JUDGMENT
Dr. B.P. Saraf, J.
1. By this reference under section 256(1) of the Income-tax Act, 1961, made at the instance of the assessee, the Income-tax Appellate Tribunal, Bombay Bench “A”, Bombay, has referred the following question of law to this court for opinion :
“Whether, on the facts and in the circumstances of the case, the Tribunal was right in holding that the provisions of section 41(1) of the Income-tax Act, 1961, were attracted in this case and that the amount of Rs. 1,19,564 being the provision for gratuity liability claimed and allowed as deduction in the assessment year 1972-73, requires to be added as the assessee’s income for the year ?”
2. The assessee is a company and this reference pertains to the assessment year 1977-78. In the assessment year 1972-73, the assessee had claimed and was allowed a deduction of Rs. 1,19,564 as gratuity liability on the basis that the amount represented the assessee’s liability for gratuity for that year on accrual basis. Section 40A(7) was introduced in the Income-tax Act, 1961 (“the Act”), with effect from the assessment year 1973-74. As the assessee did not comply with the requirements of the provisions of the newly inserted sub-section (7) of section 40A, no claim was made by the assessee for deduction on account of gratuity liability on accrual basis in computation of its income for the assessment year 1973-74 and onwards. In the previous year relevant to the assessment year 1977-78, the assessee wrote back the aforesaid amount of Rs. 1,19,564 being the provision for gratuity liability claimed and allowed as a deduction in the computation of its income for the assessment year 1972-73 and credited it to the profit and loss appropriation account. This was done as the assessee had decided to follow the cash system of accounting with regard to its gratuity liability. The Income-tax Officer being of the view that writing back the liability of Rs. 1,19,564 and crediting the amount thereof to the profit and loss appropriation account by changing its method of accounting in respect of gratuity liability from the mercantile to the cash system resulted in the cessation of liability within the meaning of section 41(1) of the Act and, hence, the value of such liability was includible in the computation of the assessee’s income for the said assessment year.
3. The assessee appealed to the Commissioner of Income-tax (Appeals). It was contended before the Commissioner (Appeals) that the entries made by the assessee in its books of account did not conclusively prove that the liability for gratuity ceased to exist and hence section 41(1) of the Act was not applicable to the case of the assessee. This contention of the assessee was accepted by the Commissioner (Appeals). Aggrieved by the above order, the Revenue appealed to the Tribunal. The Tribunal observed that for the purpose of assessment under the Income-tax Act, 1961, the question whether the assessee incurred any liability or there was a cessation of liability depended very much on the method of accounting followed by the assessee and not on the basis of abstract principles of law. Considering the uncontroverted facts of the case, the Tribunal held that having switched over to the cash system of accounting from the mercantile system followed by it in the past as regards its gratuity liability and having written back the gratuity liability claimed by it and allowed by the Income-tax Officer as a deduction in the computation of its income for the assessment year 1972-73, the assessee’s case clearly fell within the provisions of section 41(1) of the Act. The Tribunal, therefore, allowed the appeal of the Revenue, set aside the order of the Commissioner (Appeals) and affirmed the order of the Income-tax Officer. Hence, this reference under section 256(1) of the Act at the instance of the assessee.
4. The contention of learned counsel for the assessee is that the provisions of section 41(1) of the Act have no application to the facts and circumstances of the present case inasmuch as there was no cessation of liability to pay gratuity. According to learned counsel for the assessee, though the liability was written back by the assessee in its books of account and the amount appearing on the liabilities side of its balance-sheet as a “provision for gratuity” credited to the profit and loss appropriation account because of the change of the method of accounting as regards its gratuity liability made by it, there was no cessation of liability within the meaning of section 41(1) of the Act. According to him, the liability for gratuity accrued from year to year and continued despite the provision being written back and the amount credited to the profit and loss appropriation account. Reliance was placed in support of this contention on the decision of the Supreme Court in the case of Shree Sajjan Mills Ltd. v. CIT [1985] 156 ITR 585. In support of his contention that there was no cessation of liability, counsel relied on the decisions of this court in the case of J. K. Chemicals Ltd. v. CIT [1966] 62 ITR 34, in CIT v. Sadabhakti Prakashan Printing Press (P.) Ltd. [1980] 125 ITR 326 and in CIT v. Bennett Coleman and Co. Ltd. [1993] 201 ITR 1021.
5. We have carefully considered the above submissions. We, however, find it difficult to agree with learned counsel for the assessee that there was no cessation of liability for payment of gratuity for which provision had been made by the assessee in the assessment year 1972-73 following the mercantile system of accounting, even after writing off the provision created by it for that purpose, for which deduction had also been allowed by the Income-tax Officer as claimed by the assessee in the assessment year 1972-73 in its books, and appropriation of the value thereof to the profit and loss appropriation account. In our opinion, there was a clear cessation of liability in the instant case, because this action of the assessee has the effect of enhancing the capital of the assessee.
6. Section 41(1) of the Income-tax Act, so far as relevant, reads as under :
“41. (1) Where an allowance or deduction has been made in the assessment for any year in respect of loss, expenditure or trading liability incurred by the assessee, and subsequently during any previous year the assessee has obtained, whether in cash or in any other manner whatsoever, any amount in respect of such loss or expenditure or some benefit in respect of such trading liability by way of remission or cessation thereof, the amount obtained by him or the value of benefit accruing to him, shall be deemed to be profits and gains of business or profession and accordingly chargeable to income-tax as the income of that previous year, whether the business or profession in respect of which the allowance or deduction has been made is in existence in that year or not.”
7. It is clear from the above provision that two pre-conditions must be fulfilled for applicability of section 41(1) of the Act : First, an allowance or deduction must have been made in the assessment for any year in respect of loss, expenditure or trading liability incurred by the assessee. Second, during any previous year, the assessee must have obtained, whether in cash or in any other manner whatsoever, (i) any amount in respect of such loss or expenditure, or (ii) some benefit in respect of some trading liability by way of remission or cessation thereof. If these two conditions are fulfilled, the amount obtained by the assessee or the value of the benefit accruing to him would be deemed to be profits and gains of business or profession chargeable to income-tax as the income of the previous year.
8. There is no dispute in this case about the fulfilment of the first condition. The only controversy is in regard to the second condition. According to the Revenue, it is a case of cessation of a trading liability. The contention of the assessee is that there is no cessation in the present case as the gratuity liability accrues from year to year which can be quantified and provision can be made therefor and it is for that reason that deduction was allowed on account of the same as business expenditure. According to the assessee, as it was following the mercantile system of accounting in relation to its gratuity liability in the year 1972-73, provision was made for the accrued liability. Later, when it switched over to the cash system of accounting in relation to gratuity liability, it decided to write back the amount of provision for gratuity standing in its accounts and to credit the same to its profit and loss appropriation account. This action of the assessee, according to learned counsel for the assessee, cannot amount to cessation of liability because the liability for gratuity accrues from year to year and continues till the actual payment of gratuity is made on retirement or termination of the services of the employees. This contention, in our view, is not tenable in law. Payment of gratuity is by the employer to the employee on his retirement or termination of his service. The right to receive it accrues to the employees only on the retirement or termination of their services and the liability to pay gratuity became the accrued liability of the assessee when the employees retire or their services are terminated. Until then, as held by the Supreme Court in Shree Sajjan Mills Ltd. v. CIT [1985] 156 ITR 585, it is a contingent right and the liability to pay gratuity continues to be a contingent liability qua the employer. An employer might pay gratuity when the employee retires or his service is terminated and claim the payment made as an expenditure incurred for the purpose of business under section 37. He might, “if he follows the mercantile system”, provide for the payment of gratuity which became payable during the previous year and claim it as an expenditure “on accrued basis” under section 37 of the Act. Since the amount of gratuity payable in any given year would be a variable amount depending upon the number of employees who would be entitled to receive the payment during the year, the amount being a large one in one year and a small one in another year, the employer often finds it desirable and/or convenient to set apart for future use, a sum every year to meet the contingent liability as a provision for gratuity or a fund for gratuity. He might create an approved gratuity fund for the exclusive benefit of his employees under an irrevocable trust and make contributions to such fund every year. Contingent liabilities do not constitute expenditure and cannot be the subject-matter of deduction even under the mercantile system of accounting. Expenditure which is deductible for income-tax purposes is towards a liability actually existing at the time, but setting apart money which might become expenditure on the happening of an event is not expenditure. A distinction is often made between an actual liability in praesenti and a liability de futuro, which for the time being is only contingent. The former is deductible but not the latter.
9. As there are several methods which the assessee might choose to adopt in meeting his liability to pay gratuity, the treatment which he would receive under the Income-tax Act would depend upon the method adopted by him. The assessee is only under an obligation to pay gratuity when it becomes due and payable. The other methods adopted by the assessee for meeting the liability for gratuity as and when it arises are provisions or arrangements made by him at his option. It is not obligatory on him to make any such provision and if no such arrangement or provision is made, no question would arise to consider its deductibility or allowance under the Act. (See the observations of the Supreme Court in Shree Sajjan Mills Ltd.’s case [1985] 156 ITR 585 (at page 600)).
10. It is thus clear that only assessees following the mercantile system of accounting can set apart for future use a sum every year to meet the contingent liability as a provision for gratuity or fund for gratuity. In Metal Box Co. of India Ltd. v. Their Workmen [1969] 73 ITR 53, the Supreme Court held that contingent liabilities discounted and valued as necessary could be taken into account as trading expenses if these were sufficiently certain to be capable of being valued. An estimated liability under a gratuity scheme even if it amounted to a contingent liability, if it was properly ascertainable and its present value was fairly discounted was, therefore, held to be deductible from the gross profits while preparing the profit and loss account. In view of this decision and other decisions that followed it, it became permissible for an assessee if he so chose to provide in his profit and loss account for the estimated liability under a gratuity scheme by ascertaining its present value on actuarial basis and claiming it as an ascertained liability to get deduction for the same in the computation of the profits and gains of the previous year. This position, however, continued only till the year 1972-73. Thereafter deduction of amount set apart as provision in the manner set above was made subject to the provisions of sub-section (7) of section 40A. In this case, however, we are not concerned with the effect of the above amendment.
11. From the above discussion, it is clear that an assessee who maintains its accounts on the cash system is not entitled to claim deduction on account of any provision made for contingent liability of gratuity. Deduction in such a case will be available only during the year in which the actual payment is made. In the instant case, the assessee switched over to the cash system of accounting in respect of gratuity liability. Consequently, it will be entitled to claim deduction in respect of gratuity due to its employees only on payment in the year in which such payment is made. The assessee might have retained the provision in its accounts which it had created earlier even after switching over to the cash system of accounting. It, however, did not do so. On the other hand, it wrote back the amount appearing in its accounts as provision for gratuity. As a result, no contingent liability for gratuity remained any more in the accounts of the assessee. The amount was also appropriated by the assessee treating it as its profits for the year by crediting the same to the profit and loss appropriation account. Consequently, no liability, even contingent, remained in the accounts of the assessee on account of gratuity.
12. As indicated earlier, the right to gratuity gets vested in the employees only on retirement or termination of their services. So, the liability to pay gratuity also becomes an accrued liability of the employer only when the employees retire or their services are terminated. Till then, it continues to remain a contingent liability. It was taken into account as a trading expense only if it was properly ascertained by actuarial valuation. In such case, it was treated as a trading liability and allowable as a deduction for the purpose of ascertaining the real income of the assessee. If such a liability on account of which deduction had been claimed by the assessee and allowed by the Income-tax Officer is written off and the amount is credited back to the profit and loss account, evidently it would cease to be a liability on account of gratuity.
13. In the present case, the provision for liability was made voluntarily by the assessee during the previous year relevant to the assessment year 1972-73 for its own convenience though there was no enforceable liability on that account. In that view of the matter, the effect of writing off the provision for gratuity and appropriating the same to the profit and loss account is a clear cessation of trading liability of the assessee. The liability had been created voluntarily and unilaterally by the assessee. It was not a result of any bilateral act between the assessee and its employees. No law required the assessee to make a provision for gratuity from year to year. The liability of the assessee under the Payment of Gratuity Act arises on termination of the services and/or retirement of the employees. The provision made by the assessee having been written back, even the liability for gratuity created by the assessee ceased to exist. In that view of the matter, in our opinion, section 41(1) is clearly attracted.
14. We have perused the decisions of this court in J. K. Chemicals Ltd. v. CIT [1966] 62 ITR 34; CIT v. Sadabhakti Prakashan Printing Press (P.) Ltd. [1980] 125 ITR 326 and in CIT v. Bennett Coleman and Co. Ltd. [1993] 201 ITR 1021, relied upon by counsel for the assessee. In our opinion, the ratio of these decisions has no application to the facts and circumstances of the present case. The observations in the case of CIT v. Bennett Coleman and Co. Ltd. [1993] 201 ITR 1021 (Bom), to the effect that in case where the liability is not barred by operation of law, for cessation of liability a bilateral act of the parties might be necessary, has no application to the facts of the present case where the provision for gratuity made by the assessee was neither in pursuance of the mandate of any law nor a bilateral act on the part of the assessee and its employees. It was for his own convenience that the assessee decided to claim deduction of the amount of gratuity that might be payable to its employees in future. The assessee himself having reversed its decision and written back the provision, no liability enforceable in law survived.
15. In view of the above, we are of the clear opinion that the Tribunal was right in holding that the provisions of section 41(1) of the Act are attracted to the facts of the present case, and the amount of Rs. 1,19,564, which was written off in the year under consideration and credited to the profit and loss account of the assessee for the said assessment year, being the provision for gratuity liability claimed and allowed as deduction in the assessment year 1972-73, has to be added as the assessee’s income in the year under consideration.
16. The question referred to us is, therefore, answered in the affirmative and in favour of the Revenue.
17. Under the facts and circumstances of the case, we make no order as to costs.