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Commissioner Of Inco... v. Sri Ranilakshmi Ginn...
Case Summary — Reference under s. 256(1) of the Income-tax Act, 1961 (Sethuraman, J.)
Factual and Procedural Background
The reference under s. 256(1) raised two questions about whether the assessee was entitled to a deduction for an estimated gratuity liability under s. 37(1) of the Income-tax Act, 1961, and whether a provision for gratuity made by the assessee was deductible for the assessment year 1971-72.
The assessee was a yarn-manufacturing company that originally had no gratuity scheme. After wage-board recommendations and industry negotiations, the Southern India Mill Owners' Association agreed in 1969 to increase gratuity by 25% for member units; the assessee did not immediately adopt that settlement. Following continued pressure and negotiations, the assessee entered into a settlement with its labour on 7 September 1971, agreeing to introduce a gratuity scheme with retrospective effect from 1 January 1969, making gratuity payable to employees who retired after 31 December 1968 subject to qualifying service.
The assessee obtained an actuarial valuation of gratuity liability as at 31 December 1970 (the end of the accounting year), which amounted to Rs. 1,20,338, and made a provision in its accounts claiming that amount as a deduction in the assessment for 1971-72.
The Assessing Officer (ITO) allowed only the accrual attributable to the current year (Rs. 16,009, being the increase in accrued liability from 31-12-1969 to 31-12-1970) and disallowed the remainder. The assessee appealed; the AAC allowed the entire provision under s. 37(1). The Department appealed to the Tribunal, which upheld the AAC. The reference to the High Court followed, posing the two questions quoted above.
Legal Issues Presented
- Whether, on the facts and in the circumstances of the case, the assessee was entitled to the deduction of the estimated gratuity payable to its employees under section 37 of the Income-tax Act, 1961?
- Whether, on the facts and in the circumstances of the case, the provision for gratuity made by the assessee was a deduction admissible for the assessment year 1971-72 in computing the total income of the assessee?
Arguments of the Parties
Revenue's Arguments (as presented in the opinion)
- The revenue (department) contended that the gratuity liability relating to earlier years should not have been allowed as a deduction in the assessment year 1971-72; only liabilities arising in the current year ought to be deductible.
- It was suggested that the gratuity attributable to past years could be allowed only when payments were actually made to the workers (or as and when the liability related to the relevant future years arose), not as a provision based on past service.
- The revenue emphasised that prior to the 1971 agreement there was no liability, and therefore the amount claimed to relate to earlier years could not be treated as an allowable deduction in the present year.
Assessee's Arguments (as presented in the opinion)
- The assessee maintained accounts on the mercantile (accrual) system, so actual payment was not necessary for deductibility; an accrued liability may be deductible if it had arisen.
- The assessee had introduced the gratuity scheme with retrospective effect and had obtained an actuarial valuation (a "scientific" method) quantifying the liability as at 31-12-1970; it made a provision in the accounts accordingly and claimed the amount as a deduction.
- The assessee relied on the principle that an estimate for a future liability worked out on a legal or scientific basis, and properly reflected in the accounts, may affect real income and thus be allowable as a deduction.
Table of Precedents Cited
| Precedent | Rule or Principle Cited For | Application by the Court |
|---|---|---|
| CIT v. Andhra Prabha P. Ltd., (T.C. No. 263 of 1975) [1980] 123 ITR 760 (Mad) (judgment dated 27 Feb 1979) | Principle that estimates for future liabilities should be related to the current year so far as possible; such estimates are present ones for future liabilities and must be worked out on a legal or scientific basis; arbitrary claims cannot be allowed. | The court relied on this authority to support the proposition that a gratuity provision computed on an actuarial (scientific) basis and reflected in accounts can be an allowable deduction as it properly adjusts the assessee's real income. The present case was held to be analogous and therefore eligible for allowance. |
| Swadeshi Cotton Mills Co. Ltd. v. ITO, [1978] 112 ITR 1038 (Allahabad High Court) | Held that a claim for gratuity would be admissible if based on actuarial valuation, even if no provision had been made in the books of account. | The court treated this as supportive: in the present case a provision was already made, making the assessee's position stronger (a fortiori). The precedent was used to reject the contention that a mere provision prevents deductibility. |
Court's Reasoning and Analysis
The court proceeded through a succinct multi-step analysis grounded on the facts and authorities cited in the opinion:
- Nature of the expenditure: The court observed that the gratuity expenditure was "wholly and exclusively" for the purposes of the assessee's business since it was intended to pay employees on retirement; there was no doubt about its commercial character.
- Accounting basis: Because the assessee kept accounts on the mercantile (accrual) system, actual cash payment was not a prerequisite to claim a deduction; an amount may be deductible if it had accrued as a liability in the accounting year.
- Scientific/actuarial valuation: The court emphasized that the assessee had employed an actuary and arrived at the gratuity liability by a scientific/actuarial method. It referred to the Andhra Prabha decision which articulated that an estimate for a future liability, properly worked out on a legal or scientific basis, is a present estimate that must be related to the current year for profit computation purposes.
- Distinction concerning "earlier years": The revenue's argument focused on the fact that the actuarial amount was calculated with reference to earlier years of service. The court rejected the submission that this made the amount non-deductible in the present year. The court clarified that the claim was not for an expenditure attributable to an earlier accounting year, but rather for a present provision based on earlier service to quantify the current accrued liability under the retrospective scheme introduced in the present year.
- Lack of statutory prohibition: The court noted that there was no provision in the Income-tax Act that precluded allowance of such a provision where it is based on a scientific actuarial valuation. While other sections (s. 36(1)(v) and s. 40A(7)) had been relevant in related cases, they did not operate to deny allowance in the present facts; s. 40A(7) was not in force for 1971-72 and the court did not consider it necessary to delve further into that provision.
- Application of authorities: The court applied the Andhra Prabha principle and the Allahabad High Court decision in Swadeshi Cotton Mills to conclude that an actuarially computed provision reflected in accounts is an appropriate deduction. The Swadeshi decision strengthened the conclusion because it allowed such a claim even where no provision had been made — here, a provision did exist.
- Conclusion on both questions: On these bases, the court answered both reference questions in the affirmative: the actuarially determined gratuity provision was deductible under s. 37(1), and the fact that the amount was presented as a provision did not preclude its allowance for assessment year 1971-72.
Holding and Implications
Holding:
Both questions were answered in the affirmative: the assessee is entitled to the deduction of the estimated gratuity payable to its employees (arrived at scientifically/actuarially) under s. 37(1), and the provision for gratuity made by the assessee is an admissible deduction for assessment year 1971-72.
Immediate consequences for the parties:
- The deduction claimed by the assessee for the actuarially determined gratuity provision (Rs. 1,20,338 as at 31-12-1970) was held to be allowable for the assessment year 1971-72.
- The assessee was awarded costs of Rs. 500.
Broader implications: The opinion reasons by reference to the concept of "real income" and relies on prior authorities to permit an actuarial provision as an allowable deduction where accounts are maintained on an accrual basis and the valuation is scientific. The opinion does not purport to lay down a novel statutory rule beyond applying those principles to the facts of this case.
Sethuraman, J.:— The reference under s. 256(1) of the I.T Act, 1961, has been made on the following two questions:
“(i) Whether, on the facts and in the circumstances of the case, the assessee was entitled to the deduction of the estimated gratuity payable to its employees under section 37 of the Income-tax Act, 1961?
(ii) Whether, on the facts and in the circumstances of the case, the provision for gratuity made by the assessee was a deduction admissible for the assessment year 1971-72 in computing the total income of the assessee?”
2. The assessee is a company engaged in the manufacture of yarn. It did not have any gratuity scheme. In 1956, the Govt, of India constituted a wage board for textile industry. This board recommended that a uniform gratuity scheme should be applied in the case of all the textile mills. Though several units at Coimbatore region implemented the recommendations, the assessee did not do so, and in 1968, a second wage board was constituted to consider the entire matter afresh. This board recommended that the units which had a gratuity scheme should increase the gratuity payable by 25%. In pursuance of_the recommendations, the Southern India Mill Owners' Association conducted negotiations with the labour unions and arrived at a settlement on 5th September, 1969, under which the Association agreed on behalf of its member units to increase the gratuity by 25%. In view of the agreement entered into by the Association, the labour unions kept on pressing the management of the assessee-company to fall in line with the other mills. The assessee was resisting the claim on the ground that it was not a party to the original settlement made by the Southern India Mill Owners' Association and that the agreement to increase the gratuity by 25% did not bind it. After protracted negotiations, a settlement was reached on 7th September, 1971, by which the assessee-company also agreed to introduce the gratuity scheme with effect from 1st January, 1969. It was agreed that the assessee would pay gratuity to all its employees who retired after December 31, 1968, and who had put in a minimum qualifying service. The assessee then employed an actuary for determining the liability towards gratuity as on December 31, 1970, which is the last day of the year with which we are now concerned. According to the actuarial valuation, the liability to gratuity as on December 31, 1970, amounted to Rs. 1,20,338. The assessee made the necessary provision and it claimed the amount as a deduction in the assessment in the assessment year 1971-72. The ITO rejected this claim. He restricted the allowance to the provisions made in respect of the current year holding that gratuity liability on the basis of the actuarial valuation relating to past years would be allowed as deduction as and when the, payments were made to the workers. The way in which he worked out the allowable amount will be clear from the following figures:
Rs. Accrued liability up to the end of the account year 1,20,338 Less: accrued liability up to 31-12-1969 as per actuarial valuation 1,04,329 Balance 16,009
3. The sum of Rs. 16,009 was allowed as deduction. The assessee appealed against the disallowance of the balance of the claim before the AAC. The AAC held that the entire liability was an admissible deduction under s. 37(1) of the I.T Act, 1961, as the assessee had introduced the scheme with effect from January 1, 1969, as a liability by an actuarial valuation. The department appealed to the Tribunal contending that the liability for gratuity in respect of earlier years should not have been allowed as a deduction in computing the income for the assessment year 1971-72 and that the gratuity relating to the past years had been rightly disallowed by the ITO. It was also pointed out that such amount would rank for allowance as and when the payments were made to the workers in addition to the anticipated liability in the relevant future years. The Tribunal did not agree with this submission. It was held that since the gratuity liability claimed as a deduction had been arrived at by adopting a scientific method of valuation and provision had been made for it in the accounts, it had to be regarded as business expenditure incurred by the assessee wholly and exclusively for the purposes of business, and that the deduction claimed by the assessee was rightly allowed by the A AC under s. 37(1) of the I.T Act. It is this claim that has given rise to the two questions mentioned already.
4. That the expenditure was incurred wholly and exclusively for the purposes of the assessee's business cannot be open to doubt. The assessee made the provision only to pay its employees when they retired. The assessee had also been forced to adopt the scheme by giving it retrospective operation from 1st January, 1969. The effect of the retrospective introduction of the scheme was to permit payment of gratuity even to persons who had retired on or after 1st January, 1969, and before the scheme was actually agreed with the labour on 7th September, 1971. The agreement with the labour was arrived at bona fide. In these circumstances, the only question that arises for consideration is whether by reason of the fact that the amount of actuarial valuation was obtained with reference to the period of service of earlier years, the amount referable to the earlier period of service cannot be allowed as deduction in this year.
5. The assessee has been maintaining its accounts on the mercantile system. It is, therefore, not necessary for the allowability of the expenditure that there should be an actual payment made by the assessee before he could get the deduction. In a case like this, the amount may be allowed as deduction provided that the amount of expenditure had accrued as liability.
6. This identical question came to be considered in CIT v. Andhra Prabha P. Ltd. (T.C No. 263 of 1975) [1980] 123 ITR 760 (Mad) in the judgment dated 27th February, 1979. In that case, the assessee claimed deduction of the gratuity payable to the employees and shown as such in the profit and loss account of the relevant accounting year. The ITO disallowed this claim on the basis of the adjusted statement of income prepared by the assessee itself. After receipt of the assessment order, when the assessee preferred an appeal to the AAC, he took the point that the initial disallowance in the statement was due to a mistake. The AAC permitted the claim to be made before him. He held that the gratuity claimed had not become an ascertained or accrued liability and that the provision made for payment of gratuity was not based on any legal or-scientific basis. The assessee appealed to the Tribunal and, according to the assessee, the amount had been calculated on a scientific basis. This contention was accepted and the amount was allowed as deduction. The question raised before this court on reference was whether the allowance made by the Tribunal was correct. The case came to be argued in the light of the provisions of ss. 36(1)(v) and 40A(7). For our present purpose, it is not necessary to go into the applicability of the provisions of s. 36(1)(v) or s. 40A(7) as those provisions are not referred to in the present case. In the said case, after referring to the relevant statutory provisions on the point, the principle applicable was set out as follows (p. 770):
“So, the very concept of profit would require adjustment being made for the claims of the employees for gratuity in so far as it is possible to relate it to the current year. The estimate is a present one for a future liability. This will have to be properly worked out on legal or scientific basis. Any arbitrary claim in this behalf cannot be countenanced.”
7. It was pointed out in that case that where provision was made for a future payment on a scientific method of calculation which is not covered by either s. 36(1)(v) or s. 40A(7), then for considering the deductibility of such amount, there is no specific provision in the Act. It had to be considered only in the light of the concept of the real income of the assessee. It was also pointed out that the assessee would be eligible for the allowance so long as there was no provision prohibiting the allowance
8. There is no provision which stands in the way of allowance of the assessee's claim in this case too. Having regard to the fact that the assessee had arrived at the amount on an actuarial basis and having provided for the amounts in the accounts, the assessee would be eligible for the deduction.
9. The learned counsel for the revenue contended that the claim in so far as it related to the earlier years would not be liable for allowance as deduction. The assessee agreed to implement the gratuity scheme in 1971. Prior to that, in the absence of any agreement, there was no liability. The scheme of paying or providing for gratuity arose consequent on the agreement arrived at with the labour. Therefore, the amount concerned in this case is a present or current liability which arose during the relevant year. It may be that the assessee could get deduction for the amounts as and when paid, but that is no ground for disallowance in this year. Though the question referred to s. 37 of the Act, we consider, as pointed out in the unreported decision mentioned above [since reported in [1980] 123 ITR 760 (Mad)], that the question would have to be considered in the light of the concept of real income. The I.T Act cannot tax the assessee on what does not form part of his income. There is no specific provision dealing with a claim like this. The I.T Act contemplates deductions for allowances as contrasted with expenditure, in arriving at profit. This sum is a proper outgoing or allowance in arriving at the profit. After all, when part of the provision, to the extent it relates to the liability incurred in the current year, viz., Rs. 16,009, has been allowed as deduction by the ITO himself, there can be no valid objection to the allowance of the rest of the amount. This is not a case of an expenditure or allowance in respect of an earlier year being claimed as deduction. What has been taken into account is the earlier years' service and not any liability as such which arose in those years. In the result, the first question is answered in the affirmative and the assessee is entitled to the deduction of the estimated gratuity payable to its employees arrived at scientifically or actuarially, under the agreement with the labour arrived at in this year.
10. The second question is merely a variation of the first. It appears to proceed on the basis that merely because it was a provision, it cannot be allowed as a deduction. We do not consider that this manner of considering the scheme of allowances or deductions is justified under the Act. The Allahabad High Court in Swadeshi Cotton Mills Co. Ltd. v. ITO, [1978] 112 ITR 1038, has pointed out that the claim for gratuity would be admissible if based on actuarial valuation, even if no provision had been made in the account books. In the present case, there is already a provision. This is an a fortiori case. Section 40A(7) introduces further aspects for consideration in this context. But it was not in force in 1971-72, and we do not think it necessary to go into it. The result is, the second question is also answered in the affirmative and in favour of the assessee. The assessee will be entitled to its costs. Rs. 500.
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