Kapur, J.
1. This reference is at the instance of the assessed which is a company manufacturing and selling refractories. A gratuity scheme was introduced on March 31, 1970, with effect from January 1, 1970, which applied only to such employees who were not entitled to the benefit of provident fund or bonus. The ITO disallowed the gratuity relating to earlier years, but allowed the gratuity relating to the assessment year in question. On appeal, the AAC held that the liability for Rs. 1,55,997 had accrued before the beginning of the accounting year; hence, the ITO was justified in disallowing that amount.
2. On appeal to the Tribunal, it was urged that though the scheme was introduced from March 31, 1970, it was to operate from January 1, 1970. The Tribunal noted that the actuarial valuation was made on May 24, 1972, and, hence, the account must have been kept open and antedated. It was observed that the liability which was ascertained on May 24, 1972, could not be provided for in the accounting year ending on December 31, 1970, on the reasoning that the liability did not accrue in the previous year, and hence, the deduction could not be allowed. The liability was discounted when the actuary made the actuarial valuation. It was also held that the amount was not set apart and handed over to any trustees and the dominion and the control over the funds continued to be vested in the management. The liability was, thereforee, of a contingent nature.
3. For various reasons, the deduction was disallowed.
4. As a result of this conclusion, the assessed had sought a reference of the following question referred to us of assessment year 1971-72, the accounting year being the calendar year 1970 :
'Whether, on the facts and in the circumstances of the case, the Appellate tribunal was justified in holding that the assessed's liability to payment of gratuity to its employees was not deductible in the computation of its business income for the assessment year 1971-72 ?'
5. The learned counsel for the assessed referred to the Supreme Court's decision in Calcutta Co. Ltd. v. CIT : [1959]37ITR1(SC) , to submit that it was there held that in the mercantile system of accounting, any liability to be discharged at a future date was an allowable expenditure. It was urged that once the gratuity scheme came into operation, there was an accrued liability which should be determined and debited to the period in question. Hence, the liability under the gratuity scheme should not have been disallowed.
6. Reference was also made to another judgment of the Supreme Court CIT v. Swadeshi Cotton and Flour Mills P. Ltd. : [1964]53ITR134(SC) , where a profit bonus was paid under an award dated January 13, 1949, for the calendar year 1947. It was there held that the amount was deductible in 1949 and not in 1947, the reason being that under the mercantile system of accounting the liability was incurred when the claim is settled amicably or by industrial adjudication. The system of re-opening the accounts does not fit into the scheme of the I.T. Act. Thus this would support the view that the amount in the present case had to be debited in the year the scheme became effective and not on the date when the gratuity became payable.
7. Reference was made to CIT v. Sri Ranilakshmi Ginning, Spinning & Weaving Mills (P.) Ltd. [1981] 32 ITR 360 , where there was a dispute regarding a gratuity scheme. An agreement was made on September 7, 1971, between the management and labour by which the scheme was to be implemented with retrospective effect from January 1, 1969. The actuarial valuation was made on December 31, 1970, and the amount was debited in the accounts. It was held that the amount could be allowed as a deduction on the real income principle.
8. As this is a case nearer to the one we have before us, it is useful to analyze the facts further. Though the settlement was reached on September 7, 1971, the liability arose in respect of the employees wh o retired after December 31, 1968. An actuary was employed to determine the liability as it existed on December 31, 1970, which was the last date of the accounting period relevant to the assessment year 1971-72. It may be pointed out that actuarial valuation was made after the settlement had been arrived at, but related to a past period. Though the ITO had rejected the claim, the AAC as well as the Tribunal allowed the same. This case would appear to support the assessed in the present case as it is quite similar on facts.
9. Another case referred to, which was also decided by the Madras High Court, was CIT v. Sitalakshmi Mills Ltd : [1983]141ITR415(Mad) , which was a case of gratuity. It was there observed that where an employer had a gratuity scheme, the employer should obtain a scientific actuarial calculation under which the present discounted value of the gratuity liability is ascertained and then the employer can charge his profit and loss account with the incremental value of the year and make a provision for that amount. It was also observed that a provision for gratuity although charged against current profits, is not an item of expenditure strictly so called, but the deduction is warranted by sound principles of commercial accountancy and such deduction is not prohibited by any of the express provisions relating to business deduction which can be allowed. The principle on which the claim for gratuity could be allowed be deducted was explained.
10. In the above decision of the Madras High Court, reference was made to the case of Vazir Sultan Tobacco Co. Ltd. v. CIT : [1981]132ITR559(SC) , where there are valuable observations regarding gratuity. Although that was a surtax case, the question does not appear to be very different under the Income-tax Act. It was help (p. 574 of 132 ITR) :
'Ordinarily, an appropriation to gratuity reserve will have to be regarded as a provision made for a contingent liability, for, under a scheme framed by a company, the liability to pay gratuity to its employees on determination of employment arises only when the employment of the employee is determined by death, incapacity, retirement or resignation......'
11. It was further observed :
'but the company can work out on an actuarial valuation its estimated liability (i.e., discounted present value of the liability under the scheme on a scientific basis) and make a provision for such liability not all at once but spread over a number of years. It is clear that if by adopting such scientific method any appropriation is made such appropriation will constitute a provision representing fairly accurately a known and existing liability for the year in question; if, however, an ad hoc sum is appropriation without resorting to any scientific basis, such appropration would also be provision intended to meet a known liability, though a contingent one....'
12. The court then observed that any excess liability or provision made over and above the correct amount be treated as a reserve for the purpose of the Surtax Act.
13. Another judgment which was referred to as a parallel case was the decision in noneuch Tea Estate Ltd. v. CIT : [1975]98ITR189(SC) , where the Supreme Court was dealing with the reappointment of a managing agent. The Central Government had approved the same in September, 1970, with effect from April 1, 1956, and the question was whether the liability accrued only after the approval. It was there held that the liability did not arise during the accounting period starting from April 1, 1956, in view of the prohibition to appoint or reappoint a managing agent without agent without the approval of the Central Government, and hence, the amount could be deductible in computing the profits for the period ended on June 30, 1958, i.e., though the remuneration related to an earlier period, it was deductible for the late period because the liability arose only after the Central Government gave its approval.
14. Reference was made to this High Court's decision in Delhi Flour Mills Co. Ltd. v. CIT : [1974]95ITR151(Delhi) , which was a gratuity case. The facts of the case were that there was a settlement between the assessed and its employees on February 14, 1956, providing for gratuity to be paid in certain circumstances. A sum of Rs. 55,712 and Rs. 12,001 was transferred to the Employees' Gratuity Fund as payable for the assessment year 1957-58 and 1958-59. Out of this sum, the ITO allowed Rs. 3,078 in the first year and Rs. 425 in the second year and disallowed the balance. The disallowance was confirmed by the AAC as well as the Tribunal. Referring to a number of decided case, the court came to the conclusion that the amount actually transferred to the gratuity fund by the assessed had to be allowed as a deduction. The contention before the court urged on behalf of the Revenue was that the gratuity was not payable unless there was death or voluntary retirement of an employee and hence liability had not accrued. The court came to the conclusion that the amount was an expenditure which could properly be appropriated at an earlier stage. The court appears to have adopted the point that though the gratuity was payable much later, it accrued during each year of service and, thereforee, on the mercantile system of accounting, a prudent businessman would appropriate the expenditure to the right year.
15. In another case of the Delhi High Court, Escorts (Agents) (P.) Ltd. v. CIT : [1971]80ITR61(Delhi) , the deduction was not allowed on account of the fact that it was not shown as a debit in the books of the assessed. It was held that the deduction could only be allowed if it had been valued or quantified provisionally and actually paid or entered as a debit according to the system of accounts maintained by the assessed. In yet another case decided by the Delhi High Court Dalmia Dadri Cement Ltd. v. CIT [1980] 126 ITR 851, it was held that the present value of the liability referable to the current year on an actuarial basis was an allowable deduction. It is noteworthy that in this case Rs. 52,882 had been debited to the profit and loss account, but the court determined that the actuarially valued liability had to be deducted and this should be done by giving an opportunity to the assessed to establish the extent to which the claim could be allowed during the implementation of the judgment of the court.
16. In a case decided by the Kerala High Court, CIT v. High Land Produce Co. Ltd. : [1976]102ITR803(Ker) , it was held that the liability towards gratuity was deductible but the liability had to be verified.
17. There is, thereforee, no doubt that when, a proper valuation has been made, the deduction can be allowed. But there are some other objections to the gratuity deduction in the present case and it is, thereforee, necessary : to note that the Tribunal had refused the deduction on the ground that the liability was not ascertained on a scientific basis during the previous year and it was not a result of an award, notification, or statute, but it was only on an ad hoc basis. Moreover, the liability accrued after the close of the previous year.
18. We have examined the scheme and particularly rule 18 which seems to have caused some difficulty. The scheme is a simple one; it provides that gratuity is to be paid for every completed year of service. But, the scheme was restricted to those persons who are not entitled to any benefit under the Payment of Bonus Act or the Employee's Provident Funds Scheme of 1952. The objected rule 18 gives the board of directors the power to alter, amend or to add to the rules from time to time. What happened when the scheme was put into operation was that the accrued liability as on December 31, 1970, was determined at Rs. 1,71,496 and the accrued liability as on December 31, 1969, was determined as Rs. 1,55,997 and, thereforee, the liability was worked out, by the ITO, as Rs. 15,499 for the year in question. The earlier amount was disallowed and it is with this earlier amount that we are concerned.
19. The reason for disallowing the amount was that the liability as on December 31, 1969, was Rs. 1,55,997 which did not relate to this particular accounting year. The problem is whether the amount relating to the earlier year can also be claimed in this particular year The cases cited earlier show the principle on which the valuation of the liability has to be done. Undoubtedly, the gratuity amount is accumulated in the account of each member of the scheme from year to year, but is payable only on the date of retirement or death, as the case may be. The gratuity scheme is in reality salary which is not paid to the employee but is retained to be paid in a lump sum on his retirement date. In the event of his death, the accumulated gratuity is to be paid to his heirs. Hence the liability arises from year to year, but is payable much later. There is no difficulty about finding out how much gratuity has accumulated during a particular year, but the difficulty arises at the inception of the scheme. For instance, in the present case, the scheme came into operation on March 31, 1970, but effective from January 1, 1970. This meant that any one of the person covered by the scheme who retired or died after December 31, 1969, became entitled to get the gratuity amount. But as the calculation was based on years of service, some of the liability necessarily had to relate to earlier years. The conclusion of the Tribunal that this amount could not be allowed in this year is inconsistent with the judgment just refereed to. The liability arose only when the scheme came into operation and it become a known liability because it could be calculated on the basis of years of service of the existing members, i.e., employees covered by the scheme. thereforee, the liability, which related to the period before January 1, 1970, also arose in the accounting year in question and, hence, had to be allowed in the same manner as the liability which actually arose during the year. To emphasis the point in a different way, the liability for the accounting year in question was rightly determined to be Rs. 15,499, being the difference between the liability on December 31, 1970, but the remaining amount, i.e., Rs. 1,55,997, was not a liability before the scheme came into operation. Hence, it was also a liability for this year and could only be debited in the accounts for this period. Of course, the amount could be disallowed on some other reason, but not on the ground that it related to an earlier period.
20. It now remains for us to examine the other point mentioned in the 8th paragraph of the Tribunal's order. The point is that the dominion and the control over the funds continued to be vested in the management. Apparently, this is based on rule 17 of the scheme, which reads as follows;
'The administration and management of the gratuity fund shall be vested in the board of directors and all costs, charges and expenses in connection with all or any matters pertaining to the gratuity fund shall be borne and paid by the company.'
21. This rule gives misleading impression in the sense that it appears to show that the fund is being utilised by the company in its own affairs. In fact, rule 14 of the scheme makes the position of the company more clear. That rule states :
'Rule 14. - The company shall not have any lien or charge on the gratuity fund and no moneys belonging to on/or credited to the gratuity fund shall be receivable by the company under any circumstances except as provided in this scheme.'
22. It thus appears that as soon as the amount is credited to the gratuity fund, it is no longer capable of being used by the company for its own purposes. At another place in the scheme, the definition of 'gratuity fund' is given. It is as follows :
'Gratuity Fund. - The fund consisting of any sum or sums specifically provided and set apart by the company for the purpose of payment of gratuity to the members under the scheme.'
23. The other terms of the scheme show that the company has to make an annual contribution in respect of every member and credit the amount to the gratuity fund at the end of the accounting year. Paragraph 10 shows that the initial contribution, etc., will be computed by a competent expert or actuary and the amount shall be debited to the profit and loss account of the relevant accounting year.
24. No doubt, a scheme can be operated by having trustees separately, but it can as well be operated by having board of directors managing the scheme. As soon as the debit is created and the amount credited to the members concerned, it does not appear that it can be said that the scheme was not operating or the right of any member was deferred.
25. As explained in Vazir Sultan Tobacco Company's case : [1981]132ITR559(SC) , by the Supreme Court, a provision in the gratuity scheme can be made on an ad hoc basis or on a scientific basis. No doubt the calculations were deferred till May 24, 1972, when the actuarial valuation was made, but this hardly makes any difference. Even in the other cases referred to above the actuarial valuation was made later, but the amount was allowed as a deduction.
26. In the circumstances, considering the body of case law that has been referred to us, the liability under the gratuity scheme must be considered to arise as soon as the scheme is operated. The calculation of the exact liability can be made earlier or later. We note that in the case of Dalmia Dadri Cement Ltd. v. CIT [1980] 126 ITR 851 , it was held by this court that the actual amount to be allowed under the scheme should be verified. In the present case, the actual amount has been worked out on an actuarial valuation. Even if this valuation was not available the amount would have to be determined on a proper scientific basis by the ITO, but when the calculation is available, the same, although made later, is the basis for allowing the deduction in the year in question.
27. The analysis of the case-law and the facts of the case do not really explain fully the accountancy problem involved in the application of a gratuity scheme as far as the settlement of the company's account is concerned. If there is no gratuity scheme as was the case up to December 31, 1969, in the case of this company, there was no liability to pay anything to any one under the scheme. thereforee, no liability arose before and up to December 31, 1969. The amount of Rs. 1,55,997 which is discussed above as the liability on December 31, 1969, was actually non-existent on the date. It continued to be non-existent till the gratuity scheme was put into operation on March 31, 1970. It was on that date that the company could calculate its liability under the scheme. It could then say : We have not to pay anything to the persons who have retired or died before January 1, 1970. We have only to pay those who retired or die on January 1, 1970, or afterwards. The company could then calculate the liability as it existed. According to the scheme, it could work out the liability for each completed year of service as defined by the scheme, and hence, the liability as on December 31, 1969, could be determined. Similarly, the liability as on December 31, 1970, could be worked out. This had to be verified under the scheme by an actuary. The valuation thus made would determine the liability on these two dates, December 31, 1969 and December 31, 1970. As the fund under the scheme had to remain with the company and was to be treated separately, it could immediately be put down as a debit in the accounts on the mercantile system of accounting. It was know liability and thus could be debited in the accounts. What could be debited in the accounts for the period January 1, 1970, to December 31, 1970, was, (a) the liability under the scheme arising during the accounting period as well as, (b) the liability which related to the previous period ending on December 31, 1969. Though calculated in relation to the previous period as Rs. 1,55,997, it become a liability only during the accounting year in question. The feature of the mercantile system of accounting is that debits and credits can be entered as soon as they are known though no actual payments have been made, nor payment received. The system treats as paid or received, amounts which are yet to be paid and yet to be received. No entry regarding this sum of Rs. 1,55,997 could be made in any earlier period. The entry could only be made as soon as the liability arose, which was on December (March ?) 31, 1970, the date when the gratuity scheme came into operation. It is on this basis that the amount is to be debited to this accounting year and not to any other period. Hence, it is an allowable deduction in this assessment year.
28. On this analysis, the question referred to us has to be answered in the negative, in favor of the assessed and against the Department. As the wording of the question is ambiguous, we make it clear that what we are dealing with is the liability under the gratuity scheme accruing up to December, 31, 1969, because the liability for the year in question has been allowed even by the ITO. The accrued liability for the previous years has also to be allowed in this year. As the point was one of some difficulty, we leave the parties to bear their own costs.