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TMI Blog2009 (5) TMI 16X X X X Extracts X X X X X X X X Extracts X X X X ..... g 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 and Civil Appeal No. 3524 of 2009 - Arising out of S.L.P. (C) No. 12064 of 2009 (SLP(C) For Appearing Parties: S. Ganesh, V. Shekhar, K. Radhakrishnan, Vikas Singh and N., Venkat Raman, Sr. Advs., Preetesh Kapur, Radha Rangaswamy, Navin Prakash, Vismai Rao, Arijit Prasad, C.V. Subba Rao, Shweta Garg, Ashish Gopal Garg, A. Deb Kumar, M. Khairaty, Y. Lokesh, B.V. Balaram Das, Kaanan Kapur, H. Raghavendra Rao, Muthu Venkatraman, S. Nandakumar, Achin Goel, R. Arvind, V.N. Raghupathy, Advs. JUDGMENT 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) p ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... 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 1983-84 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 ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ld. 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 accrued liabil ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ay 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 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 esca ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... e in below 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". 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 ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ved 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 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 busin ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... nsiders 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 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 relevan ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... y are - provisioning which relates to present obligation, it arises out of obligating events, it involves outflow of 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 ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... tion 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 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. I ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... 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 ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... 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, 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 : "Cl ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... sible 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 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 Bh ..... X X X X Extracts X X X X X X X X Extracts X X X X
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