Supreme Court Upholds Validity of Section 43B(f) of Income Tax Act in Leave Encashment Deductions: Union of India vs. Exide Industries Limited (2020) INSC 305 (24 April 2020)

Date of the Judgment: 24 April 2020
Citation: (2020) INSC 305
Judges: A.M. Khanwilkar, J., Hemant Gupta, J., and Dinesh Maheshwari, J.
The Supreme Court of India addressed a critical question regarding the validity of Section 43B(f) of the Income Tax Act, 1961, which deals with deductions for leave encashment. The core issue was whether this clause, which mandates actual payment for claiming deductions on leave encashment, is constitutionally valid. The three-judge bench unanimously upheld the validity of the clause, reversing the decision of the High Court at Calcutta.

Case Background

The case arose from a dispute regarding the interpretation and application of Section 43B of the Income Tax Act, 1961, specifically clause (f), which was introduced by the Finance Act, 2001, effective from April 1, 2002. This clause stipulates that deductions for leave encashment can only be claimed in the year the payment is actually made, regardless of the accounting method used by the assessee. The respondents, Exide Industries Limited, challenged this clause, arguing it was arbitrary and violated Article 14 of the Constitution of India.

The respondents contended that they followed the mercantile system of accounting, where income and expenditure are determined on an accrual basis, not on actual receipt or payment. They argued that Section 43B, which mandates actual payment for certain deductions, is an exception to this general rule and should not apply to leave encashment, which they consider a trading liability rather than a statutory one. They relied on the Supreme Court’s judgment in Bharat Earth Movers vs. Commissioner of Income Tax, Karnataka [(2000) 6 SCC 645], which held that leave encashment is a present and definite liability, not a contingent one, and thus, deductible in the year it accrues.

Timeline

Course of Proceedings

The constitutional validity of clause (f) was first challenged before a single judge of the High Court, who upheld its validity. The single judge observed that the clause was inserted to curb the abuse of existing law and protect the interests of employees. The judge also stated that the insertion of the clause did not amount to an encroachment upon the powers of the judiciary, but rather a prospective change in the law.

However, on appeal, a Division Bench of the High Court reversed the single judge’s decision, holding clause (f) unconstitutional. The Division Bench argued that no special reasons were disclosed for inserting the clause, that it was inconsistent with the original purpose of Section 43B, and that it was enacted solely to nullify the Supreme Court’s judgment in Bharat Earth Movers. The High Court did not question the power of the legislature to enact the clause, but stated that the legislature must disclose reasons consistent with the Constitution.

Legal Framework

The core legal provisions at play in this case are:

• Section 43B of the Income Tax Act, 1961: This section specifies that certain deductions are allowed only on actual payment. It includes various liabilities such as tax, duty, cess, employer contributions to welfare funds, and, as of the 2001 amendment, leave encashment. It states:
  
  “43B. Certain deductions to be only on actual payment. — Notwithstanding anything contained in any other provision of this Act, a deduction otherwise allowable under this Act in respect of—
  (f) any sum payable by the assessee as an employer in lieu of any leave at the credit of his employee, shall be allowed (irrespective of the previous year in which the liability to pay such sum was incurred by the assessee according to the method of accounting regularly employed by him) only in computing the income referred to in section 28 of that previous year in which such sum is actually paid by him:”
• Section 145 of the Income Tax Act, 1961: This section allows assessees to choose between the cash or mercantile system of accounting. The mercantile system recognizes income and expenses when they accrue, not when they are received or paid. It states:
  
  “145. (1) Income chargeable under the head “Profits and gains of business or profession” or “Income from other sources” shall, subject to the provisions of sub-section (2), be computed in accordance with either cash or mercantile system of accounting regularly employed by the assessee.”
• Article 14 of the Constitution of India: This article guarantees equality before the law and equal protection of the laws within the territory of India.

The Supreme Court also considered the interplay of these provisions with the principles of legislative competence under Article 245 of the Constitution, which grants Parliament the power to make laws for the whole or any part of the territory of India.

Arguments

The arguments presented before the Supreme Court can be summarized as follows:

Respondents’ Arguments (Exide Industries Limited)

• Mercantile System of Accounting: The respondents argued that Section 145 of the Income Tax Act allows them to follow the mercantile system of accounting, which recognizes liabilities on an accrual basis. They contended that Section 43B is an exception to this rule, applicable only to statutory liabilities and employee welfare liabilities, not to trading liabilities such as leave encashment.

• Nature of Leave Encashment Liability: Citing Bharat Earth Movers, the respondents asserted that leave encashment is a present and definite liability, not a contingent one. Therefore, it should be deductible in the year it accrues, not when it is actually paid.

• Inconsistency with Section 43B: The respondents argued that clause (f) is inconsistent with the original intent of Section 43B, which was to prevent evasion of statutory liabilities. They claimed that leave encashment is a trading liability and does not fit within the scope of the section.

• Legislative Overreach: The respondents contended that clause (f) was enacted solely to nullify the Supreme Court’s decision in Bharat Earth Movers, without changing the underlying basis of that judgment. This, they argued, is an encroachment on the judiciary’s domain.

Appellants’ Arguments (Union of India)

• Legislative Competence: The appellants argued that Parliament has the legislative competence to enact clause (f) under Article 245 of the Constitution. They emphasized that the clause does not violate any fundamental rights and is a valid exercise of legislative power.

• Purpose of Section 43B: The appellants contended that Section 43B is designed to prevent tax evasion by ensuring that deductions are claimed only when payments are actually made. They argued that clause (f) was inserted to address a specific mischief: employers claiming deductions for leave encashment without actually paying their employees.

• No Inconsistency: The appellants argued that Section 43B is not restricted to statutory liabilities but includes various types of deductions. They argued that clause (f) is consistent with the overall purpose of the section, which is to regulate deductions to protect public revenue and employee welfare.

• Prospective Change in Law: The appellants stated that the insertion of clause (f) was a prospective change in the law and did not overrule the judgment in Bharat Earth Movers, which was based on the law as it existed at the time.

Submissions Table

Issues Framed by the Supreme Court

The Supreme Court framed the following key issue for consideration:

1. Whether clause (f) of Section 43B of the Income Tax Act, 1961, is constitutionally valid.

Treatment of the Issue by the Court

The following table demonstrates as to how the Court decided the issues

Authorities

The Supreme Court considered the following authorities:

Cases

Legal Provisions

Judgment

How each submission made by the Parties was treated by the Court?

How each authority was viewed by the Court?

• Bharat Earth Movers vs. Commissioner of Income Tax, Karnataka [(2000) 6 SCC 645]: The Court distinguished this case, noting that while it established leave encashment as a present liability, it did not preclude the legislature from regulating deductions prospectively.
• State of Madhya Pradesh vs. Rakesh Kohli & Anr. [(2012) 6 SCC 312]: The Court followed this case to reiterate that a legislative enactment can be struck down only on two grounds: lack of legislative competence or violation of fundamental rights.
• Bhanumati & Ors. vs. State of Uttar Pradesh & Ors. [(2010) 12 SCC 1]: The Court followed this case to support the two-fold approach for examining the validity of a provision.
• State of Andhra Pradesh & Ors. vs. Mcdowell & Co. & Ors. [(1996) 3 SCC 709]: The Court followed this case to support the two-fold approach for examining the validity of a provision.
• Kuldip Nayar & Ors. vs. Union of India & Ors. [(2006) 7 SCC 113]: The Court followed this case to support the two-fold approach for examining the validity of a provision.
• State of Tamil Nadu & Ors. vs. K. Shyam Sunder and Ors. [(2011) 8 SCC 737]: The Court followed this case to highlight that objects and reasons are useful for understanding the intent of the legislature but are not essential for the validity of a provision.
• State of West Bengal vs. Union of India [AIR 1963 SC 1241]: The Court followed this case to emphasize that the Statement of Objects and Reasons cannot be used to determine the true meaning of a statute.
• Sanjeev Coke Manufacturing Company vs. Bharat Coking Coal Limited and Anr. [(1983) 1 SCC 147]: The Court followed this case to state that the Court is the only authentic voice to interpret the Parliament’s intent.
• K.C. Gajapati Narayan Deo & Ors. vs. The State of Orissa [(1954) SCR 1]: The Court followed this case to state that if the legislature is competent to pass a law, the motives behind it are irrelevant.
• Anant Mills Co. Ltd. vs. State of Gujarat & Ors. [(1975) 2 SCC 175]: The Court followed this case to state that the legislature has a larger discretion in the matter of classification in taxation laws.
• Welfare Association. A.R.P., Maharashtra and Anr. vs. Ranjit P. Gohil and Ors. [(2003) 9 SCC 358]: The Court followed this case to state that the legislature cannot directly overrule a judicial decision but can render it ineffective by removing the base on which the decision was rendered.
• Indian Aluminium Co. and Ors. vs. State of Kerala and Ors. [(1996) 7 SCC 637]: The Court followed this case to state that the legislature can render a judicial decision ineffective by fundamentally altering the conditions on which it was based.
• State of T.N. vs. Arooran Sugars Ltd. [(1997) 1 SCC 326]: The Court followed this case to state that the legislature can remove defects pointed out by the court or amend provisions retrospectively.
• State of Tamil Nadu vs. MK Kandaswamy [(1975) 4 SCC 745]: The Court followed this case to state that remedial statutes should be interpreted to preserve their workability and efficacy.
• United States vs. Butler et al. [297 US 1 (1936)]: The Court followed this case to state that courts are concerned only with the power to enact statutes, not with their wisdom.

What weighed in the mind of the Court?

The Supreme Court’s decision was primarily influenced by the following:

• Legislative Competence: The Court emphasized that the Parliament has the power to enact laws on matters within its legislative field, as long as such laws do not violate the Constitution.
• Presumption of Constitutionality: The Court reiterated that there is a presumption in favor of the constitutionality of a law, and the burden is on those challenging it to prove its unconstitutionality.
• Mischief Rule: The Court applied the mischief rule, noting that clause (f) was enacted to address the problem of employers claiming deductions for leave encashment without actually making payments to employees.
• Public Interest: The Court acknowledged that the clause serves public interest by preventing tax evasion and protecting the welfare of employees.
• No Violation of Fundamental Rights: The Court found that clause (f) did not violate any fundamental rights and was a valid exercise of legislative power.
• Prospective Application: The Court clarified that the clause was a prospective change in the law and did not overrule the judgment in Bharat Earth Movers, which was based on the law as it existed at the time.

The Court’s reasoning was also influenced by the fact that Section 43B includes various types of deductions, not just statutory ones, and that the legislature has a wide discretion in matters of taxation. The Court also emphasized that the absence of a stated objective and reason does not invalidate a statute if the text is clear and unambiguous.

Logical Reasoning

The Court’s decision was unanimous, with all three judges agreeing on the validity of clause (f). The Court analyzed the arguments presented by both sides and found that the clause was a valid exercise of legislative power, aimed at preventing tax evasion and protecting employee welfare. The Court also clarified that the clause was a prospective change in the law and did not overrule the judgment in Bharat Earth Movers.

The Supreme Court quoted the following from the judgment:

“The existence of Section 43B traces back to 1983 when the legislature conceptualised the idea of such a provision in the 1961 Act.”

“Section 43B is a mix bag and new and dissimilar entries have been inserted therein from time to time to cater to different fiscal scenarios, which are best determined by the government of the day.”

“The mischief sought to be remedied by this clause, as discussed above, clarifies the position.”

The Court rejected the argument that clause (f) was enacted solely to defeat the judgment of the Supreme Court in Bharat Earth Movers. The Court emphasized that the legislature has the power to amend laws prospectively and that the insertion of clause (f) was a valid exercise of this power.

Key Takeaways

• Validity of Section 43B(f): The Supreme Court upheld the constitutional validity of Section 43B(f) of the Income Tax Act, 1961.
• Actual Payment for Deductions: Deductions for leave encashment can only be claimed in the year the payment is actually made, regardless of the accounting method used by the assessee.
• Legislative Power: Parliament has the power to regulate deductions and amend laws prospectively.
• Protection of Revenue and Employee Welfare: The clause serves to prevent tax evasion and protect the interests of employees.
• No Overruling of Bharat Earth Movers: The judgment in Bharat Earth Movers was not overruled, but the law was amended prospectively to regulate deductions.

Directions

No specific directions were given by the Supreme Court in this judgment.

Development of Law

The ratio decidendi of this case is that Section 43B(f) of the Income Tax Act, 1961, is constitutionally valid. This judgment clarifies that the legislature has the power to regulate deductions prospectively, even if it affects the interpretation of a previous judgment. It also reinforces the principle that the legislature has wide discretion in matters of taxation and that the absence of a stated objective and reason does not invalidate a statute if the text is clear and unambiguous. This case does not change the previous position of law as laid down in Bharat Earth Movers, but it regulates the deductions prospectively.

Conclusion

The Supreme Court’s decision in Union of India vs. Exide Industries Limited (2020) is a significant ruling that clarifies the legal position regarding deductions for leave encashment under the Income Tax Act. The Court’s upholding of the validity of Section 43B(f) reinforces the legislative power to regulate deductions and ensures that such deductions are claimed only when payments are actually made. This ruling has a significant impact on businesses and their accounting practices, as it requires them to align their deduction claims with actual payments made to employees for leave encashment.