Lease equalization charges are deductible in computing book profit-High Court

Lease equalization charges are deductible in computing book profit. Provisions for NPA are also not need to be added back-High Court

ABCAUS Case Law Citation:
ABCAUS 2216 (2018) (02) HC

The Challenge/Grievance:
The case law involves the appeal filed by the Income Tax Department (Revenue) against the order of the Income Tax Appellate Tribunal (ITAT/Tribunal) on the question of treatment of lease equalization charges while computing book profits u/s 115JA of the Income Tax Act, 1961 (the Act). 

Important Case Laws Cited/relied upon by the parties:
Commissioner of Income Tax v Virtual Soft Systems 2012 (341) ITR; Commissioner of Income tax v. Weizmann Finance [2013] 357 ITR 74 (Karn); Manipal Finance Corporation Ltd v. Assistant Commissioner of Income Tax 2014 49 353; Prakash Leasing Ltd. v. Commissioner of Income Tax (2012) 208 Taxman 464 (Karn); Commissioner of Income Tax v. Indian Railway Finance Corp. Ltd (2014) 362 ITR 548; Commissioner of Income Tax v. ICICI Ventures Funds Management Co. Ltd 2015 234 Taxman 569 (Karn); Commissioner of Income Tax v. Pact Securities and Financial Services Ltd (2015) 374 ITR 681 (AP & T); Commissioner of Income Tax v. Sun Pharmaceutical Industries Ltd. 2016 (240) Taxman 686 (Guj); Commissioner of Income Tax v. HCL Comnet Systems and Services Ltd. 2008 (305) ITR 409 (SC); TVS Finance and Services Ltd., Jayalakshmi Estates v. The Joint Commissioner of Income Tax Special Range – XI (2009) 318 ITR 435(Mad); Principal Commissioner of Income Tax-2 v. Sun Pharmaceutical Industries Ltd. [2016] 240 TAXMAN 686 (Guj)

Brief Facts of the Case:
The respondent assessee’s was earning income from leasing of assets. In terms of lease agreements, the ownership of the assets continued to vest with the assessee and the assets were shown in the balance sheet under the head “Fixed Assets” in which depreciation was claimed.

Lease equalization charges are deductible in computing book profit

However in profit and loss account, it did not credit the full amount of lease charges and some amounts were set apart to be carried over to the lease equalization reserve and thus only the balance amount was credited to the profit and loss account.

In the relevant assessment year, the footnotes to the profit and loss account reflect that the amount of lease charges was the net of the lease equalization reserve. The said amount was however added to the total income while filing the return of income. However, in the course of assessment proceedings, the assessee contended that as it was lease equalization charge, the sum (offered for taxation) should be withdrawn and that this position was based on legal opinion.

The Assessing Officer (AO) reasoned that the Act does not distinguish between a finance lease and operating lease, because the legal ownership of the underlying asset continues unchanged. Therefore, the charges received by the owner should be taxed as a whole and no artificial provision can bifurcate such amounts.

It was further held that lease equalization could not fall within any allowable deduction or expense as it was a provision similar to depreciation and that the assessee incurred no liability of any nature. Accordingly, the AO added back the amount.

CIT(A) rejected the assessee’s appeal however, the ITAT noted that similar claims had been allowed in the past and accordingly granted relief on this ground.

Contentions made on behalf of the Petitioner Revenue:
It was contended that the assessee could not rely only on the Guidance Note issued by the ICAI with respect to accounting for leases, in deciding what was the income. Whether a particular deduction ought to be allowed or disallowed, has to be in accordance with provisions of the Act.

The Revenue argued there is no provision in the Act supporting such deduction. Furthermore, there was no determination by the AO, whether the lease transactions were finance or operating leases.

It was also submitted that on expiry of the lease period alone the lease assets are transferred and it cannot be said that till such only would it be necessary to have a lease equalization reserve.

It was next submitted that the reserve created by the assessee is only to cover a loss, which may or may not occur in future and therefore, has to be considered only as a contingent liability. According to counsel such contingent liability cannot be allowed as a deduction.

Contention made on behalf of the Respondent Assessee:
It was submitted that the amount was nothing but the difference between the statutory depreciation on rentals and the recovery of cost of capital. Therefore, merely because it entered in the P&L account, did not make any difference. At any rate, it could not be treated as a reserve.

The assessee also argued that lease equalization is not a provision for diminution in asset value and is a mere adjustment entry. Therefore, no adjustment was made which could be treated as being adjustment towards diminution in the value of assets

The question of Law framed/urged:
Whether the lease equalization charges can be deducted while computing book profit; and whether the provisions for non-performing assets are liable to be adjusted while computing book profit under Section 115JA of the Act.

Observations made by the High Court:
The Hon’ble High Court opined that the consistent view adopted in the various authorities is that in monetary terms, lease rentals are the sum total of financing charges and the amount included in it towards the capital sum. While offering for tax income derived from lease, a taxpayer has to separate the amount received towards capital, from the financing charge. The financing charge is determined by applying a separate formula to the net investment made in the asset. Depreciation too needs to be provisioned on the capital value fixed in the lease rental.

Regarding the lease equalization charge, the Hon’ble High Court noted its earlier the decision where it explained the result of the adjustment, which the assessee has to make whenever, the amount put aside towards capital recovery is not equivalent to the depreciation claimed by the assessee. It was held that the assessee, may claim depreciation based on the provisions of the IT Act or, may even adopt the method of depreciation provided under the Companies Act. In the event, the depreciation claimed is less than the capital recovery, the difference is debited in the profit and loss account in the form of lease equalization charge, and similarly if, for any reason the depreciation claimed is more than capital recovery then, the difference is credited, once again, in the form of lease equalization charge to the profit and loss account. Therefore, the assessee in effect debits or credits its profit and loss account with a lease equalization charge depending on whether or not the depreciation claimed is, less or more than the capital recovery.

It was held that in sum and substance, lease equalization charges is a method of re-calibrating the depreciation claimed by the assessee in a given accounting period. The method employed by the assessee, therefore, over the full term of the lease period would result in the lease equalization amount being reduced to a naught, as the debit and credits in the profit and loss account would square off with each other.

Therefore, the Hon’ble High Court rejected the Revenue’s contention that the deduction is unknown to the Act as misappreciation of what constitutes a lease equalization charge.  It was clarified that as long as the method of accounting follows some established principles, one of which, includes offering only Revenue income for tax, we cannot find fault with the assessee debiting lease equalization charges in the AYs in issue, in its profit and loss account. It represents a true and fair view of the accounts, which is a statutory requirement under Section 211(2) of the Companies Act.

The Hon’ble High Court noted the Supreme Court has held that that provision for diminution of an asset is not provisioning for a liability. The Hon’ble High Court expressed wagreement with the views of the Gujarat and Madras High Courts that the lease equalization charges are not to be treated as adjustments needing to be added back while computing book profits, under Section 115JA on account of Explanation-1.

Decision/ Conclusion/Held:
The questions were answered in favour of the assessee and against the Revenue.

Lease equalization charges are deductible in computing book profit

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