DEPUTY COMMISSIONER OF INCOME TAX CIRCLE-5(1)(2), BANGALORE vs. M/S PACE POWER SYSTEMS PVT LTD , BANGALORE

This appeal by the revenue is against the order of the CIT(Appeals)- 5, Bengaluru dated 31.3.2018 for the assessment year 2014-15 on the following grounds:- “a) The order of the learned CIT(A) is opposed to law and facts of the case. (b) Whether on the facts and circumstances of the cases and in law, CIT(A) was right in deleting the addition made by disallowance of provision for loss on onerous contract of Rs 7,35,30,657/- despite the fact that this is a contingent liability and not an ascertained liability as the same had not been created on the basis of Scientific Analysis and thus is not allowable U/s 37 of the Income Tax Act,1961 ? (c) Whether on the facts and circumstances of the cases and in law, CIT(A) was right in deleting the addition made by disallowance of provision for services rendered but not due of Rs 11,34,01668/- as the same is a contingent liability and not an ascertained liability since both the payee and the quantum of payment are not known and thus is not allowable U/s 37 of the Income tax Act,1961 ? (d) Whether on the facts and circumstances of the cases and in law, CIT(A) was right in holding that since no exempt income has been received by the assessee during the year no disallowance/addition can be made u/s 14A rw Rule 8D of Income tax Rules, ignoring the Board's circular No. 5/2014 ? (e) For these and other grounds that may be urged upon at the time of hearing, it is prayed that the order of CIT(A) in so far as it relates to the above grounds, may be reversed and that of the Assessing Officer may be restored. (f) The appellant craves leave to alter, amend or delete any of the grounds mentioned above and / or add any new grounds on or before the hearing.”

The assessee is engaged in the manufacture and supply of power management products for telecom operators, power telecom infrastructure producers and distributors both in India and overseas. The assessee is also responsible for installation and commissioning of products sold by them and third parties like battery and power supplies. It also undertakes warranty and after sales service for the products supplied by them. After sales services, annual maintenance contracts of products are also part of the assessee’s business. It also carries out operations and maintenance (O&M) of telecom towers consisting of diesel generator, power management unit, AC, batteries, etc.

The assessee filed the return of income for the AY 2014-15 on 29.11.2014 declaring an income of Rs.25,99,73,830. The case was selected for scrutiny and assessment was completed u/s. 143(3) of the Income-tax Act, 1961 [the Act] where the AO has made the following disallowances:-

During the year under consideration, the assessee had creation provision of Rs.7,35,30,657 under the head ‘provision for estimated losses on onerous contracts’. The AO noted that assessee had created short term provisions under the head ‘Provision for estimated losses on onerous contracts’ (Provision for underperformance charges) and the same was not added back in the computation.

The assessee submitted that as per the agreement, the assessee was under an obligation to render services at the specified level and within specified time. In case of any lapse or shortfall in the services rendered, the customer deducts the amount as under performance charges (loss on onerous contracts). During the year, these charges are created at Rs. 7,35,30,657. The actual debit notes are received from the customers at a later date and booked in the subsequent period by debiting the provision account. However, the AO disallowed these expenses on the ground that the expenditure is not incurred during the previous year and that the loss is not consistent in proportion to the revenue earned by the assessee compared to the earlier years.

On appeal before the CIT(Appeals), the assessee reiterated the submissions made before the AO and submitted the complete list of debit notes and other relevant details. The CIT(Appeals) after considering the submissions deleted the disallowance observing as under:-

The CIT(Appeals) relied on the Supreme Court decision in the case of Rotork Controls India Pvt. Ltd. v. CIT (314 ITR 62) wherein it was held that in case of warranties the sale price itself includes the price of warranty and therefore any expenditure incurred or any provision made for warranty is deductible. The loss on sale of onerous contract as claimed by the appellant is akin to warranty. He also relied on other judicial pronouncements and deleted the disallowance.

Aggrieved, the revenue is in appeal before the Tribunal. The ld. DR profoundly supported the disallowance made by the AO stating that the loss is not incurred during the previous year and the manner in which the loss is worked out by the assessee subsequently based on the debit not notes is not a proper analysis on scientific basis.

The ld. AR submitted that the period to which the losses are incurred is mentioned in the debit notes raised by the customers and accordingly the proportionate loss is claimed as a deduction in the year under consideration.

We have considered the rival submissions and perused the material on record. As per the contracts entered into by the assessee with the customers, there is a performance obligation whereby the assessee is under an obligation to maintain certified specified service level within specified time. For any shortfall, the customers could raise debit notes with charges in respect of deficiency in services. The assessee therefore during the year makes a provision towards the charges based on the past performance. These are negotiated with the customers and actual debit note is raised by the customers during the course of next year. In the year under consideration, the assessee made provision as follows:-

During the proceedings before the CIT(Appeals), the assessee submitted the list of debit notes received subsequently which matches with the provision made with a minor difference which is as follows:-

We also notice that the customers while raising the debit note mention the period and the assessee has claimed only the loss proportionate to the financial year concerned. The sample debit notes is given below for reference:-

Accounting Standard [AS-29] talks about the recognition of contracts which are onerous. The CIT(Appeals) in his order has dealt with the same in detail. Accordingly, the assessee is required to create a provision towards the onerous contract. With regard to the manner in which the assessee has computed the amount of provision, we find that the assessee assessee has considered the period mentioned in the debit note/invoices as the basis for proportionately creating the provision. This, in our considered view, is correctly done with proper analysis of documents and the relevant period. We therefore see no reason to interfere with the order of the CIT(Appeals) who has considered all the aspects of the issue on merits. Therefore, the ground raised by the revenue is dismissed.

During the year, the assessee created provision for services rendered by third party vendors for Rs.11,34,01,668. Before the AO it was submitted that the assessee is outsourcing portion of service contracts to third party vendors, whose work is certified by the assessee and subsequently the vendors raise actual invoices. The assessee therefore creates provision towards the services rendered on an estimate basis for the year end. These provisions would get reversed on the first day of the next financial year when the actual bills are accounted for after TDS. The assessee had already billed its customers including the outsourced services for which revenue is recognized. Hence, as a matching principle, the corresponding expenses payable towards services rendered by the vendors is also accounted for.

The AO rejected the submissions of the assessee and proceeded to disallow the entire expenses stating that the expenses are unascertained and does not pertain to the assessment year under consideration since not billed by the vendors. The AO disallowed the entire expenses since, according to him, the conditions prescribed u/s. 37 were not satisfied.

On appeal, the CIT(Appeals) allowed it in favour of the assessee stating as follows:-

The revenue is in appeal before the Tribunal, aggrieved by the order of the CIT(Appeals).

The ld. DR supported the order of the AO. Alternatively, the ld. DR submitted that the expenses ought to be disallowed u/s. 40(a)(ia) as the assessee has not deducted tax at source.

The ld. AR submitted that the bill wise details of expenses have been furnished before the lower authorities. After due verification of the same, the CIT(Appeals) has allowed the assessee’s claim for deduction u/s. 37 of the Act, which has to be upheld.

We have considered the rival submissions and perused the material on record. We notice that the assessee has submitted the complete break- up of the expenses with party name, bill no. etc. [pages 76 to 94 of PB] before the CIT(Appeals), who has verified the same from perspective of its allowability u/s. 37 of the Act and deleted the disallowance. We uphold the order of the CIT(Appeals) on this count.

Thus, this ground of the revenue is partly allowed.

The AO invoked the provisions of section 14A r.w. Rule 8D to disallow a sum of Rs.12,36,884 as expenses attributable to earning of exempt income. For this purpose, he considered the average investment based on opening and closing balance of investments and applied 0.5% on the same. The AO also took the expenses proportionate of the investments to the average of total assets and disallowed the expenses in the computation u/s. 14A.

The assessee submitted before the CIT(Appeals) that during the year the assessee has not earned any exempt income so as to invoke the provisions of section 14A of the Act. The assessee relied on the following decisions:-

Before us, the ld. DR submitted that the expenditure incurred towards earning of exempt income should be disallowed irrespective of whether exempt income is actually earned or not. In this regard, the ld. AR submitted that the decision of the Special Bench of Delhi ITAT is set aside by the Delhi High Court and accordingly the law is settled that section 14A will not apply where there is no exempt income.

We have carefully considered the rival submissions. The Hon’ble Delhi High Court in the case of Cheminvest Ltd., 61 taxmann.com 118 (Delhi) has held as under:-

Respectfully following the judgment of the Hon’ble Delhi High Court in Cheminvest Ltd. (supra), we hold that since the assessee in the present case did not have any exempt income during the year under consideration, no disallowance is warranted u/s. 14A of the Act. With regard to the contention of the ld. DR that the Explanation inserted in section 14A of the Act by the Finance Act, 2022 is retrospective and applicable to assessee’s case, we hold that the Explanation is inserted w.e.f. 1.4.2022 and therefore prospective and not applicable to the assessee’s case for the year under consideration. This ground raised by the revenue is dismissed.

In the result, the appeal of the revenue is partly allowed.