Monday 3 June 2013

Whether provision made for performance warranty and other contractual liability as per AS-7 cannot be said to be an ascertained liability and accordingly not allowable as deduction - Partly allowed: ITAT

THE issues before the Bench are - Whether provision made for the performance warranty and other contractual liability as per AS-7 cannot be said to be an ascertained liability and accordingly not allowable as deduction; Whether such provision is also not allowable while computing the income of the assessee u/s 115JB of the Act; Whether the disallowance u/s 14A for the years prior to A.Y. 2008-09 has to be made on some reasonable basis and Rule 8D cannot be applied to those assessment years and Whether the mobilization and other advances received by the assessee by raising progress billings cannot be said to represent income of the assessee at the time of raising the progress bills and the same therefore had no effect whatsoever on the income of the assessee, which was recognized by following consistently a well recognized method of percentage of completion. And the verdict partly favours the assessee.
Facts of the case
Assessee is a company which is engaged in the business of construction of oil terminal, providing engineering services and performed operation and maintenance of the terminals. The return of income for A.Y. 2004-05 was filed by it on 29-10-2004 declaring total income at Rs.Nil under the normal provisions of the Act and book profit of Rs.23,35,18,636/- u/s 115 JB of the Act. In the P&L account filed along with the said return, a sum of Rs.2,77,45,147/- was debited by the assessee on account of provision made for the performance warranty and other contractual liability. The case of the assessee before A.O. was that the said provision is made as per Accounting Standard- 7I (AS-7), which deals with accounting for construction contract, issued by the ICAI. It was submitted that as required by the said AS-7, while recognizing income under percentage of completion method, an appropriate allowance for future enforceable factor has to be made on either a specific or percentage basis. It was contended that enforceable factor included fulfillment of performance warranty on the completed contract and accordingly the assessee recognizing income on percentage completion method has made the provision for performance warranty @ 1-2% of the contract value in progress. This contention of the assessee was not found acceptable by the A.O. According to him, the provision made for performance warranty was nothing but the provision for liability which was not ascertainable and the same was made merely in anticipation of some future expenses. He held that the said provision thus was not allowable as deduction under the Income Tax Act although the same was claimed to be made by the assessee as per the Accounting Standard – 7 (AS-7) issued by the ICAI. He also relied on the provisions of section 36(1)(vii) of the Act to hold that the provision can be claimed as expenses only when the same has been irrecoverably written off in the books of account. Accordingly the entire provision of Rs.2.77 crores made by the assessee for performance warranty was disallowed by the A.O. The CIT(A) held on the basis of past data that provision for warranty @ 0.20% of the contract value completed was fair and reasonable and restricted the disallowance made by the A.O. to that extent.

A.O. also made disallowance on account of provision for warranty while computing the income of the assessee u/s 115JB of the Act which has been sustained by the CIT(A) to the extent of 0.20% of the value of work completed.

Disallowance u/s 14A - During the year under consideration, the assessee had earned dividend income of Rs.49,91,262/- and income from mutual funds of Rs. 23,796/- which were exempt u/s 10(34) of the Act. No disallowance on account of expenses incurred in relation to the said income however was made by the assessee as required by the provisions of section 14A of the Act. The A.O., therefore, worked out such expenses incurred by the assessee in relation to earning of exempt income at Rs.8,23,274/- by applying Rule 8-D of the Income Tax Rules, 1962 and made a disallowance to that extent u/s 14A of the Act. On appeal, the CIT(A) confirmed the said disallowance relying on the decision of the Special Bench of ITAT in the case of Daga Capital Management P. Ltd. (2008-TIOL-509-ITAT-MUM-SB) wherein it was held that Rule 8-D was applicable with retrospective effect.

Addition representing the amount due to customers (advance billing) - During the course of assessment proceedings, it was noticed by the A.O. that the assessee has shown amount due to the customers at Rs. 10.86 crores as on 31-3-2007. On further verification, he found that the said amount represented the difference between progress billings as done by the assessee up to 31-3-2007 and the revenue booked up to that date in respect of three contractors. According to him, the said difference was nothing but the under statement of profits and accordingly the assessee was called upon by him to offer its explanation in the matter. In reply, it was submitted that the percentage completion method was being followed by the assessee for recognizing the revenue from construction contracts as per AS-7 issued by the ICAI. It was submitted that the progress billing, on the other hand, was inclusive of advances received from the customers which did amount not necessarily reflect the work performance. It was explained that the contractor, for example, may be allowed to raise the bill upon mobilisation of construction equipment like cranes etc. but the said cannot have any reflection in the revenue recognition. Another example was also given by the assessee stating that a contractor may also be allowed to raise the bill upon finalization of drawings or on finalization of long lead items, however the same cannot be recognized as revenue in the books of account. It was contended on behalf of the assessee that this situation, however, would prevail only temporarily during the course of execution of the contracts but finally there would be no difference between the progress billing and amount recognized as revenue by the time of completion of the contracts. It was pointed out that out of Rs.10.80 crores, a sum of Rs.9.62 crores was due to one customer namely Indian Oil Sky Tank Limited and the same was mainly on account of progress bill raised by the assessee as per the contract for 15% advance payment of the contract value.

The submissions made on behalf of the assessee on this issue were not found acceptable by the A.O. According to him, all the amounts of progress billing raised by the assessee should have reflected in the total sales recorded in the books of account and the amount due to the customers as shown by the assessee was nothing but the under statement of its profits by the assessee. He therefore did not accept the method of percentage of completion claimed to be followed by the assessee relying on the various judicial pronouncements discussed in the assessment order and added a sum of Rs. 10.86 crores shown by the assessee as amount due to the customers to the total income of the assessee. The CIT(A) upheld the additions.

On cross-appeals by both the assessee and the Revenue, ITAT held that,

++ provision for warranty expenditure – It is observed that although the provision made by the assessee for warranty @ 5% was allowed by the Tribunal for A.Y. 2001-02 which was the first year of the assessee’s operation, it was observed by the Tribunal in its order for 2001-02 that such provision should be made on the basis of relevant past data. In A.Y. 2001-02, being the first year of assessee’s operation, past data was not available but the year under consideration is the 4th year of the operation of the assessee and the past data now being available atleast for the first three years, such past data should be taken into consideration to decide this issue. The assessee has furnished the relevant data in this regard for the past three years as well as for the subsequent eight years giving details of provision made for warranty in each year, warranty expenses actually incurred in each year and the reversal of warranty provision made in each year. A perusal of such details shows that no expenditure was incurred by the assessee on warranty in the first three years i.e 2001-02, 2002-03 & 2003-04 as well as in the year under consideration i.e A.Y. 2004-05. In the absence of any expenditure incurred on warranty in assessment years 2001-02, 2002-03 & 2003-04, the provision made @ 5% for warranty in assessment years 2001- 02 & 2002-03 was substantially reversed by the assessee in A.Y. 2003-04. It is thus clear that when the provision for warranty was made by the assessee for A.Y. 2004-05, it was aware that no expenditure on warranty was actually required to be incurred in the earlier years i.e. assessment years 2001-02, 2002-03 & 2003-04 as well as in the year under consideration i.e. 2004-05. It was also aware that the provision made for 2001-02 & 2002-03 @ 5% was required to be substantially reversed in A.Y. 2003-04 and no warranty expenditure was incurred even in the year under consideration i.e. 2004-05. Still a provision of Rs. 2.77 crores was made by the assessee being 1-2% of the value of work completed which, cannot be justified on the basis of the past data and the assessee has not been able to controvert this position when it was confronted to him;

++ It is, no doubt, true that warranty expenditure of Rs. 19.41 lacs and Rs. 15.73 lacs was incurred by the assessee in A.Y. 2005-06 and 2006-07. However, the said expenditure actually incurred by the assessee in the subsequent year, can only justify and support the view taken by the CIT(A) that provision to the extent of 0.2% of the value of work completed is fair and reasonable in the facts of the case. As regards the contention raised on behalf of the assessee that the provision made for warranty in A.Y. 2004-05 to the extent found to be excess has been reversed and offered to tax in the subsequent years, such reversal of provision in the subsequent year cannot justify the provision made in the year under consideration, the correctness of which is to be decided mainly on the basis of past data relating to expenditure actually incurred on warranty. Once the deduction on account of provision is not allowed to the extent it is found to be excess, the reversal of provision in the subsequent year to that extent cannot give rise to any income and if the assessee has offered such income in the subsequent years, it can seek appropriate relief from the A.O. who shall allow the same in accordance with law. As such, considering all the facts of the case, the provision made by the assessee for warranty was rightly allowed by the CIT(A) only to the extent of 0.2% of the value completed in the year under consideration being fair and reasonable and upholding his impugned order on this issue, assessee’s ground of appeal as well as Revenue’s appeal was dismissed;

++ having held that the provision made for warranty by the assessee is fair and reasonable only to the extent of 0.2% of the value of work completed during the year under consideration on the basis of past data, the said provision to that extent alone can be said to be the ascertained liability of the assessee and the balance provision, which is found to be excessive on the basis of past data clearly represents unascertained liability which is liable to be added back while computing the book profit of the assessee u/s 115JB of the Act. Therefore, there is no infirmity in the order of the CIT(A) allowing the provision for warranty only to the extent of 0.2% of the value of work completed while computing the income of the assessee u/s 115JB of the Act;

++ Disallowance u/s 14A – As held by the Bombay High Court in the case of Godrej and Boyce Mfg.Co. Ltd. Reversing the decision of Special Bench of ITAT in the case of Daga Capital Management P. Ltd. Rule 8-D is applicable only prospectively i.e. from A.Y. 2008-09. As further held by the Bombay High Court in the case of Godrej and Boyce Mfg.Co. Ltd. The disallowance u/s 14A for the years prior to A.Y. 2008-09 has to be made on some reasonable basis. In this connection, it is observed that the exempt income earned by the assessee is 0.244% of the total income earned by it and accordingly the general administrative expenses to the extent of Rs.1,13,385/- being 0.244% of the total general administrative expenses of Rs. 4.64 crores can reasonably attributed to the earning of exempt income on pro rata basis. This amount also comes to about 2% of the exempt income earned by the assessee. The assessee has also agreed that this is a reasonable basis to quantify the disallowance of expense to be made u/s 14A of the Act and since the D.R. has also not raised any material objection in this regard, it was considered fair and reasonable to sustain the disallowance u/s 14A of the Act to the extent of Rs.1,13,383/-;

++ Addition representing the amount due to customers (advance billing) – It is observed that the difference in the amount of progress billing and revenue recognized by the assessee in relation to three contracts shows as “amount due to customers” was explained by the assessee before the A.O. as well as before the CIT(A) by filing a detailed written submission. It appears that neither of them however has been able to appreciate the same in the correct prospective. As explained by the assessee, progress billing was done not only for the amount of work done but also for mobilization and other advances receivable by it as per the terms of the relevant contract. The revenue from the said contracts was recognized by the assessee by following the percentage of completion method and the said method as well as the basis adopted by the assessee to ascertain the percentage of work done was accepted by the department in the earlier years. The mobilization and other advances received by the assessee by raising progress billings did not represent income of the assessee at the time of raising the progress bills and the same therefore had no effect whatsoever on the income of the assessee, which was recognized by following consistently a well recognized method of percentage of completion. As rightly submitted on behalf of the assessee, the entire revenue from the contracts executed by the assessee was finally recognized on the completion of the relevant contracts as per the method consistently followed by the assessee and the mobilization and other advances received by the assessee as per progress billings were liable to get adjusted on such completion. The amount due to the customers as shown by the assessee was nothing but receipt of advance before accrual of income and as held by the Punjab & Haryana High Court in the case of Punjab Tractors Co-Operative Multi-Purpose Society Ltd., the said amount representing advance against the work cannot be treated as income of the assessee at the point of receipt. Therefore, the addition of Rs. 10.86 crores made by the A.O. and confirmed by the CIT(A) on this issue is not sustainable.

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