Introduction:

Section 41(1) provides for taxing any amount benefit which was obtained by a person with respect to any loss, expenditure or trading liability incurred in any earlier Assessment Years. The Section is re-produced as under:-

“ 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,-

(a)   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 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

(b)  the successor in business has obtained, whether in cash or in any other manner whatsoever, any amount in respect of which loss or expenditure was incurred by the first-mentioned person or some benefit in respect of the trading liability referred to in clause (a) by way of remission or cessation thereof, the amount obtained by the successor in business or the value of benefit accruing to the successor in business shall be deemed to be profits and gains of the business or profession, and accordingly chargeable to income tax as the income of that previous year.

[Explantion-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 sub­section by way of writing off such liability in his accounts.]

[Explantion-2:- For the purposes of this sub-section, ”successor in business” means:-

i) where there has been an amalgamation of a company with another company, the amalgamated company;

ii) where the first-mentioned person is succeeded by any other person in that business or profession, the other persons;

iii) where a firm carrying on a business or profession is succeeded by another firm, the other firm;

iv)  where there has been a demerger, the resulting company.”

2. Loss, Expenditure and trading liability:

2.1 In order to invoke Section 41(1), it is not sufficient that an allowance or deduction have been granted in assessment to the assessee in an earlier year, it is also necessary that the allowance or deduction so granted should relate to a “loss expenditure or trading liability.”

2.2 Loss:

The expression ‘loss’ is normally used to denote the minus figure resulting in the trading and reflected in the Profit & Loss A/c. However, even in a case of profit, there may be individual items of losses which may be embedded in the P&L A/c. These losses are called ‘itemized’ losses, for eg. Loss of stocking trade by fire, loss of capital or money by embedment etc. Section 41(1) of the I.T. Act deals with losses of such itemized losses.

2.3 Expenditure:

Section 41(1) of the I.T. Act does not concern itself with the validity or otherwise of an expenditure. It comes into operation the moment that the assessee obtains some amount in respect of any expenditure which have been allowed as deduction in an earlier year. What is material is the allowance or deduction in an earlier year and not the validity or the nature of expenditure. In the case of Nectar Beverages Pvt. Ltd. Vs. DCIT (2004) 267ITR 385(BOM) the assessee company deriving income from sale of soft drinks had purchased bottles and crates and had been allowed 100% depreciation under Section 32(1)(ii) and then sold those bottled and crates as scrap in the accounting year relevant to Assessment Year 1991-92. It was held that amount obtained was deemed profits and gains of business under Section 41(1) and was chargeable to tax.

2.4 Trading liability:

The concept of trading liability is relevant and arises only where the assessee follows mercantile system of accounting in so far as the provisions of Section 41(1) are concerned. As regards the other 2 items namely viz. “Loss” and “expenditure”, the section would apply irrespective of the method of counting followed.

3. Allowance or Deduction :

3.1 Allowance in earlier year:

Section 41(1) would not be attracted unless deduction or allowances has been made in the assessment of an earlier year . In the case of Swan Ltd. Vs. CIT (1995) 215 ITR 1 (BOM), assessee was allowed gratuity liability on accrual basis. Later on he switched over to cash system and wrote back the liability to P&L A/c. Cessation of liability was held to be chargeable under Section 41(1). According to the decision in the case of Mysore Thermo Electric Pvt. Ltd. Vs. CIT (1996) 221 ITR 504 (KAR), provisions of Section 41(1) can be invoked to tax the refunds of Excise Duty received even when the part of Excise Duty was not claimed as expenditure in the P & L A/c. of earlier years and the applicant had kept a separate account in respect of collection and demand of excise duty.

3.2 Actual Allowance:

One of the conditions for invoking Section 41(1), is that the allowance or deduction should have been actually allowed in the earlier assessment years. Section 41(1) envisages actual allowance or deduction are not a notional one. In the case of CIT Vs. AVM Ltd. (1984) 146 ITR 355 (MAD) , the transfer of unclaimed security deposits in a later year to P&L A/c. was held not to attract Section 41(1) since no actual allowance or deduction was earlier granted.

3.3. Burden of proof:

3.3.1 The burden lies on the Department to prove that such allowance or deduction has been made (Steel & General Mills Co. Ltd. Vs. CIT – 96 ITR 438) The section does not warrant a detailed enquiry whereby an assessee is called up on to produce his books of accounts and other documents to establish his case. Any direction to the assessee to produce his accounts and other documents related to the years in which the allowance was supposed to have been granted is not justified. [CIT Vs. ANCHERRY PAVOO KAKKU (1986) 160 ITR 88 (KER)]. Hence it is suggested that the Assessing Officers would verify the records available with the department in order to prove the allowance or deduction in any earlier assessment year.

3.3.2 However, the burden of proving that the liability did not cease and still subsists lies on the assessee [CIT Vs. Haryana Co-operative Sugar Mills Ltd.(1985) 154 ITR 751(P&H) Kesoram Industries & Cotton Mills Ltd. Vs. CIT (1992) 196 ITR 845 (CAL)].

4. Nexus between amount obtained and loss etc. allowed:

One of the conditions for attracting Section 41(1) of the I.T. Act is that the assessee should have obtained some amount in respect of the loss or expenditure or some benefit in respect of the trading liability by way of remission or cessation. The word “Such” appearing in the second part of Section 41(1) signifies that the amount of compensation or other amount must have been received in respect of the loss, expenditure or trading liability mentioned in the first part of Section 41(1) and there should be nexus between them. So long as the assessee obtains a refund of the amount for which deduction or allowance was granted earlier, the provisions of Section 41 (1) stand attracted and it is not necessary that amount refunded should be of the same nature as the amount earlier paid. In Panyam Cements and Mineral Industries Vs. Addl.CIT (1979) 117 ITR 770 (AP), the State Government granted subsidy in respect of power tariff as a result of which the assessee obtained refunds of certain amount in respect of Electricity charges paid earlier to Electricity Board and it was held that the amounts so received back was taxable under Section 41(1). In CIT Vs. Sahney Steel & Press Works Ltd. (1985) 152 ITR 39 (AP), the Sales Tax paid by the assessee was allowed as deduction. Part of it was refunded under G.O. issued by the Government with a view to speed up industrial development of the State and the amount of refund was required to be used specifically for the development of industry. It was held that the words “any amounts” and “ in respect of” indicated that it was not necessary that Sales Tax paid by assessee should be refunded as sales tax only and it was immaterial that refund was made under an altogether different scheme of a different Department of Government. What was necessary was that the refund should represent “amount obtained in respect of expenditure” which was allowed as deduction.

This view was subsequently affirmed by the Supreme Court in Sahney Steel & Press Works Ltd. Vs. CIT (1997) 142 CTR (SC) 261.

5. Treatment of refund of Sales Tax, Excise Duty etc: 5.1 Trading receipt:

It is now well settled that sales tax collected by the trader is his trading receipt irrespective of the fact whether there is liability for payment under the relevant Sales Tax Act. Refund of sales tax in a subsequent year which was paid in the earlier year to the Government and allowed as deduction would be deemed to be income under Section 41(1). [CIT Vs. Taj Gas Service (1980) 122 ITR 1034 (ALL)]. On the same principle refund of Excise Duty would be deemed as income under Section 41(1) [ D.V. Aswathiah & Bros. Vs. CIT (1993) 201 ITR 711 (ALL)].

5.2 Pending appeals:

The controversy on the question of taxability of refund of excise duty obtained by the assessee when appeal against refund by Excise Department is pending, has been settled by hon’ble Supreme Court in Poly Flex (India)(P) Ltd. Vs. CIT (2002) 257 ITR 343 (SC). It was held that where the assessee obtained refund of excise duty during the relevant previous year, the amount of refund was taxable irrespective of the fact that the Special Leave Petition filed by Excise Department against the grant of refund is pending. Following the above decision it was held that refund of sales tax received by assessee during the relevant year is chargeable to tax irrespective of the fact that the Dept. of Revenue has filed an appeal against the decision of the High Court [CIT Vs. Kwality Ice-cream (2008) 304 ITR 384 (DEL)].

5.3 Unpaid Sales Tax :

In the case of CIT Vs. Markanda Vanspati Mill Ltd. (2009) 311 ITR 306 (P & H)], it has been held that amount collected towards Sales Tax which remained unpaid and unpayable to the Department, which was also not refunded to the customers, was liable to be treated as income in the hands of the assessee under Section 41(1).

5.4 Liability towards customers:

In some cases, submissions have been made to contend that at the time of receipt of refund from the Government, the liability to pass on the refund to the customers subsists. Hence the amount of refund cannot be treated as deemed income under Section 41(1). The High Courts have given different decisions both in favour and against this view. In the case of CIT Vs. Saraswati Industrial Syndicate Ltd. (1973) 91 ITR 501 (PUN), the High Court held that the amount collected as Sales Tax was a trading receipt and chargeable to tax. If and when the purchaser demanded the amount of refund and the assessee made actual payment, it would be open to him to claim relief in subsequent years. The Supreme Court, in Tirumalai Swami & Sons (1998) 146 CTR (SC) 529, held that the entire amount of sales turnover of the assessee inclusive of the amount of tax collected was clearly includible in the assessee’s taxable income. If any deduction was given from that income and later the same was refunded back to the assessee, the refund will have the character of revenue receipt. It has to be treated as a receipt on the revenue account and had to be assessed as such . The position has been placed beyond doubt by the express provisions of Section 41(1). Admitted, the assessee had not refunded any part of this amount to any one of its customers in the year of account. As and when such refund is made, the assessee will be entitled to claim deduction.

5.5 Refund of Excise Duty:

Refund of Excise Duty received during the relevant assessment year would be taxable in that year and mere show cause notice to dispute such refund can not be interpreted to mean that income is not taxable during said year. The assessee shall be entitled to claim expenditure of such excise duty, if it is found payable in pursuance of the show cause notices during the Assessment Year in which such liability is discharged. CIT Vs. Agarwal Steel Rolling Mills (2010) 321 ITR 290 (P&H), following the decision in Poly Flex India P. Ltd. Vs. CIT (2002) 257 ITR 343 (SC).

6. Remission or Cessation of Trading Liability:

6.1 The remission of the liability arises when the creditor voluntarily gives up the claim . It is a positive act of the creditor. The cessation of the liability arises only when such liability ceases to exist in the eye of law for all intents and purposes.

6.2 Liability shown in the Balance Sheet:

In some cases the assessee may be showing certain liability in the Balance Sheet year after year. However, Section 41(1) cannot be applied in each such cases, just because the liability is existing for so many years. In the case of CIT Vs. Tamil Nadu Warehousing Corporation (2007) 212 CTR (MAD) 228, an amount representing liability was being shown year after year. It was held that unless and until there is cessation of said liability, Section 41 (1) was not applicable. Since there was no evidence of cessation of liability, the amount was held not assessable as income. In the case of CIT Vs. Smt. Sitadevi Juneja (2010) 325 ITR 593 (P&H), it was held that assessee having shown the impugned liabilities in its balance sheet and filed copies of account of sundry creditors signed by the concerned creditor, such liabilities cannot be treated to have ceased merely because they are outstanding for six years and therefore, the addition made by invoking Section 41(1) cannot be sustained.

6.3 In the case of CIT Vs. Modern Farm Services (2007) 207 CTR (P&H) 466, it was held that the amount credited in the Post Warranty Service Scheme Account for more than 3 years from the date of credit has to be treated as income. Any refund claimed by any purchaser would be a permissible deduction in the subsequent years. The plea of the assessee that the amount had not be transferred to P & L A/c., did not make a difference on principle. Considering the terms of the Post Warranty Service Contract , the amount remaining credited in the account for more than 3 years from the date of credit has to be treated as income for the year.

6.4 Remission or Cessation by Unilateral Act:

The Finance Act, 1997 w.e.f. 1/4/1997 has inserted Explanation-I, which provides for inclusion of remission or cessation of any liability by any Unilateral Act of the assessee. This explanation is applicable to A.Y. 1997-98 and subsequent assessment years but not the earlier assessment year. Hence, as far as earlier years are concerned, the legal position is that Unilateral entry in the accounts transferring amounts representing unclaimed balances to P & L A/c. would not attract Section 41(1) of the I.T. Act.

7. Treatment of loans and Interest:

Assessee transferred the credit entries to the partner’s Capital Accounts thereby neutralizing the liability towards creditors. The assessee’s explanation was that the creditors who were relatives, gifted these amounts to the partners. The Court held that on such transfer, the assessee ceased to be liable for the interest liability which was claimed as deduction in the previous years. Therefore the cessation of liability in respect of interest credited to the account of the creditors was assessable under Section 41(1). [Shree Hanuman Trading Co. Vs. ITO (2010) 328 ITR 662 (KAR)].

8. Penalty for concealment :

When the assessee does not show the amount taxable under Section 41(1) in its return of income, penalty would be leviable under Section 271(1)(c) for concealment. Once the income has accrued, whether it has actually accrued or deemed to have accrued will not make any difference. As per the provisions of Section 5 (1) of the I.T. Act, 1961, the total income of the previous year, includes all income received or deemed to be received or accrued in India. [CIT Vs. Shri Sai Prakash (1990) 83 CTR (P&H) 181].

9. Method of accounting:

The provisions of Section 41(1) can be invoked both in the case of assessee following the mercantile system of accounting as well as those having the cash system of accounting. For invoking Section 41(1) the system of accounting is not relevant. [ Visnagar Taluka Audyogik Sahakari Mandali Ltd. Vs. CIT (2000) 242 ITR 627 (GUJ)].

10. Applicability of the section in BIFR cases:

10.1 CBDT originally issued Circular No. 523 dated 5/10/1988. As per the circular, if BIFR sanctions a scheme under Section 17(3) of the Sick Industrial Companies (Special Provisions) Act, 1985, specifically excluding the application of Section 41(1) of the Act, then the Assessing Officer will have to take due cognizance of this order and give effect to the same. Subsequently the above circular was withdrawn by another Circular No.683 dated 8/6/1994 (208 ITR St. 98).

10.2 In view of the last circular on the subject as above, the BIFR makes only recommendation, which may or may not be accepted by the CBDT. According to Section 19 (2) of Sick Industrial Companies (Special Provisions) Act, 1985, all parties concerned with giving financial assistance for the rehabilitation scheme should give their “consent”. Each individual case will be considered on merits for the purpose of ‘consent’ as contemplated in Section 19(2) of the Sick Industrial Companies (Special Provisions) Act, 1985 and consent or denial will be contemplated to the BIFR by the Central Government. In view of the above, Section 41(1) is applicable even in BIFR cases, unless the CBDT has consented to the provision limiting/excluding the liability under Section 41(1).

11. Section 59 of the I.T. Act.

Section 59 of the I.T.Act,1961 provides for charging of any profits with respect to Section 56 as under:

“The provisions of sub-section (1) of Section 41 shall apply, so far as may be, in computing the income of an assessee under Section 56, as they apply in computing the income of an assessee under the head ‘Profits and gains of business or profession’ ”

12. Action points for Assessing Officer:

  • Assessing officer should look into the Profit & Loss A/c. and see whether any itemized losses/ expenditure/trading liability are credited back to the P&L A/c.
  • Assessing Officer will compare the Profit & Loss A/c. with the computation statements and find out whether assessee has offered the same for taxation. If not, explanation may be called for from the assessee.
  • Assessing Officer will closely scrutinize the balance sheet for any such items eligible for addition under Section 41(1) of the I.T. Act hidden in the balance sheet as liabilities and not offered for taxation.
  • Assessing Officer will ensure before making any addition under this section that any such loss/ expenditure/trading liability had been claimed and allowed in the earlier years.
  • Burden of proving that the liability is still subsisting lies on the assessee.
  • In BIFR cases provisions of Section 41(1) will not be applicable, only if the CBDT has consented to give relief.
  • If the assessee does not show the amount taxable under Section 41(1) in its return of income, penalty would be leviable under Section 271(1)(c) of the I.T. Act for concealment.

(Republished With Amendments)

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