Supreme Court settles deduction of lease equalization charges in income tax: Commissioner of Income Tax vs. Virtual Soft Systems Ltd. (24 April 2018)

Introduction

Date of the Judgment: 24 April 2018
Citation: (2018) INSC 341
Judges: R.K. Agrawal, J. and Abhay Manohar Sapre, J.

Can a company deduct lease equalization charges from its income tax calculations, based on accounting standards set by the Institute of Chartered Accountants of India (ICAI)? This was the core question before the Supreme Court of India in the case of Commissioner of Income Tax-VI vs. Virtual Soft Systems Ltd. The court examined whether the Income Tax Act, 1961 allows for such deductions, especially when the Act itself does not explicitly mention them. The judgment, delivered by a two-judge bench of Justices R.K. Agrawal and Abhay Manohar Sapre, addressed this important aspect of income tax law.

Case Background

The case involves the Income Tax Department (the appellant) and Virtual Soft Systems Ltd. (the respondent), a company registered under the Companies Act, 1956. On December 29, 1999, the respondent filed its income tax return for the assessment year 1999-2000, declaring a loss of Rs 70,24,178. The company also claimed a deduction of Rs 1,65,12,077 as lease equalization charges. The Assessing Officer, during scrutiny, disallowed the deduction of Rs 31,65,12,077, adding it to the respondent’s income under the Income Tax Act, 1961.

The respondent appealed to the Commissioner of Income Tax (Appeals), who upheld the Assessing Officer’s decision on September 15, 2005. Subsequently, the Income Tax Appellate Tribunal (ITAT) allowed the respondent’s appeal on February 19, 2010, setting aside the orders of the CIT (Appeals) and the Assessing Officer. The Revenue then appealed to the High Court, which dismissed the appeals on February 7, 2012, confirming the ITAT’s decision. This led the Revenue to file the instant appeal before the Supreme Court.

Timeline

Course of Proceedings

The Assessing Officer disallowed the deduction claimed by the Respondent for lease equalization charges. The Commissioner of Income Tax (Appeals) upheld this decision. However, the Income Tax Appellate Tribunal (ITAT) reversed these orders, allowing the deduction. The High Court upheld the ITAT’s decision, leading the Revenue to appeal to the Supreme Court.

Legal Framework

The core legal issue revolves around the interpretation of the Income Tax Act, 1961, specifically whether it allows for the deduction of lease equalization charges. The court also considered Section 211 of the Companies Act, 1956, which pertains to the form and content of balance sheets and profit and loss accounts. Sub-section (3C) of Section 211, added by a 1999 amendment, defines “accounting standards” as those recommended by the Institute of Chartered Accountants of India (ICAI), until the Central Government prescribes its own standards. The relevant portion of Section 211 of the Companies Act, 1956 is reproduced below:

“(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.”

The court also examined the Guidance Note on Accounting for Leases issued by the ICAI, particularly the 1995 revision. This note outlines how to account for leases, including the concept of lease equalization charges. According to the Guidance Note, lease rentals should be shown separately under ‘Gross Income’ in the profit and loss account. A matching lease annual charge should be made to the profit and loss account, representing the recovery of the net investment/fair value of the leased asset over the lease term. This annual lease charge comprises minimum statutory depreciation and a lease equalization charge, where applicable.

Arguments

Revenue’s Arguments:

• The Revenue argued that lease equalization charges are an artificial calculation, which bifurcates lease rental into capital recovery and interest components.
• According to the Revenue, the entire lease income should be considered as the income of the assessee.
• The Revenue contended that there is no provision for deduction of lease equalization charges under the Income Tax Act, 1961.

Respondent’s Arguments:

• The Respondent argued that the Guidance Note issued by the ICAI carries significant weight, and the method of accounting prescribed in it cannot be disregarded unless it falls under Section 145(3) of the Income Tax Act, 1961.
• The Respondent submitted that lease equalization charges are a method of adjusting depreciation to reflect real income, as approved by a professional body like ICAI.
• The Respondent contended that the High Court’s judgment was well-founded and within the parameters of law.

The Revenue argued that the lease equalization charge is an additional deduction, which is not allowed under the Income Tax Act, 1961, and the entire lease income should be taxed. The Respondent argued that the Guidance Note issued by the ICAI is a valid method of accounting to compute real income, and the lease equalization charge is a method of adjusting depreciation to reflect the real income and not an additional deduction.

Issues Framed by the Supreme Court

The Supreme Court framed the following issue for consideration:

1. Whether the deduction on account of lease equalization charges from lease rental income can be allowed under the Income Tax Act, 1961, on the basis of the Guidance Note issued by the Institute of Chartered Accountants of India (ICAI)?

Treatment of the Issue by the Court

The following table demonstrates as to how the Court decided the issues

Authorities

The Court considered the following authorities:

Judgment

How each authority was viewed by the Court?

• The Guidance Note on Accounting for Leases (1995) of the ICAI was considered as a valid method of accounting to compute real income.
• Section 211 of the Companies Act, 1956 was referred to highlight that accounting standards prescribed by ICAI are valid until the Central Government prescribes its own standards.
• The case of Commissioner of Income Tax-VII, New Delhi vs. Punjab Stainless Steel Industries (2014) 15 SCC 129 was used to emphasize the relevance and reliance on materials published by bodies of accountants like ICAI.

What weighed in the mind of the Court?

The Supreme Court’s decision was primarily influenced by the need to determine the real income of the assessee. The Court emphasized that the method of accounting prescribed by the ICAI in its Guidance Note is a valid way to separate the capital recovery component from the finance income in lease transactions. The court noted that taxing the entire lease rental without such bifurcation would be contrary to the principles of the Income Tax Act, 1961. The court also emphasized that the ICAI is an expert body and its guidance notes should be given due consideration.

The court’s reasoning was that the Guidance Note of ICAI provides a method to capture the real income. The court held that the bifurcation of lease rental is essential to ensure that only the revenue receipts are taxed and not the capital recovery component. The court also held that the ICAI is an expert body and its guidance notes should be given due consideration.

The court considered the method of accounting provided in the Guidance Note of 1995, which adjusts the inflated cost of interest of the assets in the balance sheet. The court also considered the fact that the Guidance Note captures “real income” by separating the element of capital recovery and the finance income. The court also considered the principle of substance over form, which is a fundamental principle of accounting. The court also considered that there is no express bar in the Income Tax Act, 1961, which bars the bifurcation of the lease rental.

The court rejected the argument that the bifurcation of the lease rental is an artificial calculation. The court held that the lease equalization is an essential step in the accounting process to ensure that only the real income is captured for the purposes of income tax. The court also held that the bifurcation of the lease rental is analogous to the manner in which a bank would treat an EMI payment made by the debtor on a loan advanced by the bank.

The court quoted from the judgment:

“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 equalization 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.”

“To sum up, we are of the view that the Respondent is entitled for bifurcation of lease rental as per the accounting standards prescribed by the ICAI. Moreover, there is no express bar in the IT Act regarding the application of such accounting standards.”

Key Takeaways

• Lease equalization charges can be deducted from lease rental income for income tax purposes, based on the accounting standards prescribed by the ICAI.
• The Guidance Note issued by the ICAI is a valid method of accounting to compute real income.
• The Income Tax Act, 1961 does not expressly bar the bifurcation of lease rental into capital recovery and finance income.
• The entire lease income cannot be taxed as it includes capital recovery, which is not a revenue item.

Directions

No specific directions were given by the Supreme Court in this judgment.

Development of Law

The Supreme Court’s judgment clarifies that the accounting standards prescribed by the ICAI can be used to bifurcate lease rentals for the purpose of income tax. This is a significant development as it recognizes the importance of accounting standards in determining real income. The ratio decidendi of the case is that the lease equalization charges can be deducted from the lease rental income based on the accounting standards prescribed by the ICAI. This judgment clarifies that the entire lease income cannot be taxed as it includes capital recovery, which is not a revenue item.

Conclusion

The Supreme Court dismissed the appeal filed by the Income Tax Department, upholding the High Court’s decision. The court held that lease equalization charges can be deducted from lease rental income based on the Guidance Note issued by the ICAI. This judgment settles the legal position on the deduction of lease equalization charges and provides clarity for businesses that engage in lease transactions.

Category

Parent Category: Income Tax Act, 1961
Child Categories:

• Deductions under Income Tax Act, 1961
• Lease Equalization Charges
• Section 145, Income Tax Act, 1961

FAQ

Q: What are lease equalization charges?
A: Lease equalization charges are a method of adjusting depreciation claimed in the books of accounts to reflect the real income from a lease transaction. It separates the capital recovery component from the finance income.

Q: Can lease equalization charges be deducted for income tax purposes?
A: Yes, the Supreme Court has ruled that lease equalization charges can be deducted from lease rental income, based on the accounting standards prescribed by the Institute of Chartered Accountants of India (ICAI).

Q: What is the significance of the ICAI Guidance Note in this context?
A: The ICAI’s Guidance Note on Accounting for Leases is considered a valid method of accounting to compute real income. The Supreme Court has recognized the ICAI as an expert body, and its guidelines are to be given due consideration.

Q: Does the Income Tax Act, 1961, explicitly allow this deduction?
A: While the Income Tax Act, 1961, does not explicitly mention lease equalization charges, the Supreme Court has clarified that there is no express bar against such deductions when they are based on valid accounting standards.

Q: What is the practical implication of this judgment for businesses?
A: Businesses that engage in lease transactions can now deduct lease equalization charges, based on the ICAI’s Guidance Note, to arrive at their real income for tax purposes. This ensures that they are not taxed on the capital recovery component of lease rentals.