Unsettled Claims As Well As IBNR Would Amount To Contingent Liabilities; Section 37 Deduction Allowable: Delhi High Court

The Delhi High Court has held that the deduction under Section 37 of the Income Tax Act is allowable on unsettled claims as well as Incurred But Not Reported (IBNR), which would amount to contingent liabilities.

The bench of Justice Yashwant Varma and Justice Purushaindra Kumar Kaurav has observed that if the historical trend indicates that a large number of sophisticated goods were being manufactured in the past and if the facts established show that defects existed in some of the items manufactured and sold, then the provision made for warranty in respect of the army of such sophisticated goods would be entitled to deduction from the gross receipts under Section 37 of the 1961 Act. It would all depend on the data systematically maintained by the assessee.

Section 37 of the Income Tax Act states that any business expenditure, excluding capital expenditure and the individual's personal expenses, that is spent or set out solely and entirely for the business's operations shall be eligible for deduction.

The appellant, the Principal Commissioner of Income Tax, has challenged the ITAT's order. The ITAT deleted the disallowance of provision for unsettled claims outstanding as of March 31st, ignoring that the amount is shown as a provision in the books of account of the assessee and can be allowed in the year when it materializes. The department submitted that ITAT erred in deleting the disallowance on account of the provision for unlogged claims, ignoring that this provision was purely on an ad hoc basis and the assessee was already allowed a special provision in terms of Rule 6E of the Income Tax Act.

The principal questions that arise pertain to the provisions made for “unsettled outstanding claims” and the alleged but not reported claims. For the years in question, the Assessing Officer had held that both the provision for unsettled claims as well as IBNR would amount to contingent liabilities and thus could not be validly claimed under Section 37 of the Income Tax Act, 1961.

Insofar as outstanding or unsettled claims are concerned, the Tribunal took note of the contention of the respondent-assessee that the provision for unsettled claims cannot be viewed as being ad hoc or an estimate since they record all outstanding claims to the extent lodged by policy holders. It is on the basis of the claims so lodged that the respondent appears to have made appropriate provisions in its books of account. It was asserted before the Tribunal that while the quantification or adjudication of the claim may happen subsequently, it would only have an impact in the subsequent period and that such post facto circumstances, which were not envisaged, would not warrant the same being viewed as a contingent liability. The assessee also appears to have contended that once the claim comes to be lodged by the policyholder, it is only an exercise of verification and quantification that remains.

The assessee contended that IBNR reserves are created by general insurers based on an actuarial exercise that is undertaken in accordance with one of the stipulated methods noticed in Clause 4. It is thus an empirical estimation for claims on the basis of an identified predictive methodology that, in the opinion of the general insurer, has already been incurred but may not have been reported at the time when a provision is made. The procedure has been historically followed in the general insurance business.

The court, while upholding the Tribunal's order, held that as long as a liability is properly ascertainable on the basis of empirical data or a known methodology, the same cannot possibly be held to be a contingent liability.

Counsel For Appellant: Prashant Meharchandani

Counsel For Respondent: Ajay Vohra

Case Title: Principal Commissioner Of Income Tax 1 Versus M/S Care Health Insurance Limited

Citation: 2024 LiveLaw (Del) 707

Case No.: ITA 304/2024

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