Provision for warranty made on scientific way and based on past history is allowed as deduction

Where the provision of warranty was made on scientific way and based on past history it was allowed as deduction: Dell International case

Provisions for expenditures have to be made in the reasonable way otherwise the same may be disallowed while computing the income and tax thereon of an assessee. Recently, in Dell International Services India Pvt. Ltd. vs. DCIT [IT(TP)A No.85/Bang/2014 & CO No.21/Bang/2016 [in IT(TP)A No.1838/Bang/2013] and JCIT vs. Dell International Services India Pvt. Ltd.[ IT(TP)A Nos.1838/Bang/2013 & 1026/Bang/2014],{decided on 13.10.2017}, one of the ground raised by Revenue was that the CIT(A) had  erred in allowing the excess provision towards warranty expenses created by the assessee without appreciating the fact that the AO has clearly brought out the fact that the provision was made in an unscientific way.

Briefly, the assessee was in the business of trading in computer systems besides providing software development services (IT services) and also Information Technology Related Services (ITRS). The AO found from the profit and loss account of the assessee that in arriving at the profits of the business, the Assessee had claimed as deduction a sum of Rs. 4,71,61,000/- towards ‘warranty expenditure’. Out of this amount, a sum of Rs. 2,21,80,000/- was actually paid by the assessee on account of warranty claims made by the customers. Thus the balance amount of Rs. 2,49,81,000/- was only a provision made for possible claims on account of warranty liability. According to the AO, the expenditure being contingent one, the same cannot be allowed as a deduction only computing income from business.

The plea of the Assessee before the AO was that the provision for liability on account of possible warranty claim was made on a scientific basis with minimum margin of error. The Assessee claimed that the liability to incur the expenditure on account of warranty liability was a certain liability and that the quantification of such liability was based on sales made in each year and the quantum of claims on account of warranty liability as a percentage of sales in the past. The assessee also relied on the decision of the Hon’ble ITAT in its own case for the assessment years 2003-04 and 2004-05, wherein similar claim was held to be a liability of the Assessee and allowable as deduction while computing income from business of the Assessee. The Assessee thus claimed that the liability in question was not contingent liability and should be allowed as deduction.

The AO examined the aspect whether the provision by the Assessee on account of warranty liability was made on scientific basis with minimum margin of error. He was of the view that in making a provision on account of warranty liability the Assessee merely adopts a formula and by doing so claims that the liability was an ascertained liability. He was of the view that the estimation made should be more or less equal to the actual expenditure incurred. The AO examined the provision made for liability on account of warranty claims by the Assessee in the past and the actual liability it discharged on account of such claims, which was as follows:

According to the AO, a perusal of the above table showed that the provisions made in each year (which is shown under the head, ‘Accruals during the year), are way off the mark, compared to the actual expenditure (shown under the head ‘payments made during the year). He, therefore, held that when the estimation for the provision is nowhere near the actual expenditure, it cannot be said that the provision is on a scientific basis. It can only be called an ad hoc provision. The fact that the excess provision is written back in the next year does not alter the position in this year. The AO relied on the decision of the Hon’ble Madras High Court in the case of CIT vs. Rotork Controls India Ltd. [293 ITR 311 (Mad)], wherein it was held that if the provision for warranty is made on an ad hoc basis, the same cannot be allowed as a deduction. According to the AO, the provision made by the assessee cannot be said to be on a scientific basis and as such, cannot be allowed as a deduction.

On the argument of the Assessee that the liability of the Assessee on account of warranty liability is a certain liability which had arisen during the relevant previous year, the AO held there was a wide gap in the estimation made by the assessee and the actual expenditure incurred by it later. Therefore at least to the extent of excess provision made it cannot be said that the liability to incur the expenditure has arisen during the year. As far as the assessee’s reliance on the decision in its own case for the earlier years, the AO was of the view that the ITAT’s decision was not accepted by the Department and the matter was agitated before the Hon’ble High Court of Karnataka.

For the above reasons, the AO held that the provision made by the assessee in its books and debited in the profit and loss account, towards warranty expenditure, in excess of the actual expenditure has to be treated as a contingent liability. Accordingly, an amount of Rs.2,49,81,000/-, being the excess provision made, was disallowed and added back to the assessee’s total income.

On appeal by the assessee, the CIT(Appeals) accepted the submission of the assessee that similar disallowance made in assessee’s own case for the AYs 2002-03 & 2003-04 was deleted by the Tribunal and the CIT(A) found that the facts and circumstances under which the disallowance was made in the present assessment year was identical to the facts as it prevailed in AYs 2002-03 & 2003-04. The CIT(Appeals) accordingly deleted the addition made by the AO. The CIT(A) was of the view that provision for warranty as made by the assessee company was in conformity with the ruling of the Hon’ble Supreme Court in the case of Rotork Controls India Pvt. Ltd. vs. CIT, 223 CTR 425.

Before ITAT, the DR pointed out that the AO has clearly brought out in the order of assessment that provision made by the assessee on account of liability towards warranty claim was not made by the assessee on a scientific basis and this finding has not been countered by the assessee before the CIT(Appeals) nor has the CIT(A) given a finding that the provision made by the assessee was scientific.

The counsel for the assessee, on the other hand, brought to notice that in AYs 2002-03 & 2003-04 in ITA Nos.362 & 363/Bang/2007, order dated 18.03.2016, the Tribunal held that provision for warranty made by the assessee was scientific and based on the claim of warranty expenses made in the case of assessee in the past.

The learned Members of the ITAT, Bangalore observed that the basis on which provision for warranty was made by the assessee was that the Assessee has arrived at a model for ascertaining the warranty cost, based on the type of equipment, periodicity of warranty and nature of commitment. The Assessee has a specialized warranty accounting team which tracks the incidents reported for each product country-wise and associated cost of providing warranty services. The total sales are divided into various categories of IT hardware products based on the warranty periods attached to each such product. The faults are tracked on the basis of a unique identification number attached to each IT hardware so as to identify cases of faults. The warrant cost is a product of the Field Incident Rate i.e., the number of repairs and the Cost per Incident. Field Incident Rate is determined based on the actual faults reported over the earlier years, the Cost per Incident is determined a scientific basis based on the past experience, which is the sum of the following:

– Cost of Spare Parts;

– Cost of logistics; and

– Labour

The learned Members further observed that it is not in dispute that the basis on which the provision for warranty was made was identical in AYs 2002-03 & 2003-04 as well as in AY 2005-06. The Tribunal has in the appeal for the AYs 2002-03 & 2003- 04 after considering the method of providing for warranty liability by way of a provision, specified that the provision made was based on past history and was on scientific method of estimating liability on account of warranty claims. It is clear from the chart which has been extracted in the order of assessment that as and when the period of warranty expires, the assessee writes back the provision made in the books of account to the extent it relates to the warranty liability which the assessee does not incur and which was already provided by way of a provision and allowed as deduction in the past. It appears to us that the provision made by the assessee is scientific and is based on past history. The learned Members held that we are also of the view that in view of the parity of basis of provision of warranty in AYs 2002-03 & 2003-04 and AY 2005-06, the ruling of the Tribunal in AYs 2002-03 & 2003-04 is squarely applicable to AY 2005-06 also. The ground raised by the Revenue was dismissed.