TaxTMI 
TaxTMI 
2007 (3) TMI 325
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....ould be allowed as deduction. The Assessing Officer was of the view that the claim was merely a provision on account of a contingent liability and not on account of an ascertained liability. The assessee submitted a written reply dated September 16, 1999, where the details of the provisions were given as under : Name of the client Provision made Chemical and Plastics India Ltd. 27,525 Cochin Refineries 10,00,000 Kanoria Chemicals Ltd. 13,62,000 Madras Fertilisers Ltd. 16,83,855 4. It was further submitted by the assessee before the Assessing Officer that in all the above cases, commissioning of the boilers was delayed beyond the contractual dates and, therefore, the company was liable to pay liquidated damages, a provision thereof has been taken into account by the assessee. A further submission before the Assessing Officer was made on February 28, 2000, which has been reproduced by the Assessing Officer in his order as under : " First and foremost in compliance with the statutory provisions contained in sub-section (3)(b) of section 209 of the Companies Act, 1956, the accounts of the company are maintained on the ac....
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....e subject financial year. The provision was made on account of contract for manufacture of boilers and supply thereof to four parties as follows : 1. Kanoria Chemical and Industries Ltd. 13,62,000 2. Madras Fertilisers Ltd. 16,83,835 3. Chemplast Ltd. 27,725 4. Cochin Refineries 10,00,000 Total 40,73,560 Although the provision required to be made as computed exactly in terms of the clause pertaining to liquidated damages in the contract with each of the aforesaid parties (copies of relevant clauses annexed hereto) would have been much higher the company made a reason able estimate in each case of the abatement from the amount of such liquidated damages which would be obtained through negotiations and determined the amount of the provision to be made after such deduction. While it would indeed be inappropriate in the context of the mercantile method of accounting followed by the company we shall all the same provide you with an insight into the subsequent settlement which is as under : 1. In respect of Kanoria Chemicals and Industries Ltd., liquidated damages were finally levied in the amount of Rs. 40,00,000....
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.... " A typical clause providing for liquidated damages specifies the manner in which the amount of liquidated damages is to be computed in the event of breach of term by the company. It also provides for the maximum amount that the company is liable to pay by way of liquidated damages. This clause is legally enforceable. However, based on an appraisal of all facts technical and non technical, the company attempts to extract a waiver reduction in the amount of liquidated damages. This process of waiver could take a long time and usually coincides with completion of the project when the buyer, after taking into account various factors, including the overall performance of the company during project execution, either agrees to waiver or to reduce the amount of penalty or rejects its claim together. This exercise of reduction of waiver takes into account not only the subject project but could also take into account the likely foreseable relations which the two parties envisage for themselves. . . . . We have not received any debit note on account of liquidated damages during the year though as mentioned above, the buyer would have withheld moneys which were otherwise rightfu....
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....ne the accrual of any liability (by way of liquidated damages) in the books of the appellant . . . ." Pages 13 and 14 : " The point of time when the right to receive the money is deter mined and stated in the agreement. The invoices floated by the appellant clearly are towards sales executed (may be in part). The appellant pays sales tax and excise duty thereof and debits such taxes and duties in his books of account treating the amount of invoice as sales. At this stage itself, the right to receive the money accrues to the appellant and the liability to pay fastens on to its customers. The factor of actual settlement of the remaining consideration, inclusive of liquidated damages at a later date cannot alter the nature and time of the right to receive the money that vested in the appellant." Pages 16 and 17 : " In this case, the customers of the appellant acknowledge constructively the debt they owe to the appellant when the invoices floated by the appellant are accepted as per the agreement between them. The claim if any against the appellant for delay in installation of the system provided by appellant, is purely and wholly dependent upon cont....
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....e event of acceptance by the assessee of the claim for liquidated damages for its inadequate performance . . ." " In view of the above, it is clear that when the appellant issues invoice to its customers, the debt in favour of the appellant is created generating right to receive the amounts mentioned in the invoice issued. At this stage, neither the customer forfeits or has any right to forfeit any amount nor has the appellant foregone claim of any such amount called liquidated damages. At this stage, therefore, the entire amount billed to the customers turnover of the appellant and is rightly taken by the appellant to the sales account. The so-called liability of liquidated damages is nothing but contingent liability. The entire amount of Rs. 70,43,560 is nothing but contingent liability as the appellant has not accepted such liability till closure of the books of account for the relevant accounting year. The addition is therefore warranted and is confirmed. The appeal fails on this ground." 9. Still aggrieved, the assessee has preferred this appeal before us. 10. The learned authorised representative appearing for the assessee has reiterated the submissions and con....
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....he learned Commissioner of Income-tax-Departmental representative also cited a decision of the hon'ble Allahabad High Court in the case of CIT v. Lachhman Das Mathura Das [1980] 124 ITR 411. It was further contended by the learned Commissioner of Income-tax-Departmental representative that even in case the system of accounting followed by the assessee as per the Accounting Standard 7 is taken into account, the assessee has not been able to prove as to whether the receipt of contract work giving rise to the claim of liquidity damages has at all been offered for taxation by the assessee in this year. 12. The learned Commissioner of Income-tax-Departmental representative also submitted that in the case of an assessee following the mercantile system of accounting, a liability can be said to have actually incurred only when the dispute between the parties is amicably settled or finally adjudicated in the case where the liability in question is not a statutory liability. He further submitted that as per the Contract Act, liquidated damages accrue only when the liability is adjudicated upon. In this connection, he has made a reference to page 678 of the Commentary on Indian Contrac....
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....50 of the photocopy enclosed) wherein the abovesaid interpretation cited by the Departmental representative has been produced. However, their Lordships have observed that in the case of H. M. Kamaluddin Ansari and Co. v. Union of India [1983] 4 SCC 417 the three judge Bench of this court (Supreme Court) has over ruled the decision in Raman Iron Foundry' s case AIR 1974 SC 1265 and have further observed that the court while interpreting the similar term of the contract has observed that it gives wider power to Union of India (customer) to recover the amount claimed by appropriating any sum then due (Kindly refer to page 24 paragraph 51 highlighted portion of photocopy enclosed). The hon'ble Supreme Court has at paragraph 67(2) page 29 of the photocopy enclosed observed that ' If the terms (of contract with customer) are clear and unambiguous stipulating the liquidated damages in case of breach of the contract unless it is held that such estimate of damages/compensation is unreasonable or is by way of penalty, party who has com mitted the breach is required to pay such compensation and that is what is provided in section 73 of the Contract Act' . Thereafter the hon'ble Su....
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..... C. P. Ltd. [1990] 34 ITD 50 (Hyd) [SB] ; (2) Kaveri Engineering Industries Ltd.[1992] 43 ITD 527 (Mad) ; (3) F. F. E. Minerals India (P.) Ltd. [2004] 84 TTJ 907 (Chennai) ; (4) Indian Transformers Ltd. [2004] 270 ITR 259 (Ker) ; (5) Vinitec Corporation P. Ltd. [2005] 278 ITR 337 (Delhi) ; and (6) Bharat Earth Movers [2000] 245 ITR 428 (SC)." 14. We have considered the rival submissions of both the parties and have perused the orders of the authorities below. We have carefully perused various papers placed in the paper book filed by the assessee. The various decisions cited at the bar were also deliberated upon. 15. In this case, the assessee had entered into a contract for manufacture of boilers and supply thereof to the following four parties : 1. Kanoria Chemical and Industries Ltd. 2. Madras Fertilisers Ltd. 3. Chemplast Ltd. 4. Cochin Refineries 16. In all the work agreements entered into by the assessee, with the aforesaid customers, there exists a clause to pay liquidated damages of the amount specified in the agreements itself, for delay in commissioning the work. As far as the delay ....
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.... the amount to be expended could be debited in accounts maintained in the mercantile system of accounting before it was actually disbursed. The difficulty in the estimation thereof did not convert the accrued liability into a conditional one, because it was always open to the income-tax authorities concerned to arrive at a proper estimate thereof having regard to all the circumstances of the case. (ii) That the sum of Rs. 24,809 represented the estimated amount which would have to be expended by the assessee in the course of carrying on its business and was incidental to the business and having regard to the accepted commercial practice and trading principles, was a deduction which, if there was no specific provision for it under section 10(2) of the Income-tax Act, was certainly an allowable deduction, in arriving at the profits and gains of the business of the appellant, under section 10(1) of the Act, there being no prohibition against it, express or implied, in the Act. The expression ' profits or gains' in section 10(1) of the Income-tax Act has to be understood in its commercial sense and there can be no computation of such profits and gains until th....
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....pts in the profit and loss account. The company had worked out on an actuarial valuation its estimated liability and made provision for such liability not all at once but spread over a number of years. The practice followed by the company was that every year the company worked out the additional liability incurred by it on the employees putting in every additional year of service. The gratuity was payable on the termination of an employee' s service either due to retirement, death or termination of service-the exact time of occurrence of the latter two events being not determinable with exactitude before hand. A few principles were laid down by the hon'ble Supreme Court, in this case which are extracted and reproduced as under : " (i) For an assessee maintaining his accounts on the 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 ; (ii) Just as receipts, thoug....
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....ed, 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 the case of amounts actually expended or paid ; (ii) 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 profits and gains of the business ; (iii) a condition subsequent, the fulfilment of which may result in the reduction or even extinction of the liability, would not have the effect of converting that liability into a contingent liability ; (iv) a trader computing his taxable profits for a particular year may properly deduct not only the payment actually made to his employees but also the present value of any payments in respect of their services in that year to be made in a subsequent year if it can be satisfactorily estimated." 23. On the issue as to whether the provision for warranty liability is deductible for income-tax purposes, a useful reference may be made to a decision of....
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....ad made for the costs of its antici pated liabilities under outstanding warranties in respect of vehicles sold in that year." 25. Regarding the warranty liability, the Privy Council further observed as follows (page 701) : "The evidence of accounting practice adduced before Doogue, J. left no doubt about the proper treatment of the outstanding warranty liabilities. They were part of the cost of the vehicle sales and therefore so far as capable of reasonable estimation, should be matched against the corresponding revenue. The evidence satisfied the judge that a reasonable estimate could be placed upon the anticipated liabilities. All vehicles which leave the taxpayer' s assembly plant at Porirua have been tested and examined for defects. So far as the taxpayer is aware, there is nothing wrong with them. Nevertheless, experience shows that in many cases, a defect will be discovered during the warranty period. Often it is no more than a blemish in the paintwork. Some times it is more serious. Sixty three per cent. of the vehicles sold by the taxpayer in the year 1988 were returned to the dealers for some kind of work to be done under the warranty. Although it cannot of....
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....ee maintenance or replacement of its parts within a particular period on sale of the goods. The contention of the Revenue that the liability was contingent upon a defect appearing and being notified within the warranty period and till such time there was no liability in law and, therefore, the claim for deduction on account of estimated liability could not be allowed has not been accepted by the courts by holding and observing that once the liability arising on account of warranty claims is in-built in the sale mechanism itself, it cannot be viewed that it is contingent in nature. It was further held by the court, that a contingent liability is to be understood as one, which is not only dependent on the happening of a future event but is also incapable of ascertainment or even estimation with a fair degree of precision. In contrast, a liability whose happening and valuation is possible to be made with reasonable certainty and would arise continually so as to be coterminus with the carrying on of the business of the assessee, cannot be construed as a contingent liability. It was further emphasized by the court that as the assessee was in the year of sale under an accrued legal oblig....
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....e and certain liability actually existing at the relevant time. Therefore, a pure contingent liability distinguished from a definite and actual liability arising in praesenti, do not constitute expenditure and cannot be the subject-matter of deduction even under the mercantile system of accounting. The other condition to be satisfied is that the definite liability in praesenti should also be capable of being estimated with reasonable certainty though the actual quantification may not be possible. If these conditions are satisfied, it does not make any difference if the liability may have to be discharged at a future date, and the future date, on which the liability shall have to be discharged, is not certain. It is also clear that a condition subsequent, the fulfilment of which may result in the reduction or even extinction of the liability, would not have the effect of converting that definite liability into a contingent one. However, an answer to the question as to whether the liability, in respect of which a deduction is claimed by the taxpayer, has definitely arisen, under a definite obligation of a trader, in any accounting year, depends on the facts of each and every case. ....
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....e provision made by the assessee were contingent in nature and may or may not be payable. (4) However, the assessee will be entitled to claim liquidated damages paid by the assessee to its parties as and when they were actually paid. 32. On the other hand, the Commissioner of Income-tax (Appeals) has rejected the assessee' s claim by saying, inter alia, that the claim, if any, against the assessee for delay in installation of the system is purely and wholly dependent upon contingency of further negotiations and mutual acceptance of the final amount of liquidated damages. The Commissioner of Income-tax (Appeals) has further observed that since such contingency has not arisen during the relevant accounting year, as admitted before the Assessing Officer as well as during the appellate proceedings, the assessee' s claim is not allowable. It was further observed by the Commissioner of Income-tax (Appeals) that when the customers of the assessee find, after commissioning or completing or erection of the system or plant and machinery, as the case may be, that the clause relating to liquidated damages is to be invoked as the performance of the assessee-company was not c....
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....d in the mercantile system of accounting before it was actually disbursed, and the difficulty in the estimation thereof did not convert the accrued liability into a conditional one, because it was always open to the income-tax authorities concerned to arrive at a proper estimate thereof having regard to all the circumstances of the case. In this case, the hon'ble Supreme Court has given emphasis on the assessee' s own unconditional undertaking to carry out development works within six months from the dates of the deed of sale whereby the assessee bounded itself absolutely to carry out the same, though the work was to be carried out within six months from the deed of sale. The very undertaking given by the assessee to carry out the development work within six months from the dates of deeds of sale has imported a liability on the assessee which accrued on the dates of the deeds of sale, though that liability was to be discharged at a future date. In this case, the hon'ble Supreme Court has also pointed out that the taxable income is not on gross receipts, but on profits and gains of the business. The profits should be understood in its natural and proper sense, in a sense which n....
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....e vehicles were sold the tax payer was entitled to deduct from its total income the provision which it had made for the cost of its anticipated liabilities under outstanding warranties in respect of the vehicles sold in that year. In the case of warranty, although it cannot of course be predicted whether any particular vehicle will turn out to be defective or how serious the defect will be, the taxpayer can make a reasonably accurate forecast based on previous experience, of what will be the total cost of remedial work for all the vehicles sold in a given year. In these cases, a view was therefore taken that the anticipated liabilities under unexpired warranties when estimated with reference to statistical information would be a charge on the profit arising from the sale of the goods in respect of which warranty was given and, thus, have to be allowed as deduction. On the issue of claim of deduction on account of warranty in respect of the goods sold in a particular year, a reference was also made to the decision of the Privy Council in the case of IRC v. Mitsubishi Motors New Zealand Ltd. [1996] 222 ITR 697 by the hon'ble Delhi High Court in the case of CIT v. Vinitec Corporation ....
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....esent case and the position of law as enunciated in the above referred decisions. In the present case, the assessee has never disputed its liability to pay liquidated damages on account of causing delay in completing the works. As far as the assessee' s liability to pay liquidated damages for causing delay in executing the contract works, no dispute has ever been raised by the assessee. There could be a dispute only with regard to the exact quantification thereof, but that by itself would not convert the definite liability into a contingent one. There is no dispute as to the proposition that when there is a dispute between the parties as to importing a liability on one party, a liability can be said to have actually and definitely incurred only when the dispute between the parties is amicably settled or finally adjudicated in case where the liability in question is in the nature of contractual liability and not a statutory liability. In order to apply this proposition, one has to prove first that there was a dispute and difference between the parties as to the importing liability on one party or the other itself. Ascertainment of liability by way of amicable settlement or by a ....
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....esult in the liability to pay damages. In the light of this clause of damages for delay, the Tribunal held that the claim for damages arises at the point of breach, but the quantification of the damages may be subject to negotiation. It was further held that as far as the concerned liability to pay damages arose at the point of time when the breach occurred, i.e. when it failed to deliver on the due date, and at that point of time the liability accrued which, as a prudent trader, it could quantify and take into account by means of a provision. The decision of K. C. P. Ltd. v. ITO [1990] 34 ITD 50 was followed by the Income-tax Appellate Tribunal, Madras Bench in the case of Kaveri Engineering Industries Ltd. v. Deputy CIT [1992] 43 ITD 527, where the facts were summed up as under (page 541) : " (a) the assessee, in some instances, did delay the delivery of the goods which it had contracted to supply. The assessee did not deny the said factum of delay. (b) As a direct consequence of its failure to stick to the stipulated delivery schedule, the assessee rendered itself liable to penal pecuniary consequences stipulated in the delayed delivery clauses. The assessee di....
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....lowed by all the assessees following the mercantile system of accounting where it is provided as under (page 2) : " (i) Prudence.-Provisions should be made for all known liabilities and losses even though the amount cannot be determined with certainty and represents only a best estimate in the light of available information." 38. From the said notification, it is thus clear that the Department has itself accepted the principle that a provision should be made for all known liabilities and losses even though the amount cannot be determined with certainty and represents only a best estimate in the light of available information. 39. Thus, in the present case before us once the liability arising on account of liquidated damages for delay caused by the assessee in erecting or commissioning the work accepted by the assessee to do is in-built in the contract agreement itself, and it has arisen on the happening of the delay in executing the contract works and its valuation is possible to be made with reasonable certainty and since the corresponding sales revenue of the said contract works has been accounted for in the given period, this liability arising on account of liquid....
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....ion, he has made a reference to page 678 of A Commentary on Indian Contract and Specific Relief Act, by Mr. J. L. Kapur (10th edition). The commentary referred to above reads as under : "A claim for liquidated damages stands on the same footing as a claim for unliquidated damages. A claim for unliquidated damages does not give rise to a debt until the liability is adjudicated upon the damages assessed. A party in breach of contract does not incur eo instanti a pecuniary liability nor does the injured party become entitled to claim a debt. He is only entitled to sue for damages and have them adjudicated upon." 41. In this commentary, a reference has been made to the decision of Union of India v. Raman Iron Foundry, AIR 1974 SC 1265 ; [1973] 3 SCR 556 ; [1974] 2 SCC 231. 42. In a reply to the departmental aforesaid contention, learned counsel for the assessee has drawn our attention to the decision of the hon'ble Supreme Court in the case of Oil and Natural Gas Corporation Ltd. v. Saw Pipes Ltd. [2003] 5 SCC 705 Civil Appeal No 7419 of 2001. In this latter decision of the hon'ble Supreme Court in the case of Oil and Natural Gas Corporation Ltd. [2003] 5 SCC 705, the ho....
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....issioning the work, and the assessee' s customer was not entitled to recover from the assessee the liquidated damages as agreed. The hon'ble Supreme Court in the case of Oil and Natural Gas Corporation Ltd. [2003] 5 SCC 705 has taken the following factors into account while deciding the issue in favour of the ONGC (page 745) : "(i) there is specific stipulation in the agreement that the time and date of delivery of the goods was the essence of the contract ; (ii) in case of failure to deliver the goods within the period fixed for such delivery in the schedule, ONGC was entitled to recover from the con tractor liquidated damages as agreed ; (iii) it was also explicitly understood that the agreed liquidated damages were genuine pre-estimate of damages ; (iv) on the request of the respondent to extend the time limit for supply of goods, ONGC informed specifically that time was extended but stipulated liquidated damages as agreed would be recovered ; (v) liquidated damages for delay in supply of goods were to be recovered by paying authorities from the bills for payment of cost of material supplied by the contractor ; (vi) there....
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....h the demand was raised, but would be allowed in the year in which the final settlement would be made. 48. Similarly in the case of Alembic Chemical Works Ltd. v. Deputy CIT [2004] 266 ITR 47 (Guj), there arose a dispute regarding contractual liability, and thus it was so held that in case of an assessee following the mercantile system of accounting the liability is said to be properly incurred when the dispute between the parties is amicably settled or finally adjudicated, where the liability in question is not a statutory liability. 49. In both these cases of the hon'ble Gujarat High Court, i.e., the cases of CIT v. Ashwin Vanaspati Industrial P. Ltd. [2006] 283 ITR 439 and Alembic Chemical Works Ltd. v. Deputy CIT [2004] 266 ITR 47 (Guj), a reliance has been placed upon a decision of the hon'ble Supreme Court in the case of CIT v. Swadeshi Cotton and Flour Mills P. Ltd. [1964] 53 ITR 134, which was also rendered in the background of the fact that there was a dispute as to the payment of bonus to the employees and, thus it was held that since the dispute was settled by the award of the Industrial Tribunal in the year of 1949, deduction of the payment of bonus had to be give....
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....see has not denied or disputed its obligation to pay liquidated damages for breach of the contract by not executing or erecting the work within specified time, and the assessee' s customer was entitled to deduct the amount of damages from the monies payable to the assessee as held by the hon'ble Supreme Court in the case of Oil and Natural Gas Corporation Ltd. [2003] 5 SCC 705, and all the revenues towards contract work executed by the assessee in the year has been taken into the account for determining the profit, the assessee' s obligations to pay a corresponding damages relating to the period falling within the relevant accounting year has imported an accrued liability on the assessee, for which a reasonable provision made in the books of account is deductible, while computing the profit from the said contract works, of the year under appeal, though that liability was to be discharged at a future date. 54. The view we have taken above is further strengthened and supported by the logic or the reasoning that is being applied in holding that the monies retained by the contractee from the bills raised by the contractor till the obligation of satisfactory completion of the....
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....the entire amount on the completion of the work or on the submission of bills. The assessee had no right to claim any part of the retention money till the verification of satisfactory execution of the contract." 56. The aforesaid decision of hon'ble Calcutta High Court in the case of CIT v. Simplex Concrete Piles (India) P. Ltd. [1989] 179 ITR 8 has been followed by the hon'ble Madras High Court in the case of CIT v. East Coast Constructions and Ind. Ltd. [2006] 283 ITR 297, where it was held that the assessee was entitled to receive the retention money only after completion of the contract, and on the date of the bills, no enforceable liability had accrued or arisen to the assessee, and when the assessee had no right to receive the money by virtue of the contract between the parties, and the assessee also had no right to enforce payment, it could not be said that the right to receive payment of the remaining 10 per cent. of the value of job had accrued. 57. A similar view has also been taken by the hon'ble Madras High Court in the case of CIT v. Ignifluid Boilers (I.) Ltd. [2006] 283 ITR 295. 58. The aforesaid decisions of the hon'ble Calcutta High Court and the hon'ble M....
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....exercise to ascertain the estimated liability of the assessee on account of liquidated damages with reasonable certainty. The assessee has quantified its liability of liquidated damages payable to the contractee in its books of account. Whether the estimated liability provided by the assessee in the books of account can be said to be a proper estimation with reasonable certainty has not been deliberated upon by the Assessing Officer or by the Commissioner of Income-tax (Appeals). It is not in dispute that the allowable liability on account of liquidated damages payable by the assessee should be only in relation to the period of delay falling within the relevant year in dispute. 61. In the contract agreement entered into with Cochin Refineries Ltd., it has been provided that the assessee-company shall be liable to pay a liquidated damages at the rate of 0.5 per cent. of the contract value of the boiler per day of delay or part thereof subject to a maximum of 15 per cent. of the contract value of that boiler. It is also provided therein that all sums payable by way of liquidated damages under any of the conditions shall be considered as reasonable compensation without reference to....