1956 (6) TMI 15 - HC - Income Tax

Appeal Dismissed: Accounting for Future Liabilities Must Comply with Legal Requirements

Southern Railway of Peru Ltd. Versus Owen (Inspector of Taxes)

The House of Lords dismissed the appeal, affirming that the appellant's method of accounting for future liabilities was impermissible. They held that the ... - Issues Involved:1. Computation of profits for income tax purposes.2. Deductibility of future liabilities.3. Applicability of Peruvian social legislation.4. Contingency of liabilities.5. Correct accountancy practice.6. Legal principles governing contingent liabilities.Detailed Analysis:1. Computation of Profits for Income Tax Purposes:The central issue was whether the appellant company, Southern Railway of Peru Ltd., could deduct future liabilities for employee retirement payments from its annual profits for income tax purposes. The appellant argued that these payments, which were mandated by Peruvian social legislation, should be accounted for annually as they accrued, rather than only when they were paid out at the end of an employee's service.2. Deductibility of Future Liabilities:The appellant contended that the amounts to be deducted should be the proportionate amount of each payment estimated as ultimately to be paid on retirement, on the basis of that proportionate amount having accrued at the end of each period of account. This method, they argued, was necessary to reflect the true cost of the services rendered by employees each year. The Crown, however, argued that the liability was contingent and should only be deducted in the year it was actually paid.3. Applicability of Peruvian Social Legislation:The Peruvian legislation required the company to make lump sum payments to employees upon termination of their service. These payments were considered deferred remuneration. The appellant argued that since employees could claim their compensation at any time by giving notice, the company was entitled to charge the estimated future payments against the profits of the current year. The Crown countered that no liability existed until the actual termination of employment, making any such deduction premature.4. Contingency of Liabilities:The Crown's primary argument was that the company's liability to pay these lump sums was contingent upon the termination of employment, and thus could not be deducted until the contingency was resolved. The appellant argued that the probability of having to make these payments was so high that it should be considered a current liability.5. Correct Accountancy Practice:The Special Commissioners found that it was a matter of correct accountancy practice in England to make provision in the accounts for such sums. They held that the sums in question were deferred remuneration and that there was nothing in the Income Tax Act, 1918, to prohibit their deduction in computing the company's profits. The Crown disputed this, arguing that the sums were too speculative to be included as current liabilities.6. Legal Principles Governing Contingent Liabilities:The House of Lords examined whether there was an overriding principle of law that contingent liabilities must be disregarded. The appellant cited precedents like Sun Insurance Office v. Clark, where future liabilities were allowed to be deducted to reflect true profits. The Crown argued that the principle did not apply as the company's liability was not definite within the relevant year.Judgment:The House of Lords ultimately dismissed the appeal. They agreed with the Court of Appeal that the appellant's method of accounting for these future liabilities was not permissible. They held that the liability to pay the lump sums was contingent upon the termination of employment and could not be deducted until it was actually paid. The Lords emphasized that while it might be correct accountancy practice to make such provisions, it did not align with the legal requirements for income tax purposes. The judgment reinforced that contingent liabilities, unless they can be fairly estimated and are practically certain, cannot be deducted from annual profits for tax purposes.