Commissioner Of Income-Tax v. Kelvinator Of India Ltd.

K. Shivashankar Bhat, J.:— This is a reference under section 256(1) of the Income-tax Act, 1961, pertaining to the assessment year 1971-72. The question referred reads as follows:

“Whether, on the facts and in the circumstances of the case, the Tribunal was legally correct in allowing the provision of Rs. 87,665 for gratuity as an admissible deduction in the computation of the business income of the assessee for the assessment year 1971-72, under the provisions of the Income-tax Act, 1961?”

2. There was a settlement of disputes between the assessee and its employees on August 10, 1970, under which a gratuity scheme was agreed to be framed and it was brought into force during the relevant year in question. The assessee charged to the profit and loss account a sum of Rs. 2,51,695 as provision for gratuity payable to employees. However, in the course of the assessment proceedings, the assessee confined its claim for deduction to Rs. 1,43,124 as per the valuation of the actuary. The Income-tax Officer allowed a sum of Rs. 55,459 and disallowed the balance of Rs. 87,665 on the ground that the latter sum related to the liability for earlier years. The Appellate Assistant Commissioner, however, allowed the assessee's claim. This order was affirmed by the Appellate Tribunal. The Appellate Tribunal followed the observations of the Bombay High Court in Tata Iron and Steel Co. Ltd. v. D.V Bapat, ITO, [1975] 101 ITR 292 that the provision for gratuity would be an admissible deduction in the computation of the assessee's income if such a provision is not for a contingent liability but is based on a scientific estimate of the present liability which is allowable in the case of an assessee who keeps its accounts under the mercantile system. Learned counsel for the Revenue contended that the assessing authority was justified in excluding the sum of Rs. 87,665 because it related to the earlier years, and that the accounting period was July 1, 1969, to June 30, 1970. If so, the gratuity scheme comprising the estimated value of the liability towards gratuity for the earlier years is a liability that could be claimed only during the particular accounting years to which a part of the gratuity liability belongs. In the mercantile system of accounting, the deduction has to be given only during the year to which the part of the gratuity liability is attributable.

3. There is no dispute that the valuation of the liability was on an actuarial basis. There is also no dispute that the assessee has made a specific provision in view of the commitment made by the assessee under the settlement arrived at with the employees.

4. As to the non-applicability of section 40A(7), there is no dispute. It is concluded by the decision of the Supreme Court in CIT v. Garware Synthetic Bristles, [1994] 205 ITR 426. The said decision arose out of proceedings pertaining to the assessment year 1972-73. It was pointed out that sub-section (7) of section 40a is not applicable to the said assessment year and that the sub-section was introduced by the Finance Act, 1975, with retrospective effect from April 1, 1973, and that in other words, the said sub-section applies on and from the assessment year 1973-74.

5. Learned counsel for the Revenue contends that the order of the Appellate Tribunal is based on the decision of the Bombay High Court in Tata Iron and Steel Co. Ltd.'s case, [1975] 101 ITR 292 and the said decision was reversed and the matter was remanded by the Supreme Court in D.V Bapat, ITO v. Tata Iron and Steel Co. Ltd., [1986] 159 ITR 938. It should be noted here that the decision of the Bombay High Court was rendered on February 26, 1975. section 40a(7) was introduced by the Finance Act, 1975, retrospectively with effect from April 1, 1973. In other words, the Bombay High Court did not have the benefit of the retrospective amendment made to the relevant section when the judgment was pronounced. The relevant assessment year in the said case was 1973-74. From this, it cannot be said that the principles enunciated by the Bombay High Court as to the deductibility of the value of the provision for gratuity, prior to the insertion of section 40A(7), cannot be accepted. In fact, the relevant principles are quite exhaustively stated by the Supreme Court in Shree Sajjan Mills Ltd. v. CIT, [1985] 156 ITR 585. While construing the provisions of section 40a(7), the Court also had occasion to point out the law which was prevalent earlier. The relevant observations of the Supreme Court are at page 599 and they read as under:

“It would thus be apparent from the analysis aforesaid that the position till the provisions of section 40a(7) were inserted in the Act in 1973 were as follows:

(1) Payments of gratuity actually made to the employee on his retirement or termination of his services were expenditure incurred for the purpose of business in the year in which the payments were made and allowed under section 37 of the Act,

(2) Provision made for payment of gratuity which would become due and payable in the previous year was allowed as an expenditure of the previous year on accrued basis when the mercantile system was followed by the assessee.

(3) Provision made by setting aside an advance sum every year to meet the contingent liability and gratuity as and when it accrued by way of provision for gratuity or by way of reserve or fund for gratuity was not allowed as an expenditure of the year in which such sum was set apart.

(4) Contribution made to an approved gratuity fund in the previous year was allowed as deduction under section 36(1)(v).

(5) Provision made in the profit and loss account for the estimated present value of the contingent liability properly ascertained and discounted on an accrued basis as falling on the assessee in the year of account could be deductible either under section 28 or section 37 of the Act.”

6. If the assessee falls within any one of the five situations, the allowance shall have to be given. According to Mr. Pandey, the sum of Rs. 87,665 disallowed by the Income-tax Officer was the value of the liability towards gratuity relatable to the earlier years, though the gratuity scheme was formulated to comply with the terms of the settlement arrived at with the employees in August, 1970. Only the balance sum of Rs. 55,459 represented the gratuity liability attributable to the accounting year ending June 30, 1970 (assessment year 1971-72); hence the Appellate Tribunal erred in law in upholding the order of the Appellate Assistant Commissioner, who had granted the assessee relief in respect of the entire amount. To appreciate the contention, the following facts are relevant:

1. The gratuity scheme was the result of a settlement between the assessee and its employees.

2. The scheme was implemented for the first time in the assessment year 1971-72.

3. The legal liability towards gratuity, therefore, arose for the first time during the assessment year 1971-72.

4. Though gratuity is actually paid as and when an employee retires or dies, etc., the assessee has to make a provision for discharging its liability as and when it arises; therefore, the assessee is entitled to estimate the liability and set apart every year some amount as a provision towards the liability. Depending upon the number of years of service of an employee and other relevant factors, if any, the liability with reference to each employee has to be estimated and the amount appropriated as a provision.

7. The basic facts could be gathered from the order of the Income-tax Officer, who recorded as follows:

“The report of the actuary shows that only a sum of Rs. 55,459 relates to the financial year 1969-70 relevant to the assessment year 1971-72 and the balance amount of Rs. 87,665 relates to the earlier period. The actuary has also certified that since the gratuity scheme is to come into effect only from the financial year 1969-70, the entire gratuity liability of Rs. 1,43,124 can be said to have arisen in the financial year 1969-70. The gratuity scheme was implemented for the first time in the assessment year 1971-72 relating to the accounting year ending June, 1970. Since the assessee follows the mercantile system of accounting, only the liability pertaining to the year ending 1970 can be said to be a liability for this year. The liability for the earlier years cannot be claimed against the profits of the current year. I would, therefore, allow only a sum of Rs. 55,459 and the balance amount of Rs. 1,76,236 is disallowed.”

8. The provision made by the assessee for gratuity was found by the Appellate Tribunal as based on a scientific estimate of a present liability and, therefore, allowable as a deduction.

9. In the circumstances, we do not think we can accept Mr. Pandey's contention.

10. In Metal Box Company Of India Ltd. v. Workmen, [1969] 73 ITR 53 : 39 Comp Cas 410 : 35 FJR 181, the Supreme Court held that it is legitimate for a company keeping accounts on the mercantile basis to estimate its liability under a gratuity scheme for its employees on an actuarial valuation and deduct such estimated liability from gross profits in the profit and loss account while working out its net profits. In such a system of mercantile accounting, a liability already accrued, though to be discharged at a future date, would be a proper deduction while working out the profits and gains of the business; it is not as if such deduction is permissible only in the case of amounts actually expended. Therefore, while working out the net profits, the trader can provide from the gross receipts, his liability to pay a certain sum for every additional year of service of the employees, if such liability is properly ascertainable and it is possible to arrive at a proper discounted present value.

11. Therefore, when a gratuity scheme is introduced for the first time, the gratuity payable to the existing employees who have already rendered some years of service and are still in service, shall have to be considered to make a provision, because the gratuity payable depends on the entire length of service of an employee. An employee may retire in the year 1980, while the scheme is brought into force in the year 1970. By that time he would have rendered, say, five years' service. The provision for gratuity has to value the liability with reference to 15 years of service, but this is distributed for the entire 15 years, out of which, when the scheme comes into force, a part of the total liability dependent upon the completed five years service of the employee has arisen. Though this liability, in turn, is referable to each of the previous five years, the legal liability arises only when the gratuity scheme is brought into force. Therefore, to that extent, the liability attributable to those five years could be stated as having arisen during the accounting year in which the scheme is brought into force. No doubt, thereafter, the trader (the company) will be entitled to charge from each year's receipts the cost of making the provision for gratuity which would ultimately be payable as the company would have the benefit of the employee's service during those years. However, the present value of the future payment has to be fairly estimated by a proper discounting.

12. In the aforesaid Metal Box Co.'s case, [1969] 73 ITR 53 (SC), the court pointed out the distinction between making a provision against anticipated losses and contingencies which are charged against profits and, therefere, to be taken into account against gross profits in the profit and loss account and the balance-sheet, on the one hand, and “reserves”, which are appropriations of profits. “Provisions” are usually shown in the balance-sheet by way of deductions, whereas general reserves and reserve funds are shown as part of the proprietor's interest. The provision for a contingency is set aside out of profits.

13. Therefore, there can be no doubt that the provision made for payment of gratuity in future is a liability; but its current value can be fairly estimated and if so, it can be deducted as business expenditure. Since the liability is first recognised and sought to be enforced when the gratuity scheme is first introduced, the existing liability as valued as on the said date, shall necessarily have to be considered as a deductible expenditure out of the profits of the said year, because the provision is made during that year for the first time and the legal liability arose also during the said year.

14. The above inference drawn by us finds considerable support in the decision of the Madras High Court in CIT v. Mettur Spinning Mills, [1983] 140 ITR 991. There, the relevant question referred to the High Court was (at page 992):

“Whether, on the facts and in the circumstances of the case, the Appellate Tribunal was right in holding that the sum of Rs. 5,09,661 being the provision made for gratuity payable, but relating to the past assessment years, should be allowed as a deduction in computing the total income of the assessee for the assessment year 1971-72?”

15. In the said case also the gratuity scheme was formulated and then implemented in view of a settlement between the workers and the assessee. The assessee made a provision of Rs. 5,80,892 in its accounting year ended July, 1970. The Income-tax Officer held that only some part of the provision, which was referable to the accounting year could be allowed as a deduction against profits. But the Appellate Tribunal granted full deduction. The High Court upheld this decision of the Appellate Tribunal.

16. In Vazir Sultan Tobacco Co. Ltd. v. CIT, [1981] 132 ITR 559 (SC), the broad principles governing the fact situation is stated at page 574, thus:

“Ordinarily an appropriation to gratuity reserve will have to be regarded as a provision made for a contingent liability, for, under a scheme framed by a company, the liability to pay gratuity to its employees on determination of employment arises only when the employment of the employee is determined by death, incapacity, retirement or resignation— an event (cessation of employment) certain to happen in the service “career of every employee; moreover, the amount of gratuity payable is usually dependent on the employee's wages at the time of determination of his employment and the number of years of service put in by him and the liability accrues and enhances with the completion of every year of service; but the company can work out on an actuarial valuation its estimated liability (i.e, discounted present value of the liability under the scheme on a scientific basis) and make a provision for such liability not all at once but spread over a number of years. It is clear that if by adopting such scientific method any appropriation is made such appropriation will constitute a provision representing fairly accurately a known and existing liability for the year in question; if, however, an ad hoc sum is appropriated without resorting to any scientific basis such appropriation would also be a provision intended to meet a known liability, though a contingent one, for, the expression ‘liability’ occurring in clause (7)(1)(a) of Part III of the Sixth Schedule to the Companies Act includes any expenditure contracted for and arising under a contingent liability; but if the sum so appropriated is shown to be in excess of the sum required to meet the estimated liability (discounted present value on a scientific basis) it is only the excess that will have to be regarded as a reserve under clause 7(2) of Part III to the Sixth Schedule.”

17. Similar is the view taken by the Calcutta High Court in CIT v. Bally Jute Co. Ltd., [1990] 182 ITR 428. Nowhere has the Revenue contended so far that the liability after formulating the scheme arose only during the accounting year ending June 30, 1971, of which the assessment year was 1972-73 and hence the claim for deduction during the assessment year 1971-72 is impermissible. Hence, we need not go into the said question, faintly suggested by Mr. Pandey.

18. The question referred is accordingly answered in the affirmative and against the Revenue. No costs.