1997-VIL-92-ITAT-HYD
Equivalent Citation: ITD 065, 017, TTJ 062, 033,
Income Tax Appellate Tribunal HYDERABAD
Date: 21.04.1997
DEPUTY COMMISSIONER OF INCOME-TAX
Vs
NAGARJUNA INVESTMENT TRUST LTD.
BENCH
Member(s) : T. V. RAJAGOPALA RAO., R. P. GARG., B. M. KOTHARI.
JUDGMENT
Per Bench ---
The President, Income-tax Appellate Tribunal who is one among us has referred the following question for consideration of this Bench :
"Whether, on the facts and in the circumstances of the case, the SOD/ Indexing system followed by the assessee can be ignored while computing the income on the ground that the income accounted on that basis is not the same as the income which has accrued or arisen under the mercantile system as understood under the Income-tax Act?"
2. The facts relating to the aforesaid case are that the assessee-company (hereinafter referred to as the 'Company') is a Financial company operating in the area of granting credits in various forms to its clients such as in the area of consumer credit, hire purchase. The company is also continuing its activities of Portfolio investments.
2.1 The total profit as per the printed (Audited) Profit and Loss account of the company for the year ended on 31st December, 1986 (relevant to the year under appeal for assessment year 1987-88) is Rs. 1,04,10,150. The company has adopted a system of accounting called the "SUM OF DIGITS METHOD" (for short referred to as the 'SOD' method) which is also known as the 'Indexing Method' for recognition of its income from the business of hire-purchase and leasing. According to the SOD method, the company recognises its income on a time proportion basis taking into consideration the amount outstanding from time to time and the rate applicable. The loading of the entire income is apportioned over the period of the contract in proportion to the reducing balances that will be outstanding from time to time after taking into consideration the repayment schedule in the form of monthly equated instalments. According to the 'SOD' method, the income is thus overstated in the earlier years and in the latter years covering the period of Hire Purchase Agreement/lease Agreements, it is understated.
2.2 However, the company, while filing its income-tax return for assessment year 1987-88, as in the earlier years, has claimed deduction for differential income aggregating to Rs. 52,83,931 as income not accrued to the assessee. According to the assessee, what is chargeable to tax is only that income which has accrued and in determining whether income has accrued or not one has to have regard to the Agreements entered into between the parties and not the method adopted by the assessee to account for finance charges in its books of account.
3. The Assessing Officer (for short referred to as the 'AO') addressed a letter dated 5th March, 1990 to the Company inviting their objections as to why their claim for allowance of an amount of Rs. 52,83,931 as "income which has not accrued as per Hire Purchase/lease Agreement" be not disallowed.
3.1 The company submitted a letter dated 30-3-1990 in reply to certain specific points raised by the AO that since on the basis of book profits computed as per SOD method, dividend of Rs. 60 lakhs has been paid in accordance with section 205 and other provisions of the Companies Act and the audited statements give a true and fair view, the same method of accounting is required to be followed for computation of income under section 145(1) and the company is not entitled to adopt a different method of accounting for income-tax purposes.
3.2 The Company filed a note on the method of accounting adopted for the purpose of books of account and for income-tax purposes. The Assessing Officer after a careful consideration of the various submissions made on behalf of the assessee arrived at the following conclusions recorded on pages 8 and 9 of the assessment order dated 30-3-1990 which are reproduced hereunder:
"I am of the view that for the following reasons, the assessee's books of account should be considered as true and fair and incomes declared therein should be considered real and correct to the assessee :
(i) Section 145 of the Income-tax Act provides that the income chargeable under the head 'profits and gains of business or professions, or income from 'Other Sources' shall be computed in accordance with the method of accounting regularly employed by the assessee. Since the method of accounting followed by the assessee is not disputed and the proviso to section 145 is not applicable, the claim of disallowance to the extent of Rs. 52,83,931 cannot be considered.
(ii) The assessee has shown to the investing public, to the Registrar of Companies, to the other public institutions that the affairs of the Company is true and fair manner and, hence, rejection of books is not warranted.
(iii) The assessee has paid an amount of Rs. 60 lakhs as dividend to the shareholders and created reserve to the tune of Rs. 44 lakhs. Thus, an amount of Rs. 1,04,00,000 is transferred to either capital account or paid as dividend. If the income has not accrued to the assessee to the tune of Rs. 52,83,931 so much of the amount out of the borrowed funds have been paid to the shareholders as dividend. Alternatively, the interest the claim on this amount should not be allowed. However, I am of the view that the assessee-company did receive this much of profit so that they are in a position to pay dividend to the shareholders.
(iv) On the above points and also considering that the other companies in this group are claiming various allowances on the basis of book results even though they are following similar method of accounting, the assessee's contention is not accepted and rejected."
4. The company preferred an appeal against the said assessment order before the Commissioner of Income-tax (Appeals)-IV, Andhra Pradesh, Hyderabad [hereinafter referred to as the 'CIT(Appeals)'], who decided the said appeal vide the impugned order dated 13th February, 1991.
4.1 The learned CIT(Appeals) observed that in assessee's own case for the earlier years, his predecessor had held that the income from hire purchase and leasing was to be computed on accrual basis and not on the basis of SOD method. The CIT(Appeals), however, called for a remand report from the DC(Asstt.) in relation to a different ground relating to management charges paid for service rendered by Nagarjuna Finance Ltd. The DC(Asstt.) in his remand report dated 3-12-1990 had sought for re-appraisal of the decision taken by his predecessor-in-office on the point in issue, which is presently under consideration before us. The CIT(Appeals) has made the following observations at page 3 of his order:
"Though the DC(Asstt.) is not opposed to adopting income from leasing on accrual basis, he is very much emphatic on the need to follow the appellants's own method, as far as income from hire purchase is concerned."
4.2 The CIT(Appeals) then observed as under:
"The income accruing to the appellant under the hire purchase scheme has to be examined only by looking into the very agreement of hire purchase. In the hire purchase agreement, the value of the equipment as well as the finance charges to be collected, usually at 14 per cent over a period of 3 years are mentioned. The consolidated monthly equated installments payable by the hirer is mentioned in the Schedule II of the hire purchase agreement. Composite installment payable by the hirer consists of two elements, namely, part of the principal being the value of the equipment and the finance charges. The principal received constitutes capital receipt while the amount collected towards finance charges is revenue in nature. If as per Schedule II of the hire purchase agreement, the appellant were to receive finance charges at 14 per cent in equated installments for 36 months, it stands to reason that the finance charges as indicated in Schedule II of the hire purchase agreement should be spread equally over 3 years."
The CIT(Appeals) then formulated a question for his consideration "Whether the sum of digits method adopted by the appellant to account for finance charges would prevail over what is stipulated in Schedule II of the Hire Purchase Agreement?' and answered the said question as under:
"The answer is, according to me, that the terms, conditions of hire purchase agreement should prevail over whatever method the appellant had adopted to account for finance charges. The income in the scheme of a contract accrues on the basis of the terms of agreement or the contract and not on a tortium quid. When the appellant is entitled only to collect whatever is stated in Schedule II of the hire purchase agreement, it cannot be said that the appellant collected more by virtue of book entries made by it following indexing method. Where the parties are governed by the terms of the contract and the contractual obligations, it would be far fetched to state that the right to receive for duties performed in accordance with the terms of the contract was, outside the purview of the contract - Such a proposition would be paradoxical. Accordingly, it would stand to reason that Schedule II of the hire purchase agreement dealing with finance charges would prevail over any other method adopted by the appellant to account for finance charges."
He, therefore, held that the finance charges arrived at as per the index system does not definitely represent the amount due to the appellant in a given year. The income due to the appellant for a given year depends upon what is stipulated in Schedule II of the Hire Purchase agreement. That being so, the DC(Asstt.) went wrong in assuming that index system of accounting disclosed the correct income of the appellant under the mercantile system of accounting when both the systems are poles apart. The CIT(Appeals) further observed that the aforesaid view is also fortified by the Board's Circular No. 9 (R. Dis. No. 27(4)-IT/43 dated 23-3-1943) dealing with depreciation on assets acquired under hire purchase agreement.
The CIT(Appeals) then proceeded to formulate another question as to whether the SOD method adopted by the appellant to account for finance charges is a method of accounting or only a principal way of recognising the income ? After examining the relevant aspects, the learned CIT(Appeals) held that as a matter of fact, there is no warrant to exalt the index system of recognising the income to the status of a method of accounting. It is just a formula and nothing more than that and it has no place within the scheme of Income-tax Act.
The learned CIT(Appeals) then examined the principle that tax can be levied only on the real income and not on hypothetical or notional income, although a book keeping entry recognising such a hypothetical income has been made in the books of account. The learned CIT(Appeals) placing reliance on the judgment of the Hon'ble Supreme Court in the case of CIT v. Shboorji Vallabhdas & Co. [1962] 46 ITR 144 and in the case of State Bank of Travancore in paras 6 to 8 of his order and arrived at the following final conclusion in para 9 of his order:
"On a conspectus of the Supreme Court decisions as above, I feel that the issue under appeal is susceptible of an easy resolution by applying the guidelines laid down by the Supreme Court. Accordingly, it would follow that the differential income credited by the appellant was only hypothetical or theoretical income and not real income that either accrued to or was received by it during the year. In that view of the matter, the differential income cannot be brought to tax."
The CIT(Appeals), thus, deleted the addition of Rs. 52,83,931.
5. The revenue has preferred this appeal against the said findings given by the learned CIT(Appeals) and has raised the following grounds:
" 1. The CIT(Appeals) erred in allowing the assessee's claim of differential income as loss.
2. The CIT(Appeals) should have considered that the assessee's books of account are maintained on the method of accounting followed regularly and recognised internationally and as per provisions of section 145, the book results are not rejected and profits from business are computed on the basis of books of account maintained.
3. The CIT(Appeals) should have considered that the assessee paid dividends to the tune of Rs. 60 lakhs on the basis of the income which are shown in the P & L Account.
4. The CIT(Appeals) should have considered that the assessee has maintained the books of account as per the provisions of company law and the same is submitted to the shareholders also.
5. Any other grounds of appeal that may be urged at the time of hearing."
6.1 The learned Senior Departmental Representative (hereinafter referred to as "Sr. D.R.") at the outset invited our attention towards the decision in the case of Nagarjuna Finance (P.) Ltd. in [IT Appeal Nos. 2777 and 2967 (Hyd.) of 1988 dated' 13-3-1995] in which the Tribunal, on identical facts, decided the similar issue in favour of the Revenue. The Tribunal, in the aforesaid decision, has held that the index/SOD method followed by the assessee in its books is a method accepted by the Accounting principles and sanctioned by commercial practice and that income can properly be deduced from the said method. It was held that the Assessing Officer has very rightly computed the income of the assessee in accordance with the said method regularly employed by the assessee. It is not permissible for the assessee to ignore its own method of accounting and its book results and recompute its income in accordance with another method for income-tax purposes. Such findings have been given by the Tribunal in relation to income derived from both hire purchase as well as lease rental income. The Tribunal has given sound and convincing reasons and has also relied upon the judgments of Apex Court and other Courts to support the conclusions arrived at by them. The learned Sr. DR. invited our attention towards various paras of the said order passed by the Tribunal.
6.2 The learned Sr. D.R. submitted that the Company has maintained its books of account on the basis of mercantile method or accrual method in conformity with the provisions of Companies Act. The SOD/indexing method followed by the assessee is based on well-recognised accounting norms specified in the International Accounting Standards, which have duly been approved by the Institute of Chartered Accountants of India. He invited our attention towards the International Accounting Standards 17 as well as the compendium of Guidance Notes issued by the Institute of Chartered Accountants of India. He explained as to what is the meaning of term 'accrual' as he has been explained in the accounting standards as well as the principles as to how the revenue should be recognised in relation to income by way of financial charges received pursuant to hire purchase and lease agreements. He pointed out that according to the said accounting standards, the interest accrues on the time basis determined by the amount outstanding and the rate applicable. The learned D.R. further submitted that the Board of Directors as well as the auditors of the company have to give a report as required by the provisions of Companies Act to confirm as to whether the profit and loss account gives a true and fair view of the profits or loss for its financial year and as to whether the balance sheet as at the end of the financial year give a true and fair view. In the present case, the profit and loss account prepared in accordance with the books of account maintained by the assessee has been approved by the Board of Directors confirming, inter alia, the fact that the profit and loss gives a true and fair view of the profit for the relevant financial year. The company has approved the said audited accounts in its General Meeting. The auditors have also certified that the profit and loss account give a true and fair view of the profits of the company for the relevant financial year. The learned D.R. invited our attention towards auditors' report to corroborate the aforesaid contention. He submitted that the audited profit and loss account disclose a net profit of Rs. 104. 10 lakhs out of which dividends of Rs. 60 lakhs were declared for payment to shareholders and Rs. 44 lakhs were transferred to reserves. Section 205 of Companies Act provides that dividends can be paid only out of profits. The amount of Rs. 60 lakhs has been paid by way of dividend to the share holders in conformity with the requirement of section 205 of the Companies Act. The assessee has, therefore, treated the book profit of Rs. 104. 10 lakhs as its true and real income. Such amount of book profit of Rs. 104. 1 0 lakhs has been notified as true and real profits to the investing public, to its shareholders, to the Registrar of Companies, to the financial institutions and other connected outside world. In view of these facts, the contention of the assessee that differential income to the extent of Rs. 52,83,931 did not in fact accrue to the assessee for the purposes of computation of taxable income under the provisions of Income-tax Act, 1961 is not at all valid or justified.
6.3 The learned D.R. further submitted that the method of accounting adopted by the assessee is a recognised method. It gives a true and correct picture of the profits derived by the company during the relevant financial year. Such a method has been regularly followed from year to year. The assessee is still maintaining its accounts on the basis of similar method of accounting. The Assessing Officer was, therefore, bound to compute the income of the assessee in accordance with such method of accounting regularly followed by the assessee as per the main provisions of section 145(1). The learned Sr. D.R. submitted that before going into the proviso to section 145(1), the Assessing Officer has to consider whether the method of accounting followed by the assessee is a regular and recognised method or not, He has to further examine the question as to whether income, can be properly deduced from such a method of accounting followed by the assessee. The Assessing Officer after carefully considering the correctness of the method of accounting regularly and consistently followed by the assessee came to the conclusion that income may be properly deduced on the basis of such a method of accounting followed by the assessee. The question of applying the proviso to section 145(1), therefore, does not arise at all. The assessee cannot be allowed to adopt a different method of calculating its taxable income for the purposes of filing its returns of income by ignoring the profits determined as per such a recognised method of accounting followed by the assessee for the purpose of maintaining its books of account as required under the provisions of Companies Act.
6.4 The learned Sr. D.R. then explained in a detailed manner as to how the income is recognised according to the SOD method in relation to hire purchase system. For this purpose, he explained the examples given in para 7 of the order passed by the Tribunal in the case of Nagarjuna Finance (P.) Ltd. He submitted that according to the SOD/indexing method followed by the assessee the interest income is recognised in the books of account in such a manner that the entire amount of interest income covering the period of hire purchase agreement/lease agreement will be apportioned over the period of the contract in proportion to the reducing balances that will be outstanding from time to time. It ensures determination of income at a uniform rate of interest implicit in the hire purchase and lease agreement. Such a method of apportionment of the interest income over the period of the hire purchase agreement/lease agreement represents real and true income of the relevant financial year. If the method adopted by the assessee for the purposes of computing its taxable income is accepted, it will lead to absurd results as has been aptly discussed by the Tribunal in the case of Nagarjuna Finance (P.) Ltd. in para 8 of their order. The examples given in para 8 of the said order indicate that interest income, according to the assessee in the first year of hire purchase agreement will come to 14 per cent, in the second year it will come to 21 per cent and in the third year it will come to 42 per cent, if assessee's contention is accepted. However, the assessee in its books of account has recognised such interest income in relation to hire purchase agreement at a uniform rate of interest which is the implicit rate of interest as per the hire purchase agreement. The interest income recognised in the books of account is based on uniform rate of interest on the reducing balance of principal amount outstanding at the end of each month. Such interest income has been calculated in a more systematic and appropriate manner, according to the SOD/indexing method. He, therefore, submitted that the view taken by the Tribunal in the case of Nagarjuna Finance (P.) Ltd. should be approved.
6.5 The learned Sr. D.R. further submitted that the SOD method of accounting followed by the assessee for recognition of its income relating to hire purchase and leasing business is also in conformity with the well-known accounting principles explained in various commentaries by eminent authors. Such as Book of Advance Accounts by Shukla and Grewal, in which the different methods of accounting in relation to apportionment of interest income in relation to hire purchase agreement has been explained as under:
"The methods mostly prevalent, according to the Institute of Chartered Accountants in England and Wales, are the following :---
(a) Actuarial method: The loading is apportioned over the period of the contract in proportion to the reducing balances that will be outstanding from time to time. If installments are irregular, specially prepared interest tables are used for the purpose. This method would be proper if interest forms the only considered cost.
(b) Sum of digits method: This method is almost the same as above but is used when all installments are uniform and fall due at regular intervals. The apportionment of the loading is according to the formula :
Number of installments still outstanding (including the one being paid)
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The total of all numbers of installments (e.g., 12 + 11 + 10 + 1)
If H.P. price is payable in 20 equal installments, the amount of loading included in the first installment will be 20/210 of the total; in the second installment it will be 19/210 of the total loading and so on.
(c) Equal installment or straight line method : Under this method, income from finance charges is treated as accruing uniformly over the life of each agreement.
This method automatically creates a provision against bad debts and possible increase in the cost of providing finance, since in the initial years the credit to the profit and loss account will be less than under methods (a) and (b) given above. But this method ignores to a large extent initial expenses interest paid, etc.
(d) Direct or arbitrary percentage method : A percentage of the outstanding balance is carried forward as deferred income. For best results, the percentage should be determined annually after considering a good sample of the agreement.
6.6 The learned Sr. D.R. submitted that income by way of financial charges derived by the assessee in relation to a transaction of hire purchase is nothing but interest income. Interest is compensation for use of money. He invited our attention towards the definition of the expression 'interest' as given in various dictionaries:
"FROM STROUD'S JUDICIAL DICTIONARY (VOL. 3, FOURTH EDITION).
----------------------------------------------------------------------------------
"Interest 'on the said sum', which sum is payable by instalments, means that the interest is payable on so much of the sum as from time to time shall be unpaid.'
FROM A DICTIONARY FOR ACCOUNTANTS BY BRIC L. KOHLER (FIFTH EDITION):
---------------------------------------------------------------------------------
'Interest: 1. The service charge for the use of money or capital, paid at agreed intervals by the user, and commonly expressed as annual percentage of outstanding principal.
2. The return on any investment of capital."
The learned Sr. D.R. submitted that the SOD method followed by the assessee for maintaining its books of account is the real accrual method for recognition of such interest income. The other method followed by the assessee for the purposes of computing their income liable to tax and which they call as the accrual method, in fact cannot be regarded as an accrual method and would lead to absurd results. The learned D.R. once again submitted that the examples given by the Tribunal in the case of Nagarjuna Finance (P.) Ltd. in paras 7 and 8 of their order can be further explained and for this purpose he submitted an elaborate note as under :
"Note on accounting of such amounts. This also recommends index System of accounting. The assessee is also following Index System of accounting in the Books of account. The Cardinal Principle of revenue recognition recommends in Index System of accounting is "constant income in the form of interest which should be proportionately distributed so as to bear a constant relation with the amount of investment outstanding".
Example : If an amount of Rs. 1,00,000 is given by the assessee for hire purchase of Machinery and the conditions being 14 per cent flat rate of interest and the entire amount (principal Rs. 1,00,000 and interest Rs. 14,000 X 3 years) is repayable in 36 fixed equal monthly instalments, the total amount repayable by the hirer works out to Rs . 1,42,000 comprising Rs. 1,00,000 towards repayment of principal amount and Rs. 42,000 interest amount at flat rate of 14 per cent for the 3 years (36 months).
The Index method gives a mechanism to calculate the interest component in each installment taking all attendant factors into account to give an actuarial result. In this example, there are 36 installments. The quantum of each installment is fixed as under :
1,42,000
--------------- = Rs. 3,944.44
36
Thus, the hirer pays Rs. 3,944.44 in the first month and each of the succeeding 35 months.
Out of Rs. 3,944.44, there is a principal repayment component and interest component. To calculate the actuarial interest the method takes into account all the factors, viz.
(a) Principal amount financed
(b) Total interest amount
(c) Total period
(d) Total number of instalments
(e) The fact of reducing principal amount on each successive instalment.
(f) To give the result in such a way that the rate of interest is approximately constant throughout to give consistent results.
The mechanism is as under:
The total interest (Rs. 42,000) is Multiplied by the specific number of instalments which is divided by a particular factor.
The factor is calculated by using the formula :
N(N+ 1) Note: 'N' is the total number of instalments.
-------------
2
Thus the factor (index) applicable to the examples would be as under :
36 (36 + 1)
------------------- = 666
2
The formula for working out the interest component of a given installment is as under :
Total amount of interest X Total number of installments remaining including the present, installment.
--------------------------------------------------------
Factor
The assessee has calculated the interest income in this manner in the books of account.
The exact figures of interest income in each of the 36 instalments are as under :
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Installment Installments Interest Principal Outstanding
Number amount component component Principal amount after installments
------------------------------------------------
I Year
1. 3944 2270 1674 98,326
2 3944 2208 1736 96,590
3. 3944 2145 1799 94,791
4. 3944 2081 1863 92,928
5. 3944 2018 1926 91,002
6. 3944 1955 1989 89,013
7. 3944 1892 2052 86,961
8. 3944 1830 2114 84,847
9. 3944 1765 2179 82,668
10. 3944 1704 2240 80,428
11. 3944 1639 2305 78,123
12. 3944 1576 2368 75,755
II Year
13. 3944 1513 2431 73,324
14. 3944 1450 2494 70,830
15. 3944 1387 2557 68,273
16. 3944 1325 2619 65,654
17. 3944 1262 2682 62,972
18. 3944 1198 2746 60,226
19. 3944 1135 2809 57,417
20. 3944 1072 2872 54,545
21. 3944 1010 2934 51,611
22. 3944 946 2998 48,613
23. 3944 884 3060 45,553
24. 3944 820 3224 42,429
III Year
25. 3944 757 3187 39,242
26. 3944 693 3251 35,991
27. 3944 630 3314 32,677
28. 3944 567 3377 29,300
29. 3944 504 3440 25,860
30. 3944 441 3503 22,357
31. 3944 378 3566 18,791
32. 3944 315 3629 15,162
33. 3944 252 3692 11,470
34. 3944 189 3755 7,715
35. 3944 126 3816 3,897
36. 3944 63 3897 NIL
----------------- --------------- --------------- ------------------
1,42,000 42,000 1,00,000 --
----------------- --------------- --------------- ------------------
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Interest and principal amounts - summary - yearwise :
Index method :
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Year Total of Interest Principal installments Component Component
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I 47,333 23,083 24,250
II 47,333 14,000 33,000
III 47,334 4,917 42,417
----------------- ------------------ ------------------
1,42,000 42,000 1,00,000
----------------- ------------------ ------------------
The interest income is progressively reducing with the reduction in the outstanding principal amount. The overall interest rate is constant. (This interest rate is the ordinary rate).
II Accrual Method
(Note : The name given to this method is accrual method whereas in reality this is not based on accruals).
Interest rates in accrual method when calculated with reference to the outstanding principal amounts:
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Year Outstanding Total of Interest in Principal Interest amt at the installments year begin accrual component rate
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I 1,00,000 47,334 14,000 33,334 14 per cent
II 66,666 47,333 14,000 33,330 21 per cent
III 33,333 47,333 14,000 33,330 42 per cent
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Thus, in the accrual method sought by the assessee, the interest rate works out to 14 per cent in first year and 42 per cent in 3rd year and, therefore, accrual method does not give correct interest income.
Comparison of Index Method With Accrual Method
1. Index method is recommended - Accrual method is not recommended for accounting interest income on Hire Purchase and Lease transactions. Index method is followed in books.
2. Index method gives actuarial results, whereas accrual method gives hypothetical results. Accrual method gives disproportionately low interest income in first year and high income in last, which finally results in postponement of tax. From the same Hire Purchase agreement, the assessee seeks to offer different incomes at different interest rates in different years which is contrary to facts and law.
3. Principal amount financed - Index system takes into account the reducing principal amount in each instalment payment and, thus, gives realistic picture. Whereas, accrual method ignores the reducing principal amount and presumes that it is constant at the financed amount while the assessee utilises the repayment of principal amount for further financing.
4. Rate of Interest - If the reducing principal amounts are considered the Index method gives a uniform rate of interest over the hire purchase period; whereas the accrual method gives different rates for different years. In 3-year contract - it gives 14 per cent in first year, 21 per cent in second year and 42 per cent in third year. Hence, the accrual method gives distorted picture."
The learned Sr. D.R. submitted that the SOD method is the real accrual method. It presents a true and fair view. It has been accepted as a recognised accrual method for the purpose of complying with the various provisions of Companies Act. It is in accordance with the International Accounting Standards as well as the guidance notes issued by the Institute of Chartered Accountants of India. The Board of Directors and the Auditors were satisfied about the correctness of such a method of accounting followed by the assessee for maintaining its books of account. They have certified that the audited statement give a true and fair view. Such a method was followed by the company even after amendment of section 209(3) making it mandatory for the companies to maintain their accounts on accrual basis. Therefore, the Assessing Officer was bound to compute the taxable income in accordance with the profits shown as per books of account maintained by the assessee in accordance with such a well-recognised method of accounting. The assessee cannot adopt another method by computing its taxable income on the basis of a different method of accounting which gives distorted figures of income and results in deferment of tax liability. The SOD method is more appropriate, logical, scientific and is in accordance with the prudential norms mentioned in International Accounting Standards as well as the accounting standards now issued by the Institute of Chartered Accountants of India. The method chosen by the assessee for showing its taxable income is illogical, incorrect and has been chosen purely for deferment of the tax liability. There is a perpetual postponement of the tax liability, if the method suggested by the assessee for computing its taxable income is accepted.
6.7 The learned Sr. D.R. submitted that income shown by the assessee in its books of account, therefore, clearly comes within the ambit of charging section 5 and it cannot be said that the assessee has accounted for certain hypothetical or extra income, which in fact did not accrue to the assessee in the relevant previous year.
6.8 The learned D.R. further submitted that in the present case, the interest has been accounted for on accrual basis in the books of account and an entry in that regard has already been made on the basis of a recognised, scientific and correct method in relation to accrual of income under the provisions of Company Law, Income-tax Law and all other connected laws and which has also been accepted by the auditors, dividends have been declared and paid on the basis of such real income accounted for in the books of account and, therefore, there could be no reversal or claim of non-accrual of that income. The only exception is provided in section 43D of Income-tax Act which contain special provision in case of accounting for of interest income in the case of certain public financial institutions, etc., Hence, the assessee's claim that income accounted for on mercantile basis in its books of account did not in fact accrue, is not tenable. Section 5 of Interest Act also recognised the same principle.
6.9 The learned Sr. D.R. also highlighted the principles of law laid down by various Courts which have been discussed and referred in the order passed by the Tribunal in the case of Nagarjuna Finance (P.) Ltd. The learned Sr. D.R., thus, strongly urged that the order passed by the CIT(Appeals) should be set aside and that of the Assessing Officer should be restored.
7. The learned counsel for the assessee submitted that the only issue which arises in the appeal before the Special Bench is whether the respondent having treated certain sums as hire purchase rentals and lease rentals in its accounts for the assessment year 1987-88 can in its tax assessment take the stand that amounts lesser than those included in its profit and loss account are assessable to tax. According to the learned counsel, this would be evident from the order of the CIT(Appeals), the grounds of appeal of the department and the question referred to the Special Bench. The Commissioner has held that the said income as reflected in its books of account is hypothetical and has not accrued. The learned counsel submitted that such findings given by the CIT(Appeals) has not been disputed but the ground is whether because of section 145, profit must be assessed as per the respondents' books even though not accrued. The learned counsel, thus, strongly submitted that the aforesaid undisputed finding of fact given by the CIT(Appeals) and the question referred to the Special Bench necessarily postulates that income in the books of account maintained by the assessee on the basis of SOD method is more than income to be computed on accrual basis. If the assessee by following the SOD system has accounted for certain income which did not accrue to the assessee, it cannot be taxed on that income because such differential income has not accrued to the assessee in accordance with the charging provisions contained in the Income-tax Act.
7.1 The learned counsel submitted that even if the question whether the income as returned by the respondent is the only income which has accrued is to be regarded as being in issue, the observations made by the CIT(Appeals) at pages 2 and 3 of his order, wherein he has mentioned that the DC(Asstt.) in his remand report dated 3-12-1990 is not opposed to adopting income from leasing on accrual basis, make it clear that the issue will arise only in respect of hire purchase amounts and not lease rentals. The Assessing Officer in his aforesaid remand report has accepted that only income which has accrued in respect of lease rental is that which has been returned by the assessee in its return of income. He submitted that the arguments advanced on behalf of the learned Sr. D.R. were mainly confined to the hire purchase agreements and he has not submitted any arguments in relation to income returned by the assessee in relation to lease rentals. The learned counsel submitted that the lease agreements stand on a different footing and the income which actually accrued to the assessee will have to be computed in accordance with the terms of agreements executed with its clients regardless of the system on the basis which income has been recognised in its books of account.
7.2 The learned counsel without prejudice to the aforesaid submission contended that the issue is whether the assessee is to be assessed to the income reflected in its books of account or is to be assessed to the income which actually accrued to it in terms of agreements with its clients. He submitted that the income recognised in its books of account on the basis of SOD method, which is in excess of the income which actually accrued to the assessee in terms of the agreements executed with the clients has been claimed as differential income, which did not in fact accrue to the assessee as per the relevant agreements and as per the meaning of accrual of income as understood under the provisions of Income-tax Laws.
7.3 The learned counsel invited our attention towards charging sections 4 & 5 of the Income-tax Act and submitted that section 4 provides that income-tax shall be charged for any assessment year at the prescribed rates in respect of the total income of the previous year. Section 5 defines the scope of total income. It says that all incomes from whatever source derived which is received or is deemed to have been received or which accrues or arises or is deemed to accrue or arise to the assessee during previous year would be liable to tax. If an income has not been received or has not accrued in the previous year within the meaning of these charging sections, it cannot be brought to tax merely because a book keeping entry has been made recognising such hypothetical or notional income, which in law did not accrue or arise in the previous year as per the terms of the agreements executed with the various clients. The learned counsel submitted that the Assessing Officer has taken the view that in view of section 145 of the Act, the income has mandatorily to be computed in accordance with the method of accounting regularly employed by the assessee and as the method of accounting followed is not disputed and the proviso to section 145 is not applicable, the assessee's contention cannot be accepted. The ITO has also held that the assessee has shown to the investing public, to the Registrar of Companies and to other public financial institutions that the affairs of the company are reflected in a true and fair manner and, hence, rejection of books of account is not warranted. The Assessing Officer has further observed that the assessee has paid an amount by way of dividends which is in excess of the amount which it could have paid on the basis of the taxable income declared by it. Lastly, the Assessing Officer has stated that whereas the other companies in the group are claiming various allowances on the basis of book results even though they have for tax purposes taken a lesser income into consideration. The learned counsel submitted that the Assessing Officer has brushed aside the assessee's contention that unless income has accrued to an assessee within the meaning of charging sections 4 & 5 of the Act, namely, it has a right to receive the same, the assessee cannot be assessed to tax and it is the duty of the Assessing Officer to compute the income which has accrued. The learned counsel submitted that the provisions of section 145(1) cannot override section 5 of the Act. If an income has neither been received nor it has accrued, whatever section 145 may say the charging provisions cannot be ignored by section 145. The provisions of section 145(1) does not in any manner affect the charging section 5. If this contention is accepted, the departmental appeal should automatically fail.
7.4 The learned counsel submitted that proviso to section 145(1) gives a power to the Assessing Officer which is coupled with a duty. The Assessing Officer is under an obligation to apply his mind as to whether the income entered in the books of account is chargeable to tax. If it is not chargeable to tax, the method of accounting or the system on the basis of which income has been recognised in its books of account becomes irrelevant. Section 145, therefore, does not affect the ambit of taxation but it is only income which is chargeable to tax that can be brought to charge in accordance with the method of accounting adopted.
7.5 The learned counsel invited our attention towards the judgment of Hon'ble Supreme Court in the case of CIT v. A. Krishnaswami Mudaliar [1964] 53 ITR 122 at page 128 reading as under:
"Again as observed by this count in Commissioner of Income-tax v. McMillan and Co., the expression 'in the opinion of the Income-tax Officer' in the proviso to section 13 of the Indian Income-tax Act, 1922, does not confer a mere discretionary power; in the context it imposes a statutory duty on the Income-tax Officer to examine in every case the method of accounting employed by the assessee and to see whether or not it has been regularly employed and to determine whether the income, profits and gains of the assessee could properly be deduced therefrom."
He further submitted that the Hon'ble Supreme Court in the aforesaid judgment at page 129 further explained that under the mercantile system, the income will accrue on the date on which rights accrue or liabilities are incurred irrespective of the date of payment. The income, therefore, can be said to have accrued only when the assessee acquires a right to receive such income in accordance with the respective agreements executed with its clients.
7.6 The learned counsel further invited our attention toward the judgment of Hon'ble Supreme Court in the case of State Bank of Travancore v. CIT [1986] 158 ITR 102/24 Taxman 337. Our particular attention was drawn towards the view expressed by Hon'ble Tulzapurkar, J. (dissenting and minority view) at pages 114 and 116 :
"The material provisions in regard to the computation of income of an assessee under the head 'Profits and gains of business' are to be found in sections 28(i), 29 and 14(1) but these have to be read subject to section 5 of the Act. Though these provisions provide for charging the income by way of profits and gains of business and prescribe the manner of computation, the question as to what point of time its chargeability arises is answered by section 5 of the Act which states that the total income of a resident assessee from whatever source derived becomes chargeable either when it is received by him or when it accrues or arises to him during the previous year, In other words, taxability is attracted even when income has accrued and it is clear that the receipt of income is not the sole test of taxability under the Act; but, whether on receipt of basis or on accrual basis, it is the real income and not any hypothetical income which may have theoretically argued that is subjected to tax under the Act and this latter aspect arising under our Act is well-settled by the decisions of this court and the High Courts to which I will presently refer. Obviously, for the content of taxable income one must have regard to the substantive charging provisions of the Act. This decision in my view has emphasised two important aspects in regard to the two methods of accounting usually employed by businessmen. In the first place, the Court has pointed out that both the methods are some what rough and in some cases, these methods may not give a clear picture of the true profits earned and certainly not of taxable profits; and, secondly, whatever be the method regularly employed by an assessee, the same has to be adopted as the basis and is relevant only for the purpose of the computation of income, profits and gains under sections 28 and 56 of the Act, but it cannot enlarge or restrict the content of the taxable income, profits and gains under the Act. It is thus clear that, under section 145, the assessee's regular method of accounting determines the mode of computing the taxable income but it does not determine or even affect the range of taxable income or the ambit of taxation. In other words, any hypothetical income which may have theoretically accrued but has not truly resulted or materialised in the concerned accounting year cannot be brought to charge simply because the assessee has been regularly employing the mercantile system of accounting and makes entries in his books in regard to such hypothetical income."
The learned counsel submitted that there was no difference between the majority view and the minority view so far as it relates to the aforesaid principle of law laid down by the Hon'ble Apex Court. He invited our attention towards the majority view expressed by Hon'ble Sabyasachi Mukherjee, J. at page 139, the Court has observed as under :
"The profits and gains chargeable to tax under the Act are those which have been either received by the assessee or have accrued to the assessee during the period between the first and the last day of the year of account and are receivable. Income received or income accrued are both chargeable to tax under section 28 of the Act. The computation of this income is provided for in section 29 of the Act. Section 56 of the Act deals with income from other sources and section 57 deals with deductions in the computation of income from other sources. Section 145 deals with the method of accounting. Sub-section (1) of the said section provides that income chargeable under the heads 'Profits and gains of business or profession' or 'Income from other sources' shall be computed in accordance with the method of accounting regularly employed by the assessee."
At page 144, the Hon'ble Court has further observed as under :
"For the content of the taxable income, one has to refer to the substantive provisions of the Act, mainly section 5 of the Act read with other relevant sections."
7.7 The learned counsel thereafter invited our attention towards the Commentary (Law and Practice of Income-tax) by Kange and Palkiwala at page 1166 (Eighth edition), Vol. I. It has been mentioned in the said commentary that the assessee's regular method of accounting determines the mode of computing the taxable income but it does not determine or even affect the range of taxable income or the ambit of taxation. The provisions for computation of income contained in section 145 cannot derogate from the provisions of charging section. In other words, the charge on income accruing or received in India, imposed by section 5, cannot be avoided by any method of accounting.
7.8 The learned counsel on the strength of the aforesaid submissions and the judgments submitted that once this contention is accepted that the provisions for computation of income contained in section 145 cannot override the charging section and cannot affect the range of taxable income or ambit of taxation, the question which has been raised and referred to the Special Bench stand answered in favour of the assessee as the department has not specifically challenged the finding given by the CIT(Appeals) that the differential income credited by the respondent was only hypothetical or theoretical income and not the real income that had either accrued to or was received by the respondent during the year. The department has not challenged the said findings in the grounds of appeal nor by way of an affidavit as required as per the ITAT Rules.
7.9 Without prejudice to the aforesaid submissions, the learned counsel submitted that the differential income aggregating to Rs. 52,83,931 did not in fact accrue to the assessee in the relevant previous year as per the terms of hire purchase and lease agreements executed with the various clients nor the said amount of differential income was received in the relevant previous year. He submitted that the differential income in relation to hire purchase agreements and lease agreements claimed as income not having accrued as per the terms of agreement in the relevant previous year but was recognised as income, according to the SOD system. can be bifurcated into two separate categories:
(i) Finance income in relation to hire purchase agreements : Rs. 4,61,038
(ii) Lease rental agreements : Rs. 48,22,893
-------------------------------
Total : Rs. 52,83,931
------------------------------
He invited our attention towards the specimen copies of one of the lease agreements and one of the hire purchase agreements executed by the company with its clients. A copy of the lease agreement executed on 27th day of July, 1984 with M/s. The Vijaykumar Mills Ltd. was placed in the compilation at pages 82 to 87. A copy of the hire purchase agreement executed with Shri Kanak Durga Press on 28th November, 1986 has been placed at pages 35 to 61. The learned counsel thereafter explained the basic facts relating to the two types of agreements, namely. Hire Purchase Agreement and Lease Agreement.
8. He submitted that the income in respect of hire purchase agreement has been shown in the books of account according to the SOD/index method while for the purposes of income-tax return, it has been shown as per equated method, namely, as per the rate of 14 per cent per annum on interest specified in the said hire purchase agreement read along with application given by the client for the said hire purchase agreement. The income as per these two methods, one, namely, index method adopted for maintaining books of account and other, namely, equated method adopted for filing the income-tax return was as under as per the exact detail submitted at page 88 in relation to the specimen hire purchase agreement submitted at page 35 of the compilation. The learned counsel submitted that in the hypothetical example given by the learned DR the income by way of finance charge in relation to hire purchase agreement according to the aforesaid two methods can be briefly illustrated as under :
Hire Purchase :
Amount Financed is Rs. 100
Period of Agreement (in years) 5
Finance Charges 14 per cent p.a. flat
finance charge is Rs. 70
Gross Receivable is Rs. 170
In the hands of Hire Purchase Company depreciation will not be admissible.
Income as per two different methods will be as under :
Index Years Equated
70 X (5/(5 X 6)/2) 23.33 5 70/5 14.00
70 X (4/(5 X 6)/2) 18.67 4 70/5 14.00
70 X (3/(5 X 6)/2) 14.00 3 70/5 14.00
70 X (2/(5 X 6)/2) 9.3 2 70/5 14.00
70 X (1/(5 X 6)/2) 4.67 1 70/5 14.00
The learned counsel submitted that interest rate as per the hire purchase agreement is flat rate of 14 per cent. Therefore, interest income shown by the assessee 14 per cent p.a. on equated method is in accordance with the hire purchase agreement. The equated monthly instalment consisting of principal component and the interest component has been apportioned by the assessee on equated method for disclosing its income in the income-tax return. Such a method adopted by the assessee for income-tax purpose is in conformity with the Board's Circular No. 9 (R) (Dis-No. 27(4) IT/43) dated 23-3-1943. A copy of the said Circular has been placed at page 34 of the paper book. The said circular clearly provides that the allowance to be made in respect of hire should be the difference between the aggregate amount of the periodical payments under the agreement and the initial value, the amount of this allowance being spread evenly over the term of the agreement. The borrower will get deduction of only Rs. 14 in the example given above and he cannot claim deduction based on index system according to the said circular. The expenditure, which is deductible in the hands of the payee is the other side of the same coin which represents income accrued in the hands of the assessee. These are two sides of the same coin and income more than Rs. 14 cannot be said to have accrued to the assessee under the aforesaid hire purchase agreement .The learned counsel submitted that the said circular has been re-affirmed vide Instruction No. 1097 dated 19th September, 1977. A copy of the said instruction issued in the year 1977 was also submitted by the learned counsel for the assessee. He also submitted that the aforesaid circular has been followed by the Hon'ble Delhi High Court in case of Addl. CIT v. General Industries Corpn. [1985] 155 ITR 430/23 Taxman 347.
8.1 The learned counsel submitted that the commentaries on Advance Accounting by Shukla and Grewal relied upon by the learned D.R., inter alia, clearly shows that the equal instalment or straightline method is also one of the recognised method which clearly provides that income from finance charges can be treated as accruing uniformly over the life of each agreement. He submitted that income from hire purchase business has been shown on accrual basis as per the terms of contract for income-tax purposes and the extra income shown on the basis of index method/ SOD method in the books of account cannot be regarded as income accrued to the assessee in the previous year. It may be a good accounting policy but it cannot be regarded as income chargeable to tax within the ambit of section 5 of the Income-tax Act, 1961.
8.2 The learned counsel also submitted that the income from hire purchase agreement shown @ 14 per cent p.a. for income-tax purposes on the basis of rate of interest specified in the agreement is in accordance with the accepted principles and accepted commercial practice as has been approved by the decision by the Bombay High Court in the case of CIT v. Tata Sons Ltd.[1939] 7 ITR 195 at page 198.
9. The learned counsel then explained the basic facts relating to the lease agreement. He once again repeated that the remand report submitted by the Assessing Officer before the CIT(Appeals) which has been quoted at page 2 of the order passed by him clearly indicates that the Assessing Officer had no objection to the adoption of accrual basis so far as lease rental is concerned. Without prejudice to this, the learned counsel submitted that as far as the agreements for lease are concerned, the only income which accrues is the monthly instalment specified in Article 1.3 read with Schedule II of the specimen agreement submitted in the compilation. Whatever be the method of accounting revenue adopted in the books of account, in no circumstances can income in excess of the monthly lease instalments be said to have accrued in law. The assessee submitted that income can accrue only when a debt is created in favour of an assessee. For this purpose, the learned counsel relied upon the judgment in the case of E.D. Sassoon & Co. Ltd. v. CIT [1954] 26 ITR 27 (SC) at pages 51 and 52. It will be worthwhile to reproduce the particular portion of the said judgment on which the learned counsel laid emphasis. At page 51 of 26 ITR, the Hon'ble Supreme Court held as under :
"It is clear therefore that income may accrue to an assessee without the actual receipt of the same. If the assessee acquires a right to receive the income, the income can be said to have accrued to him though it may be received later on its being ascertained. The basic conception is that he must have acquired a right to receive the income. There must be a debt owed to him by somebody. There must be as is otherwise expressed debitum in praesenti, solvendum in futuro, See W.S. Try Ltd. v. Johnson (Inspector of Taxes) and Webb v. Stenton and others, Garnishees. Unless and until there is created in favour of the assessee a debt due by somebody it cannot be said that he has acquired a right to receive the income or that income has accrued to him."
"A debt must have come into existence and he must have acquired a right to receive the payment. Unless and until his contribution or parenthood is effective in bringing into existence a debt or a right to receive the payment or in other words a debitum in praesenti, solvendum in futuro it can not be said that any income has accrued to him. The mere expression "earned" in the sense of rendering the services etc. by itself is of no avail."
The learned counsel explained as to how the income has been worked out as per the SOD method for the purposes of recognition of income in the books of accounts in relation to income from lease rent. The income shown in respect of the specimen lease deed submitted in the compilation was explained by way of the following note submitted at page 39 of the compilation :
LEASE :
Equipment cost is Rs. 4,07,800.00
Period of Contract 8 years 96 months
(From Aug. 1984 to July 1992)
Monthly Lease Rental is Rs. 7,816.20
Gross Lease Rental is Rs. 7,50,355.20
1. In the hands of Lessor Company :
a. Depreciation will be available.
b. On sum of Digits Method Rs. 7,50,355.20 Lease Rental will be credited over Eight years - as follows :
Year 1 2 3
Finance charges 1,75,018.42 1,51,811.55 28,604.69
4 5 6 7 8
1,05,397.83 82,190.97 58,984.11 35,777.25 12,570.38
Total : Rs. 7,50,355.20
c. On Accrual Method Rs. 93,794.40 per annum as lease rental returned (7816.20 X 12 months)
2. In the hands of Lessee.
a. No Depreciation
b. Lease Rental of Rs. 93,794.40 per annum will be allowed as deduction."
The learned counsel thereafter also submitted a simple illustration to explain the two different systems of recognition of income according to SOD/index method in its books of accounts and equated method for the purposes of income-tax return in a chart submitted at page 93 as under :
LEASE
Equipment Cost is Rs. 100
Period of Agreement (in years) 5
Annual Lease Rental is Rs. 20
Gross Lease Rental is Rs. 150
Index Years Equated
150 + (5/(5+6/2) 50.00 5 150/5 30.00
150 + (4/(5+6/2) 40.00 4 150/5 30.00
150 + (3/(5+6/2) 30.00 3 150/5 30.00
150 + (2/(5+6/2) 20.00 2 150/5 30.00
150 + (1/(5+6/2) 10.00 1 150/5 30.00
The learned counsel submitted that the amount of monthly instalment in case of a lease agreement has been shown in its entirety as income liable to tax. It has been bifurcated between the principal component and the interest component because the entire amount of rent is of a revenue nature in the hands of the assessee. Therefore, not a pie more than the amount of monthly lease rental agreed in the agreement can be said to have accrued to the assessee as income in the previous year. The assessee has shown the income from lease rentals strictly as per the amount of monthly lease rental stipulated in the lease agreement.
10. The learned counsel submitted that only basis on which the addition had been made is that revenue from leasing business has been recognised in the books of account and not that the income to that extent recognised in the accounts has accrued. He further invited our attention towards the action of the Assessing Officer in not making an addition on account of lease rental on the basis of the index method while completing the assessment in the case of M/s. Mid West Leasing Co. while company in its accounts had accounted for lease rentals in terms of the agreements entered into. The learned counsel submitted that these facts are borne out by the accounts of M/s. Mid West Leasing Co. filed in the course of hearing and the papers in IT Appeal No. 1007/Hyd/90.
11. The learned counsel further submitted that the accrual of income has to be determined on a construction of the agreement entered into by the parties and not in accordance with the entries made in the books of account. For this purpose, he invited our attention towards the judgment of Hon'ble Supreme Court in the case of CIT v. Chamanlal Mangaldas & Co. [1960] 39 ITR 8 at page 14. The relevant extract from the said judgment are reproduced hereunder :
"Counsel for the appellant relied on the entry in the books of account of the company where the words used are "amount accrued Rs. 5,11,875", but this entry must be read as a whole and it shows that the amount which the managing agents were entitled to receive was Rs. 4,11,875. No doubt in this case the amounts of commission were credited every six months which only means that as an interim arrangement the accounts of all sales were made up at the end of six months also. But this would not affect the construction of the clause containing the terms for payment of commission nor the reduction made therein as a result of the modified arrangement. The amount which would arise or accrue and the managing agent would have the right to receive cannot be affected by the manner in which the entry was made."
12. The learned counsel further submitted that the mere fact that in the books of account certain income is reflected it does not necessarily follow that the same is assessable. For this purpose, he placed reliance on judgments in the case of Shoorji Vallabhdas & Co. , CIT v. Kerala State Drugs & Pharmaceuticals Ltd.[1991] 192 ITR 1/39 Taxman 515, Pandit Pandurang v. CIT 2 ITC 69 (Nag.) and Sahu Jagmandar Das v. CIT [1935] 3 ITR 140 (All.).
13. The learned counsel submitted that the Assessing Officer has noted in the assessment order that the method of accounting followed by the assessee is mercantile method of accounting. Accordingly, on a combined reading of section 5 and section 145 what can be brought to tax is income that has accrued. What is relevant is the method of accounting and not the actual entries in the accounts made by the assessee. For this purpose, the learned counsel relied upon the judgment of Hon'ble Supreme Court in the case of CIT v. Chunilal Mehta & Sons (P.) Ltd. [1971] 82 ITR 54 at page 61. The learned counsel submitted that its only income which has in fact accrued can be brought to tax.
14. The learned counsel further contended that if the accounts do not reflect the correct income chargeable to tax then in that event the Assessing Officer not only has a power under the proviso to sub-section (1) of section 145 to compute the correct income but the Assessing Officer is under a legal duty to compute correct assessable profits. For this purpose, the learned counsel relied upon the judgment of Hon'ble Supreme Court in the case of CIT v. Sarangpur Cotton Mfg. Co. Ltd. [1938] 6 ITR 36 (PC) and CIT v. British Paints (India) Ltd.[1991] 188 ITR 44/ 54 Taxman 499 at pages 52 and 53.
15. The learned counsel submitted that on a careful consideration of the hire purchase agreement and the lease agreement and the principle of law relating to accrual of income as discussed hereinbefore it would be amply clear that the income declared by the assessee in its return of income on accrual basis at Rs. 14 in hire purchase agreement and at Rs. 30 in case of lease agreement in the examples given hereinbefore at pages 36 and 41 alone can be treated as income chargeable to tax. Anything more than what has been declared by the assessee in the income-tax return on the aforesaid basis will not fall within the ambit of charging section and cannot, therefore, be made liable to tax.
16. The learned counsel thereafter submitted that the SOD method or indexing method is merely a system of recognising income in relation to hire purchase and leasing business. The meaning of expression "accrual" as understood under the provisions of Companies Act is different than the meaning of accrual of income within the meaning of section 5 of the Income-tax Act. The concept of 'true and fair" is applicable for the purposes of Companies Act. The method of recognition of income according to SOD/indexing method may be permissible for the purposes of compliance with the provisions of Companies Act. It may be good accounting for the purposes of reporting to the investing public or the shareholders but it may not give a correct picture about income liable to tax under the provisions of Income-tax Act. He submitted that even in the guidance note at page 2) of the paper book submitted by the department, it has been clearly indicated in para 27 that the specific treatments for determining taxable income would have to be in accordance with the provisions of the Taxation Laws. Such treatments may differ from the recommendations contained in the guidance note. The learned counsel submitted that there may be various circumstances under which the income recorded in the books of account does not tally with the income chargeable to tax. For this purpose, he invited our attention towards the judgment of Hon'ble Supreme Court in the case of British Paints (India) Ltd. The learned counsel submitted that such a situation may happen on account of certain statutory deductions being available e.g. depreciation in the books may be provided for on a straight line basis but for tax purposes would have to be allowed as a deduction under the written down value method. Even if not provided it would have to be allowed. There are other instances where an account of certain accounting policies adopted the book profits would not tally with the tax profits. For example :
(a) certain expenditure is treated as deferred revenue expenditure in the books of account and written off over a period of time but for tax purposes it is claimed as a deduction in the year in which the liability arises Hindustan Commercial Bank Ltd., In re [1952] 21 ITR 353 (All.), CIT v. Tungabhadra Industries Ltd. [1994] 207 ITR 553/76 Taxman 185, CIT v. Gujarat Mineral Development Corpn. [1981] 132 ITR 377/[1980] 4 Taxman 526 at page 384 ;
(b) certain expenditure is accounted for in the books by applying the matching principle but would be claimed for tax purposes in the year in which the expenditure is incurred Addl. CIT v. Buckau Wolf New India Engg. Works Ltd. [1986] 157 ITR 751 at 757;
(c) Valuation of closing stock :
The FIFO method may be an acceptable accountancy principle but would not be acceptable for determination of tax profits (Minister of National Revenue v. Anaconda American Brass Ltd.[1956] 30 ITR 84 (PC) at 98;
(d) Expenditure which is treated in the books of account as capital expenditure but claimed for tax purposes as revenue for e.g. interest and expenses incurred on raising loans (India Cements Ltd. v. CIT [1966] 60 ITR 52 (SC);
(e) Payments under collaboration Agreement :---
May be allowed as revenue (Alembic Chemical Works Co. Ltd. v. CIT [1989] 177 ITR 377/43 Taxman 312 or as capital expenditure eligible for depreciation and other allowances (Scientific Engg. House (P.) Ltd. v. CIT [1986] 157 ITR 86/[1985] 23 Taxman 66 ) irrespective of the method of reflecting the same in the accounts adopted by the assessee;
(f) Claim for disputed statutory liabilities not provided for in the books of account and treated therein as contingent liabilities but claimed as a deduction for tax purposes. (Kedarnath Jute Mfg. Co. Ltd. v. CIT [1971] 82 ITR 3 63 (SC)).
(g) Broken period interest in case of banks which may be treated as a revenue expenditure/interest income in the books but for tax purposes is treated as part of the cost of the securities (Vijaya Bank Ltd. v. Addl. CIT [1991] 187 ITR 541/57 Taxman 152 and
American Express International Banking Corpn. v. IAC [1983] 6 ITD 373;
(h) Foreign Exchange fluctuation accounted for in books of account on any analised basis but not considered for tax purpose until the loss is incurred in profit actually earned (Indian Overseas Bank v. CIT [1990] 183 ITR 200 (Mad.));
(i) Interest earned in pre-commencement period is for accounting purposes reduced from the cost of assets in accordance with the Guidance Note issued by the Institute but for tax purposes assessed as income (CIT v. Cap Steels Ltd. [1986] 162 ITR 533/29 Taxman 125 (Kar.) at 536; CIT v. Derco Cooling Coils Ltd.[1992] 198 ITR 375 (AP)).
17. The aforesaid judgments clearly and conclusively prove that if an amount which has not accrued as income according to the provision of Income-tax Act but has been included as income in the books of account, it is the duty of the Assessing Officer to exclude such items of income. The Claim of differential income made by the assessee represent the income which did not accrue as per the terms of contract executed with the clients and which cannot be regarded as income chargeable to tax under the provisions of Income-tax Act and therefore, the same ought to have been excluded for the purpose of computing the taxable income.
18. The learned counsel also submitted elaborate arguments as to why the decision of the Tribunal in IT Appeal No. 2067/Hyd/88 in the case of Nagarjuna Finance (P.) Ltd. should not be followed. He also submitted a note in this regard which is reproduced hereunder :
"1. In that case the Tribunal has come to the conclusion that income that is reflected in the books of account would have to be charged to tax. In coming to this conclusion, the Tribunal has primarily relied on the following:
(a) section 145(1) requires income to be computed in accordance with the method of accounting adopted by an assessee and as the assessee has maintained its accounts in accordance with an accepted method of accounting its profits for tax purposes has to be computed in accordance therewith: (see paras 14, 16, 19, 21);
(b) there cannot be different methods of accounting one for shareholders and another for tax purposes (see paras 17, 20, 23);
(c) as per the index method adopted by the assessee income not only has accrued but was physically received and dividends were distributed therefrom (see paras 21, 22, 24, 25, 26);
(d) method adopted by the assessee does not affect the provisions of section 5(1) as the income in fact had accrued and was received (see para 28);
(e) the method of accounting adopted by the assessee was the index method of accounting (see paras 15, 16, 21, 24); the treatment in the hands of the hirer is not material and in any event in view of the subsequent accounting developments the Circular of the Board relied upon is of no relevance (see para 29);
(g) the index method is also applicable for leases as International Accounting Standard 17 includes within its ambit financial leases also; (see para 30);
(h) it also relies on the following decisions:
(i) CIT v. Maharaja Diraja Kameshwar Singh [1933] 1 ITR 94;
(ii) CIT v. Sarangpur Cotton Manufacturing Co. Ltd.[1938] 6 ITR 36,
(iii) CIT v. Smt. Singaribai [1945] 13 ITR 224;
(iv) Amrapali Mercantile Private Ltd. v. Asstt. CIT [1933] 45 ITD 386;
(v) CIT v. State Bank of Travancore [1986] 158 ITR 102.
2. The Assessee submits that as regards the first reason given by the Tribunal, it is submitted that the settled position in law, is that section 145(1) does not override the provision of section 5 (See the decisions of the Supreme Court in CIT v. A. Krishnaswamy Mudaliar [1964] 53 ITR 122, CIT v. State Bank of Travancore [1986] 158 ITR 102) and Kanga and Palkhivala Law and Practice of Income-tax page 1166.
3. As regards the reasons at (b) above, it is submitted that it has already been illustrated that there can be various circumstances under which the income computed in terms of the accounts presented for the Companies Act would not tally with the tax profits. It is further submitted that, method of accounting adopted by the assessee is not the index method of accounting as held by the Tribunal. The method of accounting adopted by the assessee is admittedly mercantile. It is only for recognising the revenue in its books of account that a particular accounting entry has been passed.
4. As regards (e) and (d) above, it is submitted that it is not even the case of the Revenue that the income reflected in the books of account has in fact been physically received. No sum in excess of the monthly lease rental or the monthly hire purchase payment has been received. The revenue also accepts that the differential income which is the subject-matter of the presents appeal has not accrued. As regards the declaration of dividends, it is submitted that in Sree Meenakshi Mills v. CIT[1957] 31 ITR 28 at 59, the Supreme Court has clearly stated that one must not confuse the accrual of income with its disposal. According to the Court the provisions of the Companies Act as to the disposal of the profits are designed to protect the interest of the shareholders and have no effect on the right which the state has under the provisions of the Act to impose a tax on income when it accrues or arises. The observations of the Supreme Court in CIT v. British Paints India Ltd. [1991] 188 ITR 44 at 52 also make it clear that the fact that dividends have been declared on the basis of the book profits is irrelevant for the determination of the correct assessable profits.
5. The assessee further submits that in so far as (d) above is concerned income accrues in accordance with the contract entered into by the parties as has been held by the Supreme Court in CIT v. Chamanlal Mangaldas & Co. [1960] 39 ITR 8 and the adoption of the index method of accounting for recognising revenue for book purposes cannot give rise to any accrual of income, if under the contract no accrual takes place.
6. As regards (e) above, it is submitted that in law there are two principle methods of accounting viz. cash and mercantile. There are other systems which are commonly referred to as hybrid in which certain elements and incidents of cash and mercantile systems are combined (CIT v. A. Krishnaswamy Mudaliar [1964] 53 ITR 122 at 129/130). The assessee submits that in its case admittedly the mercantile method of accounting has been followed and accordingly what can be assessed is only the income which accrues in the previous year. The assessee submits that the method of recognition of income cannot be equated with the method of accounting adopted.
7. As regards (f) above, the assessee submits that the Circular has not been withdrawn and the view expressed in the Circular has been reiterated in instruction No. 1097 dated July 19, 1977. In Addl CIT v. General Industries Corpn. [1985] 155 ITR 430, the Delhi High Court has upheld the order of the Tribunal directing the Assessing Officer to allow depreciation on the basis of the circular of 1943. The assessee submits that the Circular lays down a method for recognition of the expenditure by way of finance charges in the hands of the hirer. When, as in the instant case, as per the assessee's agreement income also accrues in accordance with the method prescribed in the Circular there is no reason why a larger amount at all ought to be assessed.
8. As regards (g) above, the assessee submits that the crucial issue is that as far as lease rentals go what can accrue is only the monthly lease rental in accordance with clause 1.3 read with Schedule II of the agreement for lease. By no accounting entry can any sum in excess of the monthly lease rental accrue. Even IAS 17 does not contemplate a recognition of revenue in excess of what has accrued.
9. The decision in CIT v. Kameshwar Singh is distinguishable inasmuch as in that case the Privy Council upheld the assessability to tax of income which the assessee there had himself disclosed in the return of income. In the instant case, the assessee has not returned the income as assessed. The peculiar facts of that case have to be borne in mind. The decision of the Gujarat High Court in CIT v. Chunilal Kushaldas 93 ITR 369 at 381 makes it clear that the observations in a judgment have to be read in the context of the fact situation prevailing. What is also to be borne in mind is that if the Privy Council had not upheld the revenue's contention certain income would have escaped assessment altogether. That is not so in the assessee's case as is borne out by the illustrations at pages 86-93 of the compilation which disclose that over a period of time the entire lease rentals/hire purchase finance charges have been offered for tax, In totality there would be no difference between the aggregate income offered by the assessee for tax purposes and the aggregate income assessed by the Assessing Officer in accordance with the method of recognition of income adopted in the books of account. Further, this decision of the Privy Council has been distinguished by the Allahabad High Court in Sahu Jagmandar Das v. CIT [1935] 3 ITR 140.
10. As regards the decision in CIT v. Sarangpur Cotton Company the same actually supports the case of the assessee. In that case, the assessee had been regularly under valuing its closing stock in its books of account i.e., at a figure which was lesser than both the cost as well as the market price. It filed its return by taking into account the result of the undervaluation of the stock which meant that the income returned was less than the book income. The Privy Council held that the Income-tax Officer was not entitled to take the profit shown in the books of account as the real income of the assessee but was bound to consider whether the true income could be deduced from the accounts of the assessee. This decision brings out that it is the duty of the Assessing Officer to apply the proviso to Section 145(1) irrespective of whether it results in a taxable profit more or less than the book profit. The Privy Council interpreted Section 13 of the Indian Income-tax Act, 1922 to mean that there is a duty cast on the Income-tax Officer to compute the correct taxable profits (see pages 40, 42 and 43 of the report). The Privy Council has held that "Their Lordships desire to add that the view of the Asstt. Commissioner that the Income-tax Officer is prima facie entitled to accept the profits shown of the accounts, where there is a method of accounting regularly employed by the assessee, is not a correct view. It is the duty of the Income-tax Officer, where there is such a method of accounting to consider whether income, profits and gains can properly be deduced therefrom and to proceed according to his judgment on this question. The decision in 6 ITR 36 has been approved and followed on this very point by the Supreme Court in CIT v. British Paints (I) Ltd.[1991] 188 ITR 44 at pp. 52 and 53.
11. The decisions mentioned at Serial Nos. (iii) and (iv) are completely distinguishable inasmuch as in those cases assessees who had adopted mercantile system of accounting in their books of account were seeking to be assessed in accordance with the cash method which the High Court as well as the Tribunal held was impermissible. The assessee submits that it has not adopting a different method of accounting for its books as well as for tax purposes. The method of accounting adopted is admittedly the mercantile method. It is only applying certain sophisticated accountancy principles in preparing its financial statements for recognising revenue. That a distinction between the profits and book profits in brought out by the decision of the Privy Council in CIT v. Sarangpur Cotton Co. [1938] 6 ITR 36 at pages 40 and 43.
12. The decision of the Supreme Court in State Bank of Travancore's case is also distinguishable inasmuch as in that case income which admittedly had accrued in accordance with the contract entered into between the parties and which was debited to the borrowers account, was sought to be excluded from the ambit of taxation. It is in these circumstances that the Supreme Court held that income which had really accrued or arisen to the assessee is taxable and whether the income had really accrued or arisen to the assessee must be judged in the light of the reality of the situation and that of the conduct of the parties in treating the income in a particular manner is material evidence of the fact as to whether income has accrued or not. The assessee submits that in its case in terms of the agreement no income has accrued and therefore, the mere fact that entries have been passed in a particular manner is not determinative of the issue. 'Conduct' may be relevant but cannot override the contractual and legal position of accrual. The assessee has in the instant case recognised revenue in the case of lease rentals far in excess of what has accrued, what it could sue for or be entitled to receive during this year. This decision also lays down that the provision of Section 5 override the other provisions."
19. The learned counsel thus strongly urged that decision of the Tribunal in the case of Nagarjuna Finance (P.) Ltd. should not be followed.
20. The learned counsel further submitted that Section 209(3) of the Companies Act, 1956 by which accrual method of accounting has been made mandatory for all companies, was not in existence in the year under consideration. The said provisions came into force with effect from 15-6-1988. He further submitted that the company has changed its method of recognition of income by way of lease rentals from the year 1990-91 or so. The learned counsel submitted that the term "accrual' used in Companies Act, Income-tax Act or other laws may have different meanings depending on the purpose of legislation and the context in which such expression has been used. The concept of accrual under the Companies Act is different. The soul is "true and fair" for the purposes of Company Law, while for tax purposes "accrual" means whether the assessee has a right to receive a particular amount in the relevant previous year or in other words, whether it comes within the ambit of charging Section 5 of Income-tax Act. In the present case, the entire amount of differential income did not accrue to the assessee as per the terms of the respective Hire Purchase/Lease Agreements.
21. The learned counsel also invited our attention towards the decision dated 13-6-1995 of Income-tax Appellate Tribunal "A" Bench, Allahabad in the case of Sahara Investment India Ltd. in [IT Appeal No. 254 (All) of 1995 dated 13-6-1995] and others. In that case, it was, inter alia claimed by the assessee that credit to the profit and loss account of administrative and process charges Rs. 3,17,529 being part of deposit received under the scheme had been erroneously credited to the profit and loss account and that the same be withdrawn since subscription received under the scheme was capital in nature and no part thereof was liable to tax. On behalf of the Department, it was inter alia, argued that nobody else could be a better judge than the businessman who in his prudence thought fit to return a part of the loan or deposit as income under the head Administrative and Process charges, and, therefore, the assessee should not be allowed to go back on its own entries which had been originally returned as income. The Tribunal observed that notwithstanding entries in the books of account; there was a revision of computation of income which could not be ignored by the Assessing Officer while computing the taxable income under the Income-tax Act, 1961. The Tribunal relying upon the judgment of Hon'ble Madras High Court in the case of Indian Overseas Bank and the judgment of Hon'ble Apex Court in the case of CIT v. India Discount Co. Ltd. [1970] 75 ITR 191 observed that the receipt being one, which in law could not be regarded as income merely because the assessee erroneously credited it to the profit and loss account. The Tribunal further endorsed the arguments of Shri Dastur, the learned counsel appearing for the assessee that there cannot be any concession or estoppel or res judicata in income-tax proceedings and recorded a finding that notwithstanding the transfer of a part of deposit to revenue income, the assessee was not stopped from claiming that the deposits under all the scheme were not liable to tax under the Income-tax Act.
22. The learned counsel thus strongly supported the order of the CIT(Appeals) and urged that the revenue's appeal should be dismissed as it has no merit.
23. The learned Sr. D.R. in the rejoinder submitted that income has to be assessed on accrual basis and it has been taxed on accrual basis by the Assessing Officer. The income shown by the assessee in its books of account has in fact accrued to the assessee as per the terms of the Agreements. He submitted that income by way of financial charges is nothing but interest income on intermediate term financing, which accrues from day-to-day. The SOD method followed by the assessee for recognition of its income recognises the income which has really accrued in the relevant previous year.
23.1 The learned Sr. D.R. invited our attention towards the decision in the case of Sarangpur Cotton Mfg. Co. Ltd. at page 37 wherein it was held that ITO is bound to consider as to whether true income could be arrived at from the method of accounting employed by the assessee. The Assessing Officer in the present case found that profits could be properly deduced from the books of account maintained by the assessee. Once true income can be properly deduced, as certified by the Auditors, the question relating to invoking of the proviso to section 145(1) does not arise. He also placed reliance on judgment in the case of CIT v. McMillan & Co. [1958] 33 ITR 182 (SC) at page 183 in which it was held that the non-exercise of a power is also a decision inasmuch as it amounts to acceptance of the method of accounting followed by the assessee.
23.2 The learned Sr. D.R. further submitted that the expression used in the relevant provisions of Companies Act in relation to Profit and Loss account and Balance Sheet was "true and correct", which was subsequently substituted by the expression "true and fair". There is a subtle distinction between these two expressions and the concept of "true and fair" requires disclosure of real income in the profit and loss account and a true and fair view of the state of affairs as on the date of the Balance Sheet. He submitted that the meaning of term "accrual" under mercantile system of accounting is a same under the provisions of Companies Act as well as under the Income-tax Act.
23.3 The learned D.R. submitted that all the cases cited by the learned counsel for the assessee falls under the exceptions enumerated in the Accounting Standards, which have been carved out to meet particular type of exceptional circumstances and situations. For example, the judgment of Hon'ble Bombay High Court in the case of CIT v. Citi Bank N.A. was considering the question relating to applicability or non-applicability of the proviso to section 145(1) in respect of interest on problem loans credited only on actual receipt. The various Accounting Standards also provide for adopting cash basis for recognising interest income on doubtful loans, etc. All such decisions, which deal with exceptional items, which were excluded or included by invoking the proviso to section 145 cannot be made applicable in the facts of the present case as true profits can be properly deduced from the books of account maintained by the assessee. The learned Sr. D.R. submitted that the Tribunal in the case of Nagarjuna Finance (P.) Ltd. had rightly relied upon the decision in the CIT v. Maharajadhiraj Kameshwar Singh [1933] 1 ITR 94 (PC). He invited our attention to the following extracts from the said judgment appearing at page 101 :
"What the officer is directed to compute is not the assessee's receipts but the assessee's income and in dubio what the assessee himself chooses to treat as income may well be taken to be income and to arise when he so chooses to treat it. (See per Lord Dunedin in delivering the judgment of the Board in Commissioner of Taxes v. Melbourne Trust Ltd.). The sums which the officer has brought into account from the interest register insofar as consisting of allocations from sums received in previous years have never borne tax and in their Lordships' opinion the assessee cannot complain if the officer agrees with the assessee in treating them as income of the year in which the assessee himself first thought fit so to regard them. Their Lordships see nothing contrary to principle in the computation of an assessee's total income for a particular year as consisting in part of actual receipts in that year and in part of sums carried by the assessee to income account in that year out of the receipts of previous years which have been held in suspense and no part of which has previously been returned as income."
23.4 The learned Sr. D.R. submitted that whether accrual of income has taken place or not, must be judged on the principles of the real income theory. In determining the question whether it is hypothetical income or whether real income has materialised or not, various factors will have to be taken into account. That has really accrued to the assessee has to be found out and what has accrued must be considered from the point of view of real income taking the probability or improbability of realisation in a realistic manner. But once accrual takes place, on the conduct of the parties subsequent to the year of closing, an income which has accrued cannot be made 'no income'. These submissions were made on the strength of judgment of Hon'ble Bombay High Court in the case of Western India Oil Distributing Co. Ltd. v. CIT [1994] 206 ITR 359/73 Taxman 565. The learned Senior D.R. also placed reliance on judgment of Hon'ble Rajasthan High Court in the case of S.M.S. Investment Corpn. (P.) Ltd. v. CIT [1993] 203 ITR 1001 to support his contention that income had accrued to the assessee as soon as the assessee acquired the right to receive the income under the said agreement. The income covering the entire period of agreements has been apportioned according to SOD method in a rationale, systematic and appropriate method by the assessee in its books of account.
23.5 The learned Sr. D.R. further pointed out that copy of one of the Hire Purchase Agreements executed by the company shows that no rate of interest has been mentioned in the contract. The proposal given by the borrower mentions the flat rate of 14 per cent p.a. The flat rate has no meaning. The Schedule gives the total amount of interest finance charges covering the entire period of contract. The real implicit rate of interest can be precisely and correctly determined only by SOD method.
23.6 The learned Sr. D.R. at one point of time conceded that so far as income by way of lease rental is concerned, income may be taxed as per the lease agreements as per illustration given at page 89 of the paper book submitted by the assessee, subject to verification of each agreement, but after few minutes, he withdrew the concession so made and submitted that the Agreements for lease would go on shifting from an operational lease to finance lease. He submitted that lease agreement is like a Term loan. The period of lease is known. The income by way of Finance charge/ interest is known. The income is to be spread over the period of lease. Once the income has accrued as per Agreement, apportionment in each previous year has to be made as per accepted accounting principles, and that is what has been done by the assessee by adopting SOD method for recognition of such income in its books of account. The learned Sr. DR. invited our attention towards the following extracts for the judgment of Hon'ble Supreme Court in the case of Kerala Financial Corpn. v. CIT [1994] 210 ITR 129/75 Taxman 573 at page 134:
"We have duly applied our mind to the rival views expressed in the aforesaid case and with respect we are in agreement with the stand taken by the majority. The reason is that, according to us, the majority's assessment is more logical and sound, because in every case accrual of such income cannot be presumed to be hypothetical, as would be the result if the minority view were to be accepted. Further, the stand taken by the majority takes care of probable injustice (which may be caused) because of what has been stated in its proposition No. (3) above, which is that where a debt has become bad, deduction would be allowed. We would, therefore, observe that though Misra, J., while agreeing with Mukharji, J. stated, inter alia, in paragraph 74 that in a taxing statute, where the law is clear, considerations of even injustice do not afford justification for exempting income from taxation, as opined in Mapa v. Oram [1969] 3 All ER 215 (HL), no injustice would really be caused in the cases at hand, inasmuch as if the advance in question can ultimately be established to have become a bad debt, the assessee would be entitled to refund of the tax already paid by him in this regard."
23.7 The learned Sr. D.R. also drew our attention towards the following para from the judgment of Hon'ble Supreme Court in the case of Morvi Industries Ltd. v. CIT [1971] 82 ITR 835 at page 840:
"The appellant-company admittedly was maintaining its account, according to the mercantile system. It is well-known that the mercantile system of accounting differs substantially from the cash system of book-keeping. Under the cash system, it is only actual cash receipts and actual cash payments that are recorded as credits and debits whereas under the mercantile system, credit entries are made in respect of accounts due immediately they become legally due and before they are actually received; similarly, the expenditure items for which legal liability has been incurred are immediately debited even before the amounts in question are. actually disbursed. Where accounts are kept on mercantile basis, the profits and gains are credited though they are not actually realised, and the entries thus made really show nothing more than an accrual or arising of the said profits at the material time. The same is the position with regard to debits made."
23.8 The learned Sr. D.R. also invited our attention towards the judgment of Hon'ble Kerala High Court in the case of St. Teresa's Oil Mills v. State of Kerala [1970] 76 ITR 365 in which it was held that rejection of accounts should not be done fight heartedly and the Court has also explained the circumstances in which the accounts should be rejected, namely, where the account books are unreliable, incorrect or incomplete.
23.9 The learned Sr. D.R. submitted that the Assessing Officer in the present case did not doubt the correctness of the method of accounting adopted by the assessee. He did not find that it is not possible to deduce correct profits from the said method of accounting. The Tribunal in its earlier decision in the case of Nagarjuna Finance (P.) Ltd. has given elaborate and convincing reasons. He, therefore, urged that the said decision should be followed.
24. Mr. Dastur, the learned counsel appearing for the assessee, submitted that the facts of the cases of Kerala Financial Corpn. and S.M.S. Investment Corpn. (P.) Ltd. relied upon by the Sr. D.R. are clearly distinguishable as interest income in those cases had already accrued in the relevant previous years. The theory of real income comes into play only where there is accrual of income in law as per the relevant contracts. The facts of the case of Western India Oil Distributing Co. Ltd. , which deals with waiver of interest six months after end of accounting year is clearly distinguishable and the ratio of that judgment cannot be applied on the facts of the present case. The learned counsel submitted that IAS-17 itself clearly provides that rental income in case of lease should be recognised on a straightline basis over the lease term, unless another systematic basis is more representative of the time pattern of the earnings process contained in the lease. In the present case, the lease agreement clearly specifies the monthly lease rental. There is no question of apportionment between the finance charge and the reduction of outstanding liability in case of lease rentals, as the entire amount of lease rental specified in the lease agreements has been shown as income liable to tax in the return of income. Amounts in excess of such agreed amount of lease rental accounted for in the books on the basis of SOD method represents hypothetical income, which did not in fact, accrue in the relevant previous year. The learned counsel once again urged that the Revenue's appeal being devoid of any merit, should be dismissed.
25. We have carefully considered the submissions made by the learned representatives of the parties and have perused the orders passed by the learned Departmental authorities. We have carefully considered the decision of the Division Bench of the Tribunal in the case of Nagarjuna Finance (P.) Ltd. We have also carefully gone through all the judgments relied upon by the learned representatives of both sides, the judgments referred to in the impugned order of the CIT(Appeals), as well all the decisions referred to in the order of the Tribunal in the case of Nagarjuna Finance (P.) Ltd. We have given our thoughtful consideration to all other documents, International Accounting Standards (IAS), and the Guidance Notes issued by the Institute of Chartered Accountants of India to which our attention was drawn during the course of hearing. We have also examined the relevant provisions of Income-tax Act, Companies Act and other relevant laws.
26. The principles of law as enunciated by the various judgments of the Hon'ble Apex Court relied upon by the learned representatives of the parties and as clearly emerging from a plain reading of the relevant provisions of Income-tax Act, 1961 can be summarised as under :---
(a) An analysis of section 4 of Income-tax Act, 1961 (hereinafter referred to as the 'Act'), inter alia, provides that tax will be charged on the total income of the previous year. The income which is charged to tax is that referred to in section 5 of the Act. The income should be assessed under the appropriate head and should be computed in accordance with and subject to the provisions of the Act.
(b) The ambit of taxation is governed by section 5 defining the scope of total income, which varies with the factor of residence in the previous year. All the assessees are divided into three categories : (i) Resident & Ordinary resident; (ii) Resident but not ordinarily resident; and (iii) Non-resident. The residential status is governed by section 6 of the Act. In the present case, we are concerned with the scope of total income in the case of "Resident in India and who is not ordinarily resident". Such persons are charged to tax on :---
(i) income received or deemed to be received in India in the relevant accounting year. The date or place of accrual would not be material.
(ii) income which accrues or arises or is deemed to accrue or arise in India during the relevant accounting year. The date or place of receipt would not be material.
(iii) income which accrues or arises outside India during the accounting year, even though it is not received in or brought into India.
In the present case, income specified in category (iii) does not exist and, therefore, we will have to consider as to whether the disputed amount of differential income can be treated as income received or deemed to be received or income accrued or deemed to accrue or arise in the relevant accounting year within the ambit of section 5 of the Act.
(c) From a reading of the provisions of section 145 in conjunction with the charging provision contained in section 4, the scope of total income defined in section 5 and other relevant provisions in the light of principles of law laid down in the various judgments discussed hereinbefore, the following well-settled principles of law clearly emerge:
(i) That the provisions of section 145 cannot override section 5 of the Act. If an income has neither accrued nor received within the meaning of section 5 of the Act, whatever section 145 may say, such income cannot be charged to tax even though a book-keeping entry has been made recognising such hypothetical income, which in law and on fact did not really accrue or arise or received in previous year. Section 145 determines the mode of computing the taxable income. It does not affect the range of taxable income or the ambit of taxation. The computation provisions cannot enlarge or restrict the content of taxable income. The range of taxable income or ambit of taxation is to be determined in accordance with the charging provisions.
(ii) The proviso to section 145(1) does not merely confer a discretionary power upon the Assessing Officer but also imposes a statutory duty on the Assessing Officer to examine in every case whether income, profits and gains chargeable to tax in the relevant year, could properly be deduced from the method of accounting followed by the assessee;
(iii) The term "accrual" of income used in the Companies Act, as explained in the various Accounting Standards and as understood for the purposes of taxation laws in certain circumstances may have different meanings depending on the purpose of legislation, the context in which such expression has been used and on the interpretation of the terms of relevant contracts. For tax purposes, the accrual or receipt of income in the relevant previous year will have to be determined in consonance with the ambit of taxable income as per section 5 of the Act on the basis of a careful scrutiny of the terms of contract for Hire Purchase and Lease Agreements regardless of the method of accounting followed by the assessee for recognition of such income in its books of account.
27. In view of the foregoing discussions, there can be no quarrel so far as principles of law canvassed on behalf of the assessee are concerned. But we do not agree with the submissions made by the learned counsel that once these principles of law are accepted, the revenue's appeal should automatically fail, as the findings given by the CIT(Appeals) that income in the books of account maintained by the assessee on the basis of SOD method is more than income to be computed on accrual basis has not been disputed nor such a ground has been raised in the grounds of appeal or in the question referred to the Special Bench. The Revenue has specifically challenged the finding given by the CIT(Appeals) allowing the assessee's claim of differential income of Rs. 52,83,931 as loss. The Special Bench has been constituted to dispose of the entire appeal including the main question formulated for consideration by the Special Bench. We are, therefore, of the view that the real issue, which requires our consideration is as to whether the differential income aggregating to Rs. 52,83,931 (which was recognised as income on the basis of SOD method in the books of account but claimed as not liable to tax in the returns of income on the ground that income to that extent did not accrue to the assessee) can be regarded as income accruing or received in India in the relevant previous year within the ambit and scope of section 5 of the Act.
28. According to the assessee, the claim of differential income not liable to tax, can be bifurcated into the following two categories of income :
(i) Finance income in relation to Hire Purchase Agreements : Rs. 4,61,038
(ii) Income by way of Lease Rentals as per lease agreement : Rs. 48,22,893
-------------------------
Rs. 52,83,931
-------------------------
The aforesaid bifurcation of differential income is not borne out or verifiable from the orders passed by the Assessing Officer or the CIT(Appeals) and that will be a matter of verification by the Assessing Officer in the light of entries in the books of account and the terms and conditions of each and every Hire Purchase Agreement and Lease Agreement. The assessee has submitted copy of one of the H.P. Agreements and one of the Lease Agreements in the compilation and it was the contention of the learned representatives of both sides that all other Hire Purchase Agreements and Lease Agreements are almost identical and similarly worded. We will, therefore, consider the submissions made by the learned representatives of the parties with regard to the aforesaid two categories of differential income keeping in view these specimen and illustrative Hire Purchase Agreement and Lease Agreement submitted in the compilation.
29. Finance income in relation to Hire Purchase Agreement :
The copy of Hire Purchase Agreement submitted at pgs. 35 to 61 of the compilation shows that Sri Kanakadurga Press (hereinafter referred to as 'the Hirer') in terms of the proposal form signed by the Hirer requested the assessee-company (hereinafter referred to as "the owner") for finance of the machinery being imported from England and for that purpose, a Hire Purchase Agreement was executed between them on 28th day of November, 1936. The details of the value of machinery, amount financed by the owner, the schedule of repayment, etc., are as under :
(Rs.)
Basic Price of the Machine 5,67,000
Customs Duty 3,11,850
--------------------
Total value of the Machinery 8,78,850
Less: Initial payment by the Hirer to the owner 1,28,850
--------------------
Amount financed by the owner 7,50,000
Add : finance charges 14 per cent for 4 years 4,20,000
--------------------
Gross amount repayable by the Hirer to the owner 11,70,000
The aforesaid amount is repayable in 48 monthly equated instalment of Rs. 24,375 each (24,375 X 48 months): Rs. 11,70,000
A sum of Rs. 7,500 was paid by the Hirer to the owner as service charges at the time or before the execution of the Agreement.
30. The terms of the H.P. Agreement, inter alia, provides that the machinery shall eventually become the property of the hirer and confer upon the hirer an option to purchase the said machinery in consideration of payment of a token sum of Re. 1 on payment of the entire sum of Rs. 11,70,000 and all other sums of money which may become due and payable by the Hirer to the owner under the aforesaid Agreement. The owner has not claimed any depreciation on the said equipment, which has been claimed by the Hirer. The assessee has shown total income by way of Finance income over a period 4 years covered by this Agreement to the tune of Rs. 4,20,000. Each monthly equated instalment of Rs. 24,375 has actually and really been received by the assessee from the Hirer every month, which contains both the (i) finance charges/interest component, and (ii) repayment of principal component. The apportionment of each monthly equated instalment of Rs. 24,375 between the principal content and-finance charges/interest content both according to SOD method followed by the assessee for recognition of finance income in its books of account and on the basis of equated method for the purposes of income-tax returns is given below : The said working given by the assessee for disclosure of income from hire purchase at page 88 is reproduced hereunder :
Amount financed 7,50,000
Finance charges
(@) 14 per cent for 48 months) 4,20,000
-------------------
Gross Receivable 11,70,000
Period in months 48
Equated monthly instalment (EMI)
(Gross Receivable/Period) 24,375
------------------------------------------------------------------------------------
Formula Index Inst. Equated Method No. Method
-------------------------------------------------------------------------------------
420000 x (48/(48 x 49)/2)) 17142.86 48 420000/48 8750
420000 x (47/(48 x 49)/2)) 16785.74 47 420000/48 8750
420000 x (46/(48 x 49)/2)) 16428.75 46 420000/48 8750
420000 x (45/(48 x 49)/2)) 16071.43 45 420000/48 8750
420000 x (44/(48 x 49)/2)) 15714.29 44 420000/48 8750
420000 x (43/(48 x 49)/2)) 15357.14 43 420000/48 8750
420000 x (42/(48 x 49)/2)) 15000.00 42 420000/48 8750
420000 x (41/(48 x 49)/2)) 14642.86 41 420000/48 8750
420000 x (40/(48 x 49)/2)) 14285.71 40 420000/48 8750
420000 x (39/(48 x 49)/2)) 13928.57 39 420000/48 8750
420000 x (38/(48 x 49)/2)) 13571.48 38 420000/48 8750
420000 x (37/(48 x 49)/2)) 13214.10 37 420000/48 8750
420000 x (36/(48 x 49)/2)) 12857.14 36 420000/48 8750
420000 x (35/(48 x 49)/2)) 12500.00 35 420000/48 8750
420000 x (34/(48 x 49)/2)) 12142.86 34 420000/48 8750
420000 x (33/(48 x 49)/2)) 11785.71 33 420000/48 8750
420000 x (32/(48 x 49)/2)) 11428.75 32 420000/48 8750
420000 x (31/(48 x 49)/2)) 11071.43 31 420000/48 8750
420000 x (30/(48 x 49)/2)) 10714.29 30 420000/48 8750
420000 x (29/(48 x 49)/2)) 10357.14 29 420000/48 8750
420000 x (28/(48 x 49)/2)) 10000.00 28 420000/48 8750
420000 x (27/(48 x 49)/2)) 9642.86 27 420000/48 8750
420000 x (26/(48 x 49)/2)) 9285.71 26 420000/48 8750
420000 x (25/(48 x 49)/2)) 8928.57 25 420000/48 8750
420000 x (24/(48 x 49)/2)) 8571.43 24 420000/48 8750
420000 x (23/(48 x 49)/2)) 8214.29 23 420000/48 8750
420000 x (22/(48 x 49)/2)) 7857.14 22 420000/48 8750
420000 x (21/(48 x 49)/2)) 7500.00 21 420000/48 8750
420000 x (20/(48 x 49)/2)) 7142.86 20 420000/48 8750
420000 x (19/(48 x 49)/2)) 6785.71 19 420000/48 8750
420000 x (18/(48 x 49)/2)) 6428.57 18 420000/48 8750
420000 x (17/(48 x 49)/2)) 6071.43 17 420000/48 8750
420000 x (16/(48 x 49)/2)) 5714.29 16 420000/48 8750
420000 x (15/(48 x 49)/2)) 5357.14 15 420000/48 8750
420000 x (14/(48 x 49)/2)) 5000.00 14 420000/48 8750
420000 x (13/(48 x 49)/2)) 4642.36 13 420000/48 8750
420000 x (12/(48 x 49)/2)) 4285.71 12 420000/48 8750
420000 x (11/(48 x 49)/2)) 3928.57 11 420000/48 8750
420000 x (10/(48 x 49)/2)) 3571.43 10 420000/48 8750
420000 x (9/(48 x 49)/2)) 3214.29 9 420000/48 8750
420000 x (8/(48 x 49)/2)) 2857.14 8 420000/48 8750
420000 x (7/(48 x 49)/2)) 2500.00 7 420000/48 8750
420000 x (6/(48 x 49)/2)) 2142.86 6 420000/48 8750
420000 x (5/(48 x 49)/2)) 1785.71 5 420000/48 8750
420000 x (4/(48 x 49)/2)) 1428.57 4 420000/48 8750
420000 x (3/(48 x 49)/2)) 1071.43 3 420000/48 8750
420000 x (2/(48 x 49)/2)) 714.29 2 420000/48 8750
420000 x (1/(48 x 49)/2)) 357.14 1 420000/48 8750
-------------------- ----------------
420000.00 420000
-------------------- ----------------
We have to consider the question as to which method of apportionment or appropriation of each equated Monthly Instalment (hereinafter referred to as 'EMI') between principal component and finance charges/ interest component is more rational, appropriate and in consonance with law, so that the correct accrual of income by way of finance charges chargeable to tax of the relevant previous year may be determined.
31. The finance charges/interest calculated @ 14 per cent p.a. on Rs. 7,50,000 comes to Rs. 1,05,000 for one year. The total amount for 4 years has, thus, been computed at Rs. 4,20,000. The gross amount recoverable from the Hirer has been arrived at Rs. 11,70,000 (7,50,000 + 42,000) which will be repaid in 48 equated monthly instalments of Rs. 24,375 every month. In the model agreement, it is stated against Rs. 4,20,000 as finance charges and not interest. It is no doubt the argument of Departmental Representative that 'finance charges' are nothing but interest, but when we are applying the theory of appropriation, this distinction, if any, found existing between the finance charges and the interest, assumes significance. The further question would be whether any distinction is to be maintained between the payment of Rs. 4,20,000 and Rs. 7,50,000 while considering the question of appropriation. Though Schedule 11 forming part of the H.P. Agreement specifies that the gross amount of Rs. 11,70,000 will be repaid in 48 monthly instalments of Rs. 24,375 each commencing from 12-12-1986 to 12-11-1990, the Agreement does not give the bifurcation or apportionment of the amount of each EMI of Rs. 24,375 between the principal component and interest component.
32. It is an undisputed fact that the assessee-company is entitled to recover an EMI of Rs. 24,375 p.m. in accordance with the said H.P. Agreement. The EMI of Rs. 24,375 undoubtedly consists of interest component as well as principal component. The agreement as aforesaid does not give the apportionment or bifurcation of each equated monthly instalment of Rs. 24,375 between the principal and interest components. The Hirer in the present case has agreed to repay the entire amount of loan along with interest by way of EMI of Rs. 24,375 p.m. for 48 months without specifying as to what extent, each monthly instalment is towards interest and principal. Where the debtor/Hirer pays an instalment without specifying or ear marking any amounts towards the principal or interest, the creditor (the respondent-company) is entitled to appropriate the amount of instalment first towards the payment of interest and the balance amount towards the principal. That is what has been precisely done by the respondent-company while recognising the finance income in relation to H.P. Agreement on the basis of SOD method in its books of account. It will be worthwhile to reproduce the relevant extracts from the judgment of Hon'ble Supreme Court in the case of Meghraj v. Mst. Bayabai AIR 1970 SC 161, wherein their Lordships held as under :
"The normal rule in the case of a debt due with interest is that any payment made by the debtor is in the first instant is to be applied towards satisfaction of interest and thereafter to the principal."
The Privy Council in the case of Maharajadhiraj Kameshwar Singh at pages 103 & 104 also observed as under :
"Where interest is outstanding on a principal sum due and the creditor receives an open payment from the debtor without any appropriation of the payment as between capital and interest, by either debtor or creditor, the presumption is that the payment is attributable in the first instance towards the outstanding interest."
It is universally known fact that interest is the price for use of money. In other words, it is a payment by way of compensation for use of funds provided by the Company to the Hirer. It is a uniform rate of interest charged not with reference to original amount of funds made available but in proportion to the outstanding balance from time to time. The principal amount which is paid does not have to suffer interest burden on the assessee simply because it was originally given at that figure. The real and effective rate of interest implicit in the contract of Hire Purchase will, therefore, have to be determined by apportioning the amount of each EMI of Rs. 24,375 in such a manner that the entire amount of interest income of Rs. 4,20,000 covering the period of 4 years of the contract is apportioned over the period of the contract in proportion to the reducing balances that will be outstanding from time to time. A perusal of chart given at page 35 indicates that out of first equated monthly instalment of Rs. 24,375, the assessee-company has appropriated in its books of account a sum of Rs. 17,142.86 towards interest and the balance amount has been appropriated towards repayment of principal. In the second month, interest has been calculated on the reduced amount of principal and interest component has been worked out at Rs. 16,785.74. Thus, each EMI has been apportioned in such a manner that it recognises interest income at a constant and uniform rate of interest on the reducing balance of principal amount outstanding from month to month, which represents the true and real rate of interest implicit in the H.P. Agreement. The amount of EMI Rs. 24,375 is receivable by the assessee every month. The apportionment of interest component in each EMI has been made on the basis of such a recognised appropriate and correct method which is known as SOD method. The apportionment so made by the assessee in its books of account for recognition of interest income reflects the true and correct income accrued and received by the assessee in accordance with the real and effective rate of interest implicit in the H.P. Agreement in the relevant accounting year.
33. The elaborate example given by the learned Sr. D.R. in the note presented by him (reproduced at pages 17 to 23 of this order) clearly explains that the assessee has rightly accounted for its finance interest income in relation to H.P. Agreement on SOD method in its books of account, by apportioning each EMI between interest component and principal component in such a manner that it gives a uniform rate of interest over the entire hire purchase period and duly takes into consideration the reducing principal amount in each instalment payment. The interest income is progressively reducing with the reduction in the outstanding principal amount. The interest income has been recognised in the books of account as per the real rate of interest implicit in the H.P. Agreement. If the method adopted by the assessee for tax purposes in relation to such interest income is accepted the interest rate in the example given in the said note at page 18 of the order will come to 14 per cent in first year and 42 per cent in the third year, which cannot be said to be in conformity with the H.P. Agreement. The Index method/SOD method takes into account the reducing principal amount in each instalment and gives a realistic, constant and uniform rate of interest, which is the real rate of interest implicit in the H.P. Agreement.
34. The Division Bench of the ITAT, Hyderabad Bench "B" in the case of Nagarjuna Finance (P.) Ltd. has inter alia considered similar arguments as were advanced before us in relation to recognition of finance/interest income arising under the H.P. Agreement on SOD method and has given elaborate and convincing reasons in the order while deciding this issue against the assessee. After giving our deep and thoughtful consideration to the entire relevant material, we find ourselves in agreement with the reasonings and the finding given by the Tribunal in the case of Nagarjuna Finance (P.) Ltd. in so far as the income under hire purchase agreements are concerned. Since we have expressed our agreement with the reasonings given in the aforesaid earlier order passed by the Tribunal in relation to income under the H.P. Agreements, we do not consider it necessary to repeat the elaborate reasons recorded in the said order of the Tribunal by which all the Submissions made on behalf of the assessee in this regard were repelled.
35. The reliance placed by the learned counsel on the Circular No. 9 dated 23-3-1943 and its reaffirmation vide Instruction No. 1057 dated 19-9-1977 would not in any manner help the assessee. The said circular mainly clarifies that depreciation on plant and machinery purchased on hire purchase system would be admissible to the Hirer (lessee) and that the periodical payments made by the Hirer should for tax purposes be regarded as made up of (i) consideration of hire (interest) and (ii) payment on account of purchase (principal component). It further mentions that allowance for interest/hire should be evenly spread over the term of the agreement for being allowed as deduction in the case of the hirer cannot convert the income accrued in the hands of the financier as income having not accrued. The said circular does not give any guidelines relating to accrual of income in the hands of the financier. The said circular cannot be interpreted to mean that an income which comes within the ambit of charging section should not be charged to tax in the year of accrual of income because deduction by way of hire and depreciation in the hands of the Hirer is to be allowed in a particular manner as clarified in the said circular. Moreover, the circular says that that interest should be evenly spread over the terms of the agreement. The interest income according to the SOD method has been spread over the term of the contract in such a manner that it evenly gives a uniform, constant and uniform rate of interest on the reducing balances of principal amount for the entire period of contract. In any case, the said circular cannot override the charging provisions of the Income-tax Act, 1961.
36. In view of the foregoing discussions, we are of the considered opinion that the finance income/interest income in relation to Hire Purchase Agreements recognised on the basis of SOD method by the assessee in its books of account represents the real income accrued to the assessee in the relevant previous year and which having been apportioned from the amount of equated monthly instalment also represents the income received/receivable in the relevant accounting year as per the terms of the respective Hire Purchase Agreements. The income so recognised in the books of account on the basis of SOD method so far as it relates to H.P. Agreements clearly come within the ambit of charging section 5 of the Act. The assessee's claim with regard to exclusion of differential income so far as it relates to H.P. Agreements is not sustainable. The order of the CIT(Appeals) to that extent is set side and that of the Assessing Officer is restored.
37. We will now examine the facts relating to income by way of lease rentals as per lease agreements.
38. The assessee has submitted a copy of one of the lease agreements, as a specimen copy of such lease agreements executed with various clients, at pages 62 to 87 of the compilation. The Vijaya Kumar Mills Ltd., the lessee was desirous of acquiring the equipment described in Schedule I of the Lease Agreement and had, therefore, approached the assessee-company (the lessor) to purchase the said equipment and give it on lease to the lessee for a period of 96 months (8 years) on the terms and conditions set forth in the lease agreement executed between them on 27-7-1984. The cost of the equipment was Rs. 4,07,800. The lessee agreed to pay monthly lease rental @ Rs. 7,816.20 per month for a period of 96 months. Thus the gross lease rent payable by the lessee to the lessor over a period of 96 months come to Rs. 7,816.20 X 96 months Rs. 7,50,355.20. The fixed period of the lease of 96 months was a non-cancellable term of the said agreement. The lessors were entitled to recover the entire amount of the rentals for the fixed period in the event of termination of the agreement on a prior date. The lessor shall remain the owner of the equipment at all times. Upon termination of the agreement by efflux of time or otherwise, the lessee is bound to deliver to the lessor the said equipment in good repair, order and condition subject to normal wear and tear. The lessee also inter alia, agreed not to claim any relief by way of depreciation or other deductions available to the owner of the equipment under the provisions of income-tax Act, 1961.
39. The assessee-lessors in their books of account has recognised the income by way of lease rentals on the basis of SOD method as per chart given at page 40 of this order. However, for tax purposes, the assessee has declared lease rental income @ Rs. 7,816.20 p.m. i.e., Rs. 93,794.40 per annum as per the terms of the lease agreement. As against this, the income recognised in its books of account as per the SOD method during the period of 8 years is as under :---
1 st year Rs. 1,75,018.42
2nd year Rs. 1,51,811.55
3rd year Rs. 1,28,604.69
4th year Rs. 1,05,397.83
5th year Rs. 82,190.97
6th year Rs. 58,984.11
7th year Rs. 35,777.25
8th year Rs. 12,570.38
----------------------------
Total Rs. 7,50,355.20
----------------------------
The total income shown during 8 years for tax purposes @ Rs. 93,794.90 X 8 years come to the same figure of Rs. 7,50,355.20.
40. It is noteworthy to mention that in case of lease rentals, the entire amount of monthly instalment of Rs. 7,816.20 paid by the lessees to the lessors by way of lease rent has been shown as income and question of apportionment of the amount of monthly instalment between interest component and principal component does not arise in case of lease rentals. The other significant and vital fact is that the lessor remains the owner of the equipment at all times and the lessee is bound to handover the equipment to the lessor upon the termination of the agreement. The lease does not claim any depreciation on the equipment unlike in the case of a Hire Purchase Agreement where the Hirer has an option to purchase the equipment and also claims depreciation on the initial cost/WDV of the said equipment. In view of these distinguishing features between the H.P. Agreement and lease agreements, the gross amount of hire/lease rent receivable as per the lease agreement is recognised as income and no apportionment is being made between the finance charge (interest) and the principal component. The impact of the principal on the credit side included in gross lease rent is neutralised by depreciation provision in the hands of the lessor.
41. We may also examine the various prudential norms for income recognition, accounting standards clarified in some of the Guidance Note issued by the Institute of Chartered Accountants of India as well as in the International Accounting Standards.
41.1 The International Accounting Standard 17(IAS 17) has recommended the accounting of lease transactions in the books of the lessors as under :
"Accounting for Leases in the Financial Statements of Lessors.
Finance Leases :
An asset held under a finance lease should be recorded in the balance sheet not as property, plant and equipment but as a receivable, at an amount equal to the net investment in the lease. Subject to the consideration of prudence, the recognition of finance income should be based on a pattern reflecting at constant periodic rate of return on either the lessor's net Investment outstanding or the net cash investment outstanding in respect of the finance lease. The method used should be applied consistently to lease of a, similar financial character.
Operating Leases :
Assets held for equating lease should be recorded as property, place and equipment in the balance sheet of leases. Rental income should be recognised on a straight line basis over the lease term, unless another systematic basis is more representative of the time pattern of the earnings process contained in the lease. The depreciation of leased assets should be on a basis consistent with the lessor's normal depreciation policy for similar assets, and the depreciation charge should be calculated on the basis set out in International Accounting Standard 4, Depreciation Accounting."
The Institute of Chartered Accountants of India have announced Revised Guidance Notes on Accounting for leases in its monthly journal of September, 1995 to replace the earlier guidance note issued in the year 1988.
41.2 The said Guidance Note, inter alia, defines the following terms as under :
"Lease: An agreement whereby the lessor conveys to the lessee, in return for rent, the right to use an asset for an agreed period of time.
Finance Lease: A lease under which the present value of the minimum lease payments at the inception of the lease exceeds or is equal to substantially the whole of the fair value of the leased asset.
Operating Lease: A lease other than a finance lease.
Non-cancellable Lease: A lease that is cancellable only:
(a) upon the occurrence of some remote contingency,
(b) with the permission of the lessor,
(c) if the lessee enters into a new lease for the same or any equivalent asset with the same lessor, or
(d) upon payment by the lessee of an additional amount such that, at inception, continuation of the lease is reasonably certain."
41.3 The said Guidance Note, the Institute has recommended Accounting for leases in the Books of a lessor as under :
"Finance Leases:
Assets leased under finance leases should be disclosed as 'Assets given on lease', as a separate section under the head 'Fixed Assets' in the balance sheet of the lessor. The classification of 'Assets given on lease' should correspond to that adopted in respect of other fixed assets. In addition to the particulars required by statute, e.g. Schedule VI to the Companies Act, 1956, particulars relating to Lease Adjustment Account should be disclosed as stated in para 11.
10. Lease rentals (those received and those due but not received) under a finance lease should be shown separately under 'Gross Income' in the profit and loss account of the relevant period.
11. It is appropriate that against the lease rentals, a matching lease annual charge is made to the profit and loss account. This annual lease charge should represent recovery of the net investment/fair value of the leased asset over the lease term. The said charge should be calculated by deducting the finance income for the period (as per para 12 below) from the lease rental for that period. This annual lease charge would comprise (i) minimum statutory depreciation (e.g. as per the Companies Act, 1956) and (ii) lease equalisation charge, where the annual lease charge is more than the minimum statutory depreciation.
However, where annual lease charge is less than minimum statutory depreciation, a lease equalisation credit would arise. In this regard the following accounting entries/disclosures should be made :
(a) A separate Lease Equalisation Account should be opened with a corresponding debit or credit to Lease Adjustment Account, as the case may be.
(b) 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'.
(c) Statutory depreciation should be shown separately in the profit and loss account. Accumulated statutory depreciation should be deducted from the original cost of the leased asset in the balance sheet of the lessor to arrive at the net book value.
(d) Balance standing in Lease Adjustment Account should be adjusted in the net book value of the leased assets. The amount of adjustment in respect of each class of fixed assets may be shown either in the main balance sheet or in the Fixed Assets Schedule as a separate column in the section related to leased assets.
(e) the aggregate amount included under Lease Adjustment Account on account of lease equalisation credits should be disclosed separately.
The method of income measurement suggested in this paragraph, is in consonance with the inherent nature of a finance lease.
The above method is illustrated in the Appendix to this Guidance Note.
12. The finance income for the period should be calculated by applying the interest rate implicit in the lease to the net investment in the lease during the relevant period. This method would ensure recognition of net income in respect of a finance lease at a constant periodic rate of return on the lessor's net investment outstanding in the lease. However, some lessors use a simple method for calculating the finance income for each of the periods comprising the lease term by apportioning the total finance income from the lease in the ratio of minimum lease payments outstanding during each of the respective periods comprising the lease term. (The total finance income from the lease is the difference between the aggregate minimum lease payments receivable over the lease term and the fair value of the leased asset at the inception of the lease). This method may be used where the finance income in respect of all individual periods as per this method approximates the finance income for the corresponding periods determined according to the former method. It is however clarified that where this method is used, overdue lease rentals, i.e., lease rentals fallen due but not collected should not be taken into account for determining the amount of minimum lease payments outstanding during each of the respective periods comprising the lease term.
13. Net investment in the lease may often be equal to the capital cost/fair value of the asset at the inception of the lease. However, as per the definition, net investment is the difference between the gross investment in the lease (i.e., the aggregate of the minimum lease payments from the standpoint of the lessor and any residual value accruing to the lessor) and the unearned finance income (i.e., the difference between the lessor's gross investment in the lease and its present value).
14. Initial direct costs, such as commissions and legal fees, often incurred by lessors in negotiating and arranging the lease should normally be expressed in the year in which they are incurred. Similarly, income on account of lease, e.g. management fees, should be recognised in the year in which they accrue."
Operating Leases :
A lease is classified as an operating lease if it does not secure for the lessor the recovery of his capital outlay plus a return on the funds invested during the lease term. Therefore the asset and rentals receivable should be included in income over the lease term.
Costs, including depreciation, incurred in earning the rental income should be charged to income. Rental income should normally be recognised on a systematic basis which is representative of the time pattern of the earnings process contained in the lease. In many cases, recognised of rental income on a straight line basis over the lease term would be representative of the time pattern.
A leased asset for an operating lease should be depreciated on a basis consistent with the lessor's normal depreciation policy for similar assets.
Initial direct costs incurred by lessor in negotiating and arranging the lease should be expensed in the year in which they are incurred.
The Institute in the aforesaid guidance note in para 27 has given the following clarification :
"Computation of taxable income:
It is clarified that the specific treatments for determining taxable income would have to be in accordance with the provisions of the taxation laws; such treatments may differ from the recommendations contained in the Guidance Note."
42. We may now compare the SOD method of accounting followed by the assessee in relation to lease rentals in its books of account with the norms recommended in the aforesaid IAS 17 and the Guidance Note. In the example given by the assessee reproduced at pages 40 and 41, the assessee has recognised such income as per SOD method in the books of account as under:
Equipment cost Say Rs. 100
Period of lease agreement say Five Years.
Annual Lease rental Rs. 30
Gross Lease Rental Rs. 150
The Gross amount paid by the lessee over a period of 5 years Rs. 150 has been accounted for in the book of account as income as under :---
First Year 150 x 5 or say 150 x 5 = 50
-------------- -----------
(5 X 6/2) 15
Second Year 150 x 4 or say 150 x 4 = 40
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(5 X 6/2) 15
Third Year 150 x 3 or say 150 x 3 = 30
Third Year 150 x 3 or say 150 x 3 = 30
-------------- -----------
(5 x 6/2) 15
Fourth Year 150 x 2 or say 150 x 2 = 20
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(5 x6/2) 15
Fifth Year 150 x 1 or say 150 x 1 = 10
-------------- -----------
(5 X 6/2) 15
-----------
Gross income for 5 years : 150
-----------
The cost of equipment has been shown as asset on which the lessor has claimed depreciation. In the case of lease rentals the assessee has not apportioned the total amount realised from the lessees between the finance charge and the principal component, but has credited the entire amount as income of revenue nature. The assessee has not periodically transferred any amount in lease Equalisation Account with a corresponding debit or credit to lease adjustment account, as indicated in the Guidance Note. In fact, the IAS- 17 shows that where plant and equipment is shown as an asset and depreciation is claimed by the lessor, the rental income should be recognised on a straight line basis over the lease term and depreciation of leased assets should be claimed on a basis consistent with the lessor's normal depreciation policy.
42.1 In the aforesaid example, the assessee has a right to receive annual lease rent of Rs. 30 per annum as per the lease agreement. The income which accrues to the assessee as per the Agreement is only Rs. 30 per annum. Any amount of income accounted for in the books of account in the first few years of the lease term beyond the amount of Rs. 30 clearly represents hypothetical income which did not in fact accrue to the assessee in the relevant accounting year.
43. The assessee in its income-tax returns has declared income by way of lease rentals on the basis of lease rent fixed in the respective lease agreements and has claimed the excess amount recognised in the books of account beyond the agreed amount of lease rental, as differential income not liable to tax on the ground that income to that extent has not accrued in the relevant previous year. The assessee in relation to the specimen lease agreement has shown income from lease rental @ Rs. 7,816.20 i.e., Rs. 93,794.40 per annum for tax purposes. The assessee is entitled to receive lease rent @ Rs. 7,816.20 p.m. as the lease agreement and, therefore, the income which can be said to have accrued to the assessee in accordance with the terms of the agreement, which alone comes within the ambit of charging provisions is Rs. 7,816.20 p.m. only and not a pie more even though income higher than that has been accounted for on SOD method/index method in the books of account.
44. In view of the aforesaid discussions, we hold that so far as income by way of lease rental is concerned, the only income which accrues in the relevant year is the monthly instalment specified in the respective lease agreements and in no circumstance, the income in excess of the monthly lease instalment can be said to have accrued in law. The excess income beyond the monthly lease instalment accounted for as income on the basis of SOD method/Index method does not come within the ambit and range of taxable income within the meaning of charging provisions of the Act and therefore, such excess income, termed as differential income in relation to lease agreements cannot be brought to tax. The Assessing Officer is, therefore, directed to exclude such excess income, if any, found on verification.
45. We would, however, like to clarify that the Assessing Officer will be entitled to verify the correctness of the bifurcation of figures of differential income between (i) finance income, relating to H.P. Agreement; and (ii) income by way of lease rentals as per lease agreements, with the relevant entries in the books of account and the respective agreements.
46. Before parting, we would like to express our feelings of appreciation for the admirable manner in which the learned representatives of both sides presented their case.
47. In the result, the appeal is partly allowed.
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