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2007 (3) TMI 325 - AT - Income TaxDisallowance of provision for liquidated damages - Method Of Accounting - Mercantile system Or Accrual - delay in completing the work - contract agreement - HELD THAT - In the present case, where the assessee had taken the undertaking to carry out the work within the stipulated time, in default thereof the assessee was under an obligation to pay damages specified in the work agreement, and the assessee has not denied or disputed its obligation to pay liquidated damages for breach of the contract by not executing or erecting the work within specified time, and the assessee' s customer was entitled to deduct the amount of damages from the monies payable to the assessee as held in the case of Oil and Natural Gas Corporation Ltd. 2003 (4) TMI 438 - SUPREME COURT and all the revenues towards contract work executed by the assessee in the year has been taken into the account for determining the profit, the assessee' s obligations to pay a corresponding damages relating to the period falling within the relevant accounting year has imported an accrued liability on the assessee, for which a reasonable provision made in the books of account is deductible, while computing the profit from the said contract works, of the year under appeal, though that liability was to be discharged at a future date. The view we have taken above is further strengthened and supported by the logic or the reasoning that is being applied in holding that the monies retained by the contractee from the bills raised by the contractor till the obligation of satisfactory completion of the contract work is fulfilled would not amount to income of the contractor of the year in which the amount is retained. We may hold that till the assessee discharges its obligation to pay liquidated damages on account of delay caused by the assessee in executing the contract work, sum equal to the estimated liability of liquidated damages payable by the assessee to the contractee would not accrue to the assessee as income in the year in which the bills were raised. This view is further strengthened by the decision in the case of Oil and Natural Gas Corporation Ltd. 2003 (4) TMI 438 - SUPREME COURT , where it has been categorically held that the contractee is entitled to recover the liquidated damages for delay in supply of goods, from the bills for payment of cost of material supplied by the contractor. The hon ble Supreme Court in the case of Calcutta Co. Ltd. v. CIT 1959 (5) TMI 3 - SUPREME COURT , Metal Box Company of India Ltd. v. Their Workmen 1968 (8) TMI 53 - SUPREME COURT and as well as Bharat Earth Movers v. CIT 2000 (8) TMI 4 - SUPREME COURT , the assessee' s liability to pay liquidated damages can be estimated with reasonable certainty, though actual quantification may not be possible. The Assessing Officer has not done this exercise to ascertain the estimated liability of the assessee on account of liquidated damages with reasonable certainty. The assessee has quantified its liability of liquidated damages payable to the contractee in its books of account. Whether the estimated liability provided by the assessee in the books of account can be said to be a proper estimation with reasonable certainty has not been deliberated upon by the Assessing Officer or by the CIT(A). It is not in dispute that the allowable liability on account of liquidated damages payable by the assessee should be only in relation to the period of delay falling within the relevant year in dispute. In the contract agreement entered into with Cochin Refineries Ltd., it has been provided that the assessee-company shall be liable to pay a liquidated damages at the rate of 0.5 per cent. of the contract value of the boiler per day of delay or part thereof subject to a maximum of 15 per cent. of the contract value of that boiler. It is also provided therein that all sums payable by way of liquidated damages under any of the conditions shall be considered as reasonable compensation without reference to the actual loss or damage which shall have been sustained. In the contract agreement entered into with Kanoria Chemicals and Industries Ltd., the clause of liquidated damages states that in the case of delay in commissioning of the complete equipment beyond October 25, 1995, liquidated damages at the rate of 1 per cent. (one per cent.) per week subject to a maximum of 10 per cent. of ex-works price shall be applicable. In the case of Madras Fertilizers Ltd., liquidated damages are leviable at the rate of 0.5 per cent. per week or part thereof, subject to a maximum of 5 per cent. of the total value of the contract, if the boiler parts of 110 Ata boiler package is not delivered by the end of 18th month. In the case of Chemical and Plastics India Ltd., the provision has been made only of Rs. 27,525, which was subsequently settled between the parties. We, therefore, restore this issue back to the file of the Assessing Officer for a limited purpose with a direction that the Assessing Officer should ascertain and determine the accrued liability pertaining to the year in question, in respect of the liquidated damages in the light of the terms and conditions of the contract agreement, and then to allow the same as a deduction from the profits in the year under consideration. The assessee shall be at liberty to furnish the actuarial valuation in respect of the assessee' s accrued liability on account of liquidated damages for the delay caused by the assessee in erecting or commissioning the contract work as per the terms of the contract agreement. This ground is, thus, decided accordingly.
Issues Involved:
1. Disallowance of provision for liquidated damages. 2. Nature of liability: contingent vs. ascertained. 3. Admissibility of deduction under mercantile system of accounting. 4. Application of Accounting Standards. 5. Treatment of liquidated damages in contractual agreements. 6. Legal precedents and their applicability. 7. Determination and quantification of liability. 8. Reassessment and remand to Assessing Officer. Detailed Analysis: 1. Disallowance of Provision for Liquidated Damages: The primary issue revolves around the disallowance of Rs. 40,73,560 claimed by the assessee as a provision for liquidated damages. The Assessing Officer (AO) disallowed this provision, considering it a contingent liability rather than an ascertained one. The AO argued that the provision was not supported by evidence of actual payment and lacked certainty in quantum. 2. Nature of Liability: Contingent vs. Ascertained: The AO and the Commissioner of Income-tax (Appeals) (CIT(A)) held that the provision for liquidated damages was contingent. The AO noted that the provision might not be payable, illustrating with the example of Cochin Refineries where the actual liquidated damages were less than the provision made. The CIT(A) emphasized that the liability was dependent on future negotiations and mutual acceptance, thus not crystallized in the relevant accounting year. 3. Admissibility of Deduction under Mercantile System of Accounting: The assessee argued that under the mercantile system of accounting, liabilities that have accrued, even if payable in the future, should be deductible. The assessee maintained that the provision was in line with the accrual basis of accounting and was a reasonable estimate based on contractual obligations. 4. Application of Accounting Standards: The assessee referenced Accounting Standard 7 (AS-7) and Accounting Standard 1 (AS-1) issued by the Institute of Chartered Accountants of India, asserting that the provision was in compliance with these standards. The AS-7 mandates accounting for foreseeable losses, and AS-1 emphasizes the prudence principle, requiring provisions for all known liabilities. 5. Treatment of Liquidated Damages in Contractual Agreements: The contractual agreements with clients included clauses for liquidated damages in case of delays. The assessee accepted the delays and the resulting liability, making provisions in the books accordingly. The contracts specified the method of calculating liquidated damages, which the assessee followed. 6. Legal Precedents and Their Applicability: The Tribunal referred to several legal precedents, including: - Calcutta Co. Ltd. v. CIT [1959] 37 ITR 1 (SC): Established that an accrued liability, even if payable in the future, is deductible. - Metal Box Company of India Ltd. v. Their Workmen [1969] 73 ITR 53 (SC): Affirmed that liabilities accrued due are deductible, even if the exact amount is uncertain. - Bharat Earth Movers v. CIT [2000] 245 ITR 428 (SC): Held that a definite liability, even if payable in the future, is deductible. - Oil and Natural Gas Corporation Ltd. v. Saw Pipes Ltd. [2003] 5 SCC 705: Clarified that liquidated damages stipulated in a contract are enforceable without the need for final adjudication. 7. Determination and Quantification of Liability: The Tribunal noted that the AO did not perform the necessary exercise to ascertain the estimated liability with reasonable certainty. The provision made by the assessee was based on contractual terms, and the exact quantification could be determined later. The Tribunal emphasized that the AO could arrive at a proper estimate based on the facts and circumstances. 8. Reassessment and Remand to Assessing Officer: The Tribunal remanded the issue back to the AO to determine the accrued liability for liquidated damages pertaining to the relevant year. The AO was directed to allow the deduction after ascertaining the liability based on the terms of the contract agreements. The assessee was permitted to provide actuarial valuations for the liability. The Tribunal also noted that any surplus or shortage in the provision in subsequent years should be adjusted accordingly. Conclusion: The Tribunal concluded that the provision for liquidated damages made by the assessee was in line with the mercantile system of accounting and applicable accounting standards. The liability was definite and arose from contractual obligations, even if the exact amount was to be determined later. The case was remanded to the AO for proper determination and allowance of the provision.
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