Facts of the Case

·         The reference relates to the Assessment Year 1976-77.

·         The assessee, M/S Kwality Ice Cream, strictly followed the mercantile system of accounting.

·         Initially, there was a dispute regarding whether ice cream sold by the assessee was exigible to sales tax. The Delhi High Court, vide its judgment dated March 27, 1974, ruled that the ice cream manufactured and sold by the assessee was not exigible to sales tax.

·         Aggrieved by the judgment, the Revenue preferred an appeal before the Supreme Court of India. While this appeal was pending (ultimately decided on September 6, 1995, affirming the High Court's view), the assessee created a provision of Rs. 1,01,507/- for sales tax in its books during the previous year relevant to AY 1976-77.

·         Additionally, the assessee received a refund of sales tax amounting to Rs. 3,22,482/- during the relevant year.

Issues Involved

1.      First Part: Whether the sales tax refund of Rs. 3,22,482/- received by the assessee during the relevant year was chargeable to tax.

2.      Second Part: Whether the provision of Rs. 1,01,507/- made for sales tax during the pendency of the Revenue’s appeal before the Supreme Court was a permissible deduction or chargeable to tax for AY 1976-77.

Petitioner’s (Revenue) Arguments

·         Regarding the provision of Rs. 1,01,507/-, the learned counsel for the Revenue argued that creating such a provision was completely unwarranted.

·         The Revenue contended that since the High Court had already explicitly declared that no sales tax was payable on the sale of ice cream, and because the Supreme Court did not grant any stay on the operation of that judgment, there was no active liability.

·         Consequently, they argued that since no sales tax was legally payable during the relevant previous year, no provision should have been accounted for or deducted.

Respondent’s (Assessee) Arguments

·         The learned counsel for the Assessee relied heavily on the landmark Supreme Court ruling in Kedarnath Jute Manufacturing Co. Limited v. Commissioner of Income Tax [1971] 82 ITR 363. They argued that under the mercantile system, the obligation to pay sales tax arises the moment a dealer executes a purchase or sale of a commodity.

·         The Assessee maintained that liability is independent of final assessment or quantification. The liability does not cease to exist merely because it is being disputed in court. So long as the Revenue's appeal was dynamically pending before the Supreme Court, the legal hazard and liability remained accrued for the assessee.

·         They further cited J.K. Synthetics Limited v. O.S. Bajpai, ITO [1976] 105 ITR 864 (Allahabad HC), which was upheld by the Supreme Court in Union of India v. J.K. Synthetics Limited [1993] 199 ITR 14, establishing that creating a provision under such circumstances does not prejudice the Department.

Court Findings & Order

On the First Part (Sales Tax Refund of Rs. 3,22,482/-):

The counsel for both parties mutually agreed that in view of the Supreme Court precedent in Polyflex (India) Pvt. Limited v. Commissioner of Income Tax [2002] 257 ITR 343 (SC), this question must be answered in the affirmative—meaning it is chargeable to tax, thereby ruling in favor of the Revenue and against the assessee.

On the Second Part (Sales Tax Provision of Rs. 1,01,507/-):

·         The High Court observed that because the Revenue had appealed the 1974 order to the Supreme Court, the liability had not definitively ceased from the perspective of an assessee maintaining mercantile records.

·         The Court highlighted the safeguarding mechanism of Section 41 of the Income Tax Act. Under Section 41, if an assessee obtains any subsequent benefit, remission, or cessation regarding a trading liability that was previously allowed as a deduction, that exact amount is legally deemed to be profits and gains of business in the year of cessation/remission.

·         Therefore, there is absolutely no loss of revenue to the Department. Since the Supreme Court ultimately dismissed the Revenue's appeal on September 6, 1995 (affirming no sales tax was due), the Revenue retains full authority to tax the entire provided amount of Rs. 1,01,507/- in the Assessment Year 1996-97.

·         As a result, the second part of the question was answered in the negative—in favor of the assessee and against the revenue. The reference was disposed of accordingly.

Important Clarification

Under the mercantile system of accounting, a tax liability continues to accrue and remains deductible as long as its validity is being actively litigated in higher forums (such as a pending appeal in the Supreme Court). The Revenue is fully protected against tax loss by Section 41 of the Income Tax Act, which permits taxing the provisioned amount as income in the specific assessment year when the dispute concludes and the liability officially ceases or is remitted.


Section Involved

·         Section 256(1) of the Income Tax Act, 1961 (Reference to the High Court)

·         Section 41 of the Income Tax Act, 1961 (Profits chargeable to tax / Remission or cessation of trading liability)


Link to download the order -

https://delhihighcourt.nic.in/app/case_number_pdf/2007:DHC:1041-DB/SMD03092007ITR5531983.pdf


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