Valve Actuator(s). In other words, warranty
stood attached to the sale price of the product. These aspects are
important. As stated above, obligations arising from past events
have to be recognized as provisions. These past events are known
as obligating events. In the present case, therefore, warranty
provision needs to be recognized because the appellant is an
enterprise having a present obligation as a result of past events
resulting in an outflow of resources. Lastly, a reliable estimate can
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be made of the amount of the obligation. In short, all three
conditions for recognition of a provision are satisfied in this case.
13. In this case we are concerned with Product Warranties. To
give an example of Product Warranties, a company dealing in
computers gives warranty for a period of 36 months from the date
of supply. The said company considers following options : (a)
account for warranty expense in the year in which it is incurred; (b)
it makes a provision for warranty only when the customer makes a
claim; and (c) it provides for warranty at 2% of turnover of the
company based on past experience (historical trend). The first
option is unsustainable since it would tantamount to accounting
for warranty expenses on cash basis, which is prohibited both
under the Companies Act as well as by the Accounting Standards
which require accrual concept to be followed. In the present case,
the Department is insisting on the first option which, as stated
above, is erroneous as it rules out the accrual concept. The second
option is also inappropriate since it does not reflect the expected
warranty costs in respect of revenue already recognized (accrued).
In other words, it is not based on matching concept. Under the
matching concept, if revenue is recognized the cost incurred to earn
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that revenue including warranty costs has to be fully provided for.
When Valve Actuators are sold and the warranty costs are an
integral part of that sale price then the appellant has to provide for
such warranty costs in its account for the relevant year, otherwise
the matching concept fails. In such a case the second option is
also inappropriate. Under the circumstances, the third option is
most appropriate because it fulfills accrual concept as well as the
matching concept. For determining an appropriate historical trend,
it is important that the company has a proper accounting system
for capturing relationship between the nature of the sales, the
warranty provisions made and the actual expenses incurred
against it subsequently. Thus, the decision on the warranty
provision should be based on past experience of the company. A
detailed assessment of the warranty provisioning policy is required
particularly if the experience suggests that warranty provisions are
generally reversed if they remained unutilized at the end of the
period prescribed in the warranty. Therefore, the company should
scrutinize the historical trend of warranty provisions made and the
actual expenses incurred against it. On this basis a sensible
estimate should be made. The warranty provision for the products
should be based on the estimate at year end of future warranty
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expenses. Such estimates need reassessment every year. As one
reaches close to the end of the warranty period, the probability that
the warranty expenses will be incurred is considerably reduced and
that should be reflected in the estimation amount. Whether this
should be done through a pro rata reversal or otherwise would
require assessment of historical trend. If warranty provisions are
based on experience and historical trend(s) and if the working is
robust then the question of reversal in the subsequent two years, in
the above example, may not arise in a significant way. In our view,
on the facts and circumstances of this case, provision for warranty
is rightly made by the appellant-enterprise because it has incurred
a present obligation as a result of past events. There is also an
outflow of resources. A reliable estimate of the obligation was also
possible. Therefore, the appellant has incurred a liability, on the
facts and circumstances of this case, during the relevant
assessment year which was entitled to deduction under Section 37
of the 1961 Act. Therefore, all the three conditions for recognizing
a liability for the purposes of provisioning stands satisfied in this
case. It is important to note that there are four important aspects
of provisioning. They are – provisioning which relates to present
obligation, it arises out of obligating events, it involves outflow of
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resources and lastly it involves reliable estimation of obligation.
Keeping in mind all the four aspects, we are of the view that the
High Court should not to have interfered with the decision of the
Tribunal in this case.
14. In this case the High Court has principally gone by the
judgment of the Supreme Court in the case of Shree Sajjan Mills
(supra). That was the case of gratuity. For the assessment year
1974-75 the assessee-company sought to deduct a sum of
Rs.18,37,727/- towards the amount of gratuity payable to its
employees and worked out actuarially. No provision was made for
Rs.18,37,727/-. The claim for deduction was made on the ground
that the liability stood ascertained by actuarial valuation and,
therefore, was deductible under Section 37 of the 1961 Act. The
ITO allowed the deduction only in respect of the amounts actually
paid by the assessee and the rest was disallowed on the ground of
non-compliance with the provisions of Section 40A(7) of the 1961
Act. This view of the ITO was affirmed by CIT(A). The Tribunal
held that for the earlier assessment year relating to 1973-74,
actuarially ascertained liability for gratuity arising under Payment
of Gratuity Act, 1972 was an allowable deduction. However, for the
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assessment year in question, the Tribunal held that the increased
liability claimed by the assessee for deduction was allowable on
general principles of accounting. This view was taken by the
Tribunal on the basis that the actuarially determined liability was
not provided for in the assessee’s books of account. In appeal by
the Department, the High Court held that the assessee was not
entitled to deduction without complying with the provisions of
Section 40A(7) of the 1961 Act. This view of the High Court was
affirmed by this Court. It was held that Section 40A(7) which stood
inserted by Finance Act, 1975 w.e.f. 1.4.73 has been given an
overriding effect over Section 28 as well as Section 37 of the 1961
Act. Consequently, the deduction allowable on general principles
was ruled out as Section 40A(1) made it clear that Section 40A had
effect notwithstanding anything contained in Sections 30 to 39 of
the 1961 Act. In other words, as regards deduction in respect of
gratuity, the assessee was required to comply with the provisions of
Section 40A(7) after Finance Act, 1975. It is interesting to note that
prior to 1.4.73 actual payment or provision for payment was eligible
for deduction either under Section 28 or under Section 37 of the
1961 Act. This has been reiterated in Shree Sajjan Mills (supra).
The position got altered only after 1.4.73. Before that date,
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provision made in the P & L Account for the estimated present
value of the contingent liability properly ascertained and
discounted on an accrued basis could be deducted either under
Section 28 or Section 37 of the 1961 Act. This has been explained
in Shree Sajjan Mills (supra) at page 599. Section 40A(7) deals
only with the case of gratuity. Even in the case of gratuity but for
insertion of Section 40A(7), provision made in the P & L Account on
the basis of present value of the contingent liability properly
ascertained and discounted on an accrued basis was entitled to
deduction either under Section 28 or under Section 37 of the said
Act. This aspect, therefore, indicates that the present value of the
contingent liability like the warranty expense, if properly
ascertained and discounted on accrued basis, could be an item of
deduction under Section 37 of the said Act. This aspect is not
noticed in the impugned judgment. We may add a caveat. As
stated above, the principle of estimation of the contingent liability
is not the normal rule. As stated above, it would depend on the
nature of business, the nature of sales, the nature of the product
manufactured and sold and the scientific method of accounting
being adopted by the assessee. It will also depend upon the
historical trend. It would also depend upon the number of articles
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produced. As stated above, if it is a case of single item being
produced then the principle of estimation of contingent liability on
pro rata basis may not apply. However, in the present case, it is
not so. In the present case, we have the situation of large number
of items being produced. They are sophisticated goods. They are
supported by the historical trend, namely, defects being detected in
some of the items. The data also indicates that the warranty cost(s)
is embedded in the sale price. The data also indicates that the
warranty is attached to the sale price. In the circumstances, we
hold that the principle laid down by this Court in the case of Metal
Box Company of India (supra) will apply. In that case this Court
held that contingent liabilities discounted and valued as out-of-
necessity could be taken into account as trading expenses if these
were capable of being valued. It was further held that an estimated
liability even under a gratuity scheme even if it was a contingent
liability if properly ascertainable and if its present value stood fairly
discounted, was deductible from the gross profits while preparing
the P & L Account. In view of this decision it became permissible
for an assessee to provide, in his P & L Account, for the estimated
liability under a gratuity scheme by ascertaining its present value
on accrued basis and claiming it as an ascertained liability to be
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deducted in the computation of profit and gains of the previous
year either under Section 28 or under Section 37 of the 1961 Act.
However, the above principle would not apply after insertion of
Section 40A(7) w.e.f. 1.4.73. It may be stated that the principles of
commercial accounting, mentioned above, formed the basis of the
judgment of this Court in the case of Metal Box Company of India
(supra) and those principles are affirmed by the judgment of the
Supreme Court in Shree Sajjan Mills (supra) upto 1.4.73. In this
case we are concerned with warranty claims. In respect of
warranty claims during the relevant assessment years in question
there is no provision similar to Section 40A(7) of the 1961 Act. We
may add that the above principle of commercial accounting in
Metal Box Company of India (supra) also find place in the
judgment of this Court in the case of Madras Industrial
Investment Corporation Ltd. v. Commissioner of Income-tax –
(1997) 225 ITR 802 (SC), in which the Court has explained the
meaning of the word “expenditure” in Section 37 of the 1961 Act.
In other words, the principle enunciated in Metal Box Company of
India (supra) which has been reiterated in Shree Sajjan Mills
(supra) (upto 1.4.73) which deals with making of provision on the
basis of estimated present value of contingent liability holds good
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during the assessment years in question qua warranty claims.
15. Before concluding, we may refer to the judgment of this Court
in the case of Indian Molasses Co. (supra). In that case the facts
were as follows:
“One John Bruce Richard Harvey was the managing director of the assessee company in 1948. He had by then served the company for 13 years, and was due to retire at the age of 55 years on September 20, 1955. There was, it appears, an agreement by which the company was under an obligation to provide a pension to Harvey after his retirement. On September 16, 1948, the company executed a trust deed in favour of three trustees to whom the company paid a sum of Pound 8,208- 19-0 (Rs. 1,09,643) and further undertook to pay annually Rs. 4,364 (Pound 326.14 sh.) for six consecutive years, and the trustees agreed to execute a declaration of trust. The trustees undertook to hold the said sums upon trust to spend the same in taking out a deferred annuity policy with the Norwich Union Life Insurance Society in the name of the trustees but on the life of Harvey under which Pound 720 per annum were payable to Harvey for life from the date of his superannuation. It was also provided in the deed that notwithstanding the main clause the trustees would, if so desired by the assessee company, take out instead a deferred longest life policy, with the said insurance company in their names, but in favour of Harvey and Mrs. Harvey for an annuity of Pound 558-1-0 per annum payable during their joint lives from the date of Harvey's superannuation and during the lifetime of the survivor, provided further that if Harvey died before he attained the age of 55 years the annuity payable to Mrs. Harvey would be Pound 611-12-0 during her life. It was further provided that should Harvey die before attaining the age of 55 years, the trustees would stand possessed of the capital value of the deferred annuity policy, upon trust to purchase therewith an annuity for Mrs. Harvey with the above insurance company or other insurance company of repute. The other conditions of the deed of trust need not be considered, because they do not bear upon the controversy.
In furtherance of these presents, the trustees took out a policy on January 12, 1949. In addition to conditions usual in such policies, it provided for the following benefits :
Amount per annum of Pound 563-5-8 p.a. if both Mr. and deferred annuity. Mrs. Harvey be living on September
20, 1955. Pound 720-0-0 p.a. if Mrs. Harvey should die before September 20,
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1955, leaving Harvey surviving her. Pound 645-0-0 p.a. if Harvey should die before September 20, 1955, leaving Mrs. Harvey surviving him.
There was a special provision which must be reproduced :
"Provided the contract is in force and unreduced, the grantees (i.e., the trustees) shall be entitled to surrender the annuity on the option anniversary (i.e., September 20, 1955), for the capital sum of Pound 10,169 subject to written notice of the intention to surrender being received by the directors of the society within the thirty day preceding the option anniversary."
Two other clauses of the Second Schedule of the policy may also be quoted :
"(III) If both the nominees shall die whilst the contract remains in force and unreduced and before the option anniversary the said funds and property of the society shall be liable to make repayment to the grantees of a sum equal to a return to all the premiums which shall have been paid under this contract without interest after proof thereof and subject as hereinbefore provided.
(IV) The grantees shall before the option anniversary and after it has acquired a surrender value be entitled to surrender the contract for a cash payment equal to return of all the premiums (at the yearly rate) which have been paid less the first year's premium or five per cent of the capital sum specified in the special provision of the First Schedule whichever shall be the lesser sum, provided that if the deferred annuity has been reduced an equivalent reduction in the guaranteed surrender value as calculated above will be made."
The assessee company paid the initial sum and the yearly premia for some years before Harvey died. In the assessment years 1949-50, 1950- 51, 1951-52 and 1952-53, it claimed a deduction of these sums from its profits or gains under section 10(2) (xv) of the Indian Income-tax Act (hereinafter called the Act), which provides :
"Such profits or gains shall be computed after making the following allowances, namely :-
any expenditure (not being in the nature of capital expenditure or personal expenses of the assessee) laid out or expended wholly and exclusively for the purposes of such business, profession or vocation."
This claim was disallowed by the Department and the Appellate Tribunal. The Tribunal held that it was not necessary to decide if the expenditure was wholly or exclusively for the purposes of the company's business, and if so,
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whether it was of a capital nature, because in the Tribunal's opinion there was no expenditure at all. The reason why the Tribunal held this way may be stated in its own words :
"Clauses (I) and (II) do not contain any provision having a material bearing upon clause (III). Therefore, if it happens that both Mr. and Mrs. Harvey die before 20th September, 1955, all the payments till then made through the trustees to the Insurance Society will come back to the trustees and, as there is not the slightest trace of any indication anywhere that the trustees should have any beneficial interest in these moneys there would be a resultant trust in favour of the company in respect of the moneys thus far paid out. In other words, what has been done amounts to a provision for a contingency which may never arise. Such a provision can hardly be treated as payment to an employee whether of remuneration or pension or gratuity, and cannot be a proper deduction against the incomings of the business of the company for the purpose of computing its taxable profits. In short, there has been no expenditure by the company yet; there has been only an allocation of a part of its funds for an expenditure which may (or may not) have to be incurred in future."
16. The question which arose for determination was : whether
during the assessment years 1949-50, 1950-51, 1951-52 and
1952-53 the assessee-company was entitled to claim deduction of
the yearly premium from its profits under Section 10(2)(xv) of the
Income-tax Act, 1922. It was held that the provision in the policy
for surrendering annuity and the provision in policy for return of
premium was not entitled to deduction as the payment made to the
trustees by the assessee-company was towards a contingent
liability or towards a liability depending on a contingency, namely,
the life of a human-being. It was held that putting aside of money
which may become expenditure on the happening of an event is not
an expenditure under Section 10(2)(xv) of the 1922 Act. It was held
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on facts that the money was placed in the hands of trustees and/or
the insurance company to purchase annuities, if required, but to
be returned if the annuities were not purchased. Therefore, it was
a case of setting apart of the money and consequently the assessee
was not entitled to deduction under the said section.
17. At this stage, we once again reiterate that a liability is a
present obligation arising from past events, the settlement of which
is expected to result in an outflow of resources and in respect of
which a reliable estimate is possible of the amount of obligation.
As stated above, the case of Indian Molasses Co. (supra) is
different from the present case. As stated above, in the present
case we are concerned with an army of items of sophisticated
(specialiased) goods manufactured and sold by the assessee
whereas the case of Indian Molasses Co. (supra) was restricted to
an individual retiree. On the other hand, the case of Metal Box
Company of India (supra) pertained to an army of employees who
were due to retire in future. In that case the company had
estimated its liability under two gratuity schemes and the amount
of liability was deducted from the gross receipts in the profit and
loss account. The company had worked out its estimated liability
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on actuarial valuation. It had made provision for such liability
spread over to a number of years. In such a case it was held by
this Court that the provision made by the assessee-company for
meeting the liability incurred by it under the gratuity scheme would
be entitled to deduction out of the gross receipts for the accounting
year during which the provision is made for the liability. The same
principle is laid down in the judgment of this Court in the case of
Bharat Earth Movers (supra). In that case the assessee company
had formulated leave encashment scheme. It was held, following
the judgment in Metal Box Company of India (supra), that the
provision made by the assessee for meeting the liability incurred
under leave encashment scheme proportionate with the entitlement
earned by the employees, was entitled to deduction out of gross
receipts for the accounting year during which the provision is made
for that liability. The principle which emerges from these decisions
is that if the historical trend indicates that large number of
sophisticated goods were being manufactured in the past and in
the past if the facts established show that defects existed in some
of the items manufactured and sold then the provision made for
warranty in respect of the army of such sophisticated goods would
be entitled to deduction from the gross receipts under Section 37 of
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the 1961 Act. It would all depend on the data systematically
maintained by the assessee. It may be noted that in all the
impugned judgments before us the assessee(s) has succeeded
except in the case of Civil Appeal Nos. of 2009 – Arising
out of S.L.P.(C) Nos.14178-14182 of 2007 – M/s. Rotork Controls
India (P) Ltd. v. Commissioner of Income Tax, Chennai , in which the
Madras High Court has overruled the decision of the Tribunal
allowing deduction under Section 37 of the 1961 Act. However, the
High Court has failed to notice the “reversal” which constituted
part of the data systematically maintained by the assessee over last
decade.
18. For the above reasons, we set aside the impugned judgment
of the Madras High Court dated 5.2.07 and accordingly the civil
appeals stand allowed in favour of the assessee with no order as to
costs.
Civil Appeal No. of 2009 – Arising out of S.L.P. (C) No.7490 of 2009 Civil Appeal No. of 2009 – Arising out of S.L.P. (C) No.5616 of 2009 Civil Appeal No. of 2009 – Arising out of S.L.P. (C) No. of 2009 (SLP(C) ………CC No.4633 of 2009) Civil Appeal No. of 2009 – Arising out of S.L.P. (C) No.722 of 2009 Civil Appeal No. of 2009 – Arising out of S.L.P. (C) No.723 of 2009 Civil Appeal No. of 2009 – Arising out of S.L.P. (C) No.4776 of 2009 Civil Appeal No. of 2009 – Arising out of S.L.P. (C) No.3440 of 2009 Civil Appeal No. of 2009 – Arising out of S.L.P. (C) No.4182 of 2009 Civil Appeal No. of 2009 – Arising out of S.L.P. (C) No.4183 of 2009 Civil Appeal No. of 2009 – Arising out of S.L.P. (C) No.4184 of 2009
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Civil Appeal No. of 2009 – Arising out of S.L.P. (C) No.8983 of 2009 Civil Appeal No. of 2009 – Arising out of S.L.P. (C) No.8982 of 2009 Civil Appeal No. of 2009 – Arising out of S.L.P. (C) No.8311 of 2009 Civil Appeal No. of 2009 – Arising out of S.L.P. (C) No. of 2009 (SLP(C) ………CC No.5279 of 2009)
19. For the reasons given hereinabove in Civil Appeal
Nos.______________of 2009 – Arising out of S.L.P.(C) Nos.14178-
14182 of 2007 – M/s. Rotork Controls India (P) Ltd. v. Commissioner of
Income Tax, Chennai, the civil appeals filed by the Department stand
dismissed with no order as to costs.
..…………………………J. (S.H. KAPADIA)
……….………………….J. (AFTAB ALAM)
New Delhi; May 12, 2009.
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