Income Tax Appellate Tribunal - Delhi
Palm Logistic & Automation (P) Ltd, New ... vs Assessee on 29 September, 2009
IN THE INCOME TAX APPELLATE TRIBUNAL
DELHI BENCH 'F': NEW DELHI
BEFORE SHRI C.L. SETHI, JUDICIAL MEMBER &
SHRI SHAMIM YAHYA, ACCOUNTANT MEMBER
ITA no. 4340/Del/2009
Assessment Year: 2006-07
Palm Logistic & Automation (P) Ltd. Income Tax Officer
9/27, Kalkaji Extn., Vs. Ward - 14(1),
New Delhi New Delhi
(Appellant) (Respondent)
PAN: AADCP 5553 B
Appellant by : Shri K. Sampath, Advocate
Shri S. Krishnan, Advocate
Respondent by : Shri Istiyaque Ahmad, Sr. DR
ORDER
PER: C.L. SETHI, J.M. The assessee has filed this appeal against the order dated 29.09.2009 passed by the ld. CIT(A) in the matter of an assessment made by the AO u/s. 143(3) of the Income Tax Act, 1961 ("the Act"), for the A.Y. 2006-07.
2. The only ground raised by the assessee is as under:-
"That on the facts and in the circumstances of the case and in law the learned CIT(A) erred in confirming the action of the AO in estimating turnover in a sum of Rs.25,22,466/- as undisclosed sales and thereby making an addition of the amount to the returned income. The action is wholly arbitrary, ITA no. 4340/Del/2009 palpably erroneous and grossly unlawful and, therefore, must be quashed."
3. The assessee filed its E-return declaring total income at Rs. 2,71,979/- on 29.11.2006. The case was selected for scrutiny and the first notice u/s. 143(2) was issued by the AO on 05.10.2007, which has been duly served upon the assessee. The assessee is engaged in the business of selling modems and their installation. During the year, the assessee's clients were M/s. BSES Rajdhani Power Ltd. and M/s. BSES Yamuna Power Ltd. In the Profit and Loss account for the relevant year, the assessee had shown following items of income:-
Sales Rs.2,20,27,534/-
Income from installation Rs.2,30,525/-
Short & excess recovery Rs.10/-
Interest received Rs.9,649/-
Total Rs.2,26,67,718/-
Against the aforesaid total receipt of Rs. 2,26,67,718/-, the assessee had debited various expenses to the extent of Rs. 2,19,75,576/- in the Profit & Loss account, and had shown the net profit at Rs.2,92,142/-. In the course of assessment proceedings, the assessee was asked to furnish a copy of VAT return of the relevant year, in response to which the assessee filed the copies of VAT return for the four quarters in which the assessee had disclosed the sales and paid taxes there upon as under:- Page 2 of 49
ITA no. 4340/Del/2009 Quarter Gross turnover of sales 01-04-2005 to 30-06-2005 0 01-07-2005 to 30-09-2005 49,90,000 01-10-2005 to 31-12-2005 0 01-01-2006 to 31-03-2006 1,95,60,000 Total turnover of sales 2,45,50,000
4. On comparison of total turnover of sales disclosed in the VAT return with the sales disclosed in the Profit & Loss account filed alongwith the return of income, it was noticed by the AO that there was a difference of Rs. 25,22,466/- (Rs.2,45,50,000/- (-) Rs.2,26,67,718/-), in the amount of sales disclosed in the I.T. return viz-a`-viz VAT return. The assessee was, thus, asked by the AO to explain as to why the difference of Rs.25,22,466/- as pointed out above, should not be treated as suppression of sales, and the why it should not be added to the assessee's total income.
5. In reply to the AO's query to explain the difference of Rs. 25,22,466/-, in the sales shown in the VAT return as compared to the sales shown in the Income Tax Return, the assessee filed its reply, which has been reproduced by the AO in his assessment order as under:-
"Our sale is performance based sale as we received orders from BSES Rajdhani Power Ltd. and BSES Yamuna Power Ltd. for supply of AMR (Automatic Meter Readers) with the performance and commissioning guarantee for the Page 3 of 49 ITA no. 4340/Del/2009 next 18 months. With one more conditions of open bank guarantee of 10% of the value of the order.
As we have the performance guarantee of 18 months out of which 10% amount retain as open bank guarantee i.e. BSES Rajdhani Power Ltd. and BSES Yamuna Power Ltd. can invoke anytime during the period of 18 months without citing any reason for the same, this gives the buyer unlimited right to return up to 10% of the total sale.
Accordingly, we recognized revenue of 10% when the time period of bank guarantee over to comply the condition of the accounting standard of revenue recognition."
6. It was further submitted by the assessee before the AO that the assessee has been following Accounting Standard - 9 for recognition of revenue.
7. After considering the assessee's reply, the AO has taken a view that adopting the Accounting Standard - 9 by the assessee for recognition of the revenue/sale arising out in the course of ordinary activities of the enterprise, i.e., the sale of goods, is not correct and not as per the provisions of law. The AO has made a reference to the provisions contained in section 145(1), and, then held that any method of accounting adopted by the assessee must satisfy the following conditions:-
a. It must be a method recognized by the accounting practice and sanctioned by the commercial practice. b. The system of accounting must be regularly followed by the assessee.Page 4 of 49
ITA no. 4340/Del/2009 c. Accounts maintained under the said system must be complete and correct.
d. It must be possible to deduce profits from it.
8. The AO further observed that Finance Bill 1995 has brought about two major changes in section 145 of the Act. Firstly, that the income from business or profession and income for other sources are to be computed w.e.f. A.Y. 1997-98, in accordance with either cash system or mercantile system of accounting. The AO further observed that this would mean that hybrid system, which has elements of both the above stated two methods, is no longer recognized method of accounting for the purpose of section 145 of the Act. It was then observed by the AO that as per the Tax Audit Report, it was evident that the assessee was followed mercantile system or accrual system of accounting, where the accounts are kept on mercantile basis and the profit or gain are credited on due basis though they are not actually received or realized. The AO, therefore, stated that out of this total sale of Rs. 2,45,50,000/-, the assessee had shown only sales of Rs.2,20,27,534/- and the remaining amount of Rs. 25,22,466/- equivalent to the margin income of bank guarantee was not shown on the ground that the same would be recognized only at the time of actual receipt after performance guarantee of 18 months is over. The AO, thus, taken a view, though the assessee Page 5 of 49 ITA no. 4340/Del/2009 has followed mercantile system of accounting for recognition of purchases and other expenses, but, has followed hybrid system of accounting in respect of sales made by the assessee, which in the opinion of the AO was not recognized method u/s. 145(1) of the Act. The AO was also of the view that the assessee's reliance on Accounting Standard
- 9 in support of his system is misplaced in so far as recognition of sales by the assess is concerned. In this respect, the AO made reference to para 10 & 11 of Accounting Standard - 9, and then held that the revenue in case of sales should be recognized when all the following conditions are satisfied:-
(i) The seller has transferred to the buyer all significant risks and rewards of ownership and the seller retains no effective control on the goods sold.;
(ii) No significant uncertainty exists regarding the amount of the consideration that will be derived from the sales; and
(iii) It is not unreasonable to expect ultimate collection.
9. Having said so, the AO had taken a view that once the assessee raised the bills and, its customers accepted the physical delivery of the goods sold by the assessee, the assessee should have recognized the total sales for the purpose of determining its income. In this respect, the following observations and discussions made by the AO is material: Page 6 of 49
ITA no. 4340/Del/2009 "Once the assessee sends the bills and the BSES Rajdhani Power Pvt. Ltd. and BSES Yamuna Power Ltd accept the physical delivery of the goods sold the assessee ceased to have any effective control on the goods sold. As far as risk and rewards are concerned, the price risk is considered as one of the most significant risk which is also transferred at the time physical delivery of goods are made and bills raised. Since BSES Rajdhani Power Ltd. and BSES Yamuna Power Ltd., which are joint venture of the Delhi Government and Reliance group, are responsible for distribution of power in National Capital Territory of Delhi, these companies entered into a transaction with the assessee company after considering the risk and rewards aspects in respect of transaction. This is only after all the significant risks and rewards have been transferred to the buyers that the assessee has obliged to perform any substantial acts lie commissioning and installation of goods etc. When the AMR (Automatic Reader Machine) is installed at the site of the assessee losses effective control which also subsequently transfers to the BSES Rajdhani Power Ltd. and BSES Yamuna Power Ltd. As regards existence of uncertainty regarding the amount of the consideration is considered, the amount of consideration is clearly specified in the agreement purchase order/Letter of Award. Therefore, no significant uncertainty exists regarding the amount of consideration that will be derived from the sales. It also, shows the evidence of buyers' commitment for this transaction with the assessee company and their commitment to make complete payment. From the details submitted it is seen that there was no occasion to see that the purchaser would not be willing to fulfill its part of the contract. As stated above the buyers have already paid substantial consideration as per the schedule of payment during the year itself. Part performance of the contract, is therefore, sufficient. Since BSES Rajdhani Power Ltd. and BSES Yamuna Power Ltd. are reputed concerns and they had the responsibility of generation and distribution of electricity in Delhi, they have invested a lot in obtaining and getting the material commissioned. Hence, it is not possible that these parties after having invested so much would not be willing to fulfill the remaining part contract. Thus, reasonableness to expect ultimate collection cannot be also questioned."Page 7 of 49
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10. Even otherwise, the AO has taken a view that accounting practice cannot override the provisions of the Income Tax Act, where the assessee is required to recognized its revenue as per provisions of section 145(1) of the Act. The AO then decided the issue against the assessee by concluding as under:-
"It is also pertinent to mention here that for the purpose of VAT return the assessee has disclosed the entire amount Rs.2,45,50,000/- as sales turnover and has also paid the VAT on the entire amount of sales without deducting the margin money. However for the purpose of Income Tax the assessee in its Profit and Loss Account has deducted the amount of Rs.25,22,466/- from the total turnover stating that the same amount has not been recognizable during the year as sales. Thus, the assessee has adopted two different yardsticks for reflecting same item of income-once for the purpose of Sales Tax Act and other for the Income Tax which is not allowable. The margin money of 10% which the assessee is required to open as performance bank guarantee is nothing but a deposit and the same cannot be deducted while arriving at the value of sales once the sales is complete with bills and physical delivery of goods has been duly acknowledged by the buyers.
In view of above, it is held that the assessee has not disclosed the full and true value of sales in the Profit & Loss Account only with a view to avoid payment of tax. Therefore, the amount of Rs.25,22,466/- which is included in the sales turnover as per the VAT return and not included in the sales turnover as per the Income Tax return is added in the income of the assessee as undisclosed sales. Undersigned is satisfied that to the extent of Rs. 25,22,466/- the assessee has concealed its income or/and furnished inaccurate particular of its income and therefore, penalty proceedings u/s. 271(1)(c) is also initiated against the assessee."Page 8 of 49
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11. Being aggrieved, the assessee preferred an appeal before the CIT(A).
12. Before the CIT(A), the assessee contended as under:-
"1. The company was incorporated on 21.04.2005 and year under appeal is the first year of operation. It got license from Ministry of Communication for import of modems.
Accordingly, it imported modem and software to run the modem. The modem was imported from M/s. Horteic Technology Lyd., Hong Kong. The average cost of the modem was Rs.1200/-. Thus total cost of the modem was Rs. 3700/-.
2. The reliance group Company BSES Yamuna Power Ltd. & BSES Rajdhani Power Ltd. awarded two contracts to the company. 1st for supply of modem @ Rs. 5000/- per modem and second for installation of modem @ Rs. 450/- per modem. The purchase orders stated various Terms and Conditions which we have already been filed vide our letter dated 19.06.2009. The supplier of modem had not granted any warranty to the products as the foreign supplier was also dealer of the modem and the rate were negotiated accordingly. Therefore, the company got average margin of Rs. 1300/- per modem beside installation charges of Rs. 450.00 per modem.
The appellant company granted 18 months warranty to BSES since terms of offer of BSES was such that orders shall be given to those parties who give warranty/guarantee for 18 months. The average margin of Rs. 1300/- per modem thus covered warranty period expenditure. The BSES could itself import the material but it wanted a firm who could offer onsite warranty of the modem as it was a highly professional work and require good team of professionals.Page 9 of 49
ITA no. 4340/Del/2009 The modem so imported require installation at site and frequent adjustments in the form of:
• Declining Tones
Antenna not working
• Adopter wire loose etc.
• Adopt failure etc.
• Reloading of software
3. It is submitted before your honour
that, it is not necessary that the warranty can be undertaken by the manufactures only. Warranty can be undertaken by the traders also if the contract between the parties are so.
4. We have already quoted various judgments whereby it is held that provisions for warranty is eligible business expenses vide our letter dated 19-06-2009. Your kind attention is invited to judgment of CIT (2000) 245 ITR 428 wherein it was held that if a business liability has definitely arisen in accounting year, deduction should be allowed although liability may have to be quantified and discharged at future date but what should be definite is incurring liability.
In the case of the appellant company, the company had written agreement (purchase orders) whereby the company had undertaken to service the products. At the end of financial year 31-3- 2006, company had to incurred expenditure for the remaining period of warranty hence there was a clear crystal liability as on 31-3-2006. The company had booked the entire amount of sales as its revenue at Rs. 2,45,50,000.00 therefore the company had to make adequate provision for the remaining period of warranty.
5. We have already filed and placed on record a statement showing the total estimated liability for the remaining period of warranty was about Rs. 24,70,000.00 but the Appellant company Page 10 of 49 ITA no. 4340/Del/2009 had given Bank guarantee for Rs. 24,55,000.00 only hence the lower of the two amount was provided in the books by debited the sales account.
The second reason for debiting the sales a/c. by Rs. 24,55,000/- was the company had given bank guarantee of Rs.10% of the sale value to BSES Which they can revoke any time during warranty period. Therefore there was considerable risk and uncertainty to the tune of Rs. 24,55,000.00 as on 31-3-2006.
6. It is also submitted before your honor that basic requirement implicit in the provision of section 145 as well as the general commercial world is that the financial statements of an enterprise should in respect of the same source, the assessee followed mercantile system for "purchase and other expenses" and hybrid system for sales which is no longer a recognized method u/s. 145(1).
The Learned Assessing Officer did not consider that performance warranty of 18 months require expenditure during warranty period and adequate provision must be made by the Appellant company for the remaining period of warranty so as to give true and fair view of the profit of the company.
The reason for debiting the sale a/c to the extent of bank guarantee has already been explained herein above.
The company vide its letter (copy already filed) had stated the following reasons of debiting the Rs. 24,55,000.00 to the sales a/c.
• Our sale is performance based sale as we received orders from BSES Rajdhani Power Ltd. and BSES Yamuna Power Ltd. for supply of AMR (Automatic Meter Reader) with the performance and commissioning guarantee for the next 18 months.Page 11 of 49
ITA no. 4340/Del/2009 • One more condition of open bank guarantee of 10% of the value of order.
• Accordingly, we recognize revenue of 10% when the time period of bank guarantee is over to comply the condition of the accounting standard of revenue recognition."
9. It is submitted before your honour that the Institute of Chartered Accountants of India has prescribed various accounting standard and the basic reason for doing so is to give true and fair view of the financial accounts of a concern.
The basic requirement implicit in the provisions of section 145 as well as the general commercial world is that the financial statements of an enterprise should give a true & fair view of its position & working results, (2201) 79 ITD 196 (AHD)."
13. In support of the assessee's contention before the ld. CIT(A), the assessee had relied upon various decisions including the following:-
(i) Bharat Earth Movers Ltd. vs. CIT 245 ITR 428
(ii) M/s. Vinitec Corp. Pvt. Ltd. (2005) 278 ITR 337 (Delhi).
14. After carefully considering the submission of the assessee and the assessment order of the AO, the CIT(A) decided the issue against the assessee by holding that the assessee has not been able to prove the actual incurring of liability under the warranty clause, which was made merely on the basis of certain percentage of the turnover. The CIT(A) Page 12 of 49 ITA no. 4340/Del/2009 further observed that the decision of Hon'ble Delhi High Court in the case of CIT vs. M/s. Vinitec Corp. Pvt. Ltd. (2005) 278 ITR 337 (Delhi), the decision of Kerala High Court in the case of CIT vs. Indian Transformers Ltd. (2004) 270 ITR 259 (Ker.) and decision of Privy Council in the case of Commissioner of Inland Revenue vs. Mitsubishi Motors New Zealand Ltd., (1996) 222 ITR 697 (PC), would be of no held to the assessee in as much as those cases claim of warranty was allowed on the basis of data of the previous year of incurring actual warranty expenses in respect of the warranty provided by the assessee in respect of the goods sold by the assessee. The CIT(A) further observed that in the absence of such details in the present case, an ad-hoc percentage on the basis of the total turnover is not allowable. The CIT(A) further observed that the in relevant year, being the first year of the business, there could not be any data of the previous year on the basis of which exact warranty expenses could be ascertained. The CIT(A) further observed that the assessee has reversed the entry of provisions of warranty of this year, in the next year by crediting entire provisions to the Profit & Loss account, which would go to establish that there was no actual likelihood of any defect arisen to the goods supplied by the assessee.
Page 13 of 49
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15. The ld. CIT(A) has placed reliance upon the decision of Hon'ble Madras High Court in the case of CIT vs. Rotork Controls India Ltd. (2007) 293 ITR 311 (Mad.) The CIT(A) was, therefore, of the opinion that entire sale proce xeds was to be included in the turnover for the purpose of determining the assessee's profit, and in that view of the matter, the AO was justified in making the addition of Rs. 25,22,466/- on account suppression of sales.
16. Still aggrieved, the assessee is in appeal before us.
17. The ld. counsel for the assessee has reiterated the contentions and submissions that were made before the authorities below and relied upon the decision of Hon'ble Delhi High Court in the case of Vinitec Corporation Pvt. Ltd. (supra) in support of the contention that warranty provisions are in the nature of ascertained liability and not contingent one. He further submitted that out of the provisions made during this year, the amount found to be excessive after the expiry of warranty period has been duly credited to the profit and loss account in subsequent year and, has been offered to tax and, therefore, no tax liability of the assessee has been otherwise been reduced. In this connection, a reliance has been placed upon the decision of the Hon'ble Delhi High Court in the case of CIT vs. Vishnu Industries Gases Pvt. Ltd. decided on Page 14 of 49 ITA no. 4340/Del/2009 06.05.2008 in ITR no. 229 of 1988 where the Hon'ble High Court has held that the question as to the year in which the deduction is allowable may be material when rate of tax chargeable on the assessee in two different two years is different; in the case of income of a company, the tax is attracted at a uniform rate and, whether deduction in respect of bonus was granted in the A.Y. 1952-53 or in the A.Y. 1953-54, it should be a matter of no consequences to the department and, thus, there is hardly a question that should required the court to exercise their mind particularly since there was no doubt that the tax has been paid and the rate of tax remain the same for both the assessment years.
18. The ld. DR, on the other hand, supported the orders of the authorities below and contended that the assessee's claim of provisions towards warranty made merely on the basis of certain percentage of the turnover cannot be considered to be ascertained liability incurred by the assessee during the year, so as to entitled the assessee to claim the deduction. The various observations and the discussions made by the AO as well as by the CIT(A) in their respective orders has been reiterated by the ld. DR.
19. Rival contentions of both the parties have been considered and orders of the authorities below have been perused. We have deliberated Page 15 of 49 ITA no. 4340/Del/2009 upon the various decisions cited at the bar as well as decisions relied upon by the authorities below.
20. The assessee company is engaged in the business of selling modems and their installation. During the year under consideration, the assessee was awarded two contracts by BSES Yamuna Pvt. Ltd. and BSES Rajdhani Pvt. Ltd. to supply modem @ Rs. 5,000/- per modem and for installation of modem @ Rs. 450/-per modem. The purchase orders placed by the aforesaid two parties contained various terms and conditions. As per terms and conditions of the purchase orders, the assessee company granted 18 months performance and commissioning warranty to the purchaser in respect of the goods supplied by the assessee company. As per the warranty, the assessee had to undertake certain services to the products supplied by it for a period of 18 months from the date of supply. During the current year ended on 31.03.2006, the assessee had incurred certain expenses amounting to Rs. 4,76,000/- towards warranty and, for the remaining period of warranty, the assessee made a provisions of Rs. 24,55,000/-. With a view to ensure that the assessee would undertake services to the products supplied by the assessee to these two companies, the assessee had to give a Bank Guarantee to the extent of Rs. 24,55,000/- to the purchaser, which is Page 16 of 49 ITA no. 4340/Del/2009 equivalent to 10% of the sale value of the items. The bank guarantee given by the assessee was revocable at any time during the warranty period and the respective party could encash the guarantee amount in case the assessee failed to discharge its obligation arising from the warranty clause. In the light of these facts, it is, therefore, to be seen as to whether the assessee has incurred any ascertained liability towards warranty during the year under consideration, so as to allow it as deduction while computing the assessee's profit from business of supply of goods sold with warranty clause. It is not in dispute that the assessee has been maintaining its books of accounts on mercantile basis. The law is well settled that under the mercantile system of accounting, if a business liability is definitely arisen in the accounting year, the deduction should be allowed, although the liability may have to be quantified and discharge at a future date. What should be ascertained is the incurring of the liability. It should also be capable of being estimated with a reasonable certainty though the actual quantification may not be possible. If these requirements are satisfied, the liability is not a contingent one. The liability is in presenti though it will be discharged at a future date. It does not make any difference if the future date on which the liability shall have to be discharge is not certain. This is so observed and held by Page 17 of 49 ITA no. 4340/Del/2009 the Hon'ble Supreme Court in the case of Bharat Earth Movers vs. CIT (2000) 245 ITR 428 (SC).
21. At the same time, it is well settled that contingent liability did not constitute expenditure and cannot be the subject matter of deduction even under the mercantile system of accounting.
22. Therefore, for determining whether there is a expenditure to be allowed as deduction, it is necessary to see whether there is a existing liability to pay out money irretrievably. The Hon'ble Supreme Court in the case of Calcutta Co. Ltd. v. Commissioner of Income-tax [1959] 37 ITR 1 (SC), has pointed out that distinction should be made between contingent liability which may or may not arisen in the future and present liability which has to be performed in future. In the latter case, the liability having accrued in the year of account, the amount to be expended in discharge of that liability would have to be estimated in order that, under the mercantile system of accounting, the amount so estimated could be debited before its actual disbursed. In the case of CIT vs. Gemini Cashew Sales Corporation (1967) 65 ITR 643 (SC), the Hon'ble Supreme Court reiterated the above legal position and observed as under:-
"Broadly stated, the present value on commercial valuation of money to become due in future, under a definite obligation, will be a permissible outgoing or deduction in Page 18 of 49 ITA no. 4340/Del/2009 computing the taxable profits of a trader, even if in certain conditions the obligation may cease to exist because of the forfeiture of the right. Where, however, the obligation of the trader is purely contingent, no question of estimating its present value may rise, for to be a permissible outgoing or allowance, there must in the year of account be a present obligation capable of commercial valuation."
23. It is also well settled that in deciding the question whether present liability is accrued against the assessee, all the circumstances of the case have to be taken into account. Therefore, we now proceed to see whether any business liability has definitely arisen on account of warranty provision in the current year under consideration, and for that purpose we have to take into account all the facts and circumstances of the present case.
24. At this stage, we find it fit necessary to refer the provisions contained in section 145 of the Act. Sub section (1) of section 145 provides that income chargeable under the head "profit and gains of business or profession" or "income from other sources" shall, subject to the provisions of sub-section (2) of section 145, be computed in accordance with either cash or mercantile basis of accounting regularly employed by the assessee. In the present case, it is not in doubt that the assessee has been maintaining regularly mercantile system of accounting, and its income chargeable under the head "profit and gain of business or Page 19 of 49 ITA no. 4340/Del/2009 profession" or "income from other sources" is to be computed in accordance with this mercantile system of accounting regularly employed by the assessee. Sub-section (2) of section 145 provides that the Central Government may notify in the Official Gazette from time to time accounting standards to be followed by any class of assessee or in respect of any class of income. In the light of sub-section (2) of section 145, the Central Government has issued Accounting Standard - I u/s. 145 of the Act vide notification no. SO.69(E), dated 25.01.1996, where it has been provided under paragraph 4(i) of the said standard in the following words:-
"(i) Prudence: Provisions should be made for all known liabilities and losses even though the amount cannot be determined with certainty and represents only a best estimate in the light of available information;"
Therefore, in the light of the said notification, it is clear that the assessee can make prudent provisions for all known liabilities and losses even thought the amount cannot be determined with certainty and represents only a best estimate in the light of available information. Therefore, provision for known liability of warranty can be made by the assessee even though the amount cannot be determined with certainty and it is based on best estimate in the light of the facts of the present case. Page 20 of 49
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25. In the light of the facts of the present case as could be gathered from the orders of the authorities below and the submissions of the assessee, it is clear that the assessee had supplied modems to two parties viz., BSES Rajdhani Power Ltd. and BSES Yamuna Power Pvt. Ltd. with the performance and commissioning guarantee for a period of next 18 months from the date of supply. For due compliance and discharge of the performance and commissioning warranty provided to the customers, the assessee had given a bank guarantee to the extent of 10% of the value of the purchase orders. From the details submitted by us, the sum of Rs. 4,76,000/- has been incurred by the assessee in the warranty year being expenses incurred towards performance and commissioning guarantee. The assessee supplied goods from the month of August 2005 during this first of its operation. The guarantee period of 18 months in respect of each supply from their respective dates has not been expired during the year itself. The position about the date on which guarantee period would expire and the number of months remaining left over at the end of the present year under consideration with reference to the each sale are tabulated as under:-
Page 21 of 49
ITA no. 4340/Del/2009 Sales Date of Date on which Remaining Amount of sale guarantee months of Provisions period expired warranty period 499000 01.08.2005 31.01.2007 10.00 33000 499000 18.08.2005 18.02.2007 10.00 33000 998000 31.08.2005 28.02.2007 10.00 66000 2994000 06.09.2005 06.03.2007 11.00 220000 9780000 31.01.2006 31.07.2007 15.50 1010000 7335000 18.03.2006 30.09.2007 17.0 830000 2445000 24.03.2006 30.09.2007 17.00 278000 24550000 2470000
26. From the aforesaid details, it is clear that assessee had a liability towards commissioning and performance guarantee to be discharged in future in respect of the sales effected by the assessee during the year under consideration, and in respect of which provisions to the extent of Rs. 24,70,000/- was made, restricting it to the amount of bank guarantee given for Rs. 24,55,000/-. The total after-sales expenditure towards warranty obligation incurred by the assessee during the first year of operation ending on 31.03.2006, and in subsequent periods ending on 31.03.2007 and 31.03.2008 are to the extent of Rs. 4,76,000/-, Rs. 25,79,797/-, and Rs.10,75,546/- respectively. The total sales made by the assessee in the year ended on 31.03.2006 to 31.03.2008 are to the extent Page 22 of 49 ITA no. 4340/Del/2009 of Rs. 2,45,50,000/-, 99,80,000/- and Rs, NIL respectively. From the above it is clear that the assessee has been incurring after sales service expenses even in the year in which no sales has taken place because of the reasons that the warranty given by the assessee in the year of sale was in force during the period falling within the subsequent years. It is, thus, clear that the warranty clause is embedded in the sales of the goods itself. In other words, the warranty is integral part of the sale price of the modems supplied by the assessee or the warranty stood attached to the sale price of the product. Therefore, when whole of the sale is recognized as the revenue, a reasonable estimate of warranty provision is to be provided in the accounts so as to determine the true and real income of the assessee in the relevant year. This would also satisfy the criteria of matching concept. Under the matching concept, if the revenue is recognized the cost incurred to earn that revenue including warranty cost has to be fully provided for. When modems are sold and the warranty clause is an integral part of the sale price of the modem, then the assessee has to provide for such warranty cost in its accounts for relevant year, otherwise the matching concept fails. The past event of providing warranty as an integral part of sale has created a definite liability upon the assessee to be discharged within warranty period. Therefore, providing provision for warranty at certain percentage of the turnover Page 23 of 49 ITA no. 4340/Del/2009 fulfills the accrual concept as well as matching concept. In the present case, there could not be possibility of any data of actual defects occurring to the goods being available of past years but the warranty expenses actual incurred by the assessee in the year under consideration as well as in the future years and the terms and conditions of supply order wherein warranty was provided to the customers with a bank guarantee to the extent of 10% of value of goods sold can be a best guiding factors to make a reasonable provisions for warranty expenses. In the present case, after making sensible estimate in one year on the basis of terms of sale, the surplus of provisions remaining after actual expenditure were incurred has been reversed and credited in the profit and loss account in the year in which the warranty period expires and the same has been offered to tax.
27. In this connection, a reliance may be placed upon the decision of Jurisdictional Delhi High Court in the case of Vinitec Corporation Pvt. Ltd. (supra), where it has been observed and held as under:-
"In our opinion, the judgment of the Supreme Court in Bharat Earth Movers [2000] 245 ITR 428 has a direct bearing on the issue in controversy before us. Dealing with the proposition whether the assessee would be allowed deduction in the accounting year, although the liability may have to be quantified and discharged at a future date, the liability is to be treated in the present time and would or would not be a contingent liability, the court held as under :Page 24 of 49
ITA no. 4340/Del/2009 "So is the view taken in Calcutta Co. Ltd. v. CIT [1959] 37 ITR 1 (SC) wherein this court has held that the liability on the assessee having been imported, the liability would be an accrued liability and would not convert into a conditional one merely because the liability was to be discharged at a future date. There may be some difficulty in the estimation thereof but that would not convert the accrued liability into a conditional one ; it was always open to the tax authorities concerned to arrive at a proper estimate of the liability having regard to all the circumstances of the case.
Applying the above said settled principles to the facts of the case at hand we are satisfied that the provision made by the appellant-company for meeting the liability incurred by it under the leave encashment scheme proportionate with the entitlement earned by employees of the company, inclusive of the officers and the staff, subject to the ceiling on accumulation as applicable on the relevant date, is entitled to deduction out of the gross receipts for the accounting year during which the provision is made for the liability. The liability is not a contingent liability. The High Court was not right in taking the view to the contrary.
The appeal is allowed. The judgment under appeal is set aside. The question referred by the Tribunal to the High Court is answered in the affirmative, i.e. in favour of the assessee and against the Revenue."
It will be useful for us to make a reference to the judgment of the Privy Council in the case of Commissioner of Inland Revenue v. Mitsubishi Motors New Zealand Ltd. [1996] 222 ITR 697 where the Privy Council dealing with a taxpayer who was selling new motor vehicles to the dealers to indemnify them against warranty claims which, in turn, resulted in providing of warranty clause for 12 months from the date of delivery to the pur-chaser by the dealer, held as under (headnote):
"Held, dismissing the appeal, that, although the taxpayer's liability under the warranty for each vehicle sold was contingent on a defect appearing and being notified to the dealer within the warranty period so that no liability was incurred by the taxpayer until those conditions were satisfied, regard could be had to its estimation of warranty claims based on statistical information, which showed that Page 25 of 49 ITA no. 4340/Del/2009 as a matter of existing fact not future contingency 63 per cent. of all vehicles sold by the taxpayer contained defects likely to be manifested within the warranty period and require work under warranty ; that since theoretical contingencies could be disregarded, the taxpayer was in the year of sale under an accrued legal obligation to make payments under those warranties and even though it might not be required to do so until the following year, it was definitively committed in the year of sale to that expenditure ; and that, accordingly, in computing the profits or gains derived by the taxpayer from its business in the year in which the vehicles were sold, the taxpayer was entitled under section 104 to deduct from its total income the provision which it had made for the costs of its anticipated liabilities under outstanding warranties in respect of vehicles sold in that year."
The ratio decidendi of the above cases is squarely applicable to the facts of the present case. It is not disputed that the warranty clause is part of the sale document and imposes a liability upon the assessee to discharge its obligations under that clause for the period of warranty. It is a liability which is capable of being construed in definite terms which has arisen in the accounting year. May be its actual quantification and discharge is deferred to a future date. Once an assessee is maintaining his accounts on the mercantile system, a liability accrued, though to be discharged at a future date, would be a proper deduction while working out the profits and gains of his business, regard being had to the accepted principles of commercial practice and accountancy. There is nothing on record before us which even can remotely suggest that the change in accountancy system was motivated or was improper. There is also nothing on record to suggest that the provisions made in the accounting year and deduction claimed as business expenditure are unduly exhaustive and are intended to evade taxation. For the reasons aforestated and in view of the above referred judgments of the Supreme Court and other courts, we are of the considered view that no question of law much less a substantial question of law arises for determination in the present appeal. The appeal of the Revenue, thus, is dismissed while leaving the parties to bear their own costs."
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28. In the case Vinitec Corp. Pvt. Ltd., the Hon'ble Delhi High Court has relied upon the ratio of decision of Privy Council in the case of Commissioner of Inland Revenues vs. Mitsubishi Motors New Zealand (supra), the decision of Hon'ble Supreme Court in the case of Bharat Earth Movers (supra) and in the case of Calcutta Co. Ltd. vs. CIT (supra). In the case of Commissioner of Inland Revenue vs. Mitsubishi Motors New Zealand, it has been observed that the tax payer was in the year of sale under an accrued legal obligation to make payments under the warranty clause, and even though it might not be required to do so until the following year, it was definitely committed in the year of sale to that expenditure, and therefore, the tax payer was entitled to deduct from its total income the provision which it had made for the cost for its anticipated liabilities under outstanding warranty in respect of vehicle sold in that year. Similarly, the Hon'ble Supreme Court in the case of Calcutta Co. Ltd. vs. CIT has held that liability to incur certain expenses in respect of the property sold during the year and in respect of which the revenue has been recognized in the accounts, the assessee was entitled to make a provision for the expenditure to be incurred in the following years, as because the liability to incurred expenditure having been imported upon the assessee at the time of sale of the property although the liability may have to be quantified and discharged at a future date. Page 27 of 49
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29. Hon'ble Kerala High Court in the case of CIT vs. Indian Transformers (supra) also has observed and held as under:-
"It is evident from the findings of the two appellate authorities which we have extracted above that they came to the conclusion that the provision created was towards a definite liability accrued at the time of supply of the machinery and so the assessee is entitled to the claim for deduction. As already noted, the first appellate authority has clearly noted that during the accounting period relevant to the assessment year 1991-92 itself defects in the transformers supplied were brought to the notice of the assessee and that the second transaction referred to in the appellate order is in respect of ten transformers supplied to BHEL and that all the ten transformers failed within a year of operation which resulted in serious islocation of production at Rourkela. It is also relevant to note that the BHEL itself had brought this fact to the notice of the chairman of the GEC and requested him to give serious attention to the quality. The Tribunal considered the further fact that the actual expenses incurred for the assessment year 1991-92 was Rs. 7,98,958 as against the provision made for Rs. 3,50,000. The Tribunal had also noted that the amount of Rs. 12,23,381 written back as the provision did not relate to the warranty claim. Thus it is clear that the Tribunal has found as a fact that the claim of deduction for the amount of Rs. 3,50,000 made towards after sales services is an ascertained liability. We do not find any illegality in the said finding of the Tribunal. As already noted if the finding of the two appellate authorities that the provision made is for an ascertained liability is upheld questions Nos. 1 and 2 stand answered to the effect that the assessee is entitled to the claim for deduction made before the Assessing Officer on this account.
Now we will deal with the decisions relied on by standing counsel for the Revenue. In Indian Molasses Co. (P.) Ltd. v. CIT [1959] 37 ITR 66, the Supreme Court considered the question regarding the principles to be applied for allowing business expenditure and observed thus (page 75):Page 28 of 49
ITA no. 4340/Del/2009 "The income-tax law does not allow as expenses all the deductions a prudent trader would make in computing his profits. The money may be expended on grounds of commercial expediency but not of necessity. The test of necessity is whether the intention was to earn trading receipts or to avoid future recurring payments of a revenue character. Expenditure in this sense is equal to disbursement which, to use a homely phrase, means something which comes out of the trader's pocket. Thus, in finding out what profits there be, the normal accountancy practice may be to allow as expense any sum in respect of liabilities which have accrued over the accounting period and to deduct such sums from profits. But the income-tax laws do not take every such allowance as legitimate for purposes of tax. A distinction is made between an actual liability in praesenti and a liability de futuro which, for the time being, is only contingent. The former is deductible but not the latter . . ."
Again the Supreme Court in Shree Sajjan Mills Ltd.'s case [1985] 156 ITR 585 in the context of allowance of provision for gratuity, reiterated the above principles and observed thus (headnote):
"Contingent liabilities do not constitute expenditure and cannot be the subject matter of deduction even under the mercantile system of accounting. Expenditure which is deductible for income-tax purposes is towards a liability actually existing at the time but setting apart money which might become expenditure on the happening of an event is not expenditure."
It is also observed that the position till the provisions of section 40A(7) were inserted in the Act in 1973 was that, the provision made in the profit and loss account for the Page 29 of 49 ITA no. 4340/Del/2009 estimated present value of the contingent liability properly ascertained and discounted on an accrued basis as falling on the assessee in the year of account could be deductible either under section 28 or section 37 of the Act.
These decisions would show that if the provision made is towards a contingent liability and not for a liability in praesenti, such provision is not deductible under section 37. In other words if the provision made is towards an actual liability in praesenti it is deductible. The decision of the Privy Council in Mitsubishi Motors New Zealand Ltd.'s case [1996] 222 ITR 697, relied on by senior counsel for the assessee is relevant. In that case the taxpayer sold new motor vehicles to dealers undertaking to indemnify them against warranty claims. On selling a vehicle to a purchaser the dealer gave the purchaser a warranty in respect of defects in materials or workmanship appearing within 12 months after delivery, subject to the purchaser returning the vehicle to the dealer with notification of the defect. Based on statistical information the taxpayer estimated that 63 per cent. of all vehicles sold would contain defects requiring repair under warranty. In calculating its assessable income for the year ending December 31, 1988, the taxpayer claimed as a deduction the amount of a reserve for its anticipated liabilities under unexpired warranties in respect of vehicles sold in that year. In assessing the taxpayer to income-tax for the year ending March 31, 1989, based on the taxpayer's return of income furnished on December 31, 1988, the Commissioner disallowed that deduction. On a case being stated in the High Court of New Zealand the judge held that the warranty provision was deductible expenditure within section 104. However, the Court of Appeal of New Zealand held that it was not deductible under section 104. On the Commissioner's appeal to the Judicial Committee of the Privy Council it was observed thus (headnote) :
"The taxpayer's liability under the warranty for each vehicle sold was contingent on a defect appearing and being notified to the dealer within the warranty period so that no liability was Page 30 of 49 ITA no. 4340/Del/2009 incurred by the taxpayer until those conditions were satisfied, regard could be had to its estimation of warranty claims based on statistical information, which showed that as a matter of existing fact not future contingency 63 percent of all vehicles sold by the taxpayer contained defects likely to be manifested within the warranty period and require work under warranty ; that since theoretical contingencies could be disregarded, the tax-payer was in the year of sale under an accrued legal obligation to make payments under those warranties and, even though it might not be required to do so until the following year, it was definitely committed in the year of sale to that expenditure ; and that, accordingly, in computing the profits or gains derived by the taxpayer from its business in the year in which the vehicles were sold, the taxpayer was entitled under section 104 to deduct from its total income the provision which it had made for the costs of its anticipated liabilities under outstanding warranties in respect of vehicles sold in that year."
Section 104 of the New Zealand Income Tax Act, 1976, uses the expression, "all losses and outgoings to the extent to which they are incurred in gaining or producing the assessable income, or are necessarily incurred in carrying on a business for the purpose of gaining or producing such income, shall be allowable deductions except to the extent to which they are losses or outgoings of capital, or of a capital, private or domestic nature, or are incurred in relation to the gaining or production of exempt income." The said expression was interpreted to mean that the taxpayer must have either paid or become "definitively committed" to the expenditure. Regarding the warranty liabilities the Privy Council observed as follows (page 701):
Page 31 of 49
ITA no. 4340/Del/2009 "The evidence of accounting practice adduced before Doogue J. left no doubt about the proper treatment of the outstanding warranty liabilities. They were part of the cost of the vehicle sales and therefore, so far as capable of reasonable estimation, should be matched against the corresponding revenue. The evidence satisfied the judge that a reasonable estimate could be placed upon the anticipated liabilities. All vehicles which leave the taxpayer's assembly plant at Porirua have been tested and examined for defects. So far as the taxpayer is aware, there is nothing wrong with them. Nevertheless, experience shows that in many cases, a defect will be discovered during the warranty period. Often it is no more than a blemish in the paintwork. Sometimes it is more serious. Sixty three per cent. of the vehicles sold by the taxpayer in the year 1988 were returned to the dealers for some kind of work to be done under the warranty. Although it cannot of course be predicted whether any particular vehicle will turn out to be defective or how serious the defect will be, the taxpayer can make a reasonably accurate forecast, based on previous experience, of what will be the total cost of remedial work for all the vehicles sold in a given year. Normal commercial practice, therefore, requires that this amount should be brought into account as a deduction from income in estimating the profits or gains of the business in the year in which the vehicles were sold."
It was observed that the question whether the expenditure has been "incurred" involves characterising the nature of the legal relationship between the taxpayer and the person to whom the obligation is owed, that one view is that it requires one to decide as a matter of construction whether the obligation is contingent or vested but defeasible and that this is a nice distinction which can easily become a matter of language rather than substance and on which judicial views may differ. After referring to the warranty, the Privy Council further considered the matter and observed thus (page 707):
"The relevance of this principle is that estimation on the basis of statistical experience can be used to conclude that 63 per cent. or thereabouts of the Page 32 of 49 ITA no. 4340/Del/2009 vehicles sold by the taxpayer in fact had defects which would manifest themselves within the warranty period of 12 months or 20,000 km. The finding of Doogue J. on the evidence was that '63 per cent. or thereabouts of all vehicles sold by (the taxpayer) contain defects'. Since this information could only be derived from the tax-payer's experience of warranty claims, their Lordships understand the finding to mean that this was the level of defects notified to dealers in accordance with the terms of the warranty. It also seems a fair inference that the defects were present at the time of sale. Mr. Andrew Park, who appeared for the Commissioner, said that the terms of the warranty did not require that the defect should have existed at the time of sale. It could have come into existence within the warranty period. As a matter of construction this is true. It is however hard to imagine the circumstances in which a defect in the 'material or workmanship' of the vehicle would appear within 12 months of sale unless it was present, even if hidden, at the time the vehicle left the assembly plant. At any rate Mr. Park could not think of an example. In deciding whether the tax payer had incurred a liability at the time when the vehicle was sold, it is therefore legitimate to have regard to the evidence establishing that 63 per cent., would in fact have had defects.
This, however, is not in itself enough to show that a liability was incurred. As has been said, their Lordships agree with the Court of Appeal that the language in which the warranty was expressed made liability dependent upon the manifestation and notification of the defect within the 12 months period. But the Australian authorities show that the question of whether the taxpayer is 'definitively committed' to an expenditure or whether it is merely 'impending, threatened or expected' (to adopt the language used in the leading case of Federal Commissioner of Taxation v. James Flood Pty. Ltd. [1953] 88 CLR 492, 506-507) does not depend simply upon whether future events which may determine liability are expressed in the language of Page 33 of 49 ITA no. 4340/Del/2009 contingency or defeasance. Their Lordships think it would be strange if a concept so eminently practical as the computation of profits for income-tax depended upon theoretical distinctions more appropriate to the rule against perpetuities. The question is rather whether, in the light of all the surrounding circumstances, a legal obligation to make a payment in the future can be said to have accrued. For this purpose, merely theoretical contingencies can be disregarded. In Coles Myer Finance Ltd. v. Federal Commissioner of Taxation 176 CLR 640, 671-672, Deane J. gave some examples of linguistic contingencies which were soon unlikely as not to affect the certainty of the obligation. And in Commercial Union Assurance Co. of Australia Ltd. v. Federal Commissioner of Taxation 14 ALR 651, 659-660, Newton J. felt able to disregard a condition in an insurance policy requiring notice of the occurrence of an insured event to be given within a stipulated time on the ground that, according to the evidence, the condition was hardly ever insisted upon.
If one asks whether in respect of each of the vehicles sold by the tax-payer, the warranty conditions make its liability contingent in substance as well as in form, the answer must be yes. A substantial number--37 per cent.-- will have no defects at all. But, for the reasons given above their Lordships think it legitimate to narrow the focus to those vehicles which left the assembly plant with defects of a kind likely to manifest themselves within the warranty period of 12 months or 20,000 km. That 63 per cent. of vehicles had such defects was a matter of existing fact not future contingency. Since these defects were by definition likely to show themselves within the warranty period, their Lordships consider that the contingency that the owners might be content not to require remedial work would be real only in the case of the most trivial defects. It would not make any material difference to the accuracy of the estimated amount of expenditure to which the taxpayer could be said, as a matter of law, to be definitively committed."
The Supreme Court in Bharat Earth Movers' case [2000] 245 ITR 428 considered the general principles regarding Page 34 of 49 ITA no. 4340/Del/2009 allowance of business expenditure and the difference between accrued and contingent liabilities. It was held that, (page 431) "if a business liability has definitely arisen in the accounting year, the deduction should be allowed although the liability may have to be quantified and discharged at a future date. What should be certain is the incurring of the liability. It should also be capable of being estimated with reasonable certainty though the actual quantification may not be possible. If these requirements are satisfied the liability is not a contingent one. The liability is in praesenti though it will be discharged at a future date. It does not make any difference if the future date on which the liability shall have to be discharged is not certain".
The decision of the Privy Council is almost on the point. Even though the warranty provides for that the purchaser returning the vehicle to the dealer with notification of the defect within 12 months after delivery, the taxpayer had made provision on an estimated basis even before any such event on the basis of the statistical information that 63 per cent. of all vehicles sold would contain defects requiring repair under warranty. The provision made based on this experience was held to be deductible. In the present case also, as we have already noted, the two instances of defects came to the notice of the assessee of which one was with respect to ten numbers of transformers sold to BHEL and as per the complaint all the transformers failed within one year of such purchase. This gave a clear picture that a major portion of the trans-formers sold were defective and therefore a reasonable provision has to be made. We have noted that for the assessment year, the assessee had made a provision of Rs. 3,50,000 but the actual expenses incurred for that year was Rs. 7,98,958. These circumstances clearly show that the provision is made on a reasonable basis. By applying the principles laid down by the Supreme Court in Bharat Earth Movers' case [2000] 245 ITR 428, it has to be held that the Tribunal has rightly held that the provision made for the three years is based on an ascertained liability and that it cannot be treated as a contingent liability. Thus, our answer to the question referred is in the affirmative, that is, in favour of the assessee and against the Revenue. Page 35 of 49
ITA no. 4340/Del/2009 In the above circumstances we do not find any merit in these appeals filed by the Department. They are accordingly dismissed."
30. At this stage, it is pertinent to note that the CIT(A) has decided the issue against the assessee by observing that making provisions of warranty on certain percentage of turnover is not in accordance with the preposition laid down by the Hon'ble Delhi High Court in the case of Vinitec Corporation Pvt. Ltd. or by the Privy Council in the case of CIT vs. Mitsubishi Motors New Zealand, and has relied upon the decision of Hon'ble Madras High Court in the case of CIT vs. Rotork Controls India Ltd. (2007) 293 ITR 311 (Mad.). But, the aforesaid decision of Hon'ble Madras High Court in the case of CIT vs. Rotork Controls India Ltd. has been reversed by the Hon'ble Supreme Court in the case of Rotork Controls India Ltd. vs. CIT alongwith other cases viz., CIT vs. Wipro GE Medical Systems Ltd., Hewlett Packard India (P.) Ltd. and Compaq Computer (I) Pvt. Ltd. reported in (2009) 314 ITR 62 (SC), where reversing the decision of Hon'ble Madras High Court, the Hon'ble Supreme Court has held that when the warranty became an integral part of sale, the amount towards the warranty provisions had to be recognized because the assessee had present obligation as a result of past event Page 36 of 49 ITA no. 4340/Del/2009 resulting in outflow and reliable estimate could be made of the amount of the obligation. The Hon'ble Supreme Court has observed and held as under:-
"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.
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.
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 business of the enterprise that are recognized as provision. For a liability to qualify for recognition there must be not only present obligation but also the probability of an outflow of resources to settle that obligation. Where there are a number of obligations (e.g., product warranties or similar contracts) the probability that an outflow will be required in settlement, is determined by considering the said obligations as a whole. In this connection, it may be noted that in the case of a manufacture and sale of one single item, the provision for warranty could constitute a contingent liability not entitled to deduction under section 37 of the said Act. However, when there is manufacture and sale of an army of items running into thousands of units of sophisticated goods, the past event of defects being Page 37 of 49 ITA no. 4340/Del/2009 detected in some of such items leads to a present obligation which results in an enterprise having no alternative to settling that obligation. In the present case, the appellant has been manufacturing and selling valve actuators. They are in the business from the assessment years 1983-84 onwards. Valve actuators are sophisticated goods. Over the years the appellant has been manufacturing valve actuators in a large numbers. The statistical data indicates that every year some of these manufactured actuators are found to be defective. The statistical data over the years also indicates that being sophisticated item no customer is prepared to buy valve actuator without a warranty. Therefore, the warranty became integral part of the sale price of the valve actuator(s). In other words, the warranty stood attached to the sale price of the product. These aspects are important. As stated above, obligations arising from past events have to be recognized as provisions. These past events are known as obligating events. In the present case, therefore, the warranty provision needs to be recognized because the appellant is an enterprise having a present obligation as a result of past events resulting in an outflow of resources. Lastly, a reliable estimate can be made of the amount of the obligation. In short, all the three conditions for recognition of a provision are satisfied in this case.
In this case, we are concerned with product warranties. To give an example of product warranties, a company dealing in computers gives a warranty for a period of 36 months from the date of supply. The said company considers 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 per cent. 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 Page 38 of 49 ITA no. 4340/Del/2009 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 the 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 relevant year, otherwise the matching concept fails. In such a case the second option is also inappropriate. Under the circumstances, the third option is the most appropriate because it fulfils accrual concept as well as the matching concept. For determining an appropriate historical trend, it is important that the company has a proper accounting system for capturing the relationship between the nature of the sales, the warranty provisions made and the actual expenses incurred against it subsequently. Thus, the decision on the warranty provision should be based on past experience of the company. A detailed assessment of the warranty provisioning policy is required particularly if the experience suggests that warranty provisions are generally reversed if they remained unutilised at the end of the period prescribed in the warranty. Therefore, the company should scrutinise the historical trend of warranty provisions made and the actual expenses incurred against it.
On this basis a sensible estimate should be made. The warranty provision for the products should be based on the estimate at the year end of future warranty expenses. Such estimates need reassessment every year. As one reaches close to the end of the warranty period, the probability that the warranty expenses will be incurred is considerably reduced and that should be reflected in the estimation amount. Whether this should be done through a pro rata reversal or otherwise would require assessment of historical trend. If warranty provisions are based on experience and historical trend(s) and if the working is robust then the question of reversal in the subsequent two years, in the above example, may not arise in a significant way. In our view, on the facts and circumstances of this case, provision for warranty is rightly made by the appellant-enterprise Page 39 of 49 ITA no. 4340/Del/2009 because it has incurred a present obligation as a result of past events. There is also an outflow of resources. A reliable estimate of the obligation was also possible. Therefore, the appellant has incurred a liability, on the facts and circumstances of this case, during the relevant assessment year which was entitled to deduction under section 37 of the 1961 Act. Therefore, all the three conditions for recognising a liability for the purposes of provisioning stands satisfied in this case. It is important to note that there are four important aspects of provisioning. They are- provisioning which relates to the 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.
In this case, the High Court has principally gone by the judgment of the Supreme Court in the case of Shree Sajjan Mills [1985] 156 ITR 585. That was a 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, there- fore, was deductible under section 37 of the 1961 Act. The Income-tax Officer 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 Income-tax Officer was affirmed by the Commissioner of Income-tax (Appeals). The Tribunal held that for the earlier assessment year relating to 1973-74, actuarially ascertained liability for gratuity arising under the Pay-
ment of Gratuity Act, 1972, was an allowable deduction. However, for the assessment year in question, the Tribunal held that the increased liability claimed by the assessee for deduction was allowable on general principles of accounting. This view was taken by the Tribunal on the basis that the actuarially determined liability was not provided for Page 40 of 49 ITA no. 4340/Del/2009 in the assessee's books of account. In appeal by the Department, the High Court held that the assessee was not entitled to deduction without complying with the provisions of section 40A(7) of the 1961 Act. This view of the High Court was affirmed by this court. It was held that section 40A(7), which stood inserted by the Finance Act, 1975, with effect from April 1, 1973, has been given an overriding effect over section 28 as well as section 37 of the 1961 Act. Consequently, the deduction allowable on general principles was ruled out as section 40A(1) made it clear that section 40A had effect notwithstanding anything contained in sections 30 to 39 of the 1961 Act. In other words, as regards deduction in respect of gratuity, the assessee was required to comply with the provisions of section 40A(7) after the Finance Act, 1975. It is interesting to note that prior to April 1, 1973, actual payment or provision for payment was eligible for deduction either under section 28 or under section 37 of the 1961 Act. This has been reiterated in Shree Sajjan Mills [1985] 156 ITR 585. The position got altered only after April 1, 1973. Before that date, provision made in the profit and loss account for the esti-mated present value of the contingent liability properly ascertained and discounted on an accrued basis could be deducted either under section 28 or section 37 of the 1961 Act. This has been explained in Shree Sajjan Mills [1985] 156 ITR 585 (SC) at page 599. Section 40A(7) deals only with the case of gratuity. Even in the case of gratuity but for insertion of section 40A(7), provision made in the profit and loss account on the basis of the present value of the contingent liability properly ascertained and discounted on an accrued basis was entitled to deduction either under section 28 or under section 37 of the said Act. This aspect, therefore, indicates that the present value of the contingent liability like the warranty expense, if properly ascertained and discounted on accrued basis, could be an item of deduction under section 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 Page 41 of 49 ITA no. 4340/Del/2009 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 a 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 [1969] 73 ITR 53 will apply. In that case, this court held that contingent liabilities discounted and valued as out of necessity could be taken into account as trading expenses if these were capable of being valued. It was further held that an estimated liability even under a gratuity scheme even if it was a contingent liability if properly ascertainable and if its present value stood fairly discounted, was deductible from the gross profits while preparing the profit and loss account. In view of this decision it became permissible for an assessee to provide, in his profit and loss account, for the estimated liability under a gratuity scheme by ascertaining its present value on accrued basis and claiming it as an ascertained liability to be deducted in the computation of profit and gains of the previous year either under section 28 or under section 37 of the 1961 Act. However, the above principle would not apply after insertion of section 40A(7) with effect from April 1, 1973. It may be stated that the principles of commercial accounting, mentioned above, formed the basis of the judgment of this court in the case of Metal Box Company of India [1969] 73 ITR 53 and those principles are affirmed by the judgment of the Supreme Court in Shree Sajjan Mills [1985] 156 ITR 585 up to April 1, 1973. In this case, we are concerned with warranty claims. In respect of warranty claims during the relevant assessment years in question there is no provision similar to section 40A(7) of the 1961 Act. We may add that the above principle of commercial Page 42 of 49 ITA no. 4340/Del/2009 accounting in Metal Box Company of India [1969] 73 ITR 53 (SC) also find place in the judgment of this court in the case of Madras Industrial Investment Corporation Ltd. v. CIT [1997] 225 ITR 802, in which the court has explained the meaning of the word "expenditure" in section 37 of the 1961 Act. In other words, the principle enunciated in Metal Box Company of India [1969] 73 ITR 53 (SC) which has been reiterated in Shree Sajjan Mills [1985] 156 ITR 585 (SC) (up to April 1, 1973) which deals with making of the provision on the basis of estimated present value of contingent liability holds good during the assessment years in question qua warranty claims.
Before concluding, we may refer to the judgment of this court in the case of Indian Molasses Co. [1959] 37 ITR 66. In that case, the facts were as follows (page 68) :
"One John Bruce Richard Harvey was the managing director of the assessee-company in 1948. He had by then served the company for 13 years, and was due 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 £ 8,208- 19-0 (Rs. 1,09,643) and further undertook to pay annually Rs. 4,364 (£ 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 £ 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 £ 558-1-0 per annum payable during their joint lives from the date of Harvey's superannuation and during the lifetime of the survivor, Page 43 of 49 ITA no. 4340/Del/2009 provided further that if Harvey died before he attained the age of 55 years the annuity payable to Mrs. Harvey would be £ 611-12-0 during her life. It was further provided that should Harvey die before attaining the age of 55 years, the trustees would stand possessed of the capital value of the deferred annuity policy, upon trust to purchase therewith an annuity for Mrs. Harvey with the above insurance company or other insurance company of repute. The other conditions of the deed of trust need not be considered, because they do not bear upon the controversy.
In furtherance of these presents, the trustees took out a policy on January 12, 1949. In addition to conditions usual in such policies, it provided for the following benefits :
Amount per annum of deferred annuity. £ 563-5-8 p.a. if both Mr. and Mrs. Harvey be living on September 20, 1955.
£ 720-0-0 p.a. if Mrs. Harvey should die before September 20, 1955, leaving Harvey surviving her. £ 645-0- 0 p.a. if Harvey should die before September 20, 1955, leaving Mrs. Harvey surviving him.
There was a special provision which must be reproduced:
'Provided the contract is in force and unreduced, the grantees (i.e., the trustees) shall be entitled to surrender the annuity on the option anniversary (i.e., September 20, 1955), for the capital sum of £ 10,169 subject to written notice of the intention to surrender being received by the directors of the society within the thirty day preceding the option anniversary.' Two other clauses of the Second Schedule of the policy may also be quoted :
'(III) If both the nominees shall die whilst the contract remains in force and unreduced and before the option anniversary the said funds and property of the society shall be liable to make repayment to the Page 44 of 49 ITA no. 4340/Del/2009 grantees of a sum equal to a return to all the premiums which shall have been paid under this contract without interest after proof thereof and subject as hereinbefore provided.
(IV) The grantees shall before the option anniversary and after it has acquired a surrender value be entitled to surrender the contract for a cash payment equal to return of all the premiums (at the yearly rate) which have been paid less the first year's premium or five per cent. of the capital sum specified in the special provision of the First Schedule whichever shall be the lesser 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 :Page 45 of 49
ITA no. 4340/Del/2009 'Clauses (I) and (II) do not contain any provision having a material bearing upon clause (III). Therefore, if it happens that both Mr. and Mrs. Harvey die before September 20, 1955, all the payments till then made through the trustees to the Insurance Society will come back to the trustees and, as there is not the slightest trace of any indication anywhere that the trustees should have any beneficial interest in these moneys there would be a resultant trust in favour of the company in respect of the moneys thus far paid out. In other words, what has been done amounts to a provision for a contingency which may never arise. Such a provision can hardly be treated as payment to an employee whether of remuneration or pension or gratuity, and cannot be a proper deduction against the incomings of the business of the company for the purpose of computing its taxable profits. In short, there has been no expenditure by the company yet ; there has been only an allocation of a part of its funds for an expenditure which may (or may not) have to be incurred in future.' The question which arose for determination was : whether during the assessment years 1949-50, 1950-51, 1951-52 and 1952-53 the assessee-company was entitled to claim deduction of the yearly premium from its profits under section 10(2)(xv) of the Income-tax Act, 1922. It was held that the provision in the policy for surrendering annuity and the provision in policy for return of premium was not entitled to deduction as the payment made to the trustees by the assessee-company was towards a contingent liability or towards a liability depending on a contingency, namely, the life of a human-being. It was held that putting aside of money which may become expenditure on the happening of an event is not an expenditure under section 10(2)(xv) of the 1922 Act. It was held on facts that the money was placed in the hands of the trustees and/or the insurance company to purchase annuities, if required, but to be returned if the annuities were not purchased. Therefore, it was a case of setting apart of the money and consequently the assessee was not entitled to deduction under the said section.Page 46 of 49
ITA no. 4340/Del/2009 At this stage, we once again reiterate that a liability is a present obligation arising from past events, the settlement of which is expected to result in an outflow of resources and in respect of which a reliable estimate is possible of the amount of obligation. As stated above, the case of Indian Molasses Co. [1959] 37 ITR 66 (SC) is different from the present case. As stated above, in the present case we are concerned with an army of items of sophisticated (specialised) goods manufactured and sold by the assessee whereas the case of Indian Molasses Co. [1959] 37 ITR 66 (SC) was restricted to an individual retiree. On the other hand, the case of Metal Box Company of India [1969] 73 ITR 53 (SC) 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 Bharat Earth Movers [2000] 245 ITR 428. In that case, the assessee- company had formulated leave encashment scheme. It was held, following the judgment in Metal Box Company of India [1969] 73 ITR 53 (SC), that the provision made by the assessee for meeting the liability incurred under the leave encashment scheme proportionate with the entitlement earned by the employees, was entitled to deduction out of gross receipts for the accounting year during which the provision is made for that liability. The principle which emerges from these decisions is that if the historical trend indicates that a large number of sophisticated goods were being manufactured in the past and in the past if the facts established show that defects existed in some of the items manufactured and sold then the provision made for Page 47 of 49 ITA no. 4340/Del/2009 warranty in respect of the army of such sophisticated goods would be entitled to deduction from the gross receipts under section 37 of the 1961 Act. It would all depend on the data systematically maintained by the assessee. It may be noted that in all the impugned judgments before us the assessee(s) has succeeded except in the case of Civil Appeal Nos. of 2009--Arising out of S. L. P. (C) Nos. 14178-14182 of 2007-- Rotork Controls India (P) Ltd. v. CIT, in which the Madras High Court has overruled the decision of the Tribunal allowing deduction under section 37 of the 1961 Act. However, the High Court has failed to notice the "reversal" which constituted part of the data systematically maintained by the assessee over last decade.
For the above reasons, we set aside the impugned judgment of the Madras High Court dated February 5, 2007, and accordingly the civil appeals stand allowed in favour of the assessee with no order as to costs."
31. In the light of the discussions made above and relying about the aforesaid decision of Hon'ble Supreme Court in the case of CIT vs. Rotork Controls India Ltd. (supra), Calcutta Co. Ltd. v. Commissioner of Income-tax (supra), Bharat Earth Movers Ltd. vs. CIT (supra), and Hon'ble Delhi High Court in the case of CIT vs. M/s. Vinitec Corp. Pvt.
Ltd. (supra), and Hon'ble Kerala High court in the case of CIT vs. Indian Transformers Ltd. (supra), and Privy Council in the case of Commissioner of Inland Revenue vs. Mitsubishi Motors New Zealand Ltd. (supra), we hold that the assessee is entitled to claim the deduction on account of provisions made towards warranty, which was embedded in the sale document itself, and the same warranty provision has been Page 48 of 49 ITA no. 4340/Del/2009 claimed by the assessee by reducing the amount of sale value by the amount of provisions made towards warranty. We, therefore, decide this issue in favour of the assessee and direct the AO to allow the assessee's claim. We order accordingly.
32. In the result, the appeal filed by the assessee is allowed.
33. This decision is pronounced in the open court on 5th February, 2010.
Sd/- Sd/-
(SHAMIM YAHYA) (C.L. SETHI)
ACCOUNTANT MEMBER JUDICIAL MEMBER
Dated: 5th February, 2010
*Nitasha
Copy to:
1. Appellant
2. Respondent
3. CIT
4. CIT(A)
5. DR, ITAT, New Delhi.
By Order
Deputy Registrar
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