Timeshare Membership fee taxable over the term of contract

Special Bench Tribunal Ruling: Entire amount of timeshare membership fee receivable by the assessee up-front should not be taxed at the time of enrollment of a member in the initial year on account of contractual obligation that is fastened to the receipt to provide services in future over the term of contract (ACIT Vs. Mahindra Holidays & Resorts (India) Pvt. Ltd.)

Facts:

Mahindra Holidays & Resorts (India) Pvt. Ltd. (the assessee/ company) is in the business of selling timeshare units in its various resorts. The assessment completed under section 143(3) of the Income tax Act (Act) was reopened under section 147 of the Act. It was noticed by the Assessing Officer (AO) that the relevant balance sheet showed an amount under the heading “Deferred income – advance towards members facilities– see note 1 (vi)(a)”. This figure represented the amount collected from timeshare members but not recognized as revenue for the current year.

The assessee had considered only 40% of the membership fees collected as income in the year of collection and the balance 60% was treated as deferred income, which was to be spread over the next 33 years (tenure of membership) during which the assessee is expected to provide timeshare facilities to the members. This method of accounting had been followed consistently by the assessee up to first 3 years of its operation and later on instead of 40%, it started recognizing 60% as revenue in the year of collection and balance 40% was to be deferred over a period of membership.

As the assessee had not offered remaining 60%/40% of membership fees as income in the year of collection of membership fees, the AO had reason to believe that the remaining income had escaped assessment in the year of collection of fees.

The assessee explained that the consideration for future obligations received in the initial stages is towards transfer facility from one resort to another, split, accumulation and advancing facility, domestic and international exchange, transmission, up-gradation etc. Therefore, entire fees cannot be taxable in the year of collection.

The AO observed that the assessee is following mercantile system of accounting and hence, income has to be accounted for on accrual basis. He was of the view that the receipt was undisputedly income as the assessee itself had shown it as deferred income. However, the Act does not recognize the concept of deferred income and hence, the assessee’ s explanation cannot be accepted. The AO was not convinced about the future costs to be incurred by the assessee. He also pointed out from the agreement that the assessee was not under any contractual or other obligation to provide the facilities as all the requests for holiday were subject to availability. Considering all these aspects, the AO added the remaining 60% membership fees, which was shown by the assessee as advance subscription.

On appeal, the Commissioner of Income tax [CIT (A)] observed that the assessee has to construct holiday resorts and provide timeshare facilities over a period of time. Further, the annual subscription fee collected meets only the maintenance of the resorts. The utility charges collected are as per actual consumption of things like electricity, water etc. It does not cover major renovation and repairs. The CIT (A) also took note of the fact that over a period of 24 years, the assessee has to incur about 171% of the original investment for major renovation and replacement of assets. Accordingly, he upheld the contentions of the assessee and deleted the addition after relying upon the judgements in the case of Calcutta Co. Ltd. Vs. CIT (37 ITR 1) (SC), Treasure Island Resorts Pvt. Ltd. (90 ITD 814)(Hyd) and T.K. International Ltd. (91 ITD 481) (Cut).

On appeal to the Tribunal, the Honorable President constituted a Special Bench to hear and decide the matter.

Question before the Special Bench of Income tax Appellate Tribunal:

“Whether the entire amount of the time-share membership fee receivable by the assessee upfront at the time of enrollment of a member is the income chargeable to tax in the initial year when there is a contractual obligation fastened to the receipt to provide the services in future over the term of the contract?”

Contention of the Revenue:

• The cost of accommodation constitutes 40% of the total cost of membership and advance payment towards facilities (APF) constitutes 60% of the total cost of membership. The member was also liable to pay AMC for the maintenance and upkeep of the various resorts. AMC was payable irrespective of the fact whether the facilities were used or not. In essence, it was submitted, a person becoming member was actually purchasing occupancy right for a specific floor area for specified days. Further, the member had a right to transfer, bequeath or gift his membership/timeshare unit to any person.
• Reliance was placed on the affidavit filed by the Managing Director of the assessee company before the Madras High Court in a litigation relating to service tax matter, wherein it was averred that the company had no further service to be rendered once the contract and enrollment making a person member were executed. Therefore, the argument of the Revenue was that the claim of the assessee that it had to incur expenses in future was not correct.
• There is no concept of deferred income in the Act. As regards the observation of the CIT(A) on the point that the assessee had to incur marketing expenses, the Revenue contended that once sale to a particular person has taken place there is no further need for advertisement qua that person. It is not like a hotel which would always expect repeat customers. Further, there was no obligation on the part of the assessee to refund the amount and there was no provision made for any liabilities which the assessee claimed it would incur in future. Even as per the Accounting Standard (AS) – 9 issued by the Institute of Chartered Accountants (ICAI), once the sale has taken place, revenue had to be recognised.

Contention of the Assessee:

• The reason for not offering the entire amount as income is that the assessee had to incur huge marketing expenses and that it was under an obligation to provide service to the Members for 33 years during which the membership subsisted.
• The immediate reason to bifurcate the sum received in the ratio of 40:60 was stated to be to follow what Sterling Holiday Resorts, a company engaged in similar business, had done. Three years later, when the industry gained more maturity and when the asses see almost reached the break-even point, 60% of the amount received was offered as income and balance 40% was treated as deferred income.
• Though the assessee received the amount in full, in reality it had not become richer as there was a corresponding liability to service the Members for 33 years.
• The assessee can be said to be the owner of the entire sum only when service is fully discharged for the entire period of membership. Till then, it was only an advance in the hands of the assessee. It was argued that though income may accrue but when the benefit is spread over a period, income also should be spread or else, the accounts will show distorted profits. The importance of the accounts showing a true and fair view of the profits/  losses and the state of affairs was emphasised.
• After the provision of section 145 amended w.e.f. 1.4.1997, the AO had no right to tinker with the accounts of the assessee, if the method of accounting was systematically followed and also had been accepted by the Department. The method followed was not irrational but was sanctified by usage.
• Distinction was sought to be drawn between the words “accrue” and “arise”. It was stated that income, profits and gains accrue when they first come into existence or the right to receive them comes into existence; but they may be said to arise when the method of accounting shows them in the shape of profits or gains. It was submitted that depending on the system of accounting, a case may very well arise where income accrues in one year, arises (according to the method of accounting) in a different year and is received at some third point of time. When the statute requires that income, profits or gains should accrue, arise or be received in the previous year, it contemplates three different points of time at which they can possibly be brought to charge, the actual charge being at such one of the three points of time as the assessee’ s method of accounting warrants.
• The assessee had to incur heavy costs to induce customers to become Members and it had to incur huge costs for the upkeep of the Resorts.
• The assessee tried to distinguish the decision in the case of Sterling Holidays & Resorts (111 ITD 116). As regards the observation made in the said decision that the concept of deferred income is alien to the Act, it was contended that it is not deferred income but it is the amount waiting in the wings to assume the form of income. It assumes the form of income only when the obligation spread over the 33 year period is discharged. As regards the other observation in the said decision that not offering the entire receipt as income was a subterfuge devised to hoodwink the Revenue, it was argued that it was purely a commercial transaction and there is nothing like subterfuge.
• The assessee relied upon various judgements mainly to press in service the principles of matching concept, distortion of profits, true accounting principles in the light of the method of accounting followed, ascertainment of profits as per normal book keeping practice, emphasis on business aspect rather than a theoretical or doctrinaire aspect and so on.
• As per AS- 9 which also deals with the recognition of revenue from service transactions, the revenue from such transactions is usually recognized as the service is performed, either by the proportionate completion method or by the completed service contract method. The emphasis was made on proportionate completion method. When services are provided by an indeterminate number of acts over a specific period of time, revenue is recognised on a straight line basis over the specific period unless there is evidence that some other method better represents the pattern of performance.
• The membership is an independent marketable commodity and therefore the fees are not refundable. There is a continuing obligation to provide occupancy to the members. The resorts are highly rated and therefore, the assessee is obliged to maintain them immaculately. Marketing expenses have to be incurred not only to attract new members but also to motivate the existing members to use the resorts. It is a continuous and a seamless activity related to the new and old members alike. There is no provision for refund because it is not anticipated by the assessee. Despite these facts, 60% of the collection (earlier 40%) is already taxed. If taxing the entire receipt in a single year would have given a distorted picture, taxing 1/33rd of the receipts in each year would have made the picture more distorting.

Contention of the Interveners:

• As regards the Revenue’s reliance on the affidavit filed before the service tax authorities by the Managing Director is concerned, it was argued that no services were rendered after selling the membership; it means that there was no taxable event once the membership was sold.
• The assessee has been following a consistent method to recognize the revenue which is in accordance with AS- 9 and hence, the same should not be disturbed.
• As per the Guidance Note on Accrual Basis of Accounting issued by the ICAI, the goal of accrual basis of accounting is to relate the accomplishments (measured in the form of revenue) and the efforts (measured in terms of cost) so that reported net income measures an enterprise’s performance during a period instead of merely listing its cash receipts and payments. Reliance was also placed on the International Accounting Standard (IAS) 18 pertaining to Revenue.

Counter- reply by the Revenue:

• Depreciation and marketing expenses were allowed and when a person became a member, he got a television as gift, which was also allowed as revenue expenditure. Therefore, there is no logic to incur any marketing expenditure in future and how can it be matched with the revenue which is collected today.
• Reliance was placed on the decision in the case of CIT v. British Paints India Ltd. (188 ITR 44)(SC) to support the action of the AO in bringing to tax the entire membership fee collected by the assessee, particularly when no provision in the Act has been pointed out to show as to how 60%/40% of the fee collected is left out.

Tribunal’s observation and Ruling:

• Thousands of liters of ink have been consumed lavishly over the past more than hundred years in discussing the concept of accrual and yet there is no end to it, and rightly so as it indicates the ever changing dynamics of business and commerce.
• There is no basis for recognizing the income in the ratio of 40:60 and it is stated to be as per industry norms. The basis for the ratio of 60:40 is stated to be that with experience, the assessee has become wiser.
• As per the decision in the case of E.D. Sassoon & Co. Ltd. Maharishi Housing Development Finance Corporation Ltd. Vs ACIT (Delhi High Court); (ITA No. 222 of 2009)s. CIT (26 ITR 27)(SC), two conditions are necessary to say that income has accrued to or earned by the assessee. They are, (i) it is necessary that the assessee must have contributed to its accruing or arising by rendering services or otherwise, and (ii) a debt must have come into existence and he must have acquired a right to receive the payment.
• In the present case, a debt is created in favor of the assessee immediately on execution of the agreement. However, it cannot be said that the assessee has fully contributed to its accruing by rendering services. The assessee is bound to provide accommodation to the members for one week every year till the currency of the membership. Till the assessee fulfills its promise, the parenthood cannot be traced to it.
• As per the membership rules, the reservation for holiday can be done 90 days to 1 day before the commencement of holiday but the same is subject to availability. In other words, if the resort requested for is not available, the member would be deprived of the holiday. If the assessee confirms the reservation but is not able to provide the allotted or the alternate accommodation, assessee is liable to pay liquidated damages to the member. It is worth noting that the assessee is liable to pay liquidated damages only if it is not in a position to provide accommodation as per confirmed reservation. But it is not liable to pay any damages if it is not able to provide an accommodation on account of non-availability. Under such circumstances, the only recourse for the member is to approach the Consumer Forum which will term it as deficiency in services and direct the assessee to pay damages.
• This shows that the matter does not end on signing of the agreement and on a person becoming a member. There is a continuing liability on the part of the assessee not only to provide accommodation but also to provide other incidental services attached with the accommodation. This is an important aspect of the matter.
• The Tribunal has not been impressed by the assessee’s argument in relation to spreading of the balance amount of membership fees over the tenure of membership is that it has to incur heavy expenditure for the upkeep and maintenance of its various resorts. This is because separate charges are collected for maintenance and for use of utilities and therefore, the matching concept cannot be pressed into service so far as membership fee is concerned.
• No doubt, it will be the constant endeavor of the assessee to go on adding new resources which will be available to the existing members also. To that extent one can say that some portion of the membership fees will go to finance new properties. But membership fee is essentially a consideration for the right to occupy a resort for one week in a year for 33 years. But the contingency of non availability of accommodation will always be there. Sometimes, if the assessee is not able to provide accommodation in any of its notified resorts, it will try to procure alternate accommodation. This also will entail additional expenditure on the part of the assessee over and above paying liquidated damages to the assessee. Unlike the case in Calcutta Co. Ltd. v. CIT (37 ITR 1)(SC), the liability in this case is difficult not only to quantify but also to reasonably estimate it. The liability is undoubtedly there. However, no scientific basis has been brought to the notice to quantify the same even reasonably. Just as life insurance premium or provision for encashment of leave can be quantified reasonably on actuarial basis, there is no such method brought to notice to quantify the liability of the assessee in the present case.
• Even if the assessee had chosen to provide for the liability in every year to comply with the matching concept, it would have been wholly unscientific and arbitrary.
• The argument made by the Revenue, on the basis of affidavit filed in service tax matter before the High Court; that once the agreement is signed, there is no service left to be rendered by the assessee, has to be rejected. This is on the basis that the department itself admits that the assessee is bound to provide accommodation for one week in a year during the tenure of the membership. Secondly, by saying that no service is left to be rendered, what the assessee means to say is that there is no taxable event under the Service Tax laws once a person becomes member. Therefore, the reliance of the department on the affidavit has no substance at all.
• As per the judgment of the Supreme Court in the case of Rotork Controls India Pvt. Ltd. v. CIT (314 ITR 62)liability is defined as a present obligation arising from past events, the settlement of which is expected to result in an outflow from the enterprise of resources embodying economic benefits. Applying the same analogy in the present case, it can be said that the past event is admitting a person as a member with a promise to fulfill the obligation of providing him accommodation for one week every year for the next 33 years. It is not an ordinary obligation; in fact the obligation is heavier than that in the case of sale of goods. In the case of sale of goods, the goods are already in possession of the buyer and are being used by the buyer. On the other hand, the sale of timeshare unit is not as tangible as sale of goods but becomes tangible when the assessee fulfills its promise.
• There may be several reasons for non- availability of accommodation. These types of contingencies will always entail outflow of resources for the assessee in future. Therefore, the Tribunal is of the view that there is every possibility of an obligating event arising which will result in an outflow of resources. It is difficult to estimate the liability which is likely to be incurred in future, more so in the absence of any scientific basis or historical data. Therefore, the only way to minimize the distortion is to spread over a part of the income over the ensuing years.
• There is a definite liability cast on the assessee to fulfil its promise and therefore, it cannot be said that the entire fee received by it has accrued as income. The Tribunal has also considered the peculiar nature of the activity along with the complexity attached to it as a result of which no reasonable provision for the liability can be made. Therefore, recognising the entire receipt as income in the year of receipt can lead to distortion.
• The Tribunal has relied upon the judgement of the Supreme Court in the case of Madras Industrial Investment Corporation Ltd. v Commissioner of Income Tax, 225 ITR 802 (SC) wherein it was held that allowing the entire expenditure in one year might give a very distorted picture of the profits of a particular year. The only difference is that in the case of Madras Industrial Investment Corporation (supra), the distortion was supposed to be on account of expenditure, in the present case the distortion is on account of the entire income being accounted in the year of receipt.
• In view of the above, the Tribunal has held that the entire amount of timeshare membership fee receivable by the assessee up front at the time of enrollment of a member is not the income chargeable to tax in the initial year on account of contractual obligation that is fastened to the receipt to provide services in future over the term of contract.

Our View:

This Special Bench decision is an important judgement from the perspective of Revenue Recognition. The decision is line with the AS-9 which provides that the revenue from service transactions is usually recognized as and when the service is performed, either by the proportionate completion method or by the completed service contract method. When services are provided by an indeterminate number of acts over a specific period of time, revenue is recognized on a straight line basis over the specific period unless there is evidence that some other method better represents the pattern of performance, and hence revenue recognition.

This judgement reiterates that the income is said to be accrued to or earned by the assessee only if the assessee has contributed to its accruing or arising by rendering services or otherwise, and a debt must have come into existence and he must have acquired a right to receive the payment.

This judgement will be useful to all those cases where the revenue precedes performance of services and the contractual obligation is fastened to the receipt to provide services in future over the term of contract, such as, turnkey contract, annual maintenance contract, engineering contract, construction contract, lump- sum fees received by educational institution for the entire syllabus, etc.

NF