Can A.O. could invoke section 41(1) on the pretext that liability has been long outstanding and the assessee is willingly not writing off the debts from its books?

Section 41(1) is not applicable when the long outstanding liabilities have not been written off from books of accounts and continue to be reflected in the Balance Sheet

Brief Facts:

In the instant case, the assessee had received advance/loan in earlier years and as such, had booked liabilities in its books in earlier years nearly ten years ago. The said liabilities has been continued from a period prior to ten years or more. The assessee had never debited the aforesaid liability to its P&L in any of the earlier years or during the relevant year and has continued to appear as the closing liability and has been carried forward to next year.

Concern:

Can the A.O. could invoke section 41(1) of the Act on the pretext that the liability has been long outstanding and the assessee is willingly not writing off the debts from its books?

Views:

At the outset, reference is invited towards the provision of section 41(1) of the Income Tax Act, 1961. The relevant extracts of the same are reproduced here under:

“Profits chargeable to tax.

(1) Where an allowance or deduction has been made in the assessment for any year in respect of loss, expenditure or trading liability incurred by the assessee (hereinafter referred to as the first-mentioned person) and subsequently during any previous year,—

the first-mentioned person has obtained, whether in cash or in any other manner whatsoever, any amount in respect of such loss or expenditure or some benefit in respect of such trading liability by way of remission or cessation thereof, the amount obtained by such person or the value of benefit accruing to him shall be deemed to be profits and gains of business or profession and accordingly chargeable to income-tax as the income of that previous year, whether the business or profession in respect of which the allowance or deduction has been made is in existence in that year or not; or…

 …Explanation 1.- For the purposes of this sub-section, the expression “loss or expenditure or some benefit in respect of any such trading liability by way of remission or cessation thereof” shall include the remission or cessation of any liability by a unilateral act by the first mentioned person under clause (a) or the successor in business under clause (b) of that sub-section by way of writing off such liability in his accounts.”

[Emphasis Added]

On perusal of the aforesaid section, it could be said that the above provision enacts adjustment provisions whereby the revenue takes back what it has already allowed if the following two conditions come to pass and as such, the under noted conditions needs to be fulfilled in order to treat the cessation of a liability as income under section 41(1) of the Act:

1. The assessee has to avail an allowance or deduction in any earlier year in respect of loss, expenditure or trading liability and

2. In subsequent year, the assessee has to obtain benefits in cash or any other kind in respect of such loss, expenditure and trading liability by way of remission or cessation of liability.

As the assessee had not debited the aforesaid liability to its P&L in any of the earlier years and hence, the question of receiving any benefit, allowance or deduction by the assessee in earlier years, as specified in (1) above, has not been fulfilled in the instant case and thereby there lies no application of section 41(1) in the instant case.

Further, the assessee had also not received any benefit either in cash or otherwise during the relevant year. In fact the said sum will decrease the cash inflows of the assessee in the subsequent years. The assessee has not written back the liability during the relevant year and the said liability continued to appear as the closing liability and has been carried forward to next year. Hence, condition (2) above has also not been fulfilled.

Thus, it can be said that both conditions needed for the application of section 41(1) of the Act has not been fulfilled in the instant case and therefore the addition made under section 41(1) of the Act would have no legs to stand and would be thereby liable to be struck.

I would like to mention that in order to apply section 41(1) of the Act, an assessee should have obtained a deduction in respect of loss, expenditure or trading liability. The core intent of section 41(1) of the Act was to take back the benefit in the cases, where the benefit was granted earlier but the subsequent event shows that the benefit should not have been granted.

However, in the instant case, the benefit is neither granted in the earlier years nor during the relevant year and thereby no addition may be made under section 41(1) of the Act. Had the assessee availed any benefit in earlier years or during the relevant year then section 41(1) of the Act would have application. In the instant case, it is not disputed that the assessee never debited any sum in the Profit & Loss account and as such, the assessee has not obtained such allowance or deduction in respect of expenditure or trading liability and therefore, the question of section 41(1) of the Act is not applicable.

Reliance in this regard is placed on the decision in the case of CIT -vs.- Sugauli Sugar Works (P). Ltd. (1999) 236 ITR 518 (SC) wherein the ITO held that the liability had come to an end as a period of more than 20 years had elapsed and the creditor had not taken any step to recover the amount and therefore, there was a cessation of the debt under section 41 of the Act. The Hon’ble Supreme Court while affirming the decision of the Hon’ble Calcutta High Court held that obtaining benefit by virtue of remission or cessation is sine qua nonfor section 41(1). The Hon’ble Apex Court inter alia held,

“3. It will be seen that the following words in the section are important : ‘the assessee had obtained, whether in cash or in any other manner whatsoever any amount in respect of such loss or expenditure or some benefit in respect of such trading liability by way of remission or cessation thereof, the amount obtained by him’. Thus, the section contemplates the obtaining by the assessee of an amount either in cash or in any other manner, whatsoever, or a benefit by way of remission or cessation and it should be of a particular amount obtained by him. Thus, the obtaining by the assessee of a benefit by virtue of remission or cessation is sine qua non for the application of this section.”

[Emphasis Added]

On the kind perusal of the said decision, it may be highly appreciate the fact that the Hon’ble Apex Court has clearly laid down the law that when an amount has been continuously shown by assessee in its balance sheet, it could not be construed as ceased so as to bring it within mischief of section 41(1) of the Act. It cannot be said that the liabilities have ceased to exist on the basis of the fact that the sum is outstanding for a period of 20 years. In the instant case, the assessee has shown its liabilities in the books of accounts. It is indeed that the liabilities are outstanding for nearly ten years but there has been no remission/cessation of liability and as such, applying the above ratio, it can be said that the addition under section 41(1) of the Act has no legs to stand and is liable to be struck.

The aforesaid provision of the Act came up for further consideration before the Constitutional Bench of three learned Judges of the Hon’ble Apex Court in the case of Chief CIT -vs.- Kesaria Tea Co. Ltd. (2002) 254 ITR 434 (SC) wherein in the context of the similar facts, it was held that section 41(1) of the Act could arise only if the liability of the assessee has ceased without the possibility of reviving it and if there has been no cessation during the year then section 41(1) of the Act has no application. The Hon’ble Apex Court reiterated the views taken in the case of Sugauli Sugar(supra.) and had laid the following points for the application of section 41(1):

  1. In the course of the assessment for an earlier year, allowance or deduction has been made in respect of any loss, expenditure, or trading liability incurred by the assessee;
  2. Subsequently, a benefit is obtained in respect of such trading liability by the way of remission or cessation thereof during the year in which such event occurred;
  3. The value of benefit accruing to the assessee is deemed to be the profit and gains of business which otherwise would not be his income;
  4. The value of benefit is made chargeable to tax as the income of the year wherein such benefit was obtained.

In the instant case, the assessee has neither claimed any allowance and/or deduction in the earlier years nor had received any benefit by way of remission or cessation of liabilities during the relevant year and therefore it may be safely concluded that the assessee has fulfilled none of the above prescribed conditions and thereby applying the ratio laid down by the Hon’ble Supreme Court, it may be stated that section 41(1) would have no legs to stand.

Further, in the case of CIT -vs.- Mahindra & Mahindra Ltd. (2018) 93 taxmann.com 32 (SC) the Hon’ble Supreme Court elucidated that it is a sine qua non that there should be an allowance or deduction claimed by the assessee in any assessment for any year in respect of loss, expenditure or trading liability incurred by the assessee and subsequent waiver/remission of the liability. It was further stated that if an amount has not been debited to P&L in the earlier years then the same would not be covered under the mischief of section 41(1) of the Act. The Hon’ble Apex Court explained the provisions of the said section in the following words,

“15. On a perusal of the said provision, it is evident that it is a sine qua non that there should be an allowance or deduction claimed by the assessee in any assessment for any year in respect of loss, expenditure or trading liability incurred by the assessee. Then, subsequently, during any previous year, if the creditor remits or waives any such liability, then the assessee is liable to pay tax under Section 41 of the IT Act. The objective behind this Section is simple. It is made to ensure that the assessee does not get away with a double benefit once by way of deduction and another by not being taxed on the benefit received by him in the later year with reference to deduction allowed earlier in case of remission of such liability

It is important to note that the said purchase amount had not been debited to the trading account or to the profit or loss account in any of the assessment yearsHence, we find no force in the argument of the Revenue that the case of the Respondent would fall under Section 41 (1) of the IT Act.”

[Emphasis Added]

Applying the ratio of the above judgement in the instant case, there is no dispute that the assessee has not debited the said amount to the trading account or to the profit or loss account in any of the earlier assessment years and has not claimed any benefit, allowance or deduction in respect of the aforesaid liability in any of the earlier assessment years. Hence, in light of the decision of Mahindra & Mahindra (supra.) it can be said that section 41(1) of the Act has no application in the instant case.

Furthermore, in the case of Tirunelveli Motor Bus Service Co. (P.) Ltd. -vs.- CIT (1970) 78 ITR 55(SC) wherein the Hon’ble Apex Court had categorically held that unless it is proved that an allowance or deduction has been made in any preceding assessment year in respect of loss, expenditure or trading liability, it is not open to the revenue to refer to section 10(2A) of Indian Income-tax Act, 1922 (corresponding to section 41(1) of the Act). It was held,

“On that finding of the Tribunal it could hardly be regarded as established that either any allowance or deduction had been granted in respect of a trading liability of the assessment year 1950-51, or it had been proved that the assessee had obtained any benefit relating to such trading liability in the assessment year 1957-58, which would attract the provisions of section 10(2A) of the Act. That provision only applies when an allowance for deduction has been made in the assessment of any year in respect of any loss, expenditure or trading liability incurred by the assessee and, subsequently, during any previous year the assessee receives any amount in respect of such loss or expenditure or has obtained some benefit in respect of such trading liability by way of remission or cessation thereof in which event the amount received by him has to be deemed to be profits and gains. On the finding of the Tribunal the condition of section 10(2A) could not be said to have been satisfied and the addition of Rs. 54,479 made by the Income-tax Officer in the assessment for the year 1957-58 was not justified.”

The creditors balance standing as on last day of the relevant year has been carried forward as the opening balance of the creditor in the immediately next year, there was opening balance in the ledger account in the books it could not be said that there was cessation of liability and hence dis-allowance under section 41(1) was not justified. Applying the ratio laid down in the above judgement, it is apparent that before the section 41(1) of the Act can be invoked, it is necessary that allowance or deduction has been granted for any year in respect of loss, expenditure or trading liability and subsequently the assessee obtains, whether in cash or in any other manner, any amount in respect of such trading liability by way of remission or cessation of such liability. However, in the instant case, neither any benefit had accrued to the assessee nor had the assessee claimed any deduction for the said sum and hence the same cannot be deemed to be the profits and gains of a business and as such, there lies no question of applying the provision the provision of section 41(1) of the Act.

The disclosure of debt in the books makes the liability enforceable and thus when the assessee’s liability has subsisted and did not cease, section 41(1) has no application. In order to attract the provisions of section 41(1) of the Act, it is necessary that there should have been a cessation or remission of liability.

In this regard, I would like to mention that the disclosure of creditors by the assessee in its balance sheet amounts to an acknowledgement of the debts in its favor. An acknowledgement of debt in the audited financials makes the liability enforceable in a court of law. Thereby assessee’s liability to the creditors subsisted during the relevant year and had not ceased till the relevant year and as such, the application of section 41(1) is void-ab-initio.

The duly signed balance sheet of the assessee by the directors constitutes an acknowledgement of a legally enforceable debt by the assessee. The assessee has presented the said financials before all the stakeholders including the creditors of the company and thereby it can be said that that a debt shown in a balance sheet of a company is enough to acknowledge debt and such acknowledgement need not be addressed by the creditors. The assessee acknowledges a liability in its financials and claims that the debts are subsisting and it continues to be liable to pay the creditors by disclosing the sum as liability payable in its balance sheet.

Reliance in this regard, is placed upon the decision in the case of Mahabir Cold Storage -vs.- CIT (1991) 188 ITR 91 (SC), wherein the Hon’ble Supreme Court held that the entries in the books of accounts of the assessee would amount to an acknowledgement of the liability as debt. To the same effect, in the case of Ambica Mills Ltd. -vs.- CIT (1964) 54 ITR 167 (Guj.), wherein it was further held that a debt shown in a balance sheet of a company amounts to an acknowledgement of debt and further the balance sheet in which such acknowledgement is made need not be addressed to the creditors.

Similarly, after a detailed analysis of the legal matter and after consideration of various judicial pronouncements, the Hon’ble Delhi High Court in the case of CIT -vs.- Shri Vardhman Overseas Ltd. (2011) 343 ITR 408 (Delhi) held that the acknowledgement made by a company in its balance sheet amounts to acknowledgement of debt. The assessee’s liability to the creditors thus, subsisted and did not cease nor was it remitted by the creditors and thereby section 41(1) was not applicable. The Hon’ble High Court held,

“17…In an early case, in England, in Jones v. Bellgrove Properties [1949] 2KB 700, it was held that a statement in a balance sheet of a company presented to a creditor-share holder of the company and duly signed by the directors constitutes an acknowledgement of the debt. In Mahabir Cold Storage v. CIT [1991] 188 ITR 91, the Supreme Court held:

 “The entries in the books of accounts of the asessee would amount to an acknowledgement of the liability to Messrs. Prayagchand Hanumanmal within the meaning of Section 18 of the Limitation Act, 1963, and extend the period of limitation for the discharge of the liability as debt.”

 In several judgments of this Court, this legal position has been accepted. In Daya Chand Uttam Prakash Jain v. Santosh Devi Sharma [1997] 67 DLT 13, S.N. Kapoor J. applied the principle in a case where the primary question was whether a suit under Order 37 CPC could be filed on the basis of an acknowledgement. In Larsen & Tubro Ltd. v. Commercial Electric Works [1997] 67 DLT 387 a Single Judge of this Court observed that it is well settled that a balance sheet of a company, where the defendants had shown a particular amount as due to the plaintiff, would constitute an acknowledgement within the meaning of Section 18 of the Limitation Act. In Rishi Pal Gupta v. S.J. Knitting & Finishing Mills (P.) Ltd. [1998] 73 DLT 593, the same view was taken. The last two decisions were cited by Geeta Mittal, J. in S.C. Gupta v. Allied Beverages Co. (P.) Ltd. (I.A. No. 7987/2004, decided on 30/4/2007) and it was held that the acknowledgement made by a company in its balance sheet has the effect of extending the period of limitation for the purposes of Section 18 of the Limitation Act. In Ambica Mills Ltd. v. CIT [1964] 54 ITR 167 (Guj.), it was further held that a debt shown in a balance sheet of a company amounts to an acknowledgement for the purpose of Section 19 of the Limitation Act and in order to be so, the balance sheet in which such acknowledgement is made need not be addressed to the creditors. In light of these authorities, it must be held that in the present case, the disclosure by the assessee company in its balance sheet as on 31st March, 2002 of the accounts of the sundry creditors amounts to an acknowledgement of the debts in their favour for the purposes of Section 18 of the Limitation Act. The assessee’s liability to the creditors, thus, subsisted and did not cease nor was it remitted by the creditors. The liability was enforceable in a court of law.”

[Emphasis Added]

In the said case of Shri Vardhman Overseas Ltd. (supra.), the AO had asked the assessee to submit confirmation letter from the sundry creditors but the assessee did not submit the confirmation letters. The AO rejected the assessee’s explanation and added the sum as income. On appeal before the the Hon’ble Delhi High Court, it was held that the amounts payable to the sundry credits were not credited to its profit and loss account for the year and were still shown as outstanding and therefore the provisions of section 41(1) were not attracted. The Court categorically held that though the liability to creditors were outstanding for more than four years, since there was no cessation of liability, section 41(1) has no application and after analyzing various decisions, it was held that the disclosure of liability by the assessee company in its balance sheet amounts to an acknowledgement of the debts and the liability was enforceable in a court of law. The assessee’s liability to the creditors, thus, subsisted and did not cease. The Hon’ble High Court inter alia held that,

16. In our opinion, the judgment of the Supreme Court in Sugauli Sugar Works (P.) Ltd. (supra) is a complete answer to the contention of the learned standing counsel. In the case before the Supreme Court for a period of almost 20 years the liability remained unpaid and this fact formed the basis of the contention of the revenue before the Supreme Court to the effect that having regard to the long lapse of time and in the absence of any steps taken by the creditors to recover the amount, it must be held that there was a cessation of the debts bringing the case within the scope of Section 41(1). In the case before us, the identical contention has been taken on behalf of the revenue, though the period for which the amount remained unpaid to the creditors is much less

[Emphasis Added]

The said case is squarely applicable in the instant case. In the instant case, the appellant had disclosure the liability in its balance sheet  and therefore the same amounts to an acknowledgement of the debt and thus in case where the debt exists there lies no question of remission/cessation and thereby there arises no question of application of section 41(1) of the Act.

Merely because the liabilities were outstanding for long periods it could not be inferred that such liabilities had seized to exist. In this regard, it is submitted that the judgment of the Hon’ble Supreme Court in the case of Sugauli Sugar Works (P.) Ltd. (supra.) is a complete rebuttal answer to the contention of the A.O. In the said case before the Hon’ble Apex Court, the liability had been long outstanding for almost 20 years and the creditor had not taken any step to recover the amount and this fact formed the basis of the contention of the revenue to the effect that having regard to the long lapse of time and in the absence of any steps taken by the creditors to recover the amount, it must be held that there was a cessation of the debts bringing the case within the scope of Section 41(1). The Hon’ble Apex Court held that the amount has been continuously shown by assessee in its balance sheet, it could not be construed as ceased so as to bring it within mischief of section 41(1) of the Act. It cannot be said that the liabilities have ceased to exist on the basis of the fact that the sum is outstanding for a period of 20 years.

In the instant case,  the amount remained unpaid to the creditors is nearly ten years i.e. almost half of the time as before the Hon’ble Supreme Court. The liabilities are outstanding for nearly ten years but there has been no remission/cessation of liability and as such, applying the above ratio laid down in the case of Sugauli Sugar Works (P.) Ltd. (supra.) , it can be said that the section 41(1) is not applicable in the instant case.

Similarly, in the case of CIT vs. Sita Devi Juneja (2010) 325 ITR 593 (P&H) assessee’s balance sheet showed the amount as the liability of Rs. 1.47 crore payable to the creditors. The Hon’ble Punjab & Haryana High Court held that such liability shown in the balance sheet indicated the acknowledgement of the debt payable by the assessee. Merely because such liability was outstanding for the last six years, it could not be presumed that the said liability had ceased to exist in following words,

4…It is the conceded position that in the assessee’s balance sheet, the aforesaid liabilities have been shown, which are payable to the sundry creditors. Such liabilities, shown in the balance sheet, indicate the acknowledgement of the debts payable by the assessee. Merely because, such liability is outstanding for the last six years, it cannot be presumed that the said liabilities have ceased to exist…In view of these facts, the CIT(A) as well as the ITAT have rightly come to the conclusion that the Assessing Officer has wrongly invoked the Explanation I of section 41(1) of the Act and made the aforesaid addition on the basis of presumption, conjectures and surmises. It has been further found that the Assessing Officer failed to show that in any earlier year, allowance of deduction had been in respect of any trading liability incurred by the assessee. It was also not proved that any benefit was obtained by the assessee concerning such trading liability by way of remission or cessation thereof during the concerned year. Thus, there did not accrue any benefit to the assessee which could be deemed to be the profit or gain of the assessee’s business, which would otherwise not be the assessee’s income”

[Emphasis Added]

In light of the same, it can be said that when the liability continues to appear in the balance sheet and the same has been carried forward to the subsequent year, the liability was legally enforceable and thereby there arises no question of remission or cessation of liability and accordingly, section 41(1) is not applicable in the instant case.

Hope it helps!!

In case of any further clarifications, Kindly let me Know at agarwalnitesh03@gmail.com

Limitation: The views expressed herein above are based on facts/assumptions as indicated above. No assurance is given that the revenue/judicial authorities will concur with the above views. The views are based on the existing provisions of law and its interpretation, which are subject to change from time to time. No responsibility is assumed to update the views consequent to such changes. The views should not be considered as a legal opinion. Copying the same without consent is not permitted.

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