Case: M/S. Rotork Controla India (P) Ltd Vs. Commnr. Of Income Tax, Chennai

FACTS IN THE LEAD MATTERCivil Appeal Nos. of 2009 - Arising out of S.L.P.(C) Nos.14178-14182 of 2007 - M/s. Rotork Controls India (P) Ltd. v. Commissioner of Income Tax, Chennai.3. In these civil appeals filed by the assessee we are concerned with the assessment years 1991-92, 1992-93, 1993-94 and 1994- 95. For the sake of convenience we hereby refer to the facts concerning assessment year 1991-92.4. Appellant-company sells Valve Actuators. Bulk of the sales is to BHEL. At the time of sale appellant (assessee) provides a Standard Warranty whereby in the event of any Beacon Rotork Actuator or part thereof becoming defective within 12 months from the date of commissioning or 18 months from the date of dispatch whichever is earlier, the company undertakes to rectify or replace the defective part free of charge. This warranty is given under certain conditions stipulated in the warranty clause. For the assessment year 1991-92, the assessee made a provision for warranty at Rs.10,18,800/- at the rate of 1.5% of the turnover. This provision was made by the assessee on account of warranty claims likely to arise on the sales effected by the appellant and to cover up that expenditure. It may be noted that since the provision made was for Rs.10,18,800/- which exceeded the actual expenditure, the appellant reversed Rs.5,00,246 as Reversal of Excess Provision. Consequently, the assessee claimed deduction in respect of the net provision of Rs.5,18,554/- which was disallowed by the A.O. on the ground that the liability was merely a contingent liability not allowable as a deduction under Section 37 of the Income-tax Act, 1961 ("the 1961 Act", for short). This decision was upheld by CIT (A). The matter was carried in appeal to the Tribunal by the appellant. It was held by the Tribunal that right from the assessment year 1983-84 the CIT (A) as well as the Tribunal had allowed the warranty claim(s) on the ground that Valve Actuators are sophisticated equipments; that in the course of manufacture and sale of Valve Actuators a reasonable warranty was given to the purchasers; that every item of sale was covered by the warranty scheme; that no purchaser was ready and willing to buy Valve Actuators without warranty and consequently every item sold had a corresponding obligation under the warranty clause(s) attached to such sales. This has been the view of the Department and the Tribunal right from assessment year 1983-84. In fact the Department allowed deduction on the above facts constituting normal trading practice. For example, during the assessment year 1983-84 the total sales during the year was Rs.1,45,36,599/- and in that year the appellant had earmarked 1% of the total sales towards the warranty claims which it would have to meet. This amount provided for was held to be reasonable having regard to the anticipated liability which was discharged in the subsequent year. From that year onwards it has been consistently held that looking to the nature of the business and the nature of the product manufactured and sold it was necessary for warranty clause to be attached to the sales effected by the appellant and that the warranty obligations constituted an integral part of the sales effected during the year. All throughout this period between assessment year 1983-84 and assessment year 1991-92, the Tribunal took the view that the provision made by the appellant was realistic. Applying the Rule of Consistency, the Tribunal held that the assessee on the facts and circumstances of the case was entitled to deduction under Section 37 of the 1961 Act in respect of provision for warranty amounting to Rs.5,18,554. At this stage one point needs to be emphasized. During the assessment year 1983-84 to assessment year 1991-92 there was one instance when the Tribunal disallowed the warranty claim that was in the assessment year 1985-86. The reason was in that year the assessee had not adjusted the excess out of the provision to the expense of the immediate following year and as a result the Closing Balance of the Provision Account was found to be swelling up from year to year. In other words, during that year reversal was not effected. That is not the position during the assessment years 1991-92, 1992-93, 1993-94 and 1994-95. Accordingly, for the assessment year 1991-92, the appellant herein succeeded before the Tribunal. Aggrieved by the decision of the Tribunal, the Department carried the matter in appeal to the Madras High Court vide Tax Case Appeal No.163 of 2003 etc. Those appeals were for all the assessment years 1991- 92, 1992-93, 1993-94 and 1994-95. By common judgment dated 5.2.07, the High Court held that the assessee was not entitled to deduction in respect of the provision made for warranty claims. It was held that no obligation was ever cast on the date of the sale and consequently there was no accrued liability. According to the impugned judgment, the liability had not crystalised on the date of the sale and, therefore, appellant was not entitled to deduction in respect of the provision made for warranty charges payable under the terms of sale. According to the impugned judgment, warranty provision was made against the liability which had not crystalised against the appellant and consequently it was a provision made for an unascertained liability and, therefore, the appellant was not entitled to claim deduction under Section 37 of the 1961 Act. The case of the Department was accepted by the High Court, hence these civil appeals are filed by the assessee.

Reasoning:
A provision is a liability which can be measured only by using a substantial degree of estimation. A provision is(a) an enterprise has a present obligation as a result of a past event; (b) it is probable that an outflow of resources will be required to settle the obligation; and (c) a reliable estimate can be made of the amount of the obligation. If these conditions are not met, no provision can be recognized.11. Liability is defined as a present obligation arising from past events, the settlement of which is expected to result in an outflow from the enterprise of resources embodying economicthe present case, the appellant has been manufacturing and selling Valve Actuators. They are in the business from assessment years 1983-84 onwards. Valve Actuators are sophisticated goods. Over the years appellant has been manufacturing Valve Actuators in large numbers. The statistical data indicates that every year some of these manufactured Actuators are found to be defective. The statistical data over the years also indicates that being sophisticated item no customer is prepared to buy Valve Actuator without a warranty. Therefore, warranty became integral part of the sale price of the Valve Actuator(s). In other words, warranty stood attached to the sale price of the product. These aspects are important. As stated above, obligations arising from past events have to be recognized as provisions. These past events are known as obligating events. In the present case, therefore, warranty provision needs to be recognized because the appellant is an enterprise having a present obligation as a result of past events resulting in an outflow of resources. Lastly, a reliable estimate can be made of the amount of the obligation. In short, all three conditions for recognition of a provision are satisfied in this case.13. In this case we are concerned with Productthe present case, the Department is insisting on the first option which, as stated above, is erroneous as it rules out the accrual concept. The second option is also inappropriate since it does not reflect the expected warranty costs in respect of revenue already recognized (accrued). In other words, it is not based on matching concept. Under the matching concept, if revenue is recognized the cost incurred to earn that revenue including warranty costs has to be fully provided for. When Valve Actuators are sold and the warranty costs are an integral part of that sale price then the appellant has to provide for such warranty costs in its account for the relevant year, otherwise the matching concept fails. In such a case the second option is also inappropriate. Under the circumstances, the third option is most appropriate because itthe present case, we have the situation of large number of items being produced. They are sophisticated goods. They are supported by the historical trend, namely, defects being detected in some of the items. The data also indicates that the warranty cost(s) is embedded in the sale price. The data also indicates that the warranty is attached to the sale price. In the circumstances, we hold that the principle laid down by this Court in the case of Metal Box Company of India (supra) will apply. In that case this Court held that contingent liabilities discounted and valued as out-of-necessity could be taken into account as trading expenses if these were capable of being valued. It was further held that an estimated liability even under a gratuity scheme even if it was a contingent liability if properly ascertainable and if its present value stood fairly discounted, was deductible from the gross profits while preparing the P & L Account. In view of this decision it became permissible for an assessee to provide, in his P & L Account, for the estimated liability under a gratuity scheme by ascertaining its present value on accrued basis and claiming it as an ascertained liability to be deducted in the computation of profit and gains of the previous year either under Section 28 or under Section 37 of the 1961 Act. However, the above principle would not apply after insertion of Section 40A(7) w.e.f. 1.4.73. It may be stated that the principles of commercial accounting, mentioned above, formed the basis of the judgment of this Court in the case of Metal Box Company of India (supra) and those principles are affirmed by the judgment of the Supreme Court in Shree Sajjan Mills (supra) upto 1.4.73. In this case we are concerned with warranty claims. In respect of warranty claims during the relevant assessment years in question there is no provision similar to Section 40A(7) of the 1961 Act. We may add that the above principle of commercial accounting in Metal Box Company of India (supra) also find place in the judgment of this Court in the case of Madras Industrial Investment Corporation Ltd. v. Commissioner of Income-tax -(1997) 225 ITR 802 (SC) , in which the Court has explained the meaning of the word "expenditure" in Section 37 of the 1961 Act. In other words, the principle enunciated in Metal Box Company of India (supra) which has been reiterated in Shree Sajjan Mills (supra) (upto 1.4.73) which deals with making of provision on the basis of estimated present value of contingent liability holds good during the assessment years in question qua warranty claims.At this stage, we once again reiterate that a liability is a present obligation arising from past events, the settlement of which is expected to result in an outflow of resources and in respect of which a reliable estimate is possible of the amount of obligation. As stated above, the case of Indian Molasses Co. (supra) is different from the present case. As stated above, in the present case we are concerned with an army of items of sophisticated (specialiased) goods manufactured and sold by the assessee whereas the case of Indian Molasses Co. (supra) was restricted to an individual retiree. On the other hand, the case of Metal Box Company of India (supra) pertained to an army of employees who were due to retire in future. In that case the company had estimated its liability under two gratuity schemes and the amount of liability was deducted from the gross receipts in the profit and loss account. The company had worked out its estimated liability on actuarial valuation. It had made provision for such liability spread over to a number of years. In such a case it was held by this Court that the provision made by the assessee-company for meeting the liability incurred by it under the gratuity scheme would be entitled to deduction out of the gross receipts for the accounting year during which the provision is made for the liability. The same principle is laid down in the judgment of this Court in the case of Bharat Earth Movers (supra). In that case the assessee company had formulated leave encashment scheme. It was held, following the judgment in Metal Box Company of India (supra), that the provision made by the assessee for meeting the liability incurred under leave encashment scheme proportionate with the entitlement earned by the employees, was entitled to deduction out of gross receipts for the accounting year during which the provision is made for that liability. The principle which emerges from these decisions is that if the historical trend indicates that large number of sophisticated goods were being manufactured in the past and in the past if the facts established show that defects existed in some of the items manufactured and sold then the provision made for warranty in respect of the army of such sophisticated goods would be entitled to deduction from the gross receipts under Section 37 of the 1961 Act. It would all depend on the data systematically maintained by the assessee. It may be noted that in all the impugned judgments before us the assessee(s) has succeeded except in the case of Civil Appeal Nos. of 2009 – Arising out of S.L.P.(C) Nos.14178-14182 of 2007 - M/s. Rotork Controls India (P) Ltd. v. Commissioner of Income Tax, Chennai, in which the Madras High Court has overruled the decision of the Tribunal allowing deduction under Section 37 of the 1961 Act. However, the High Court has failed to notice the "reversal" which constituted part of the data systematically maintained by the assessee over last decade.