Provision on wages on account of mandatory wage revision deductible under Income tax

The Delhi High Court passed and order on 06.02.2020 in the case of Housing and Urban Development Corporation vs ACIT. The case covered a number of issues. The case was on general principles of allowability of expenses of the Income Tax Act; whether provision for revision of pay by government committee is a contingent liability or ascertained liability? ; Is addition on account of financial impact due to change in accounting policy permissible?

Facts of the Case:-

Appellant is a Public Sector Undertaking (PSU), filed its return of income for the AY 2007-08 on 30th October, 2007
Appellant’s case was selected for scrutiny and an assessment order under Section 143(3) of the Act was passed on 30th December, 2009, enhancing the total income of the appellant.
The Commissioner of Income Tax [CIT(A)] examined the records and exercising his jurisdiction under Section 263 of the Act, directed the Respondent to reframe the assessment inter alia on the ground that Assessing Officer (AO) had not disallowed the provision for salary of Rs. 1.60 crores and has erred in not making an addition of Rs. 1.28 crores on account of the financial impact due to change in the accounting policy with respect to revenue recognition for application fee, front end fees, administrative fee and processing fee of loans from the date of signing of the loan agreement to the date of realization.

Order of AO

Pursuant to the aforesaid directions, the AO framed the assessment order under Section 263/143(3) of the Act, and made the following additions/disallowances:-

disallowance of the claim for provision of salary of Rs.1.60 crores
addition of Rs. 1.28 crores on account of financial impact due to change in accounting policy.

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Order of CIT(A)

In the appeal to CIT(A), CIT (A) upheld the order of the AO and sustained the disallowance and the addition. The appellant challenged the order of the CIT(A) before the Income Tax Appellate Tribunal (ITAT).

Proceedings of ITAT pertaining to disallowance of provision of salary

ITAT noticed that the Pay Revision Committee had not completed its deliberations before the end of the FY 2006-07 and was yet to submit its report at the time when the FY 2006-07 came to an end.
Furthermore, the pay revision was finally implemented in pursuance of aforesaid Office Memorandum dated 26.11.2008 of Ministry of Heavy Industries & Public Enterprises.
Under these facts and circumstances, it concluded that the liability for Rs. 1.6 crore, deduction for which was claimed by the Assessee on account of ad hoc provision for pay revision, had not accrued during the relevant FY i.e., 2006-07 (AY 2007-08).
Merely because Pay Revision Committee was constituted during the year, it cannot be said that liability towards pay revision had accrued during the year.
During FY 2006-07 (AY 2007-08), there was neither any statutory liability nor any legally enforceable liability against the Assessee in respect of the Assessee’s claim for Rs. 1,60,00,000 deduction for which was claimed by the Assessee on account of ad hoc provision for pay revision. In fact, there was no such liability at all.
Even if there was a liability, it was purely a contingent liability which is not deductible for income tax purposes.

Proceedings of High Court

Facts of the deduction relating to provision on account of pay revision

The appellant is a PSU under Government of India. A Pay Revision Committee (PRC) was constituted by the Ministry of Heavy Industries and Public Enterprises.
The pay revision fell due during the Assessment Year 2007-08, with effect from 1st January, 2007.
The committee held a total of 39 meetings out of which 4 meetings were held during the Assessment Year 2007-08, and it furnished its final report on 26th November, 2008.
Pursuant to the recommendations of PRC, the appellant declared expenditure of Rs.1.60 crores on account of provision for revision of pay in books of account from 1st January 2007, since the effective date of implementation was not known.
The report of the PRC was implemented later in September, 2008; nevertheless, this would not render the expenditure to become “unascertained liability”, making it ineligible for deduction for the year under consideration i.e. 2007-08.
The pay revision of employees of the appellant, a PSU is due every ten years with the expiry of one wage settlement or agreement.
Invariably, there is a time lag between expiry of a wage revision and negotiation of a fresh wage revision.
The appellant had made provision of Rs.1.60 crores on scientific foundation and on the basis of its past experience in its accounts for Financial Year 2006-07. The provision was made for the period from January 1, 2007 to March 31, 2007 and deduction was claimed on the standpoint that appellant is under an obligation to pay revised pay to its employees with effect from 1st January, 2007, determination whereof, was a matter of time.
The appellant, thus had a reasonable basis to make provision for this expenditure. Similar provisions were also made in subsequent years in the following manner.

Submissions by both parties:-

Appellant has assailed the aforesaid findings and argued that the tax authorities and the Tribunal have ignored the fact that the provision of salary of Rs.1.60 crores was an ‘ascertained liability’ in light of the recommendation of PRC, appointed by Department of Public Enterprises (DPE).
Appellant submits that the effective date of commencement of the revised pay is important and not the date of signing of the agreement or its approval granted by DPE.
Revenue argued that the provision for salary was not finally ascertained and determined, and thus the appellant could not have made a deduction for the same on ad hoc basis.

Opinion of High Court on claiming deduction on provisions made for wage revision:-

The position in the current case is that the liability had already arisen with certainty.
The committee was constituted for the purpose of wage revision. That the wages would be revised was a foregone conclusion.
Merely because the making of the report and implementation thereof took time, it could not be said that there was no basis for making the provision.
Therefore the HC held that the ITAT and CIT (A) have fell in error by disallowing the expenditure of Rs.1.60 crores on account of anticipated pay revision in Assessment Year 2007-08.
Accordingly, it is directed that the revenue to pass consequential orders accepting the deduction of Rs. 1.60 crores.

Facts pertaining to addition of Rs.1.28 crores on account of financial impact due to change in accounting policy in respect of revenue recognition of application fee, front end fees, administrative fee and processing fee of loans from the date of signing of the loan agreement to the date of realization

The appellant was following accrual/mercantile system of accounting and was accounting the fees as its revenue from the date of signing of the loan agreement.
The amount was finally deducted/ realized from the loan amount, when it was actually disbursed to the borrower. There were instances when the loan agreement was signed and the borrower would not take the disbursement and, accordingly, fees would not be realized.
The CAG objected to the same on the ground that the accounting treatment was not in accordance with Accounting Standards (AS-9), issued by ICAI which provides guidance for determination of income on accrual basis.
Appellant assured the CAG that the accounting policy shall be reviewed for FY 2006-07 and, accordingly, the Board approved the change in accounting policy in its meeting held on September, 2007.
The revised accounting policy recognized the aforementioned fees as on the date of its realization, instead of date of signing of the loan agreement. The AO made an addition of Rs. 1.28 crores on the ground that the change had resulted in under-statement of profits and also because the change was introduced after the closing of the financial year.
The CIT (A) and ITAT confirmed the addition holding that change in accounting policy was not in accordance with the provisions of the Act.

View of High Court on addition of Rs.1.28 crores on account of financial impact due to change in accounting policy

The appellant’s income on account of the fees did not accrue with certainty on the date of signing of the loan agreement.
The income fell due only when the loan was disbursed, as the fee was to be collected at that stage. It cannot be said that on the date of signing, the income accrued in conformity with the mercantile system and AS-9 adopted by the appellant.
There was no reasonable certainty of the realization of the amount of Rs. 1.28 crores, and that since it follows the mercantile system of accounting, the same can be treated as an income only if it had convincingly accrued.
The amount here is not determinable and there is no certainty about the same as it remains uncertain whether the borrower who has signed the loan agreement, would, eventually, avail the loan, or not.
Merely because the appellant may have signed the agreement with the borrower, that, by itself, does not lead to the certainty of income accruing to the Appellant, so as to bring it within the ambit of income.
Here, the addition has resulted on account of change in accounting policy by recognizing the realised revenue, instead of the assumed revenue on the date of signing of loan agreement.
There can be no liability to pay Income Tax on hypothetical income. The regular method of accounting determines only the mode of computing the taxable income and the particular stage at which the tax liability arises.
If there is no income, then merely because the assessee had followed the mercantile system of accounting and has in his books of account reflected certain receipt or credits or debits in a particular way, it cannot be said that income has accrued. Income accrues only when there is a right to receive such income, regardless of the fact if it is actually received or not.
The tax authorities should have proceeded to determine and ascertain as to whether, the income has in reality accrued to the assessee, or not, notwithstanding the change in accounting policy.
If the income had indeed accrued, the addition would have been permissible. However, to determine this, the treatment given in the assessee’s books of account would not be necessary, but would be dependent on the answer to the question as to whether the income has indeed accrued, having regard to the test as discussed hereinabove.
The question whether real income has materialized or not, has to be scrutinized, having regard to the commercial and business certainties and realities of the situation in which the assessee is positioned, and not with reference to system of accounting.
The answer to such decision would then relate to the chargeable accounting year in which such profits actually arose and assessee would be liable to tax accordingly.
Applying this yardstick, we do not find that any income accrued at the point of mere execution of the agreement and, thus, the income did not accrue in the relevant AY. The financial impact has since been factored in the subsequent year.
HC also found merit in the submissions of the appellant that the change in accounting policy is a result of the audit objection raised by CAG.

Therefore, the High Court passed the appeal in favour of the assessee, deduction for provision of salary on account of pay revision was allowed and addition of Rs. 1.28 crores on account of financial impact due to change in accounting policy was deleted.

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