Introduction: The case of DCIT vs. Red Hat India Pvt. Ltd. before ITAT Mumbai revolves around the intricate matter of revenue recognition and compliance with Accounting Standard-9 (AS-9).
Detailed Analysis: Red Hat India Pvt. Ltd. (RHIPL) operates in the business of marketing, promotion, and distribution of “Red Hat Subscriptions” that offer support services for Red Hat Open-Source Software. These subscriptions enable customers to access and modify the source code as per their needs. The dispute in this case pertains to the assessment year 2011-12.
The Assessing Officer (AO) observed that out of the total revenue generated by RHIPL, a significant portion was declared as “Unearned Revenue.” This unearned revenue was to be recognized in subsequent years when RHIPL would provide the associated services. The AO added this unearned revenue to RHIPL’s total income, leading to an assessment.
In response to the AO’s actions, RHIPL contended that they followed the “completed service contract method” of revenue recognition, aligning with Accounting Standard-9 (AS-9) issued by the Institute of Chartered Accountants of India (ICAI). They argued that the practice of recognizing revenue as unearned was in line with AS-9, which allows for revenue to be recognized either on a straight-line basis over a specified period or when significant uncertainties exist about the amount of consideration to be derived.
The dispute also involved allegations that RHIPL violated the “Matching Principle” by deferring revenue but recognizing expenses upfront.
The CIT (A) upheld RHIPL’s revenue recognition method and rejected the allegations of violation of the Matching Principle.
Conclusion: The ITAT Mumbai, in its ruling, upheld RHIPL’s consistent practice of revenue recognition in accordance with AS-9. It emphasized that unless there is a change in the facts and circumstances or it can be proven that the earlier method was incorrect, the revenue recognition method should not be disturbed.
Furthermore, the ITAT agreed that RHIPL’s approach of recognizing revenue and related expenses in proportion to each other was justified, resulting in a revenue-neutral situation.
In summary, the case of DCIT vs. Red Hat India Pvt. Ltd. highlights the importance of adhering to established revenue recognition methods and compliance with accounting standards. It reinforces that revenue recognition practices, when consistent and in line with accounting standards, should not be altered without valid reasons. This ruling provides clarity on revenue recognition for businesses that offer subscription-based services and serves as a precedent for similar cases.
FULL TEXT OF THE ORDER OF ITAT MUMBAI
This appeal by revenue is directed against the order of National Faceless Appeal Centre (for short “NFAC”) dated 09.12.2022 u/s. 250 of the Income TaxAct, 1961 (in short ‘the Act’) for A.Y. 2011-12. The revenue has raised the following grounds (revised) of appeal:-
1.Whether on facts and in circumstances of case and in law, the Ld CIT(A) was justified in deleting the addition made on account of unearned revenue on the transaction of sale when the assessee company did not provide complete details to the Ld DRP and thus had approached the Ld CIT(A) with unclean hands
2. Whether on the facts and in the circumstances of the case and in law, the Ld. CIT(A) was correct in not applying the provisions of Accounting Standard-9 pertaining to ‘retail sale’ specifically referred by the Ld. AO whereas the assessee company is a distributor and makes sales to end customer?”
3. Whether on the facts and in the circumstances of the case and in law, the Ld. CIT(A) was justified in deleting the additions made on account of unearned revenue on the transaction of sale when unearned revenue on transaction of sale when undisputedly assessee company is only a reseller and is not, itself, providing any support services
4. Whether on the facts and in the circumstances of the case and in law, the Ld. CIT(A) was correct in upholding the recognition of revenue by the assessee company for sale following the proportionate completion method as in Accounting Standard-9 when in fact the assessee company, being only reseller of subscription, in undisputedly itself not providing the support services
5. Whether on the facts and in the circumstances of the case and in law, the Ld. CIT(A) was correct in not dealing with the point of contention that whether the assessee company, being only reseller of subscription and itself not providing the support services, is eligible to follow proportionate completion method in recognizing the revenue as per Accounting Standard- 9?
6. The Appellant pray that the order of CIT (A) on the above ground be set- aside and that of Assessing Officer be restored
7. The Appellant craves leaves to add, amend or alter any grounds of add new ground, which may be necessary
2. The brief facts of the case are that assessee RHIPL engaged in the business of marketing, promotion and distribution of “Red Hat Subscriptions” to customers. The “Red Hat Subscription” enables the subscriber to avail support services for Red Hat Open-Source Software. Open-Source Software grants every user free access to the source code and enables the user to modify/customize the same to suit its requirements. Assessee filed its return of income on 25-11-2011, declaring NIL income after set-off of brought forward losses of Rs. 25,40,93,477/-. Thereafter, assessee filed a revised return on 27-03-2013 again at NIL, but after set-off of brought forward losses of Rs. 30,36,05,076/-. This reflects that either assessee has reduced its revenue or enhanced expenses, that why a higher figure of B/f. losses required to be absorbed. Case of the assessee was selected for scrutiny vide notice dated 02.06.2012.
3. It was observed by the AO that out of total revenue of Rs. 65,61,86,084/-assessee declared Rs. 35,53,56,525/- as current year’s revenue and balance amount of Rs. 30,08,29,559/- was being carried forward through balance sheet as “Unearned Revenue” for which the services would be rendered by the assessee in future years. AO added this amount “Unearned Revenue” to the total income of assessee and assessment was completed. Assessee being aggrieved with this order of AO preferred an appeal before the Ld. CIT (A), who in turn deleted the addition made by AO and allowed the appeal of assessee vide his order passed u/s. 250 of the Act.
4. Now, revenue being aggrieved with this order of Ld. CIT (A), preferred this appeal before us for further adjudication. We have gone through the order of AO, order of Ld. CIT (A) and submissions of the assessee. We observed that during the assessment proceedings, assessee vide its submission confirmed that they are following “completed service contract method” and relied upon the Accounting Standard-9, issued by the Institute of Chartered Accountants of India. As per Para 6 and 8 of the assessment order, we observed that these are the part of assessee’s submission, which became part of the assessment order. Whereas, vide para 12 of the Ld. CIT (A)’s order (Under the head assessee’s submissions) on page 15, it is mentioned that “Appellant has never claimed Completed Service Contract Method” as appropriate method to recognize revenue from subscription services. Rather, it is the Percentage Completion Method for recognition of revenue, which is applicable to the facts of the appellant.” It was further stated in assessment order vide para 13 on page no 4, that “Assessee has deferred its revenues, but has charged all the related expenses- training cost, marketing cost and other costs attributable to the sales without matching it with the revenue in the year of sale, which is in violation of “Matching Principle”. The revenue recognition cannot be deferred in the instant case, even if certain services are required to be performed by the assessee, expenses on such maintenance services can be charged to P&L account on actual basis.”
5. On this issue of Matching Principle, assessee submitted its explanation before the Ld. CIT (A) vide para 40, 41 and 42 of the Ld. CIT (A)’s order (Under the head assessee’s submissions) on page 30 as under:
“40. without prejudice to our submissions, the Ld. AO has also erred in observing that the Appellant is not following the matching concept of revenue and expense and that revenue has been deferred while claiming expenses upfront. The Ld. AO has failed to appreciate that the business model of the Appellant has changed from AY 2011-12 as also identified by the Hon’ble Tribunal in its order (refer para 46, page 114)
41. under the current model applicable for the subject AY, the Appellant is required to pay Royalty and Service Fee to Red Hat US as a specified percentage of the revenues recorded in the profit and loss account.
42. Given the same, we wish to submit that the expenses recognized by the Appellant from AY 2011-12 onwards (i.e. the royalty and service fee charges) correspond to and link with the amount of revenue recognized by the Appellant and the corresponding expenses pertaining to the unearned revenue recorded by the Appellant in its books are recognized in the year in which such unearned revenues are recognized and offered to tax by the Appellant.”
6. In view of above discussion, it can be pointed out that bone of contention between assessee and revenue is of two-fold, namely assessee is neither following correct method of revenue recognition and principle of matching cost and revenue is being violated. On this, we have analysed the earlier order of coordinate benches also for A.Y. 2012-13, 2013-14 and 2014-15 vide ITA Nos. 1456 & 7271/Mum/2017, Dated:10-04-2019 and ITA No.7210/Mum/2018, Dated: 29-06-2021. On revenue recognition issue relevant extract of coordinate bench’s finding vide ITA No. 7210/Mum/2018 is reproduced herein below as under:
“61. Upon careful consideration we find that assessee has been following consistent system of revenue recognition. The assessee is inter alia engaged in the business of marketing, promotion and sale of ‘Red Hat subscriptions’ to customers in Indian subcontinent to avail support services that are for the open-source software system during the subscription period ranging from one to seven year, which is established by the special services agreement or contract. As per the consistent policy of revenue recognition, the assessee accounts for the revenue for service which would be performed in future year in its books as unearned revenue. Assessee’s claim is that this practice by the Assessee in respect of accounting for the sale of subscription is in with Accounting Standard-9 issued by ICAI. In support of this it is submitted that for rendering of service AS-9 provides that revenue should either be recognized on straight line basis over a period in which services are proposed to be rendered. The Assessing Officer has tinkered with this regularly adopted system on the plea that no further services are required to be performed by the assessee, that there is no significant uncertainty existing regarding amount of consideration that will be derived. The Assessing Officer has also found fault with completed contract method claimed to have been followed by the assessee.
62. Assessee’s contention in this regard is that the assessee never claimed that it is recognizing revenue from subscription under completed service contract method rather it is following the percentage competition method for recognition of revenue. Assessee has further reiterated that the assessee has been regularly recognizing revenue over a period to which such subscription relates. It has been claimed that the said practice of recognizing revenue is in accordance with percentage complete method of AS-9. The assessee has further placed reliance upon the Income Computation and Disclosure Standard (ICDS) issued by the CBDT pursuant to section 145(2) vide Notification No. 21/2016 dated 29.9.2016 for the proposition that when services are provided by indeterminate number of acts over a period of specified time. Revenue may be recognized on straight line basis over specified period. The assessee has further relied upon the analogy from recently introduced section 43CB. In the light of the above assessee’s contention is that subscription package agreed may involve various support services which cannot be pre-determined. Recipient of service can raise queries numerous times during the tenure of agreement. Similarly, any correction bug fixes etc. can be required by the customers any time during the duration of the agreement. In the light of the above submissions in our considered opinion the Assessing Officer has clearly erred in changing consistently followed method of revenue recognition adopted by the assessee. In the facts and circumstances elaborately dealt with above, we find due merits of the revenue recognition adopted by the assessee which is duly supported by mandate of AS-9 and other parameters referred above.
63. We also note that it is also a settled law that unless there is change in the facts and circumstances or that it can be said that earlier adopted system was wrong, revenue recognition method cannot be disturbed. We note that such case exists here. In these circumstances, we set aside the order of the Assessing Officer and delete the addition in this regard.”
7. We also respectfully concur with the findings of coordinate bench discussed (supra) as assessee is consistently following this practice of accounting and upheld the same by Ld. CIT (A) and Coordinate Benches. On the issue of violation of principle of Matching, it is noticed that assessee himself has offered the income before the Ld. CIT (A) vide page 30 of the Ld. CIT (A)’s order, but the same with a rider that royalty and other charges payable to Red Hat USA should also be allowed, because the same has been deferred by the assessee in the same ratio, in which receipts are being deferred. In that situation, the preposition which emerges is revenue neutral and no action is required. In the given situation we are not inclined to interfere in the order of Ld. CIT (A). Resultantly, all the grounds raised by revenue are dismissed.
8. In the result, appeal of the revenue is dismissed.
Order pronounced in the open court on 14th day of August, 2023.