Case Law Details
HIGH COURT OF KARNATAKA
Prakash Leasing Ltd. v/s. DCIT
I T APPEAL NOS. 301,302 & 491 OF 2007
FEBRUARY 27, 2012
JUDGMENT
N. Kumar, J.
As the questions involved in all these three appeals are one and the same they are taken up for consideration and disposed off by this common order.
2. The assessee is the same in all the three appeals. ITA No. 301/2007 pertains to the assessment year 1998-99. ITA No. 302/2007 pertains to the assessment year 1999-2000 and ITA No. 491/2007 pertains to 2000-01. The assessee is a non-banking financial Company. For the assessment year 1998-99 the assessee had entered the amount inter alia under the head ‘lease equalisation account’ at Rs. 4,35,89,486/-. Under the profit and loss account for the said year the assessee had reduced the aforesaid amount representing the lease equalisation account from the lease rental of Rs. 11,84,21,434/-. The assessing authority disallowed the said claim on the ground that the same was neither a liability nor an allowance nor an expenditure. The same was just a matching entry for the purpose of tallying the accounts with regard to the assets leased out. He was also of the opinion that the said claim was made for the first time during the year and also that the depreciation was provided for the books and the lease income was recognised. Aggrieved by the said order the assessee preferred an appeal before the Commissioner of Income-Tax (Appeals), Bangalore who dismissed the appeal. Aggrieved by the said order the assessee preferred an appeal to the Tribunal. The Tribunal held that this is an appropriation of profit and thus cannot be allowed as a deduction. The assessee admittedly classified all the assets under the category of furniture and fixtures and has claimed 100% depreciation. He has not claimed it as a revenue expenditure but has capitalised the same having shown the item as fixed asset under the head furniture and fixtures and for which the question of following 100% depreciation does not arise. Thus the appeal came to be dismissed. Aggrieved by the said order the assessee is before this Court.
3. These appeals were admitted to consider the following substantial questions of law:-
“1. Whether in law the Tribunal was justified in confirming the disallowance made by the lower authorities on the claim of the appellant with regard to the lease equalisation account to the extent of Rs. 4,35,89,466 ?
2. Whether in law the Tribunal is justified in not appreciating that the appellant being a NBFC had followed the norms required by its regulatory authority namely RBI and hence the claim made by the appellant with regard to the lease equalisation account was perfectly in order ?
3. Whether in law the Tribunal was justified in declining to accept the deduction claimed by the appellant which was in accordance with accounting standard which was consistently followed which declares the real income in the relevant year ?
4. Whether in law the Tribunal was justified in concluding that Lease Equalisation Reserve is an appropriation of profit and thus cannot be allowed as a deduction ?”
The learned counsel appearing for the assessee assailing the impugned order contended that the rentals received by the assessee does not constitute income for the purpose of levying tax under the Income-Tax Act. The total rentals received is of two components, namely the financing charge and the amount embedded in it in the form of capital sum. The financing charging is the real income on which the assessee is liable to pay tax. He is not liable to pay tax on the capital value which forms part of the total rental receipt. The said capital value which is called as lease equalisation charges is to be excluded from the total rental receipts as per the accounting standards which the assessee is bound to follow by virtue of the directions issued by the Reserve Bank of India in its Circular to a non-banking Institution, Therefore the authorities were not justified in refusing to exclude the said amount from liability to tax.
4. Per contra, the learned counsel for the Revenue submitted that as is clear from the accounts, the assessee is claiming depreciation charges. The entire amount received by way of rental charges is taken into the profit and loss account and therefore the question of deducting this lease equalisation charges from the total rental receipts and paying the tax only on financing charges is not correct. Therefore, he submits that no case for interference is made out.
5. From the material on record it is clear that for the assessment year 1998-99 the assessee has received a sum of Rs. 11,84,21,434/- as the lease rentals. The said amount is shown in the profit and loss account. Thereafter they have deducted a sum of Rs. 4,35,89,486/- representing the lease equalisation account. The assessee contends that the lease equalisation account deducted from profit and loss should not be added as income. The assessing authority was of the view that since the assessee is in receipt of the entire lease rentals shown in the profit and loss during the year, the same is taxable income. There is no deduction in such a lease equalisation charges from the taxable income because this is neither the liability nor an allowance nor an expenditure. The income to the aforesaid extent has accrued to the assessee. Hence on both accrual as well as on receipt basis, the total lease rentals received is the real income. The assessee did not follow the system till last year. The claim is being made for the first time during this year which makes a deviation from the accounting method so far followed by the assessee. In the earlier years the assessee did not claim it as a deduction from its taxable income. The assessee cannot change its method of accounting which was being followed for many years. The accounting policy suggested by ICAI is deducting the lease account only to reflect the correct value of the depreciated assets. It is a matching accounting entry for the purpose of tallying the balance sheet with regard to the assets leased out, depreciation provided in the books and the lease income recognised. This in no way affects the taxable income which is determined as per the Income-Tax Act. The guidance note issued by RBI itself makes this very clear. Therefore, such a deduction of lease equalisation charge from the taxable income is not to be allowed. Therefore the same is brought to tax by making an addition of Rs. 4,35,89,486/-. The appellate Commissioner was of the view that so far as computation of taxable income is concerned, since the adoption of such norms is in tune with the guidelines prescribed by the ICAI, yet, as per the same guidelines in so far as computation of taxable income is concerned, since adoption of such norms undoubtedly distorts the extent of depreciation being different under the Income-Tax Act: vis-a-vis the Companies Act, one has to conclude, as clarified by the ICAI guidelines, that there are specific treatment for determining the taxable income in accordance with the provisions of the Taxation laws. As per the provisions of the Income-Tax Act, the entire lease rental is recoverable during the year and therefore the disallowance of the claim of lease equalisation account as a deduction from the lease rentals as done by the assessing officer is in order and therefore the addition on this score is held. The appellate Commissioner held that this is a case of appropriation of profit and thus cannot be allowed as a deduction. The assessing officer was of the view that as the total rental received satisfies both the requirements of law namely, the accrual and receipt, it constitutes real income. Merely because, the assessee received the entire lease rent, thus it constitutes the real income so as to attract tax liability on the entire amount.
6. The Apex Court in the case of Poona Electric Supply Co. Ltd. v. CIT AIR 1966 SC 30, had an occasion to consider the meaning of the real income. After reviewing several Judgments, the Apex Court held as under:
“Income tax is a tax on, the real income, i.e., the profits arrived at on commercial principles subject to the provisions of the Income-tax Act. The real profits can be ascertained only by making the permissible deductions. There is a clear-cut distinction between deductions made for ascertaining the profits and distributions made out of profits. In a given case whether the outgoings fall in one or the other of the heads is a question of fact to be found on the relevant circumstances, having regard to business principles. Another distinction that shall be borne in mind is that between the real and the statutory profits, i.e., between the commercial profits and statutory profits. The latter are statutorily fixed for a specified purpose. If we bear in mind these two principles there will be no difficulty in answering the question raised.”
7. The Apex Court in the case of State Bank of Travancore v. CIT [1986] 158 ITR 102/24 Taxman 337, after considering various decisions of the Apex Court, held as under:
“An acceptable formula of co-relating the notion of real income in conjunction with the method of accounting for the purpose of the computation of income for the purpose of taxation is difficult to evolve. Besides, any strait-jacket formula is bound to create problems in its application to every situation, it must depend upon the facts and circumstances of each case. When and how does an income accrue and what are the consequences that follow from accrual of income are well-settled. The accrual must be real taking into account the actuality of the situation. Whether an accrual has taken place or not must, in appropriate cases, be judged on the principles of the real income theory. After accrual, non-charging of tax on the same because of certain conduct based on the ipse dixit of a particular assessee cannot be accepted. In determining the question whether it is hypothetical income or whether real income has materialised or not, various factors will have to be taken into account. It would be difficult and improper to extend the concept of real income to all cases depending upon the ipse dixit of the assessee which would then become a value judgment only. What has really accrued to the assessee has to be found out and what has accrued must be considered from the point of view of real income taking the probability or improbability of realisation in a realistic manner and dovetailing of these factors together but once the accrual takes place, on the conduct of the parties subsequent to the year of closing, an income which has accrued cannot be made ‘no income’.”
8. The Apex Court in the case of Godhra Electricity Co. Ltd., v. CIT [1997] 225 ITR 746/91 Taxman 351 explaining the principles of ‘real income’ has held at page 760 as under:
The question whether there was real accrual of income to the assessee company in respect of the enhanced charges for supply of electricity has to be considered by taking the probability or improbability of realisation in a realistic manner. If the matter is considered in this light, it is not possible to hold that there was real accrual of income to the assessee-company in respect of the enhanced charges for supply of electricity which were added by the Income-tax Officer while passing the assessment orders in respect of the assessment years under consideration. The Appellate Assistant Commissioner was right in deleting the said addition made by the Income-tax Officer and the Tribunal had rightly held that the claim at the increased rates as made by the assessee-company on the basis of which necessary entries were made represented only hypothetical income and the impugned amounts as brought to tax by the Income-tax Officer did not represent the income which had really accrued to the assessee-company during the relevant previous years. The High Court, in our opinion, was in error in upsetting the said view of the Tribunal.”
9. The Delhi High Court in the case of CIT v. Dinesh Kumar Goel [2011] 331 ITR 10/197 Taxman 375 explaining the meaning of the word ‘accrued’, held as under:
“Section 145 of the Act deals with the method of accounting and states that in case of business income, inter alia, the same is to be computed in accordance with the cash or mercantile system of accounting. Sub-section (2) thereof authorizes the Central Government to notify in the Official Gazette from time to time accounting standards to be followed by any class of assessees or in respect of any class of income. Section 211 of the Companies Act, on the other hand, prescribes the form and contents of balance-sheet and profit and loss account, which are to be maintained by the companies under the said Act. Sub-section (2) casts a duty on a company to give a true and fair view of the profit and loss of a company for the financial year in its profit and loss accounts. Sub-section (3A) adheres to the accounting standards for preparing profit and loss and balance-sheet. Sub-section (3C) defines “accounting standards” as under:
“(3C) For the purposes of this section, the expression ‘accounting standards’ means the standards of accounting recommended by the Institute of Chartered Accountants of India constituted under the Chartered Accountants Act, 1949 (38 of 1949) as may be prescribed by the Central Government in consultation with the National Advisory Committee on Accounting Standards established under sub-section (1) of section 210A:
Provided that the standards of accounting specified by the Institute of Chartered Accountants of India shall be deemed to be the Accounting Standards until the accounting standards are prescribed by the Central Government under this sub-section.”
A conjoint reading of the aforesaid provisions of the Income-tax Act and the Companies Act shows that those assessees, which are companies and showing income, inter alia, under the head “business or profession” have to follow the accounting standards prescribed. The Government of India has notified accounting standards in exercise of its power under section 145(2) of the Act, which are dated May 29, 1996. Accounting Standard-1 relates to the disclosure of accounting policy and puts an obligation on the assessee to disclose all significant accounting policies adopted in the preparation and presentation of financial statements. Paragraph 6 thereof defines certain expression which occurred in paragraphs 1 to 5. Clause (b) whereof spells out the definition of accrual in the following manner:
“(b) ‘Accrual’ refers to the assumption that revenues and costs are accrued that is, recognized as they are earned or incurred (and not as money is received or paid) and recorded in the financial statements of the period to which they relate;”
From the above, that the term “accrual” relates to revenues earned or cost incurred. Two things follow from this, viz., unless the revenue is earned, it is not accrued. Likewise, the expenses unless are incurred, cost in respect thereof cannot he treated as accrued. Secondly, it recognizes the matching concept, viz., receipts are to be matched income to arrive at the net income, which would then be exigible to tax.”
10. The Apex Court in the case of J.K. Industries v. Union of India [2008] 297 ITR 176/[2007] 165 Taxman 323, has explained the ‘matching’ concept as under:
“We may refer to the passage extracted by the Supreme Court from its judgment in the case of J.K. Industries v. Union of India reported in [2007] 13 Scale 204; [2008] 297 ITR 176 in the following terms (page 277 of 297 ITR):
“82. Matching concept is based on the accounting period concept. The paramount object of running a business is to earn profit. In order to ascertain the profit made by the business during a period, it is necessary that ‘revenues’ of the period should be matched with the costs (expenses) of that period. In other words, income made by the business during a period can be measured only with the revenue earned during a period is compared with the expenditure incurred for earning that revenue. However, in cases of mergers and acquisitions, companies sometimes undertake to defer revenue expenditure over future years which brings in the concept of deferred tax accounting. Therefore, today it cannot be said that the concept of accrual is limited to one year.
83. It is a principle of recognizing costs (expenses) against revenues or against the relevant time period in order to determine the periodic income. This principle is an important component of accrual basis of accounting. As stated above, the object of AS 22 is to reconcile the matching principle with the fair valuation principles. It may be noted that recognition, . measurement and disclosure of various items of income, expenses, assets and liabilities is done only by Accounting Standards and not by the provisions of the Companies Act.””
11. It is in this background, we have to find out in the case of ‘finance lease’ what is the method to be employed by the assessee with the regard to determination of the ‘real income’. Paragraphs 11 and 12 of the Guidance Note of ICAI read with the appendix attached to it, is quite instructive in this regard. The said guidelines provide for four elements which arise for consideration for treatment of the amount received as lease rentals by the lessor in order to bring to tax, what is the ‘real income’ and present it in a true and fair view of the transaction in issue. The four elements which are considered are lease rentals; the implicit rate of return [IRR]; depreciation; and lease equalization charge, In fact, the Delhi High Court had an occasion to consider this aspect in the case of CIT v. Virtual Soft Systems Ltd [2012] 205 Taxman 257/18 taxmann.com 119 and connected matters which are disposed of on 7.2.2012. At paragraph 14.3, it has been held as under:
“Lease rental in monetary terms is a sum total of the financing charge and the amount embedded in it in the form of the capital sum. What the assessee needs to do, while offering for tax income derived from lease is, to separate the financing charge from the amount recovered towards capital, that is, the capital recovery amount. The financing change is determined by applying the IRR to the net investment made in the asset. The assessee also needs to provide for depreciation, on the capital value embedded in the lease rental. The fourth element which is the lease equalization charge is the result of the adjustment, which the assessee has to make whenever, the amount put aside towards capital recovery is not equivalent to the depreciation claimed by the assessee. The assessee, may claim depreciation based on the provisions of the IT Act or, may even adopt the method of depreciation provided under the Companies Act. In the event, the depreciation claimed is less than the capital recovery, the difference is debited in the profit and loss account in the form of lease equalization charge, and similarly if for any reason the depreciation claimed is more than capital recovery then, the difference is credited, once again, in the form of lease equalization charge to the profit and loss account. Therefore, the assessee in effect debits or credits its profit and loss account with a lease equalization charge depending on whether or not the depreciation claimed is, less or more than the capital recovery. The capital recovery can be known, as is evident, on deduction of financing charges from the lease rentals. In sum and substance, lease equalization charges is a method of re-calibrating the depreciation claimed by the assessee in a given accounting period. The method employed by the assessee, therefore, over the full term of the lease period would result in the lease equalization amount being reduced to a naught, as the debit and credits in the profit and loss account would square off with each other. Hence, the contention of the revenue that it is a claim in the form of a deduction which cannot be allowed, as there is no provision under the I.T. Act is, in our view, a complete misappreciation of what constitutes a lease equalization charge. In our opinion, as long as the method employed for accounting of income meets with the rudimentary principles of accountancy, one of which, includes offering only revenue income for tax, we cannot find fault with the assessee debiting lease equalization charges in the Ays in issue, in its profit and loss account. This represents true and fair view of the accounts; a statutory requirement under Section 211(2) of the Companies Act. As explained by us above, the rationale is that over the entirety of the lease period the said debit would work itself out.”
Lease rental in monetary terms is a sum total of the financing charge and the amount embedded in it in the form of a capital sum. What the assessee needs to do, while offering for tax the income derived from lease is to separate the financing charge from the amount recovered towards capital, that is the capital recovery amount. The said financing charge constitutes the real income, which is to be offered for tax. The said financing charge is determined by applying the ‘implicit rate of return’ (IRR) to the ret investment made in the asset. The assessee also needs to provide for depreciation on the capital value embedded in the lease rental. The lease equalization charge is the result of the adjustment, which the assessee has to make whenever the amount put aside towards capital recovery is not equivalent to the depreciation claimed by the assessee. The assessee, may claim depreciation based on the provisions of the IT Act or the Companies Act. The capital recovery thus can be known after deduction of financing charges from the lease rentals. Thus, lease equalization charges is a method of recalibrating the depreciation claimed by the assessee in a given accounting period. As long as the method employed for accounting of income meets with the rudimentary principles of accountancy, one of which, includes offering only revenue income for tax, we cannot find fault with the assessee debiting lease equalization charges in its profit and loss accounts. The authorities firstly refused to give benefit to the assessee on the ground that till the previous year, the assessee did not follow this system, which he has now putforth. The said claim is being made for the first time during the assessment year 1998-99, which makes a deviation from the accounting policy so far followed by the assessee. In the earlier years, the assessee did not claim it as a deduction from its taxable income. Therefore, the assessee cannot change its method, which was followed or many years. The Apex Court in the case of CIT v. Bilahari Investment (P.) Ltd. [2008] 299 ITR 1/168 Taxman 95 has held that every assessee is entitled to arrange its affairs and follow the method of accounting, which the Department has earlier accepted. It is only in those cases where the Department records a finding that the method adopted by the assessee results in distortion of profits that the Department can insist on substitution of the existing method. Therefore, certainly the method adopted by the assessee in maintaining its accounts for the earlier period is an important factor, which the authorities have to keep in mind at the time of framing the assessment orders. But in the instant case, in the Finance Act, 1995 which came into effect from 1.4.1987, the present Section was substituted providing that income chargeable under the head ‘profit and gains of business or profit 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 assessees. Sub-Section(2) of Section 145 provides that the Central Government may notify in the Official Gazette from time to time the accounting standards to be followed by any class of assessees or in respect of any class of income. Therefore, with the change in law, an opportunity was given to the assessees to adopt either cash or Mercantile system of accounting. It is in this context, with the change in law, the assessee adopted the Mercantile system of accounting. This aspect has not been noticed by the authorities. Therefore, the reason for the assessee making a claim for the first time during the assessment year 1998-99 is because of change in the law, which came into effect from 1.4.1987. Therefore, on that ground, the authorities were not justified in rejecting the claim of the assessee.
12. Yet another reason given by the Authorities for not accepting the claim of the assessee is that the accounting practice cannot be justified by any provisions of the Statute or is contrary to it. The Income-Tax law does not march step by step in the divergent footprints of the accountancy provisions. The question is whether the receipt of money is taxable or not, whether certain deductions from that receipt are permissible in law or not. The question has to be decided according to the principles of law and not in accordance with the accounting practice. The accounting practice cannot override the statutory provisions of the Act. In support of the said contention reliance is placed on the judgment of the Apex Court in Tuticorin Alkali Chemicals & Fertilizers Ltd. v. CIT [1997] 227 ITR 172/93 Taxman 502. There cannot be any dispute as far as the said proposition of law is concerned. However, when the law, as amended subsequent to the aforesaid judgment of the Apex Court, expressly provided that the Central Government may notify in the Official Gazette from time to time the accounting standards to be followed by any class of assessees or in respect of any class of income, the assessment orders to be passed under the Act by the authorities have to be in conformity with the accounting standards notified by the Central Government. In terms of the aforesaid provisions, the Central Government has notified in the Official Gazette the accounting standards, which explains the meaning of what is accrual for the purpose of this Act. The accrual refers to the assumption that revenues and costs are accrued that is, recognized, as they are earned and incurred (and not as money is received or paid) and recorded in the financial statements to which period they are related. Admittedly, insofar as the lease equalization charges are concerned, it is not provided in the notified accounting standards by the Department. It is also not in dispute that in the Act what the lease equalization charges is not explained. In the absence of any specific provision in the Act dealing on the subject, when the accounting standard is now made the basis for maintaining the accounts for the purpose of income tax, even if the Central Government has not notified in the Official Gazette the accounting standards, certainly the accounting standards prescribed by the Institute of Chartered Accountants has to be followed. In fact, the Hon’ble Supreme Court in Challapalli Sugars Ltd. v. CIT [1975] 98 ITR 167 has put its seal of approval on adopting the accounting standards while interpreting Section 10(2)(vi), (via), (vib) and Section 10(5) of the Indian Income-Tax Act, 1922, while interpreting the expression “actual cost” The Supreme Court held in (ITR page 173): “as the expression ‘actual cost’ has not been defined, it should, in, our opinion, be construed in the sense which no commercial man would misunderstand. For this purpose, it would be necessary to ascertain the connotation of the above expression in accordance with the normal rules of accountancy prevailing in commerce and industry. Therefore, it is judicially accepted that when determining whether there has in fact been accrual of liability or income, the accountancy standards prescribed by the ICAI would have to be followed and applied.” Therefore, the reasoning of the authorities though the claim of the assessee is based on such accounting standards of ICAI while deciding whether receipt of money is taxable or not it has to be decided in accordance with the provisions of law and not in accordance with the accounting practice has no substance as there is no inconsistency between the said accounting practice and any provisions of the Act.
13. The third reasoning adopted by the Authorities is that the assessee is in receipt of entire lease rentals shown in the profit and loss account during the year and the same is taxable income. There cannot be any deduction of any such lease equalization charges from the taxable income because it is neither a liability nor the allowance nor an expenditure. It is in fact the income to the extent accrued to the assessee and in fact received by the assessee. Therefore, on both accrual as well as receipt basis total lease rentals received is the real income. The precise question to be decided in this case is “Whether the entire receipt from the lease rentals constitute the real income, which can be taxed under the Act?”. It is here one has to bear in mind the concept of lease rentals. As explained in the judgment of the Delhi High Court, the lease rentals is not the real income of the assessee. The lease rental consists of financing charge as well as capital recovery. The amount received towards capital recovery constitute the capital expenditure, whereas, the financing charge represents the revenue receipt, which is the real income. It is as per the accounting standards prescribed by the ICAI. Therefore, the assessee under the Act has to offer to tax only the real income and not the total receipt. He is not liable to pay any tax under the Act on the capital recovery. It is in this background that when we look at the profit and loss account of the assessee, a sum of Rs. 1,83,43,948/- is shown as the income from the hire charges, whereas, the total receipt from lease rentals is shown as Rs. 11,84,21,434/-. Out of the total receipts under the heading “lease rentals” they have claimed Rs. 4,35,89,486/- representing the lease equalization account, in respect of which they are not liable to pay, as it represents excess capital recovery. Therefore, it is only Rs. 7,48,31,948/- that is the real income which has to be offered for tax. In fact, in the very same Profit and Loss account a sum of Rs. 1,70,80,212/- has been claimed under the heading “transfer to. lease equalization amount” which deduction has been granted by the authorities. It is only in respect of the current lease equalization amount the aforesaid objections are raised on the ground that the said amount also has accrued and received by the assessee. Though the said amount is also accrued and received by the assessee, it does not represent the real income, which represents capital recovery. Therefore, in view of the change in law from 1.4.1998, when the Act was amended prescribing only two methods of accounting. In the case of receipts under the heading of lease rentals the entire receipt cannot be construed as real income as it consists of two components, i.e., the capital receipt as well as the financing charges. It is only the financing charges which represents the real income, which has to be offered for tax. The aforesaid claim made by the assessee is in accordance with the accounting standards. In the absence of any provision in the Act, for calculating the said lease equalization charges, the assessee was justified in adopting the accounting standards and he is entitled to claim the said amount as deductions. It is also relevant note that lease equalization entry is revenue neutral and taken care of under recovery of depreciation in a particular years. At any rate, that cannot be construed as income for offering it to tax. In that view of the matter, the impugned orders are liable to be set aside and the substantial question of law have to be answered in favour of the assessee and against the revenue.
Hence, we pass the following:-
ORDER
All the three appeals are allowed. The impugned orders are set aside. The substantial questions of law are answered in favour of the assessee and against the Revenue.
Parties to bear their own costs.
