Two recent decisions of the Income tax Appellate Tribunals have provided important guidelines on the scope of the deductions under the Income Tax Act. One deal with what expenditures cannot be deducted on grounds of being ‘prohibited by law’, and the other dealt with the extent to which foreseeable losses could be allowed as deductions prior to their crystallisation.
The first of these was a decision of the Nagpur Bench of the ITAT in Western Coalfields Ltd. v. ACIT. The assessee here was a colliery company, which transported coal in wagons to customers. In the case of under-loading of the railway wagons, reimbursement had to be provided to the customers who had paid on the basis of the weight of a standard wagon. In case of over-loading, extra charges had to be paid to the Railways. These overloading charges were referred to as a ‘penalty’ in the rules of the Railways. Hence, the issue before the Court was whether these over-loading charges could be claimed as business expenditures by the assessee, and deducted from its taxable income. The Department relied on the Explanation to section 37, which states-
... any expenditure incurred by an assessee for any purpose which is an offence or which is prohibited by law shall not be deemed to have been incurred for the purpose of business or profession and no deduction of allowance shall be made in respect of such expenditure.
The Tribunal began by dismissing the Department’s contention on the under-loading charges since they were merely in the nature of a contractual agreement, and could not be considered a penalty. The only real issue before it was whether the over-loading charges, referred to as a ‘penalty’ in the Railway Rules, were in the form of expenditure incurred for a purpose ‘prohibited by law’. The Tribunal answered this question in the negative for three reasons:
First, the Court relied on a decision of the Punjab and Haryana High Court in CIT v. Hero Cycles, where it was held that if the illegality was not a result of a deliberate violation of law, the expenditure could not be disallowed. On facts here, the Tribunal concluded that the over-loading was not due to any deliberate act on the part of the assessee, but due to poor infrastructural facilities and the nature of the commodity in question (coal). Due to the lack of any deliberate intent, the Tribunal held that the Explanation to section 37 was not attracted.
Secondly, the Tribunal looked at the object of the provision, observing that it was meant to disallow illegal/unlawful expenditure in the nature of protection money, extortion, bribes, and the like. Thus, it had limited application to cases like the one at hand.
Finally, and most significantly, the Tribunal emphasised the commercial nature of the expenditure. Assuming the Railways were to be replaced by a private carrier, the over-loading charges would clearly have been in the nature of a business expenditure. In that case, the Tribunal held that, the mere fact that the Railways was a Government entity would not affect the nature of the expenditure.
It is this third basis that is of the most significance in future cases of a similar nature, since it seems to relies on the nature of the transaction in the course of which the expenditure was incurred, as opposed to the entity with whom the transaction was entered into. This interpretation would be useful for all expenditures incurred for breaches or modifications of contracts entered into with Government entities, which otherwise may have been considered as expenditure incurred for a purpose ‘prohibited by law’.
The other decision was one by the Bombay Bench of the ITAT in Jacobs Engineering v. ACIT. The issue here was whether deductions made on account of foreseeable losses could be allowed before the losses actually crystallised. The assessee relied on paragraph 13.1 of Accounting Standard-7, which allowed a provision to be made for the entire amount of the loss when the current estimate of total contract cost and revenue indicated a loss. The Department pointed out that this Accounting Standard had not been notified by the Government and could not be used in assessment proceedings. Also, it placed reliance on the well-accepted ‘matching principle’ for the contention that only so much of the loss that had actually crystallised could be allowed in the current year.
Deciding the issue in favour of the assessee, the Tribunal held that the non-notification of AS-7 did not necessarily mean that it could not be used for the purposes of assessment. It also observed that a couple of earlier decisions had placed reliance on AS-7, and hence it allowed the amount of foreseeable losses to be deducted. While this decision may seem to proceed on the narrow basis of the provisions of AS-7, it is of considerable significance in the current economic climate. As pointed out by an article carried by the Economic Times on this case,
Typically, when a contract is planned, an estimate is made based on various factors of production involved such as steel, cement, labour. These are subject to changes in the external economic environment that aren’t under the control of the company. The costs could, hence, increase while the revenue or business estimated from such a contract may not see a corresponding increase.
Given the large number of incomplete or remodelled projects due to the recent economic downturn, this decision could provide considerable respite to assessees.