Tuesday, 10 November 2020

India: Direct Tax Alert: Ad-hoc Year-end Provisions Attracts Tax Withholding

 Reproduced with permission from BDO India LLP.

Background

As per general accounting principles, under mercantile system of accounting, provisions need to be created in respect of expenses which have been accrued in order to have a true and fair picture of the financials. Hence, all businesses which follow the mercantile system of accounting are required to create year-end provisions for the expenses incurred in respect of services availed till 31 March of a financial year. More often than not, provision for expenses is reversed in subsequent month(s) when the actual invoice is received. This has led to a vexed issue – whether tax is required to be withheld on such year-end provisions or not. Even the judiciary is divided on this front.

Recently the Mumbai Tax Tribunal1 had an occasion to consider, apart from other issues, whether the disallowance under section 40(a)(ia) of the Income-Tax Act, 1961 (IT Act) is attracted on ad-hoc year-end provision for expenses. We, at BDO in India, have summarised the ruling of Mumbai Tribunal and provided our comments on the impact of this decision.

Facts of the case

Taxpayer, a public limited company, is engaged in the business of Direct to Home Services (DTH). It provides DTH services through Set Top Box installed at the subscriber's premises. For the fiscal year 2008-09, the taxpayer created an ad-hoc year-end provision of expenses aggregating to INR 56.92mn which included expenses such as sales promotion, legal and professional, interest and programming costs. The taxpayer did not withhold tax at source (TDS) in the absence of the receipt of invoices from the service providers. As the taxpayer had not withheld tax, the tax officer disallowed these ad-hoc provisions under section 40(a)(ia) of the IT Act and thereby added it to the taxpayer's income. Aggrieved, the taxpayer filed an appeal before the First Appellate Authority which upheld the additions made by the tax officer.

Tribunal ruling

Before the Tax Tribunal, the taxpayer relied on various judicial precedents2 to contend that it is not under an obligation to withhold tax on the ad-hoc year-end provisions. Hence, the same should not be disallowed under section 40(a)(ia) of the IT Act. The taxpayer also submitted that in the subsequent year, the year-end provisions were either reversed or paid after TDS. Revenue Authorities submitted that as per the provisions of Chapter XVII-B of the IT Act, TDS is required to be done either at the time of payment or at the time of credit (including even a credit in the suspense account) whichever is earlier. Therefore, there is no merit in the taxpayer's contention that TDS is not applicable on an ad-hoc year end provision for expenses.

After hearing the contentions of the taxpayer and the Revenue Authorities, Mumbai Tax Tribunal held that TDS is attracted on the year-end provision. For coming to this conclusion, it observed that:

  • The year-end provisions were debited in the profit and loss account and not added back to the computation of total income.
  • Once, the taxpayer has claimed these expenses by debiting in profit and loss account, it needs to withhold tax on such expenditure, even if not credited to respective vendor account.
  • Since, the taxpayer has not withheld tax, the provisioned expenses claimed as deduction are liable to be disallowed under section 40(a)(ia) of the IT Act.
  • Also, the taxpayers contention that in the subsequent year the provision has either been reversed or paid subject to TDS does not alter the legal position in so far as disallowance of expenses under section 40(a)(ia) of the IT Act is concerned.
  • With respect to judicial precedents relied by the taxpayer, all the cases are contrary to the provisions of Chapter XVII-B read with section 40(a)(ia) of the IT Act and hence are not followed.

BDO comments

This decision has only increased the complexity revolving around applicability of tax withholding provisions to ad-hoc year-end provisions. It is imperative to observe that Hon'ble Mumbai Tax Tribunal has simply brushed aside its earlier decision in case of Mahindra and Mahindra by stating that the decision is contrary to the provisions of Chapter XVII-B read with section 40(a)(ia) of the IT Act. It is pertinent to observe that in the case of Mahindra and Mahindra, Hon'ble Mumbai Tax Tribunal had held that if the party(ies) is not identified/identifiable, the tax withholding provisions are not attracted. While the instant decision has not given detailed reasoning, the Revenue Authorities could take support of this decision to make disallowance under section 40(a)(ia) of the IT Act. 

Further, the Revenue authorities could also treat the taxpayer as assessee-in-default for the purpose of section 201 and thereby initiate TDS proceedings against the taxpayer. Also, sight should not be lost to the recent decision of Delhi Tax Tribunal in case of Inter Globe Aviation Ltd3 wherein it held that "The amount of expenditure incurred can be determined only if, there is a recipient identified of the sum, there is a methodology available for working out the amount payable by the assessee to the recipient, there is a corresponding liability arising out of the existing contract or customs by the assessee with the recipient. If generally these ingredients are not satisfied assessee cannot be said to have incurred the expenditure. In absence of one of one of these criteria, if provision is made, it is not an ascertained liability but an unascertained liability, which does not satisfy the concept of accrual of expenditure. There may be reasons for receiving the bills by the service providers after certain time lag but that does not absolve the assessee from the liability of deduction of tax at source.

 In the present case the provision is made under the specified head, provision is also made to on certain basis thereby ascertaining the amount. It is not the case of the assessee that it has made an ad hoc provision. Thus, it cannot be said that the payee is not identified. Therefore, according to us, the tax is required to be deducted on the year-end provisions made by the assessee which are ascertained liabilities"

While the Delhi Tribunal has not relied on Mahindra and Mahindra4 decision, it has made an important observation that in its peculiar facts that the year-end provision for expenses were liable for withholding tax as these were ascertained liabilities and ad-hoc in nature.

From the said decisions, one may sum up that tax is required to be withheld on behalf of an identified payee. If the fact pattern suggests that while the liability has accrued but there is no precision as to the identity of the person to whom payment is to be made, the tax withholding requirement may not be capable of being implemented.

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