The Judgment of the Court was delivered by

K.P Balanarayana Marar, J.:— The respondent, a Government company engaged in the manufacture and sale of titanium dioxide, is an assessee to income-tax. For the assessment year 1976–77, the assessee claimed deduction of Rs. 8,15,070 in respect of provision made for contribution to the recognised gratuity fund. The Income-tax Officer recomputed the liability finding that the amount claimed exceeded the limits prescribed in rule 103 of the Income-tax Rules. He, therefore, made a disallowance of Rs. 5,56,963 only., An amount of Rs. 2,32,669 claimed by way of ex gratia payment for the Inability incurred in the year 1974 was also disallowed for the reason that the deduction should have been claimed for the assessment year 1975–76 and on the further ground that the payment was in excess of the statutory limit of 20 per cent, stipulated in the Bonus Act. On appeal, the Commissioner of Income-tax (Appeals) deleted the addition on account of gratuity on the ground that the liability was certain and that the exceptions (sic) were insignificant in quantum. The addition made under that head was, therefore, found, to be without justification. As regards ex gratia payment, it was held that the liability arose on account of the receipt of communication of the Government's decision and, in view of the practice followed by the assessee, that claim was allowed.

2. The Revenue carried the matter to the Income-tax Appellate Tribunal which upheld the order of the Commissioner of Income-tax (Appeals) finding that the contribution was made in conformity with the rules and regulations and satisfying the requisite conditions for its recognition. The ex gratia payment being customary in nature was also held to be a permissible deduction.

3. The Appellate Tribunal having refused to refer the questions of law, the Revenue approached this court by O.P No. 10093/83. By judgment dated January 24, 1985, this court directed the Income-tax Appellate Tribunal, Cochin Bench, to draw up a statement of case and refer the following questions of law to this court under section 256(2) of the Income-tax Act. It is in these circumstanced that the questions of law hereafter mentioned were referred to this court:

“(i) Whether, on the facts and in the circumstances of the case, the Tribunal was justified in law in holding that the provision made by the assessee for contribution to the recognised gratuity fund is to be allowed in full?

(ii) Whether, on the facts and in the circumstances of the case, the Tribunal was correct in law in deleting the disallowance of Rs. 5,56,963 out of provision made for contribution to the recognised fund in excess of 8 y per cent, of salary?

(iii) Whether, on the facts and in the circumstances of the case, the Tribunal was correct in law in deleting the disallowance of Rs. 2,32,669 as ex gratia payment in excess of 20% is only a customary bonus?

(iv) Whether, on the facts and in the circumstaces of the case, the Tribunal was justified in law in finding that the payment made by the assessee in excess of the statutory limit of 20% is only a customary bonus?

(v) Whether, on the facts and in the circumstances of the case, there was any material before the Tribunal to come to the conclusion that payment made in excess of the statutory limit of 20% customary bonus, and that it is customary for this assessee to make payments which are not linked to the profits of the business but are the creation of usage and tradition and that it is an unbroken flow of annual payments flowering into custom?

(vi) Whether, on the facts and in the circumstances of the case, the Tribunal is correct in law in finding that the claim of the assessee is admissible under section 37(1) and that the payment of Rs. 2,32,669 is an admissble deduction in the assessment year 1976–77?”

4. Questions Nos. 3 to 6.— In computing the income referred to in section 28 of the Income-tax Act under the head “Profits and gains of business or profession”, the deduction provided for under section 36(1)(ii) is allowable where any sum has been paid to an employee as bonus or commission. The material part of the section as it stood then reads:

“36. Other deductions.—(1) The deductions provided for in the following clauses shall be allowed in respect of the matters dealt with therein, in computing the income referred to in section 28—…

(ii) any sum paid to an employee as bonus or commission for services rendered, where such sum would not have been payable to him as profits or dividend if it had not been paid as bonus or commission:

Provided that the deduction in respect of bonus paid to an employee employed in a factory or other establishment to which the provisions of the Payment of Bonus Act, 1965 (21 of 1965), apply shall not exceed the amount of bonus payable under that Act;

Provided further that the amount of the bonus (not being bonus referred to in the first proviso) or commission is reasonable with reference to—

(a) the pay of the employee and the conditions of his service;

(b) the profits of the business or profession for the previous year in question; and

(c) the general practice in similar business or profession.”

5. By the Payment of Bonus (Amendment) Act, 1976, section 36 of the Income-tax Act was amended by which the present first proviso was added and the original proviso was retained as second proviso with the additional words “not being bonus referred to in the first proviso”. The position, therefore, is that where bonus has been paid in accordance with the requirements of the Bonus Act to an employee covered by the Act, the amount so paid is an allowable deduction. If bonus or commission is paid in excess of what is required to be paid under the Bonus Act or if bonus or commission is paid to an employee not covered by the Bonus Act, the amount so paid is not automatically allowable as a deduction. Deduction of such amount will be allowed only on the Assessing Officer being satisfied that it is a reasonable payment when considered in the light of the three clauses (a) to (c) of the second proviso. In other words, the amount so paid must be justifiable by reason of the pay of the employee and the conditions of service, the profits of the business or profession for the previous year and the general practice in similar business or profession. In short, all the three conditions enumerated in clauses (a) to (c) of the second proviso are to be satisfied in order that the payment which is not required to be paid under the Bonus Act is to be regarded as a reasonable deduction. On behalf of the Revenue, Sri P.K.R Menon, urges that employees of the respondent are paid bonus under the Payment of Bonus Act and the first proviso is, therefore, attracted. It is his contention that the second proviso comes into operation only if the first proviso is not applicable. In other words, the amount of bonus or commission is deductible according to the second proviso only if the Payment of Bonus Act has not been made applicable to the establishment. This contention was raised before this court in Commr. Of Income Tax v. Alikunju, Cashew Industries, [1987] 166 ITR 611. This court rejected that contention and held that the two provisos must be read together to correctly understand the permissible deduction in respect of clause (ii) of sub-section (1) of section 36. It is observed that the object of that clause is to encourage the management to pay bonus not only to the extent to which it is statutorily bound to pay to the employee, but also in excess of that limit, provided the payment is justifiable as a reasonable payment. This court further observed that to show that the second proviso has no application in respect of employees covered under the Bonus Act is to put an artificial construction upon a beneficial provision.

6. A Division Bench of this court in CIT v. Calicut Modern Spinning and Weaving Mills Ltd., [1990] 186 ITR 509, observed after referring to Alikunju's case, [1987] 166 ITR 611 (Ker), and the later decisions of this court that the amounts paid over and above the amount payable under the Payment of Bonus Act can be claimed as a deduction under section 36(1)(ii) of the Act provided the conditions stipulated in the second proviso to those sub-clauses are fulfilled. The position, therefore, is settled that any payment made over and above the sum payable under the Payment of Bonus Act is deductible provided the three conditions embodied in the second proviso to section 36(1)(ii) are fulfilled.

7. The Supreme Court had occasion to consider the question whether certain commission paid by the assessee to two of his employees is an allowable expenditure in computing the profits of the assessee from business in Shahzada Nand and Sons v. CIT, [1977] 108 ITR 358. The question for determination was whether this commission qualifies for deduction as an allowable expenditure under section 36(1)(ii). The High Court took the view that there must be correlation between the payment of commission and the services rendered and since commission was paid by the assessee for the first time during the relevant accounting year, there must be some extra services rendered by the employees in that year over and above the usual services rendered by them in the earlier years. Since there was no proof regarding rendering of any extra service, the High Court held that the payment of commission could not be said to be for services rendered within the meaning of section 36, sub-section (1), clause (ii). The Supreme Court observed that this view of the High Court was plainly erroneous. Even though there was no obligation on the assessee to make payment of this commission, the Supreme Court observed that the mere fact that the commission was paid ex gratia would not necessarily mean that it is unreasonable. Commercial expediency does not mean that an employer should not make any payment to an employee unless the employee is entitled to it under a contract. The Supreme Court held (at page 366):

“Even where there is no contract, an employer may pay commission to an employee if he thinks that it would be in the interest of his business to do so. It is obvious that no business can prosper unless the employees engaged in it are satisfied and contented and they feel a sense of involvement and identification and this can be best secured by giving them a stake in the business and allowing them to share in the profits. It would indeed be a wise step on the part of an employer to offer incentives to his employees by sharing a part of his profits with them. This would not only be good business but also good ethics. It would be in consonance with Gandhian concept as also modern socialistic thought which, with its deeply rooted faith in social and economic democracy, regards the employees as much as the employer as co-sharers in the business.”

8. After observing that a business or undertaking is a product of the combined efforts of the employer and the employees and where there is sufficiently large profit after providing for the salary or remuneration of the employer and the employees and other prior charges such as interest on capital, depreciation, reserves, etc., it was stated that a part of it should, in all fairness, go to the employees. The amount paid by way of commission was, therefore, held to be allowable as a deductible expenditure under section 36, sub-section (1), clause (ii), of the Income-tax Act, 1961.

9. On behalf of the Revenue, Sri P.K.R Menon contends that bonus paid in excess of what is payable under the Bonus Act is not deductible under the Income-tax Act, in view of the express prohibition contained in the latter limb of the first proviso to section 36(1)(ii). He would also contend that, as regards employees who are not covered by the Payment of Bonus Act, anything in excess of what is reasonable, going by the criteria laid down in the second proviso to section 36(1)(ii), is not an allowable deduction. Ex gratia payment is seen to have been made on the basis of a Governmental order. That payment was made in view of the agitation by the employees which resulted in the Government order. It is contended that the theory of payment due to custom is inconsistent and baseless, and payment of bonus on the basis of a Governmental order or orders is the very negation of custom. It may be that ex gratia payment was made on the basis of negotiations which followed agitation by the employees. But the question to be considered is whether the payment is allowable under the second proviso to section 36(1)(ii) of the Act.

10. Pooja bonus or customary bonus is distinct and different from profit-sharing bonus which has now been codified in the Payment of Bonus Act, 1965. Section 17(a) of the Act enables an employer to deduct any such bonus paid to an employee in a particular accounting year from the profit-sharing bonus payable to him under the Act in that year. No machinery is seen provided in the Act for quantification of that bonus. The tests for determining the liability of the employer to pay customary or traditional bonus were laid down by the Supreme Court in Grahams Trading Company (India) Ltd. v. Workmen, [1959–60] 17 FJR 130 : AIR 1959 SC 1151. The main aspects to be looked into are whether the payment has been made over an unbroken series of years and whether it has been paid for a sufficiently long period. The circumstance that the payment depended upon the earnings of profits would have to be excluded and, therefore, it must be shown that payment was made in years of loss also. The fact that payment was made ex gratia by the employer would not make any difference because the proof of custom depends upon the effect of the relevant factors. The payment must have been at a uniform rate throughout to justify an inference that the payments at such and such rate had become customary and traditional in the particular concern.

11. The Tribunal found the ex gratia payment to be customary bonus and that payment was made on the basis of a Government order directing such payment on settlement of employees' claim. The practice of making such customary payment every year is also seen mentioned by the Tribunal. Such extra payment ranged from 5 per cent, to 15 per cent, each year and those payments had been allowed in the year of payment for assessment years 1972–73 to 1975–76. For the calendar year 1974, ex gratia payment at the rate of five per cent, of the salary was paid to the employees over and above the statutory liability up to 20 per cent, during the calendar year 1975. Such payment for the calendar year 1975 was made during the year 1976 on the basis of a Government letter to pay additional payment at the rate of five per cent, of the salary. The Tribunal observed that it was thus customary for the assessee to make payments which are not linked to the profits of the business but are the creation of heritage and tradition. The reasonableness of the claim and the fulfilment of the three conditions embodied in the second proviso to section 36(1)(ii) were also considered by the Tribunal. It is stated that the assessee had made the payments regularly on the basis of instructions received from the Government for settlement of the employees' claims and such payments were made for maintaining peace in the industrial concern. The Tribunal having found that the conditions embodied in section 36(1)(ii) had been fulfilled, the direction to deduct the ex gratia payment was properly made in the light of the decisions of this court and the principles enunciated by the Supreme Court in Shahzada Nand and Sons v. CIT, [1977] 108 ITR 358. The ex gratia payment made as per the Government order was, therefore, rightly held to be allowable as a deductible expenditure under section 36(1)(ii) of the Income-tax Act, 1961.

12. The Tribunal has also considered the admissibility of the deduction with reference to the provisions of section 37 of the Income-tax Act. It was found that the claim is admissible even under section 37(1) of the Act. This finding is assailed by counsel for the Revenue. Drawing attention to the provisions contained in section 37(1), it is contended that the subsection is not applicable to a case where the expenditure is one of the nature described in section 36 of the Act. Section 37(1) permits allowance of expenditure laid out or expended wholly and exclusively for the purpose of the business or profession not being expenditure of the nature described in sections 30 to 36. As observed by the Madhya Pradesh High Court in Malwa Vanaspati and Chemical Co. Ltd. v. CIT, [1985] 154 ITR 655, section 37(1) of the Income-tax Act, 1961, being a residual provision, the aid of that section cannot be resorted to unless and until it is established that none of the provisions of sections 30 to 36 are applicable to a given case. Having found that section 36 of the Act applies and the expenditure is deductible under section 36(1)(ii), the assessee cannot make use of the provision contained in section 37(1) of the Act. The Tribunal was in error in finding that the claim is admissible under section 37(1) of the Act.

13. Questions Nos. 1 and 2: A gratuity fund was constituted by the assessee in the name of “Travancore Titanium Products Gratuity Fund” under an irrevocable trust for the benefit of its employees. A copy of the rules and regulations does not form part of the paper book but the relevant rules are seen extracted in the order of the Appellate Tribunal. The gratuity payable has to be taken as the last pay drawn by the employee concerned at the time of retirement/death and so much of the contribution as cannot be properly treated as ordinary annual contribution shall be treated as initial contribution in respect of past services and such contribution shall not exceed 3½ per cent, of the employee's salary for each year of his past services. On the death of an employee with a continuous and completed year of service or part thereof in excess of six months, the extent of gratuity payable was at the rate of 15 days' salary for each year of service subject to the maximum. The gratuity payable under the scheme shall be 20 months' salary or wages or Rs. 20,000, whichever is lower: The assessee is following the mercantile system of accounting. We are concerned with the assessment year 1976–77 for which the previous year is the calendar year 1975. For this accounting period, the assessee has made a provision of Rs. 8,15,070 as contribution to the recognised gratuity fund. The Income-tax Officer found the recognised gratuity fund unduly large and recomputed the liability and made a disallowance of Rs. 5,56,963. This was done on the basis that the liability is only to contribute 15 days' salary of each employee in that year. The contribution made on behalf of employees who had not put in more than five years of service was also deleted by the assessing authority. The Commissioner of Income-tax (Appeals) on the other hand, deleted the addition for the reason that the liability is certain and the exceptions are insignificant in quantum. This view was approved by the Tribunal on second appeal.

14. Assailing the finding of the Tribunal, learned counsel for the Revenue submitted that the contribution made towards the gratuity fund is not in conformity with rule 103 of the Income-tax Rules. That rule provides that the contribution shall not exceed 84- per cent, of the salary of each employee during each year. The calculation made by the assessing authority at that rate was correct, according to counsel. The deletion of the amount contributed towards the gratuity fund of employees who had not put in more than five years of service has also been properly done, argues counsel. Attention is also drawn to rule 104 which provides that the amount to be allowed as a deduction on account of an initial contribution which an employer may make in respect of the past services of an employee admitted to the benefits of a fund shall not exceed 8 ⅓ per cent, of the employee's salary for each year of his past service with the employer. These rules only prescribe the outer limit of the amount which can be contributed towards a gratuity fund. The Tribunal found that the contribution made was in conformity with the rules approved by the Department and satisfying the requisite conditions for its recognition. The Tribunal further found that, under section 40A(7)(b)(ii), any provision made by the assessee for the previous year in accordance with an actuarial valuation of the ascertainable liability on their retirement or on termination of their employment for any reason is taken out of the bar in clause (a) of section 40A(7). It is pointed out by counsel for the Revenue that the Tribunal has committed an error in finding that the provision comes under section 40A(7)(b)(ii) of the Act. It is submitted that there is some confusion regarding the exact provision of law that is applicable regarding the deduction permissible for gratuity payment. An identical question arose before this court in CIT v. Tranvancore Cements Ltd., [1990] 184 ITR 319, where this court held thus (at page 322):

“If section 40A(7)(b)(i) of the Act applies, we see no reason why there should be any actuarial valuation regarding the liability. That is postulated only in cases coming under section 40A(7)(b)(ii) of the Act, which deals with three prior years, the three prior years previous to that relevant year. All that the assessee is entitled to is the provision made by it for the payment of the sum by way of contribution to the gratuity fund or for the purpose of payment of gratuity due that has become payable during the previous year. We are unable to understand as to why any actuarial valuation is necessary in that matter. Be that as it may, it cannot be that the assessee is entitled to any deduction in addition to the entitlement available to him under section 40A(7)(b)(i) of the Act. This position is clear. We state that whatever deduction the assessee is entitled to under section 40A(7)(b)(i) of the Act alone is permissible and the deduction of Rs. 1,52,164 under section 36(1)(v) was not called for. This position is also made clear.”

15. We have, therefore, to see whether the amount contributed to the gratuity fund is excluded from the operation of clause (a) of section 40A(7). The scope of section 40A(7) was considered by the Supreme Court in Shree Sajjan Mills Ltd. v. CIT, [1985] 156 ITR 585. After a survey of the decisions and an analysis of the position till the provisions of section 40A(7) were inserted in the Income-tax Act, by Finance Act, 1975, with effect from April 1, 1973, the Supreme Court noticed the intention of the Legislature in enacting the provision as revealed from the Notes on Clauses of the amendment. That note, inter alia, mentioned that the restriction imposed in the computation of profits and gains of business in respect of any reserve created or provision made for the payment of gratuity will not apply in relation to a provision made for the purpose of a sum by way of contribution towards an approved gratuity fund that has become payable during the relevant year or for the purpose of meeting actual liability in respect of payment of gratuity to the employees that has arisen during each year. The Supreme Court observed that, in interpreting or in trying to find out the meaning of that provision contained in section 40A(7) of the Act, one should, if possible, give effect to the intention and not to make a nonsense of that intention. It is stated that the expression “provision” has not been used in any artificial sense but in its ordinary meaning and that is clear from the words “whether called as such or by any other name” occurring in the sub-section. On an interpretation of sub-clauses (i) and (ii) of clause (b) of section 40A(7), the Supreme Court observed that clause (b)(i) excludes from the operation of clause (a) contribution to an approved gratuity fund and the amount provided for or set apart for payment of gratuity which would be payable during the year of account. Clause (b)(ii) deals with a situation where the assessee might provide by the spread over method and provides that such provision would be excluded from the operation of clause (a) provided the three conditions laid down by the sub-clauses are satisfied. The Supreme Court cautioned that the principle that fiscal statues should be strictly construed does not rule out the application of the principles of reasonable construction to give effect to the purpose or intention of any particular provision as apparent from the scheme of the Act with the assistance of such external aids as are permissible under the law. It was held that, for gratuity to be deductible under the Act, it must fulfil the conditions laid down in section 40A(7). The deduction could not be allowed on general principles under any other section of the Act because sub-section (1) of section 40A makes it clear that the provisions of the section shall have effect notwithstanding anything to the contrary contained in any other provision of the Act relating to the computation of income under the head “Profits and gains of business or profession”. It, therefore, means that section 40A would have effect notwithstanding anything contained in sections 30 to 39 of the Act.

16. The question that arises is whether the contribution made by the respondent towards the gratuity fund is deductible under section 40A(7)(b)(i) or under section 40A(7)(b)(ii) of the Act. Sub-section (7) of section 40A which was inserted by the Finance Act, 1975, with retrospective effect from the assessment year 1973–74, supersedes the general principle as regards liability for gratuity. By clause (b)(ii) of that sub-section, a special provision has been made for deduction of gratuity for the assessment years 1973–74 to 1976–77 and in order to claim deduction, the conditions embodied in the sub-clause are to be complied with. In this reference, we are concerned with the assessment year 1976–77. The relevant provision of law applicable is clause (b)(i) and not clause (b)(ii). The Tribunal has, therefore, committed an error in finding that the provision made by the assessee for the previous year is taken out of the bar in clause (a) of section 40A(7) by virtue of the provision contained in clause (b)(ii). The assessee is entitled to the deduction available to him under section 40A(7)(b)(i) of the Act. The question whether any incremental liability has been included and whether deduction in respect of that sum can be claimed does not, therefore, arise. The decision of this court in CIT v. Periya Karamalai Tea and Produce Co. Ltd., [1987] 167 ITR 32 has, therefore, no application.

17. Deduction is claimed on the basis of the calculation of total liablity as on December 31, 1975. Fifteen days' emoluments per employee per year of service for the total number of years were calculated. It was on that basis that the total liability as on that date was estimated at Rs. 39,80,868.15. The funds available with the trustees on that date is only Rs. 31,67,793.65. The balance amount of Rs. 8,15,070 was contributed towards the fund in that year. According to the Revenue, the fifteen days' wages per employee per year alone need be contributed according to rule 103 of the Income-tax Rules. That was worked out on the basis of the salary paid to the employees at Rs. 3,72,060. The initial contribution shall not exceed 3 ½ per cent, of the employee's salary for each year of his past service as per rule VI(F) of the rules and regulations of the trust. But that rule only relates to payment towards initial contribution in respect of past services. On the death of an employee, gratuity is payable at the rate of fifteen days' salary subject to the maximum prescribed. Even according to rule 103, the ordinary annual contribution to the fund shall be made on a reasonable basis and should not exceed 8⅓ per cent, of the salary of each employee during each year. That will work out to One month's salary. The employer can, therefore, contribute up to a maximum of one month's salary. The deduction allowed by the assessing authority is only fifteen days' salary per employee per year. The contribution towards the gratuity fund was made in order to meet the demands of the employees as on December 31, 1975. It may be that the liability to pay in full arises on a future date. But, if all the employees are to be paid the gratuity on December 31, 1975, the employer should have necessary funds with him to meet those demands. The calculation made by the employer cannot, therefore, be said to be on a wrong basis nor can it be said that the amount deducted exceeds the maximum amount stipulated in rule 103. What has been made by way of contribution is the provision by the assessee for the purpose of payment of gratuity that has become payable during the previous year as well as the contribution towards the approved gratuity fund. The Tribunal has, therefore, not Committed any error in allowing the deduction of the contribution made towards the gratuity fund.

18. Learned counsel for the Revenue has a further contention that the contributions made in respect of employees who had not put in five years of service are not deductible. It is true that section 4 of the Payment of Gratuity Act directs the employer to pay gratuity only to employees who have rendered continuous service for not less than five years. But the assessee is a public undertaking and the employees are likely to continue in service. The liability for each year has to be provided for in the gratuity fund. The intention of the provision as apparent from the scheme of the Act is to make necessary provision for the employees towards gratuity payable to them. Consistent with that intention and the scheme, the contribution towards the gratuity of employees who had not put in five years of service does not appear to be improper or against the provisions contained in section 40A(7)(b)(i) of the Act. The Tribunal has not committed any error of law in allowing the deduction by way of contribution towards gratuity fund in respect of employees who had not put in more than five years of service. For the aforesaid reasons, questions Nos. 1 and 2 are answered in the affirmative, i.e, in favour of the assessee and against the Revenue. Questions Nos. 3 to 5 are also answered in the affirmative, i.e, in favour of the assessee and against the Revenue. Question No. 6 is answered in the negative, i.e, in favour of the Revenue and against the assessee.

19. A copy of this judgment under the seal of the court and the signature of the Registrar shall be forwarded to the Income-tax Appellate Tribunal, Cochin Bench.