2009 (5) TMI 16 - SC - Income Tax

Provision for Warranty - 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 certain period, the company undertakes to rectify or replace the defective part free of charge. For the AY1991-92, the assessee made a net provision for warranty at ₹ 5,18,554/-. In this matter, honorable Apex Court allowed the claim of provision for warranty stating that, with making of provision on the basis of estimated present value of contingent liability holds good during the assessment years in question qua warranty claims .

Summary

Issues Involved:
1. Whether the provision for warranty is an allowable deduction under Section 37 of the Income-tax Act, 1961.
2. Whether the warranty provision constitutes a contingent liability or an accrued liability.
3. Whether the High Court erred in not following the Rule of Consistency in allowing the warranty provision as a deduction.

Issue-wise Detailed Analysis:

1. Allowability of Warranty Provision under Section 37 of the Income-tax Act, 1961:

The appellant-company sells sophisticated Valve Actuators and provides a standard warranty for rectification or replacement of defective parts within a specified period. For the assessment year 1991-92, the appellant made a provision for warranty at Rs.10,18,800/- (1.5% of turnover), claiming a deduction of Rs.5,18,554/- after reversing excess provision. The Assessing Officer (A.O.) disallowed this deduction, terming it a contingent liability, not allowable under Section 37 of the Income-tax Act, 1961. This decision was upheld by the CIT (A). However, the Tribunal allowed the deduction, citing the Rule of Consistency, as the Department and Tribunal had consistently allowed similar claims from assessment year 1983-84 onwards. The Tribunal noted that the provision was realistic and integral to the sales, considering the sophisticated nature of the product and the warranty being a standard trading practice.

2. Contingent Liability vs. Accrued Liability:

The Department argued that the provision for warranty was towards unforeseen liability and hence contingent, not allowable under Section 37. They contended that Section 37 refers to actual expenditure incurred, not anticipated claims. The High Court held that the liability had not crystallized on the date of sale and thus was an unascertained liability, disallowing the deduction. However, the Supreme Court noted that a provision is a liability measurable by estimation and is recognized when there is a present obligation due to a past event, probable outflow of resources, and a reliable estimate of the obligation amount. The Court emphasized that the appellant's warranty provision met these conditions, as the warranty became an integral part of the sale price due to the nature of the sophisticated goods and historical data showing defects in some items.

3. Rule of Consistency:

The appellant argued that the High Court erred by not following the Rule of Consistency, as the Tribunal had consistently allowed similar provisions from assessment year 1983-84 onwards. The appellant's method included the concept of "reversal," where excess provision was credited back to the profit and loss account and offered for tax, ensuring no income escapement and revenue neutrality. The Supreme Court highlighted the importance of consistent application of accounting principles and noted that the High Court failed to consider the "reversal" aspect, which was part of the appellant's systematic accounting method.

Findings:

The Supreme Court concluded that the provision for warranty was rightly made by the appellant, satisfying the conditions for recognizing a liability for provisioning. The Court emphasized that the warranty provision was based on past events, present obligation, probable outflow of resources, and reliable estimation, making it an accrued liability. The Court also noted that the High Court's reliance on the case of Shree Sajjan Mills was misplaced, as it pertained to gratuity provisions governed by Section 40A(7) of the Income-tax Act, which did not apply to warranty claims. The principles of commercial accounting, as affirmed in Metal Box Company of India and Bharat Earth Movers, supported the appellant's case for warranty provision as an allowable deduction.

Conclusion:

The Supreme Court set aside the impugned judgment of the Madras High Court, allowing the civil appeals in favor of the appellant with no order as to costs. The Court upheld the Tribunal's decision, recognizing the warranty provision as an allowable deduction under Section 37 of the Income-tax Act, 1961, based on the principles of commercial accounting and the Rule of Consistency.