ITA 873/2008 & 1156/2008 Page 1 of 25 * THE HIGH COURT OF DELHI AT NEW DELHI % Judgment delivered on : 27.02.2009 ITA 873/2008 & 1156/2008 COMMISSIONER OF INCOME TAX-IV, NEW DELHI ..... Appellant versus INSILCO LIMITED ..... Respondent Advocates who appeared in this case: For the Appellant : Ms Prem Lata Bansal, Mr Sanjeev Rajpal & Mr Mohan Prasad Gupta For the Respondent : Mr V.P. Gupta & Mr Basant Kumar CORAM :- HON'BLE MR JUSTICE VIKRAMAJIT SEN HON'BLE MR JUSTICE RAJIV SHAKDHER 1. Whether the Reporters of local papers may be allowed to see the judgment ? Yes 2. To be referred to Reporters or not ? Yes 3. Whether the judgment should be reported Yes in the Digest ? RAJIV SHAKDHER, J 1. These are appeals preferred by the Revenue against the judgment dated 25.01.2008 passed by the Income Tax Appellate Tribunal (hereinafter referred to as the „Tribunal‟) in ITA No. 626/Del/2004 and ITA No. 16/Del/2004 filed by the Appellant/Revenue and Respondent/assessee respectively pertaining to assessment year 2000-01. 2. The Revenue had filed an appeal before the Tribunal against the order of the Commissioner of Income Tax (Appeals) [hereinafter referred to as the „CIT(A)‟] allowing deduction on account of provision made by ITA 873/2008 & 1156/2008 Page 2 of 25 the assessee in the sum of Rs 47,15,782/- in respect of amounts payable to its employees on account of “Long Service Award”. 2.1 The assessee, on the other hand, had preferred an appeal to the Tribunal against the order of the CIT(A) in rejecting its claim of depreciation amounting to Rs 35,41,123/- on emergency/insurance spares valued at Rs 1,41,64,495/- in its books of accounts. 2.2 The Tribunal by the impugned judgment, rejected the appeal of the Revenue on the issue of allowance of provision for “Long Service Award” payable by the assessee to its employees and consequently confirmed the order of the CIT(A), and also, allowed the appeal of the assessee on the issue of capitalization of emergency/insurance spares and resultantly, reversed the order of CIT(A). 3. As stated above, the Revenue being aggrieved by the impugned judgment, has preferred these appeals on the aforementioned issues. 4. In so far as issue with respect to allowance of provision made by the assessee in the sum of Rs 47,15,782/- with regard to “Long Service Award” payable to its employees is concerned, the following brief facts require to be noted:- 4.1 The assessee, which is in the business of manufacturing of spray dried silica in technical collaboration with a German company, during the relevant period, had evolved a scheme whereby, employees who render long period of service to the assessee are, as per the scheme, entitled to ITA 873/2008 & 1156/2008 Page 3 of 25 monetary awards at various stages of their employment equivalent to a defined period of time. As per the facts recorded by the authorities below, employees of the assessee who had completed 10 years, 15 years and 20 years of service; on completion of the above number of years in service, were eligible by way of an award, salary equivalent to 2 months, 3 months and 4 months respectively under the aforementioned scheme. 4.2 Based on the provisions of the scheme, the assessee engaged an Actuary to make an actuarial calculation as regards the provision which it would be required to make in respect of the liability on account of “long service award” as envisaged in the scheme evolved by it. The Actuary made his calculations by taking into account 201 employees as also factors, such as probable future withdrawals under the scheme as well as increase in salary of the employees. Based on the actuarial report, a provision in the sum of Rs 47,15,782/- was made by the assessee. 4.3 The Assessing Officer, however, rejected the deduction claimed by the assessee in respect of the said provision primarily on the ground that the grant of award was at the discretion of the management of the assessee and, therefore, could not be said to be a provision towards ascertained liability. 4.4 The assessee, being aggrieved, preferred an appeal to the CIT(A). The CIT(A) reversed the order of the Assessing Officer. He accepted the view of the assessee that as per the mercantile system of accounting ITA 873/2008 & 1156/2008 Page 4 of 25 provision of liability has to be made even though it was required to be discharged at some future date. The CIT(A), after taking into account the judgments of the Supreme Court in the case of Shree Sajjan Mills Ltd vs CIT; (1985) 156 ITR 585, Bharat Earth Movers Ltd vs CIT; (2000) 245 ITR 428 and Metal Box Company of India Ltd vs Their Workmen; (1969) 73 ITR 53, and, upon perusing the provisions of the CBDT Circular No. 47 dated 21.09.1970, came to the conclusion, that a provision for „long service award‟ is akin to a provision for gratuity, and if such a provision is made on a scientific basis, it would be in the nature of an ascertained liability and not a contingent liability as contended by the Revenue. The CIT(A) was also of the view that as per the Accounting Standards notified by the Central Government u/s 145(2) of the Act, it was incumbent upon the assessee to make provision for all known liabilities on the basis of best estimate in the light of available information. The CIT(A) specifically rejected the contention of the Revenue that since there was some discretion vested with the management with regard to the payment under the “long service award” scheme that would by itself make it contingent and that the deduction should be disallowed on this ground. The Revenue carried the matter in appeal to the Tribunal. The Tribunal after recording the facts noted in the order of the CIT(A) concurred with his view and held; that as per the mercantile system of accounting, provision for liability ascertained during the course of the relevant accounting period, which is payable at a future ITA 873/2008 & 1156/2008 Page 5 of 25 date, was admissible in view of the decisions of the Supreme Court relied upon by the assessee before the CIT(A) as well as in the light of Circular No. 47 dated 21.09.1970 of the CBDT. 5. Having heard the learned counsel for the Revenue as well as the assessee, we are of the view that no fault can be found with the reasoning of both the CIT(A) as well as the Tribunal. In our view, the issue raised by the Revenue before us that the liability under the “long service award” scheme of the assessee is contingent as the payment under the same scheme is dependent on the discretion of the management is a submission which deserves to be rejected at the threshold. It is well settled that if a liability arises within the accounting period, the deduction should be allowed though it may be quantified and discharged at a future date. Therefore, the provision for a liability is amenable to a deduction if there is an element of certainty that it shall be incurred and it is possible to estimate the liability with reasonable certainty even though the actual quantification may not be possible as such a liability is not of a contingent nature. See Bharat Earth Movers (supra). The principles enunciated above have been applied by the Supreme Court also in the case of Metal Box Company (supra) wherein the Supreme Court was considering the question whether estimated liability under gratuity schemes were amenable for deduction from gross receipts shown in the profit and loss account. The observation of the Supreme Court being pertinent are extracted herein below:- ITA 873/2008 & 1156/2008 Page 6 of 25 “But the contention was that though Schedule VI to the Companies Act may permit a provision for contingent liabilities, the Income Tax Act, 1961, does not, for under Section 36(v), the only deduction from profits and gains permissible is of a sum paid by an assessee as an employer by way of his contribution towards and approved gratuity fund created by him for the exclusive benefits of his employees under an irrevocable trust. This argument is plainly incorrect because Section 36 deals with expenditure deductible from out of the taxable income already assessed and not with deductions which are to be made while making the P. & L. Account. In our view, an estimated liability under gratuity schemes such as the ones before us, even if it amounts to a contingent liability and is not a debt under the Wealth-tax Act, if properly ascertainable and its present value is fairly discounted is deductible from the gross receipts while preparing the P. & L. Account. It is recognised in trading circles and we find no rule or direction in the Bonus Act which prohibits such a practice.” 6. In the case of Shree Sajjan Mills Ltd (supra), the Supreme Court was examining the provision made by the assessee towards gratuity under the Income Tax Act, 1961. The Supreme Court, after noticing the judgment in Metal Box Company (supra), crystallized its analysis at page 599 and made the following observations:- “It would thus be apparent from the analysis aforesaid that the position till the provisions of section 40A(7) were inserted in the Act in 1973 was as follows:- 1 xxxx 2 xxxx 3 xxxx 4 xxxx 5 Provision made in the profit and loss account for the estimated present value of the contingent liability properly ascertained and discounted on an accrued basis as falling on the assessee in the year of account could be deductible either under Section 28 or section 37 of the Act.” ITA 873/2008 & 1156/2008 Page 7 of 25 7. The Division Bench of this Court, while considering deductibility of a provision for warranties made by an assessee, which dealt in computers in the case of CIT vs Hewlett Packard India (P) Ltd, by its judgment passed in Appeal No. ITA 486/2006 dated 31.03.2008, upheld the deductibility of the provision for warranty on the ground that it was made on the basis of actuarial valuation being covered by the principle set out in Metal Box Company (supra). In view of the aforesaid decisions and given the fact that the provision was estimated based on actuarial calculations, we are of the opinion that the deduction claimed by the assessee had to be allowed. We find no fault with the reasoning of the Tribunal. No substantial question of law arises for our consideration. 8. As regards the second issue, we had at the time of hearing indicated to the counsel for both parties that a question of law arises for consideration of this Court and that we would frame a question as indicated hereinbelow and dispose of the appeal finally. Accordingly, with the consent of the counsel, submissions were heard and the appeal was taken up for final hearing. On hearing the counsel, we are of the view that the following question of law arises for our consideration:- “Whether ITAT was correct in law in allowing depreciation of Rs 35,41,123/- to the assessee on spare parts u/s 32 of the Act as against Rs 5,49,806/- allowed by the Assessing Officer.” 9. In regard to the aforesaid issue, the following facts need to be noticed. ITA 873/2008 & 1156/2008 Page 8 of 25 9.1 The assessee prior to the assessment year in issue, i.e., assessment year 2000-01 had been following the practice of charging the cost of spares as a revenue expense based on actual consumption during the relevant period. The Council of the Institute of Chartered Accountant of India (hereinafter referred to as the „ICAI‟) in 1999 revised the Accounting Standard (AS) 2 with respect to valuation of inventories which came into effect in respect of accounting period commencing on or after 01.04.1999. The said Accounting Standard was made mandatory and superseded the existing Accounting Standard on „valuation of inventories‟ which was originally issued in June, 1981. The assessee pursuant to the change in accounting standard capitalized the cost of spares valued at Rs 1,41,64,495/- and claimed depreciation on the said capitalized spares to the extent of Rs 35,41,123/-. Before the Assessing Officer, the assessee in the first instance, claimed deduction by way of depreciation on capitalized spares as indicated above to the extent of Rs 35,41,123/- and in the alternative, claimed by way of deduction cost spares consumed amounting to Rs 31,76,187/-. 9.2 The Assessing Officer rejected the claim of the assessee for depreciation on the ground that the assessee had not “put to use” the emergency spares during the relevant period. Curiously, the Assessing Officer also rejected the alternative plea of the assessee that it should be allowed deduction of Rs 31,76,187/- being the cost of emergency spares actually consumed during the relevant period. The Assessing Officer on ITA 873/2008 & 1156/2008 Page 9 of 25 the contrary allowed depreciation to the assessee in the sum of Rs 5,49,806/- with reference to the cost of spares consumed during the relevant period, that is, on Rs 31,76,187/- 10. The assessee being aggrieved, preferred an appeal to the CIT(A). The CIT(A) while sustaining the order of the Assessing Officer that no depreciation could be allowed on the cost of emergency spares capitalized by the assessee, however, allowed the alternative claim of the assessee, by directing the Assessing Officer to allow the assessee a deduction of Rs 31,76,187/-, being the cost of spares actually consumed by the assessee during the relevant period. 11. The assessee being aggrieved, preferred an appeal to the Tribunal. The Tribunal by the impugned judgment allowed the appeal of the assessee. In the impugned judgment, the Tribunal noted that the Assessing Officer had accepted the claim of the assessee that emergency spares were entitled to depreciation, but while doing so, had limited the depreciation with reference to the cost of spares actually consumed during the relevant period as against the claim of the assessee for depreciation on total cost of spares, i.e., Rs 1,41,64,495/-. The Tribunal also noted that the CIT(A) had given a clear finding of fact that the spare parts were readily available for use as and when required. Applying the judgment of the Madras High Court in the case of CIT vs Southern Petrochemicals Industries Corporation Ltd; (2007) 292 ITR 362 the ITA 873/2008 & 1156/2008 Page 10 of 25 Tribunal allowed the claim of the assessee for depreciation on “critical spare parts of plant and machinery kept as stand by”. 12. The Revenue being aggrieved, preferred an appeal as indicated above to this Court. 13. We have heard the learned counsel for the Revenue, Ms Prem Lata Bansal and for the assessee, Mr V.P. Gupta. It is contended by the learned counsel for the Revenue that depreciation is available to an assessee on fulfillment of the twin conditions prescribed under Section 32 of the Act, these being: the ownership of the asset and its use during the relevant period. The learned counsel submitted that the assessee had not used the emergency spares during the relevant period. The provisions of Section 32 does not contemplate „passive user‟ and hence depreciation could not have been permitted on the cost of the spares capitalized i.e., on a sum of Rs 1,41,64,495/-. The learned counsel thus relied upon the order of the Assessing Officer and submitted that the approach adopted by the Assessing officer by allowing depreciation with reference to only such emergency spares actually used during the relevant period was the correct approach in law being in accordance with the provisions of Section 32 of the Act. 14. On the other hand, the learned counsel for the assessee, Mr V.P. Gupta relied upon the judgments of various High Courts to support his submission that Section 32 of the Act brings within its ambit even ITA 873/2008 & 1156/2008 Page 11 of 25 „passive user‟ for claim of depreciation. The judgments relied upon by the learned counsel for the assessee were CIT vs Pepsu Road Transport Corporation; (2002) 253 ITR 303 (P&H), CIT vs Southern Petro Chemical Industries Corporation Ltd; (2007) 292 ITR 362 (Mad), Capital Bus Service (P.) Ltd vs CIT; (1980) 123 ITR 404 (Del), CIT vs Refrigeration & Allied Industries Ltd; (2001) 247 ITR 12 (Del) and lastly CIT vs Swarup Vegetable Products India Ltd; (2005) 277 ITR 60(All). 15. The learned counsel for the assessee also relied upon the revised Accounting Standard (AS) 2 on „Valuation Of Inventories‟ along with Accounting Standard (AS) 10 on „Accounting For Fixed Assets‟ to buttress his argument that the emergency spares in issue requires to be capitalized. OUR ANALYSIS 16. The accounting treatment, which is prescribed by the Council of the ICAI, clearly stipulates that after the revised Accounting Standard (AS) 2 comes into effect, it shall apply with respect to accounting period commencing on or after 01.04.1999. The revised Accounting Standard has been made mandatory by the Council of the ICAI. 16.1 At this point, it may be helpful to extract the relevant clauses of the Accounting Standards (AS) 2 and (AS) 10. In this regard, clause 4 of the Accounting Standard is of relevance which reads as follows:- ITA 873/2008 & 1156/2008 Page 12 of 25 “Inventories encompass goods purchased and held for resale, for example, merchandise purchased by a retailer and held for resale, computer software held for resale, or land and other property held for resale. Inventories also encompass finished goods produced, or work in progress being produced, by the enterprise and include materials, maintenance supplies, consumables and loose tools awaiting use in the production process. Inventories do not include machinery spares which can be used only in connection with an item of fixed asset and whose use is expected to be irregular; such machinery spares are accounted for in accordance with Accounting Standard (AS) 10, Accounting for Fixed Assets.” 16.2. Similarly, Accounting Standard (AS) 10 issued by the Council of ICAI for fixed assets in paragraph 8.2 clearly provides as follows:- “Stand-by equipment and servicing equipment are normally capitalized. Machinery spares are usually charged to the profit and loss statement as and when consumed. However, if such spares can be used only in connection with an item of fixed assets and their use is expected to be irregular, it may be appropriate to allocate the total cost on a systematic basis over a period not exceeding the useful life of the principal item.” 16.3 Apart from the above, the Council of the ICAI has also issued what are known as Accounting Standards Interpretation (ASI) 2 for the purpose of elucidating as to the machinery spares which are covered under the Accounting Standards (AS) 2 and (AS) 10 and what should be the accounting for machinery spares under the respective standards. In this context, it may be pertinent to note the following:- “1 Which machinery spares are covered under AS 2 and AS 10 and what should be the accounting for machinery spares under the respective standards. 2 Machinery spares which are not specific to a particular item of fixed asset but can be used generally for various items ITA 873/2008 & 1156/2008 Page 13 of 25 of fixed assets should be treated as inventories for the purpose of AS 2. Such machinery spares should be charged to the statement of profit and loss as and when issued for consumption in the ordinary course of operations. 3 Whether to capitalise a machinery spare under AS 10 or not will depend on the facts and circumstances of each case. However, the machinery spares of the following types should be capitalised being of the nature of capital spares/insurance spares— (i) Machinery spares which are specific to a particular item of fixed asset, i.e., they can be used only in connection with a particular item of the fixed asset, and (ii) their use is expected to be irregular. 4 Machinery spares of the nature of capital spares/insurance spares should be capitalised separately at the time of their purchase whether procured at the time of purchase of the fixed asset concerned or subsequently. The total cost of such capital spares/insurance spares should be allocated on a systematic basis over a period not exceeding the useful life of the principal item, i.e., the fixed asset to which they relate. 5 x x x x 6 x x x x 7 x x x x 8 x x x x 9 Machinery spares of the nature of capital spares/insurance spares are capitalised. Capital spares/insurance spares are meant for occasional use. Since they can be used only in relation to a specific item of fixed asset, they are to be discarded in case that specific fixed asset is disposed of. In other words, such spares are integral parts of the fixed asset.” 16.4 It is clear upon reading the provisions of Accounting Standards (AS) 2 and (AS) 10 that, the opinion of the Council of the ICAI in respect ITA 873/2008 & 1156/2008 Page 14 of 25 of treatment of machinery spares is briefly that; machinery spares which are not specific to any fixed asset and can be used generally should be treated as part of inventory and charged to profit and loss account as and when they are consumed during the ordinary course of business. On the other hand, if the machinery spares are of the nature of capital spares/insurance spares which are specific to a particular item of fixed asset and their use is irregular, then, they should be capitalized separately and depreciated on a systematic basis over a time frame not exceeding the useful life of the fixed asset to which they relate. As a matter of fact, in case the fixed asset to which they relate, is discarded, the machinery spares will also have to be disposed of as these spares are integral parts of the fixed asset. 16.5 It is to be noted that these Accounting Standards are mandatory in nature and applied to accounts prepared after 01.04.1999. In that sense the submission of the assessee has to be accepted that the change in the accounting policy had been brought about by virtue of the issuance of the revised accounting standards issued by the Council of the ICAI, which was, applicable for the assessment year under consideration. Furthermore, the provisions of sub-section (3A), (3B) and (3C) of Section 211 of the Companies Act, 1956, clearly provide that every profit and loss account and balance sheet of a company shall comply with the Accounting Standards prescribed. Where the accounts of the company do not comply with the Accounting Standards it is required to disclose in the ITA 873/2008 & 1156/2008 Page 15 of 25 profit and loss account and the balance sheet: (a) the deviation from the Accounting Standards; (b) the reasons for such deviation; and (c) the financial effect, if any, arising, due to such deviation. What is important is that; sub-section (3) of Section 211 provides that until the Central Government prescribes an accounting standard in consultation with the National Advisory Committee as set up under Section 210A of the Companies Act, 1956 pursuant to a recommendation of the ICAI; the Accounting Standard issued by the ICAI shall prevail. Therefore, we have no difficulty in accepting the submissions of the learned counsel for the assessee that it was obliged to capitalize the entire cost of spares in consonance with the mandatory provisions of Accounting Standards (AS) 2 and (AS) 10. 16.6 It is not disputed that the assessee is maintaining the accounts based on a mercantile system. Under sub-section (1) of Section 145 of the Act the assessee‟s income which is chargeable under the head “profits and gains of business or profession” is required to be computed in accordance with either cash or mercantile system of accounting regularly employed by the assessee. 16.7 As indicated above the assessee has been maintaining a mercantile system of accounting, therefore, the treatment of emergency spares in accordance with the revised Accounting Standard (AS) 2 and (AS) 10 would be in consonance