The Commissioner Of Income Tax In Karnataka-I v. Motor Industries Co. Ltd. Audugodi, Bangalore

Raveendran, J.:—

These three reference under Section 256(1) of Income-Tax Act, 1961 (‘Act’ for short) relate to the Order of Assessment dated 11.8.1978 passed in regard to the Assessment Year 1976-1977 (year ending 31.12.1975). Feeling aggrieved by the disallowance of certain expenditure in computing income chargeable under the Head ‘Profits and Gains of Business’ and disallowance of certain deductions in computing the total income, the Assessee filed an Appeal before the CIT (Appeals) I, Bangalore. The Appeal was partly allowed by Order dated 28.2.1980 Feeling aggrieved, the Assessee filed I.T.A No. 322.BANG/80 and the Department filed I.T.A No. 340.BANG/1980. The Tribunal by a Common Order dated 31.10.1981, partly allowed both the appeals. The Assessee sought reference of some question of law in regard to the decision of the Tribunal in I.T.A No. 322.BANG/1980 in R.A No. 962.BANG/1981. The Department sought reference of some questions arising out of the Order of the Tribunal in I.T.A No. 322.BANG/1980 and I.T.A No. 340.BANG/1980 in R.A Nos. 2 & 3.BANG/1980.

2. In pursuance of the said applications, the Tribunal by Order dated 30.11.1982, has referred the following 12 questions (Questions 1 to 9 at the instance of the Revenue and questions 10 to 12 at the instance of the Assessee) for opinion:

Whether on the facts and in the circumstances of the case:

1) The Appellate Tribunal is right in law in holding that the Assessee was entitled to get higher depreciation on Canteen Building?

2) The Appellate Tribunal is right in law in holding that the provision for salary and wages payable for non-utilised leave amounting to Rs. 75,51,000/- is an admissible deduction?

3) The Appellate Tribunal is right in law in holding that expenses incurred in connection with issue of rights shares, constitutes revenue expenditure deductible in computing the business income?

4) The Appellate Tribunal is right in law in holding that depreciation has to be allowed on increase in the value of assets due to fluctuation in exchange rate?

5) The Tribunal was right in upholding the jurisdiction of the Commissioner of Income Tax (Appeals) in entertaining the additional claim of the Assessee for weighted deduction under Section 35B on expenses incurred on advertisement and technical literature?

6) The Appellate Tribunal is right in law in holding that the Assessee is entitled to depreciation on roads, culverts and drainages around the Assessee's factory?

7) The Appellate Tribunal is correct in holding that ground rent, repairs, municipal tax and depreciation in respect of the buildings owned by the Assessee and used as residential quarters by an employee, cannot be treated as expenditure resulting in benefit or amenity granted to the employees by the Assessee and considered as ‘perquisite’ for the purposes of Section 40A(5)?

8) The Appellate Tribunal is right in holding that the depreciation allowance has to be allowed on the pipeline and sanitary fittings treating it as plant and machinery?

9) The Appellate Tribunal is correct in holding that the Assessee is entitled for extra shift allowance on the storage tank as the same is part of plant and machinery?

10) The Income-Tax Appellate Tribunal was right in law in holding that the Assessee would not be entitled to the benefit of initial depreciation under Section 32(1)(vi) of the Income-Tax Act?

11) The Tribunal was right in law in holding that the surtax payable is not a proper deduction in computing the total deduction for income-tax purposes?

12) The Income-Tax Tribunal was justified in holding that the Assessee was not entitled to weighted deduction under Section 35B in respect of Insurance Premium of Rs. 35,581/- paid to Export Credit Guarantee Corporation Limited?

3. Though in para 21 of the statement of case, the Tribunal states that 13 questions are referred, it is seen that only 12 questions are referred. Though the reference sought in regard to question referred to in Para 9 has been rejected, apparently by oversight the Tribunal has stated in Para 21 that the question referred to in Para 9 is also referred. This is ignored. Question No. (5) has been reframed by the Tribunal.

4. Re: Question No. (1):

This relates to a claim for depreciation on Canteen Buildings at the same rate applicable for factory buildings, on the basis that they formed part of the factory buildings. The Income-Tax Officer disallowed the claim. This was confirmed in Appeal. The Tribunal however upheld the Assessee's claim for higher depreciation. The same question arose in regard to the earlier assessment year 1974-1975 and this Court, following the decision of the Madras High Court in C.I.T v. Engine Walls Ltd. . 126 ITR 347. answered the question in favour of the Assessee holding that Canteen Building should be regarded as part of Factory Buildings. Following the said decision relating to the earlier year, reported in C.I.T v. Motor Industries Co. Ltd. . 1986 158 ITR 734., this question is answered in the affirmative, against the Revenue and in favour of the Assessee.

5. Re: Question No. (3):

This question relates to the expenses incurred by the Assessee in connection with the issue of Rights Shares. The Assessee contended that it is a revenue expenditure deductible in computing business income. The I.T.O rejected the contention and held it to be a capital expenditure. The Appellate Commissioner and Tribunal accepted the contention of the Assessee. This question arose, in regard to Assessment Year 1974-1975 and this Court held it to be a capital expenditure - vide C.I.T v. Motor Industries Co. Ltd. . 1988 173 ITR Page 374. Following the said decision, this question is answered in the negative, against the Assessee and in favour of the Revenue.

6. Re: Question No. (4):

This question relates to entitlement to the benefit under Section 43A on the increase in liability on account of fluctuations in the exchange rates. On account of fluctuations in exchange rates, the Assessee revalued its liability in respect of foreign currency loans obtained for purchase of machinery, tools and spare parts as on 31.12.1975 and made a provision of Rs. 3,44,838/-. Out of it, Rs. 2,89,582/- relatable to machinery was capitalised and apportioned among various assets and depreciation was claimed; and the balance of Rs. 55,256/- relatable to tools/spares was debited to the Profit and Loss Account as revenue expenditure. The claims were rejected by the I.T.O The Appellate Commissioner and the Tribunal held that the Assessee was entitled to the benefit of Section 43A. The same question arose in regard to Assessment year 1974-1975 and this Court upheld the view of the Tribunal holding that the claim of the Assessee also attracted the Board's Circular No. FI (408/67-TPL) dated 19.10.1967 which properly interpreted the scope and ambit of Section 43A - vide C.I.T v. Motor Industries Co. Ltd. 1988 (173) ITR 374. The Revenue also conceded the correctness of the decision of the Tribunal having regard to the subsequent decision of the Supreme Court in C.I.T v. Arvind Mills Ltd. . 1992 193 ITR 255. The question is therefore answered in the affirmative, against the Revenue and in favour of the Assessee.

7. Re: Question No. (5)

7.1 In the appeal filed against the order of assessment, the Assessee claimed weighted allowance under Section 35B in regard to expenses incurred for advertisement and technical literature. The Appellate Commissioner held that the Assessee was eligible for weighted allowance under Section 35B. The Department challenged the same before the Tribunal on the ground that the claim had not been made before I.T.O The Tribunal held that as the material and details were available on record, the Appellate Commissioner was justified in admitting the additional claim. In this context, the question whether the CIT (A) could have entertained the claim of the Assessee for weighted deduction under Section 35B is referred.

7.2 Though the Assessee had not claimed such weighted deduction before the I.T.O, the CIT (A) entertained the claim as the material and details were available in the records. When the necessary material was available and the weighted deduction is permissible under Section 35B, the claim cannot be rejected merely on the ground that it was not made before the I.T.O It is now well settled that when the assessment is not under Section 143(1), the Appellate Authority may permit the Assessee to claim a deduction or exemption in appeal, which he had not claimed before the I.T.O, particularly when the relevant material is on record - See decision of the Supreme Court in Jute Corporation of India Ltd. v. CIT . 1991 187 ITR 689.; Union Coal Co. Ltd. v. Commissioner Of Income-Tax, Calcutta. . 70 ITR 45. and CIT v. Sayaji Mills Ltd. . 94 ITR 26. We therefore answer Question No. (5) in the affirmative and against the Revenue.

8. Re: Question No. (6):

This question relates to claim for depreciation on the written down value of roads, culverts and drains within the factory premises. The ITO disallowed the claim. The CIT (A) and the Tribunal held that the Assessee is eligible for such depreciation following the decision of the Bombay High Court in C.I.T v. Colour Chem Ltd. . 106 ITR 323. and of the Madras High Court in C.I.T v. Lucas TVS Ltd. . 110 ITR 346. The matter is now covered by the decision of the Supreme Court in C.I.T v. Gwalior Rayon Silk Mfg. Co. Ltd. . 196 ITR 149. wherein it is held that roads and drains laid within the factory premises are necessary adjuncts to factory buildings to carry on the business activity of the Assessee and would fall under the definition of ‘Building’ under Section 32 and the capital expenditure incurred thereon is admissible to depreciation of written down value. We therefore answer question No. (6) in the affirmative, against the Revenue and in favour of the Assessee.

9. Re: Question No. (7):

This relates to the addition of Rs. 44,269/- by the I.T.O being the amount spent on repairs, municipal taxes and ground rent, and depreciation in respect of Assessee's own buildings allowed to be used as residential quarters by its employees, treating them as expenditure resulting in a benefit or amenity granted to the employees by the assessee considered as a perquisite for the purpose of Section 40A(5). The addition was deleted by CIT (A) and that was affirmed by the Tribunal by following the decision in C.I.T v. Travancore Tea Estates Ltd. . 122 ITR 557. The matter is now covered by the decision of this Court in the case of the Petitioner relating to the Assessment Year 1974-1975 (173 ITR 374). Following the said decision, question No. (7) is answered in the affirmative, against the Revenue and in favour of the Assessee in regard to (i) depreciation on buildings and (ii) payment of property tax and ground rent, and (iii) expenditure on repairs. This is subject however to a rider in so far as repairs are concerned; what cannot be added under Section 40(A)(5) is only the amount spent for normal and routine upkeep and maintenance; and any amount spent in excess to meet the special requirements of the employee in occupation can be added under Section 40A(5). Having regard to the modest amount involved in this case, it has to be held that nothing need be added under Section 40A(5).

10. Re: Question No. (8) & (9):

10.1 Question No. (8) is whether depreciation is admissible on pipelines and sanitary fitting treating them as plant and machinery. The I.T.O held that pipelines and sanitary fittings, tanks cannot be held to be plant. He allowed depreciation of only 5% and held that extra shift allowance was admissible. The CIT (A) held that they should be treated as plant and depreciation should be allowed at 10%. This was upheld by the Tribunal.

10.2 Question No. (9) is whether extra shift allowance is admissible on storage tanks treating them as part of plant and machinery. The I.T.O held that storage tanks were not ‘plant’, but only formed part of Building. The CIT (A) and the Tribunal have accepted the Assessee's claim that storage tanks will have to be classified as ‘Plant’, and entitled to extra shift allowance.

10.3 These are covered by the decision of this Court in the case of Petitioner relating to Assessment Year 1974-1975 in 173 ITR 374. Following the said decision, this question has to be answered in the negative and against the Assessee. This Court held that the question whether water supply system (pipelines/sanitary fittings) and storage tanks are ‘plant’ or not, depends on their relation to the nature of the business carried on by the Assessee and the question will have to be decided in each case, on the facts and circumstances, by applying the ‘functional test’ evolved by the High Court of Allahabad in CIT v. Kanodia Warehousing Corporation . 1980 121 ITR 996.. As the Tribunal had not determined the matter by applying such principle, this Court answered the question in the negative and held that the Tribunal should apply the functional test evolved in Kanodia'a case and re-determine the facts afresh.

10.4 We find that neither the I.T.O nor the CIT (A) nor the Tribunal has examined the matter by applying the functional test. Hence, following the decision in 173 ITR 374, we answer questions (8) and (9) in the negative and hold that the Tribunal shall re-examine whether pipelines, sanitary fittings and storage tanks are ‘plant’ by applying the functional test, and then decide the rate of depreciation and decide whether extra shift allowance is admissible.

11. Re: Question No. (10):

11.1 The Assessee claimed an initial depreciation of Rs. 43,08,219/- on machinery, under Section 32(1)(vi). The I.T.O denied the same on the ground that manufacture of spark plugs and fuel injection equipment is not manufacture or production of any of the items specified in the Ninth Schedule to the Act. This was confirmed by the CIT (A) and also by the Tribunal.

11.2 The Assessee contends that Section 32(1)(vi) allowed a deduction of 20% of the actual cost of machinery or plant installed for the manufacture or production of any of the articles specified in Items 1 to 24 in the list in the Ninth Schedule; that Item 8 enumerated in the said list is ‘Industrial and agricultural machinery’; the Assessee manufactures spark plugs and fuel injection equipment which are fitted in agricultural machines like tractors; that ‘industrial and agricultural machinery’ will include their components also; and therefore, Assessee is entitled to the benefit of initial depreciation under Section 32(1)(vi).

11.3 Ninth Schedule does not refer to components of Industrial and agricultural machinery. Section 32(1)(vi) gives the benefit of initial depreciation in respect of plant and machinery installed for the manufacture or production of any article or thing by a small scale industrial undertaking; but in regard to Assessees other than small scale industrial undertakings, initial depreciation is admitted only in regard to manufacture or production of any one or more of the articles or things specified in Items 1 to 24 in the list in the Ninth Schedule. If the legislative intent was to include components or accessories, it would have been specifically mentioned in the list. When the Section specifically states that initial depreciation is available in respect of articles or things specified in Items 1 to 24 in the Ninth Schedule, it is not possible or permissible to include something which is not in the list and read Item 8 of ‘Industrial and agricultural machinery and its components’. In fact, a comparison with Section 33(1)(a)(B)(i) read with Fifth Schedule is of some assistance to show that where the legislature intended to include components, it specifically did so. Section 33(1)(a)(B)(i) provided for development rebate at the rates specified in regard to machinery or plant installed for the purpose of business of construction, manufacture or production of any one or more of the articles or things specified in the list in the fifth Schedule. In the list contained in Fifth Schedule. Item (4) is Industrial Machinery as specified, Item (9) is tractors, earth-moving machinery and agricultural implements and Item (24) is component parts of the articles mentioned in Items (4), (9) and other articles specified. It is thus clear that manufacture or production of spark plugs and fuel injection equipment for ‘agricultural machinery’ cannot be equated to production of ‘agricultural machinery. In fact, in regard to the Assessment Year 1975-1976, a similar view has been taken by this Court in the case of the Assessee, by Order dated 28.3.1989 in ITRC 189-193/1980. The decision of the ITO, CIT (A) and the Tribunal is in accordance with law. Question No. (10) is therefore answered in the affirmative, against the Assessee and in favour of the Revenue.

12. Re: Question No. (11):

12.1 The Assessee claimed deduction of the surtax liability in computing total income for purposes of Income-Tax. The I.T.O rejected it on the ground that surtax is a tax on income. The CIT (A) and the Tribunal confirmed the said rejection.

12.2 Section 40(a)(ii) provides that notwithstanding anything to the contrary in Section 30 to 39, any sum paid on account of any rate or tax levied on the profits or gains of any business or profession or assessed at a proportion of, or otherwise on the basis of, any such profits or gains shall not be deducted in computing the income chargeable under the Head ‘Profits and Gains of business or Profession’. Even apart from the provisions of this clause, a sum paid as tax on profits or gains of any business cannot be deducted in computing profits for purposes of Income-Tax, under the general law of Income-tax. This Court in Commissioner Of Income-Tax, Karnataka v. International Instruments (P.) Ltd. (1983) 144 ITR 936, has held that surtax payable under the Companies (Profits) Surtax Act, 1964 on the chargeable profit is nothing but an additional tax on the profits and gains of an assessee's business and therefore surtax cannot be deducted for computing total income. Hence question No. (11) is answered in the affirmative, against the assessee and in favour of the Revenue.

13. Re: Question No. (12):

The Assessee claimed weighted deduction under section 35B(1)(b)(ii) in respect of Insurance Premium paid to Export Credit Guarantee Corporation Ltd. The I.T.O did not allow weighted deduction in that behalf. In fact, he clubbed it with certain other matters in regard to which weighted deduction was claimed and disposed of the matter without any independent consideration of this claim. The CIT (A) confirmed the said decision. He also did not consider the matter separately. The Tribunal also confirmed the disallowance following its decision on a similar question in regard to Assessment Year 1975-1976. The matter is now covered by the decision of this Court in CIT v. J.B Advani & Co. (Mysore) Pvt. Ltd. . 1987 163 ITR 639., wherein this Court held that premium paid to ECGCL is for obtaining information regarding markets outside India in respect of goods in which it was doing business and therefore it would fall under Section 35B(1)(b). Following the said decision, question No. (12) is answered in the negative, i.e in favour of the Assessee and against the Revenue.

Re: Question No. (2):

14. This question relates to a provision of Rs. 75,51,000/- made and debited by the Assessee, under the head ‘Salaries and Wages’ in respect of unutilised leave by its employees as on 31.12.1975 During the earlier years, the Assessee had not made any such provision, as it used to debit only the actual payments made in the accounting year, towards unutilised leave.

14.1 The Assessee contended that the provision of Rs. 75,51,000/- was made by evaluating the number of days of leave standing to the credit of the individual employee, with reference to their salary, as at the end of the accounting year; that a systematic and regular record of leave earned and utilised by its employees was maintained and the liability had been quantified with reference to the individual rate of salary, as at the end of December 1975. It was stated that the leave entitlement was as per the provisions of the Factories Act, 1948 read with Memoranda of Settlement entered between the Assessee and the Employees Association from time to time and there was no separate scheme governing the matter.

14.2 The I.T.O held that the provision made was only to meet a contingent liability and not an ascertained liability and, therefore, disallowed the expenditure relying on the decision of the Madhya Pradesh High Court in Chhaganlal Textile Mills Ltd. v. CIT . 1966 62 ITR 274. and the decision of the Bombay High Court in CIT v. Raj Kumar Mills Ltd. . 1979 80 ITR 244..

14.3 In an appeal by the Assessee, the C.I.T (A) found that the Assessee had got regular leave records for all its employees in conformity with the Factories Act, 1948 and had given full details in regard to the provision made; that apart from Annual leave, the employees were also entitled to premium leave depending on the length of their service as also sick leave; that the Assessee had a systematic and regular record of leave earned and utilised during the year in respect of each employee and the liability of Rs. 75,51,000/- had been quantified from such records. He, therefore, held that the provision of Rs. 75,51,000/- was not a contingent liability, but an expenditure that was allowable. He purported to follow two decisions of the Supreme Court in Calcutta Co. Ltd. v. CIT . 1959 37 ITR 1. and Metal Box Company Of India Ltd. v. Workmen . 1969 73 ITR 53. The Revenue filed a Second Appeal before the Tribunal. The Tribunal upheld the decision of C.I.T (A) holding that the Assessee was entitled to claim the said provision as an expenditure. Feeling aggrieved, the Revenue has sought this reference.

15. Before examining the rival contentions, it is necessary to notice the provisions relating to leave, as applicable to the employees of the Assessee. The Assessee does not have any ‘Scheme’ in regard to leave. The certified Standing Orders for Employees of the Assessee provides that an employee shall be allowed leave with salary/wages subject to and in accordance with the Indian Factories Act.

15.1 Chapter VIII of the Factories Act, 1948, deals with Annual leave with wages. Section 78 provides that provisions of the said Chapter shall not operate to the prejudice of any right to which a worker may be entitled under any law or under the terms of any award, agreement (including settlement) or contract of service.

15.2 Section 79 deals with Annual leave with wages. Section 80 deals with wages during leave period.

15.3 Sub-section (1) of Section 79 inter-alia provides that, every worker who has worked for a period of 240 days or more in a factory during a calendar year shall be allowed during the subsequent calendar year, leave with wages at the rate of one day for every twenty days of work performed by him during the previous calendar Year. Explanation (1) clarifies that the leave earned in the year prior to that in which the leave is enjoyed shall be deemed to be days on which the worker has worked in a factory for the purpose of computation of the period of 240 days or more, but he shall not earn leave for those days.

15.4 Sub-section (3) of Section 79 provides that if a worker is discharged or dismissed from service or quits his employment or is super-annuated or dies while in service, during the course of the calendar year, he or his heir/nominee as the case may be, shall be entitled to wages in lieu of the quantum of leave to which he was entitled immediately before such date, even if he had not worked for the entire period specified for making him eligible to avail of such leave.

15.5 Sub-section (5) of Section 79 provides that if a worker does not, in any one calendar year, take the whole of the leave allowed to him, any leave not taken by him shall be added to the leave to be allowed to him in the succeeding calendar year; provided that the total number of days of leave that may be carried forward to a succeeding year shall not exceed thirty days; provided further that a worker, who has applied for leave with wages but has not been given such leave shall be entitled to carry forward the leave refused without any limit.

15.6 Section 80 of Factories Act provides that for the leave allowed to a worker under Section 78 or 79, he shall be entitled to wages, at a rate equal to the daily average of his total full time earning for the days on which he actually worked, during the month immediately preceding his leave, exclusive of any overtime and bonus.

15.7 The Memorandum of Settlement for the period 1965-67, provided that the entitlement and availing of annual or earned leave by workmen will be strictly in accordance with the provisions of the Factories Act. The next Settlement for the period 1968-70 provides that workmen will be entitled to accumulate unavailed sick leave to the maximum extent of 18 days in case of workmen covered under ESI Scheme and 33 days in case of others. It also provides that with effect from 1.1.1968, workmen will be entitled to premium days as annual leave (one day for workmen with service of 5 years and above but below 10 years; two days for workmen with service of 10 years and above but below 15 years; three days for workmen with service of 15 years and above but below 20 years; and four premium days for workmen with service of 20 years and above) depending upon the workmen's period of service with the Company as on first of January of every calendar year in addition to the annual leave. The same leave benefits were continued subsequently.

15.8 The Memorandum of Settlement for the period 1971-73 provides that the workmen will continue to have sick leave facility six days in a year for those covered under ESI scheme and eleven days for those who are not) and enabled the workmen to encash the unavailed sick leave at the end of each calendar year in such a manner that they will have balance of six days/eleven days as the case may be, to their credit, to carry forward to the following calender year.

15.9 The Assessee claims to have calculated the leave entitlement of each employee for the year ended 31.12.1975 and calculated the salary/wage for such period and made a provision for payment of such amount aggregating to Rs. 75,51,000/-. It is the case of the Assessee that as and when an employee utilises such leave, the wages to be paid for the leave period will be paid from that account; and when an employee retires from service, leave encashment amount will also be paid from that account; and therefore it is an admissible deduction.

16. On behalf of the Revenue, it was contended before us that a provision for leave salary in the accounting year, cannot be considered as a provision for a liability in praesenti, as it is a contingent liability. It is further contended that the question is now covered by two decisions of this Court in CIT v. Hal . 1988 174 ITR 340. and CIT v. Bharat Earth Movers Ltd. . 1995 211 ITR 515., and therefore the question should be answered in favour of the Revenue.

16.1 In the case of Hal, the question considered was whether provision of accrued leave salary is an admissible deduction to arrive at the assessable profits of a company. This Court held that payment on account of encashment of leave to a workman could arise only when his employment is terminated and till then, the liability that rests on the employer to pay a worker, wages in accordance with the Rules for unutilised leave period, remains a contingent liability which the employer may or may not be called upon to discharge. Hence, if any amount is set apart by an employer in a year for meeting such contingency, it cannot be regarded as a permissible deduction. This Court followed the decision of Calcutta High Court in Bengal Enamel Works Ltd. v. CIT . ILR 1955 2 CAL 13. and the decision of Madhyapradesh High Court in Chaganlal Textiles Pvt. Ltd. v. CIT : (1966 (62) ITR 274).

16.2 In the case of BEML also, the question that arose for consideration was whether provision for meeting the liability for encashment of earned leave in an admissible deduction. This Court held that neither leave salary nor leave encashment benefit payable to the employees can be said to be a present liability and it is only a contingent liability and therefore the Assessee-Employer is not entitled to deduction in regard.to provision made to meet such a liability.

16.3 In Bengal Enamel Works case, the Calcutta High Court considered whether an Assessee is entitled to deduction of an amount which was debited to its expense account to meet the liability to the employees on account of holiday wages which would have to be paid to them in the following year. The Court held:—

“It should be clear from what I have stated above that such statutory liability for holiday wages as the Factories Act creates is only a contingent liability which may or may not have to be discharged: and, secondly, the measure of that liability can never be known in advance. It cannot be so known, because it cannot be known in advance how many employees will avail themselves of how many holidays and when and, necessarily, at what rate, holiday wages would be payable. In those circumstances it is perfectly clear that not only is the amount claimed not allowable as an item of expenditure, because, in fact, no expenditure had been incurred and not a price had gone out of the funds of the company, but also that the amount does not even represent a certain liability which will have to be discharged in any event. It may be that although a particular amount is not actually expended during the currency of a particular accounting year, the assessee will still be entitled to a deduction if a certain liability for its payment has arisen so that it may be said that the expenditure is as good as made. The amount claimed in the present case is certainly not even of that character and, as I have already pointed out, it is not an amount which was actually spent.

Mr. Bose contended that his client kept its accounts in the mercantile method and therefore the fact that it had debited the amount in its books would be sufficient to establish expenditure. I entirely disagree. It is true that under the mercantile system of accounting a debit can often be equated with actual expenditure provided a liability has been incurred, but on the facts I have stated, the debit in the present case is no better than a fictitious debit and is liable to be disregarded on that account.”

16.4 In Chhaganlal's case, the question considered was whether an Assessee is entitled to a deduction of an amount set apart in the balance-sheet for payment to be made to workers in respect of leave under Section 79 of Factories Act. The Court held that under Section 10(2)(xv) of Income Tax Act, 1922, deduction is not permissible for a contingent liability, as it is not an ‘expenditure’; that liability for holiday wages under Section 79 is only a contingent liability; and any sum set apart by an employer in any year to meet the contingency of some workers going on leave the next year cannot be regarded as a permissible expenditure; and every amount set apart by an Assessee out of prudence, to meet a contingent liability will not become an ‘expenditure’.

16.5 A similar view was taken by the Andhra Pradesh High Court in C.I.T v. Sileman Khan Mahaboob Khan . 1988 174 ITR 200. and by the Bombay High Court in C.I.T v. Rajkumar Mills Ltd.

17. The Assessee contends that the liability for unutilized leave arises in the year in which such leave was earned and not in the year in which it is availed or encashed; and the liability for salary for such leave being a component of the remuneration payable to the employee for services rendered during the year, the profits for the year in which the leave is earned, should bear the charge in respect of the salary for such leave. It is pointed out that the employee has an option of either availing leave in the subsequent year or encashing the leave in certain circumstances; and if he avails the leave, he will be paid the salary for the period for which he would not be working and if it is debited to the profits of the subsequent year, the profits of the subsequent year would be understated. Therefore, if an employee avails leave earned in an earlier year, during the subsequent year, the salary for the period the employee is on leave, is debited to the provision Account and not against the profits of the subsequent year in which the leave is availed of. On the other hand if the employee encashes his leave, the employer will pay the employee monetary equivalent and debit it to the provision account and not against the profits for the year in which such leave is encashed. It is, therefore, contended that the provision made for salary/wages payable on account of unutilised leave of employees is a provision for a known liability and must accordingly be allowed as a deduction. It is pointed out that the liability is certain, but only the method by which the liability has to be discharged is uncertain. Elaborating on this submission, Mr. Dastur, the learned Senior Counsel for the Assessee argued that it is a certainty that the liability in respect of leave earned will be discharged by the employer either by ‘detriment’ or by ‘disadvantage’ and the only uncertainty is the manner in which the said liability will be discharged, that is whether by ‘detriment’ (monetary out flow) or by disadvantage (non-availability of the service of the employee during the subsequent year if the employee utilises the leave); and the only contingency is that leave may be forfeited under certain circumstances. But such forfeiture is a remote possibility and even a contingent liability which is properly ascertainable can be taken into account in computing the profits for the year.

17.1 The Assessee relied on the decision in Delhi Flour Mills Co. Ltd. v. C.I.T . 1974 95 ITR 151. to contend that if an amount represents a part of the emoluments payable to an employee for rendering services during a year, such amount accrues to the employee as soon as he completes each year of service and there is a corresponding liability on the part of the employer to pay such amount to the employee at the end of each year; and if the amount of liability is ascertainable, then, the same has to be allowed as a deduction; and the mere fact that the employer has not actually paid the amount, but has merely created a liability in the books of account in accordance with the mercantile system of accounting adopted by the Assessee, would not mean that the Assessee is not entitled to the deduction in that behalf.

17.2 The Assessee also contended that leave encashment is a part of retirement benefit; and the cost of retirement benefits, to an employer, results from receiving services from the employees, who are entitled to receive such benefits; and consequently the cost of retirement benefits is to be accounted for in the period, during which such services are rendered. The Assessee relied on Accounting Standard No. 15 relating to “Accounting for Retirement benefits in the Financial Statements of Employers” from the Statement of Auditing Practices of Institute of Chartered Accountants of India (1995) in this behalf.

17.3 The learned Counsel for the Assessee relied on the decision of the Supreme Court in Metal Box Company of India Ltd. v. Their Workmen (1969) 73 ITR 53 and the decision of the House of Lords in Southern Railway of Peru Ltd. v. Owen . 1957 AC 334. which is approved and followed in Metal Box case. He contended that in Metal Box case, the Supreme Court following the decision of the House of Lords in Southern Railway Peru, has held that even a contingent liability if properly ascertainable was deductible. He submitted that the decisions of this Court in the case of Hal & BEML and the decisions of the High Courts of Calcutta, Madhya Pradesh, Bombay and Andhra Pradesh referred to above which held that a contingent liability is not deductible are contrary to the decision of the Supreme Court in Metal box case and therefore, not good law. We will now consider the decisions relied on by the assessee.

18. In the case of Southern Railway of Peru, the point in dispute related to the principle on which the profits should be computed with reference to certain payments which the appellant company made under the laws of the Republic of Peru, to its employees on their retirement from their service with it. Then question was whether the amounts to be deducted as outgoings in each year of account were the payments made or actually owing to an employee who had retired in that year (as contended the Revenue) or whether the amounts to be deducted were a proportionate amount of each payment estimated as ultimately to be paid on retirement, on the basis of that proportionate amount having accrued at the end of each period of account, though the employee had not retired and was still in the service of the appellant company (as contended by the Assessee). In that case as per the Statutory Scheme in force, the employer Assessee was liable to pay to the employees a lumpsum payment on termination of their services and the said payment did not depend on any prescribed length of service. An employee could, however, forfeit his right to the said payment by wrongful conduct or certain other given circumstances. The House of Lords held that the Assessee was not entitled to make the said deduction on the ground that the Assessee had not taken note of the discount factor while calculating the deduction. But the House of Lords, however, recognised the important principle that the company was entitled to charge against each year's receipts, the cost of making provision for the retirement payments which would ultimately be payable, as the employer had the benefit of the employees services during that year, provided the present value of the future payment could be fairly estimated. The House of Lords found that where an employer dealt with a number of similar obligations that arose from its business, although it was true to say that each separate obligation may never mature, if the aggregate of the obligations can be fixed with some precision while each of the obligation may remain uncertain the aggregate can be accepted as a recognised obligation. The House of Lords also came to the conclusion that even though the liability to pay a lumpsum could be avoided on the breach of contract or misconduct on the part of the employed and to that extent the liability of the employer was contingent, such contingency would seem to be too remote which justify a prudent employer in ignoring the said liability until the day for such payment arrived. On a consideration of the relevant provisions which entitled the employee to such payment, the Court came to the conclusion that the lumpsum payment was to be regarded as a deferred remuneration in respect of the entire period of service. The following observations of the House of Lords are relevant:

“What the appellant claims the right to do is to charge against each year's receipts the cost of making provision for the retirement payments that will ultimately be thrown upon it by virtue of the fact that it has had the benefit of its employees' services during that year. As a corollary it will not make any charge to cover the actual payments made in the year in respect of retirement benefits. Only by such a method, it is said, can it bring against the receipts of the year the true cost of the services that it has used to earn those receipts. Generally speaking this must, I think, be true. For, whereas it is possible that any one of its many employees may forfeit his benefit and so never require a payment, the substantial facts of the situation are that when the company has paid every salary and wage that is due for current remuneration of the year it has not by any means wholly discharged itself on the pecuniary burden which falls upon it in respect of the year's employment. This is a long term application of the practice by which provision for holidays with pay in the coming year is charged in part against the receipts of the previous year. It does not seem to me inconsistent with the theory on which the claim is based that in the year when an increase of salary takes place and the expectation of a larger ultimate payment materializes an adjustment has to be made to take care of what has thus become the under-provision of earlier years. I agree that it is arbitrary to describe such an adjustment as accruing in respect of that year's service; but, on the other had, it is a provision which is required in that year to take account of the increased burden which the year's salary for the year's service has thrown upon the employer”

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“…where you are dealing with a number of similar obligations, that arise from trading, although it may be true to say of each separate one that it may never mature, it is the sum of the obligations that matters to the trader, and experience may show that, while each remains uncertain, the aggregate can be fixed with some precision. For the trader the practical question is always the same in these cases: How much more shall I have to pay out or shall I be able to get in than my current accounts of the year are recording? Legal analysis of the obligation may present it in a variety of different forms. There is the deferred payment which is subject to nothing more than the practical contingency that it may not be received. That is dealt with, as we know, by bringing it in at its face value, subject to allowance, or, in some cases, at a valuation. There is the future payment for work done which is only legally exigible if the whole work is completed. A large part of this particular aspect must be covered by such items of receipt as work in progress, but I do not know enough of the methods of valuing or allowing for this to speak with any confidence about it. And, lastly, there is the contingent obligation to make a future payment, which is our present case. But, whatever the legal analysis, I think that for liabilities as for debts their proper treatment in annual statements of profit depends not upon the legal form but upon the trader's answers to two separate questions. The first is: Have I adequately stated my profits for the year if I do not include some figure in respect of these obligations? The second is do the circumstances of the case, which include the techniques of established accounting practice make it possible to supply a figure reliable enough for the purpose?”

19. In the Metal Box case, the question that arose for consideration was whether a liability under a Scheme of Gratuity in respect of the accounting year stated in the profit and loss account could be deducted for the purpose of computation of bonus under the Payment of Bonus Act. The Supreme Court held that contingent liabilities discounted and valued as necessary, can be taken into account as trading expenses if they are sufficiently certain to be capable of valuation and if profits cannot be property estimated without taking them into consideration. An estimated liability under a scheme of gratuity, if properly ascertainable and its present value is discounted, is deductible from the gross receipts while preparing the profit and loss account. This is recognised in trade circles and there is Nothing in the Bonus Act which prohibits such a practice. Such a provision provides for a known liability of which the amount can be determined with substantial accuracy. It cannot, therefore, be termed a “reserve”. Therefore, the estimated liability for the year on account of a scheme of gratuity should be allowed to be deducted from the gross profits. The allowance is not restricted to the actual payment of gratuity during the year.

20. The question whether a provision for a such liability could be deducted in the computation of profits and gains of previous year, under the Income Tax Act was not considered in Metal Box, as it was rendered while considering the question whether such a liability could be deducted for the purpose of bonus under Payment of Bonus Act. But in view of the principles laid down in Metal Box, several High Courts held that it was permissible for an assessee to make a provision in his profit and loss account for the estimated liability under a gratuity scheme, by ascertaining its present value on the basis of acturarial valuation, to claim that such liability is an ascertained liability in present though payable in future, to be deducted in the computation of the profits and gains of the previous year. Sub-section (7) of Section 40A was introduced with effect from 1.4.1973 clause (a) made it clear that whatever is provided for future use by the assessee out of the gross profits of the year of account for payment of gratuity to employees on their retirement or on the termination of their services would not be allowed as deduction in the computation of profits and gains of the year of account subject to the exceptions contained in Clause (b). The intention of the legislature in enacting Section 40A(7) is made evident in the Notes on clauses of amendment thus:

“A reading of these two provisions (that is Section 37(1) and 36(i)(v) of the Act) clearly shows that the intention has always been that deduction in respect of gratuities should be allowed either in the year in which the gratuity is actually paid or in the year in which contributions are made to an approved gratuity fund. A doubt has been expressed that the relevant provisions, as presently worded, do not secure the underlying objective and that a provision made by a taxpayer in his accounts in respect of estimated service gratuity payable to employees will be deductible in computing the taxable income in a case where the provision has been made on a scientific basis in the form of an actuarial valuation. In order to remove uncertainty in the matter, it is proposed to specifically provide in the law that no deduction will be allowed, in the computation of profits and gains of a business or profession, in respect of any reserved created or provision made for the payment of gratuity to the employees on retirement or on termination of employment for any reason. This restriction will, however, not apply in relation to a provision made for the purpose of payment of a sum by way of contribution towards an approved gratuity fund that has become payable during the relevant account year, on for the purpose of meeting actual liability in respect of payment of gratuity to the employees that has arisen during such year.”

21. Another aspect that requires to be noticed is that the practice of making a provision for meeting the liability relating to gratuity was recognised among employers, by determining the liability on actuarial valuation basis by discounting the present value. But there is no such actuarial valuation basis for the provision for salary and wages for unutilised leave. Hence, the principle laid down in Metal Box has no bearing on the question relating to provision for leave wages.

22. The decision of the House of Lords in the case of Southern Railway of Peru can also be of no assistance to the petitioner. While the said decision was followed in Metal Box while dealing with a case arising under the Payment of Bonus Act, the Supreme Court did hot follow the said decision while dealing with a cases under the Income Tax Act. In Indian Molasses Co. v. Commissioner of Income Tax . 1959 37 ITR 66. the Supreme Court noticed the principle laid down in Southern Railway of Peru that the recurring liability of a pension which is comprised into a lumpsum payment, should itself be a legal obligation, and that, if contingent, the present value of the future payment should be fairly estimable; and what could be deducted is not the whole of the amount, but only the present value of the future liability. The Supreme Court, however, held that the said decision was of no assistance, as it did not deal with the term ‘expenditure’ which is relevant under the provisions of the Income Tax Act. To claim deduction, an Assessee should make out that the ‘provision’ made is a deduction permissible under Section 36 or is a deduction specified in Section 30 to 35E or an expenditure under Section 37. The deduction claimed by Assessee does not fall under Section 30 to 36. Let us examine whether it can fall under Section 37.

23. In Indian Molasses Co., the Supreme Court held that “Expenditure” is what is ‘paid out or paid away’ and is something which is gone irretrievably. The Supreme Court held:

“To be a payment which is made irrevocably there should be no possibility of the money forming, once again, a part of the funds of the assessee company. If this condition is not fulfilled, and there is a possibility of there being a resulting trust in favour of the company, then the money has not been spent, i.e, paid out or away, but the amount must be treated as set apart to meet a contingency. There is a distinction between a contingent liability and a payment depending upon a contingency. The question is whether in the years of account, one can describe the assessee company's liability as contingent or merely depending upon a contingency.

“…..The income-tax law does not allow as expenses all the deductions a prudent trader would make in computing his profits. The money may be expended on grounds of commercial expediency but not of necessity. The test of necessity is whether the intention was to earn trading receipts or to avoid future recurring payments of a revenue character. Expenditure in this sense is equal to disbursement which, to use a homely phrase, means something which comes out of the trader's pocket. Thus, in finding out what profits there be, the normal accountancy practice may be to allow as expense any sum in respect of liabilities which have accrued over the accounting period and to deduct such sums from profits. But the income-Tax laws do not take every such allowance as legitimate for purposes of tax. A distinction is made between an actual liability in prasenti and a liability de futuro which, for the time being, is only contingent. The former is deductible but not the latter….What a prudent trader sets apart to meet a liability, not actually present but only contingent, cannot bear the character to expense till the liability becomes real.”

The Supreme Court held that where the liability itself is contingent, as contrasted from payment being contingent, there can be no deduction. In the words of the Supreme Court “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 expenditure.”

24. The principle in Indian Molasses is followed and reiterated in Shree Sajjan Mills Ltd. v. Income Tax Commissioner, Bhopal . AIR 1986 SC 486.. The Supreme Court held:

“Contingent liabilities do not constitute expenditure and cannot be the subject matter of deduction even under the mercantile system of accounting. Expenditure which was deductible for Income Tax purposes is towards the liability actually existing at the time, but setting apart money which might become expenditure on the happening of an event, is not an expenditure….A distinction is often made between the actual liability in praesenti and a liability de futurs, which for the time being is only contingent. The former is deductible, but not the latter”.

25. We will now consider the nature of liability for payment of wages for unutilised leave by applying the said principles. Under the scheme relating to Annual Leave, an employee who works for the required number of days during a calender year, does not become entitled to any monetory benefit on account of leave earned during that year. He becomes entitled to leave with wages calculated at the rate of one day for every 20 days of work performed by him during the previous calendar year. That is, an employee who worked for a period of 240 days during 1.1.1975 to 31.12.1975 became entitled to avail 12 days of leave with wages during the calendar year 1976, that is, between 1.1.1976 and 31.12.1976 The employee does not became entitled to leave earned in a calendar year, during that calendar year. Therefore, the entitlement relating to leave with wages cannot be equated to entitlement to money payment. What is earned as ‘leave’ during an accounting year can not therefore be treated as ‘money earned’ during that year, to be paid later.

26. Having regard to Section 79, the period of such leave, if availed by an employee during the year 1976, shall be deemed to be days on which the employee had worked in the factory during 1976, and he becomes entitled to wages for the said period of leave at the rates applicable during the month immediately preceding the leave and not at the rate that was prevailing in the year 1975 when he earned the said leave. An employee had the option to either avail during the year 1976 the leave earned in 1975, or accumulate the same in which event, the unused leave gets added to the leave to be allowed in the succeeding accounting year provided, the total number of days of leave that may be carried forwarded to a succeeding year cannot however exceed 30 days (subject to the further proviso that a person who applied for leave with wages but was not been given such leave, shall be entitled to carry forward such leave without any limit). Thus, the leave earned during a year may be availed during the succeeding year or carried over to the next year. When it is not availed during the succeeding year, it can be carried over only if he has not already accumulated the maximum number of carried over leave. If he has already accumulated the maximum days of unutilised leave and if the leave earned during a year is not utilised during the next year, it will lapse. Thus, so far as accumulated leave is concerned, what can be encashed at the end, on termination can never be more than 30 days (unless the leave applied for has been refused).

27. Therefore, the only thing certain about the whole matter is earning of leave in regard to each year of service. But, thereafter any of the following three things may happen: (a) It may be utilised during the next year in which event he gets paid for it during that year; or (b) It may get accumulated in which event, wages therefor becomes payable as encashment of utilised leave at the time of termination of service; or (c) It may get lapsed on account of nonutilisation during the next year and maximum accumulation having already been reached in regard to unutilised leave.

28. Allowing the leave to lapse is not uncommon. In respect of the period of leave availed, a person is not entitled to bonus; nor will he be able to earn over-time during that period. Hence several employees may choose not to avail the leave and allow it to lapse, to enable them to earn overtime or have the maximum bonus permissible. Thus, what happens to the leave is wholly uncertain. If the employer sets apart 12 days wages at 1975 rates out of the profits for the year 1975, there is more than a reasonable possibility of the said amount not being used at all, for payment to the employee.

29. There is no way of ascertaining before hand whether the employee will utilise the leave during the year next to the year in which it is earned, or whether he will accumulate it or allow it to lapse. Therefore there is no reasonable certainty that the provision made for unutilised leave, will be used at all. This may be demonstrated by an illustration. Take an example of an employee who normally works for 240 days in a year. He becomes entitled to 12 days of leave every year. If the assessee's contention should be accepted, then, in the case of an employee who has been in service for 25 years, the Assessee will make a provision for payment of salary for 12 days every year, in all a provision for 300 days. If the employee does not utilise any leave, and allows the leave to lapse what could actually be paid as retirement benefit on account of accumulated leave encashment is salary for only 30 days. It would thus be seen that if the provision is to be permitted as an expenditure every year, there is every likelihood that as against a provision made for 300 days, which may be claimed as expenditure during a period of 25 years, the employer may ultimately be paying for only 30 days only and remaining amount equivalent to the salary for 270 days reverts back to the employer. On the other hand, if the employee uses the leave earned in a year, during the next year, he gets paid for the leave period during the next year and there is no possibility of using the provision made for the unutilised leave at all. Let us take another example. If an employee has already accumulated the maximum leave as at the end of 31.12.1994, the leave earned during the period 1.1.1975 to 31.12.1995, will unless used during the calender year 1976, will lapse; and the provision if any made will never be utilised. Thus setting apart the wages for the leave earned by every employee during a year, by way of a provision will be to a large extents to meet a liability which is either contingent or nonexistent (on account of lapse of leave). Therefore, when a provision is made and a part of the profits is set apart by the employer to meet the salaries and wages payable for unutilised leave, there is a very real possibility of the amount not being used at all and remaining in the coffers of the Assessee company.

30. A provision for unutilised leave is not a provision for payment of an amount which has become due and payment of which has got postponed depending on a contingency. If the amount has become due, but payment is to be made on the happening of an event, then, it is a case of the amount being irrevocably set apart and there is no chance of the fund coming back to the Assessee Company. In such an event, the payment is certain, but it is postponed to be made on the happening of a certain event. But where that amount is set apart to meet a liability which may or may not arise at all, it is a contingent liability and no provision can be made towards such liability.

31. The Learned Counsel for the Assessee lastly contended that making a provision for payment of leave salary is recognised as an accounting practice and recognised and accepted accounting practices entitled the assessee to claim deductions for purposes of taxation and therefore a deduction should be admitted in regard to the provision for salary/wages for unutilised leave. He relied on Accounting Standard No. 15 of Institute of Chartered Accountants India and Accounting Standards of Financial Accounting Standard Board of USA (1994). At the outset it has to be noticed that merely because a provision can be made in accounts, does not necessarily mean that the provision so made becomes a permitted expenditure for the purpose of taxation. As observed by the Supreme Court in Indian Molasses case, in finding out what is the profit, the normal accountancy practice may allow as expense any sum in respect of liabilities which have accrued over the accounting period and to deduct such sum from profits; but the income-tax laws do not take every such allowance as legitimate deduction for the purpose of tax. That apart, the contention that the said Accounting Standards recognise such provision is not correct. Accounting Standard No. 15 relied on by the Assessee relates to Accounting for retirement benefits in the financial statements of employers. It is no doubt true that leave encashment on retirement is considered as a retirement benefit. Para 12 of the Accounting Standard No. 15 provides that the cost of retirement benefits to an employer results from receiving services from the employees who are entitled to receive such benefits, and consequently the cost of retirement benefits is accounted for in the period during which such services are rendered. The American Accounting Standard (Section C44) relating to “compensation to employees; paid absence” relied on by petitioner provides that a liability shall be accrued for vacation benefits that employees have earned but have not yet taken. But, that would be only if the leave earned during each year of service, is accumulated without any lapsing and wages therefor becomes payable on retirement. Where the accumulation permissible is limited and the earned and unutilised leave, in excess of the permissible limit lapses, obviously the said accounting practice can not be applied. In fact this is made clear in the American Accounting Standard (Section C44) relied on by petitioner, which recognises the difference between cases where the accrued rights expire or lapse after a period specified, and cases where accrued fights are carried forward and accumulated without expiry. The relevant portions from the said Accounting Standard is extracted below:

“An employer shall accrue a liability for employees' compensation for future absence if all of the following conditions are met:

a) the employer's obligation relating to employees' rights to receive compensation for future absences is attributable to employees' services already rendered;

b) The obligation relates to rights that eventually vest or accumulate.

c) Payment of the compensation is probable.

d) The amount can be reasonably estimated

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If the rights expire, a liability for future absence should not be accrued at year end, because the benefits to be paid in subsequent years would not be attributable to employee's service rendered in prior year”

(emphasis supplied)

32. Hence, a provision for salaries and wages for unutilised leave cannot be deducted as an expenditure against the profit for the year when the leave was earned.

33. In the result, we answer the References as follows:—

(i) Questions 1, 4, 5, 6 and 7 are answered in the affirmative, against the Revenue and in favour of the Assessee; (The answer to question No. 7 is subject to the clarification in Para 9 above).

(ii) Questions 2, 3, 8 and 9 are answered in the negative, against the Assessee and in favour of the Revenue; and in regard to questions 8 & 9, the Tribunal is directed to re-examine the matter as directed in Para 10.4 above.

(iii) Question 10 and 11 are answered in the affirmative, against the Assessee and in favour of the Revenue;

(iv) Question 12 is answered in the negative, against the Revenue and in favour of the Assessee.