Abraham P. George, Accountant Member -
(1.) THESE are cross appeals arising from the order of CIT (A)-X, Mumbai. Assessee's appeal and Revenue's appeal are taken up in that order for disposal.
I. ITA No. 7729/Mum/2004
(2.) In its Ground number one assessee is aggrieved that CIT (A) confirmed Assessing Officer's disallowance of performance warranty provision of Rs. 4,83,72,135/- for computing income under normal Income Tax provisions. In its second ground, assessee is aggrieved that for the purpose of computing book profits as per Section 115JB also, Assessing Officer made addition of the above provision. Ground number three of the assessee is against CIT (A) not deleting interest levied Under Section 234D by the Assessing Officer.
2.1 The appellant company is engaged in providing oil terminal services. During the relevant previous year, construction of terminals were also started by it. It was awarded construction and operation of petroleum terminals of M/s. IOC at Dumad and Mathura. Two contracts were entered into for this purpose with M/s. IOC. Under these contracts, the appellant was required to design and construct storage facilities and also to provide services relating to handling, storage and dispatch of petroleum products. Return of income was filed by assessee on 30th October 2001 declaring a loss of Rs. 14,73,34,669/- as per normal provisions of the Income-tax Act and Rs. 13,44,98,910/- under Section 115JB of the Income-tax Act. Refund was also claimed and received by the assessee. During the assessment proceedings Assessing Officer made an addition of Rs. 4,83,72,135/- being provision made by the assessee in its accounts for performance warranties, while computing its income/loss under the normal provisions. For computation of book profits under Section 115JB, Assessing Officer, in addition to the provision for performance warranties Rs. 4,83,72,135/- also added Rs. 1,00,18,189/- charged to the profit and loss account as 'Preliminary and deferred Revenue expenses'.
2.2 Assessing Officer disallowed the provision of Rs. 4,83,72,135/- for performance Warranties citing the following reasons:
(i) The liability for meeting expenses and outgoes during defect liability period had not been crystallized and ascertained.
(ii) The provision is not allowable Under Section 37 of the Act since Section 37 allows only expenditures and not any provisions.
For disallowing the preliminary and deferred Revenue expenditure for the purpose of computing the book profit under Section 115JB the learned Assessing Officer gave the following reason
(i) The preliminary and deferred Revenue expenses has been written off due to a change in Accounting Policy as evident from the audit note in the assessee's audited final account statements.
(ii) The change in the accounting policy resulted in computation of book profit being understated by Rs. 1,00,18,189/-.
2.3 In its appeal before CIT (A), assessee made the following submissions with regard to provisioning for performance warranties
(i) Under the contracts with M/s. IOC, assessee was responsible for any discrepancies, errors or omissions in the plans, drawings and other information prepared pursuant to the contracts.
(ii) Onus of ensuring satisfactory performance of the facility rested with the appellant since the contracts with M/s. IOC had a defect liability period of twelve months from the date or completion of commissioning of the facility.
(iii) Provision of 5% on progressive billings were made after a detailed technical assessment carried out by qualified technical engineers to determine the nature and type of defects/performance failures which could arise under the various components of the construction work.
(iv) Para 1/.4 of AS-7, which is the Accounting Standards for construction contracts promulgated by the Institute Chartered Accountants of India (in short ICAI) requires appropriate allowance to be made for future unforeseeable factors either on a specific or a percentage basis, and hence this provision was made in strict compliance with such Accounting Standards.
2.4 While making the above submissions before learned CIT (A) reliance was also placed by the assessee on the following cases:
a) Voltas Ltd. v. DCIT 64 ITR 232 (Mum)
b) ITO v. Warson (India) Ltd. 51 ITD 102 (Pune)
c) Comm. of Inland Revenue v. Mitsubishi 222 ITR 697 (Privy Council)
2.5 Assessee's submissions before CIT (A) with regard to the additions made by Assessing Officer on the book profit for computation of MAT under Section 115JB were as follows:
(i) That under Clause (c) to Explanation to Section 115JB, only liabilities which cannot be ascertained are to be added to the book-profit and the provisioning for performance warranty was not unascertained liability, but made on the basis of a detailed technical assessment.
(ii) The assessee was following AS 7 as mandated by ICAI, and prudent accounting principle of matching cost with revenue required such provisioning.
(iii) Expert advisory committee of ICAI had opined that provisions made to meet obligations resulting from warranty or guarantee did not represent contingent liability.
(iv) That a security deposit of 10% of contract value was given to M/s. IOC and such security deposit was indicative of M/s. IOC's own assessment as regards costs that could arise during the warranty period.
(v) That, with respect to the inclusion of preliminary & deferred Revenue expenses of Rs. 1,00,18,189/- in the net profit, such addition goes against the Explanation to Section 115JB which does not specifically provide that any difference on account of change in method of accounting of preliminary and deferred Revenue expenses should be added back to the book profit.
(vi) The decision of the Hon'ble Supreme Court in the case of Apollo Tyres v. CIT 255 ITR 277 laid down the law that Assessing Officer while computing the income Under Section 115J has only the power of examining whether the books of accounts are certified by the authorities under the Companies Act as having been properly maintained in accordance with the Companies Act, and that he does not have the jurisdiction to go behind the net profit shown in the profit and loss account, except to the extent provide in the explanation to Section 115J, and this was not followed by the learned Assessing Officer.
(vii) That the Assessing Officer went wrong in concluding that the facts of the case in Calcutta Company Ltd. v. CIT 37 ITR 1 as also the principles evolved by the Hon'ble Supreme Court in the case Metal Box Company Ltd. v. Their Workmen 73 ITR 53 were different and could not be applied in assessee's case.
2.6 After hearing the assessee, CIT (A) held that the provision of 5% coming to Rs. 4,83,71,325/- made for performance warranty was not definite and ascertained liability and confirmed the order of the Assessing Officer on this aspect. Addition of this amount for computation of book profit Under Section 115JB, was also sustained by learned CIT (A), since according to him such provisions was contingent and not ascertained. However, for the purpose of computing Book profit Under Section 115JB, CIT(A) directed the Assessing Officer not to make the addition of Rs. 1,00,18,189/- on account of differential amount of preliminary and deferred Revenue expenses written off, accepting the contentions of the assesses that Section 115JB did not allow such addition.
2.7 For sustaining the Assessing Officer's order, disallowing the provision for performance warranties, in the normal computation as well as for the MAT computation Under Section 115JB learned CIT (A) gave the following reasonings:
(i) The liability has been estimated by applying the principle of probability of happening of some event, which may or may not occur, as could be made-out from the technical assessment prepared by Technical Engineers appointed by the assessee itself. According to the CIT (A), terminology used by the technical engineers in such assessment tended to rely on certain terms which only points to the likely defects which may arise during the defect liability period. In other words according to CIT (A) the technical assessment was based on a general terminology whereby only certain probable events like tendency to develop cracks, replacement of seals, etc. were noted. Hence according to learned CIT (A) such liabilities were not ascertained or crystalised.
(ii) Such liabilities are only contingent and does not give rise to any definite obligation, and hence it cannot fall within the expression "expenditure laid out or expended wholly or exclusively for the purpose of business". No enforceable liability had accrued or arisen to the assessee on account of warranty.
(iii) Mercantile system can never be stretched so as to embrace all sorts of provisions, notional or contingent payment. Projects at Dumad and Mathura had not yet been completed and was under execution. Therefore, according to him the liability, on the basis of which the deduction has been claimed, did not exist as on the last date of the relevant previous year.
2.8 For deleting the addition of differential amount of Rs. 1,00,18,189/- written off as preliminary and deferred revenue expenses by the assessee, in computing the book profit Under Section 115JB and thereby allowing the assessee's appeal on this ground, the CIT (A) gave the following reasons:
(i) The Hon'ble Supreme Court in the case of Apollo Tyres 253 ITR 273 has held that the use of words "in accordance with the provisions of Part II & III of Schedule VI of the Companies Act" in Section 115J was made for the limited purpose of empowering the Assessing Officer to rely only upon the authentic statement of account of a company.
(ii) Once a company had prepared its accounts in a manner provided by the Companies Act and the same has been scrutinized and certified by the Statutory Auditors, the Assessing Officer had to accept the authenticity of such accounts. Sub-section 1A of Section 115J does not empower the Assessing Officer to embark upon fresh enquires in regard to the entries made in the books of accounts.
(iii) By writing off the preliminary and deferred Revenue expenses of Rs. 1,00,18,189/-, being the balance remaining under that head after earlier year write offs, assessee had not violated any provisions of Accounting Standards or ICAI guidelines.
2.9 In the light of the above stated facts, let us now go into the grounds raised by the assessee, in his appeal before us. As already stated, ground No. 1 & 2 relates to the same issue of addition of Rs. 4,83,72,135/- on account of provisions for performance warrantee, first for computing the income under the normal provisions and second for computing the book profit Under Section 115JB.
2.10 In the submissions before us the learned Authorised Representative, reiterated all the grounds raised before the Assessing Officer as well as the CIT (A), with gutso. He, further, submitted as follows:
(i) As per the contract with Indian Oil Corporation (in short IOC), the assessee had given a security deposit of 10% of contract value. The learned Authorised Representative brought to our notice paper book page 68 to 238 which is a copy of the relevant clauses as contained in the agreement between the assessee and M/s. IOC (hereinafter referred to as the agreement). At page 84 the clause captioned 'Security Deposit' clearly states that the security deposit of 10% of contract value had to be given to IOC, which would be released by them only on completion of 12 months from the date storage facility is comleted by the assessee, in line with its bid package.
(ii) As per Clause 15 of the agreement as it appears at paper book page No. 222, for a period of 6 months, after the work was completed, assessee had to maintain and uphold the same in efficient condition and was also bound to remedy any omission or defects discovered or appearing in the works as directed by the Dy. GM (Project) of M/s. IOC. It is also specified in this clause that security deposit would be released only after the expiry of the said period and subject to it being ascertained that there was no defective work or material requiring repairs or maintenance. Therefore assessee was responsible for the smooth working after completion during the warranty period.
(iii) Assessee had adopted percentage completion method which is the approved methodology for accounting construction contracts, as per Accounting Standards-7 of ICAI. Though, this is not an Accounting Standard which has been notified Under Section 145(2) of the Act, assessee applied it for prudent accounting. This Accounting Standard mandates that when profit is recognized under percentage of completion method an appropriate allowance for future unforeseeable factors should be made on either specific or a percentage basis. Assessee being a Company, limited by shares, it was mandatory to follow the Accounting Standards promulgated by ICAI.
(iv) If the assessee was not creating the provision for warranty, then it would not be matching costs with Revenue, and hence could lead to unbalanced and unfair results.
(v) The Contract with the IOC, at Clause No. 33 (Paper book page 91) clearly states that the contractor would be responsible for any discrepancies, errors or omissions in the plans drawings, and other information prepared pursuant to the agreement and should at its...own expense carry out, alterations or remedial work necessitated by reasons of such discrepancies, errors or omissions.
(vi) The warranty provision of 5% on progressive bill payments received was based on proper scientific analysis and on detailed technical assessments (Paper book Pages 62 & 63) done by General Manager Project & Finance Manager, and vetted by an independent agency namely M/s. Dalai Consultant & Engineering Ltd. Though such assessment determined probable defect liability expenses at 5.74% of the total terminal cost, assessee had provided 5% only.
(vii) Assessee had also sub-contracted major parts of the work, which increased the risk factor for it and this all the more called for a prudent accounting practice.
(viii) Assessee is supported by the decision of Hon'ble Bombay High Court in CIT v. Associated Cables (P) Ltd. 236 ITR 596 wherein it was held that even retention money withheld by contractees pending completion of contract work, does not accrue to the assessee-contractor in the year in which the amount is retained.
(ix) Assessee is also supported by the following decisions:
(a) 245 ITR 428 (SC) Bharat Earth Movers v. CIT
(b) 222 ITR 697 (Privy C.) Commissioner of Inland Revenue v. Mitsubishi
(c) 270 ITR 259(Kerala) CIT v. Indian Transformers Ltd.
(d) 278 ITR 337 (Delhi) CIT v. Vintec Corporation(P) Ltd.
2.11 The learned Departmental Representative made his reply submissions as follows:
(i) The technical assessment cited point out to only certain common problems that could arise in the future and did not give rise to an ascertainable or ascertained liability.
(ii) Actual expenditure incurred by the assessee against the provision when compared to the headwise provisioning made by the technical experts varied substantially.
(iii) Hon'ble Madras High Court in the case of CIT v. Rotork Controls India Ltd. 293 ITR 311, after considering all the decisions cited by the learned AR, had held that where the nature of the liability was yet to be crystalised and was loaded with uncertainty of the event which can give rise to a liability, there is no justification to accept such a claim of the assessee.
(iv) In none of the cases cited by the learned AR, has the liability under the warranty clause determined based on a fixed percentage of the turnover and, therefore, accepting the claim of a percentage on turnover for the provisioning could not be sustained.
2.12 We have considered the order of the Assessing Officer, the CIT(A)'s order, the submissions and grounds made before the Assessing Officer as well as before the CIT (A), the relevant pages of the paper book referred to by learned AR, and learned DR as also the submissions and case laws brought to our notice. The undisputed facts are that the assessee had started a new activity in the form of construction of terminals on behalf of the clients in the relevant previous year. M/s. IOC is the first client who employed the assessee to construct two terminals at two different locations. Assessee has been hitherto before in the business of running terminals and was new to the field of building and maintaining terminals, that too on turn key basis. It is also not disputed that there is a warranty clause in the agreement whereby assessee has undertaken to make good any defects arising during the defect liability period. On a perusal of its technical assessment for possible warranty liability, we find that such assessment was vetted by M/s. Dalai Consultants and Engineers Ltd., an independent agency. The types of defects and performance failures that could arise under various components of the project has been succinctly summarized by the technical consultants in it's report.
2.13 That assessee has already provided 10% of contract value as security deposit is also not disputed. It is also clear from Clause 15 of the agreement (Paper book 222) that the security deposit would be adjusted against expenses incurred by the M/s. IOC in case of failure of assessee to maintain facility as per the terms of contract for the warranty period. Assessee had followed percentage completion method for accounting its income, which is a prudent one as evident from Accounting Standard-7 of ICAI and no doubt vide Section 211(3d) of the Companies Act 1956, a Company is bound to follow the Accounting Standards promulgated by ICAI. Assessee company was thus having no option but to follow this accounting standard. This accounting standard itself is based on the 'principle of prudency' in maintenance of accounts, whereby an entity is prevented from projecting excessive profits without considering all possible out goes. In the type of contract that assessee had with M/s. IOC, no doubt recognition of Revenue on percentage completion basis is itself an estimation, since such profits are so estimated even before a project is complete. Therefore it is only prudent that all possible expenditure are also taken into account. Since accrual system has to be followed by a Company, it is very much necessary that liabilities that are crystalised though difficult to be quantified are accounted for.
2.14 In the case of Bharat Earth Movers 245 ITR 428, the Hon'ble Supreme Court has given a guiding principle, where such liabilities have arisen though not quantifiable with certainty. According to Hon'ble Supreme Court deduction is allowable once business liability has arisen, though it could be quantified and discharged only at a future date. However, that case dealt with provisioning for liability on account of encashment of earned leave of employees. Since such liability had already arisen and could reasonably be quantified in proportion to the entitlement of each employee and their length of service, subject to the outer limit of eligibility, Hon'ble Supreme Court held provisions thereof as reasonable. To be specifically noted is that, here, there was a methodology available for making a reasonable estimate of such liability.
2.15 Hon'ble Delhi High Court in CIT v. Vinitec Corporation (P) Ltd. 278 ITR 337, held that even where actual quantification and discharge of a liability is deferred to a future date, once an assessee is maintaining its accounts in mercantile system, a liability so accrued, though to be discharged on a future date would be a proper deduction while working out the profit and gains of his business, having regard to the accepted principles of commercial practice in accountancy. In this case the provisioning for warranty was on account of sale of goods with warranty and Hon'ble High Court found that such provisioning was done on the basis of past data, whereby actual expenses relatable to warranty was 3.59%, 5.07% & 2.10% for assessment years 1997-98, 1998-99 & 1999-2000 respectively. Here also, it can be noted that there was indeed a past history based on which a reasonable estimate could be made.
2.16 In the case of Commissioner of Inland Revenue v. Mitsubishi Motors 227 ITR 697, which dealt with warranty provisioning for vehicles sold, it was observed by Privy Council that the tax payer in the year of sale was under a legal obligation to make such provisions under those warranties, even though it would not be required to do such work until the following year. Past statistical information that 63% of all sold vehicles could contain defects warranty repairs during warranty period, was accepted and provisioning allowed. Thus here also past data was used for making the provisions. It is noteworthy that P C also observed that merely theoretical contingencies are to be disregarded.
2.17 Order of Hon'ble Kerala High Court, in CIT v. Indian Transformers Ltd. 270 ITR 259, allowed provisioning for warranty based on past data which showed that
i) ten transformers sold by the concerned assessee to M/s. BHEL had failed and
ii) Actual expenses on account of warranty period repairs for the preceding year was Rs. 7.99 lakhs against provision of Rs. 3.5 lakhs.
2.18 The common vein running through all the above cases is that there was sufficient past data with the assessee to justify the reasonableness of the warranty provisioning done.
2.19 On the necessity of past data for determining whether provisioning was justified in the case of CIT v. Rotork Controls decided by Hon'ble Madras High Court (293 ITR 311) is very relevant. In this case, assessee could not adduce data on actual incidence of liability under warranty, based on any past data as a percentage of turnover. Hon'ble High Court came to a conclusion in this case that the existence of elements of certainty were not there and that the liability could not be substantiated by the party concerned. The dictum evolving out of the judgment of Hon'ble High Court is that unless actual expenses incurred against provisioning could be substantiated for justifying the quantum or unless a basis for the provisioning was given such provisioning could not be done.
2.20 Here, the assessee was for the first time executing the work of the type. Hence no past data was available with it to justify the quantum. In fact furnishing of such past data was impossible for the assessee. A warranty clause for maintaining the facility it was setting up, for a period of 12 months, was very much there in the agreement and M/s. IOC had the power to make good expenses incurred by it, in case assessee failed to meet its warranty obligations, out of the 10% security deposit with it. Since past data was not available, assessee did the best it could do in such circumstances for estimating it's liability. It made a technical assessment and had it vetted by an independent agency. Against 5.73% arrived at by such technical evaluators, which was vetted by independent contractors, as possible warranty expenses, assessee in fact had made only a 5% provisioning. Though the cited cases, supra, were not on warranties in any construction projects, nevertheless, possibility of damages and work to be done on account of various defects pointed out by the principal, would only be higher in view of the inherent uncertainties involved in a project of this magnitude. Thus the liability was very much ascertained as on the end of the relevant previous year. Just because, assessee is having no prior statistical data regarding warranty expenses, cannot by itself make him ineligible from making the claim, especially when he has just started this line of activity and hence impossible for him to have such past data. What can be done at best in this scenario, is to look for a technical assessment of possible warranty expenses and also expenses incurred on account of the warranty in a period later to the relevant previous year. Here, assessee has a technical assessment which has been vetted by independent agencies where warranty expenses during defect liability period has been estimated at 5.97% (Paper book 63). Industrial experience in this regard has also been filed by the assessee which gives instances of failure/development of defects which have actually occurred in oil industry in this line of activity (Paper book 66). Assessee had also submitted the details of expenses incurred for rectification of various damage during the defect liability period, subsequent to 31st March 2001, which comes to Rs. 3,06,79,133/-, (Paper book 13 & 14) as against the warranty provisioning of Rs. 4,83,72,135/-. Revenue has not controverted these figures except for that, heads under which actual expenses for rectification for damages were spent and the heads under which technical assessment were done varied. It is true that there are inter-head variation between the technical estimates and actual spendings, but that is well explained from the fact that one is an estimate and the other actuals. Thus assessee has been able to justify the provisioning and its' quantum in a reasonable manner.
2.21 In all the cases referred to supra, including the Madras High Court decision in CIT v. Rotork Controls 293 ITR 31 what can be discerned is that warranty provisioning is allowable, if supported by sufficient data to justify such provisioning & is based on statistical or other relevant data. We have no hesitation in the facts of the case to hold that 5% of the warranty provisioning done by the assessee was made against ascertained liability, very much reasonable and made on relevant data. Hence, we hereby set aside the CIT (A) order confirming non-allowance of deduction of performance warranty of Rs. 4,83,72,135/- in computing the income of the assessee under the normal provision of the Income-tax Act. Assessing Officer is directed to allow the deduction of the provision for warranty as claimed by the assessee for computing its' income under normal provisions of the Act.
2.22 As regards the addition of he same amount in computing the book profits as per Section 115JB, it is necessary to see the type of addition allowed under Clause (a) to (f) of Explanation to Clause (2) of Section 115JB. These explanations run as follows:
(a) the amount of income-tax paid or payable, and the provision therefor; or
(b) the amounts carried to any reserves, by whatever name called [other than a reserve specified under; Section 33AC] or
(c) the amount or amounts set aside to provisions made for meeting liabilities, other than ascertained liabilities; or
(d) the amount by way of provision for losses of subsidiary companies; or
(e) the amount or amounts of dividends paid or proposed; or
(f) the amount or amounts of expenditure relatable to any income to which (other than the provisions contained in Clause (23G) thereof) apply.
2.23 Under Clause (a) above the amounts set aside to provisions made for meeting liabilities other then ascertained liabilities has to be added for deleting book profit. Impliedly ascertained liabilities cannot be added. Since it has already been held by us vide Para 2.21 above, that provision for warranty made by the assessee company is an ascertained liability, it follows that Assessing Officer cannot make any addition thereof to the net profit of the assessee company for arriving at its book profits for the purpose of Section 115JB. Therefore we set aside the order of the CIT (A) and Assessing Officer on this aspect and delete the addition of Rs. 4,83,72,135/- made by the Assessing Officer to the net profit for computing assessee's book profit under Section 115JB. Thus, Grounds 1 & 2 of the assessee are allowed.
In Ground No. 3 assessee is aggrieved that CIT (A) has not deleted the interest levied Under Section 234D.
3.1 The learned Authorised Representative submitted that date of refund was received by the assessee on 11.02.2003 and the intimation Under Section 143(1) was dated 10.01.2003. Since the assessment order was found on 31.12.2003, according to him interest Under Section 234D could not be charged for a date prior to 01.06.2003 being the date on which that section was enacted. Issue of chargeabillty of interest where refunds were granted prior to 1st June 2003, being the date on which the said Section was enacted, has already been referred to the Special Bench of this Tribunal. Hence we feel it appropriate to set aside the CIT (A) order on this aspect so that the Assessing Officer can decide it afresh. Therefore this ground of the assessee is allowed, CIT (A) order set aside, and matter remitted back to Assessing Officer for deciding the matter afresh, taking into consideration the Special Bench directions in this regard.
3.2 Hence Ground 3 of the assessee is allowed, to the extent stated above.
(3.) IN the result, appeal of the assessee is partly allowed for statistical
II. ITA 7412/Mum/2004;