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Commissioner Of Income-Tax, Kerala-I v. Pratap Cashew Co. (P.) Ltd.
High Court Judgment (Balakrishna Eradi, J.) — Summary
Factual and Procedural Background
This opinion arises from a reference made by the Income-tax Appellate Tribunal, Cochin Bench, to the High Court under s. 256(1) of the Income-tax Act, 1961, of two questions of law originating from its order dated 4 February 1975 in I.T.A. No. 260.Coch/72-73.
The assessee is a private company engaged in processing raw cashew-nuts. The relevant assessment year was 1971–72 and the accounting year the twelve months ending 30 September 1970. During that accounting year the assessee entered into agreements with owners of three cashew factories under which "the management of the business carried on in the factories was transferred to the assessee" as going concerns together with goodwill and existing rights and liabilities (a copy of one such agreement was appended as annexure "A").
The agreements expressly required the assessee to engage all employees of the factories as on the date of the agreements, to treat their services as continuous without break and on terms not less favourable than previously applicable, and to hold itself liable to pay statutory compensation (including on retrenchment) on the basis that services were continuous. The arrangement of transfer remained terminable by either party on three calendar months' written notice.
During the accounting year the Kerala Industrial Employees' Payment of Gratuity Ordinance (later the Kerala Industrial Employees' Payment of Gratuity Act, 1970 — "the Act") came into force. Under s. 4 of the Act gratuity became payable on events such as retrenchment after completion of a minimum period of five years of continuous service.
In its books the assessee debited Rs. 1,25,952 as the liability for gratuity and claimed this deduction before the Income-tax Officer (ITO). The ITO disallowed the deduction on grounds including that (i) the company had been in existence only about two years and therefore could not have employees with five years' continuous service; (ii) annexure "A" was, in the ITO's view, merely a lease and did not evidence a taking over of liability for gratuity; and (iii) the method of quantifying the liability adopted by the assessee was defective.
On appeal the Appellate Assistant Commissioner (AAC), Trivandrum, allowed the claim, holding that the assessee had taken over the factories and thereby become legally liable under s. 4 for gratuity computed with reference to the entire period of each employee's service (before and after transfer), and also held the assessee's quantification reasonable despite lack of an actuary's certificate. The department appealed to the Tribunal. The Tribunal agreed with the AAC that the assessee, though not owner of premises, was the employer liable under s. 4 and allowed the deduction in principle but directed that an actuarial valuation be obtained for correct quantification. The Commissioner of Income-tax (CIT), Ernakulam, then applied under s. 256(1) for the two questions of law to be referred to the High Court; the Tribunal allowed the reference.
Legal Issues Presented
- Whether, on the facts and in the circumstances of the case, the Tribunal was justified in holding that in computing the liability under the Kerala Industrial Employees' Payment of Gratuity Act the number of completed years of service of every employee prior to the accounting year can also be taken into consideration?
- Whether the Tribunal had any material before it in holding that the assessee is the owner of the business and the employer and that the liability to pay gratuity is that of the assessee?
Arguments of the Parties
Revenue's (Department's) Arguments
- The assessee-company had existed for only about two years prior to the accounting year and therefore could not have employees who had completed the statutory minimum period of five years' continuous service required by s. 4 of the Act; consequently, there was no need to make provision for gratuity.
- Annexure "A" was, in substance, a lease arrangement and did not evidence a transfer of liability for payment of gratuity to the assessee.
- The liability for gratuity was a contingent one and, until crystallised by occurrence of events specified in s. 4 (e.g., retrenchment), no deduction could be allowed.
- Quantification of the claimed liability by the assessee was defective.
- Additionally, and raised later before the High Court (but not before the Tribunal), it was argued that for assessment year 1971–72 the deduction should cover only the liability which accrued during the accounting year (for example, the element of 15 days' wages for each employee for that year).
Assessee's Arguments
- The assessee had taken over three factories as going concerns under agreements which required it to engage the existing employees and to treat their services as continuous; therefore the assessee became the employer liable under s. 4 of the Act for gratuity measured by the entire period of service of those employees.
- The assessee had made a provision of Rs. 1,25,952 in its books for gratuity and sought deduction of that amount; the quantification adopted by the assessee was reasonable and should not be rejected merely because it lacked an actuary's authentication.
Table of Precedents Cited
| Precedent | Rule or Principle Cited For | Application by the Court |
|---|---|---|
| CIT v. High Land Produce Co. Ltd., [1976] 102 ITR 803 (Ker) | Held that, even though the obligation to pay gratuity arises on events specified in s. 4 (and is therefore contingent), a prudent employer may make provision for the liability during the accounting period and claim a deduction in respect of the present value of the contingent liability computed on actuarial principles. | The High Court expressed respectful agreement with the Division Bench's view and applied the same principle to the facts: the assessee was entitled to a deduction in respect of the present value of the contingent liability that arose during the accounting period, subject to actuarial valuation for quantification. |
Court's Reasoning and Analysis
The Court proceeded in stages, adhering to the factual matrix recorded in the Tribunal's reference.
First, the Court examined annexure "A" to determine whether the agreement made the assessee liable under s. 4 of the Act. Although the instrument was styled as a lease, the Court scrutinised its terms and found that it effected a transfer of the business carried on in the factories as going concerns together with goodwill and all existing rights and liabilities, subject only to termination on three months' notice. The arrangement was not merely a lease of premises but a transfer of the right to conduct the business coupled with a contractual obligation to engage existing employees on continuous service terms and to meet statutory compensation liability on retrenchment treating service as uninterrupted.
On that basis the Court concluded that the assessee had become the employer in relation to those workmen for the purposes of the Act. The Court relied on the statutory definition of "employer" in s. 2(a) of the Act, which includes the person who has ultimate control over the affairs of the establishment or any person to whom those affairs are entrusted. After the arrangement took effect, the assessee had control over the factories' affairs; therefore it was properly characterised as the employer and liable under s. 4.
The Court next considered the character of the liability and its deductibility for income-tax purposes. It relied on the Division Bench decision in CIT v. High Land Produce Co. Ltd. which recognised that although the obligation to pay gratuity is contingent upon events such as retrenchment or retirement, a prudent employer would provide for such liability during the accounting year; accordingly, a deduction in respect of the present value of the contingent liability is allowable on actuarial principles. The Court stated its respectful agreement with that view and applied it to the present case.
The Court rejected the revenue's contention that the assessee's short period of existence (about two years) precluded liability because it overlooked the contractual stipulation that services were to be treated as continuous from prior employment; accordingly the total period of service had to be taken into account in computing the assessee's liability under s. 4.
A further contention raised for the first time before the High Court — that deduction in assessment year 1971–72 should be confined to the liability that accrued in that accounting year only — had not been pressed before the Tribunal nor included in the questions referred; the Court therefore declined to consider that argument.
Finally, in relation to valuation, the Court accepted the Tribunal's direction that an actuarial valuation should be obtained to determine the present value of the contingent liability and that the assessee should place that valuation before the ITO for scrutiny.
Holding and Implications
Holding: Both questions were answered in the affirmative — in favour of the assessee and against the department.
Direct implications for the parties (as contained in the opinion):
- The agreement evidenced by annexure "A" was held to effect a transfer of the business as going concerns and to make the assessee the employer of the workmen for the purposes of the Kerala Gratuity Act; consequently the assessee was liable under s. 4 to pay gratuity taking into account the entire period of each employee's service (both prior to and after the transfer).
- The assessee was entitled to claim a deduction for the present value of the contingent liability for gratuity which had arisen during the accounting period, in line with the principle in CIT v. High Land Produce Co. Ltd., subject to actuarial valuation for quantification.
- The Tribunal's direction that an actuarial valuation be obtained and placed before the ITO for scrutiny was endorsed by the Court.
- No order as to costs was made.
Broader implications: The judgment applies the existing principle (as stated in the cited precedent) that contingent gratuity liabilities may be provided for and deducted on actuarial principles; the opinion does not purport to set a novel legal precedent beyond applying and agreeing with the cited authority.
Administrative compliance: A copy of the judgment was to be forwarded to the Appellate Tribunal under sub-s. (1) of s. 260 of the Income-tax Act, 1961, as required.
The Judgment of the Court was delivered by
Balakrishna Eradi, J.:— The Income-tax Appellate Tribunal, Cochin Bench, has referred to this court the following two questions of law as arising from its order dated February 4, 1975, in I.T.A No. 260.Coch/72-73:
“(1) Whether, on the facts and in the circumstances of the case, the Tribunal is justified in holding that in computing the liability under the Kerala Industrial Employees' Payment of Gratuity Act the number of completed years of service of every employee prior to the accounting year can also be taken into consideration?
(2) Whether the Tribunal had any material before it in holding that the assessee is the owner of the business and the employer and that the liability to pay gratuity is that of the assessee?”
2. The assessee is a private company doing business in the processing of raw cashew-nuts. The relevant assessment year is 1971–72 and the accounting year is the period of twelve months ending with September 30, 1970. During the accounting period the assessee-company had entered into agreements with, the owners of three cashew factories whereby “the management of the business carried on in the factories was transferred to the assessee” as going concerns with the goodwill and all existing rights and liabilities.
3. It was expressly stipulated in the agreements that the assessee should engage all the employees working in the three factories as on the date of the agreements, that their services in the factories shall be treated by the assessee as continuous without any break, that the terms and conditions of service applicable to the employees in the factories after the said transfer shall not be in any way less favourable than those currently applicable to them and that the employees should not be in any way adversely affected by the said transfer in respect of their service conditions. The agreements also contained a further clause to the effect that the assessee undertook to hold itself liable to pay to the employees, in the event of their retrenchment, compensation on the basis that their services have been continuous and that it had not been in any way interrupted by the transfer of management. The arrangement “transfer of management” entered into as per the agreement was to continue in force until it was terminated by either party by giving three calendar months' notice in writing to the other party. It is common ground that the agreements executed in respect of all the factories were in identical terms and a copy of one of the agreements has been appended to the statement of the case as annexure “A”.
4. In the course of the accounting year the Kerala Industrial Employees' Payment of Gratuity Ordinance came into force which was later replaced by the Kerala Industrial Employees' Payment of Gratuity Act, 1970 (hereinafter called “the Act”). Under s. 4 of the Act—the same provision was contained in the Ordinance—gratuity shall be payable to an employee, (a) on his superannuation, (b) on his retirement, resignation, retrenchment, discharge or dismissal from service after completion of a minimum period of five years of continuous service, and (c) on his death or total disablement due to accident or disease. In their books of account the assessee had debited Rs. 1,25,952 as representing the liability for payment of gratuity under the Act and a claim for deduction in respect of the said amount was put forward before the ITO. In the assessment order evidenced by annexure “B” that claim for deduction was disallowed by the ITO mainly on the ground that the assessee-company had been in existence only for two years and since no worker could have completed the minimum statutory period of continuous service for five years there was no necessity to make provision for any payment of gratuity during the relevant accounting year. Another ground on which the ITO disallowed the deduction was that annexure “A” evidenced only a lease arrangement and it was not an agreement taking over liability for payment of gratuity to employees, etc. Lastly, it was also held by the ITO that the method of quantification of liability for gratuity adopted by the assessee was defective in several respects. The assessee carried the matter in appeal before the A AC, Trivand-rum. That appeal was allowed by the appellate authority holding that under the agreement evidenced by annexure “A” the assessee-company had taken over certain existing factories and had thereby become legally liable for payment of gratuity under the Act in respect of the entire period of service of each employee working in those factories and that hence in preparing a trading account the assessee had necessarily to provide for the liability for payment of gratuity as required by the law. The A AC was also of the view that the quantification of the liability made by the assessee was reasonable, and it could not be rejected on the ground that it did not bear an actuary's authentication. Thereafter the department carried the matter in further appeal before the Tribunal. The Tribunal agreed with the AAC's view that even though the assessee is not the owner of the factory building and premises, it had the liability topay gratuity to the employees under s. 4 of the Act on the basis of the total length of service put in by the employees in the respective factories both prior to and after the date of the agreement evidenced by annexure “A”. Overruling the contentions raised by the department that the liability for payment of gratuity was only a contingent one and that unless it was actually crystallised by the happening of any of the events mentioned in s. 4 of the Act no deduction could be allowed in respect of it, the Tribunal held that the assessee was entitled to the deduction of the gratuity payable at a future date because the statute which creates the liability had come into force during the accounting year. In regard to the question of valuation of the liability for the purpose of deduction the Tribunal was of the view that for finding out the present value of the liability which has to be discharged at a future uncertain date an actuarial valuation of the liability should be made and hence the mode of valuation adopted by the assessee could not be considered as scientific or correct. Hence, the Tribunal directed the assessee to have an actuarial valuation made and to place the same before the ITO for scrutiny within a reasonable time. The CIT, Ernakulam, thereafter, applied to the Tribunal under s. 256(1) of the I.T Act, 1961, praying that the aforementioned questions should be referred to this court. That application was allowed by the Tribunal and hence this reference.
5. The first point to be examined is whether under the agreement evidenced by annexure “A” the assessee had become liable for payment of gratuity to the employees in the three factories under the provisions of s. 4 of the Act. The document (annexure “A”) is, no doubt, styled as a lease deed but a careful scrutiny of its provisions shows that what has been done thereunder is to transfer to the assessee the business carried on in the three factories as going concerns together with the goodwill and all rights and liabilities subject to the condition that the said arrangement of transfer was liable to be put an end to by either party by giving three months' notice in writing. It is not an arrangement of lease of the factory building or premises but a transfer of the right to conduct the business coupled with the liability to engage all the existing employees working in the three factories without any break in service and on the same terms and conditions as were applicable to them prior to the transfer. It is expressly stipulated in the agreement that the assessee was to be liable to pay the statutory compensation to the employees in the event of their retrenchment on the basis that their services had been continuous without being in any way interrupted by reason of the transfer of management. Obviously, the intention was that the three factories were to be taken over by the assessee as running concerns with all the existing rights and liabilities and that the workmen employed in the factories were to be retained in service on the same terms and conditions treating their service as continuous and uninterrupted. Such being the position, there cannot be any doubt that the assessee became the employer in respect of those workmen liable for the payment of gratuity under s. 4 of the Act.
6. The expression “employer” has been defined in s. 2(a) of the Act as meaning, inter alia, “the person who or the authority which has the ultimate control over the affairs of the factory, plantation, establishment or undertaking and where the said affairs are entrusted to any other person whether called a manager, managing director, managing agent, superintendent or by any other name, such person”. After the arrangement under annexure “A” came into force it was clearly the assessee who had control over the affairs of the three factories. The Tribunal was, therefore, perfectly right in holding that the liability created by s. 4 of the Act for the payment of gratuity to the workmen employed in the three factories was on the assessee-company during the accounting year and that the assessee was, therefore, justified in making provision for the said liability.
7. In CIT v. High Land Produce Co. Ltd., [1976] 102 ITR 803 (Ker), a Division Bench of this court consisting of Govindan Nair C.J and one of us (Kochu Thommen J.) had occasion to consider with reference to ss. 36 and 37 of the I.T Act, 1961, the question regarding the admissibility of a claim made by the assessee for deduction of an amount representing the liability for gratuity payable under s. 4 of the Act. The Division Bench observed that even though the actual obligation to pay the gratuity will arise only on superannuation, resignation, retrenchment, dismissal or death of the employees, no prudent employer would wait for the actual occurrence of the events mentioned in s. 4 without making provision for the liability either by creating a fund or determining his profits for the year by taking into account the liability towards gratuity relatable to the year of account. Accordingly, it was held that even though the liability towards gratuity may be said to be only a contingent one the assessee was entitled to a deduction in respect of the present value of the contingent liability which had arisen during the accounting period on actuarial principles. We are in respectful agreement with this view.
8. It was urged by counsel appearing on behalf of the revenue that since the assessee-company had been in existence only for about two years preceding the accounting year it could possibly have no liability at all to pay gratuity under s. 4 of the Act to any employee during the relevant period since the company could not have any employees working under it who had completed a minimum period of five years of continuous service. This argument overlooks the fact that the assessee-company had taken over the three factories as running concerns with all the workmen employed therein on the express stipulation that the workmen were to be treated as being in continuous and uninterrupted service. The entire period of service put in by the workmen has, therefore, to be taken into account in determining the liability of the assessee for payment of gratuity under s. 4 of the Act.
9. Lastly, it was argued by counsel for the revenue that in any event in the assessment year 1971–72 the extent of the deduction could only cover the liability for gratuity that had accrued during the accounting year, viz., 15 days' wages, etc., in respect of each employee for that particular year. No such contention had been raised by the department before the Tribunal and it is not also covered by the question specificalfy referred to us. Although the wording of question No. (1) is not very precise its scope must be understood as taking in only the points which had been raised before the Tribunal and considered by it. The contentions which had been put forward by the department before the Tribunal have been set out by the Commissioner of Income-tax in the “Enclosure to the Reference Application under section 256(1) of the Income-tax Act, 1961”, which is printed at page 16 of the printed papers. It is significant that the aforesaid contention is not at all mentioned therein. In these circumstances, we do not feel called upon to go into the merits of this argument which is sought to be urged before this court for the first time.
10. In the result, we answer both the questions in the affirmative, that is, in favour of the assessee and against the department. There will be no direction regarding costs.
11. A copy of this judgment under the seal of the High Court and the signature of the Registrar will be forwarded to the Appellate Tribunal as required by sub-s. (1) of s. 260 of the I.T Act, 1961.
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