“Clarifying Warranty Provisions Deduction in IT Act, 1961: Navigate the complexities of claiming deductions for warranty provisions with legal insights.”
In the absence of the defined rules and regulations on treatment of provision made for warranty claims by an enterprise ,there has been a confusion regarding the allowability of the same. This article aims to informs the readers that whether a company is entitled to deduction in respect of provision of warranty or not.
Let us first understand the meaning of warranty .
Warranty – a written guarantee, issued to the purchaser of an article by its manufacturer, promising to repair or replace it if necessary within a specified period of time. Further, a warranty letter is issued along with sale invoices and the seller has got an obligation to replace/repair the products sold free of cost during the warranty period. Warranty is provided on an item to establish trust and it works as a marketing tool to attract buyers, thus making it a part and parcel of every business.
Hence, warranty is the future expense of a manufacturer which he may or may not incur. It is a contingent liability, contingency being the performance of the item sold during a fixed duration of time.
Let us understand some basic terms through their definitions as provided by AS-29 by the ICAI
PROVISION – A provision is a liability which can be measured only by using a substantial degree of estimation.
LIABILITY – A liability is a present obligation of the enterprise arising from past events, the settlement of which is expected to result in an outflow from the enterprise of resources embodying economic benefits.
CONTINGENT LIABILITY – is a possible obligation that arises from past events and the existence of which will be confirmed only by the occurrence or non-occurrence of one or more uncertain future events not wholly within the control of the enterprise; or (b) a present obligation that arises from past events but is not recognized because: (i) it is not probable that an outflow of resources embodying economic benefits will be required to settle the obligation; or (ii) a reliable estimate of the amount of the obligation cannot be made.
An enterprise which gives warranty on it’s products incurs expenses either by repairing it on discounted rate or replacing it completely without charging the cost for the same. In this way an enterprise makes an estimate through the provision of warranty.
However, there has been a dispute with regard to the deduction of the provision of warranty while filing its Income Tax Return.
The Income Tax Department contends that the Company makes a provision for warranty based on the past practice and experience and it is only a contingent liability, the contingency being that the product sold by the company undergoes repairs during warranty period. Further, it is not that all the products sold become repairable and the company has to incur expenditure and there is nothing wrong on the part of the company to debit the actual expenditure incurred every year on warranties given as revenue expenditure and claim the same as a deduction.
Further, the department contends that the provision made by the company is an expenditure, which would be incurred on the happening of an event and as such, the same cannot be treated as business expenditure within the ambit and scope of Section 37 of the Income Tax Act, 1961. The provision for warranty cannot be considered as an “expenditure” at all and the expenditure has to be an actually existing liability and the expenditure, which is deductible for income tax purposes, but merely putting aside the money which may become expenditure on the happening of an event is not an expenditure.
An important point to be noted here is that there is no clearly mentioned rule/law for the same. It is a highly litigated manner with the landmark case being the judgment of Honourable Supreme court M/S. Rotork Controla India (P) Ltd vs Commnr. Of Income Tax, Chennai on 12 May, 2009
In this the Hon’ble Supreme Court gave the judgment in favor of the assessee and allowed for the deduction of the provision of warranty ,provided that the provision has been developed through a scientific methodology and is not arbitrarily made for.
The Hon’ble Supreme Court explained as to what a provision on the following lines is: 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.
The Hon’ble Supreme Court went on to examine as to what are the types of product warranties, a company would give and held that there were three options, namely,
(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 certain percentage of turnover of the company based on past experience (historical trend).
Among these three options, it was held that 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.
The second option is also inappropriate since it does not reflect the expected warranty costs in respect of revenue already recognized. In other words, it is not based on matching concept. Under the matching concept, if revenue is recognized the cost incurred to earn that revenue including warranty costs has to be fully provided for.
The third option is the most appropriate because it fulfils accrual concept as well as the matching concept.
Further, the Hon’ble Supreme Court pointed out the four important aspects of provisioning namely, provisioning which relates to present obligation, it arises out of obligating events, it involves outflow of resources and lastly, it involves reliable estimation of obligation.
Through this judgment, the Honourable Supreme Court settled the questions of law raised in such disputes. There has been many more similar court cases wherein the court has ruled in favor of the assessees ; some of which are :
1. TTK Prestige Ltd. vs .Deputy Commissioner of Income-tax ( HIGH COURT OF KARNATAKA)
2. Principal Commissioner of Income Tax, Bangalore vs . Lenovo India (P.) Ltd(HIGH COURT OF KARNATAKA)
3. M/s. Grundfos Pumpas India Limited Vs The Deputy Commissioner of Income Tax ( HIGH COURT OF TAMIL NADU)
An important point common to all of these court judgements is that the provision of warranty should be decided using a scientifically devised method based on past experience depending on factors like turnover of the company of previous years and provision for expenses on repairs during the warranty period. As warranty is a future liability and the actual expenses cannot be ascertained the provision must be made on a scientific basis and not on ad hoc basis.
This is a highly litigated matter without any rules or laws regulating the validity of deduction of provision for warranty. It depends on the company if they wish to deduct the provision of warranty or not while filing the income tax return. However, if they deduct the same, then as per various judgements of the high courts and the supreme court, it is legally valid.
DISCLAIMER: The Contents of this article are for information purpose only and does not tantamount to professional advice.
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