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Tax Alert: Leave Encashment deductible on payment basis – SC upholds constitutional validity

01 May 2020

Background

Section 43B of the Income-tax Act, 1961 (‘IT Act’) allows deduction of expenses only on payment basis. Finance Act, 2001 had inserted clause (f) in section 43B of the IT Act to provide that leave encashment shall be allowed on payment basis only. Prior to introduction of clause (f), deductibility of provision of leave encashment was a contentious tax issue. This dispute was laid to rest by the Hon’ble Supreme Court’s decision in the case of Bharat Earth Movers[1] wherein it was held that the taxpayer can claim the provision for leave encashment in the year in which the liability has accrued even though it has not been finally discharged. With the insertion of clause (f), this decision of the Supreme Court was nullified. However, the constitutional validity of clause (f) was challenged. Recently, Hon’ble Supreme Court[2] pronounced its judgement on the constitutional validity of Section 43B(f) of the IT Act and held that leave encashment, though recognised in the books of accounts on provisional basis, shall be allowed when such sum is actually paid to the employee(s). We, at BDO in India, have summarised the ruling of the Supreme Court and provided our comments on the impact of this decision.

Facts of the case

  • Taxpayer filed a writ petition challenging the constitutional validity of clause (f) in section 43B of the IT Act on following grounds:
    • Section 43B of the IT Act carves out an exception to the general rule of accrual for determination of liability, as it subjects deductions in lieu of certain kinds of liabilities to actual payment. The exception under Section 43B of the IT Act comes into operation only in a limited set of cases covering statutory liabilities like tax, duty, cess etc. and other liabilities created for the welfare of employees and therefore, the liability under the leave encashment scheme being a trading liability cannot be subjected to the exception under Section 43B of the IT Act.
    • The liability covered by clause (f) is of a completely distinct nature and without specifying clear objects and reasons for the inclusion of this liability under Section 43B of the IT Act, it cannot be slipped into the main section. Further, the nature of this liability is neither in sync with the objects and reasons of the original section nor with those of other clauses enacted from time to time in different assessment years.
    • The enactment of clause (f) was driven by the sole consideration of subjugating the legal position expounded by Supreme Court in the case of Bharat Earth Movers without removing the basis thereof. Such enactment would fall foul of the scheme of the Constitution. It would be an inroad into the sphere reserved exclusively for the judiciary and thereby violate the essential principles of separation of powers.
  • The writ was first heard by single judge of High Court who had upheld the constitutional validity of insertion of clause (f). However, on appeal the decision was reversed by the Division Bench of the High Court.
  • Hence, the issue travelled to Hon’ble Supreme Court.

Supreme Court Ruling

The Supreme Court, upholding the constitutional validity of clause (f) in section 43B, observed that:

  • To hold a provision as violative of the Constitution, on account of failure of the legislature to state the objects and reasons, would amount to an indirect scrutiny of the motives of the legislature behind the enactment. Such a course of action is unwarranted
  • The thrust of the provision is not to control the timing of payment, rather, it is strictly targeted to control the timing of claiming deduction in the name of such liability.
  • Section 43B of the IT Act is enacted to provide for deductions to be availed by the taxpayer in lieu of liabilities accruing in previous year without making actual payment to discharge the same. It is not a provision to place any embargo upon the autonomy of the taxpayer in adopting a particular method of accounting, nor deprives the taxpayer of any lawful deduction. It merely operates as an additional condition for the availment of deduction qua the specified head.
  • The decision of Division Bench of the High Court, in the present case, plainly glossed over the fundamental presumption of constitutionality in favour of clause (f) and based its judgment upon the absence of objects and reasons as striking at the root of its validity. This approach is flawed for following reasons.
    • Steers clear from the necessary attempt to discover any constitutional infirmities in the enacted provision.
    • Makes no attempt to dissect the text of the provision so as to display the need to go beyond the text.
    • Goes into the background of the enactment and ventures into a sphere which is out of bounds for the Court as long as the need for interpretation borne out of any ambiguity arises.

Further the Hon’ble Supreme Court also commented that the Hon’ble High Court’s remark that clause (f) was included only to nullify the decision of Bharat Earth Movers is misconceived.

BDO Comments

With the constitutional validity section clause (f) of section 43B of the IT Act upheld, the leave encashment is deductible only on payment basis. Where the taxpayers who had relied on Division Bench of High Court and thereby claimed the deduction on provision basis, should need to revisit the stand taken in light of this decision. The consequential tax impact and way forward in light of this decision may be taken by such taxpayers.


[1] Bharat Earth Movers v. Commissioner of Income-tax (245 ITR 428) (SC)

[2] Union of India v. Exide Industries Ltd. (Civil Appeal No. 3545/2009) (SC)