India: Calling On Bharat Earth Movers

In the recent judgment of UOI v. Exide Industries Limited and Ors [2020] 116 taxmann.com 378 (SC) decided on 24.04.2020, a three-judge bench of the apex Court upheld the constitutional validity of section 43B(f) of the Income Tax Act, 1961.

Clause (f) of Section 43B, inserted by Finance Act, 2001 w.e.f 01.04.2002, allows deduction of leave encashment on actual payment irrespective of the regular method of accounting employed by the assessee. In other words, even if the assessee follows the mercantile basis of accounting, the deduction would be provided in the assessment year when leave encashment is actually paid and not in the year when the expenditure is incurred.

This takes us back to the case where the apex Court first laid out conclusively the nature of leave encashment and its allowability. In the year 2000, the long-standing dispute on the nature of leave encashment was put to rest by the apex Court in the case of Bharat Earth Movers v. Commissioner of Income Tax, Karnataka [2000] 245 ITR 428 (SC) when the Court held that leave encashment is a certain liability eligible for deduction in the year it accrued.

In this case, the assessee-company launched two beneficial welfare schemes for its employees for encashment of leave. The officers of the company were entitled to a paid leave 2.5 days per 30 days and the staff were entitled to vacation leave of 1.5 days per month. Both were permitted to accumulate leave up to 240/126 days maximum. Once they accumulated leave, the employee in the subsequent year could either avail the leave or encash it. Any leave earned beyond the ceiling limit of 240/126 days could not be availed or encashed and would lapse. The assessee made yearly provision for the liability and claimed that provision as deduction.

The Assessing Officer disallowed such a provision citing it to be a contingent liability. Tribunal allowed such a deduction. The High Court, reasoned that the liability would arise only in the event of an employee encashing the leave instead of going on leave. It therefore held that the provision for accrued leave salary was a contingent liability and, therefore not a permissible deduction.

The apex Court while allowing such a deduction observed in para 4 of the judgment as follows:

After this judgment, Clause (f) of Section 43B was inserted by Finance Act, 2001 w.e.f 01.04.2002. Thus the only effect of insertion of clause (f) is to regulate the stated deduction by putting it in a special provision.

Whether the dictum of Bharat earth movers is still relevant?

What is crucial is the accrual of liability for payment or expenditure during the relevant accounting year.

The Bharat Earth Movers judgment dealt with more than just the allowability of leave encashment. It laid out legal principles for appreciating the accrual or mercantile basis of accounting in allowing deduction for liabilities. It laid out principles for distinguishing a certain liability from a contingent liability. It held that 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.

The arguments advanced in both the Exide Industries Case and the Bharat Earth Movers Case are different. In Bharat Earth, the allowability of the deduction of leave encashment was on the anvil. In Exide Industries, the issue was regarding the timing of deduction and not the nature of liability. Therefore, in effect, neither the amendment to Section 43B, nor the judgment of Exide Industries erodes the foundation of the Bharat Earth Movers judgment.

This is evident from the post 43B(f) era judgments of various courts, relying on Bharat Earth Movers to test the nature of liability and its consequent allowability.

In Taparia Tools Ltd. v. JCIT Special Range – I [2015] 372 ITR 605 (SC), quoting Bharat Earth, the apex Court upheld the upfront deduction of interest on debentures in the first year itself.

Similarly, in the recent judgment of Housing and Urban Development Corporation Ltd. V. ACIT [2020] 421 ITR 599 (Delhi), the Court relying on Bharat Earth amongst other judgements, held that for allowing deduction of arrears on account of pay revision, the effective date of commencement of wage revision after which the liability accrues is relevant.

In CIT v. Oberon Edifices & Estates (P.) Ltd, [2019] 267 Taxman 118 (Kerala), Bharat Earth Movers was followed by the Court to allow deduction of post-sale business expenditure incurred in subsequent financial years, for the completion of construction of an under-construction building.

In Grace Shelter v. Assistant Commissioner of Income-tax, Range - 21(2), [2019] 262 Taxman 423 (Bombay), Bharat Earth was distinguished and certain expenditure incurred by the assessee for slum rehabilitation was disallowed since the same was contingent upon the Slum Rehabilitation Authority handing over the vacant possession of a part of land where such construction would be carried out.

In Principal Commissioner of Income-tax, Faridabad v. NHPC Ltd [2018] 408 ITR 237 (Punjab & Haryana), the ratio of Bharat Earth Movers was applied to an issue under Section 115JB.

Thus, the principles enumerated in Bharat Earth movers can still be used to resolve disputes wherein the nature of a liability is to be determined.

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