Leave Encashment allowed on payment basis: SC Judgment Analysis

Leave Encashment is allowed on payment basis under Section 43B in Income Tax Act, 1961 – Analysis with Hon’ble Supreme Court recent decision in the case of Union of India & Ors. Vs Exide Industries Limited & Anr.

In computation of income under the head Profits and gains of business or profession (PGBP), some of the expenses are allowed under Income Tax Act 1961 and can be claimed by the assessee only in the year in which the payment is actually made. The following deductions are specified in this section.

a) Any tax, duty, cess or fee paid under any law in force is allowed as a deduction when it is paid- this includes GST, customs duty or any other taxes or cesses paid. Interest paid on these taxes are also eligible for deduction.

b) Contribution to any recognized employee’s benefit fund: contribution by the employer to any employee’s benefit fund namely PF fund, superannuation fund, gratuity fund before the due date for depositing those funds or before the due date of filing income tax returns

c) Bonus or commission payable to employees- this amount should be the actual bonus/ commission paid to employees and not dividends payable to them as shareholders.

d) Interest on borrowings from Public Financial Institutions or State Financial Corporation in accordance with the conditions governing such loan

e) Interest on loans and advances from Scheduled Bank in accordance with the conditions governing such loan

f) Leave encashment provided by an employer to his employees

g) Payment to Indian Railways

When the interests mentioned in the clause d and e have been converted into a loan then such conversion does not amount to payment of interest which is deductible.

Introduction of Section 43B(f):

Clause (f) to sec 43B provides that any sum payable by an employer in lieu of leave at the credit of his employee shall be allowed only on actual payment and not on mere provision. This clause was inserted by the Finance Act, 2001, w.e.f 1/4/2002, i.e., A.Y. 2002-03.

Contrary to Section 43B (f) of the Act, the Hon’ble Supreme Court held that the even thought the provision made on leave encashment is allowed as deduction in the year in which the provision made. The extract of the judgement reads as under:

 Bharat Earth Movers vs Commissioner Of Income Tax(2000) 112 TAXMAN 61 (SC), (2000) 245 ITR 428 (SC), (2000) 162 CTR 325 (SC) dated 09.0.2000 it was  held that:

“4. The law is settled; if a business liability has definitely arisen in the accounting year, the deduction should be allowed although the liability may have to be quantified and discharged at a future date. What should be certain is the incurring of the liability. It should also be capable of being estimated with reasonable certainty though the actual quantification may not be possible. If these requirements are satisfied the liability is not a contingent one. The liability is in praesenti though it will be discharged at a future date. It does not make any difference if the future date on which the liability shall have to be discharged is not certain.

 5. In Metal Box Co. of India Ltd. vs. Their Workmen (1969) 73 ITR 53 (SC) the appellant company estimated its liability under two gratuity schemes framed by the company and the amount of liability was deducted from the gross receipts in the P&L a/c. The company had worked out on an actuarial valuation its estimated liability and made provision for such liability not all at once but spread over a number of years. The practice followed by the company was that every year the company worked out the additional liability incurred by it on the employees putting in every additional year of service. The gratuity was payable on the termination of an employee’s service either due to retirement, death or termination of service—the exact time of occurrence of the latter two events being not determinable with exactitude beforehand. A few principles were laid down by this Court, the relevant of which for our purpose are extracted and reproduced as under : 

(i) For an assessee maintaining his accounts on mercantile system, a liability already accrued, though to be discharged at a future date, would be a proper deduction while working out the profits and gains of his business, regard being had to the accepted principles of commercial practice and accountancy. It is not as if such deduction is permissible only in case of amounts actually expended or paid; 

(ii) Just as receipts, though not actual receipts but accrued due are brought in for income-tax assessment, so also liabilities accrued due would be taken into account while working out the profits and gains of the business; 

(iii) A condition subsequent, the fulfilment of which may result in the reduction or even extinction of the liability, would not have the effect of converting that liability into a contingent liability. 

(iv) A trader computing his taxable profits for a particular year may properly deduct not only the payments actually made to his employees but also the present value of any payments in respect of their services in that year to be made in a subsequent year if it can be satisfactorily estimated. 

So is the view taken in Calcutta Co. Ltd. vs. CIT (1959) 37 ITR 1 (SC) : TC 16R.197 wherein this Court has held that the liability on the assessee having been imported, the liability would be an accrued liability and would not convert into a conditional one merely because the liability was to be discharged at a future date. There may be some difficulty in the estimation thereof but that would not convert the accrued liability into a conditional one; it was always open to the tax authorities concerned to arrive at a proper estimate of the liability having regard to all the circumstances of the case.

 6. Applying the abovesaid settled principles to the facts of the case at hand we are satisfied that provision made by the appellant company for meeting the liability incurred by it under the leave encashment scheme proportionate with the entitlement earned by employees of the company, inclusive of the officers and the staff, subject to the ceiling on accumulation as applicable on the relevant date, is entitled to deduction out of the gross receipts for the accounting year during which the provision is made for the liability. The liability is not a contingent liability. The High Court was not right in taking the view to the contrary.

 7. The appeal is allowed. The judgment under appeal is set aside. The question referred by the Tribunal to the High Court is answered in the affirmative, i.e., in favour of the assessee and against the Revenue.”

Present Position on Leave Encashment:

In the case of Exide Industries Ltd v. UOI (2007) 292 ITR 470 (Cal), it was held that the provision for leave encashment cannot be disallowed under sec 43B(f) of the Act. The Calcutta High Court in Exide Industries Ltd v. UOI after referring to the decision of Bharat Earth Movers v. CIT (2000) 245 ITR 428 (SC)held that amendment to sec 43B(f) was not constitutionally valid. The Court held the provision to be arbitrary and vulnerable, because there was no disclosure of reasons for the amendment. The High Court ruled that, while the Legislature was free to make such amendments, reasons therefor should be inferable and such reasons should be consistent with the provisions of the Constitution and the laws of the land.

However, the Revenue has challenged the above case before the Apex Court.  The Hon’ble court held and delivered the Judgment on 24.04.2020 upholds its constitutional validity of leave encashment disallowance u/s. 43B of The Act:  The extract of the judgment is extracted as under:

 Union of India vs M/S Exide Industries Ltd. On 24 April, 2020 [Civil Appeal No.3545/2009 dated 24.04.2020]

“Defeating the dictum in Bharat Earth Movers case and held as under:

35. We shall now examine clause (f) on the ground that it defeats the judgment of this Court in Bharat Earth Movers (supra). We have carefully analysed the decision in Bharat Earth Movers (supra) and note that the Court was sitting in appeal over the nature of liability under the leave encashment scheme and held such liability to be a present liability. Resultantly, it became deductible from the profit and loss account of the assessee in the same accounting year in which provision against the same is made. The Court rejected that leave encashment liability is a contingent one and observed thus:

“7. Applying the above said settled principles to the facts of the case at hand we are satisfied that provision made by the appellant Company for meeting the liability incurred by it under the leave encashment scheme proportionate with the entitlement earned by employees of the Company, inclusive of the officers and the staff, subject to the ceiling on accumulation as applicable on the relevant date, is entitled to deduction out of the gross receipts for the accounting year during which the provision is made for the liability. The liability is not a contingent liability. The High Court was not right in taking the view to the contrary.”

36. Before the judgment in Bharat Earth Movers (supra), various tribunals and High Courts across the country were treating the liability in lieu of leave encashment as a contingent liability. This did not go down well with the assessees following the mercantile accounting system, as they were not able to avail deductions upon mere creation of a provision against such liability without making the actual payment. A challenge to this legal position reached before this Court in Bharat Earth Movers (supra), wherein the Court reversed the position.

37. It is no doubt true that the legislature cannot sit over a judgment of this Court or so to speak overrule it. There cannot be any declaration of invalidating a judgment of the Court without altering the legal basis of the judgment ­ as a judgment is delivered with strict regard to the enactment as applicable at the relevant time. However, once the enactment itself stands corrected, the basic cause of adjudication stands altered and necessary effect follows the same. A legislative body is not supposed to be in possession of a heavenly wisdom so as to contemplate all possible exigencies of their enactment. As and when the legislature decides to solve a problem, it has multiple solutions on the table. At this stage, the Parliament exercises its legislative wisdom to shortlist the most desirable solution and enacts a law to that effect. It is in the nature of a ‘trial and error’ exercise and we must note that a law­making body, particularly in statutes of fiscal nature, is duly empowered to undertake such an exercise as long as the concern of legislative competence does not come into doubt. Upon the law coming into force, it becomes operative in the public domain and opens itself to any review under Part III as and when it is found to be plagued with infirmities. Upon being invalidated by the Court, the legislature is free to diagnose such law and alter the invalid elements thereof. In doing so, the legislature is not declaring the opinion of the Court to be invalid.

39. Reverting to the true effect of the reported judgment under consideration, it was rendered in light of general dispensation of autonomy of the assessee to follow cash or mercantile system of accounting prevailing   at   the   relevant   time,   in   absence   of   an express statutory provision to do so differently.  It is an authority on the nature of the liability of leave encashment in terms of the earlier dispensation.  In absence of any such provision, the sole operative   provision   was   Section   145(1)   of   the   1961   Act   that allowed   complete   autonomy   to   the   assessee   to   follow   the mercantile   system.     Now   a   limited   change   has   been   brought about by the insertion of clause (f) in Section 43B and nothing more.   It applies prospectively.   Merely because a liability has been held to be a present liability qualifying for instant deduction in terms of the applicable provisions at the relevant time does not ipso facto signify that deduction against such liability cannot be regulated by a law made by Parliament prospectively.  In matter of statutory deductions, it is open to the legislature to withdraw the same prospectively.   In other words, once the Finance Act, 2001 was duly passed by the Parliament inserting clause (f) in Section 43B with prospective effect, the deduction against the liability of leave encashment stood regulated in the manner so prescribed. Be it noted that the amendment does not reverse the nature of the liability nor has it taken away the deduction as such.  The liability of leave encashment continues to be a present liability as per the mercantile system of accounting.  Further, the insertion of clause (f) has not extinguished the autonomy of the assessee to follow the mercantile system.   It merely defers the benefit of deduction to be availed by the assessee for the purpose of computing his taxable income and links it to the date of actual payment thereof to the employee concerned.  Thus, the only effect of the insertion of clause (f) is to regulate the stated deduction by putting it in a special provision.

40. Notably, this regulatory   measure   is   in   sync   with   other deductions specified in Section 43B, which are also present and accrued liabilities.  To wit, the liability in lieu of tax,duty, cess,bonus,   commission   etc.   also   arise   in   the   present   as   per   them ercantile system, but assessees used to defer payment there of despite   claiming   deductions   there against   under   the   guise   ofmercantile system of accounting.  Resultantly, irrespective of the category of liability, such deductions were regulated by law under the aegis of Section 43B, keeping in mind the peculiar exigencies of fiscal affairs and underlying concerns of public revenue.   A priori, merely because a certain liability has been declared to be a present liability by the Court as per the prevailing enactment, it does not follow that legislature is denuded of its power to correct the mischief with prospective effect, including to create a new liability,   exempt   an   existing   liability,   create   a   deduction   or subject   an   existing   deduction   to   new   regulatory   measures. Strictly   speaking,   the   Court   cannot   venture   into   hypothetical spheres   while   adjudging   constitutionality   of   a   duly   enacted provision   and   unfounded   limitations   cannot   be   read   into   the process of judicial review.  A priori, the plea that clause (f) has been enacted with the sole purpose to defeat the judgment of this Court is misconceived.

41. The position of law discussed above leaves no manner of doubtasregards the legitimacy of enacting clause (f).The respondents haven either made a case of non­ existence of competencenor demonstratedany constitutional infirmity inclause (f).

In view of the clear legal position explicated above, this appeal deserves to be allowed. Accordingly,the impugned judgment of the Division Bench of the High Court is reversed and clause (f) in Section 43B of the 1961 Act is held to be constitutionally valid and operative for all purposes. No order as to costs.Pending interlocutory applications,if any, shall stand disposed of.”

Conclusion:  The Apex Court upholds constitutional validity of Sec. 43B(f) providing for leave encashment disallowance, reverses Calcutta HC judgement in Exide Industries Ltd. holding the provisions of Sec.43B(f) as arbitrary & unconstitutional. Rejects assessee’s stand that Sec. 43B disallowance comes into operation only in cases covering statutory liabilities like tax, duty, cess etc. and other liabilities created for the welfare of employees and therefore, the liability under the leave encashment scheme being a trading liability cannot be subjected to such disallowance. The hon’ble Court remarks “the broad objective of enacting Section 43B concerning specified deductions referred to therein was to protect larger public interest primarily of revenue including welfare of the employees and Clause (f) fit into that scheme and shared sufficient nexus with the broad objective.”; With respect to assessee’s strong reliance on co-ordinate bench ruling in Bharati Earth Movers case, SC accepts that the legislature cannot sit over a judgment of SC or overrule it, however, holds that “once the enactment itself stands corrected, the basic cause of adjudication stands altered and necessary effect follows the same.”