JAGADISAN J. - The assessee in this reference application under section 66 of the Indian Income-tax Act is a registered firm of four partners carrying on business as manufacturers of stainless steel-ware, brass-sheets and circles. It maintains its books of accounts on the mercantile system. In the year of account ended April 12, 1956, the relevant 'previous year' for the assessment year 1956-57, it credited a sum of Rs. 5,600 to a separate account called 'gratuity reserve account'. This amount represented approximately fifteen days wages of all its employees or workmen, who were in its service during the year of account. The stated object of the assessee in carrying this amount of Rs. 5,600 from and out of the profits of the year to the 'gratuity reserve account' is to meet an eventual liability in case some of the workers happen to be retrenched at some point of time in future.
According to the assessee, this was a statutory obligation or burden imposed upon it under section 25F of the Industrial Disputes Act. We shall refer to the provisions of this Act and to the nature of the assessees liability a little later.
In the year of assessment 1956-57, the assessee claimed this amount of Rs. 5,600 as a permissible deduction in the computation of its profits chargeable to tax. The claim for deduction was apparently based on section 10 (2) (xv) of the Indian Income-tax Act, and presumably also on the principle of computation of the true profits of the business, allowing all legitimate costs incurred in earning the income. The Income-tax Officer, City Circle III, Madras, disallowed the claim, holding that the assessee would not be entitled to make a revenue charge on the income of the year of account against prospective liabilities of a contingent nature. The assessee went up on appeal to the Appellate Assistant Commissioner of Income-tax, B-Range, Madras. The appellate authority affirmed the view taken by the Income-tax Officer. He held that the provision made for payment in respect of a statutory obligation would not amount to an 'expenditure', as the amounts had not been credited to the accounts of the respective employees, but were only placed under an account, the assessee still having domination and control over the fund. There was a further appeal by the assessee to the Income-tax Appellate Tribunal. This time it was successful. The Tribunal took the view that the assessee being under a statutory liability under section 25F of the Industrial Dispute Act to pay the employees 'gratuity' at the rate of fifteen days wages for every completed year of service, there was nothing wrong for the assessee to make provision in each of the years, as the liability is an ascertained one. In the view of the Tribunal, it is an ascertainable liability of the assessee, in respect of which it made a provision in the year of account, and that, therefore, the claim for deduction on the basis of that provision would be permissible in law. The Tribunal failed to consider the question whether the assessee did was to credit the general reserve account with this sum of Rs. 5,600 and, though the assessee now asserts that this reserve is also intended for the purposes of meeting a future statutory liability in case of retrenchment, there is nothing on record to show that the segregation of this amount from the profit and loss account was made with the specific purpose and object of meeting that liability. The assessee having succeeded in establishing its claim for deduction, the department applied for a reference under section 66 (1) of the Act to the Tribunal and the Tribunal has referred the following questions :
'Whether the aforesaid sum of Rs. 5,600 or any part thereof can be said to be an ascertained liability in respect of gratuity to the assessees employees due under the provisions of the Industrial Disputes Act, as at the end of the aforesaid previous year so as to constitute a proper deduction in the assessment of the year 1956-57 ?'
We shall now refer to the provisions of the Industrial Disputes Act to ascertain the nature of the assessees liability in respect of which it desires to forearm itself by building up a reserve fund. The assessee points out to section 25F of the Act, which reads :
'25F. No workman employed in any industry who has been in continuous service for not less than one year under an employer shall be retrenched by that employer until -
(a) the workman has been given one months notice in writing, indicating the reasons for retrenchment and the period of notice has expired, or the workman has been paid in lieu of such notice, wages for the period of the notice : . . . .
(b) the workman has been paid, at the time of retrenchment, compensation which shall be equivalent to fifteen days average pay for every completed year of service or any part thereof in excess of six months.'
The word 'retrenchment' has been defined under the Act as meaning the termination by the employer of the service of a workman for any reason whatsoever, otherwise than as a punishment inflicted by way of disciplinary action, but does not include voluntary retirement, retirement of the workman on reaching the age of superannuation or termination of the service of a workman on the ground of continued ill-health. The Supreme Court held in the Barsi Light Railway case that the word 'retrenchment', as defined under the Act, has no wider meaning than the ordinary accepted connotation of the word, and that it means the discharge of surplus labour or staff by the employer for any reason whatsoever, in a continuing industry otherwise than as a punishment inflicted by way of disciplinary action, and it has no application where the services of all workmen have been terminated as a result of bone fide closure of business. Subsequent to this decision, Parliament has introduced section 25FF and section 25FFF by Act XXIX of 1957. By these provisions compensation to workmen even in cases of transfer of undertakings and of closing down of undertakings has been provided for. Section 25F (b) is really mandatory in its terms. Retrenchment workmen are entitled to the compensation equivalent to the fifteen days average pay for every completed year of service. In State of Bombay v. Hospital Mazdoor Sabha, the Supreme Court dealing with this provision observes as follows :
'On a plain reading of section 25F (b) it is clear that the requirement prescribed by it is a condition precedent for the retrenchment of the workman. The section provides that no workman shall be retrenched until the condition in question has been satisfied. It is difficult to accede to the argument that when the sanction imposes in mandatory terms a condition precedent, non-compliance with the said condition would not render the impugned retrenchment invalid.'
Indeed, the condition of the payment of retrenchment compensation is an essential pre-requisite, which, if not complied with, would render the retrenchment itself illegal and improper : see McKenzies Ltd. v. Labour court, Madras.
The real question in this case does not, however, turn upon the express mandatory provision of section 25F of the Act, but upon the nature of the employers liability at a given moment on the apprehension that at some future date, due to the vicissitudes of business, recourse may have to be had by way of retrenchment of some members of the staff who might be felt to be surplus, having regard to the then business exigencies. It is quite obvious that an evaluation of the employers liability in respect of an unforeseen and perhaps imaginary state of business compelling retrenchment of the surplus staff must depend upon several hypothetical contingencies.
Learned counsel for the department contends, firstly, that a provision for meeting a future liability, which is uncertain and contingent, cannot be a proper charge on the business income of an assessee even under the mercantile system of accounting and, secondly, that even in a case of definite future liability, making a provision by constituting a reserve in the assessees accounts would not amount to 'expenditure', without which no deduction can be claimed. In our opinion, both these contentions are well-founded and we have only to see whether these principles apply to the present case and prevent the assessee from the deduction.
A traders profit and loss accounts, however much it may be in line with established accountancy and commercial principles, may not be sanctified for income-tax purposes by the department. In respect of costs allowable for earning income, standards of commercial men or qualified professional accountants cannot enlarge the statutory limits of proper and admissible debits. The opinion of the expert accountant and the accountancy usage or practice, must stand the scrutiny of the court, which is guided only by the statute. The angles of vision, of the department and the trading assessee, therefore, differ. A trader generally considers it to be sound business economy to build up a reserve fund to meet future liabilities or losses, and this fund is replenished annually by amounts drawn from the profits of the business. Amounts carried to the reserve fund for anticipated or even inevitable losses, or for contingent liabilities, are not permissible deductions in computing the business profits and they do not fall within section 10 (2) (xv) of the Income-tax Act. While it is true that the profits of a business have to be computed consistent with commercial sense and that the provisions under section 10 (2) of the Act are not exhaustive of all items of permissible deductions, there is no warrant for holding that every kind of prudential measure adopted by businessmen should earn allowance in taxation. The reason why claims for allowance are made by the assessee in the name of commercial expediency is not an unintelligible secret; the trade instincts of the assessee always try to get the better of the statute.
It is now settled law what a claim for deduction in respect of an anticipated, uncertain or contingent liability is not permissible. The question has been considered fully by this court in Senthikumara Nadar and Sons v. Commissioner of Income-tax. The principle laid down in that case is that only an ascertained liability justifies an entry in the assessees accounts maintained on the mercantile basis and that deductions are not permissible for anticipated losses or contingent liabilities. The following passage extracted from Simons Income Tax II edition, vol. II, page 203, paragraph 230, has been quoted with approval as governing the interpretation of the Indian enactment :
'In computing the profits of a trade it is the normal accountancy practice to allow as an expense any sum in respect of liabilities which have accrued over the accounting period, and to make a deduction of such sums from the profits. Following the decision in Peter merchant Ltd. v. Stedeford (Inspector of Taxes), however, it appears that the nature of liabilities which may be deducted on business and accountancy principles does not accord with the nature of liabilities deductible for income-tax purposes. For income-tax purposes it was held that a distinction must be drawn between an actual, i.e., legal liability, which is deductible, and a liability which is future or contingent and for which no deduction can be made.'
The same principle has been upheld by the Supreme Court in Indian Molasses Co. v. Commissioner of Income-tax. Hidayatullah J. observed thus at page 75 :
'The income-tax law does not allow as expenses all the deductions a prudent trader would make in computing his profits. The money may be expended on grounds of commercial expediency but not of necessity...... Thus, in finding out what profits there be, the normal accountancy practice may be to allow as expense any sum in respect of liabilities which have accrued over the accounting period and to deduct such sums from profits. But the income-tax laws do not take every such allowance as legitimate for purposes of tax. A distinction is made between an actual liability in praesenti and a liability de futuro which, for the time being, is also only contingent. The former is deductible but not the latter.'
The contention on behalf of the revenue is that a provision by way of reserve by the assessee to meet the liability, if any, to which the assessee may become subject in the event of its sending away a few workmen because of retrenchment of surplus staff is not a liability in praesenti in the year of account, but a liability which may arise de futuro on the happening of a particular contingency; on the other hand, the contention of the assessee is that the possibility of a retrenchment in any running business is not very remote, but is something which is usual and ordinary incidental to the carrying on of business and that if the law of the land compels payment of compensation on a particular basis to the retrenched staff, a provision to enable payment thereof even by way of anticipation would only amount to a liability in praesenti and not a contingent liability. Mr. S. Swaminathan, learned counsel for the assessee, relies upon the decision of the House of Lords in Southern Railway of Peru Ltd. v. Owen (Inspector of Taxes) in support of his contention that the liability of the kind now in question is only a present liability. It is necessary to refer to this decision in some detail as, in fact, the whole of the learned counsels submission is based only on this decision. The facts, as can be gathered from the headnote itself, were as follows : An English company was operating a railway under the legislation of Peru. Under this legislation, the company was bound to pay its employees compensation on the termination of their services; the legislative provisions were deemed to be incorporated into all contracts of service entered into with the company. This right on the part of the employees to obtain payment of compensation arose on dismissal or on termination of the employment by the employee by proper notice or on such termination by the death of the employee or on the expiry of the term of employment. The compensation fixed was an amount equivalent to one months salary at the rate in force at the date of the termination for every year of service. The company claimed to be entitled to charge against each years receipts the cost of making provision for the retirement payments which would ultimately be thrown on it, calculating what sum would be required to be paid to each employee if he retired without forfeiture at the close of the year and setting aside the aggregate. The question was whether the company was entitled to make the deductions. The House of Lords held that the company was not so entitled. The decision of the House of Lords is that though the company was entitled to charge against each years receipts of the cost of making provision for the retirement payments which would ultimately be payable as it had the benefit of the employees services during the year, the claim could be sustained only if the present value of the future payments can be fairly estimated. The assessee failed on the ground that in calculating the amount which it claimed to deduct in each year it had ignored the factor of discount. The following observations of the learned Law Lords have been relied upon by Mr. Swaminathan. At Page 751, Lord MacDermott observes thus :
'...... the true view is that the yearly increments by which a lump sum is built up ought to be reckoned for present purposes as remuneration in respect of the years in which they accrue.'
In the same page, the learned Law Lord further observes :
'.... I would hold that the appellant was right in contending that in principle it was entitled to make a deduction each year in respect of its prospective lump sum liabilities.....'
Lord Radcliffe observes thus a page 758 :
But, whatever the legal analysis, I think that for liabilities as for debts their proper treatment in annual statements of profit depends not upon the legal form but upon the traders answers to two separate questions. The first is : Have I adequately stated my profits for the year if I do not include some figure in respect of these obligations The second is : Do the circumstances of the case, which include the techniques of established accounting practice make it possible to supply a figure reliable enough for the purpose ?'
This decision of the House of Lords undoubtedly lays down the proposition that it is proper on the part of a businessman to estimate a future liability, which is almost definite and is certainly real, and make a provision each year to meet that liability and claim them as a proper charge on the revenue receipt. The legislation of Peru provided for payment of compensation to the employees on dismissal or on termination of the employment by the death of the employment by the death of the employee or by the expiry of the term of employment. These are all circumstances which can normally be expected to happen, and it cannot certainly be said that they depended upon any contingency. We must point out that the case dealt with by the House of Lords is totally different from the present case where the businessman, the assessee, is seeking to make a provision in respect of a liability which may arise out of retrenchment, which, after all, is only an event of chance. The actual decision in the English case, which went against the assessee, was on the footing that there was no proper evaluation of that liability in the particular year of account. We would like to refer to the observations of the learned Law Lords in regard to this aspect of the matter. At page 751, Lord MacDermott observes :
'.... the deduction sought be the appellant throughout has been the aggregate of the yearly increments by which the value of the future lump sum payments has been increased. That, I think, must be wrong as, apart from any adjustment to be made on account of possible forfeitures, this deduction makes no attempt to reflect the present value of payments which may not have to be made for anything up to the span of a mans industrial life. If the position is that no fair estimate or satisfactory computation of the provision to be made as respects the appellants prospective liabilities can be arrived at, then that is an end of the matter and the appeal must be dismissed.'
Lord Radcliffe dealt with this matter thus page 759 :
'When account is taken of all the circumstances, I should have though that the sums charged were a very long way from affording a scientific appraisement of the additional burden arising in respect of the years services; and were, therefore, in the nature of a rough reserve against the future rather than a measured provision. Because what the appellant has done is simply this. It has calculated what sum would be required to be paid to each employee in respect of retirement benefit if he retired, without forfeiture, at the close of the year : and the aggregate of what is required is set aside in so far as the year has contributed to the aggregate... But it seems to me to leave out of account several factors that are essential to the appraisement.'
It is clear that the assessee must fail in this case even on the principle laid down by the House of Lords in the English case referred to. It has certainly not approached the question of setting apart of funds to meet a future liability on any scientific basis. It is impossible to contend that fifteen days wages for each year in respect of all the employees in the staff would be a proper annual contribution to conserve a fund to answer the claim of retrenched staff or in other words would amount to the present equivalent of the future liability to pay retrenchment compensation as it is obvious that some discount has to be made. To put the matter quite shortly, fifteen days wages of employee A in the year 1956-57 will not be the sum that need be set apart in respect of an anticipated payment to A of compensation in the event of his being retrenched ten years thereafter. Learned counsel for the assessee frankly concedes that the assessee failed to make a proper evaluation in the matter, even assuming that it was entitled to have the deduction claimed as a matter of law. The question, therefore, boils down to this : whether the charge against the receipts of the trade is essential in order to enable the true profit to be stated for the year. Anticipated loss or contingent liability is disallowed either because it would not be a proper charge against the receipts for the ascertainment of the years profit or because the loss or liability is so much in the region of doubtful happening as to be chimerical. Broadly stated, the claim for allowance can be sustained only if three conditions are satisfied : (1) it should be a proper revenue expense; (2) it must be a fair and proper estimate of the amount accrued due; (3) it must be expended. Reserves for anticipated losses, contingent liabilities and expenses not actually incurred will be disallowed : Collins v. Commissioners of Inland Revenue; Whimster & Co. v. Commissioners of Inland Revenue; Young v. Commissioners of Inland Revenue Naval Colliery Co. v. Commissioners of Inland Revenue; Ford & Co. v. Commissioners of Inland Revenue.
Having regard to the principles of law adverted to above, we are of opinion that the liability of the assessee in respect of retrenchment compensation under section 25F of the Act is not a liability in praesenti, but is only a contingent liability, which cannot be taken into account as an accrued liability, even though the assessee has been maintaining his account books on the mercantile system. We are further of opinion that even if it is permissible to charge the years profits to built up the sinews to withstand the result of an uncertain event of retrenchment, the actual provision made is so over-generous, and is so improper an appraisement of the present value of a future liability that it has to be struck down as an over-reserve.
Mr. S. Ranganathan, learned counsel for the department, is well-founded in his submission that there is no expenditure at all incurred by the assessee by the mere process of putting the amount under the 'gratuity reserve fund'. The decision of the Supreme Court in Indian Molasses Co. v. Commissioner of Income-tax supports this contention. At page 78, Hidayatullah J. observes :
'But there is no case directly on what is expenditure, and if the authorities under the English statute were to be of real assistance, the whole of the matter should have been before us. The question, however, limits the approach to whether the payments made towards the policy were Expenditure within clause (xv). Expenditure is equal to expense and expense is money laid out by calculation and intention though in many uses of the word this element may not be present, as when we speak of a joke at anothers expense. But the idea of spending in the sense of paying out or away money is the primary meaning and it is with that meaning that we are concerned. Expenditure is thus what is paid out or away and is something which is gone irretrievably.'
In the mercantile system of accounting, a debit of an accrued liability would be a proper charge on the revenue receipts. It is not necessary that there should have been any actual disbursement in such system of accounting to enable the assessee to make the claim for deduction. But, in the present case, the amount is credited only to the 'gratuity reserve fund' account and not to the credit of each and every one of the employees concerned. The amount has been earmarked for the specific purpose for the payment of future retrenchment compensation under section 25F and of course no trust has been created in regard to this amount. The assessee has still the control and dominion over the reserve, and it would be strictly within its rights to recall the amount from the reserve account and use it for its own business purposes, if the exigencies of the business so require. There has been no transfer of the fund from the assessee to the employees, the contemplated beneficiaries. We are unable to understand how such a mere credit entry to a reserve account can at all be described as 'expenditure' within the meaning of the Act.
In our opinion, the assessee is not entitled to claim the deduction and the decision of the Tribunal holding in its favour is erroneous in law.
The reference is answered in favour of the department. The assessee will pay the costs of the department. Counsels fee Rs. 250.
Reference answered in the negative.