Direct Tax Alert

Background:

The insurance companies are required to create a specific provision incurred but not reported (IBNR) in their books of accounts in accordance with the Insurance Regulatory Development Authority of India (IRDAI) Regulations¹. These provisions are made basis the of scientific calculations and are “ascertained liability’ in the books of accounts as per the specified regulations.

However, the tax authorities have considered it an unascertainable liability and accordingly disallowed the amount as contingent liabilities not eligible to be claimed as a deduction under Section 37 of the Income-tax Act, 1961 (IT Act).

In this regard, recently the Delhi High Court² has held that the provision made for outstanding unsettled claims cannot be termed as ad hoc merely because of the fact that these claims are to be adjudicated subsequently. Further, with respect to the IBNR claims, the Hon’ble High Court concluded that the provision made in respect of IBNR is an ascertainable liability and hence, it cannot be considered as a contingent liability. Thereby, deductions under Section 37 of the IT Act was allowed to the taxpayer.

We, at BDO in India, have summarised the above ruling and have provided our comments on the impact of this decision hereunder.

Facts of the Case:

• The taxpayer is a health insurance company registered with the IRDAI.
• The taxpayer had created provisions for ‘unsettled outstanding claims’ and IBNR in the books of accounts in accordance with IRDAI regulations. Further, the taxpayer had not made any adjustments with respect to the same while computing the income as per the provisions of the Act.
• The Tax Authorities contended that the aforesaid provisions are contingent in nature and have not been crystallised during the year under consideration. Furthermore, the Tax Authorities held that the provision made on an ad hoc basis was already allowed subject to the limits specified under Rule 6E of the Income-tax Rules, 1962 (IT Rules). The Tax Authorities added the provisions while assessing taxable Income under the provisions of the IT Act.
• Aggrieved by the additions, the Taxpayer preferred an appeal before the First-Appellate Authority which deleted the additions made on account of the above-mentioned arguments.
•  Further aggrieved, the Tax Authorities, filed an appeal before the Delhi Tax Tribunal which dismissed the contention of the Tax Authorities and held that the provision for unsettled claims cannot be construed as an ad hoc estimate. The Delhi Tax Tribunal relied on the judicial precedent laid down in the case of DCIT vs. National Insurance Co Ltd³ wherein IBNR was considered to be an ascertained liability.
• Aggrieved by the order of the Tax Tribunal, the Tax Authorities, have preferred an appeal before the Delhi High Court which made the following observations while ruling in favour of the taxpayer:

Delhi High Court Ruling:

• In respect of unsettled claims, quantification or adjudication of the claim may happen subsequently, the same would only have an impact in the subsequent period and that such adjustments would not warrant the same being viewed as a contingent liability.
• IBNR provision was based upon historical trends and actuarial methods for estimation. Furthermore, these methods were in accordance with the regulations laid down by IRDAI. In light of the same, the IBNR could not be considered to be a contingent liability.
• Reliance is placed on the Supreme Court's (SC) judgement in the case of Rotork Controls⁴, wherein the concept of ‘provision’ has been elaborated, which indicates a'substantial degree of estimation’ while creating provisions in the books of accounts.
• Reliance is also placed on jurisdictional High Court decision in the case of Whirlpool India⁵ wherein it was held that additional provision for warranty made in the subsequent year was not a contingent liability as such provision was made based on estimated historical data and actuarial methods;
• 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.

BDO in India Comments:

The decision of the High Court brings a sigh of relief for the insurance industry. The High Court has elaborately dealt with the issue on hand by carrying out a detailed analysis of the relevant provisions under the tax and regulatory laws. This decision affirms that when such provisions are created based on scientific principles and actuarial valuation while preparing the financial statements as per IRDAI guidelines, they cannot be construed to be contingent liabilities based on the fact that they are going to be subsequently adjusted. Since these provisions are quantifiable, they, qualify for the claim of deduction under section 37 of the IT Act. Moreover, this ruling will also have a positive impact on the Minimum Alternate Tax calculations, wherein these provisions are considered ad hoc and/or contingent in nature.
 

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¹ Insurance Regulatory and Development Authority of India (Assets, Liabilities and Solvency Margin of General Insurance Business) Regulations, 2016
² Principal Commissioner of Income Tax v. M/S Care Health Insurance Limited [TS-386-HC-2024(DEL)]
³ IT APPEAL NOS. 674, 982 & 983 (KOL.) OF 2012
⁴ Rotork Controls India Private Limited. vs. Commissioner of Income Tax, Chennai {2009 (13 SCC 283)
⁵ The Commissioner of Income Tax vs. Whirpool of India Ltd (2011 DHC 394 DB)