2005 (8) TMI 96 - HC - Income Tax

Deduction - There is a clear distinction between an acknowledgment contemplated under the Limitation Act and an admission for the purpose of reflecting a liability or loss in the accounts maintained under the mercantile system by the assessee for the purpose of the Income-tax Act, 1961. - The admission of liability for the purpose of making entry of loss or reflection of liability in the accounts maintained in the mercantile system for the purpose of claiming deduction of loss in the course of assessment is distinct from acknowledgment of liability vis-a-vis the creditor. Inasmuch as if the amount becomes recoverable vis-a-vis the creditor, i.e., the liability ceases to be recoverable, the loss becomes income of the assessee chargeable to tax in the year of such accretion. The assessee is entitled to make such entry in the accounts maintained in the mercantile system as soon as he admits the liability. Therefore, he is entitled to the deduction of the loss in computing the income of the assessment year in which such entry is made, subject, however, to section 41 of the Income-tax Act, 1961.

Issues Involved:
1. Entitlement to deduction of the demand made by Indian Railways.
2. Crystallization of liability.
3. Applicability of the Arbitration Act, 1940.
4. Reflection of loss in mercantile system of accounts.
5. Distinction between admission and acknowledgment of liability.

Detailed Analysis:

1. Entitlement to Deduction of the Demand Made by Indian Railways:
The core question in the appeal was whether the appellant was entitled to a deduction for the demand of Rs. 46,82,142 made by the Indian Railways during the previous year relevant to the assessment year 1987-88. The Tribunal had rejected the claim on the grounds that the liability had not crystallized. The assessee had entered into a contract with the Railways, which included a condition for replacement at the cost of the assessee in case of rejection. The goods supplied were rejected twice, and the Railways demanded the said amount on May 3, 1986. The assessee neither paid the demand nor refunded the commission received from the Railways.

2. Crystallization of Liability:
The Tribunal's rejection was based on the argument that the liability had not crystallized. The assessee maintained accounts under the mercantile system and reflected the amount in his accounts. The Commissioner (Appeals) allowed the deduction, but the Tribunal reversed this decision. The court held that under the mercantile system, the assessee is bound to reflect all admitted losses. The liability must be admitted or ascertained to be reflected in the accounts.

3. Applicability of the Arbitration Act, 1940:
The respondent contended that the liability accrued in 1982 and was demanded in 1986, and no arbitration or suit was initiated by the Railways. The court found this point to be of academic interest, as the 1940 Act does not prohibit filing an independent suit in a civil court. The Railways had a 30-year limitation period under Article 112 of the Limitation Act, 1963, to file a suit.

4. Reflection of Loss in Mercantile System of Accounts:
The court discussed the principles of the mercantile system of bookkeeping, where the assessee is required to reflect admitted losses. The court referred to the case of Shewbux Jahurilal [1962] 46 ITR 688 (Cal), which held that an assessee must reflect losses in the accounts as soon as the loss is admitted or ascertained. The court emphasized that the reflection of loss in the accounts is well supported by section 41 of the Income-tax Act, 1961, which allows the income-tax authorities to charge the liability to income-tax in the year the liability ceases to exist.

5. Distinction Between Admission and Acknowledgment of Liability:
The court made a clear distinction between admission of liability for accounting purposes and acknowledgment of liability for extending the limitation period under section 18 of the Limitation Act. An admission for accounting purposes does not need to be in writing or communicated to the creditor. The court cited Bengal Silk Mills Co. v. Ismail Golam Hossain Ariff, AIR 1962 Cal 115, to support that a liability reflected in the accounts and shown in the balance-sheet is considered an admission. The court concluded that the assessee is entitled to reflect the loss in the accounts as soon as he admits the liability.

Conclusion:
The court concluded that the assessee is entitled to make an entry of loss in the accounts maintained in the mercantile system as soon as he admits the liability. The deduction of the loss in computing the income of the assessment year in which such entry is made is allowed, subject to section 41 of the Income-tax Act, 1961. The appeal was allowed, and the order of the learned Tribunal was set aside, affirming the order of the Commissioner (Appeals).

Order:
The appeal is allowed. The Tribunal's order is set aside, and the Commissioner (Appeals)'s order is affirmed. There will be no order as to costs. Xerox certified copies of the judgment and order will be supplied to the parties if applied for on usual undertaking.

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