Supreme Court Ruling – The Guidance Note issued by Institute of Chartered Accountants of India on lease rental income which helps to compute lease equalisation charges, held to be allowable as a deduction. There is no express bar in the Income-tax Act, 1961 regarding the application of such accounting standards.
CIT-VI vs. Virtual Soft Systems Ltd.
[Civil Appeal Nos. 4358 to 4376 of 2018]/  92 taxmann.com 370 (SC)
Facts of the case
The appellant is the Income Tax Department, on the other hand, the respondent (assessee) - M/s Virtual Soft Systems Ltd. is a company registered under the provisions of the Companies Act, 1956.
On 29.12.1999, the assessee filed return of income for the Assessment Year 1999-2000 declaring a loss of INR 70,24,178; after claiming a deduction of INR 1,65,12,077 for lease equalisation charges.
The case of the assessee was reopened under section 147/148 of the Income-tax Act, 1961 (the Act) and notice was issued to show cause as to why lease equalisation charges debited to the profit and loss account should not be disallowed and, thereupon, added to the assessee's income. The assessee submitted that the lease equalisation charge was in accordance with the Guidance note on Accounting For Leases issued by the Institute of Chartered Accountants of India (ICAI) dated 20.09.1995. It also submitted that on 25.01.1996, the Central Government has issued an Accounting Standard qua section 145, which mandates that the accounting policy of the assessee should be such so as to represent true and fair view of the affairs of the assessee's business.
The Assessing Officer (AO), however, rejected the submission of the assessee, and came to the conclusion that the taxable income of the assessee had to be determined as per the Act; and that the said guidance note of the ICAI only provided guidelines for preparation of financial statements for the purposes of accounting. The sum and substance of the AO’s order was that the lease equalisation charge, was a notional charge on the profits of the assessee.
The AO held that the said lease equalisation charge represented an amount set aside out of profits of the assessee to equalize the imbalance between lease rental and depreciation created over a period of time and was thus a provision, and not an expense incurred by the assessee. Therefore, a mere provision made for gauging the profitability of a business venture could not be claimed as a deduction under the Act. The AO thus, disallowed deduction claimed for the lease equalisation charges and added the same to the income of the assessee.
Being aggrieved with the said assessment order, the assessee preferred an appeal before the Commissioner of Income Tax (Appeals) [CIT(A)]. The CIT(A), vide order dated 15.09.2005, upheld the order of the AO and dismissed the assessee’s appeal.
Being dissatisfied, the assessee preferred an appeal before the Income Tax Appellate Tribunal (ITAT). The ITAT allowed the appeal of the assessee while setting aside the orders passed by the CIT(A) and the AO, vide order dated 19.02.2010.
Decision of the ITAT
The ITAT observed that the method of accounting given by ICAI, considers four elements in the profit and loss account, that is, (i) Lease rentals (ii) Implicit rate of return (IRR) (iii) Depreciation and (iv) Lease equalisation.
While three are known factors, i.e., lease rentals, IRR and depreciation; the fourth one is obviously arrived at by balancing the other three. Thus, the quantum of depreciation that is allowed does not invalidate the method of accounting, as lease equalisation varies directly in proportion to the quantum of depreciation. The Guidance Note is not rate specific or Act specific. Thus, the conclusion of the Revenue that a higher rate of depreciation provided in the Act, if availed by the assessee disentitles him to adopt the method of accounting suggested by the ICAI is totally incorrect.
Regarding objection of the Revenue that the deduction claimed by the assessee on account of lease equalisation is not covered by any section of the Act, the ITAT observed that no deduction is being allowed to the assessee if one considers the entire lease period. Even if one considers year-wise effect, it is not a deduction being allowed to the assessee as an expense but it is an adjustment in consideration of lease rental income, to ensure that correct finance income is brought to tax in each year of the lease period. Further, the same is as per the guidance note issued by ICAI and it is also held by the Hyderabad Tribunal in the case of Pact Securities & Financial Ltd.  86 ITD 115 (Hyd.), and the same should not be disturbed.
The ITAT observed that in the initial years, the assessee may get extra deduction but that is not on account of allowing deduction of lease equalisation amount debited in the profit and loss account but it is on account of depreciation allowed as per the Income-tax Rules, 1962 (the Rules). This so, if one considers the total deduction during the full period of lease, which is 30 years in the present case, it is found that no deduction stands allowed to the assessee on account of lease equalisation because these are debited in some years and credited in some other years, and sum total for the entire period of 30 years is nil.
The depreciation allowed to the assessee in the present years as per the Rules is higher as compared to depreciation as per the Companies Act, 1956 debited in books but total depreciation allowable to the assessee under the Rules in full lease period of 30 years cannot exceed the cost of assets and hence, total deduction actually allowed to the assessee will be only depreciation allowable to the assessee as per the Rules. Since, sum total of lease equalisation in full lease period of 30 years is nil, there is no case to disallow or alter the lease equalisation charge debited by the assessee in profit and loss account. Hence, this ground of the assessee is allowed in all four years.
Being aggrieved, the Revenue took the matter before the Hon’ble Delhi High Court (HC). The HC, vide order dated 07.02.2012, dismissed the appeals at the preliminary stage while confirming the decision of the ITAT.
Decision of the High Court
Based on above background, the HC discussed whether the books of accounts could be rejected by the AO, merely for the reason that recourse to the Guidance Note was taken by the assessee.
The HC observed that the Guidance Note reflects the best practices adopted by the accountants, the world over. The fact that, at the relevant point in time, it was not mandatory to adopt the methodology professed by the Guidance Note issued by the ICAI, is irrelevant, for the reason that, as long as there was a disclosure of the change in Accounting Policy in the accounts, which had a backing of a professional body such as the ICAI, it could not be discarded by the AO. This is specially so, since the ICAI is, recognized as the body vested with the authority to recommend accounting standards for ultimate prescription by the Central Government in consultation by the National Advisory Committee of Accounting Standards, for presentation of financial statements.
The HC thus concluded that in essence the lease equalisation 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 method employed by the assessee, therefore, over the full term of the lease period would result in the lease equalisation charge 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 Act is, in view of the HC, a complete misappreciation of what constitutes a lease equalisation charge.
Hence, the Revenue further filed appeal before the Hon’ble Supreme Court (SC).
Key Observations / conclusions of the SC
The ICAI is an expert body, created by the Parliament under the Chartered Accountants Act, 1949. The ICAI’s publication on the subject indicates that the Guidance Note on Accounting for Leases was issued by it for the first time in 1988 which was later on revised in 1995. The Guidance Note reflects the best practices adopted by the accountants throughout the world.
As per the Guidance Note, the annual lease charge represents recovery of the net investment/fair value of the asset over the lease term. The finance income reflects a constant periodic rate of return on the net investment of the lessor outstanding in respect of the finance lease. While the finance income represents a revenue receipt to be included in income for the purpose of taxation, the capital recovery element (annual lease charge) is not classifiable as income, as it is not, in essence, a revenue receipt chargeable to income tax.
The method of accounting followed, as derived from the ICAI’s Guidance Note, is a valid method of capturing real income based on the substance of finance lease transaction.
The bifurcation of the lease rental is, by no stretch of imagination, an artificial calculation and, therefore, lease equalisation is an essential step in the accounting process to ensure that real income from the transaction in the form of revenue receipts only is captured for the purposes of income tax. Further, if the same was not carried out, the assessee would be assessed for income tax not merely on revenue receipts but also on non-revenue items which is completely contrary to the principles of the Act and to its Scheme and spirit.
The assessee can show fair and real income which is liable to tax under the Act, only after applying such method which is prescribed in the Guidance Note. Therefore, it is wrong to say that the assessee claimed deduction by virtue of Guidance Note, rather it only applied the method of bifurcation as prescribed by the ICAI.
Further, the Hon’ble SC in the case of Punjab Stainless Steel Industries ( 15 SCC 129) held that: “….The ICAI has published some material under the head "Guidance Note on Tax Audit under Section 44B of the Income Tax Act". The said material has been published so as to guide the members of the ICAI. In our opinion, when a recognized body of Accountants, after due deliberation and consideration publishes certain materials for its members, one can rely upon the same…."
Hence, the SC in the assessee’s case held that, there was no force in the contention of the Revenue that the accounting treatment prescribed by the Guidance Note cannot be used to bifurcate the lease rental to reach the real income for the purpose of tax under the Act.
The main contention of the Revenue is that the assessee cannot be allowed to claim deduction regarding lease equalisation charges, as there is no express provision regarding such deduction in the Act. However, it is apt to note here that the assessee can be charged only on real income which can be calculated only after applying the prescribed method. However, the Act is silent on such deduction or calculation.
Moreover, the rule of interpretation says that when internal aid is not available then for the proper interpretation of the Statute, the court may take the help of external aid. If a term is not defined in a Statute then its meaning can be taken as is prevalent in ordinary or commercial parlance. Hence, the SC did not find any force in the contentions of the Revenue that the accounting standards prescribed by the Guidance Note cannot be used to bifurcate the lease rental to reach the real income for the purpose of tax under the Act.
The SC thus held that, for such calculation, it is obvious that the assessee has to take course of Guidance Note prescribed by the ICAI, if it is available. Hence, the deduction for lease equalisation charge was thus allowable.
The Hon’ble SC, considering the facts of the case, and the nuances around finance lease transactions, it has correctly held that, lease equalisation charges is a deductible expenditure, as the essence of the accounting entries, is to only capture the finance income, which is the real income, in case of such transactions.
However, one has to bear in mind that the proposition that accounting entries, Guidance Note of the ICAI, etc., determines real income is limited to the facts of the case and what is taxable under the Act, is only income, and that as laid down by the SC in various cases, books of accounts is not determinative of income, is still true.
This decision does not seem to incorporate the nuances between book depreciation and depreciation allowed under the Act, which would determine the lease equalisation charge, which in turn determines the true real income, under the finance lease transaction. The ITAT while observing on the same, took the whole lease period into account and did not consider the above nuances, which could lead to deferment of tax.