Income Tax Appellate Tribunal - Mumbai
The Dy. Commissioner Of Income Tax, Spl. ... vs Otis Elevator Co. (I) Ltd. on 22 September, 2005
Equivalent citations: [2006]99ITD73(MUM), [2006]284ITR173(MUM), (2006)100TTJ(MUM)360
ORDER
K.C. Singhal, Judicial Member
1. Since common issues are involved in these Departmental appeals, the same are being disposed of by common order for the sake of convenience.
2. The main common issue, arising in appeals pertaining to Assessment Year 1989-90 to 1993-94, 1995-96 and 1996-97, relates to the additions made on account of loss in respect of incomplete contracts.
3. Briefly stated, the facts, as gathered from the assessment order are that the assessee company is a premier company engaged in the execution of long-term contracts for installation of elevators and escalators manufactured by it. The method of accounting adopted by assesses is explained hereafter. When a contract commences, the direct materials consumed in each of the contract is charged to the respective contract by way of works billing. The direct labour costs incurred on each contract are charged by way of hourly rates depending on the labour mix for each of the contract on the basis of time sheets maintained at the factory at standard rate. Various standard materials purchased and consumed at the site of installations are charged to the said contract directly on the basis of the expense vouchers prepared by the various sites and/or the regional offices.
4. In addition to the aforesaid direct expenses/costs, various indirect costs namely, salaries and wages, freight and forwarding, insurance charges, sales cost, commission payable to the business agents on the respective contracts, if any, excise duty paid / incurred at the time of removal of goods from the factory to the sites of installation, octroi duty, free OTIS services, administrative burden, etc. are allocated to the various contracts that executed during the year. However, the expenses like interest, bad debts / advances written off and provisions for doubtful debts and advances are not allocated between contracts since these are not items of expenses incurred in manufacturing and sales.
5. The assessee company maintains contract-wise sub-legers wherein the expenses/cost incurred in relation to each contract, is recorded. Further, the assessee company follows the completed contract method whereby sales are recognized only on completion of the contract. Although, a contract value for each of the contract are ascertained at the time of entering into the contract, the actual profit is determined only on completion of the contract, after ascertaining the actual total cost incurred on the contract which is recorded in the books of accounts. Contracts which remain incomplete at the end of the year are treated asl work-in-progress.
6. In the case of an incomplete contract, where at the end of the year, the actual cost exceeds the contract price, necessary provisions is made for the resultant loss. Hence, the assessee company charges to the Profit & Loss Account of the year, the losses incurred during the year both, on contracts completed during the year and on contracts remaining incomplete, at the end of the year, even though in terms of the completed contract method the profits arising on incomplete contracts are not credited to the Profit & Loss Account.
7. The provisions for the losses on incomplete contracts are reversed in the year in which the contracts are completed. The scheme of creating the provision for losses on incomplete contracts and the reversal thereof is explained by the assessee company as under:-
(i) At the beginning of the year, the value of works in progress will be equal to the value of the works in progress as on the last day of the immediately preceding previous year. At the time of valuation of the works in progress as on the last day of the immediately preceding previous year for the purpose of the profit and loss account and the balance sheet, the total/gross value of the works in : progress were reduced by the aggregate value of losses i.e., excess cost over the value of sales price of loss making contracts. However, in the works in progress registers the values were maintained at the gross value and no reduction on account of losses have been made in order to keep track of the actual cost of each and every contract in progress. Therefore, in order to neutralize the effect given in the preceding profit and loss account and the balance sheet as on the last day of the preceding year to the losses provided for the loss making contracts, the same were reversed only to the extent of the contracts which are still in progress as at the end of this previous year by a set of journal entries in the books of account in this year. Once again losses incurred on the loss making contracts as at the end of this year are provided for at the end of this year by another set of journal entries. This is other words means the profit and loss account is charged only to the extent of fresh losses incurred on loss making contracts during this previous year.
(ii) As regards the contracts which were closed during the year and for which losses were provided up to the end of the preceding year, the same were reversed in order to arrive at the actual cost of the contract and sales are also taken into the revenues of the year and this is accounted by a set of journal entries. This is in other words mean profit and loss is charged only with the amounts of fresh losses incurred during the previous year while accounting for the entire sales value. This is how it is reflected by the term "losses reversed on completion" in Annexure-A to our letter dt. March 19, 1993. Though apparently it may appear that there can be no reversal of losses, at the time of sales, the earlier losses provided are reversed and are taken to enhance the value of cost of sale and therefore the net effect of the scheme of entries is that only the amount of resh losses incurred on such contracts closed during the year are charged to the Profit & Loss Account by this scheme of entries.
8. The crux of the above explanation is that in respect of incomplete contracts, the losses are booked in the year in which actual cost of the contract exceeds the contract price to the extent of excess of expenditure over the contracted price and in the subsequent year the balance amount of expenditure incurred is claimed as loss. Thus the loss is claimed in two years. However, in some contracts, there is escalation clause under which the assessee may realize the additional value on account of price increase. In such cases, the assessee makes provisions to the extent of estimated amount realizable and if still the expenditure is more than realizable value, then losses are booked to that extent in Profit & Loss Account. In this manner, assessee claimed loss of Rs.1,02,31,801/- for Assessment Year 1991-92. In the similar manner, the losses were claimed in other years also.
9. Since the assessee was following contract completion method, the Assessing Officer asked the assessee to show cause as to why such loss should not be disallowed. The assessee vide letter dated 15.2.1993 replied (i) that method adopted by the assessee was in accordance with Accounting Standard (A.S) 7 as well as international A.S. 11; (ii) that assessee is entitled to value the closing stock either at cost or the realizable market price. It also relied on the judgment of Supreme Court in the case of Chellapalli Sugar Ltd., 98 ITR 167, for the proportion that the recommendations of the Institute of Chartered Accountants should be followed. Thus, it was pleaded that in view of the provisions of Section 145, the claim of the assessee could not be rejected.
10. The Assessing Officer did not accept the explanation of the assessee. According to him, the purpose of valuing during stock was to determine the profits on the sales effected by the assessee but in the case of contract completion method, the valuation of closing stock was not a relevant factor. Secondly, he observed that no profits or losses could be said to accrue by unilateral transaction such as valuation of closing stock. It was also observed that loss claimed by the assessee was merely provisions in the book since such loss is reversed in the next year. In view of these observations, he held that such loss on incomplete contracts could not be allowed.
11. On appeal, the Learned CIT (Appeals) allowed the loss by observing as under:-
13. In the appellant's case, it can not be denied that the incomplete contracts have been executed by way of payment or receipt of goods during the year. The work-in-progress of incomplete contracts cannot also be regarded under the Income Tax Act as anything else apart from stock-in-trade. It is also true that the provisions for loss is based on valuation of such stock-in-trade at market price, which is lower than the cost. The contention of the Assessing Officer that such a IQSS cannot be allowed as work-in-progress (stock-in-trade) of incomplete contracts cannot be taken into account for computation of profit under computed contract method is in my opinion a criticism of the accounting standard only. Such is also the view of Board of In/and Revenue (U.K.) as it will appear from their 'statement (appendix 3 to Statement of Standard Accounting Practice relating to stocks and work-in-progress issued by Institute of Chartered Accountants in England and Wales) where they observe that where a loss on a contract as a whole in foreseen, a proportion of the overall loss calculated either by reference to time normally upto the due completion date under the terms of the contract, or to expenditure incurred, may normally be taken into account year by year during the reminder of the contract period, so long as all the contracts profitable or otherwise are dealt with similarly (Para-8). In other words, such losses can be taken into account under the percentage computation method only. I am afraid that though such a view may appeal to common sense, it cannot be accepted in the face of the specific provisions in the Accounting Standard for deduction of such losses even under the completed contract method and it has to be held that such loss is deductible according to accepted accounting practice I have also pointed out that such a claim of loss is allowable under the I.T. Act a/so, as the loss/expenditure has actually been incurred by way of costs incurred till date. In view of the above, I have no option but to allow the claim of anticipated loss from incomplete contracts of Rs.1,02,31,801/- made by the appellant in computation of profits from long term contracts and following the completed contract method.
Aggrieved by the same, the Revenue is in appeals before the Tribunal.
12. The Learned Departmental Representative has assailed the order of ' the Learned CIT (Appeals) by reiterating the reasonings given by the Assessing Officer and, therefore, the same need not be repeated. However, it was contended by him that the legislature has given the option to maintain its accounts in accordance with any method of accounting of his choice. But once the choice is opted by assessee, then profit and loss must be disclosed in accordance with such method. It was pleaded by him that once the assessee had chosen to maintain its account on the basis of contract completion method then profit or loss has to be determined in the year of completion only and not in any other year. Therefore, Assessing Officer was justified in disallowing the loss in respect of incomplete contracts. Proceeding further, he referred to the matching concept as dealt with by the Hon'ble Bombay High Court in the case of Taparia Tools Ltd., 260 ITR 102. According to him, the expenditure must match with the income. Therefore, expenditure incurred cannot be allowed as deduction unless matched with the connected income. Since the assessee had not shown any income by way of receipts, the question of allowing any loss does not arise. Proceeding further, he drew our attention to escalation clause in the contract and submitted that loss claimed was contingent or premature till the escalation price is received by the assessee. Accordingly, it was pleaded by him that order of the Assessing Officer may be restored.
13. On the other hand, the Learned Counsel for the Assessee has vehemently supported the order of the Learned CIT (Appeals). According to him, the assessee is entitled to adopt any of the methods of accounting. It was further submitted by that the assessee had been maintaining such method of accounting since decades and consistently being followed and also accepted by the Department. Therefore, the Assessing Officer could not deviate from such method from disallowing the losses. Reliance was placed on Bombay High Court judgment in the case of Manilal Kher Ambalal & Co., 176 ITR 253. Proceeding further, it was submitted that method of accounting adopted by the assessee is in consonance with the A.S. 7 as well as international A.S. 11 and, therefore, such method is an acceptable method. Hence, the Learned CIT (Appeals) was justified in accepting the same. It was also submitted by him that assessee is entitled to value the work in progress (stock in trade) either at cost or market value whichever is less as per Supreme Court judgment in the case of Chainrup Sampatram, 24 ITR 481. He also relied on Supreme Court judgment in the case of ALA Firm, 189 ITR 285, for the contention that realizable value can be taken into consideration. Accordingly the assessee could value the work in progress :at the contractual price since that was the realizable value. He also objected to the contention of Learned Departmental Representative that due to escalation clause in the agreement, the loss was contingent. It was contended by him that provisions had been made by assessee in respect of estimated amount realizable under escalation clause and, therefore, contention of Learned Departmental Representative is without force.
14. In reply, the Learned Departmental Representative submitted that A.S. prescribed by Institute of Chartered Accountants are meant for accounting purpose and not for taxation purposes. He also pointed out that A.S. 7 has not yet been accepted or notified by the Central Govt., under the amended provisions of Section 145. According to him, A.S. are normally prescribed to satisfy the shareholders and cannot be applied to determine the accrual of loss. Proceeding further, he submitted that valuation of closing stock is relevant only where profits are determined on year to year basis and the same is not relevant where contract completion method is adopted by assessee. He reiterated that in case of contract completion method, the profit / loss can only be determined in the year of completion.
15. Rival submissions of the parties have been considered carefully. The question for our consideration is whether the method of accounting adopted by the assessee in respect of incomplete contracts could be rejected in law by the Assessing Officer for the purpose of disallowing the losses declared by the assessee in such incomplete contracts. The answer to this question would depend on the interpretation of the provisions of Section 145 of the Act, which gives option to assessee to adopt any method of account. Section 145 as applicable to the years under consideration, reads as under:-.
145. Method of accounting - (1) Income chargeable under the head "Profits and gains of business or profession" or "Income from other sources" shall be computed in accordance with the method of accounting regularly employed by the assessee:
Provided that in any case where the accounts are correct and complete to the satisfaction of the Assessing Officer but the method employed is such that, in the opinion of the Assessing Officer, the income cannot properly be deduced therefrom, then the computation shall be made upon such basis and in such manner as the Assessing Officer may determine:
Provided further that where no method of accounting is regularly employed by the assessee, any income by way of interest on securities shall be chargeable to tax as the income of the previous year in which such interest is due to the assessee:
Provided also that nothing contained in this sub-section shall preclude an assessee from being charged to income-tax in respect of any interest on securities received by him in a previous year if such interest had not been charged to income-tax for any earlier previous year.
(2) Where the Assessing Officer is not satisfied about the correctness or the completeness employed by the assessee, the Assessing Officer may make an assessment in the manner provided in Section 144.
16. The above section corresponds to Section 13 of 1922 Act and these provisions have been construed by the various Courts from time to time. A bare reading of the above provisions clearly shows that profits and gains of business have to be computed as per the method of accounting regularly employed by the assessee. It is the duty of Assessing Officer to compute the income of assessee in accordance with the method regularly employed by him unless the case of assessee falls within the provisions of any of the proviso. Such method of accounting may be mercantile method or cash / receipt method of accounting. In respect of these two methods, there is no dispute between the parties. However, disputes have arisen where the method regularly employed by assessee is neither purely mercantile nor cash system but is a mixed system of accounting which is normally called as Hybrid System of accounting. The case study reveals that such system of accounting has also been accepted by the Courts. The Hon'ble Supreme Court in the case of CIT v. Krishnaswami Mudaliar 53 ITR 122, had taken note of Hybrid System of accounting being followed. The Jurisdictional High Court in the case of CIT Vs Citi Bank, N.A. 208 ITR 930, has accepted the Hybrid System of accounting by observing at Page-937 as under:-
Though the cash system and mercantile system of accounting are the two most common systems of accounting prevalent in the country, there can be no dispute about the fact that there are also innumerable other systems of accounting besides these two systems. Such systems are commonly known as "hybrid systems of accounting". In such a system, there is certain element of both cash and mercantile systems. As assessee following such a system may employ one method of accounting for one class of business or one class of customers or transactions and a different method for another class. If an assessee follows such a hybrid system and in respect of certain loan transactions does not follow the mercantile system of accounting for debiting interest to the accounts of the parties and crediting the same to the profit and loss account, no fault as such can be found with the system followed by the assessee. The only power the Income Tax Officer has in such cases is the power under the proviso to Section 145(1) of the Act which permits him, on being satisfied that the method employed by the assessee is such that his income cannot be properly deduced therefrom, to compute his income upon such basis and in such a manner as he may determine. Evidently this is not a case fa/ling under the proviso to Section 145(1) in view of the categorical finding of the Tribunal in this regard. Besides, the Income Tax Officer himself has been accepting this system which had been followed by the assessee throughout in the past as a proper method of accounting and profits had in fact been determined on the basis thereof in the past as well as in two of the three Assessment Year under consideration. The fact that the assessee, for its convenience, kept a separate note of all those parties in whose case the mercantile system of accounting had not been followed and the interest on the amounts due from them had not been debited to their accounts cannot in any way militate against the fact that the assessee was not following the mercantile system of accounting in respect of the loans in question. The system of accounting followed in respect of interest on such loans was in fact the cash system. The above system of accounting followed by the assessee does not in any way affect the real income of the assessee because, as soon as the amount of interest is recovered on any such loan a record of which is kept in the form of a memorandum record, it is treated as income of the assessee of that year and subjected to taxation. We, therefore, do not find any infirmity in the finding of the Tribunal. According to us, the Tribunal was justified in holding that having found no fault with the method of accounting followed by the assessee, it was not open to the Income Tax Officer to compute interest on the loans in question on the presumption that the assessee having generally followed the mercantile system of accounting in respect of most of its transactions it was not open to it to follow a different system of accounting in respect of a category of loans classified by the assessee as "problem loans.
17. In view of the above judgment, it is held that any system of accounting could be employed by the assessee provided it is regularly employed and the Assessing Officer was bound to determine the profits in accordance with sucti system of accounting.
18. The only exception to the above legal position is provided in the first proviso i.e., where true profits cannot be deduced from the method of accounting employed by assessee. If such method of accounting depicts the distorted picture of profits of business carried on by assessee then the Assessing Officer can invoke the proviso to Section 145 even though such method is being employed consistently as held by the Hon'ble Supreme Court in the case of British Paints India Ltd., 188 ITR 44. But the powers of Assessing Officer under such proviso are not arbitrary and must be exercised in a judicious manner as held by the Hon'ble Supreme Court in the case of A. Krishna Murthy Mudaliar (supra).
19. The legal position which emerges is that it is entirely within the discretion of the assessee to adopt any method of accounting provided it discloses a true picture of his profits and gains. Such method of accounting may be mercantile or cash basis or even Hybrid System of accounting. However, if the system followed by assessee does not show the true picture of profits of business carried on by assessee then certainly, Assessing Officer can invoke the provisions of the proviso to Section 145 though such powers are to be exercised judiciously.
20. In the above back drop, let us examine the system followed by the assessee. Assessee being a contractor can adopt either percentage completion method or contract completion method, which are duly recognized by the Institute of Chartered Accountants. It can also employ any other method provided which shows true profits of its business. In the present case, the assessee has adopted contract completion method in general. According to this method, the assessee goes on accumulating the expenditure year after year in respect of each contract and the contract price is credited in the year in which contract is completed and the resultant profit is shown in the books in that year. However, there is an exception to such system of accounting. In some cases, where, during the pendency of contract, the expenditure incurred exceeds the contracted price, the excess amount is booked as losses in the Profit & Loss Account and only contracted price is carried forwarded to next year and so on. Thus, in case'of loss in a particular contract, it is shown in more than one year. In case of escalation clause in the contract, a provision is made by assessee of estimated escalation price. This system of accounting is being employed by the assessee since decades and was also being accepted by the Revenue till Assessment Year 1988-89.
21. The system of accounting adopted by the assessee in respect of incomplete contracts resulting in losses can be explained by an example. For instance, the contract price is Rs. 20 lakhs and the contract is to be completed in 4 years, the estimated escalation price is taken at Rs.30,000/-. The entries made by the assessee in various years, as per the chart furnished by assessee, can be illustrated as under:-
YEAR - IV P and L A/C To_Raw Material 8,00,000 By Closing WIP 19,30,000 To Direct Labour 5,00,000 To Direct Overheads 3,00,000 To Indirect Overheads 3,30,333 l9,30,000 19,30,000 YEAR - II P and L A/C To Opening Balance 19,30,000 By Loss on Incomplete 70,00 Contract To Raw Material 80,000 By Closing WIP 20,30,000 To Direct Labour 30,000 To Direct Overheads 40,000 To Indirect Overheads 20,000 21,00,000 21,00,000 YEAR -III P and L A/C To Opening Balance 20,30,000 By Loss on Incom 40,000 plete Contract To Raw Material 10,000 By Closing WIP 20,30,000 To Direct Labour 10,000 To Direct Overheads 10,000 To Indirect Overheads 10,000 20,70,000 21,70,000 YEAR -IV P and L A/C To Opening Balance 20,30,000 By Sales A/C 20,30,000 To Raw Material 5,000 By Losses on completed 20,000 contracts To Direct Labour 5,000 To Direct Overheads 5,000 To Indirect Overheads 5,000 20,50,000 20,50,000
22. The reasoning given by assessee in adopting the above system is that contract price is fixed and, therefore, where the expenditure incurred already exceeds the realizable price, the losses are incurred which are ascertained and, therefore, can be booked to Profit & Loss Account. Therefore, the assessee is entitled to set off the same against profits of business of that year. However, where expenditure incurred is less than the realizable price, assessee continues to accumulate the same and profits are determined in the year of completion. In our opinion, the explanation of assessee is plausible, bonafide and must be accepted.
23. At this stage, it would be appropriate to refer to A.S. 7 prescribed by ICAI in case of contractors. Para-7 onwards of A.S. 7 prescribes the various methods which may be adopted by a contractor. Para-13.1 permits the contractor to book the losses where estimated loss is indicated. Para-13.1 reads as under:-
13.1 When current estimates of total contract costs and revenues indicate a loss, provision is made for the entire loss on the contract irrespective of the amount of work done and the method of accounting followed. In some circumstances, the foreseeable losses may exceed the costs of work don to date. Provision is nevertheless made for the entire loss on the contract."
Para-19 which is also relevant, reads as under:-
19. A foreseeable loss on the entire contract should be provided for in the financial statements irrespective of the amount of work done and the method of accounting followed.
Similar methods are recognized by International Accounting Standards - I.A.S. II and need not be repeated. Copies of the same are placed in the Paper Book.
24. The discussion in the preceding para, clearly shows that in case of foreseeable losses, the same can be booked to Profit & Loss Account. Therefore, It is held that system of accounting employed by assessee is in consonance with the accounting standard prescribed in India and also outside India.
25. The only question which remains to be considered is whether such system depicts the distorted picture of profits of business carried in by assessee. In our opinion, the answer is "NO". The contracted price is fixed under the contract. Therefore, if during the construction period, the cost incurred has exceeded the contract price, the loss accrues to the assessee to the extent of excess expenditure. The Learned Departmental Representative has argued that such loss is contingent in view of the escalation clause in the contract. This contention of Learned Departmental Representative is also untenable. Firstly, because such escalation clause is not in every contract. Secondly, wherever there is escalation clause, the provision is made of such escalation price on estimate basis. Such method has been judicially recognized by the Apex Court in the case of Calcutta Co. Ltd., 37 ITR 1. Therefore, we hold that system of accounting employed by assessee consistently since decades cannot be rejected.
26. Before parting with this order, we may mention that judgment of Hon'ble Supreme Court in the case of Chainrup Sampat Ram (supra) relied upon by the assessee's Counsel, in support of the proposition that closing stock is to be valued at cost or market price, cannot be applied in the case of contractor. Such method is applicable only where the closing stock is sold as a trader or manufacturer since profits are to be determined on year to year basis in respect of sales affected by the assessee during the year. When the assessee, as a contractor, chooses the completion method, the question of valuing the stock does not arise since work in progress is to be computed on the basis of accumulated expenditure. Hence, such contention of the assessee is rejected.
27. In view of the above discussions, the issue is decided in favour of the assessee. The orders of the Learned CIT (Appeals) are, therefore, upheld on this issue.
28. The next common issue pertaining to Assessment Year 1990-91 to 1993-94, 1995-96 and 1996-97 relates to the additions made by Assessing Officer on account of MODVAT credit. Both the parties are agreed that this issue stands covered in favour of assessee by the judgment of the Hon'ble Supreme Court in the case of Indo Nippon Chemicals Co. Ltd., 261 ITR 275. Respectfully following the same, the issue is decided in favour of assessee. The orders of the Learned CIT (Appeals) are, therefore, upheld on this issue.
29. The next issue arising from Assessment Year 1995-96 relates to computation of relief Under-section 80-HHC of the Act. The Assessing Officer, while computing such deduction, excluded 90% of interest income and export incentive from the business profits but did not exclude these elements from the total turnover. The Learned CIT (Appeals) was of the view that such income could not be included in the turnover. The Revenue is aggrieved from such order of the Learned CIT (Appeals). In our opinion, the Learned CIT (Appeals) has rightly excluded the same from the turnover. The turnover relates to the sales of the goods sold by it either locally or in course of export. The interest income has no relation to sales transaction. Accordingly, we do not find any infirmity in the order of the Learned CIT (Appeals). Accordingly, the same is upheld on this issue.
30. The last issue relates to the addition of Rs. 102,95,655/- in the intimation sheet issued Under-section 143(l)(a) for the Assessment Year 1991-92. This adjustment was by way of disallowance Under-section 43-B in respect of unpaid sales tax. However, on appeal, the Learned CIT (Appeals) deleted the addition being outside the scope of Section 143(l)(a). Aggrieved by the same, the Revenue is in appeal before the Tribunal. After hearing both the parties, we do not find any infirmity in the order of the Learned CIT (Appeals) Under-section 143(l)(a). No adjustment was possible unless it was apparent from the record that payment was not made before the due date of the return. In the absence of such detail, Assessing Officer was not justified in making such adjustment Under-section 143(l)(a). Accordingly, we hold that the Learned CIT (Appeals) was justified in directing the Assessing Officer to delete such adjustment. The order of the Learned CIT (Appeals) is, therefore, upheld on this issue.
31. In the result, the appeals of the Revenue stand dismissed.
Pronounced in the open Court on this 22ND day of September, 2005.