Accrual of Disputed Liability

The mercantile system as distinguished from the cash system brings in the concept of accrual of liability

or income in the relevant previous year which is the subject matter of the assessment. Thus, according to the term accrual the liability is reflected in the books of accounts even where there is no actual payment; likewise the income is reflected even where there is no actual receipt of money. Moreover, Section 209(3) of the Companies Act makes it mandatory for companies to keep accounts on accrual basis only. Thus, the importance of the term accrual lies in deciding as to the year in which the income is taxed, likewise, the year in which the deduction is allowed.

 

Expenditure:

 

Before we get on to the concept of accrual of liability it is important for us to know as to when the expenditure arises.

Spending in the sense of ‘paying out or away’ of money is the primary meaning of ‘expenditure’. Expenditure which is deductible for income tax purposes is one which is towards a liability actually existing at time but putting aside of money which may become expenditure on happening of an event is not expenditure and the liability arising out of such expenditure is known as contingent liability.

 

The accounting standard defines contingent liability as follows:

• a possible obligation that arises from past events and whose existence will be confirmed only by the occurrence of one or more uncertain future events not wholly within the entity’s control; or
• A present obligation that arises from past events but is not recognized because it is not probable that a transfer of economic benefits will be required to settle the obligation; or the amount of the obligation cannot be measured with sufficient reliability.

Thus, Money placed in hands of trustees and insurance company to purchase annuities of different kinds if required and to be returned if annuities were not bought would not amount to expenditure.

A contingent liability which may have to be discharged in future cannot be considered as expenditure and hence the provision for a contingent or unaccrued liability is not allowable as deduction. Therefore, it becomes important to find whether a business liability is an ascertained or a contingent one. The Hon’ble Supreme Court has reiterated the principle for deciding the same:

“If a business liability has definitely arisen in the accounting year, the deduction should be allowed although the liability may have to be quantified and discharged at a future date. What should be certain is the incurring of the liability. It should also be capable of being estimated with reasonable certainty though the actual quantification may not be possible. If these requirements are satisfied the liability is not a contingent one. The liability is in praesenti though it will be discharged at a future date. It does not make any difference if the future date on which the liability shall have to be discharged is not certain.” But it is important to note that a liability which was initially contingent becomes deductible when it becomes ascertained on the contingency coming to pass.

Therefore, expenditure is not necessarily confined to the money which has been actually paid out. It covers a liability which has accrued or which has been incurred although it may have to be discharged at a future date. However, a contingent liability which may have to be discharged in future cannot be considered as expenditure. Hence, though the expenditure has not been actually paid out but which has been incurred to be discharged at a future date, the liability can be said to have been accrued.

 

How to classify a liability as a statutory liability or a contractual liability?

 

The accrual of liability for any expense may arise either under a contract or under a statute. So, it would be germane for our purpose to identify as to when a liability would be a statutory liability and when would it amount to a contractual liability and the need to classify the same.

 

It is quite clear that where there is contract between the parties under which expenditure is incurred by the assessee, it would be termed as a contractual liability and where a liability has to be discharged by the assessee under a statute, it would be a statutory liability. But there may be situation where there is an agreement by a party with a statutory authority; in such a case the liability which has to be discharged as per such an agreement would be contractual liability and not statutory liability even though the agreement is with a statutory body.

To be clearer let us refer to the case where the license fee for the construction of a hotel which is payable to New Delhi Municipal Committee in pursuance of an agreement entered into between the assessee and the NDMC. Here the liability, therefore, accrues as a result of the contractual obligation between the assessee-company and the NDMC. The liability does not arise as a result of any statutory provisions in any of the Acts and there is, therefore, no question of treating the liability as a statutory liability.

But the question arises as to that whether royalty paid to the Government is a statutory liability or a contractual liability. When the royalty has been held as a tax by the apex court and rate of royalty can be fixed unilaterally by the State Government and its recovery also can be made as in the case of land revenue, thus, it cannot be treated as a contractual liability. It is a statutory liability and once it is a statutory liability whether it is provided for in the books or not does not make any difference.

 

To clarify further as to when there is a contractual liability let us study another situation: if there is a lease-hold property and the rent is paid by way of lease rent then the lease rent paid may not be counted as tax or duty because it is a contractual liability on the part of the assessee, but if the assessee is a tenant and the rent or the tax of the land is payable to the State Government under the provisions of any relevant Tenancy Act of State Government in that situation, naturally, it will be a tax and that is a statutory liability.

 

Moreover, the statutory liability is never a contingent liability in the sense that it does not cease to exist by reason of the fact that the taxpayer is disputing the liability and such dispute has not been completely disposed of. Thus, the discharge of such liability is certain. The statutory liability ceases to exist only when a competent court strikes down the vires of the provisions imposing a tax liability under a statute. But, there may be certain situations where even a statutory liability can be considered as contingent liability. For e.g. let us consider a situation where the constitutionality of the statute has been challenged and the decision goes in the favour of the assessee i.e. the statute is held to be not constitutional. Thus, by such a decision there would be no liability under such a statute. But, if the revenue makes an appeal to the Supreme Court against the above decision, then the liability under such a statute would depend upon the decision of the Supreme Court in which case it would be termed as a contingent liability.

 

Where the assessee having collected the amount to meet its statutory liability towards sales tax proposed to be levied by the State Government on lease rentals and kept it as contingent deposit and having not paid the same to the State Government, that amount cannot be claimed as a deduction, as the amount so collected partake of the character of trading receipt and so long as it remains with the assessee, deduction cannot be allowed and it should be treated as income of the assessee.

 

Thus, in case of a statutory liability the quantification and ascertainment cannot postpone its accrual, but if the liability is based on some contractual obligation, it arises only when it is ascertained.

 

 Accrual of disputed statutory liability:

 

As we have seen that the statutory liability is disputed either when the provisions creating a liability under such a statute is disputed or the constitutionality of the statute itself is under consideration. But, such a dispute does not cause the liability to be ceased to exist. So far as the controversy in respect of the year of accrual in view of the statutory liability is concerned it would be clear by referring to the principles culled from various decisions.

 

• Where the statutory liability has been disputed (say a tax liability), the liability would accrue the moment the tax event takes place and the accrual of such liability does not depend upon the adjudication by any court.

 

Thus, where the assessee is following mercantile system of accounting in the case of sales-tax payable by the assessee, the liability to pay sales-tax would arise the moment tax event takes place attracting sales-tax, as such the obligation to pay the sales-tax arises at that stage and that any attempt to dispute liability to pay before any higher authority is irrelevant.

 

But, it is important to note the contrary view as mentioned in Pope the King Match Factory v. CIT which has been approved by the landmark judgment in Kedarnath Jute Mfg. Co. Ltd. V. CIT, which says, “the assessee had incurred an enforceable legal liability on and from the date on which he received the collectors demand for the payment and that his endeavor to get out of that liability by preferring appeals could not in anyway detract from or retard efficacy of the liability which had been imposed upon him by the competent excise authority”.

 

Though, the two cases differ on the point of the year of the accrual of liability but the consensus between the two is that the statutory liability does not cease to exist by the mere reason of the fact that it has been disputed by the assessee.   

 

• Secondly, where a statutory liability arises in a particular year, then an assessee maintaining books of account on the mercantile basis is entitled to claim deduction in the year in which the liability arises notwithstanding the fact that the liability was disputed and no entries were made in his books of account. Moreover, the mere fact that such a deduction was not claimed before the Income-tax Officer is not of much importance. Secondly, if the liability arises then a claim can be made bona fide at any stage before the higher authority, which is competent to grant relief.

 

• Moreover, whether the assessee is entitled to a particular deduction or not, will depend on the provision of law relevant thereto and not on the view which the assessee might take of his rights, nor can the existence or absence of entries in the books of account be decisive or conclusive in the matter.

 

 

Whether the amount can be allowed as deduction under the interim orders?

This issue has to be considered only by referring to nature of the interim order as the liability depends on what is stated in the interim order. For e.g. the liability would not arise in case the assessee has challenged the constitutionality of the statute and obtained the stay on the operation of such a statute, but, if such a stay order is along with the condition that in the event the assessee fails in his petition he has a liability to be discharged under that statute since its inception even though no tax has been collected from its customers, then, in such a case the liability could be well seen in the interim order and thus the assessee is entitled to claim deduction by virtue of such an interim order. 

Thus, where the dispute is as to the constitutionality of the Hotel Receipt Tax Act, 1980 and the Supreme Court stayed the operation of the said Act during the pendency of the said writ petition subject to the condition that in the event of the assessee failing in his petition, it shall be liable to pay hotel receipt tax irrespective of the fact whether or not it had collected hotel receipt tax from its customers. Ultimately, the validity of HRT Act was upheld by the Supreme Court. Thus, the liability of the assessee to collect and pay HRT stood confirmed by the Supreme Court right from the inception of HRT Act as if HRT Act was in full force applicable to the assessee for the year under consideration. Therefore, statutory liability to pay as per the condition was inbuilt in the interim order granted by the apex Court in favour of the petitioner.

Secondly, the liability arising out of the interim order, which is to be made payable upon the final order is not a contingent liability. Moreover, such deduction is allowable in the assessment year relevant to the previous year in which the interim order is passed.

The above principle would be clear by referring to the case of CIT v. Dhampur Sugar mills limited.

In the present case an interim order was passed by the Allahabad High Court allowing the assessee to sell the levy sugar at a price higher than that fixed by the Govt. on a condition that in the event of final decision of this court against the assessee, the excess amount realized would become refundable along with the interest at the rate of 12.5%. Thus, during the accounting period relevant to assessment year 1987-88, the assessee claimed deduction on the interest being payable on the amounts realized in excess of the levy price fixed by the Govt. It was held by the High Court that such interest on excess sugar price recovered from customer as per interim order of High Court is allowable as deduction in accounting period relevant to the assessment year 1987-88. The claim of the assessing officer that the liability to pay interest would accrue only when amounts of access collection becomes refundable as a result of final decision was rejected. Moreover, the liability of the assessee to pay interest was held to be not contingent. 

On the other hand, where there is no condition to refund the amount received in excess of the price fixed in the event of the pending dispute being decided adversely to the assessee by the court, i.e., the receipt of the amount by the assessee is not associated with the liability to refund the amount, the case stands at different footing.

·        It is a settled law that as long as the receipt of the amount by the assessee was clearly associated with a liability to refund the amount, such receipt of amount would not be characterized as an income and, therefore, the same cannot be taxed vide K.C.P. Ltd. v. CIT

 Accrual of the disputed contractual liability.

 

As, we have seen it earlier, that where the liability is governed by the terms of the contract or an agreement such liability is termed as a contractual liability. So far as the controversy as to in which year the contractual liability has to be discharged the following principles culled from various decisions may be referred:

 

• In case of an assessee following the mercantile system of accounting, a liability is sought 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.
• Unless the contractual liability has become an ascertained sum of money, and proceedings have yet to be taken in some way or the other to determine the exact amount then such a vague liability to make a payment cannot be entered in the accounts.

 

Similarly, a Division Bench of the Allahabad High Court held that the amount paid in excess of what was set apart to meet the sales tax liability arose on its quantification and then alone it could be claimed for deduction in the mercantile system of accounting.

           

Whether a demand to make payment results in the accrual of liability?

 

Where there is a demand from a third party calling upon the assessee to make the payment would not result in a situation whereby the assessee would incur a loss, if the assessee is disputing demand so made. In such a case no liability could be said to have been accrued during the accounting period in which the demand so disputed was made; in other words, it is a liability which has not been crystallized. Further the liability being contractual in nature (not statutory), and the loss being notional loss as it is neither final nor paid and thus the claim is based on contingent liability which can not be deducted.

 

When the assessee is entitled to claim deduction?

 

It has been well settled that where a liability arising out of contractual obligation is disputed, the assessee becomes entitled to claim deduction in that behalf only in the assessment year relevant to previous year in which dispute is finally adjudicated upon or settled.

Moreover, where the liability to be paid relates to the immediately preceding year but such liability gets determined only during the year under consideration, in such a case, the preceding year’s liability would be allowable as deduction in the assessment year relevant to the previous year in which such liability is determined.

 

As, by now we have seen that the contractual liability arises only when it is finally adjudicated. But, the question is as to when the liability would be treated as finally adjudicated?

 

The liability could be treated as finally adjudicated when either it has been decided by the Apex Court or where no appeal lies. If the assessee does not accept the decision of a jurisdictional court and makes a further appeal against the order of such court then it would not be treated as finally adjudicated and therefore the assessee cannot claim deduction in respect of the contractual liability which has not been crystallized.

 

If the assessee assails the decision of a High Court, the liability cannot be treated as finally adjudicated and settled and where such liability is pending adjudication by way of an appeal in the Supreme Court, then, till the point of time the same is finally adjudicated, the liability in question would remain a contingent liability. Therefore, such liability is not allowable in the year in question for the reason that in the mercantile system of accounting the amount can be deducted only when liability accrues and get crystallized.

 

 

 

Contrary View:

 

The basic principle which we have seen earlier regarding the disputed contractual liability is that such a liability gets accrued only when it is finally adjudicated upon. But on the other side we cannot ignore the contrary view.

 

• It was held that because of pendency of any litigation, the liability which accrues under a contract does not become a contingent liability nor does it result in keeping the liability in a suspended animus so as not to be accounted for in the books of account by any prudent businessman. It may further be noticed that if the amount is held to be not payable by the assessee, it will be a question inviting operation of Section 40 for including the amount so deducted in the assessment year in question in the taxable income of the assessee in assessment year when he is relieved of such liability in respect of which he has claimed deduction in earlier assessment year.

 

• The liability accrued and capable of being estimated with reasonable certainty when the recovery suit is filed by the other party; the deduction is allowable even though disputed by the assessee and merely because the liability was not a statutory one could not be said that the liability was not an ascertained one but a contingent one.

 

Conclusion:

 

Though it is not too easy to conclude the topic with universal principles, as the concept of tax changes at a rate higher than any other law, but by referring to the various principles culled by the decisions of our Hon’ble Supreme Court and Hon’ble High Courts we can arrive at a consensus that in case of statutory liability the quantification and ascertainment cannot postpone its accrual, but if the liability is based on some contractual obligation, it arises only when it is ascertained. Further, the deductions as per the interim orders could be claimed only by referring to the contents of such an order. Moreover, the demand to make payment does not make the liability to get crystallized so no deduction can be claimed in respect of such a liability. Likewise, the deduction in respect of any contingent liability can be claimed only when it becomes ascertained on the contingency coming to pass.

 

As said earlier, these principles are subject to the ever changing concept of taxation, thus it should be considered only after keeping in mind the facts and circumstances of the case at hand and the application of any new provision of the law.