2020 (2) TMI 372 - HC - Income Tax

Provision for salary - deduction was made in light of the Pay Revision Committee ( PRC ) appointed by the Government of India - Disallowance on the ground that it did not accrue and the same was merely a contingent liability - pay revision of the employees of the Appellant being a Public Sector Enterprise is due every 10 years and with the expiry of one wage settlement or agreement - HELD THAT - It is a well settled principle of law that an assessee, following the mercantile system of accounting, is not entitled to claim deduction until the liability for which deduction is claimed has accrued. The Act makes a distinction between actual liability in praesentia . The pay revision of employees of the appellant, a PSU is due every ten years with the expiry of one wage settlement or agreement. Invariably, there is a time lag between expiry of a wage revision and negotiation of a fresh wage revision. The appellant had made provision of ₹ 1.60 crores on scientific foundation and on the basis of its past experience in its accounts for Financial Year 2006-07. The provision was made for the period 1st January, 2007 to 31st March, 2007 and deduction was claimed on the standpoint that appellant is under an obligation to pay revised pay to its employees with effect from 1st January, 2007, determination whereof, was a matter of time. The appellant, thus had a reasonable basis to make provision for this expenditure. nd a liability de future which, for the time being is only contingent. The former is deductible but not the latter. The question to be decided in each case is whether any present liability has accrued against the assessee. The position in the current case is that the liability had already arisen with certainty. The committee was constituted for the purpose of wage revision. That the wages would be revised was a foregone conclusion. Merely because the making of the report and implementation thereof took time, it could not be said that there was no basis for making the provision. In view of the above, we hold that the ITAT and CIT (A) have fell in error by disallowing the expenditure of ₹ 1.60 crores on account of anticipated pay revision in Assessment Year 2007-08. The first and second questions of law are thus answered in favour of the appellant. Change in accounting policy - Addition on account of financial impact due to change in accounting policy in respect of revenue recognition of application fee, front end fees, administrative fee and processing fee of loans from the date of signing of the loan agreement to the date of realization - HELD THAT - The tax authorities should have proceeded to determine and ascertain as to whether, the income has in reality accrued to the assessee, or not, notwithstanding the change in accounting policy. If the income had indeed accrued, the addition would have been permissible. However, to determine this, in our opinion, the treatment given in the assessee s books of account would not be necessary, but would be dependent on the answer to the question as to whether the income has indeed accrued, having regard to the test as discussed hereinabove. The question whether real income has materialized or not, has to be scrutinized, having regard to the commercial and business certainties and realities of the situation in which the assessee is positioned, and not with reference to system of accounting. The answer to such decision would then relate to the chargeable accounting year in which such profits actually arose and assessee would be liable to tax accordingly. Applying this yardstick, we do not find that any income accrued at the point of mere execution of the agreement and, thus, the income did not accrue in the relevant AY. The financial impact has since been factored in the subsequent year. We also find merit in the submissions of the appellant that the change in accounting policy is a result of the audit objection raised by CAG on 10th October, 2006. The appellant has claimed deduction in profits in the computation of the total income, and added it as income in the subsequent assessment year, which has been accepted by the AO. The change is, thus, revenue neutral. - Decided in favour of assessee.

Summary

Issues Involved:
1. Disallowance of claim for provision for salary of ?1,60,00,000.
2. Addition of ?1,28,00,000 on account of change in accounting policy for revenue recognition.

Issue-wise Detailed Analysis:

1. Disallowance of Claim for Provision for Salary of ?1,60,00,000:
- Factual Background: The appellant, a PSU, claimed a deduction of ?1.60 crores for pay revision based on the recommendations of the Pay Revision Committee (PRC) effective from January 1, 2007. The AO disallowed this claim, labeling it as an unascertained liability since the PRC report was implemented in September 2008, beyond the relevant financial year.
- AO and CIT (A) Findings: The AO and CIT (A) held that the liability did not accrue or crystallize during the financial year 2006-07. The provision was considered ad hoc and not eligible for deduction.
- ITAT Findings: The ITAT upheld the disallowance, stating that the liability for pay revision had not accrued during the relevant financial year and was contingent.
- Appellant’s Argument: The appellant argued that the provision was based on a reasonable estimate and past experience, and the liability was certain, citing legal precedents such as Bharat Heavy Electricals Ltd. and Bharat Earth Movers vs. CIT.
- Court’s Analysis: The court noted that the liability for pay revision was a foregone conclusion, and the provision was made on a scientific basis. The effective date of the wage revision was crucial, not the date of the PRC report or its implementation.
- Legal Precedents: The court relied on Bharat Heavy Electricals Ltd. and Bharat Earth Movers vs. CIT, which support the recognition of liability based on reasonable estimation and effective date of wage revision.
- Conclusion: The court held that the ITAT and CIT (A) erred in disallowing the expenditure of ?1.60 crores, as the liability had accrued with certainty. The questions of law were answered in favor of the appellant, directing the revenue to accept the deduction.

2. Addition of ?1,28,00,000 on Account of Change in Accounting Policy for Revenue Recognition:
- Factual Background: The appellant changed its accounting policy for recognizing fees (application, front end, administrative, and processing fees) from the date of signing the loan agreement to the date of realization, following an objection by the CAG.
- AO and CIT (A) Findings: The AO added ?1.28 crores to the income, stating that the change in accounting policy resulted in an understatement of profits and was not in accordance with the provisions of the Act. The CIT (A) upheld this addition.
- ITAT Findings: The ITAT supported the addition, emphasizing that the appellant could not selectively adopt a cash system for certain items while following a mercantile system for others. The change was based on a faulty premise that there was no financial impact.
- Appellant’s Argument: The appellant argued that under the mercantile system, income cannot be recognized unless there is reasonable certainty of its realization, citing AS-9 issued by ICAI and several legal precedents.
- Court’s Analysis: The court noted that income accrues only when there is a right to receive it with certainty. The appellant’s change in accounting policy was in line with AS-9 and the settled legal position that hypothetical income cannot be taxed.
- Legal Precedents: The court referred to Excel Industries Ltd., Annamalai Finance Ltd., and Virtual Soft Systems Ltd., which support the recognition of income based on certainty of realization.
- Conclusion: The court found that the addition of ?1.28 crores was erroneous as the income did not accrue with certainty at the point of signing the loan agreement. The change in accounting policy was justified, and the financial impact was revenue neutral. The court set aside the ITAT’s order, answering the questions in favor of the appellant.

Summary:
The court allowed the appeal, holding that the disallowance of ?1.60 crores for pay revision was incorrect as the liability had accrued with certainty. Additionally, the addition of ?1.28 crores due to the change in accounting policy was unjustified, as the income did not accrue with certainty at the signing of the loan agreement. The court directed the revenue to accept the deductions and set aside the ITAT’s order.