COMMISSIONER OF INCOME TAX-VI versus VIRTUAL SOFT SYSTEMS LTD. on 24 April 2018

COMMISSIONER OF INCOME TAX-VI

v.

VIRTUAL SOFT SYSTEMS LTD.

(Civil Appeal No. 4358 of 2018)

APRIL 24, 2018

[R. K. AGRAWAL AND ABHAY MANOHAR SAPRE, JJ.]

Income Tax Act, 1961 – Deduction on account of leaseequalization charges from lease rental income – Entitlement for –Held: The bifurcation of the lease rental is, by no stretch ofimagination, an artificial calculation and, therefore, leaseequalization is an essential step in the accounting process to ensurethat real income from the transaction in the form of revenue receiptsonly is captured for the purposes of income tax – Moreover, there isno express bar in the IT Act which bars the bifurcation of the leaserental – This bifurcation is analogous to the manner in which abank would treat an EMI payment made by the debtor on a loanadvanced by the bank – The repayment of principal would be abalance sheet item and not a revenue item – Only the interest earnedwould be a revenue receipt chargeable to income tax – Hence, wholerevenue from lease would not be subjected to tax under the IT Act –Respondent is entitled for bifurcation of lease rental as per theaccounting standards prescribed by the ICAI – CharteredAccountants Act, 1949.

Chartered Accountants Act, 1949 – Guidance note issued bythe Institute of Chartered Accountants of India (ICAI) – Reliabilityof – Held: ICAI is a recognized expert body vested with theauthority to recommend accounting standards – The method ofaccounting followed, as derived from the ICAI’s Guidance Note, isa valid method of capturing real income based on the substance offinance lease transaction.

Companies Act, 1956 – s.211 – Accounting standards asprescribed by ICAI to prevail until the accounting standards areprescribed by the Central Government.

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ADisposing of the appeals, the Court

HELD: 1.1 The ICAI is an expert body, created by theParliament under the Chartered Accountants Act, 1949. TheICAI’s publication on the subject indicates that the GuidanceNote on Accounting for Leases was issued by it for the first timeBin 1988 which was later on revised in 1995. The Guidance Notereflects the best practices adopted by the accountants throughoutthe world. The ICAI is a recognized body vested with theauthority to recommend accounting standards for ultimateprescription by the Central Government in consultation with theNational Advisory Committee of Accounting Standards for theCpresentation of true and fair financial statements. [Para 8][601-C-D]

1.2 Section 211 of the Companies Act, 1956 as it stoodbefore the amendment dealt with “the Form and contents ofbalance-sheet and profit and loss account”. Sub clause (3C) ofDSection 211 was added vide 1999 amendment with retrospectiveeffect. The purpose behind the amendment in Section 211 of theCompanies Act, 1956 was to give clear sight that the accountingstandards, as prescribed by the ICAI, shall prevail until theaccounting standards are prescribed by the Central GovernmentEunder this sub-section. The purpose behind the accountingstandards was to arrive at a computation of real income afteradjusting the permissible deprecation. It is not disputed that theseaccounting standards are made by the body of experts afterextensive study and research. [Paras 9, 10] [601-E; 602-A-B]

F2.1 The method of accounting provided in the GuidanceNote of 1995, on the one hand, adjusts the inflated cost of interestof the assets in the balance sheet. Secondly, it captures “realincome” by separating the element of capital recovery (essentiallyrepresenting repayment of principal amount by the lessee, theprincipal amount being the net investment in the lease), and theGfinance income, which is the revenue receipt of the lessor asremuneration/reward for the lessor’s investment. As per theGuidance Note, the annual lease charge represents recovery ofthe net investment/fair value of the asset lease term. The financeincome reflects a constant periodic rate of return on the netHinvestment of the lessor outstanding in respect of the finance

lease. While the finance income represents a revenue receipt tobe included in income for the purpose of taxation, the capitalrecovery element (annual lease charge) is not classifiable asincome, as it is not, in essence, a revenue receipt chargeable toincome tax. [Para 12] [604-C-E]

2.2 The method of accounting followed, as derived fromthe ICAI’s Guidance Note, is a valid method of capturing realincome based on the substance of finance lease transaction. Therule of substance over form is a fundamental principle ofaccounting, and is in fact, incorporated in the ICAI’s AccountingStandards on Disclosure of Accounting Policies being accountingstandards which is a kind of guidelines for accounting periodsstarting from 01.04.1991. It is a cardinal principle of law that thedifference between capital recovery and interest or finance incomeis essential for accounting for such a transaction with referenceto its substance. If the same was not carried out, the Respondentwould be assessed for income tax not merely on revenue receiptsbut also on non-revenue items which is completely contrary tothe principles of the IT Act and to its Scheme and spirit.[Para 13] [604-F-H]

2.3 The bifurcation of the lease rental is, by no stretch ofimagination, an artificial calculation and, therefore, leaseequalization is an essential step in the accounting process toensure that real income from the transaction in the form ofrevenue receipts only is captured for the purposes of incometax. Moreover, there is no express bar in the IT Act which barsthe bifurcation of the lease rental. This bifurcation is analogousto the manner in which a bank would treat an EMI payment madeby the debtor on a loan advanced by the bank. The repayment ofprincipal would be a balance sheet item and not a revenue item.Only the interest earned would be a revenue receipt chargeableto income tax. Hence, there is no force in the contentions of theRevenue that whole revenue from lease shall be subjected to taxunder the IT Act. [Para 14] [605-A-C]

Commissioner of Income Tax-VII, New Delhi v. PunjabStainless Steel Industries (2014) 15 SCC 129 – reliedon.

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598SUPREME COURT REPORTS

A3. The main contention of the Revenue is that theRespondent cannot be allowed to claim deduction regarding leaseequalization charges since as such there is no express provisionregarding such deduction in the IT Act. The IT Act is silent onsuch deduction. For such calculation, the Respondent has to takecourse of Guidance Note prescribed by the ICAI if it is available.BOnly after applying such method which is prescribed in theGuidance Note, the Respondent can show fair and real incomewhich is liable to tax under the IT Act. Therefore, it is wrong tosay that the Respondent claimed deduction by virtue of GuidanceNote rather it only applied the method of bifurcation as prescribedCby the expert team of ICAI. Further, a conjoint reading of Section145 of the IT Act read with Section 211 (un-amended) of theCompanies Act make it clear that the Respondent is entitled todo such bifurcation and there is no illegality in such bifurcationas it is according to the principles of law. Moreover, the rule ofinterpretation says that when internal aid is not available then forDthe proper interpretation of the Statute, the court may take thehelp of external aid. If a term is not defined in a Statute then itsmeaning can be taken as is prevalent in ordinary or commercialparlance. [Paras 16, 17] [605-F-H; 606-A-C]

Case Law reference

E(2014) 15 SCC 129 relied onPara 15CIVIL APPELLATE JURISDICTION : Civil Appeal No. 4358of 2018.

From the Judgment and Order dated 07.02.2012 of the High CourtFof Delhi at New Delhi in ITA No.404/2011

WITH

Civil Appeal Nos. 4359, 4360, 4361, 4365, 4362, 4363, 4364, 4366-4367, 4368, 4370, 4369, 4371, 4372, 4373, 4375, 4374 and 4376 of 2018.

GK. Radhakrishnan, Sr. Adv., Om Prakash Shukla, H.R. Rao, AlokShukla, Yajur Sharma (for Mrs. Anil Katiyar), Advs. for the Appellant.

Kavin Gulati, Sr. Adv., Santosh Kumar-I, Jagmohan Sharma, S.Krishnan, Mrs. Rani Chhabra, Nikhil Nayyar, Ms. Pritha Sri Kumar,Ms. Arunima Kedia, Advs. for the Respondent.

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The Judgment of the Court was delivered by

R. K. AGRAWAL, J.

SLP (C) No. 25006 of 2012

1. Leave granted.

2. This batch of appeals has been filed against the impugnedjudgment and order dated 07.02.2012 passed by the High Court of Delhiat New Delhi in ITA Nos. 216, 398, 403, 404 and 680 of 2011 wherebythe Division Bench of the High Court upheld the decision of the IncomeTax Appellate Tribunal (in short ‘the Tribunal’) dated 19.02.2010. Sincethe moot question of law in all these appeals is akin, hence, vide thiscommon judgment, all the appeals would stand disposed of.

3. In order to appreciate the controversy at hand, it is pertinent toallude to the relevant facts in a summarized way for the proper insightfulof the instant case.

(a) The appellant herein is the Income Tax Department, on theother hand, the Respondent - M/s Virtual Soft Systems Ltd. is a companyregistered under the provisions of the Companies Act, 1956.

(b) On 29.12.1999, the Respondent filed return of income for theAssessment Year 1999-2000 declaring loss of Rs 70,24,178/- whileclaiming an amount of Rs 1,65,12,077/- as deduction for lease equalizationcharges.

(c) On scrutiny, the Assessing Officer, after perusal of the returnand hearing the parties, vide Assessment Order dated 28.01.2005disallowed deduction claimed as the lease equalization charges amountingto Rs. 1,65,12,077/- and added the same to the income of the Respondentunder the Income Tax Act, 1961 (in short ‘the IT Act’).

(d) Being aggrieved with the said Assessment Order, theRespondent preferred an appeal before the Commissioner of IncomeTax (Appeals). Learned CIT (Appeals), vide order dated 15.09.2005,upheld the order of the Assessing Officer and dismissed the appeal.

(e) Being dissatisfied, the Respondent preferred an appeal beforethe ITAT. Vide order dated 19.02.2010, the ITAT allowed the appeal ofthe Respondent while setting aside the orders passed by Learned CIT(Appeals) and the Assessing Officer.

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(f) Being aggrieved, the Revenue took the matter before theHigh Court. The High Court, vide judgment and order dated 07.02.2012,dismissed the appeals at the preliminary stage while confirming thedecision of the ITAT.

(g) Hence, this instant appeal has been filed before this Court byBthe Revenue.

4. We have given our thoughtful consideration to the submissionsof learned senior counsel for the parties and perused the relevant recordsof the case.

Point(s) for consideration:-C

5. The short question that arises for consideration before this Courtis whether the deduction on account of lease equalization charges fromlease rental income can be allowed under the Income Tax Act, 1961, onthe basis of Guidance Note issued by the Institute of CharteredAccountants of India (ICAI)?

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Rival submissions:-

6. At the outset, learned senior counsel for the Revenue contendedthat the lease equalization charge is an additional deduction debited toProfit and Loss Account (P&L) in addition to the depreciation claimedin books so as to make it equal to capital recovery. This is an artificialEcalculation which bifurcates lease rental to capital recovery and interestcomponent. Learned senior counsel further contended that in fact theentire lease income constitutes income of the assessee. Also, there isno concept of deduction regarding the lease equalization charges underthe IT Act. Hence, learned senior counsel contended that impugnedFdecision of the High Court is perverse and is liable to be set aside.

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7. On the other hand, learned senior counsel for the Respondentsubmitted that this issue is no longer res integra. Now, it is a settledprinciple that a Guidance Note issued by the ICAI carries great weightand by adopting a method of accounting prescribed in such a GuidanceGNote, in order to compute real income and offering the same for taxation,cannot be disregarded by the Assessing Officer unless such action fallswithin the scope and ambit of Section 145(3) of the IT Act. Further, itwas submitted that the lease equalization charge was nothing but a methodof adjusting the depreciation claimed in the books of accounts to enable H

the Respondent to represent its real income by adopting an accountingmethodology which had surely the seal of approval of a professionalbody such as the ICAI. Learned senior counsel finally submitted thatthe judgment passed by the High Court is well-versed and within theparameters of law and no interference is sought for by this Court in thematter.

Discussion:-

8. Prior to critically examining the case, it would be appropriate tohave an understanding and significance of the Guidance Note issued bythe ICAI. The ICAI is an expert body, created by the Parliament underthe Chartered Accountants Act, 1949. The ICAI’s publication on thesubject indicates that the Guidance Note on Accounting for Leases wasissued by it for the first time in 1988 which was later on revised in 1995.The Guidance Note reflects the best practices adopted by the accountantsthroughout the world. The ICAI is a recognized body vested with theauthority to recommend accounting standards for ultimate prescriptionby the Central Government in consultation with the National AdvisoryCommittee of Accounting Standards for the presentation of true and fairfinancial statements.

9. Section 211 of the Companies Act, 1956 as it stood before theamendment dealt with “the Form and contents of balance-sheet andprofit and loss account”. Sub clause (3C) of Section 211 was added vide1999 amendment with retrospective effect. The relevant portion ofSection 211 of the Companies Act is reproduced herein as under:

“(3C) For the purposes of this section, the expression“accountingstandards” means the standards of accounting recommended bythe Institute of Chartered Accountants of India constituted underthe Chartered Accountants Act, 1949 (38 of 1949), as may beprescribed by the Central Government in consultation with theNational Advisory Committee on Accounting Standards establishedunder sub-section (1) of section 210A:

Provided that the standards of accounting specified by the Instituteof Chartered Accountants of India shall be deemed to be theaccounting standards until the accounting standards are prescribedby the Central Government under this sub-section.”

(Emphasis supplied by us)

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A10. The purpose behind the amendment in Section 211 of theCompanies Act, 1956 was to give clear sight that the accounting standards,as prescribed by the ICAI, shall prevail until the accounting standardsare prescribed by the Central Government under this sub-section. Thepurpose behind the accounting standards was to arrive at a computationof real income after adjusting the permissible deprecation. It is notBdisputed that these accounting standards are made by the body of expertsafter extensive study and research.

11. At this stage, it would be pertinent to reproduce the relevantprovisions of the Guidance Note on Accounting for Leases, revised in1995, which is as under:- C

“Accounting for leases in the Books of a lessorFinance Leases

9. 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 classificationof ‘Assets given on lease’ should correspond to that adopted inrespect of other fixed assets. In addition to the particulars requiredby statute, e.g., Schedule VI to the Companies Act, 1956,particulars relating to Lease Adjustment Account should bedisclosed as stated in Para 11.

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10. Lease rentals (those received and those due but not received)under a finance lease should be shown separately under ‘GrossIncome’ in the profit and loss account of the relevant period.

11. It is appropriate that against the lease rental, a matching leaseannual charge is made to the profit and loss account. This annuallease charge should represent recovery of the net investment/fair value of the leased asset over the lease term. The said chargeshould be calculated by deducting the finance income for the period(as per para 12 below) from the lease rental for that period. Thisannual lease charge would comprise (i) minimum statutorydepreciation (e.g., as per the Companies Act, 1956) and (ii) leaseequalization charge, where the annual lease charge is less thanminimum statutory depreciation. However, where annual leasecharge is less than minimum statutory depreciation, a leaseequalization credit would arise. In this regard the followingaccounting entries/disclosure should be made.

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(a) A separate Lease Equalization Account should be openedwith a corresponding debit or credit to Lease AdjustmentAccount, as the case may be.

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(b) Lease Equalisation Account should be transferred everyyear to the Profit and Loss Account and disclosed separatelyas a deduction from/addition to gross value of lease rentalsBshown under the head “Gross Income”.

(c) Statutory depreciation should be shown separately in theprofit and loss account. Accumulated statutory depreciationshould be deducted from the original cost of the leased assetin the balance sheet of the lessor to arrive at the net bookvalue.

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(d) Balance standing in Lease Adjustment Account should beadjusted in the net book value of the leased assets. Theamount of adjustment in respect of each class of fixed assetsmay be shown either in the main balance sheet or in theFixed Assets Schedule as a separate column in the sectionrelated to leased assets.

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(e) The aggregate amount included under Lease AdjustmentAccount on account of lease equalisation credits should bedisclosed separately.

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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 GuidanceNote.

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12. The finance income for the period should be calculated byapplying the interest rate implicit in the lease to the net investmentin the lease during the relevant period. This method would ensurerecognition of net income in respect of a finance lease at a constantperiodic rate of return on the lessor’s net investment outstandingin the lease. However, some lessor use a simpler method forcalculating the finance income for each of the periods comprisingthe lease term by appropriating the total finance income from thelease in the ratio of minimum lease payments outstanding duringeach of the respective periods comprising the lease term. (Thetotal finance income from the lease is the difference between the G

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Aaggregate minimum lease payments receivable over the lease termand the fair value of the leased asset at the inception of the lease.)This method may be used where the finance income in respect ofall individual periods as per this method approximate the financeincome for the corresponding periods determined according tothe former method. It is however clarified that where this methodBis used, overdue lease rentals, i.e., lease rentals fallen due but notcollected should not be taken into account for determining theamount of minimum lease payments outstanding during each ofthe respective periods comprising the lease term.”

12. At the first look, it appears that the method of accountingCprovided in the Guidance Note of 1995, on the one hand, adjusts theinflated cost of interest of the assets in the balance sheet. Secondly, itcaptures “real income” by separating the element of capital recovery(essentially representing repayment of principal amount by the lessee,the principal amount being the net investment in the lease), and the finance Dincome, which is the revenue receipt of the lessor as remuneration/rewardfor the lessor’s investment. As per the Guidance Note, the annual leasecharge represents recovery of the net investment/fair value of the assetlease term. The finance income reflects a constant periodic rate of returnon the net investment of the lessor outstanding in respect of the financelease. While the finance income represents a revenue receipt to beEincluded in income for the purpose of taxation, the capital recoveryelement (annual lease charge) is not classifiable as income, as it is not, inessence, a revenue receipt chargeable to income tax.

13. The method of accounting followed, as derived from the ICAI’sGuidance Note, is a valid method of capturing real income based on theFsubstance of finance lease transaction. The rule of substance over formis a fundamental principle of accounting, and is in fact, incorporated inthe ICAI’s Accounting Standards on Disclosure of Accounting Policiesbeing accounting standards which is a kind of guidelines for accountingperiods starting from 01.04.1991. It is a cardinal principle of law that theGdifference between capital recovery and interest or finance income isessential for accounting for such a transaction with reference to itssubstance. If the same was not carried out, the Respondent would beassessed for income tax not merely on revenue receipts but also on non-revenue items which is completely contrary to the principles of the ITAct and to its Scheme and spirit.H

14. The bifurcation of the lease rental is, by no stretch ofimagination, an artificial calculation and, therefore, lease equalization isan essential step in the accounting process to ensure that real incomefrom the transaction in the form of revenue receipts only is captured forthe purposes of income tax. Moreover, we do not find any express bar inthe IT Act which bars the bifurcation of the lease rental. This bifurcationis analogous to the manner in which a bank would treat an EMI paymentmade by the debtor on a loan advanced by the bank. The repayment ofprincipal would be a balance sheet item and not a revenue item. Onlythe interest earned would be a revenue receipt chargeable to incometax. Hence, we do not find any force in the contentions of the Revenuethat whole revenue from lease shall be subjected to tax under the ITAct.

15. Without a doubt, in a catena of cases, this court has discussedthe relevancy of the Guidance Note. While dealing with one of suchmatters, this Court, in Commissioner of Income Tax-VII, New Delhivs. Punjab Stainless Steel Industries (2014) 15 SCC 129 held as under:

“17. So as to be more accurate about the word “Turnover”, onecan either refer to dictionaries or to material which are publishedby bodies of Accountants. The Institute of Chartered Accountantsof India (hereinafter referred to as the “ICAI”) has publishedsome material under the head “Guidance Note on Tax Audit underSection 44B of the Income Tax Act”. The said material has beenpublished so as to guide the members of the ICAI. In our opinion,when a recognized body of Accountants, after due deliberationand consideration publishes certain materials for its members, onecan rely upon the same….”

16. In the present case, the relevant Assessment Year is 1999-2000. The main contention of the Revenue is that the Respondent cannotbe allowed to claim deduction regarding lease equalization charges sinceas such there is no express provision regarding such deduction in the ITAct. However, it is apt to note here that the Respondent can be chargedonly on real income which can be calculated only after applying theprescribed method. The IT Act is silent on such deduction. For suchcalculation, it is obvious that the Respondent has to take course ofGuidance Note prescribed by the ICAI if it is available. Only afterapplying such method which is prescribed in the Guidance Note, the A

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ARespondent can show fair and real income which is liable to tax underthe IT Act. Therefore, it is wrong to say that the Respondent claimeddeduction by virtue of Guidance Note rather it only applied the methodof bifurcation as prescribed by the expert team of ICAI. Further, aconjoint reading of Section 145 of the IT Act read with Section 211 (un-amended) of the Companies Act make it clear that the Respondent isBentitled to do such bifurcation and in our view there is no illegality insuch bifurcation as it is according to the principles of law. Moreover, therule of interpretation says that when internal aid is not available then forthe proper interpretation of the Statute, the court may take the help ofexternal aid. If a term is not defined in a Statute then its meaning can beCtaken as is prevalent in ordinary or commercial parlance. Hence, we donot find any force in the contentions of the Revenue that the accountingstandards prescribed by the Guidance Note cannot be used to bifurcatethe lease rental to reach the real income for the purpose of tax under theIT Act.

D17. To sum up, we are of the view that the Respondent is entitledfor bifurcation of lease rental as per the accounting standards prescribedby the ICAI. Moreover, there is no express bar in the IT Act regardingthe application of such accounting standards.

18. In view of above detailed discussion, we are not inclined toEinterfere in the impugned decision of the High Court. Accordingly, theappeal is hereby dismissed leaving parties to bear their own cost. Inview of the above, other connected appeals are also disposed offaccordingly.

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Devika Gujral

Appeals disposed of.

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