Article
Principles for Allowability of Prior Period Expenditure in Income Tax Assessment
1. Introduction:
The treatment of prior period expenditure has long been a contentious subject under Indian income-tax law. The core issue stems from the mercantile system of accounting, which mandates that expenses be booked in the year to which they pertain. However, in practice, liabilities are often discovered, quantified, or crystallized in subsequent years, leading to disputes as to whether such claims should be allowed in the later year or disallowed as pertaining to an earlier period.
The Department frequently resists such claims on the ground that permitting prior period expenses against current income distorts annual computation. Conversely, assessees argue that since liability can only be deducted when it crystallizes into an ascertained obligation, denial of deduction would be contrary to commercial principles and settled jurisprudence. The courts have, over time, evolved guiding principles that balance the doctrine of real income, the rule of crystallization of liability, and the matching concept of accounting.
This article seeks to consolidate the principles relating to prior period expenditure, examine case law trends, and articulate doctrinal tests for allowability, with reference to statutory provisions such as Section 37(1) of the Income-tax Act, 1961.
2. Conceptual Foundation:
2.1 Meaning of Prior Period Expenditure: “Prior period expenditure” refers to expenses that pertain to earlier years but are claimed in the current year’s profit and loss account. The dispute arises because while the mercantile system requires booking in the year to which the expense relates, practical realities often result in belated crystallization.
2.2 Crystallization Principle: The fundamental test is that liability is deductible only when it crystallizes. As explained in Bharat Earth Movers v. CIT [2000] 245 ITR 428 (SC), if a business liability has arisen in the accounting year, deduction should be allowed, even if it has to be quantified later. Conversely, a contingent liability cannot be claimed.
2.3 Symmetry Between Income and Expenditure: While the Department tends to allow taxation of prior period income when offered, but disallow prior period expenses, courts have emphasized parity in treatment, subject to crystallization. This ensures a fair determination of real income.
3. Statutory Basis:
3.1 Section 37(1): General residuary deduction for business expenditure, provided it is not capital or personal and incurred wholly and exclusively for business. The timing of the claim hinges on crystallization.
3.2 Accounting Standards (AS 5/Ind AS 8): Require separate disclosure of prior period items but do not per se disallow them.
3.3 Judicial Interpretation: Courts have repeatedly stressed that accrual under mercantile system occurs when liability becomes certain and enforceable, not merely when relating to an earlier year.
4. Judicial Precedents:
4.1 Liability Must Crystallize in the Relevant Year:
i. In SRF Ltd. v. DCIT [2009] 34 SOT 1 (Delhi - Trib.), the Tribunal held that expenses such as travel claims, audit fees, and repairs relating to earlier years but billed in the current year crystallized in that year, hence allowable
ii. Similarly, in State Bank of Bikaner & Jaipur v. ACIT [2016] 69 taxmann.com 365 (Jaipur - Trib.), the bank’s prior period expenses were allowed because they crystallized during the year and genuineness was not disputed
4.2 Mere Relating to Earlier Years is Not Fatal
i. Tata Communications Ltd. v. JCIT [2013] 32 taxmann.com 197 (Mumbai - Trib.) allowed OFC charges pertaining to earlier years because the Department of Telecom bill was received in the current year, making liability crystallize then
ii. ACIT v. Indian Farmer Fertilizer Cooperative Ltd. [2012] 21 taxmann.com 179 (Delhi - Trib.) reiterated that onus lies on the Assessing Officer to determine crystallization; merely being of earlier years does not bar deduction
4.3 When Evidence is Lacking, Disallowance Justified
i. In U.P. State Bridge Corporation Ltd. v. DCIT [2015] 62 taxmann.com 61 (Lucknow - Trib.), the Tribunal disallowed prior period expenses as the assessee failed to provide evidence of crystallization
ii. JCL Electromet (P.) Ltd. v. Addl. CIT [2017] 83 taxmann.com 250 (Jaipur - Trib.) similarly held that unsubstantiated claims of prior period expenditure cannot be allowed
4.4 Matching Concept and Percentage Completion Method
i. In DDIT v. Stork Engineers & Contractors B.V. [2010] 127 ITD 211 (Mum), the Tribunal held that when income of an entire project is considered (including pre-establishment period), expenses attributable to the project must also be deducted, even if relating to earlier periods, in line with the matching concept
4.5 Distinction Between Contingent and Ascertained Liability
i. Mazagaon Dock Ltd. v. ITO emphasized that only ascertained liabilities can be deducted; contingent ones cannot .
ii. Bharat Earth Movers v. CIT (SC) remains the leading authority distinguishing between provisions for accrued liabilities (deductible) and contingent liabilities (not deductible).
4.6 Doctrinal Tests for Allowability: Based on jurisprudence, the following tests emerge:
4.7 Crystallization Test – Was the liability ascertained and enforceable in the current year?
Evidence Test – Has the assessee substantiated the claim with bills, correspondence, or statutory orders?
Business Purpose Test – Was the expenditure wholly and exclusively for business, not penal or personal?
Matching Test – Where project revenue is considered on a composite basis, corresponding costs of earlier periods must also be deducted.
Consistency Test – If the Department has allowed similar claims in earlier years (e.g., recurring items), consistency should apply.
Symmetry of Treatment – Income of prior periods, when taxed, justifies allowing prior period expenditure under parity.
5. Critical Analysis of Key Cases:
5.1 SRF Ltd. v. DCIT: This case illustrates the practical reality of business expenditure. Even though the assessee followed mercantile accounting, the Tribunal recognized that liabilities crystallize only upon receipt and approval of claims. Disallowing them as prior period would be unjust, as the liability was not enforceable earlier.
5.2 State Bank of Bikaner & Jaipur: Here, the Tribunal stressed that in large organizations with multiple branches, expenses may be discovered after book closure. The principle of crystallization protects assessees from unfair disallowance, provided genuineness is not disputed.
5.3 U.P. State Bridge Corporation Ltd.: This case highlights the flip side—where substantiation is absent, claims cannot be mechanically allowed. The burden is on the assessee to show crystallization; otherwise, the Department’s skepticism is justified.
5.4 Tata Communications Ltd.: The Tribunal here stressed on the date of receipt of the bill from DOT as the relevant trigger. This reinforces that prior period does not automatically mean inadmissible; the decisive factor is when liability legally arises.
5.5 Practical and Policy Considerations:
i. Administrative Efficiency: Disputes often arise because assessees do not maintain detailed documentation of crystallization. Clearer disclosures and notes in accounts can reduce litigation.
ii. Revenue Neutrality: Over multiple years, allowing or disallowing prior period expenses may have limited net effect, but litigation costs are high.
iii. Judicial Balance: Courts have struck a middle path: protecting genuine claims crystallizing late while preventing misuse through unverifiable adjustments.
6. Principles for Allowability or Disallowability of Prior Period Expenditure:
6.1 Principle of Crystallization of Liability:
Core Idea: Expenditure is deductible in the year in which liability crystallizes (i.e., becomes ascertained, enforceable, and certain), irrespective of the year to which it relates.
Case Law:
i. Bharat Earth Movers v. CIT [2000] 245 ITR 428 (SC) – A present liability, even if quantification/payment is deferred, is deductible.
ii. SRF Ltd. v. DCIT [2009] 34 SOT 1 (Delhi - Trib.) – Claims raised/bills received in the current year crystallized the liability, hence allowable in that year.
iii. Tata Communications Ltd. v. JCIT [2013] 32 taxmann.com 197 (Mumbai - Trib.) – DOT bill for OFC charges received in current year; liability crystallized then, deduction allowed
iv. State Bank of Bikaner & Jaipur v. ACIT [2016] 69 taxmann.com 365 (Jaipur - Trib.) – Expenses crystallized during the year; genuineness not doubted, deduction allowed
Principle: The decisive factor is the year of crystallization, not the year to which expense relates.
6.2 Requirement of Substantiation:
Core Idea: The assessee bears the onus of proving that the liability indeed crystallized in the year of claim. Mere book entries are not sufficient.
Case Law:
i. U.P. State Bridge Corporation Ltd. v. DCIT [2015] 62 taxmann.com 61 (Lucknow - Trib.) – Disallowed because assessee failed to furnish evidence that liability crystallized in the impugned year
ii. JCL Electromet (P.) Ltd. v. Addl. CIT [2017] 83 taxmann.com 250 (Jaipur - Trib.) – Unsupported claim of prior period expenses not allowed
iii. Lupin Ltd. v. ACIT [2016] 70 taxmann.com 8 (Mumbai - Trib.) – Burden is on assessee to prove crystallization.
Principle: Substantiation with bills, orders, or correspondence is essential; absence of evidence leads to disallowance.
7. Matching Principle in Project Accounting:
Core Idea: Where income of an entire project (including earlier years) is taxed on percentage completion or composite basis, corresponding expenses must also be matched, even if pertaining to prior years.
Case Law:
i. DDIT v. Stork Engineers & Contractors B.V. [2010] 127 ITD 211 (Mumbai) – If receipts from the entire project are taken into account, then expenses from earlier periods forming part of project cost must be allowed
Principle: Under project/percentage completion method, matching of revenue and cost prevails over strict annuality.
7.1 Distinction Between Accrued vs. Contingent Liability:
i. Core Idea: Deduction cannot be claimed for contingent liabilities; only accrued/ascertained liabilities are deductible.
ii. Case Law:
i. Mazagaon Dock Ltd. v. ITO – Only ascertained liabilities deductible; contingent ones disallowed.
ii. Bharat Earth Movers v. CIT (SC) – Deduction is permissible if liability has arisen, even if quantification/payment deferred.
Principle: Contingent liabilities = disallowable; accrued/crystallized liabilities = allowable.
7.2 Symmetry Between Income and Expenditure:
i. Core Idea: If income relating to prior years is taxed in current year when offered, prior period expenses crystallizing in current year should also be allowed.
ii. Case Law:
i. State Bank of Bikaner & Jaipur (supra) – Tribunal stressed parity in treatment; income taxed on due/receipt basis, hence expenses crystallized allowed
ii. Indian Farmer Fertilizer Co-operative Ltd. v. ACIT [2012] 21 taxmann.com 179 (Delhi - Trib.) – Held that AO must inquire into crystallization; merely prior period tag does not justify rejection
Principle: Consistency and fairness require symmetry of treatment for income and expenditure.
7.3 Role of Auditor’s Report and Accounting Standards
i. Core Idea: Disclosure of prior period items in audit report/AS 5 does not bar deduction; it only ensures transparency. What matters is the timing of crystallization.
ii. Case Law: State Bank of Bikaner & Jaipur – Auditor’s note that expenses belonged to earlier period did not affect allowability since crystallization occurred in current year
Principle: Auditor’s disclosure ≠ disallowance; it only aids verification.
7.4 Consistency with Past Years
i. Core Idea: If similar expenses were allowed in earlier years, Revenue cannot take a contrary view without change in facts.
ii. Case Law: U.P. State Bridge Corporation Ltd. (supra) – Applied rule of consistency in other expense heads (though prior period expenses disallowed here for lack of proof)
Principle: Past acceptance of treatment creates a presumption of consistency unless facts materially differ.
8. Statutory or Third-Party Determination:
i. Core Idea: Liability crystallizes when statutory authority or third party (supplier, government department) quantifies demand.
ii. Case Law:
i. Tata Communications Ltd. – Liability arose on receipt of DOT bill.
ii. Sourashtra Cement & Chemical Industries Ltd. v. CIT [1995] 213 ITR 523 (Guj.) – Statutory order triggering liability makes it deductible in year of order
Principle: Demand/order from statutory or contractual authority fixes liability in that year.
9. Consolidated Principles:
i. Year of crystallization is decisive – not the period to which the expense relates.
ii. Onus on assessee to substantiate crystallization with evidence.
iii. Matching principle applies in project accounting – income and expenses must correspond.
iv. Contingent liabilities disallowed; accrued liabilities allowed.
v. Symmetry required – prior period income taxed, prior period expenses crystallized must be allowed.
vi. Disclosure in audit reports does not negate allowability.
vii. Consistency rule – treatment in earlier years relevant.
viii. Third-party/statutory demand fixes the year of crystallization.
In short, prior period expenditure is not per se inadmissible. It is allowable in the year in which liability crystallizes, is substantiated, and is genuine, regardless of the period to which it relates.
10. Conclusion: The jurisprudence on prior period expenditure reflects a consistent judicial effort to uphold fairness in tax administration. The settled principle is that expenses must be allowed in the year of crystallization, irrespective of the year to which they relate. However, the onus lies on the assessee to substantiate crystallization with credible evidence.
Thus, the following propositions emerge:
i. Prior period expenses are not per se inadmissible.
ii. Allowability hinges on crystallization, evidence, and genuineness.
iii. Contingent liabilities are not deductible; accrued and ascertained liabilities are.
iv. Symmetry in treatment of income and expenditure must be maintained.
v. Courts consistently balance strict accounting rules with business realities to arrive at real income taxation.