The Hindu Business Line : Future imperfect

UNDER tax law, `income' includes profits and gains. Tax is levied not on gross receipts but on profits embedded in the gross receipts. The profits to be assessed must be `real' profits, ascertained based on ordinary principles of commercial trading and commercial accounting. All necessary deductions will have to be made to ascertain the balance of profits.

Section 29 of the Income-Tax Act, 1961 directs that `income' referred to in Section 28 should be computed in accordance with the provisions contained in Sections 30 to 43 D. These deductions and allowances are, however, not exhaustive. A contingent liability may not be expenditure at all and will not be eligible for deduction. An unascertained liability to pay damages at a future date will represent a mere contingent liability and cannot be allowed.

The I-T code has been moving in the direction of allowing, as far as possible, actual expenditure and not merely as a provision for future expenditure. This can be seen from the frequent amendments to, and insertions in, the law laid down under Sections 43B and 40 A(7). But a liability incurred in an accounting year, for example an unconditional contractual liability, cannot be regarded as contingent merely because it is to be discharged at a future date and the cost of discharge is not definite but to be estimated.

Provision for warranty

In a recent case, the I-T department considered provision for future warranty as contingent liability not allowable under Section 37. According to the department, the expenditure claimed as deduction must be towards actually existing liability; the putting aside of money which may become expenditure on the happening of an event is not an expenditure.

It is common in commercial transactions for established and reputed companies to have a warranty clause. Sale and warranty are inextricably bound with each other and, therefore, if the sale proceeds are taken note of in a year, the liability in respect of the warranty is also to be taken note of in the same year, and this is not contingent liability. The quantification may be based on estimates, but past experience will justify the making of a provision. In most cases, the warranty clause is contained in the document of sale itself.

The I-T department disputed the claim for deduction of the provision for warranty before the Delhi High Court in CIT vs Vinitec Corpn (P) Ltd (146 Taxman 313). The assessment year was 2000-2001.

The court was not convinced about the department's stand. It pointed out that the warranty clause was part of the sale transaction and represented a committed liability by the company at the very initial stage of sale. But for prescription of such a warranty clause, the customer may not even buy the assessee's product. There was direct nexus between the assessee's claim and its obligation arising out of the warranty clause.

Records of the earlier five years indicated a warranty liability of 2 per cent of sales. In the year of sale, the company was under an accrued legal obligation to make payments under those warranties. Although it might not be required to do so until the following year, it was definitively committed in the year of sale to that expenditure and, accordingly, the company was entitled to deduct the provision made for the cost of its anticipated liabilities under outstanding warranties in respect of goods sold in that year.

The warranty clause imposed a liability on the company to discharge its obligations under that clause for the period of warranty. It is a liability which is capable of being construed in definite terms and which has arisen in the accounting year. May be its actual quantification and discharge was deferred to a future date. Once an assessee maintains his accounts based on the mercantile system, liability accrues, though to be discharged at a future date; and this would be a proper deduction while working out the profits and gains of his business, regard being had to the accepted principles of commercial practice and accountancy.

Section 37 is an omnibus clause and allows expenditure as a deduction subject to the parameters laid down in the section. However, whatever Section 37 may or may not say, the fundamental principle to be understood is that the profits to be assessed have to be a `real profits', determined on the basis of ordinary principles of commercial trading and accounting.

A claim for deduction for which there is no specific provision under the Act would be admissible under Section 28 of the Act having regard to the accepted commercial practice and trading principles, if it can be said to have been incurred for the purpose of business or in the course of carrying on the business and is incidental to it.

Business deductions will have to be considered by a harmonious interpretation of Sections 28, 29 and 37 of the Act.

(The author is a former Chief Commissioner of Income-Tax.)

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