Crystallised liability and TDS disallowance principles control deductibility of provisions and interest payments to a banker

A provision for liquidated damages was not deductible as business expenditure because the liability had not crystallised in the relevant year; the settled test for recognising a provision requires a present obligation, probable outflow, and a reliable estimate, all of which must be satisfied cumulatively. Interest paid to an Indian banker could not be disallowed under Section 40(a)(i) where the factual basis for Section 195 was absent, since the payment was not shown to have been made directly to a non-resident and the banking-company exception under Section 194A(3) also applied. Relief was therefore confined to the TDS issue.

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Issues: (i) Whether the provision made for liquidated damages was deductible as business expenditure when the liability had not crystallized during the relevant previous year; (ii) Whether interest paid to the assessee's banker in India could be disallowed under Section 40(a)(i) for alleged failure to deduct tax at source.

Issue (i): Whether the provision made for liquidated damages was deductible as business expenditure when the liability had not crystallized during the relevant previous year.

Analysis: The claim for deduction was examined in the light of the settled test for recognition of a provision. A deduction is permissible only where there is a present obligation arising from a past event, it is probable that an outflow of resources will be required to settle the obligation, and a reliable estimate can be made of the amount. The assessee had to satisfy all three requirements cumulatively. Applying the earlier decision in the assessee's own case and the principle governing contingent liabilities, the liability for liquidated damages had not crystallized in the relevant year.

Conclusion: The issue was answered against the assessee and in favour of the Revenue.

Issue (ii): Whether interest paid to the assessee's banker in India could be disallowed under Section 40(a)(i) for alleged failure to deduct tax at source.

Analysis: The factual foundation for invoking Section 195 was absent because the payment was made to the assessee's banker in India, not directly to a non-resident. In the absence of material showing a direct payment to the foreign supplier, the obligation to deduct tax at source under Section 195 did not arise. The payment to a banking company also attracted the exception in Section 194A(3). Since the threshold requirement for applying Section 40(a)(i) was not established, the disallowance could not stand.

Conclusion: The issue was answered in favour of the assessee and against the Revenue.

Final Conclusion: The appeal succeeded only on the TDS disallowance issue, while the claim for deduction of liquidated damages failed, resulting in relief to the assessee only to that extent.

Ratio Decidendi: A disallowance under Section 40(a)(i) can be made only when the Revenue first establishes that the relevant TDS provision actually applied on the proved facts, and a provision for expenditure is deductible only when the liability has crystallized by satisfying the settled recognition tests.

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