Manish Kumar Agarwal, FCA
We have to make provision for various expenses based on the estimates at the year end as we are following the accrual system of accounting. But the income tax department was disallowing the same on the ground that same being contingent in nature and hence not allowable. Here are some of the case study and opinion in this respect.
1. The assessee company would like to refer the Hon’ble Supreme Court decision in the case of Calcutta Co. Limited v CIT ( 37 ITR 1). The summary of the facts & decisions of the this case is given below.
Section 28(i) , read with section 145 of the Income-tax Act, 1961 (Corresponding to section 10(1), read with section 13 of the Indian Income-tax Act, 1922) – Business deductions – Allowable as – Assessment year 1948-49 – Asessee dealt in land and property and carried on land developing business – It maintained its accounts in mercantile method – In relevant accounting period it sold certain plots and even though assessee received only a portion of sale price, it entered in credit side of its account books whole of sale price of plots – Under terms of side deeds assessee undertook to carryout developments within six months from date of sale – Accordingly, it estimated a sum as expenditure for developments to be carried out in respect of plots sold out during relevant year and debited said sum in its books of account as accrued liability – Department did not take any exception to said estimated expenditure in regard to quantum but disallowed assessee’s claim for deduction of that sum by relying upon provisions of section 10(2) of 1922 Act – Whether estimated expenditure which had to be incurred by assessee in discharging a liability which it had already undertaken under terms of sale-deeds of lands in question was an accrued liability which according to mercantile system of accounting assessee was entitled to debit in its books of account for accounting year as against receipts which represented sale proceeds of said lands – Held, yes
2. The same was also confirmed in the case of F.F.E. Minerals India (P) Limited v JCIT (142 Taxmann 110). The summary of the facts & decisions of the same is given below.
Section 28(i) of the Income-tax Act, 1961 – Business loss/deduction – Allowable as – Assessment years 1997-98 and 1998-99 – Assessee-company claimed deduction for damages in computing its income as soon as delay in supply was noticed and case of under-performance remained at end of respective previous years – Claims in books were based on terms of contract between parties – Tribunal confirmed disallowance of claims as made by authorities below – Whether since in view of decision of Supreme Court in case of Calcutta Co. Ltd. v. CIT  37 ITR 1, liability arising out of contract should be allowed as and when it arises and should not be postponed to a later date, deduction claimed by assessee was allowable – Held, yes
3. The assessee company would like also to quote the recent decision of Jharkhand High Court in the case of TRF Limited v CIT (TAX APPEAL NOS. 42 TO 46 OF 2001). The summary of the facts & decisions of the same is given below.
Section 37(1), read with section 145, of the Income-tax Act, 1961 – Business expenditure – Year in which deductible – Assessment years 1991-92 to 1995-96 – Assessee-company was awarded a contract by Rourkela Steel Plant for modernization of coal handling plant, work related to structural fabrication, erection, dismantling and modification – It had given work to PECO on sub-contract basis – After commencement of work, PECO found sub-contract not profitable and expressed inability to work – In order to retain PECO to complete work, assessee agreed to enhance stipulated rates and to provide additional facilities such as labour payment, supply of consumables, etc., value of which was to be adjusted against revised rates – Accordingly, assessee, from time-to-time, made payments towards aforesaid facilities on actual basis of work completed – Assessee raised bills on Rourkela Steel Plant for work done during each year, value of which was duly credited to profit and loss account of that year in accordance with mercantile system of accounting followed by it – Accordingly, it made a provision in each year for additional liability based on extra payments made to PECO for work done and claimed deduction thereof – Revenue authorities disallowed deduction on ground that additional payment made by assessee was only an advance payment and same became liability only on final settlement arrived at between parties on 28-7-1997 – On appeal, Tribunal upheld disallowance – Whether since as per mercantile system of accounting, income from Rourkela Steel Plant was duly included in profit and loss account in respective years according to work done, expenditure incurred for earning such income was deductable even on estimated basis for arriving at true income – Held, yes – Whether assessee’s claim was to be upheld – Held, yes
4. The facts & decisions of CIT v Triveni Engineering & Industries Limited (196 Taxmann 94) case is given below.
Section 37(1) of the Income-tax Act, 1961 – Business expenditure – Year in which deductible – Assessment year 2000-01 – Assessee was following ‘revenue recognition’ accounting policy consistently as per which profit on its project related activities was recognized on completion or on substantial completion of project – During relevant assessment year, assessee credited profit and loss account by income in respect of projects completed/substantially completed during year – It also made provision for expenses to be incurred up to stage of completion – Assessing Officer held that such a liability, to be incurred on a future date, was a contingent liability and, therefore, could not be allowed under section 37(1) – On appeal, Tribunal allowed assessee’s claim – Whether when admittedly, expenditure incurred by assessee on project was admissible deduction and only dispute was regarding year of allowability of expenditure, considering that assessee was a company assessed at uniform rate of tax, entire exercise of seeking to disturb year of allowability of expenditure would, in any case, be revenue neutral – Held, yes – Whether therefore, no substantial question of law arose in instant case and appeal was to be dismissed – Held, yes
5. With respect to the above case, the assessee company humbly submits that in case provision for aforesaid expenses not allowed in one year, they are going to be allowed in another year and hence the effect of same is neutral.
6. Further, Provision for Warranty is allowable expenditure based on the following judgments.
- Himalaya Machinery (P) Limited v DCIT 334 ITR 64
- CIT vs. Luk India P. Ltd. 52 DTR 117.
- Siemens Public communication Networks Limited v CIT
- Rotork Controls India P. Ltd. (2009) 314 ITR 62 (SC).
- CIT v Indian Transformer Limited. 270 ITR 259
7. Also, Provision for foreign exchange loss is allowable expenditure based on the following judgments.
- DCIT v Bank of Baharain & Kuwait
- Woodword Governor 294 DTR 451
- Diamonds R US v DCIT 9 Taxmann.com 67.
- LG Electronics India (P) Limited 309 ITR 265.
- Oil & Natural Gas Corporation Limited v CIT. Civil Appeal No. 7223 of 2008 dated March 15, 2010.
8. At last, Section 145 of the Income Tax Act, 1961 prescribes the method of accounting to be followed by the assessee for computing income chargeable under the head ‘Profits and gains of business or profession’. Section 145(1) states that the computation would be ‘in accordance with either cash or mercantile system of accounting regularly employed by the assessee.’ Section 145(2) further states that the Central Government may notify from time to time ‘accounting standards to be followed by any class of assessee’s or in respect of any class of income.’ The mercantile system, as distinguished from the cash system brings in the concept of accrual of liability or income in the relevant previous year which is the subject-matter of the assessment. The liability is reflected even where there is no actual expenditure; likewise the income is reflected even where there is no actual receipt of money. Moreover, section 209(3) of the Companies Act, 1956 makes it mandatory for companies to keep accounts on accrual basis only.
9. Finally, the accounting standards issued by the ICAI require that accounting policies must be governed by the principle of ‘prudence’. In other words, ‘Provisions should be made for all known liabilities and losses even though the amount cannot be determined with certainty and represents only the basic estimate in the light of available information’. Para 6 of Accounting Standard 1 defines accrual as ‘the assumption that revenues and costs are accrued, that is, recognised as they are earned or incurred (and not as money is received or paid) and recorded in the financial statements of the periods to which they relate.’ What is required, therefore, is that all anticipated liabilities and foreseeable losses have to be provided for, while caution is to be exercised against accounting for unearned gains. Ultimately the emphasis is on presenting a true and correct state of affairs of the company as a going concern. This explains why, for instance, the valuation of closing stock as on the date of the balance sheet, is done at cost or market value, whichever is lower. Where the market value is lower than the cost, valuation at market value reflects the anticipated loss. On the other hand, where the market value is higher than the cost, the unrealised gains are not accounted for.
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