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October 7, 2020

Provisions of warranty is an allowable expenditure under Income Tax

by CA Shivam Jaiswal in Income Tax

Provisions of warranty is an allowable expenditure under Income Tax

While computing the income of an assessee, there are certain expenditures which are disallowed. This means that the income tax department does not allow the benefit of such expenditures and the assesses are required to pay taxes on such expenditures by adding it back to the net profits. Expenses which are allowed as a deduction while computing Profits or Gains from Business or Profession are covered from Section 28 to 37 of the Income Tax Act.

There are two primary reasons for disallowance of any expenditure:

  • The tax amount required to be deducted on certain expenditures are not deducted while making the payment.
  • The expenditure does not implicitly relate to the conduct of such business or profession

Let us refer to the case of Demag Delaval Industries Turbomachinery Pvt. Ltd. Vs. ACIT (ITAT Mumbai) where the AO had made several disallowances from the Income of the assessee which were confirmed by the CIT(A).

Observations of ITAT on disallowance of special adhesive stamps expenses affixed on conveyance deed for assignment of business

  • Assessee had incurred expenditure for cost of adhesive stamp in connection with preparation of deed of transfer and assignment of receivables.
  • The assessee had stated that the same was in connection with acquisition of business and was claimed as revenue expenditure.
  • However, this claim was denied on the ground that expenditure was in the capital field for the purpose of acquisition of business.
  • Assessee submitted before the ITAT that the expenditure was incurred in connection with conveyance deed of receivables which are part of current assets.
  • Hence, he pleaded that the expenditure cannot be treated as expenditure for the purpose of acquisition of capital asset.
  • He submitted that expenditure was very much incurred for the purpose of business of the assessee and the same should be allowed.
  • ITAT upon careful consideration found that CIT(A) had erred in observing that stamp fee was in connection with conveyance deed for acquisition of industrial steam turbine.
  • Hence, he inferred that it is for acquiring an industrial unit.
  • However, as submitted by the assessee as evident from the conveyance deed submitted, conveyance deed involving duty was for the purpose of assignment of receivables.
  • The expenditure was in connection with facilitating recovery of receivables which was a part of current asset.
  • Hence the expenditure in this regard could not be said to be in the capital filed of acquiring business.
  • It was in fact for facilitating the business of the assessee and in this view of the expenditure was allowed as business expenditure.

Observations of ITAT on disallowance of provision for warranty

  • The assessee had made provision for warranty which was claimed as expenditure.
  • The same was denied by the AO on the ground that it was an unascertained liability and a contingent liability.
  • CIT(A) in principal upheld the action of the AO but directed that only the provision made during the year should be disallowed.
  • The assessee submitted before the ITAT that the issue was squarely covered by the decision of Supreme Court in the case of Rotork Controls India P Ltd. Vs. CIT.
  • ITAT found that Supreme Court in the case of Rotork Controls India P. Ltd. (supra) explained the following:
    1. A provision is a liability which can be measured only by using a substantial degree of estimation. A provision is recognized when: (a) an enterprise has a present obligation as a result of a past event; (b) it is probable that an outflow of resources will be required to settle the obligation; and (c) a reliable estimate can be made of the amount of the obligation. If these conditions are not met, no provision can be recognized
    2. A Liability is defined as a present obligation arising from past events, the settlement of which is expected to result in an outflow from the enterprise of resources embodying economic benefits
    3. A past event that leads to a present obligation is called as an obligating event. The obligating event is an event that creates an obligation which results in an outflow of resources. It is only those obligations arising from past events existing independently of the future conduct of the business of the enterprise that is recognized as provision. For a liability to qualify for recognition there must be not only present obligation but also the probability of an outflow of resources to settle that obligation. Where there are a number of obligations, the probability that an outflow will be required in settlement, is determined by considering the said obligations as a whole
    4. In the case of a manufacture and sale of one single item the provision for warranty could constitute a contingent liability not entitled to deduction u/s 37. However, when there is manufacture and sale of an army of items running into thousands of units of sophisticated goods, the past event of defects being detected in some of such items leads to a present obligation which results in an enterprise having no alternative to settling that obligation.
  • Examining the present case on the above decision ITAT found that the authorities had erred in considering the provisions of warranty as contingent liability.
  • Hence, ITAT set aside the order of the CIT(A) and decided the issue in favour of the assessee.

Observations of ITAT on disallowance of depreciation claimed by the appellant

  • The assessee had claimed depreciation in respect of customer contracts.
  • The assessee had claimed that the customer contracts were valuable rights and therefore capital assets.
  • In this regard assessee referred to the provisions of section 2(11) & 32(1)(ii) of the Income Tax Act.
  • This was denied by the lower authorities and it was held that the assessee cannot be allowed depreciation as intangible asset under section 32(1)(ii) on this, as it did not fall under the definition of intangible asset as contained in section 2(11).
  • According to Section 2(11), block of assets means a group of assets falling within a class of assets, being buildings, machinery, plant or furniture, in respect of which the same percentage of depreciation is prescribed
  • Section 32(1)(ii) pertains to deductions on know-how, patents, copyrights, trade-marks, licences, franchises or any other business or commercial rights of similar nature, being intangible assets acquired on or after the 1st day of April, 1998, owned, wholly or partly, by the assessee and used for the purposes of the business or profession.
  • The assessee raised an additional ground before the ITAT that the authorities should grant depreciation on goodwill under section 32 of the Income Tax Act.
  • ITAT found that the Supreme Court in Techno Shares and Stocks Limited held that, BSE membership card can be considered as intangible asset for the purpose of depreciation u/s. 32(1)(ii).
  • From this it emerged that depreciation was allowable not only on the specified category of intangibles but also for other categories of intangible assets which fell within the purview of the expression “business or commercial rights of similar nature”.
  • Another judgment delivered by the Supreme Court in the case of Commissioner of income Tax Vs. Smifs Securities Ltd, allowed depreciation on goodwill being an intangible asset.
  • In this case, the Supreme Court held that ‘goodwill’ was an intangible asset eligible for depreciation under the provisions of section 32.
  • In that case ‘goodwill’ had arisen due to amalgamation of two companies. The difference between the consideration for amalgamation and the net book value of assets of the amalgamating company was regarded as ‘goodwill’ and depreciation was claimed thereon.
  • It was argued by the assessee that the extra consideration was paid towards the reputation which the amalgamating company was enjoying in order to retain its existing clientele.
  • The Supreme Court reaffirmed its earlier position taken in Techno Shares (Supra) and held that “goodwill” was an asset under section 32 and was accordingly eligible for depreciation.
  • ITAT noted that the above decisions were applicable for depreciation on goodwill and similar intangible assets which were purchased.
  • ITAT noted that it was the claim of assessee that goodwill arising out of slump sale agreement and customer contract which were similar to the goodwill being an intangible asset were also eligible for depreciation.
  • Although ITAT found that there is no dispute that goodwill was eligible for depreciation, it was pertinent to remember here that goodwill had arisen pursuant to slump sale agreement wherein the assessee had acquired assets, on a purchase consideration.
  • In the case of Areva T&D India Ltd. Vs. CIT, High Court held that excess amount paid over and above tangible asset for acquisition of various business and commercial rights and slump sale can be categorised under the goodwill and difference between purchase consideration and value of tangible asset taken over being the balancing figure was goodwill and depreciation thereon was allowable on the touchstone of decision of Supreme Court in the case of Techno Shares and Stocks Ltd. (supra) and CIT Vs. Simfs Securities Ltd.
  • This decision of Delhi High Court was subsequently confirmed by Supreme Court.
  • The details of value of tangible assets taken over by the assessee by the slump sale agreement were necessary to be considered for adjudication of this issue.
  • Hence, in ITAT’s opinion the issue of depreciation of goodwill and customer contracts being an intangible asset claimed in this case by the assessee needed to be examined by the Assessing Officer on the touchstone of the aforesaid decision.
  • Accordingly, the issue of depreciation of customer contracts and goodwill was remitted to the file of the AO.

In conclusion,

  • special adhesive stamps expenses affixed on conveyance deed for assignment of business is an allowable business expenditure
  • provision of warranty is not a contingent liability and the same is an allowable business expenditure
  • goodwill and customer contracts are intangible assets eligible for depreciation under the Section 32

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