Indian Kanoon - Search engine for Indian Law

(1) Whether it was legitimate in such a scheme of gratuity to estimate the liability on an actuarial valuation and deduct such estimated liability in the P & L Account while working out its net profits; and (2) If it was, whether such appropriation amounted to a reserve or a provision for, if it was a reserve, the amount would have to be added back but the company would be entitled to deduct interest at 6% thereon before arriving at the available surplus.

22. On the first question, the Supreme Court referred to Kesoram and Standard Mills and observed (p. 64 of 73 ITR).

29. It may perhaps be convenient at this stage to summarise the effect of the above decisions. The liability of an employer to pay gratuity to his employees subject to certain conditions on the occasion of death, retirement or resignation which is to occur at a future date is a contingent liability and not a liability in praesenti. It cannot be treated as a debt owed at the end of each accounting year. This being so, an employer can meet this liability in various ways. He may just meet it as and when it arises. But a prudent trader would like to place himself in a position to be ready to meet it when it arises. For this purpose, he may set aside each year such amounts as he can afford out of the profits so as to constitute a fund out of which the demands would be met when they arise. This method would be unsatisfactory in that the ad hoc amounts which he chooses to set apart may prove totally inadequate in certain circumstances : for instance, the tenure of the employees may be such that, all of a sudden, in one year most of them might retire causing unexpectedly heavy burden on the employer. To meet such a situation, an employer may undertake an assessment of the present value of his future liability on a scientific or actuarial basis and charge against the profits of each year such amount as would enable him to meet these demands when they arise. Southern Railway of Peru [1957] 32 ITR 737 (HL) and Metal Box have approved of this procedure for income-tax purposes and for other purposes such as computation of bonus wherein profits of each year have to be understood in a commercial sense. Thus, where an assessed on some scientific or actuarial basis estimates the present value of the future liability and debits it to the P & L account, such an estimate can be allowed as a deduction and would be chargeable against the profits both for income-tax purposes as well as for the purposes of the Bonus Act. However, it is not always necessary to insist on a scientific or actuarial assessment. In the case of a small employer and a comparatively simple scheme of gratuity under which the gratuity is payable in almost every case and the possibility of an employee not being entitled to gratuity is very uncertain or remote, the employer may credit to the account of each employee and charge against each year's profits a portion of the salary of the employee on the basis of which he is entitled to gratuity and claim it as a deduction. In these cases, though some decisions have referred to a present liability having arisen or accrued, the true principle seems to be that the deduction is permissible, not on this ground, but on the ground that the true commercial profits cannot be arrived at without such an allocation. In income-tax language, it is an item to be taken into account in the ascertainment of profits under s. 28 of the I.T. Act, 1961, and not a deduction claimed or permissible under ss. 29 to 37 after arriving at the figure of profits. This principle appears sufficiently from the observation of Shelat J., in the Metal Box case .

33. This takes us to a consideration of the second aspect of the matter urged on behalf of the department. The argument is that Metal Box case establishes the principle that the present actuarial valuation of the future liability could be treated as a charge on profits and that, therefore, whether an assessed makes such a valuation or not in making up its accounts, amounts set apart for meeting gratuities to the extent of such actuarial estimated value can be treated only as provisions and only to the extent the amounts exceed such estimate, can they be treated as a reserve. The argument is attractive but, in our opinion, cannot be accepted for two reasons. In the first place, we have tried to explain that even in such a case, there is no creation of a liability in praesenti and if we are right on that, no further question arises in view of the definition of "provision" we have adopted. But even if in such a case the creation of a liability in praesenti can be assumed, it will not help the department. What is a provision and what is a reserve have to be decided on the basis of the actual treatment accorded by an assessed to certain amounts in its accounts. Metal Box was dealing with a case where actually the company had chosen to take current steps to meet the future liability by estimating its present commitment in regard thereto. It only lays down the proposition that it is open to an assessed to maintain its accounts in that way and what it would be commercially prudent to charge the annual profits with such amounts so as to be in a position to meet the liability as and when it arises in future. So an assessed does not change the nature of the amount, if instead of charging it against profits, he sets it apart out of the profits and such an allocation can be rightly treated as a provision, for, truly speaking, it should even have been deducted in arriving at the true profits. But we do not think any assessed can be compelled to make up his accounts in that particular way or make any such scientific provision for the future. It can choose to merely set apart ad hoc sums of money towards the same which may or may not be sufficient to meet that liability in future. Such an allocation cannot be treated as a provision. In the present case, the assessed has not made any allotment or allocation on the principles referred to earlier. It is merely an ad hoc allocation of a certain sum of money which is shown in the books as gratuity reserve. This is a part of the general funds of the company and held by the company for its future use. All that the company means by transferring it to the gratuity reserve account is that this is a sum of money out of the profits which the company holds for future use in relation to the gratuity payable to the employees. This is not a "provision" in respect of a present charge against the profits of the company. The AAC has found that no part of the gratuity reserve has been allowed as a deduction and if necessary, this aspect can be got verified again. So long as the assessed has not estimated the current liability and set it apart or charged it to the current year and claimed a deduction therefore for purposes of income tax, it cannot be said that a provision has been made by it towards an existing liability as understood in the above decisions.

"From the aforesaid observations the principle which is deducible is, though ordinarily appropriations to gratuity reserve are to be regarded as contingent liabilities, if on actuarial basis the estimated present liability could be ascertained properly, then, such ascertained estimated present liability could be allowed as a deduction while computing the profits of a business. On the other hand, if appropriation have been made to gratuity reserve without undertaking any actuarial liability or discounting the present value, then obviously the appropriations cannot be regarded as a provision made by way of providing for any known or existing liability. In the instant case, as we have observed earlier, there is no dispute before us that there was neither the scheme of gratuity framed and got approved by the assessed-company under which the amounts were set apart towards gratuity reserve nor was scientific or actuarial valuation undertaken by the assessed-company. The three amounts which stood credited to the gratuity reserve, therefore, as on the material date, being the first day of the previous year relevant to the three assessment years will have to be regarded as amounts having been set apart not designed to meet any known or existing liability and as such will have to be regarded as reserve."