Delhi H.C : Lease equalisation charges cannot be reduced while calculating profits

High Court Of Delhi

CIT, Large Taxpayers Unit VS. Indian Railway Finance Corporation Ltd.

Assessment Year : 2001-02

Section : 30, 145, 115JB, 37(1), 32

Sanjiv Khanna And Sanjeev Sachdeva, Jj.

IT Appeal No.1189 Of 2011

October  31, 2013


Sanjiv Khanna, J. – This appeal by the Revenue pertains to the assessment year 2001-02. The Revenue has raised four questions in this appeal and for the sake of convenience these issues are being discussed separately :

Issue No. 1

“Whether the lease equalisation charges can be disallowed/deleted from the profit and loss account for the purposes of computing book profits under section 115JB of the Income-tax Act, 1961 ?”

2. The said issue need not be examined in detail as it is covered against the Revenue vide decision in the case of CIT v. Virtual Soft Systems Ltd. [2012] 341 ITR 593/205 Taxman 257/18 119 (Delhi).

Issue No. 2

“Whether the lease equalisation charges can be reduced/taken into consideration while calculating the profits under the profits and loss account provision of the Income-tax Act ?”

3. This question is also covered by the decision of the Delhi High Court in Virtual Soft Systems Ltd. (supra). In the said decision, nature and character of lease equalisation charges in the case of financial leases was examined and it was observed that the lease equalisation charges or funds have to be set off or included on the expenditure side in the profit and loss account to compute and calculate the profits. The principle of matching, i.e., matching of income with the actual expenditure which is incurred by the assessee to earn the said income applies. In the decision of the Delhi High Court in Virtual Soft Systems Ltd. (supra) from paragraph 9 onwards reference was made to section 145 of the Act and the accountancy standards prescribed by the Institute of Chartered Accountants of India. The accountancy standards prescribed underwent amendment/change from the assessment year 1996-97 in respect of financial leases. Nature and character of lease equalisation charges/funds was examined in paragraph 11 onwards, in paragraph 7.4 of the said judgment, reference was made to the decision of the Tribunal, in the present case, i.e., the impugned decision and referring to these decisions, findings of the Tribunal in the present case was quoted.

4. As we had some doubt whether allowing the lease equalisation charge as a deduction in the profit and loss account under the normal provisions would lead to double deduction and loss of revenue, we had asked, for clarifications as noted in our short order dated October 22, 2013.

5. The learned counsel for the parties were informed on October 23, 2013, and the appeals were listed today for clarification.

6. To understand and appreciate the contentions, certain undisputed facts and the legal position may be noticed. As noticed in Virtual Soft Systems Ltd. (supra), “lease” transactions may take various hues and colours. In the present case, we are concerned only with financial leases and not with an operational lease. In such cases, the lease rent includes the capital as well as purchase price and at the end of the lease tenure the lessee acquires/takes the asset as the owner. The income earned by way of lease rental was the interest (revenue earning) and the amount financed (capital financed) but during the term of the lease, as the respondent continued to be the owner he also enjoyed and claimed the benefit of depreciation (an undisputed position as the claim of depreciation was not questioned). Depreciation was duly debited and accounted in the profit and loss account.

7. In these circumstances, guidance note issued by the Institute of Chartered Accountants of India in respect of accounting for finance leases applies and the accounts of the respondents meet the requisite parameters and requirements.

8. In Virtual Soft Systems Ltd.’s case (supra), it is indicated that the Central Government on January 25, 1996, had issued an accounting standard qua section 145 of the Act which mandates that accounting policy of assessee should be such as to represent true and fair affairs of the assessee’s business. The Institute has from time to time published Accounting Standard, in respect of finance leases. Referring to the said position in Virtual Soft Systems(supra), it has been observed as under (page 602) :

“In this background what is required to be considered is whether the books of account could be rejected by the Assessing Officer merely for the reason that recourse to the guidance note was taken by the assessee. In this regard, we would be required to examine the provisions of section 145 of the Income-tax Act. Section 145 of the Income-tax Act adverts to the method of accounting followed by an assessee. Sub-section (1) of section 145 provides that income chargeable under the head ‘Profits and gains of business or profession’ or ‘Income from other sources’ shall be computed either on cash basis or on mercantile system, whichever method being regularly employed by the assessee. This provision is, however, subject to the Central Government notifying accounting standard in respect of any class of assessee or class of income. Sub-section (3) of section 145 empowers the Assessing Officer to disregard the books of account submitted by the assessee only if he is not satisfied with the correctness or completeness of the accounts of the assessee or the method of accounting employed by the assessee or on account of accounting standards notified under sub-section (2), not being particularly followed by the assessee. In this particular case, the Assessing Officer has disregarded, in substance, the method of accounting followed by the assessee qua lease rentals without basing it on the grounds provided in section 145 of the Income-tax Act. The fact that the assessee justified its method of accounting, by taking recourse to the Guidance Note issued by the ICAI in that behalf, was disregarded, on what we would term as, a disjointed reading of the provisions of the said Guidance Note. Both the Assessing Officer as well as the Commissioner of Income-tax (Appeals) have adverted to paragraph 2 of the Guidance Note to come to what we consider an erroneous conclusion inasmuch as they have held that in determining as to whether deduction on account of the lease equalisation charges ought to be allowed or not, what has to be borne in mind is ultimately the provisions of the Income-tax Act. In our view, such an observation in paragraph 2 of the Guidance Note is really saying the obvious. Therefore, even if this Guidance Note was silent on this aspect the provisions of the Income-tax Act would undoubtedly still apply. Thus, as to what is the impact of provision of paragraph 2 of the Guidance Note will be considered by us as we progress further with our judgment.”

9. In the present case also, we notice that the Assessing Officer has not based the addition on the finding that there was incorrectness or incompleteness in the account or the accounting standard employed by the assessee were contrary to the accounting standard notified by the Government under section 145(2) of the Act.

10. In Virtual Soft Systems Ltd. (supra), it has been further observed (page 607) :

“14.3 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 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 assessee may claim depreciation based on the provisions of the Income-tax 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 equalisation 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 equalisation charge to the profit and loss account. Therefore, the assessee in effect debits or credits its profit and loss account with a lease equalisation 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 equalisation 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 equalisation amount being reduced to a naught, as the debits 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 Income-tax Act is in our view, a complete misappreciation of what constitutes a lease equalisation 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 equalisation charges in the assessment years 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.”

11. The reasoning in the aforesaid paragraph can be best understood, if we refer to the following table by way of an example.

Indian Railway Finance Corporation Ltd.-Sample finance lease chart
Lease value of Rs. 1,00,000

IRR = 12.6159%

Lease Rent Primary = 15% for 15 years

Secondary = 1% for 15 years

Statutory depreciation = Rs. 4,750 per annum

Year Lease Rent Recd. Capital Cost outstanding Finance Charge at IRR Recovery Cost of capital Statutory Depreciation Lease Equalisation DR/(Cr.) Net profit Dep. as per I.T. Taxable Income
1 15,000 1,00,000 12,616 2,384 4,750 (2,366) 12,616 25,000 (7,634)
2 15,000 97,616 12,315 2,685 4,750 (2,065) 12,315 18,750 (1,685)
3 15,000 94,931 11,976 3,024 4,750 (1,726) 11,976 14,063 2,664
4 15,000 91,907 11,595 3,405 4,750 (1,345) 11,595 10,547 5,798
5 15,000 88,052 11,165 3,835 4,750 (915) 11,165 7,910 8,005
6 15,000 84,668 10,682 4,318 4,750 (432) 10,682 5,933 9,499
7 15,000 80,349 10,137 4,863 4,750 113 10,137 4,449 10,437
8 15,000 75,486 9,523 5,477 4,750 727 9,523 3,337 10,936
9 15,000 70,009 8,832 6,168 4,750 1,418 8,832 2,503 11,079
10 15,000 63,842 8,054 6,946 4,750 2,196 8,054 1,877 10,927
11 15,000 56,896 7,178 7,822 4,750 3,072 7,178 1,408 10,520
12 15,000 49,074 6,191 8,809 4,750 459 6,191 1,056 9,885
13 15,000 40,265 5,080 9,920 4,750 5,170 5,080 792 9,038
14 15,000 30,345 3,828 11,172 4,750 6,422 3,828 594 7,984
15 15,000 19,173 2,149 12,581 4,750 7,831 2,419 445 6,723
16 1000 6,592 832 168 4,750 (4,582) 832 334 5,248
17 1000 6,423 810 190 4,750 (4,560) 810 251 5,310
18 1000 6,234 786 214 4,750 (4,536) 786 188 5,349
19 1000 6,020 760 240 4,750 (4,510) 760 141 5,369
20 1000 5,780 729 271 4,750 (4,479) 729 106 5,373
21 1000 5,509 695 305 4,750 (4,445) 695 79 5,366
22 1000 5,204 657 343 250 93 657 59 847
23 1000 4,861 613 387   387 613 45 569
24 1000 4,474 564 436   436 564 33 531
25 1000 4,038 509 491   491 509 25 484
26 1000 3,549 448 552   552 448 19 429
27 1000 2,995 378 622   622 378 14 364
28 1000 2,373 299 701   702 299 11 289
29 1000 1,672 211 789   789 211 8 203
30 1000 883 117 883   883 117 24 93
  2,40,000   1,40,000 1,00,000 1,00,000 (0) 1,40,000 1,00,000 1,40,000

12. The net effect of the aforesaid table shows that the purchase value of the asset which is made subject matter of lease is not taken to the profit and loss account and treated or debited as expenditure. The purchase value or the recovery of capital cost gets distributed/divided over the term of the lease. The acronym IRR stands for Internal Rate of Return, on which there is no dispute. The lease rentals as stated above include recovery of the capital cost. The chart indicates depreciation which an assessee was entitled to claim under the Companies Act. Lease equalisation charge represents the difference between the recovery of cost of capital and the depreciation as claimed under the Companies Act. The difference between the two may be negative or positive and is not constant over the period of the lease. Thus, the net revenue or tax effect is nil in the entire term. This is clear from the net profit as declared under column G. The computation is logical, fair and true reflection of the income earned and reduces abnormalities. The above table indicates that lease equalisation charge results in debit or credit entry in the profit and loss account and it helps the income getting staggered or matched during the entire period of lease.

13. It may be appropriate to also refer to the Reserve Bank of India’s Prudential Norms on Income Recognition, Asset Classification and Provisioning-Pertaining to Advances dated 1st September, 2001, to commercial banks. Under the head “Income Recognition” in paragraph 3.2.3 it has been observed :

“3.2.3 Leased assets

(i)   The net lease rentals (finance charge) on the leased asset accrued and credited to income account before the asset became non-performing, and remaining unrealised, should be reversed or provided for in the current accounting period.

(ii)   The term ‘net lease rentals’ would mean the amount of finance charge taken to the credit of the profit and loss account and would be worked out as gross lease rentals adjusted by amount of statutory depreciation and lease equalisation account.

(iii)   As per the Guidance Note on Accounting for Leases issued by the Council of the Institute of Chartered Accountants of India (ICAI), a separate lease equalisation account should be opened by the banks with a corresponding debit or credit to lease adjustment account, as the case may be. Further, lease equalisation account should be transferred every year to the profit and loss account and disclosed separately as a deduction from/addition to gross value of lease rentals shown under the head ‘Gross income’.”

14. A perusal of the balance-sheet and the profit and loss account for the assessment year 2000-01 reflects the said position. In the said year, the assessee had received lease rentals of Rs. 2,700.48 crores, from which lease equalisation account of Rs. 142,03 crores was reduced. The paid up capital of the respondent company held by the President of India and his nominees was Rs. 232 crores. The addition of the fixed assets in the said year was Rs. 2,273 crores which is reflective as the addition to the quantum of rolling stock. If the purchase price of the rolling stock stands subjected to revenue deduction, would have its own consequences and lead to abnormal financial results and absurdities. The balance-sheet records that the total rolling stock aggregate was Rs. 19,771.35 crores. The depreciation claimed (which may include certain fixed assets also which were not subject matter of finance leases) was Rs. 5,352.57 crores. Clearly, therefore, the purchase value of the leased assets did not find reflection or deduction in the profit and loss account. Legal ratio of Virtual Soft Systems Ltd.(supra) is that as long as the assessee does not indulge in any manipulation of the figures and the capital cost, IRR, etc., are computed in accordance with the accountancy standards and no error or can be found, lease equalisation charge should not be disallowed.

15. In view of the aforesaid position, the second issue has to be decided against the appellant and in favour of the respondent-assessee.

Issue No. 3

“Whether the bond issue expenses were capital or revenue in nature ?”

16. The respondent-assessee had incurred expenditure of Rs. 10,09,92,445 towards bond issue expenses of different series during the year in question. The Tribunal referred to their earlier order in the case of the respondent-assessee for the assessment years 1997-98 to 2000-01 and held that the expenses incurred were revenue expenditure. Reliance was placed upon decision of the Delhi High Court in the case of CIT v. Thirani Chemicals Ltd. [2007] 290 ITR 196/[2006] 155 Taxman 233 wherein it has been held that issue of debentures oil rights basis to the existing shareholders was revenue expenditure and it was not mandatory to amortise the said amount under section 35D of the Act in view of the Circular No. 52, dated March 19, 1971, issued by the Central Board of Direct Taxes.

17. While dealing with a similar issue in CIT v. Havells India Ltd. [2013] 352 ITR 376/[2012] 208 Taxman 114/21 476 (Delhi), it has been held as under (page 392) :

“It is well settled that expenditure incurred in connection with the issue of debentures or obtaining loan is revenue expenditure. Reference in this connection may be made to the leading judgment of the Supreme Court in India Cements Ltd. v. CIT [1966] 60 ITR 52 (SC). The question before us, however, is whether it is a debenture issue or an issue of share capital involving the strengthening of the capital base of the company. Though it prima facie appears that there are sufficient facts to indicate that what was contemplated was an issue of shares to the Mauritius company under the investor agreement which would result in strengthening of the assessee’s capital base, having regard to the judgments cited on behalf of the assessee, in which it has been held that despite indications to the effect that the debentures are to be converted in the near future into equity shares, the expenditure incurred should be allowed as revenue expenditure on the basis of the factual position obtaining at the time of the debenture issue, we are not inclined to take a different view. The following cases have been cited on behalf of the assessee in support of the view that even in such a situation the expenditure is allowable as revenue expenditure :

(i)   CIT v. East India Hotels Ltd. [2001] 252 ITR 860 (Cal) ;

(ii)   CIT v. ITC Hotels Ltd. [2011] 334 ITR 109 (Karn) ;

(iii)   CIT v. South India Corporation (Agencies) Ltd. [2007] 290 ITR 217 (Mad) ; and

(iv)   CIT v. First Leasing Co. of India Ltd. [2008] 304 ITR 67 (Mad).

In addition to the above judgments, we also have the judgment of the Rajasthan High Court in CIT v. Secure Meters Ltd. [2010] 321 ITR 611 (Raj) against which the special leave petition filed by the Revenue was dismissed. Having regard to the predominant view taken in the above judgments, in which the judgment of the Supreme Court in India Cements Ltd. [1966] 60 ITR 52 (SC) has been noticed, we are inclined to uphold the view taken by the Tribunal that the expenditure is revenue in nature.”

18. The respondent-assessee was/is a Government of India undertaking and was engaged in the business of leasing and financing to Indian Railways. It procured funds from various sources and acquired rolling stock which was leased to Indian Railways. The expenditure which was incurred on bonds was for ensuring finance and availability of funds for carrying out the business of finance and leasing. To procure and get funds in the form of bonds etc. some expenditure had to be incurred. These funds, when procured, were used for the business activities to earn income. It is not a case wherein the respondent-assessee was yet to set up or commence their business. The business, it is accepted, had commenced much earlier and not during the year in question.

Issue No. 4

“Whether the assessee is entitled to depreciation on office premises at NBCC place, Lodi Road, New Delhi ?”

19. The contention of the Revenue raised is that the respondent-assessee was not the owner of the building or in possession in part performance under section 53A of the Transfer of Property Act. Learned senior standing counsel has referred to the observations and the contentions raised by the Revenue in paragraphs 17 and 18 of the impugned order, wherein reference is made to agreements dated April 11, 2002, and November 21, 2002. In the agreement dated November 21, 2002, it stated that NBCC had handed over vacant possession to the respondent-assessee. The respondent-assessee, on the other hand, had relied upon letter dated March 29, 2000, received from NBCC wherein it was clearly mentioned that commercial space measuring 625 square meters was allotted to the respondent-assessee, vide letter dated April 28, 1998, and commercial space measuring 285 square meters was initially purchased by MMTC but was sold by them to the respondent-assessee. After noticing the conflicting positions, the Tribunal in paragraph 20.1 has referred to their decision dated August 28, 2009, for the assessment year 2002-03. They have quoted the possession letter dated March 29, 2000, and reached a conclusion that possession was “in fact” or actually was handed over to the assessee before the end of the financial year ending March 31, 2000. The respondent-assessee, therefore, became entitled to benefit under section 53A of the Transfer of Property Act and, accordingly, the decision of the Supreme Court in Mysore Minerals Ltd.v. CIT [1999] 239 ITR 775/106 Taxman 166 was applicable.

20. The aforesaid findings are findings of fact. The Tribunal has taken into account and relied upon the possession letter dated April 28, 1998, in which NBCC had accepted that the possession of the space measuring 625 square meters and 285 square meters was handed over to the respondent-assessee on September 23, 2000. NBCC was/is a Government of India undertaking and it is difficult to accept the contention of the Revenue that they would have fudged or manipulated the date of possession. The factual finding is not perverse.

21. In view of the aforesaid position, we do not find any merit in the present appeal and the same is dismissed.

[Citation : 362 ITR 548]

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