Citation Codes

Equivalent Citations

citation codes

Case Number

Income-tax Reference No. 83 of 1983

Judges

Hon'ble Mr. Justice Niranjan Janmashankar Pandya

Acts

s. 43A of the Income-tax Act. Section 43A
s. 256(1) of the IT Act, 1961

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Smart Summary

Structured Summary of the Opinion — Welding Rods Manufacturing Co.

Factual and Procedural Background

The Tribunal referred the following question to this Court at the instance of the assessee M/s. Welding Rods Manufacturing Co. under s. 256(1) of the Income-tax Act, 1961: whether the Tribunal was right in law in not allowing deduction of Rs. 5,18,237 claimed by the assessee in respect of goods taken on loan from M/s. Ahura Welding Electrode Mfg. Co. Ltd., Coimbatore.

The assessee is a firm engaged in manufacturing welding rods. Because wire rods became scarce, the firm obtained raw material (mainly wire rods) on loan from its sister concern, M/s. Ahura Welding Electrode Mfg. Co. Ltd., Coimbatore. The loan agreement provided that the wire rods would be returned, of the same quality and quantity, when required by the sister concern; no time or date for return was fixed. The quantities taken on loan in the three relevant accounting years (asst. yrs.) were: 1972-73 — 347.412 tonnes; 1973-74 — 292.017 tonnes; 1974-75 — 104.803 tonnes. None of the goods were returned.

When filing the return for asst. yr. 1976-77, the assessee showed an increase in the liability for purchase account totalling 704.222 tonnes valued at Rs. 24,82,756.36, from which Rs. 16,16,891.05 was already provided in prior years. The assessee claimed an additional provision of Rs. 5,18,237.31 arising from a rise in the price of wire rods from Rs. 2,525.56 to Rs. 3,336.04 (applied to 639.419 tonnes). The ITO disallowed the claim; the CIT(A) and the Tribunal upheld that disallowance. The assessee succeeded in having the Tribunal refer the legal question noted above to this Court.

Legal Issues Presented

Whether, on the facts and in the circumstances of the case, the Tribunal was right in law in not allowing deduction of Rs. 5,18,237 claimed by the assessee in respect of the goods taken on loan from M/s. Ahura Welding Electrode Mfg. Co. Ltd., Coimbatore?

Arguments of the Parties

Assessee's Arguments

The assessee maintained accounts on the mercantile system and recorded liabilities for wire rods taken on loan (with entries for prior years accepted by the Department).
The claimed provision of Rs. 5,18,237.31 represents an estimated liability arising from the rise in price of loaned raw material and is necessary to ascertain true business profits under mercantile accounting.
The assessee relied on precedents (including New India Industries Ltd. and others cited) and commercial/accounting principles to justify the provision recorded in the liability account.

Revenue/Department's Arguments

The ITO disallowed the claimed amount (the Department declined the deduction at assessment and on appeal).
It was contended (as reflected in submissions attributed to Mr. Thakore, learned advocate for the Department) that the assessee is not entitled to make the said entry for Rs. 5,18,237.31 when he has not actually expended that amount.
The Department did not challenge the rate at which the goods were valued in the assessee's accounts.

Table of Precedents Cited

Precedent	Rule or Principle Cited For	Application by the Court
Keshav Mills Ltd. vs. CIT (1953) 23 ITR 230 (SC)	Explains the mercantile system of accounting: credits arise when legally due and debits when legal liability is incurred before actual receipt/payment; a liability deductible for income-tax purpose is one actually existing at the time of deduction.	The Court used this to justify that, because the assessee had an obligation to return loaned raw materials on demand, the assessee must make a provision in its accounts reflecting the estimated amount required to replace those materials in the market.
Badridas Daga vs. CIT (1958) 34 ITR 10 (SC)	Holds that s.10(2) enumerates admissible deductions but is not exhaustive; deductions not specifically in s.10(2) may be allowed if they arise out of carrying on the business and are incidental to it.	The Court relied on this principle to support the proposition that an allowance not expressly provided in the statute may still be deductible if it reflects accepted commercial practice and trading principles and is incidental to carrying on the business.
Aruna Mills Ltd. vs. CIT (1957) 31 ITR 153 (Bom)	Business profits should be ascertained according to commercial principles; expenditures or losses not within s.10(2) might still be allowed to determine true business profits.	The Court quoted this decision to emphasize that commercial/accounting principles (mercantile system) are relevant to determining taxable business profits and to support allowing the disputed entry to determine true profit.
Calcutta Co. Ltd. vs. CIT (1959) 37 ITR 1 (SC)	Approved a mercantile accounting practice where full sale consideration was credited and an estimated future expenditure (for development) was debited even though the expenditure had not yet been incurred.	The Court cited this as direct support for accepting a debit entry representing estimated future expenditure (analogous to the assessee's provision to replace loaned goods), demonstrating that such mercantile entries can be accepted for tax computation.
New India Industries Ltd. vs. CIT (1993) 203 ITR 933 (Guj)	Decision concerns s.43A (special provision related to changes in rate of exchange); contains observations that a liability to pay for purchased assets arises simultaneously with purchase even if payable in instalments.	The Court observed that the Division Bench's remarks in that case align with the Department's contention that liabilities can be recognized before actual payment; the opinion notes these observations meet the Department's argument, though s.43A is a specialized provision.

Court's Reasoning and Analysis

The Court's analysis proceeded by placing primary emphasis on the mercantile system of accounting and on commercial/business reality rather than purely technical formalities. The key steps in the Court's reasoning are:

Accounting basis and admitted facts: It was admitted that the assessee maintained mercantile accounts and had taken specified quantities of wire rods on loan from the sister concern with an agreement to return them on demand; the earlier liability entries for prior years were accepted by the Department.
Principle from mercantile accounting: Citing Keshav Mills Ltd., the Court reiterated that mercantile accounting recognizes liabilities when legally incurred even if not yet paid, and that a deductible liability is one actually existing when the deduction is made.
Commercial necessity to provide: Given the contractual obligation to return the borrowed raw material on demand, the assessee is obliged, in commerce, to provide in its accounts for the estimated cost to replace those materials (i.e., to enable purchase in the open market). The entry of Rs. 24,82,756.36 is an estimated amount the assessee would have to expend in the course of business to return the loaned materials; prior-year amounts already claimed were correctly deducted.
Relation to ascertainment of profits: The Court reasoned that computing true business profit under the mercantile system requires taking such liabilities (even contingent or future expenditures) into account; without allowing the disputed entry the profit figure would be incorrect.
Statutory context and permissibility: The Court noted there was no claim by the Department that the Income-tax Act specifically or impliedly prohibited making such an entry when the amount had not yet been expended. The Badridas Daga and Aruna Mills authorities were invoked to show that deductions not enumerated in s.10(2) may be allowable if they arise from commercial practice and are incidental to business.
Support from direct precedent: The Court relied on Calcutta Co. Ltd. where the Supreme Court approved a debit entry for estimated future expenditure under mercantile accounting despite no actual outlay having occurred at that time; this precedent directly supports acceptance of the assessee's provision.
Consideration of contrary observations: The Court acknowledged observations in New India Industries Ltd. that liabilities can arise on purchase even if payable in instalments; the opinion records that those observations meet the Department's contention but does not treat them as defeating the assessee's claim given the other authorities and context.

Holding and Implications

The reference is answered in the negative and in favour of the assessee.

Direct consequences for the parties:

The Court held that the liability account entry for Rs. 5,18,237.31 (representing the increase in liability due to the rise in price of loaned wire rods) is correct and proper and must be accepted by the Department.
The reference concludes with no order as to costs (i.e., the Court expressly recorded "with no order as to costs").

The opinion does not discuss any broader legal implications or declare that a new precedent is being established beyond applying existing commercial and mercantile accounting principles to the facts of this case.

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Welding Rods Manufacturing Co. v. Commissioner Of Income-Tax

1. The Tribunal has referred the following question to this Court at the instance of the assessee M/s. Welding Rods Manufacturing Co. under s. 256(1) of the IT Act, 1961 :

"Whether, on the facts and in the circumstances of the case, the Tribunal was right in law in not allowing deduction of Rs. 5,18,237 claimed by the assessee in respect of the goods taken on loan by it from M/s. Ahura Welding Electrode Mfg. Co. Ltd., Coimbatore ?

2. The assessee is a firm which manufactures welding rods. For the said business the assessee firm obtained on loan basis raw material mainly wire rods from sister concern M/s. Ahura Welding Electrode Mfg. Co. Ltd., Coimbatore as the said raw material had become scarce. The said sister-concern of Coimbatore was unable to use its full quota of wire rods on account of cut of electricity in Tamil Nadu State. The loan agreement between the sister-concern and the assessee was that when required by them (sister-concern) the wire rods would be returned which meant the quantity of wire rods obtained on loan basis returnable of the same quality and quantity. No time or date was fixed for returning of the raw material - wire rods. The quantity of wire rods taken on loan in the three accounting years was as under :

Asst. yr. Quantity taken on loan Tonnes

1972-73 347.412

1973-74 292.017

1974-75 104.803

None of the goods were returned by the assessee to M/s. Ahura Welding Electrode Manufacturing Co. Ltd. Coimbatore.

3. When the assessee filed the return for the year (asst. yr.) 1976-77 it had shown in the liability for purchase a/c as under :

Increase in liability of wire rods taken in past :

Tonnes

1972-73 347.402

1973-74 292.017

1974-75 104.803

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704.222

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Valued at 3364.4 Rs. 24,82,756.36

Less provision made upto last year Rs. 16,16,891.05

Thus the assessee had provided for an additional liability of 639.419 tonnes at the rate of 310.56 (3336.04 - 2525.56) Rs. 5,18,237.31 on account of the rise of price of wire rods from Rs. 2525.56 to Rs. 3336.04 in the year 1974-75 (asst. yr. 1975-76). The said claim of Rs. 5,18,237.31 was not allowed by the ITO. Though the assessee had challenged that order by preferring appeals before the CIT(A), Baroda as well as the Tribunal, he did not succeed. Hence he moved the Tribunal to make reference and accordingly this reference has come before us.

4. It is an admitted fact that the assessee is maintaining its accounts in the mercantile system. There is also no dispute of the fact that the assessee had taken the wire rods on loan from the sister-concern of M/s. Ahura Welding Electrode Manufacturing Co. Ltd., Coimbatore, as shown in his account, with an agreement to return the same on demand. It is also necessary to mention here that the assessee had shown the entries in the liability account for the asst. yrs. 1973-74 and 1974-75 of 347.402 and 292.017 tonnes at the rate of 2525.56 for Rs. 16,14,891.05. And in the asst. yr. 1975-76 the entry of 104.803 tonnes at the rate of Rs. 3336.04, Rs. 3,49,626.00 besides the entry of Rs. 5,18,237.31 on account of difference in rate of loaned goods taken in accounting year 1973-74 and 1974-75. It is very pertinent to note here that the assessee's entries in the liability account for Rs. 16,14,891.05 for the asst. yrs. 1973-74 and 1974-75 and of Rs. 3,49,626.00 for 1975-76 are accepted and allowed by the Department. In the background of these admitted facts the question referred to us is to be considered and decided.

5. In examining any transaction on entry in the mercantile system of accounts the Court must give more regard to the reality and specifically to the situation rather than to a purely technical aspect. It must give greater emphasis on the business aspect of the matter by viewing the transaction as a whole of course without disregarding statutory language. In the case of Keshav Mills Ltd. vs. CIT (1953) 23 ITR 230 (SC) the apex Court has observed that the mercantile system of accounting brings into credit what is due immediately it becomes legally due and before it is actually received and it brings into debit expenditure the amount for which a legal liability is incurred before it is actually disbursed. A liability, the amount of which is deductible for income-tax purpose is one which is actually existing at the time of making deduction. In the instant case it is an admitted fact in the asst. yr. 1973-74, 1974-75 and 1975-76, the assessee had taken on loan 347.402, 292.017 and 104.803 tonnes of wire rods respectively from sister-concern and as per the contract between the assessee and the sister-concern the assessee was liable to return the same on demand. Consequently the assessee must make provision in his account of the price of the said loan in view of material taken on loan so as to enable it to purchase the same in open market. It is very pertinent to note that the rate of the goods shown by the entry in assessee's accounts is not challenged or is not alleged to be inflated one. The amount of Rs. 24,82,756.36 is an estimated amount which will have to be expended by the assessee in course of his business in order to return the raw materials taken as loan. From the said amount of Rs. 24,82,754.36, the assessee has correctly deducted the amount of Rs. 16,14,891.05 which was claimed in previous two years. Out of the remaining amount of Rs. 8,67,836.31 the amount of Rs. 5,18,237.31 is on account of rise of the price of the raw material from Rs. 2525.56 to Rs. 3336.04. It is not at all possible to arrive at the profit of the assessee's business without the said entries. The profit of a business is the surplus by which the receipt from the business exceed the expenditure necessary for the purpose of earning these receipts. That seems to us the meaning of "profits" in relation to a business.

6. In the case of Badridas Daga vs. CIT (1958) 34 ITR 10 (SC) it has been observed as under :

"It is to be noted that while s. 10(1) imposes a charge on profits or gains of trade, it does not provide how those profits are to be computed. Section 10(2) enumerates various items which are admissible as deductions but it is well settled that they are not exhaustive of all allowances which could be made in ascertaining profits taxable under s. 10(1)"

Thereafter discussing earlier decisions, it has been further observed as under :

"The result is that when a claim is made for deduction for which there is no specific provision in s. 10(2) whether it is admissible or not will depend on whether, having regard to alleged (accepted) commercial practice and trading principles, it can be said to arise out of carrying on of the business and to be incidental to it. If that is established, then the deduction must be allowed, provided of course there is no prohibition against it, express or implied in the Act."

We would also like to quote the observations of the then Chief Justice M. C. Chagla of Bombay High Court in the case of Aruna Mills Ltd. vs. CIT (1957) 31 ITR 153 (Bom) which runs as under :

"Now we have had occasion to point out in several decisions that what the IT Act purports to tax is business profits, and business profits are the true profits of a business as ascertained according to commercial principles. There may be an expenditure or there may be loss which may not be an admissible loss under any of the provisions of s. 10(2) and yet such an expenditure or loss would have to be allowed in order to determine what were the true profits of a business, and it is the duty of every one who has anything to do with taxing business people to understand what are the principles of commercial expediency. Unless one understands these principles it is difficult to make a proper assessment on a business or on a businessman."

7. Now let us turn to the facts of the reference made to us and consider the same in the light of above observation; we are in least hesitation to record our considered opinion that unless the disputed entry is allowed it is not possible to know and find out assessee's business profit which are taxable. No doubt that the assessee has not spent the amount of the entry in question as well as the main entry of Rs. 24,82,754.36. But in the mercantile system of accounting the businessman has to take into consideration his liabilities which might be even contingent in order to arrive at what is real business profit in that year. He has to take into consideration his legal liabilities. It is not the claim of the Department that under specific or implied provision of the IT Act he could not make the entry in question unless he had actually expended that amount.

8. Thus, in view of the above discussion we are of the view that the entry in question in the liability account for Rs. 5,18,237.31 is correct and proper and the same must be accepted by the Department. This conclusion of us is supported by the decision of the Supreme Court in the case of Calcutta Co. Ltd. vs. CIT (1959) 37 ITR 1 (SC). In that case the appellant sold a plot of land for Rs. 43,692 on the condition to carry out the development of laying out roads, providing drainage system and installing lights etc. Appellant had received on the date of transaction only Rs. 29,392 and the remaining amount was to be recovered in instalments. He had credited in his accounts Rs. 43,692 representing full price and at the same time made debit entry of Rs. 24,809 as estimated expenditure towards development as per mercantile system of accounting. He had made the debit entry of Rs. 24,809 without actually spending any amount which he was to spend sometime in future. Hence the said entry was not accepted by CIT. But the said debit entry was approved and accepted by the apex Court in the said case.

9. The learned advocate for the assessee has cited before us the case of New India Industries Ltd. vs. CIT (1993) 203 ITR 933 (Guj) But it is a case covered by s. 43A of the Income-tax Act. Section 43A is a special provision consequential to changes in rate of exchange of currency. But the observations by the Division Bench of this Court in that case are meeting the contention of Mr. Thakore learned advocate for the Department that the assessee is not entitled to make the said entry for Rs. 5,18,237.31, when he has not actually spent the amount. Those observations on page No. 940 are as under :

"In our opinion, when the assessee purchased assets at a price it's liability to pay the same arise simultaneously. Merely because the said liability was to be discharged in instalments it could not be said that the liability did not exist or arise till the instalments became due and payable."

10. Therefore, in view of all the above discussion and for the reasons recorded above we answer the reference in the negative and in favour of the assessee. Reference is thus answered accordingly with no order as to costs.

Welding Rods Manufacturing Co. v. Commissioner Of Income-Tax

Structured Summary of the Opinion — Welding Rods Manufacturing Co.

Factual and Procedural Background

Legal Issues Presented

Arguments of the Parties

Assessee's Arguments

Revenue/Department's Arguments

Table of Precedents Cited

Court's Reasoning and Analysis

Holding and Implications

Welding Rods Manufacturing Co. v. Commissioner Of Income-Tax

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