Although the quantification may be postponed to a future date, as long as the event is a certainty, the claim for deduction cannot be denied. However, where the liability itself is not certain, such liabilities, contingent in character, cannot be the subject matter of deduction.
A committed, ascertained or definite liability is undoubtedly a deductible item of expense in computing the taxable income under the Income-tax Act, 1961. A contingent or conditional liability raises a hornets nest with the tax department, which invariably takes the view that such liability is not eligible for deduction in computing the taxable business income.
A committed liability is an accrued liability. Hence, even though the exact quantification is postponed to a future date, yet a provision in terms of the agreement undertaken has to be considered for deduction. In short, the determination of exactness of the liability on a future date does not make a liability as on the date of agreement a contingent liability.
In Metal Box Company of India Ltd v Their workmen (73 I.T.R. 53), the Supreme Court held that it was permissible for an assessee, if he so chooses, to provide in his profit and loss account for the liability under a gratuity scheme, by ascertaining the present value on actuarial basis and claiming it as an ascertained liability. Referring to the provisions of section 40-A(7) in that case, the apex court held that the requirements for gratuity to be deductible under the Act must be fulfilled.
Although the quantification may be postponed to a future date, as long as the event is a certainty, the claim for deduction cannot be denied. However, where the liability itself is not certain, which may happen or may not happen, such liabilities, contingent in character, cannot be the subject matter of deduction, even under the mercantile system of accounting.
C.I.T. v. Dynavision Ltd (265 I.T.R. 289) is a decision on the question of the character of a liability as a contingent liability. Referring to the decision of the apex Court in Shree Sajjan Mills Ltd v C.I.T. (156 I.T.R. 585), the Madras High Court held that the basic requirement is that the amount sought to be excluded should be an expenditure and the expenditure, which is deductible for income-tax purposes, is one which is towards a liability actually existing at the time, but the putting aside of money, which may become expenditure on the happening of an event, is not an expenditure.
In Bharat Earth Movers v C.I.T. (245 I.T.R. 428), the company created a fund making provision for meeting its liability, arising on account of earned vacation leave. A certain sum was set apart in a separate account as provision for encashment of accrued leave. The assessee made a claim for deduction.
The apex court held that the provision made by the assessee therein for meeting its liability was under the leave encashment scheme proportionate with the entitlement earned by the employees of the company, subject to a ceiling on accumulation as applicable on the relevant date. Consequently, the Court held that the liability was not a contingent liability.
Certainty of incurring liability
A perusal of the decision of the Supreme Court shows that what should be certain is the incurring of the liability.
Even though the actual quantification may not be possible, it should also be capable of being estimated with reasonable certainty. 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.
The Supreme Court decision referred to above lays down the law on the question of deductibility of a provision for contingent liability and that the deduction, to be allowable, must be of a liability existing with certainty, which is an accrued liability. Hence, where there is no difficulty in ascertaining the existence of a liability, the mere existence of difficulty in actual quantification does not convert the accrued liability to a conditional one. The settled principles emphasise the existence of an element of certainty rather than the quantification of the liability.
Warranty charges, in this instance
This point was considered by the Madras High Court in C.I.T. v Rotork Controls India Ltd (293 I.T.R. 311). The facts in this case were that the assessee made a provision for warranty charges payable under the terms of sale. It was stated that such a provision was made in the accounts to meet future requirements arising on account of the warranty clause in the sale agreement.
It was admitted by the assessee that the warranty provision made against the liability had not crystallised against the assessee. Treating the provision as an unascertained liability, the assessing authority rejected the plea of the assessee. The Tribunal allowed the deduction.
The assessee claimed deduction of additional service charges. It claimed that under the terms of the agreement, with increased sales, the amount was paid as a corporate service charge to the holding company.
The assessing authority had allowed the claim in earlier years based on this. However, in respect of the assessment year 1991-92, the assessee claimed that payment at 2 per cent required a revision commensurate with the increase in turnover.
The Assessing Officer rejected the claim as excessive and unreasonable having regard to the nature of services rendered by the holding company. The Tribunal held that it was entitled to the deduction.
On appeal, the Madras High Court held that the assessee could not prove the actual incurrence of liability under the warranty clause on the basis of fixing a percentage on the turnover. In the absence of any details, accepting the claim of percentage on the turnover could not be sustained. The deduction was not allowable.
Going by apex court decisions
Relying on the decisions of the Supreme Court, the High Court concluded that in order to claim the deduction of expenditure, what should be certain is the incurrence of the liability.
Even though the actual quantification may not be possible, it should be capable of being estimated with reasonable certainty. 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 makes no difference as to the point of time when the liability is to be discharged.
The Madras High Court also considered the decision of the Privy Council in Commissioner of Inland Revenue v Mitsubishi Motors New Zealand Ltd (222 I.T.R. 697).
In this case, the decision was prompted by the statistical data available that in respect of 63 per cent of the vehicles sold by the taxpayer, they were returned to the dealers for some kind of work to be done under the warranty clause. The Privy Council held that the taxpayer could reasonably make an accurate forecast, based on the previous experience, as to what would be the total cost of remedial work for all the vehicles sold in a given year.
To sum up, deduction of warranty charges and other similar expenses generally creates uncertainties for the tax payer on the issue of deductibility. Therefore, though it is a normal commercial practice to provide guarantees or warranties for a specific period of time when an equipment or asset is sold, the deductibility of a scientifically computed amount becomes a matter of debate and litigation.
H.P. Ranina The author, a Mumbai-based advocate specialising in tax laws.