Commissioner of Income Tax vs S.A.E. (I) Private Ltd.

Ramanujam, J.—The following question of law has been referred to this court for its opinion, at the instinct of the Revenue :

Whether, on the facts and in the circumstances of the case, the sum reprinting ''incremental liability'' towards gratuity of the current year was

deductible from the profit of the year ?

The assessee, in this case, is a private limited company manufacturing and erecting transmission towers. For the accounting year ending on June

30, 1965, corresponding to the assessment year 1966-67, it claimed deduction of a sum of Rs. 1,09,575 as provision for gratuity for two of it full

time directors by name Sri C. Valdettarao and Sri G. Abbagnane. The ITO did not allow the same on the ground that gratuity fund has not been

recognised by the Commissioner of Income Tax and that it was only a provision and not an actual payment. He also took note of the fact that the

provision has been made on the basis of twelve year'' salary for one director and 9 1/4 years'' salary for the other director and that the provision

thus, in fact, related to the earlier years and not to the year of account only. The disallowance of the claim of the assessee was questioned before

the AAC by filing appeal. The AAC, however, allowed the claim, relying on Circular No. 47 dated September 21, 1970, issued by the Central

Board of Direct Taxes. The Revenue took the matter in appeal to the Tribunal and the Tribunal upheld the claim of the assessee and held that the

business requirements of the company had compelled the assessee to provide for payment of gratuity to its directors and what was necessarily to

be debited in the year of account for the purpose of arriving at a proper profit was necessarily to be allowed. The Tribunal, however, found that

the computation made by the assessee of the current year''s liability on actuarial basis at Rs. 1,09,575 was wrong and that computation had to be

made on incremental basis. In this view, the Tribunal allowed in part the appeal and remitted the matter to the ITO for computing the incremental

liability towards gratuity in respect of the two directors in the assessment year and allowed the same. Aggrieved against the order of the Tribunal,

the Revenue sought and obtained a reference on the question set out above.

The question as to whether a provision made in relation to gratuity payable on a future date can be allowed in the year during which the

provision has been made, came up before this court and the Supreme Court under varied circumstances. The latest pronouncement of the

Supreme Court on this question is in Vazir Sultan Tobacco Co. Ltd., Hyderabad and Others Vs. Commissioner of Income Tax, Andhra Pradesh,

Hyderabad, . Though that case related to the provisions of the Surtax Act, the general discussion as to the nature of the liability for payment of

gratuity to the employees and it allowability in respect of a provision made towards that liability was considered. The decision in that case appears

to apply squarely to the facts of this case. Before dealing with the said decision, it will be useful to refer to some of the decisions of this court on the

point at issue.

In Commissioner of Income Tax Vs. Andhra Prabha P. Ltd., , the question arose whether a provision which had been made for payment of

gratuity calculated on a scientific and legal basis could be debited to the profit and loss account and whether it is allowable as a deduction under s.

37(2) of the I.T. Act. After referring to s. 36(1)(v) of the Act which provides for deduction of any amount actually paid by way of contribution to

an approved gratuity fund created by the employer and s. 40A(7) introduced by the Finance Act, 1975, prohibiting deduction of a provision for

gratuity under certain circumstances, this court held that the the said two provisions did not cover the case where a provision was made for a future

payment on a scientific method of calculation and even in the absence of any specific provisions of the statute in that regard, the provision made for

a future payment calculated on a scientific basis could be allowed in the computation of the profit under s. 28 itself. The court also held that so long

as the provisions had been made bona fide and out of commercial consideration and the allowance was not prohibited by any of the provisions of

the Act, the payment could not be disallowed merely because the payment had not been actually made during the assessment year, for the very

concept of profit would require adjustment being made for the claims of the employees for gratuity in so far as it is possible to relate it to the

current year. In taking that view, the learned judges relied on the decision of the Supreme Court in Metal Box Company of India Ltd. Vs. Their

Workmen, , and the decision of the House of Lords in Southern Railway of Peru Ltd. v. Owen [1957] 32 ITR 737.

In Metal Box Company of India Ltd. Vs. Their Workmen, , the question that arose before the Supreme Court was whether in computing the

amount of bonus payable to workmen, a provision made for payment of gratuity to the workmen on a future date could be deducted from the

profits. The Supreme Court held that such a provision for discharge of a liability on a future date would be a proper deduction in the calculation of

the commercial profits. The relevant observation of the Supreme Court is as follows (pp. 62-63) :

In the case of an assessee maintaining his accounts on mercantile system, a liability already accrued, though to be discharged at a future date,

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. It is not as if such deduction is permissible only in case of amounts actually expended or paid. Just as receipts, though

not actual receipts but accrued due, are brought in for Income Tax assessment, so also liabilities accrued due would be taken into account while

working out the profit and gains of the business.

Thus, on the question whether, in computing the amount of bonus payable to the employees, the estimated liability arising under the gratuity

schemes should be taken into account or not, the Supreme Court held that a provision for payment of gratuity to be discharged at a later date

could be taken into account on then basis of commercial practice and accountancy. The Supreme Court further observed (p. 64) :

In the instant case, the question is not whether such estimated liability arising under the gratuity schemes amounts to a debt or not. The question

that concerns us is whether, while working out the net profits, a trader can provide from his gross receipts his liability to pay a certain sum for every

additional year of service which he receives from his employees. This, in our view, he can do, if such liability is properly ascertainable and it is

possible to arrive at a proper decanted present value. Even if the liability is a contingent liability, provided its discounted present value is

ascertainable, it can be taken into account. Contingent liabilities discounted and valued as necessary can be taken into account as trading expenses

if they are sufficiently certain to be capable of valuation and if profits cannot be properly estimated without taking them into account.

In Southern Railway of Peru Ltd. v. Owen [1957] 32 ITR 737, an English Company operating a railway line in Peru, which was bound to pay

its employees compensation on the termination of their services, claimed as against each year''s profits certain amounts as and by way of provision

for gratuity and other payments which would ultimately be payable. In examining that claim, Lord Radcliffe, with whom the other two Law Lords

agreed, observed (p. 754) :

What the appellant claims the right to do is to charge against each year''s receipts the cot of making provision for the retirement payments that will

ultimately be thrown upon it by virtue of the fact that it has had the benefit of its employees'' services during that year... Only by such a method, it is

said, can it bring against the receipts of the year the true cost of the services that it has used to earn those receipts. Generally speaking, this must, I

think, be true. For, whereas it is possible that any one of it many employees may forfeit his benefit and so never require a payment, the substantial

facts of the situation are that when the company has paid every salary and wage that is due for current remuneration of the year, it has not by any

means wholly discharged itself of the pecuniary burden which falls upon it is respect of the year''s employment.

Lord Mac Dermott, in the same case, has observed (p. 747) :

As a general proposition it is, I think, right to say that, in computing his taxable profits for particle year, a trader, who is under a definite obligation

to pay hi employees for their services in that year an immediate payment and also a future payment in some subsequent year, may properly deduct,

not only the immediate payment, but the present value of the future payment, provided such present value can be satisfactorily determined or fairly

estimated.

Following the above observations of the House of Lords in Southern Railways of Peru Ltd. v. Owen [1957] 32 ITR 737, and of the Supreme

Court in Metal Box Company of India Ltd. Vs. Their Workmen, , this court has held that the gratuity based on actuarial valuation could be claimed

be a deduction, even though the actual discharge of that liability by payment aries later.

In COMMISSIONER OF Income Tax, TAMIL NADU-V Vs. SRI RANILAKSHMI GINNING, SPINNING and WEAVING MILLS

(P.) LTD., , this court was concerned with a question as to whether a provision for gratuity liability arrived at by adoption a scientific method of

valuation could be claimed as deduction. The court expressed the view that it had to be regarded as a business expenditure incurred by the

assessee wholly and exclusively for the purpose of the business and, hence, it was properly allowable as a deduction, even though there is no

specific provision for such deduction in the I.T.Act.

In Vazir Sultan Tobacco Co. Ltd., Hyderabad and Others Vs. Commissioner of Income Tax, Andhra Pradesh, Hyderabad, , a question arose

as to whether a provision for payment of gratuity determined on the basis of scientific and actuarial valuation could be debited against the profit and

loss account and claimed as a dietitian. The Supreme Court held that, normally, a liability to pay gratuity to employees arises on the determination

of their employment either by death, incapacity, retirement or resignation, an event which is certain to happen in the service career of every

employee, that the amount of gratuity payable is usually dependent on the employees'' wages at the time of the determination of their employment

and the number of years of service put in by them, that the liability accrues and enhances with the completion of every year of service that,

therefore, the company can work out on an actuarial valuation its estimated liability, that is, the discounted present value of a future liability on a

scientific basis, and make a provision for such liability, but not all at once but spread over a number of years, and that such a provision has to be

allowed as deduction as the liability with reference to that year, though discharged at a later stage, taking it as an expenditure in relation to that year

of assessment. The Supreme Court also referred to one of its earlier decision in Standard Mills Co. Ltd. Vs. Commissioner of Wealth-tax,

Bombay City, , where the question for decision was whether an estimated liability under the gratuity scheme framed under industrial award

amounted to debts and could be deducted while computing the net wealth of the assessee and the Supreme Court has taken the view that the

liability is a contingent one and, therefore, it not a debt under s. 2(m) of the W.T.Act, though it would be deductible under the I.T. Act, while

computing the taxable profits and that different considerations would have to apply to cases arising under W.T.Act and the I.T. Act. In the later

case in Metal Box Company of India Ltd. Vs. Their Workmen, , the Supreme Court was directly concerned with the nature of a liability under a

scheme of gratuity in the context of the Payment of Bonus Act, and the question was whether the estimated liability under the gratuity schemes

framed by the company could be deducted form the gross receipts in the profit and loss account, it being contended on behalf of the workmen that

such a deduction w not justified while determining the available surplus and the allocable surplus for the payment of bonus under the Payment of

Bonus Act. The Supreme Court rejected the contention and held that an estimated liability under the gratuity schemes, even if it amounted to a

contingent liability and was not a debt under the W.T. Act, was deductible from the gross receipts while preparing the profit and loss account, if its

present value was fairly ascertainable and could be discounted.

Having regard to the consistent view taken by the Supreme Court in Standard Mills Co. Ltd. Vs. Commissioner of Wealth-tax, Bombay City,

, Metal Box Company of India Ltd. Vs. Their Workmen, and Vazir Sultan Tobacco Co. Ltd., Hyderabad and Others Vs. Commissioner of

Income Tax, Andhra Pradesh, Hyderabad, , the decision of the Tribunal, in this case, is to be upheld. The question referred to us has, therefore, to

be answered in the