Case Law Details
This Tax Alert summarizes a recent ruling of the Special Bench of the Chennai Income Tax Appellate Tribunal (SB) [ITA Nos. 2412 to 2416/Mds/2005] in the case of M/s Mahindra Holidays & Resorts (India) Ltd. (Taxpayer) on the issue of tax ability, under the Income Tax Law (ITL), of timeshare membership fee received upfront by the Taxpayer in the initial year of enrollment of a member.
The SB held that the entire amount of timeshare membership fee receivable upfront by the Taxpayer, at the time of enrollment of a member, is not the income chargeable to tax in the initial year, on account of contractual obligation to provide services in future over the term of contract.
Facts
(I) The Taxpayer has resorts in tourist places and is in the business of selling timeshare units for these resorts. It grants membership for a specified number of years on payment of certain amount. It initially granted membership for 33 years which was later reduced to 25 years (Contracted Period). During the currency of the membership, the member gets a right to have a holiday for one week in a year at the place of his choice from among st the places offered by the Taxpayer. Further, the member has a right to transfer or gift his membership/ timeshare unit to any other person.
(II) The Taxpayer charges the following fees from its members:
- Membership fee, which is received in lump sum or in installments, as opted by the prospective member.
- Annual maintenance charges (AMC) or annual subscription fees (ASF) or administrative charges, which are generally collected irrespective of whether the member makes use of the resort or not.
- Additional charges towards utilities like electricity, water, air-conditioning, heater etc., if the member utilizes the resort.
(III) The entire membership fee received in lump sum by the Taxpayer is not offered for taxation in the year of receipt. During the first three years of its operation, the Taxpayer recognized 40% of the receipts as income in the year of receipt. The balance 60% amount was equally spread over the residual Contracted Period. The amount collected from members, but not recognized as income of the current year, is shown as ‘deferred income’ in the balance sheet.
(IV) The Tax Authority observed that the Taxpayer follows mercantile system of accounting and, hence, the income has to be accounted for on accrual basis. It was of the view that the receipts were undisputedly in the nature of ‘income’ and furthermore the ITL does not recognize the concept of ‘deferred income’. Hence, the entire lump sum amount of the membership fee received by the Taxpayer is taxable as income in the year of receipt itself.
(V) On appeal by the Taxpayer, the first appellate authority ruled in favor of the Taxpayer that the income may be spread over the contracted period. It observed that the Taxpayer has to construct holiday resorts and provide timeshare facilities over a period of time. It has to incur heavy costs for major renovation and replacement of assets.
(VI) Aggrieved by the above, the Tax Authority appealed before the second appellate authority and an SB was constituted to adjudicate the issue.
Issue before the SB
Whether the entire amount of the timeshare membership fee, receivable upfront by the Taxpayer at the time of enrolment of a member, is the income chargeable to tax in the initial year, under the ITL.
Tax Authority’s
contentions
(I) The Taxpayer follows mercantile system of accounting. According to the prescribed accounting standard (AS) on revenue recognition, the revenue has to be recognized once the sale has taken place. Further, all the expenses incurred during the year were allowed since the ITL does not recognize the concept of deferred income.
(II) A person becoming member was actually purchasing occupancy right for a specific floor area for a specified number of days. The fee collected by the Taxpayer becomes its exclusive asset. Only under exceptional circumstances, like default in payment of installments or AMC/ ASF, can there be cancellation of membership.
(III) The Taxpayer’s claim that it had to incur expenses in the future was incorrect. The AMC/ ASF collected on an annual basis from the members were sufficient to carry out the normal maintenance of the resorts. Further once a person has taken membership, no marketing expenses are to be incurred in the future.
(IV) There was no obligation on the part of the Taxpayer to refund the membership fee.
(V) In a litigation relating to a service tax matter of the Taxpayer, it was averred that the Taxpayer had no further services to be rendered once the contract and membership enrollment were executed.
Taxpayer’s contentions
(I) Though the membership fee was received in full, the Taxpayer had not become richer as there was a corresponding liability on the Taxpayer to service the members for the Contracted Period. The membership fee represents only an advance in the hands of the Taxpayer and it becomes owner of the entire sum only when the service obligation is fully discharged for the entire period of the membership.
(II) The recognition of income over the years of membership is purely a commercial transaction, based on the industry norms.
(III) Income may accrue in the year of receipt but when the benefit is spread over a number of years, income should also be spread, otherwise the accounts will show distorted profits. In this regard, reliance was placed on the Supreme Court (SC) decision in the case of Madras Industrial Investment Corporation Ltd.E13
(IV) Profits and gains accrue when they first come into existence or the right to receive them comes into existence. However, they may be said to arise when the method of accounting shows them in the shape of profits or gains. Hence, there may be a case, depending on the method of accounting, that the income accrues in one year but arises in a different year and is received at some third point of time. In such cases, the actual charge is at one of these three points of time as the taxpayer’s method of accounting warrants.
(V) As per the AS on recognition of revenue from service transactions, 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.
(VI) The Tax Authority had no right to tinker with the accounts of the Taxpayer if the method of accounting was systematically followed and was in accordance with the AS. The method followed by the Taxpayer was not irrational but was sanctified by usage.
(VII) Over a period of time, there has been an increase in the number of resorts and memberships and there is a continuing obligation to provide occupancy to the members. The resorts are highly rated and, therefore, the Taxpayer incurs heavy costs for their maintenance and upkeep. Marketing expenses have to be incurred not only to attract new members but also to motivate the existing members to use the resorts.
SB decision
(I) Relying on the SC decision in the case of E.D. Sassoon & Co. Ltd.E23, the SB observed that the following two conditions are necessary to say that income has accrued to or earned by a taxpayer: (i) The taxpayer must have contributed to its accruing or arising by rendering services or otherwise.(ii) A debt must have come into existence and the taxpayer must have acquired a right to receive the payment. In the present case, a debt is created in favor of the Taxpayer immediately on execution of the contract. However, it cannot be said that the Taxpayer has fully contributed to its accruing by rendering services which will be done over a number of years.
(II) There is a continuing liability on the part of the Taxpayer not only to provide accommodation but also to provide other incidental services attached with the accommodation. As per the membership rules, the Taxpayer is liable to pay liquidated damages if it is not in a position to provide accommodation as per confirmed reservation. Further, if the Taxpayer is not able to provide accommodation in any of its notified resorts, it may try to procure alternate accommodation at its own cost.
(III) There is no scientific basis to reasonably quantify future costs to be incurred to meet the contractual obligation. Reliance was placed on the SC decision in the case of Rotork Controls India Pvt. Ltd. [314 ITR 62] wherein the SC has observed that a provision of liability is recognized when:
(i) An enterprise has a present obligation as a result of a past event
(ii) It is probable that an outflow of resources will be required to settle the obligation
(iii) A reliable estimate can be made of the amount of the obligation. In the present case, the third condition is difficult to satisfy. If the Taxpayer is not able to provide accommodation, it has an obligation to make available, at its own cost, alternate accommodation to the members, resulting in additional expense for the Taxpayer. Hence, considering the difficulty in reasonably estimating the liability in monetary terms, no provision can be made.
(IV) There is a definite liability cast on the Taxpayer to fulfil its promise and, therefore, it cannot be said that the entire fee received by it has accrued as income. Further, no reasonable provision for the liability can be made. Therefore, recognizing the entire receipt as income in the year of receipt can lead to distortion of profits. Reliance was placed on the SC decision in the case of Madras Industrial Investment Corporation (supra).
(V) All that the Taxpayer contended in the service tax litigation was that there is no taxable event under Service Tax Law once a person becomes a member. The Tax Authority’s contention based on the service tax litigation that there is no service left to be rendered by the Taxpayer was rejected. The Taxpayer is bound to provide accommodation for one week in a year during the tenure of the membership and the above claim was with regard to a taxable event under the Service Tax Law.
(VI) The entire amount of timeshare membership fee receivable upfront by the Taxpayer at the time of enrollment of a member is not the income chargeable to tax in the initial year, on account of the contractual obligation to provide services in future over the term of contract.
Comments
This ruling provides guidance on recognition of income in the hospitality industry with regard to the specific business of sale of timeshare units. The SB also acknowledges the well-established principles of true and fair accounts, taxation of real income, matching principle etc.
The issue of taxation of timeshare receipt has been a subject matter of litigation, with certain appellate authorities upholding upfront taxation in the year of receipt. This ruling decides the issue in favour of the taxpayers. The principles of ruling will also apply to taxpayers in other industries such as clubs, magazine subscription etc., which operate under the business model of receipt of upfront consideration but with a covenant to provide services over a long period of time.
Under the provisions of the ITL, a special bench of a tribunal consisting of three or more members may be constituted for disposal of any particular case. Such benches are generally constituted when there are conflicting decisions or the matter pending for adjudication is of considerable importance. It is also a well-settled judicial convention to consider a decision of a special bench as binding on the other benches of the tribunal.
Please clarify whether any appeal has made by the department against the SB decision?