Normal & Abnormal Losses: and some relevant decisions from courts

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When a taxman comes with the recovery/loss related assessment on a business, a businessman rightly has an important question in his mind. He wonders, why does the taxman gets to dictate the recovery/loss related figures of my business? A simple input-output ratio is not the only variable with which my business runs. And the businessman has a point, a fair point.

A typical production processes

Before understanding the concept of normal losses, normal recovery rates and abnormal losses we need to understand how exactly a typical production process operates.

Let’s take an example of a pickle industry:
The entity obtained 100,000 kg of cucumbers from the farmers at the price of 100 NPR per kg. Cucumbers gets cut and some parts that do not meet the criteria gets discarded. The entity was able to salvage 80,000 kg of cucumbers that could actually be forwarded to pickling process, the rest had to be discarded and disposed. Then they are salted and pickled and packaged in the pickle jar consisting of 1 kg pickle each. Labor cost throughout this process adds up to 5,000,000 NPR. The salting and pickling cost are 1,500,000 NPR. The pickle jar costs NPR 10 per unit. After the pickle is packed in the jar, a quality test machine checks for the quality of the bottle and pickle, where a certain percentage of the jars gets rejected and they are discarded wholly. Some jars also get burst/damaged in the handling and packaging process. These losses accounted for around 2% of the total jar output. Due to a fire accident in the assorting machine: 7,000 jars of bottles got damaged and wasted. Compute the normal loss and abnormal loss. 

Particulars

Units in Kg

Cost in NPR

Add: Purchase of Cucumbers

100,000

10,000,000

Less: Normal discards during cutting process

(20,000)

Add: Labor Cost

 

5,000,000

Add: Salting and Picking Cost

 

1,500,000

Add: Pickle Jar Cost (80,000 × 100)

 

800,000

Less: Rejections by quality test machine and bursts/damages in the handling process (80,000 × 2%)

(1,600)

Total Costs

78,400

17,300,000

Less: Abnormal Loss (17,300,000/78,400 × 7000)

(7,000)

(1,544,643)

Cost of Production

71,400

15,755,357

As per the computation table above the cost of normal loss is not separately computed as it forms the cost of the production itself. So, the reduction of normal loss only from the units leads to the increase on the cost of production. However, abnormal loss of 7000 units causes the loss of pickle, labor and jars cost incurred till the point of packing. Cost of abnormal loss is computed and separately reported in the profit and loss account but not disclosed as the cost of production in computing the gross profits.

As can be observed from the example above, normal or abnormal losses can occur at any stage of production and as many times as per the nature of the business. In the above example the entity has been able to recover 80% of the initial raw input and later it was reduced to 78% due to additional 2% loss incurred in the quality test and handling process. So, the meaning of this is that the total normal losses accounted for 22% of the initial input and the entity is operating in 78% recovery rate. So, the term normal loss and recovery rate indicates the same metrics but only as a contra picture of each other. Abnormal losses on the other hand are never within the control of the entity. As in the above example the loss was caused due to the fire hazard in the assorting machine which of course was not within the control of the entity. Further, abnormal losses cannot be reasonably estimated in advance.

Normal Losses and Normal Recovery

To recap, normal Loss is a loss that takes place due to the inherent nature of the raw materials and process of production under ordinary circumstances. Because normal losses are inherent in nature it constitutes the normal cost of the production of the business. A reasonable estimate of the normal loss therefore can be expected beforehand, based on the past experience. Normal losses cannot be avoided due to the inherent nature of the production process. There are instances when at the time of the production process some quantity of material is lost, which is named as spoiled units, shrinkage, rusting, or evaporation. Such losses can neither be eliminated nor reduced, irrespective of the operating conditions. As discussed above normal losses constitutes the cost of production. There is no point in discussing the deductibility of the normal losses as it is never separately presented.

Normal loss should be allowed for deduction as it is always a cost of the production, and this is true and allowed even under the tax laws. But sometimes, some sensitive industries are allowed remission for only a certain percentage of the losses in the specific production process or sometimes the recovery rate of the items are specified by the regulators and if the industry fails to achieve that production unit from utilizing the raw materials the entity will be deemed as having made the product non the less and assessed to their income. In context of Nepal:

  1. Distilleries have to comply with the specific recovery rate
    (The quantity of the alcohol they need to produce from consuming a certain quantity of molasses is prespecified)
  2. Distilleries and Breweries will be allowed remission for only a specific % of the alcohol produced that can be treated as loss during the filling, bottling, pasteurizing, packaging and storing process

Some Decisions on Normal Losses and Normal Recovery

For Industries with no specified recovery rate or no limited remission on normal losses

Pashupati Iron Steels Pvt. Ltd. v/s Large Taxpayer Service Office (Supreme Court)

The case of Pashupati Iron Steels Pvt. Ltd. v/s Large Taxpayer Service Office arose when the revenue authorities went to argue that the industry should be able to meet the specified recovery/production norms specified in the raw material consumption norms prepared by the Department of Industry for that particular industry.

But what exactly is material consumption norms and did the court allow this material consumption norms to actually dictate what should be the entity recovery rate and whether it should be attributed forcibly to recover taxes?

Department of Industry has prepared several raw material consumption norms for various products. Such norm is essential for various purposes such as for export to India, to avail bonded warehouse facility, tax assessment and so on. An industry may apply to the department to have a material consumption norm established to their need if it has not been prepared by the department. The industry will typically submit the details of the production process including flow chart indicating waste sources, a detailed list of plant & machineries, and production and material consumption data for three years. As these material consumption norms are prepared on the basis of estimations, historical data and are subject to the existing operating capacity of the entity, the preface to the norm states a limitation that changes in any of these parameters may affect the materials consumption norms. The court took this limitation of the material consumption norms to decide favorably to Pashupati Iron Steels Pvt. Ltd. who had not been able to meet the recovery rate as specified in the material consumption norms for the particular year. The court further went to decide that since the normal loss or recovery rate is depended on the entity’s current utilization of the resources, the revenue authority should be able to provide basis and reasoning for the alternative assessment. Additionally, a decision from the council of ministers dated 2062/06/20 exists for the remission of the actual normal losses incurred by the entity and the same had been communicated by the niti section of the Revenue Department on 2062/08/06. Considering these facts the actual normal loss or recovery rate of the Pashupati Iron Steels are allowed for remission.

Link to decision here. 

Nepal Brewery Company Pvt. Ltd. v/s Value Added Tax Office, Hetauda (Supreme Court)

In the case of Nepal Brewery Company, among other principles, (stated in discussions above), the court goes to clarify that the recovery rate achieved by the brewery from consumption of the given quantity of the grains or raw materials should be allowed for deduction because the Breweries do not have any specific recovery rate to comply with, unlike distilleries. Thus, the actual recovery rate achieved by the Brewery should be considered, including for tax purposes.

Note: Although breweries do not have a specified recovery rate, the rate of the normal loss for beer brewing industry in case of (i) Beer Filling, (ii) Pasteurization, bottling and breakage, and (iii) Loss of crown crock; the brewery has to apply to the excise officer for the remission of the losses and the excise officer allows remission for such losses but not exceeding 2% of the total beer counted by the flow meter. Similarly, distilleries will be allowed a remission for up to 1% for shortfall in the stock of liquor, by the reason of evaporation, obscuration, leakage or bottling related losses. 

Link to the decision here.

Ministry of Finance v/s Surya Tobacco Company Pvt. Ltd (Supreme Court)

In the case of Surya Tobacco Company, among other principles, (stated in discussions above), the court goes to clarify that the recovery rate achieved by the tobacco unit from consumption of the given quantity of the tobacco should be allowed for deduction because the tobacco industries do not have any specific recovery rate to comply with unlike distilleries. Thus, the actual recovery rate achieved by the Tobacco industry should be considered, including for tax purposes. However, Under Rule 14Ka(1) of the Excise Rules 2059, the department reserves the right to determine the production recovery rate for cigarette, bidi as well. 

Link to the decision here.

Surya Tobacoo Company Pvt. Ltd. v/s Office of Auditor General (Supreme Court)

In the case of Surya Tobacco Company, among other principles, (stated in discussions above), the court goes to clarify that the recovery rate achieved by the tobacco unit from consumption of the given quantity of the tobacco should be allowed for deduction because the tobacco industries do not have any specific recovery rate to comply with unlike distilleries. Thus, the actual recovery rate achieved by the Tobacco industry should be considered, including for tax purposes. However, Under Rule 14Ka(1) of the Excise Rules 2059, the department reserves the right to determine the production recovery rate for cigarette, bidi as well. 

Link to the decision here.

Mainawati Steel Industries v/s Large Taxpayer’s Office (Revenue Tribunal)

In the case of Mainawati Steel Industries, among other principles, (stated in discussions above), the court goes to clarify that the recovery rate achieved by the steel industry from consumption of the given quantity of the iron, steel and raw materials should be allowed for deduction because the steel industries do not have any specific recovery rate to comply with. Thus, the actual recovery rate achieved by the industry should be considered, including for tax purposes.

Link to the decision here. 

For industries with specified recovery rate

Jawalakhel Distillery v/s Office of Council of Ministers (Supreme Court)

In case of the Jawalakhel Distillery, a similar reasoning was provided by the court. Here, the principle that the normal losses constitute the normal cost of production was not followed. The court held that since the Excise Rules clearly requires the specific production rate for the liquor items the Revenue Authorities thus have the right to actually assess the duties on such difference in the recovery.

Rule 34 of the Excise Rules 2059, provides a prescribed production recovery rate for the distillation output obtained through the consumption of the particular quantity of the molasses. Where an industry is not able to obtain this recovery rate, it shall submit the reasonable and adequate reasons therefore to the Department and obtain approval, elsewise the duty as chargeable on the margin of quantity as per the maximum liquors rate shall be recovered from the enterprise.  

Note: Excise Act of Nepal has specified a certain recovery rate in the case of liquor and a specific remission percentage for the normal losses occurring in the process in the case of distilleries and breweries. In my view, these constraints are applied to ensure that the indirect taxes, VAT or Excise Duties, as maybe, gets recovered, as a means to ensure that the entity is discouraged to misreport the losses and recovery percentage and manipulate the liquor output of the entity. But the tax authorities have been stretching this provision to extend upto the direct taxes. Tax authorities typically when come across such issues in Excise duties, also do assess such figures as taxable income for income tax purposes as well, which I believe should not be the case.

Link to decision here. 

Abnormal Losses

To recap, abnormal loss refers to a loss that arises due to unexpected events like defective material, carelessness, accidents, machinery breakdown, etc. Abnormal losses are unexpected and it is not treated as an element of the cost of production.

Even abnormal losses are allowable for deduction but there are reporting requirement under Income Tax Act, VAT Act and Excise Act. But an entity is generally expected to follow the loss reporting and loss recording procedures provided under the VAT Act and Excise Act.

Some Decisions on Abnormal Losses

Mittal Tea Industries v/s Inland Revenue Department (Supreme Court)

This case decided some important concepts, few of them have already been discussed above. But this case is distinct in on pertinent question. Tax Authorities have always been stretching the provision under Rule 39Ka of the VAT Rules 2053 to apply to the normal losses. However, in the case of the Mittal Tea, the Court appreciated the fact that the normal losses are already a part of the cost of the production and thus are not under the Scope of Rule 39Ka. Rule 39Ka of the VAT Rules 2053 are thus intended to apply only to the abnormal losses.

Link to decision here. 

Sumi Distillery Pvt. Ltd. v/s Large Taxpayer’s Office (Revenue Tribunal)

In case of the Sumi Distillery, the distillery failed to report the abnormal losses under the requirement of the Rule 39Ka of the VAT Rules 2053 within the prescribed period. The court went to decide that since the distillery had failed the reporting requirement under the VAT Act, the expense should therefore be denied for the said loss, even for income tax purposes. This decision has certainly brought confusion to the application Rule 39Ka of the VAT Rules 2053 and that its non-compliance will lead to adverse assessment under the separate Income Tax Act as well. In my personal opinion this decision could be more articulated and principled. 

Link to decision here.