Case Law Details
Recently, the Delhi High Court (High Court) in the case of CIT Vs. Whirlpool of India Ltd. (ITA No. 1154 of 2009) (Judgement date: 24 January 2011 Assessment Year 1996- 97) held that additional provision for warranty made was not contingent liability and was allowable as revenue expenditure. Further, the High Court held that such increased provision can be treated as expenditure under Section 37 of the Income-tax Act, 1961 (the Act) since it fulfills the accrual concept as well the matching concept.
Facts of the case
• The taxpayer is manufacturer of refrigerators and deep freezers and offers optional service contract (OSC) for a period of seven years on the machines sold. The amounts received by the taxpayer on account of OSC are included in its income in the year of sale.
• The taxpayer has been consistently making provision for warranty on the basis of actuarial valuation in respect of machines sold during the year. The actual expenditure incurred for warranty claims are deducted against the provision made. Accordingly, the warranty provisions made were shown in the books of accounts and income was calculated after the deduction of the said provision.
• For Assessment Year (AY) 1996-97, the taxpayer experienced shortages in warranty liability account. Accordingly, on the basis of the report undertaken by the independent agency, additional provision of INR 31 million was made in AY 1996-97.
• The Assessing Officer (AO) disallowed this additional warranty provision on the ground that it was a contingent liability. Further, the AO held that the additional warranty provision was ad hoc in nature and having no connection with the sale affected in AY 1996- 97.
Taxpayer’s contentions
• The variations/shortfall in the warranty provision on account of different years has arisen due to various reasons such as increase in cost between the time of provision and the time of actual repair of the machines, the failure rate of machines, available power factor at the disposal of the customers, handling of products by the customers etc. These factors were beyond the taxpayer’s control but routine in the nature of business.
• The taxpayer sold the compressor division during A.Y 1998-99. Hence the repair work of compressor under warranty was to be carried out from outside parties and, therefore, expenses on this account were expected to rise.
Tax department’s contentions
• The tax department relied on the Madras High Court decision in the case of CIT v. Indian Metal and Metallurgical Corporation [1964] 51 ITR 240 (Mad) wherein provision for gratuity payable to the employees, in case of retrenchment, were disallowed.
• The tax department also relied on the Supreme Court’s decisions in the case of Indian Molasses Co. (P) Ltd. v. CIT [1959] 37 ITR 66 (SC) and Shree Sajjan Mills Ltd. v. CIT [1985] 156 ITR 585 (SC)
High Court’s ruling
• Reliance was placed on the Supreme Court’s decision in the case of Rotork Controls India P. Ltd. v. Commissioner of Income-Tax [2009] 314 ITR 62 (SC) wherein it was held that :
-The provision created for estimated warranty claims was a present obligation, which had arisen due to the past event i.e. sale of the equipments.
– The provision made resulted into an outflow of resources i.e. expenses towards repairs and replacement of the equipments, which had been reliably estimated by the taxpayer based on the past trend. Accordingly, the obligation towards warranty was a provision and not a contingent liability.
• Accordingly, the High Court held that whenever there is a warranty clause in the bulk product sold by the taxpayer to its customers, warranty provision made cannot be treated as contingent liability. Moreover, a revision in the provision after considering the warranty period and the existing provision would also be allowed on the principles enumerated above.
• The High Court further relied on the Supreme Court’s decision in the case of CIT v. Woodward Governor India P. Ltd. [2009] 312 ITR 254 (SC) wherein it was held that the accounting method followed by the taxpayer continuously for a given period of time has to be presumed to be correct till the AO comes to the conclusion that the estimate does not reflect true and correct profits.
• The High Court observed that the Supreme Court in the case of Rotork Control India P. Ltd. had distinguished the judgements in the case of Sajjan Mills and Indian Molasses Co., on the basis of facts, which were relied on by the Tax Department.
• The High Court relied on its own decision in the case of CIT v. Vinitec Corporation (P) Ltd. [2005] 278 ITR 337 (Del) wherein it was held that once a liability is accrued, it should be eligible for deduction while working out the profits and gains of business even though it is to be discharged at a future date.
• The taxpayer could not be precluded from revising the provision after considering the fact that existing provision in respect of warranty was short of the expected claims that may be received. The High Court also held that such increased provision can be treated as expenditure under Section 37 of the Act, since it fulfills the accrual concept as well the matching concept.
Our Comments
This is a welcome decision by the Delhi High Court in which it is held that additional provision for warranty made on a scientific basis was not contingent liability and therefore allowable as revenue expenditure.
The Supreme Court in the case of Rotork Control India P. Ltd, by upholding the deductibility of provision for warranty, provided a relief to the manufacturing companies who provide for warranty on a scientific basis in respect of an obligation incurred in the course of regular business. The High Court applying the principle laid down by the Supreme Court held that even additional provision for warranty made was not a contingent liability and accordingly deductible as revenue expenditure.
However, it is important to note that the accounting system followed by the taxpayer should appropriately capture the relationship between the warranty provision and the actual expenditure incurred against the same.
Further, the High Court has stressed on the fact that the provision for warranty should be based on scientific study and actuarial basis.
