MARELLI UM ELECTRONIC SYSTEMS PRIVATE LIMITED,GURGAON vs. DEPUTY COMMISSIONER OF INCOME TAX/ ASSESSMENT UNIT, INCOME TAX DEPARTMENT , DELHI

The facts in brief are that the assessee company, M/s Marelli UM Electronic Systems Private Limited, is engaged in the business of manufacturing and sale of body computers, instrument clusters, electronic equipment and other products including telematics, navigation etc. for automobile manufacturers. During the year under consideration, the company had income from sale of finished goods viz. instrumental cluster, body computer and TRF, Antenna etc., other traded goods and sale of services as well.

During the proceedings, it was noticed that as per P&L account of the assessee for A.Y. 2021-22, the assessee has debited the P&L A/c by provision made for warranty of Rs. 90,80,952/- for the year under consideration. It was noticed that the assessee has opening balance of the provision of warranty on 01.04.2020 of Rs. 2,71,92,662/- and the assessee has also further added incremental amount of Rs. 90,80,952/- (0.5% of sales last two years) during the year however, the assessee has only utilized the provision amount of Rs.58,05,616/- during the year under consideration.

1 Revenue contended that the provision of warranty relates to repairs of the products sold during the year under consideration which is certain percentage of the total sales made. The remaining amount as evident from the books of the account of the assessee remains idle. Also, it was observed from the previous financial year i.e. 2019-20 that the amount of Rs. 14,45,350/- which is much less as compared to this year was utilized as warranty availed by the customers. Hence, it concluded that an amount of Rs. 90,80,952/- would remain unutilized with regards to warranty claimed by the customers.

The case set up by the Revenue is that the provision of warranty made by the company is an expenditure, which would be incurred on the happening of an event and as such, the same cannot be treated as expenditure incurred in regular course of business. The provision for warranty cannot be considered as "expenditure" at all and the expenditure has to be an actually existing liability and the expenditure, which is deductible for income tax purposes, but merely putting aside the money which may become expenditure on the happening of an event is not an expenditure.

1 This provision which has been utilized is for sales made in F.Y. 2019- 20 and F.Y. 2020-21 which were predefined for the year under consideration. Then it is not evident that what was the need to increase the provision by an amount of Rs. 90,80,952/- during the year under consideration while the assessee already had an opening balance of provision more than 0.5% of sales of last two years. The assessee has been creating provision regularly which is over and above the requirement as observed from the past financial statements. It is clear that the assessee is not following a scientific method to create the guarantee provision which is basic requirement for creation of this provision as per number of established judicial pronouncement.

2 Therefore, the total amount of provision of warranty of Rs. 90,80,952/- cannot be merely considered as allowable expenditure as such an huge amount was not required anticipating an expenditure which was not part of regular Course of business. The assessee had an huge opening balance under this provision and hence only the amount utilized of 58,05,616/- is considered as an allowable expense under section 37 of the I. T. Act, 1961. With regards to remaining amount of provision of warranty of Rs. 32,75,336/- (9080952- 5805616) which has not been utilized from the amount of incremental amount of provision during the year, is to be disallowed and added back to the total income of the assessee for A. Y. 2021-22. 6. Therefore, the draft assessment order u/s 143(3) r.w.s 144B r.w.s 144C(1) of the Act for A.Y. 2021-22 was served to the assessee on 20.12.2023 with proposed addition of Rs. 32,75,336/- on the account of disallowance of provision of warranty and opportunity of thirty (30) days was given to the assessee for filing his objections or accept this order. Aggrieved by this draft assessment order u/s 143(3) r.w.s 144B r.w.s 144C(1) of the I.T. Act, the assessee filed a petition before the Dispute resolution panel on P a g e | 6 Marelli Um Electronic Systems Pvt. Ltd. (AY: 2021-22)

01.2024 raising objection to the proposed addition of Rs. 32,75,336/- on the account of disallowance of provision of warranty u/s 37 of the I.T. Act.

The DRP has passed its order u/s 144C(5) of the Act dated 20.09.2024 and has given certain specific directions in the order regarding this proposed addition which is as under:- “the matter has been considered. Under the Act, expenditure towards ascertained liablility is an allowable expenditure. Assessee has himself mentioned that the actual utilization out of corpus towards warranty fluctuates widely from year to year. The quantification is provisioning account for warranty is also based on a pre-decided value at a fixed percentage of sales and has no scientific basis. Under these facts, the panel holds that AO has correctly disallowed sum of Rs. 32,75,336/- being a unascertained liability expense."

Therefore, as per the directions of the DRP vide order u/s 144C(5) of the I.T. Act dated 20.09.2024 and above discussion, in light of provision of warranty, the amount of provision of warranty of Rs. 32,75,336/- which has not been utilized from the amount of incremental amount of provision during the year, was disallowed and added back to the total income of the assessee for A.Y. 2021-22. P a g e | 7 Marelli Um Electronic Systems Pvt. Ltd. (AY: 2021-22)

Now before us. Ld. Counsel has demonstrated on the basis of material on record that the nature of provisions made it is impossible to sell the same without warranty to the customers and the companies’ sales policy accordingly provided two years warrantee to its customers for the products sold to them. It was submitted that in the assessee’s assessment for AY; 2016-17 to 2018-19, 2020-21 & 2023-24 no disallowance qua provision for warrantee was made, copies of these assessment orders have been placed on record from page 43 to 89 of the paper book. 10. The ld. DR has submitted that warrantee provisions is not absolute and not ascertained liability and in the garb of such a provision the net impact of profit and loss is prejudice of the revenue. 11. After taking into consideration the contentions and the submissions, we find that at page 41-42 of the paper book, assessee has provided the policy regarding warrantee and the same shows that the warrantee is in regard to all components supplied by the assessee against defective material and/or workmen ship. It establishes that there is a comprehensive policy of the company as to under what circumstances warrantee clause can be invoked giving rise to a liability on the assessee. Then a working of provision for warrantee for AY: 2021-2 Reversal working of the show that there was no act the same as under: 12. Further year wise o how the issue was dea convenience the same is al Marelli Um Electronic System 22 have been provided as to how the In provision would have impacted profi tual gain. As for income convenience of working of provision for warrante alt by the revenue has been provi lso reproduced below: P a g e | 8 ms Pvt. Ltd. (AY: 2021-22) ncremental vs. it and loss to we reproduce ee along with ided and for P a g e | 9 Marelli Um Electronic Systems Pvt. Ltd. (AY: 2021-22)

1 Lastly, we find that in the case of group company also similar fact was provided.

Now with regard to allowability as a deduction under Section 37 of the Act decision of Hon’ble Supreme Court in the case of Rotork Controls India (P) Ltd. Vs. CIT, Chennai (2009) 180 taxman 422 (SC) is relevant and the para 10 to 13 are reproduced as below:

Liability is defined as a present obligation arising from past events, the settlement of which is expected to result in an outflow from the enterprise of resources embodying economic benefits.

A past event that leads to a present obligation is called as an obligating event. The obligating event is an event that creates an obligation which results in an outflow of resources. It is only those obligations arising from past events existing independently of the future conduct of the business of the enterprise that is recognized as provision. For a liability to qualify for recognition there must be not only present obligation but also the probability of an outflow of resources to settle that obligation. Where there are a number of obligations (e.g. product warranties or similar contracts) the probability that an outflow will be required in settlement, is determined by considering the said obligations as a whole. In this connection, it may be noted that in the case of a manufacture and sale of one single item the provision for warranty could constitute a contingent liability not entitled to deduction under Section 37 of the said Act. However, when there is P a g e | 10 Marelli Um Electronic Systems Pvt. Ltd. (AY: 2021-22) manufacture and sale of an army of items running into thousands of units of sophisticated goods, the past event of defects being detected in some of such items leads to a present obligation which results in an enterprise having no alternative to settling that obligation. In the present case, the appellant has been manufacturing and selling Valve Actuators. They are in the business from assessment years 1983- 84 onwards. Valve Actuators are sophisticated goods. Over the years appellant has been manufacturing Valve Actuators in large numbers. The statistical data indicates that every year some of these manufactured Actuators are found to be defective. The statistical data over the years also indicates that being sophisticated item no customer is prepared to buy Valve Actuator without a warranty. Therefore, warranty became integral part of the sale price of the Valve Actuator(s). In other words, warranty stood attached to the sale price of the product. These aspects are important. As stated above, obligations arising from past events have to be recognized as provisions. These past events are known as obligating events. In the present case, therefore, warranty provision needs to be recognized because the appellant is an enterprise having a present obligation as a result of past events resulting in an outflow of resources. Lastly, a reliable estimate can be made of the amount of the obligation. In short, all three conditions for recognition of a provision are satisfied in this case.

In this case we are concerned with Product Warranties. To give an example of Product Warranties, a company dealing in computers gives warranty for a period of 36 months from the date of supply. The said company considers following options : (a) account for warranty expense in the year in which it is incurred; (b) it makes a provision for warranty only when the customer makes a claim; and (c) it provides for warranty at 2% of turnover of the company based on past experience (historical trend). The first option is unsustainable since it would tantamount to accounting for warranty expenses on cash basis, which is prohibited both under the Companies Act as well as by the Accounting Standards which require accrual concept to be followed. In the present case, the Department is insisting on the first option which, as stated above, is erroneous as it rules out the accrual concept. The second option is also inappropriate since it does not reflect the expected warranty costs in respect of revenue already recognized (accrued). In other words, it is not based on matching concept. Under the matching concept, if revenue is recognized the cost incurred to earn that revenue including warranty costs has to be fully provided for. When Valve Actuators are sold and the warranty costs are an integral part of that sale price then the appellant has to provide for such warranty costs in its account for the relevant year, otherwise the matching concept fails. In such a case the second option is also inappropriate. Under the circumstances, the third option is most appropriate because it fulfills accrual concept as well as the matching concept. For determining an appropriate historical trend, it is important that the company has a proper accounting system for capturing relationship between the nature of the sales, the warranty provisions made and the actual expenses incurred against it subsequently. Thus, the decision on the warranty provision should be based on past experience of the company. A detailed assessment of the warranty provisioning policy is required particularly if the experience suggests that warranty provisions are generally reversed if they remained

We find that ld. tax authorities had considered addition on account of provision for warrantee primarily on the basis that when assessee already had an opening balance of provision of more than .5% sales of last 2 years then assessee had no need to increase provision by an amount of Rs.90,80,952/-. We are of the considered view that once the practice of providing provision of the nature of warrantee has worked out over the years then only for the reason of the opening balance being sufficient to discharge the events of satisfying the liability during the year cannot be a basis to dilute the P a g e | 12 Marelli Um Electronic Systems Pvt. Ltd. (AY: 2021-22) warrantee claim. Provisions are established to be on the basis of experience and historical trend which have not been countered by any facts establishing that the working of the provision itself is faulty. There is no allegation that the nature of products and services do not give rise an obligating event so as to not create a provision. The year wise working of provision for warrantee provided to us and reproduced above show that the warrantee provision utilized during the year is Rs.58,05,616/- which is higher than 2013-14 and in the past 9 years warrantee provision were utilized and are consistent to policy. Thus, based on estimation of the obligation and outflow of resources the warrantee was made which need not be disturbed on assertion that opening balance would have been sufficient to discharge the possible liability during the year.

In the group entities case by order dated 10.12.2024 (supra) provision for warrantee made on similar lines was held to be scientific basis taking into account past and in respect of claim of warrantee.

Thus, we are of the considered view that ld. tax authorities below have fallen in error in making the disallowance. Consequentially grounds are P a g e | 13 Marelli Um Electronic Systems Pvt. Ltd. (AY: 2021-22) sustained. The appeal of the assessee is allowed with a direction to grant deduction provision for warrantee during the relevant year.