1. The assessee carries on the business of construction as military contractors. In the assessment years 1967-68, in computing the net profit, the assessee took into account a sum of Rs. 30,800 being the penalty leviable by Garrison Engineer, Dehu Road, for the non-completion of a word within the stipulated time. This amount was held not to be a deduction item of expenditure by the ITO as well as by the AAC
2. The Tribunal, in the appeal by the assessee, referred to condition No. 50 in the M.E.S. contract in which the penalty for delay in execution of the contract was described as compensation payable to the M.E.S. for the contractor's failure to complete the word and clear the site on or before the dates prescribed for the said completion. The amount of compensation was to be adjusted and set off against any sum payable to the contractor either in the same contract or in other contracts. Having found that the notices seeking to levy penalty were served on the assessee and the assessee maintained the mercantile system of accounting, and that the sum of Rs. 30,800 was shown as liability which has accrued on account of the fact that the work was entitled to deduct from profits and gains of the business the liability of Rs. 30,800 which had accrued. The said amount was, therefore, allowed as a deduction. Aggrieved by this decision of the Tribunal, the revenue has sought a decision on the following question of law in this reference under s. 256(1) of the I.T. Act, 1961.
'Whether, on the facts and in the circumstances of the case, the Tribunal was justified in law in allowing the sum of Rs. 30,800 which represented the liability of the assessee arising on account of the breach of the terms of the contract for the assessment year 1967-68 ?'
3. At the hearing of the reference, we have, by consent taken on record the balance-sheet, the profit and loss account for the year ended 31st March, 1967, and a true copy of the final contract bill submitted by the assessee-company in which an amount of Rs. 31,071.12 has been shown as compensation under cl. 5. The bill is dated 28th March, 1971. All these documents are treated as annex. D collectively.
4. Mr. Joshi appearing on behalf of the revenue has contended that the compensation paid for a failure to carry out the terms of the contract by the assessee-company cannot be said to be a payment made as incidental to the business and alternatively it was urged before is that all that has been done in the instant case was that a notice was issued to the assessee-company as to why a penalty should not be levied. No liability, according to the learned counsel for the revenue, had accrued and the amount could not be claimed as deduction merely because a claim had been made against the assessee-company.
5. Mr. Patil appearing on behalf of the assessee has contended that the assessee follows the mercantile system of accounting and in the accounts for the assessment year in question the liability of Rs. 30,800 which was accepted by the assessee had been taken into account in the profit and loss account. The learned counsel had contended that irrespective of the fact that the amount of compensation was adjusted in the year 1971, since the assessee was following the mercantile system of accounting, the assessee was entitled to have a deduction of the said amount in the assessment year in question.
6. Now there is no that the assessee had accepted the liability for the amount of Rs. 30,800 on account of the compensation for a delay in the completion of the contract, the assessee had also made a provision for this liability as would appear from the profit and loss account which is now taken on record, the Tribunal also seems to have proceeded on the footing that the work was not completed within the stipulated time and that the liability of Rs. 30,800 had already accrued against the assessee. Such a liability which had accrued is clearly a permissible deduction as will be clear from the decision of the Supreme Court in Calcutta Co. Ltd. v. CIT : 37ITR1(SC) . That was a case in which the assessee-company brought lands and sold them in plots for building purpose undertaking to develop them by laying out roads, providing a drainage system and and installing lights, etc. The purchasers of the plots paid only a portion of the purchase price and undertook to pay the balance in instalments, while the assessee-company in its turn undertook to carry out the development within six moths, but time was not the essence of the contract. In the relevant assessment year the assessee-company actually received in cash Rs. 29,392 towards the sale price of the lands but in accordance with the mercantile system of accounting, it actually credited a sum of Rs. 40,692 representing the full sale price of the lands. The company also debited an estimated sum of Rs. 24,809 as expenditure for the developments it had undertaken to carry out even though no part of that amount was actually spent. The department was disputing the liability of expenditure of Rs. 24,809. The Supreme court has held that the unconditional undertaking to carry out the development within six months from the dates of the deeds of sale imported liability which accrued on the dates of the deeds of sale though that liability would be discharged on a future date. The liability was thus held to be an accrued liability and it was held that the estimated expenditure, which would be incurred in discharging the same, could be deducted from the profits and gains of the business and the amounts expended could be debited in the accounts maintained under the mercantile systems of accounting before it is actually disbursed. It is thus clear that the mercantile system of accounting brings into debit as expenditure an amount, for which a legal liability has thus arisen in the accounting year, a deduction should be allowed, although the liability may have to be discharged at a future date.
7. Mr. Joshi has contended that the liability of the assessee has arisen out of its failure to carry out the term of the contract and such failure is not incidental to the business. It is difficult to accept this submission. The assessee carries on the business of building contracts. It is not unusual that in the performance of such contracts delay might occur for several reasons and if delay occurs, there is a breach of the condition relating to the completion of the contract work within the stipulated time. Such failure, if it occurs, is clearly incidental to the business of the assessee. Mr. Joshi has invited our attention to a decision of this court in Narandas mathuradas & Co. v. CIT : 35ITR461(Bom) , where, on the facts of that case, the Division Bench pointed out that that was not a case where it was suggested that the assessee had committed a breach of the contract fraudulently or he deliberately failed to discharge his obligation under the contract. That was a case in which the assessee-firm carried on business is several commodities and had submitted tenders to the B.B. and C.I. Railway and undertook to supply certain commodities. A security for properly carrying out the contract in accordance with the terms was, however, forfeited as the assessee could not carry out the contract. The question was whether the assessee was entitled to claim amount of the forfeited deposit as a trading loss.
8. The Division Bench in that case held that as the assessee was already carrying on business and the tender was only a transaction in the business and it was in order to put through that transaction that it made the deposit and it was made solely for the purpose of earning profit in the course of business, the forfeited amount was a trading loss and the assessee was, therefore, entitled to deduct that amount in order to arrive at the true profits of the business. The Division Bench held that the making of the deposit was incidental to the business he was carrying on. The ratio of this decision, therefore, was that the security deposit being incidental to the business, which the assessee was carrying on, when it was forfeited, it was a permissible deduction. It is no doubt true that the following observations were made in the judgment (p.464) :
'This is not a case where it is suggested that the assessee committed a breach of the contract fraudulently or that he deliberately failed to discharge his obligation under the contract.'
9. It appears that when these observations were made, they were made in the context of determining the question as to whether the amount was deductible or not. Now so far as the present case is concerned, those observations are not relevant because it is nobody's case that the delay in the performance of the contract was either deliberate or fraudulent.
10. It is no doubt true that the amount, which deduction is sought, is described by the Tribunal as a penalty but in effect it is really a compensation payable by the contractor to the Government and the nature thereof is wholly different a penalty which arises from a breach of a statutory provision. The said liability must, therefore, be construed as having arisen on account of a delay in performance and on account of compensation payable to the Government and not strictly in the nature of a penalty as in the case of a breach of penal provision of the law. In our view, the Tribunal was justified in holding that the assessee-company was entitled to the deduction of Rs. 30,800.
11. Accordingly, the question referred has to be answered in the affirmative and in favour of the assessee. The assessee to get costs of this reference.