M-S. ROTORK CONTROLS INDIA (P) LTD. v. COMMISSIONER OF INCOME TAX, CHENNAI

Citation: [2009] 8 S.C.R. 1152

Court: Supreme Court of India

Bench: S.H. KAPADIA, AFTAB ALAM

Case summary

M-S. ROTORK CONTROLS INDIA (P) LTD. v. COMMISSIONER OF INCOME TAX, CHENNAI.pdf

Judgment text

[2009] 8 S. C. R. 1152 MIS. ROTORK CONTROLS INDIA (P) LTD. v. COMMISSIONER OF INCOME TAX, CHENNAI (Civil Appeal Nos. 3506 - 3510 of 2009) MAY 12, 2009 [S. H. KAPADIA AND AFTAB ALAM, JJ. ) Income Tax Act, 1961: s. 37 - Provision for warranty - Estimation of contingent liability - Manufacture and sale of large number of sophisticated product for long - Every year some of the items found to be defective - Sale becoming virtually impossible without warranty - Provision for warranty made based on historical trend - Entitlement to deduction - Held: Entitled - Such obligation arising from past events to be recognized as provisions. Words and phrases: 'provision: 'liability', 'obligating event' - Meaning of, in the context of Income Tax Act, 1961. Appellant-assessee was manufacturing and selling Value Actuator. At the time of sale, the assessee .

company provided a standard warranty whereby in the event the product sold becomes defective within a specified period, the company would undertake to rectify or replace the defective part free of charge. For the assessment year 1991-92, the assessee made a provision for warranty @ 1. 5% of the turnover. This provision was made on account of warranty claims likely to arise on the sales effected by the assessee and to cover up that expenditure. The assessee made reversal of excess provision. The assessee claimed deduction in respect of net provision which was disallowed by the A. O. on the ground that the liability was merely a contingent' liability OF INCOME TAX, CHENNAI ; not allowable as a deduction under Section 37 of Income Tax Act, 1961. The decision was upheld by appellate authority.

On appeal, Tribunal held that right from the assessment year 1983-84 the CIT (A) as well as the Tribunal allowed the warranty claim on the ground that Valve Actuators were sophisticated equipments; that in the course of its manufacture and sale 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. 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. The High Court held that the assessee was not entitled to deduction in respect of the provision made for warranty claims. Hence these appeals.

Allowing the appeals of assessee and dismissing the appeals of Department, the Court HELD: 1. A provision is a liability which can be measured only by using a substantial degree of estimation. A provision is recognized when: (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. [Para 1O] [1167-B-D] 2. 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 economic benefits. A past event that leads to a present obligation is called as an obligating event. The obligating event is an event that creates an obligation which results in an outflow of resources.

It is only those obligations arising from past events existing independently of the future conduct of the business of the enterprise that is recognized as provision. For a liability to qualify for recognition there must be not only present obligation but also the probability of an outflow of resources to settle that obligation. Where there are a number of obligations, (e. g. product warranties or similar contracts) the probability that an outflow will be required in settlement, is determined by considering the said obligations as a whole. In the case of a manufacture and ·sale of one single item the provision for warranty could 0 constitute a contingent liability not entitled to deduction under Section 37 of the said Act.

However, when there is manufacture and sale of an army of items running into thousands of units of sophisticated goods, the past event of defects being detected in some of such items leads to a present obligation which results in an enterprise having no alternative to settling that obligation. In the present case, the appellant was manufacturing and selling Valve Actuators. They were in the business from assessment years 1983-84 onwards. Valve Actuators are sophisticated goods. Over the years appellant were manufacturing Valve Actuators in large numbers. The statistical date indicates that every year some of these manufactured Actuators are found to be defective. The statistical date over the years also indicated that being sophisticated item no customer is prepared to buy Value Actuator without a warranty. Therefore, warranty became integral part of the sale price of the Valve Actuator. In other words, warranty stood attached to the sale price of the product.

These past events are known as obligating OF INCOME TAX, CHENNAI events. Therefore, warranty provisions. These past • events are known as obligating events. 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. [Para 11 and 12) [1167-D-H; 1168-A-F] 3. For determining an appropriate historical trend, it is important that the company has a proper accounting system for capturing relationship between the nature of the sales, the warranty provisions made and the actual - expenses incurred against it subsequently. Thus, the decision on the warranty provision should be based on ', past eicperience of the company.

A detailed asse~sment of the warranty provisioning policy is required particularly if the experience suggests that warranty provisions are generally reversed if they remained unutilized at the end of the period prescribed in the warranty. Therefore, the company should scrutinize the historical trend of warranty provisions made and the actual expenses incurred against it. On this basis a sensible estimate .. should be made. The warranty provision for the products should be based on the estimate at year end of future warranty expenses. Such estimates need reassessment .. _ every year. As one reaches close to the end of the warranty period, the probability that the warranty expenses will be incurred is considerably reduced and that sho! Jld be reflected in the estimation amount. Whether this should be done through a pro rate reversal or otherwise would require assessment of historical ~ ' trend.

If warranty provisions are based on experience and historical trend and if the working is robust then the question of reversal in the subsequent two years, may not arise in a significant way. On the facts and circumstances of this case, provision for warranty is rightly made by the ' • -' 3, it claimed a deduction of these sums from its ,. profits or gains under section 10(2) (xv) of the Indian Income-tax Act (hereinafter called the Act), which provides "Such profits or gains shall be computed after making the 8 following allowances, namely :- any expenditure (not being in the nature of capital expenditure or personal expenses of the assessee) laid out or expended wholly and exclusively for the purposes of such business, profession or vocation. " This claim was disallowed by the Department and the Appellate Tribunal.

The Tribunal held that it was not necessary to decide if the expenditure was wholly or exclusively for the purposes of the company's business, 0 and if so, whether it was of a capital nature, because in the Tribunal's opinion there was no expenditure at all. The reason why the Tribunal held this way may be stated in its own words: "ClausE~s (I) and (II) do not contain any provision having a material bearing upon clause (Ill). Therefore, if it happens that both Mr. and Mrs. Harvey die before 20th September, 1955, all the payments till then made through the trustees . to the Insurance Society will come back to the trustees and, as there is not the slightest trace of any indication anywhere that the trustees should have any beneficial interest in these moneys there would be a resultant trust in favour of the company in respect of the moneys thus far paid out. In other words, what has been done amounts to a provision for a contingency which may never arise.

Such a provision can hardly be treated as payment to an employee whether of remuneration or pension or gratuity, and cannot be a proper deduction against the incomings of the business of the company for the purpose of computing its taxable profits. In short, there has been no expenditure by the company yet; there has been only an allocation of a part of its funds for an expenditure which may (or may not) have to be incurred in future. " 16. The question which arose for determination was : whether during the assessment years 1949-50, 1950-51, 1951- 52 and 1952-53 the assessee-company was entitled to claim ,. deduction of the yearly premium from its profits under Section 10(2)(xv) of the Income-tax Act, 1922.

It was held that the provision in the policy for surrendering annuity and the provision in policy for return of premium was not entitled to deduction as the payment made to the trustees by the assessee-company was towards a contingent liability or towards a liability depending on a contingency, namely, the life of a human-being. It was held that putting aside of money which may become . > expenditure on the happening of an event is not an expenditure under Section 10(2)(xv) of the 1922 Act. It was held on facts that the money was placed in the hands of trustees and/or the insurance company to purchase annuities, if required, but to be returned if the annuities were not purchased. Therefore, it was a case of setting apart of the money and consequently the assessee was not entitled to deduction under the said section. -l .. ; 17.

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. 14178-1. 4182 of 2007 - Mis. 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. 18. For the above reasons, we set aside the impugned ~ judgment of the Madras High Court dated 5. 2. 07 and accordingly the civil appeals stand allowed in favour of the assessee with no order as to costs. Civil Appeal No. of 2009 - Arising out of S. L. P. (C) No. 7490 of 2009 Civil Appeal No. of 2009 - Arising out of S. L. P. (C) 1' No. 5616 of 2009 Civil Appeal No. of 2009 -Arising out of S. L. P. (C) No. of 2009 (SLP(C) ......... CC No. 4633 of 2009) Civil Appeal No. of 2009 -Arising out of S. L. P. (C) No. 722 of 2009 Civil Appeal No. of 2009 - Arising out of S. L. P. (C) No. 723 of 2009 Civil Appeal No. of 2009 -Arising out of S. L. P. J (C) No. 4776 of 2009 Civil Appeal No. of 2009 -Arising out of S. L. P. (C) No. 3440 of 2009 Civil Appeal No. of 2009 -Arising out of S. L. P. (C) No. 4182 of 2009 Civil Appeal No.

of 2009 - Arising out of S. L. P. (C) No. 4183 of 2009 Civil Appeal No. of 2009 -Arising out of S. L. P. (C) No. 4184 of 2009 Civil Appeal No. of 2009 - Arising out of S. L. P. (C) No. 8983 of 2009 Civil Appeal No. of 2009 -Arising out of S. L. P. (C) No. 8982 of 2009 Civil Appeal No. of 2009 - Arising out of S. L. P. (C) No. 8311 of 2009 Civil Appeal No. of 2009 -Arising out of S. L. P. (C) No. of 2009 (SLP(C) ......... CC No. 5279 of 2009) 19. For the reasons given hereinabove in Civil Appeal Nos. of 2009 - Arising out of S. L. P. (C) Nos. 14178-14182 of 2007 - Mis. Rotork Controls India (P) Ltd. v. Commissioner of Income Tax, Chennai, the civil appeals filed by the Department stand dismissed with no order as to costs. D. G. Appeals disposed of.