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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