Article
Depreciation dichotomy between Accounting
Standard and Tax Laws on Financial Lease
Transaction
-Nidhi Jain
nidhijain@vinodkothari.com
Vinod Kothari Consultants Pvt. Ltd.
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This write up is intended to initiate academic debate on a pertinent question. It is not intended to be a
professional advice and should not be relied upon for real life facts.
VKC
Depreciation dichotomy between Accounting Standard and Tax Laws on
Financial Lease Transaction
Article
Over a few years, the instrument of lease fell out of popularity largely because of the
tax issues. Among other tax issues, the major issue is depreciation allowance. When
AS 19 on “Leases” was introduced, it was expected that the requirement of
capitalization of the leased asset by the lessee in case of financial lease transaction
would be accepted by the income tax laws as well. But the circular issued by CBDT
dated 9th February, 2001 wiped off such expectation and the intention of legislature
by not recognizing financial lease for tax purpose became clearer. Leasing industry
is reviving today and hence it is very important to understand the basic difference
between the two set of principles.
This article is dedicated to resolving the common enigma of whether a financial
lease for accounting purposes will also be a financial transaction for tax purposes.
The lessee under the prevailing accounting treatment recognises an asset and a
liability, and writes off accounting depreciation; however, under taxation laws, the
situation remains gray, and largely fact-dependant. However, direct taxes code
(DTC) intends to change this for tax purposes too, but the draft of definition of
“financial lease” is defective, and will not cover the full gamut of the accounting
definition of a financial lease. This article advocates that the uncertainty in tax
treatment is not healthy for the leasing industry and everyone including the
Revenue will be benefited if the law was to made objective and clear.
Theory of “Form” vs. “Substance”
Taxation laws, as well as accounting standards, are driven by “Substance” rather
than “Form”. Now the question is what is “substance”? Substance is the intrinsic
reality of a transaction or contract, while form is its outer appearance. Generally
speaking, form and substance are one and mutually evidencing. If it looks like a
flower, it must be a flower. But in the world of commerce, there are transactions
that often look like something, and happen to be something else. This is where the
conflict between form and substance comes.
In such cases, the idea is not to go by artificiality of the form, but the reality of the
substance. There are several critical issues in form vs. substance theory:
o The probe into substance of a transaction cannot be a roving or fishing enquiry.
It is not possible to start with the foregone conclusion that a transaction has a
substance different from its form, and then expect the counterparty to prove
why its form and substance are the same. In other words, every transaction at
first blush must be seen to be true in its form and substance. Like innocence and
Depreciation dichotomy between Accounting Standard and Tax Laws on
Financial Lease Transaction
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Article
o
o
o
o
honesty, every transaction is presumed to have the same form and substance,
unless the contrary is established. Hence, the onus of proving that the substance
is different from the form lies with the person litigating the same.
The question of substance cannot be dragged beyond a limit. In other words,
there must be reasonable limits, consistent with commercial practice, as to
where an enquiry into substance will end up. For instance, the ultimate
substance of all financial instruments is financing. Hence, if the approach is to
look at substance from the “ultimate” reality, every instrument in the world will
be the same. However, the approach to substance ends up where there is
substantive dissimilarity.
Accounting rules, taxation rules and legal treatment need to be viewed
separately, in light of particular perspectives of each. For example, preference
shares are debt as per accounting standards; however, they cannot be treated as
such either for law or for taxation purposes. Hence, the substance of one set of
rules cannot be imposed on the other.
One cannot start with the notion that it is only substance that matters; and form
is completely irrelevant. In fact, form and substance matter both. Form deals
with the legal attributes of a contract – which cannot be brushed aside
completely.
Before holding that the substance of a contract is different from its form, one has
to establish a motive for the differentiation. That is to say, the approach to
rejecting the form and going by substance is applicable only where a form was
chosen with a view to hide the substance. That is, only where the substance is a
mere cloak on reality, a façade or make-believe, then only the form is rejected. If
the form represents the bonafide legal relationship between parties, form cannot
be thrown aside.
In the world of finance, the conflict between form and substance is quite common –
there are several instruments where the legal form has been rejected and the
intrinsic substance has been taken as the guide. Examples are – securities
repurchase transactions, inventory financing transactions, bills of sale, etc. Financial
leasing and hire purchase are also trite cases of instruments where the form is one
of leasing, but the objective may be financing.
As a matter of common knowledge, as per accounting standards, in case of a
financial lease, leased asset will be reflected on books of the lessee as the lessee's
fixed asset, with a corresponding liability equal to the discounted value of lease
rentals. In the books of the lessor, a lease appears as a current asset, similar to the
way hire purchase assets accounted for.
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Depreciation dichotomy between Accounting Standard and Tax Laws on
Financial Lease Transaction
Article
However, the existing income-tax law is silent on who claims depreciation in case of
a financial lease. Under Section 32 of the Income-tax Act, in all leasing transactions,
the owner of the asset is entitled to the depreciation if the same is used in the
business. The ownership of the asset is determined by the terms of contract
between the lessor and the lessee. When AS 19 was introduced, CBDT quickly came
with a circular no.2 of 2001 dated 9th February, 2001. After issuance of the CBDT
circular, in case of a financial lease, even the new accounting standard on 'Leases'
issued by the ICAI requiring capitalization of the asset by the lessees in financial
lease transaction, by itself, will not have any implication on the allowance of
depreciation on assets under the provisions of the Income- tax Act.
However, there has never been a safe harbour on whether a financial lease will
qualify for tax deprecation or not. The situation became all the more uncertain when
the SC, in the case of Asea Brown Boveri Ltd vs. IFCI on 27 October, 2004, quoting the
below mentioned lines from Vinod Kothari’s Lease Financing & Hire Purchase
(Second Edition, 1986, at pp. 6 & 7)** what was the conclusion of the case, write:
“a finance lease, also called a capital lease, is nothing but a loan in disguise. It
is only an exchange of money and does not result into creation of economic
services other than that of intermediation”.
Tax officers have started quoting from the said ruling and started disallowing
depreciation.
However, the scenario might be different in the DTC regime. For the very first time,
the income tax law makers have made an attempt to define the term “financial
lease”. Relying on the text of the Direct Taxes Code Bill available on the website of
http://www.incometaxindia.gov.in/ the term “financial lease” means a lease
transaction where—
(a) contract for lease is entered into between two parties for leasing of a specific
asset;
(b) such contract is for use and occupation of the asset by the lessee;
(c) the lease payment is calculated so as to cover the full cost of the asset together
with the interest charges; and
(d) the lessee is entitled to own, or has the option to own, the asset at the end of the
lease period after making the lease payment;
In the DTC regime, depreciation in case of financial leases will be shifted to the
lessee – the lessee will be the one who will claim depreciation, and in case of the
Depreciation dichotomy between Accounting Standard and Tax Laws on
Financial Lease Transaction
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lessor, the lease receivables will be split into financing income and repayment of
principal.
However, this definition of financial lease is not the one that can be relied upon as
the same is defective and will not cover the complete scope of the accounting
definition of a financial lease. The reason being – i) it requires the lease payments to
cover the full cost of leased asset that is in most of the cases not possible and ii) it
requires the asset to be owned by lessee at the end of lease period after making the
lease payment i.e. the asset will be owned by the lessee at no further costs, the
practical implication of which is difficult.
However, the DTC is yet to come into effect and hence, for the depreciation
treatment on such lease transactions, one need to depend on the analysis made in
various judgments. Few cases are decided on factual basis whereas few involved the
determination of question of law.
Cases decided on the basis of fact:
•
Supreme Court in case of Mcorp Global Pvt. Ltd. Vs. Commissioner Of
Income Tax, Ghaziabad on 12 February, 2009 [CIVIL APPEAL NO. 955
/2009 (arising out of SLP(C) No. 4286/2007)] disallowed the SLP.
In this case the assessee failed to prove the lease transaction and hence
depreciation was disallowed. There was a sub-lease which is dated 8.3.1991
between lessee and sub-lessee and it precedes the lease dated 15.3.1991
between the assessee (lessor) and lessee. The Assessing Officer raised the
question that how come the lessee could have entered into a sub-lease on
8.3.1991 when it had not acquired leasehold rights till 15.3.1991 from the
assessee. Moreover, there is nothing in the alleged lease deed dated 15.3.1991
indicating commencement of the lease from a prior date. There is nothing in the
so-called lease dated 15.3.1991 as to the arrangement between the parties prior
to 15.3.1991.
•
Commissioner of Income Tax vs. Kotak Mahindra Finance Ltd. dated 2503-2009 (Income tax appeal (lodg.) No. 926 of 2007) (Bombay High
Court)
The contention of the assessee in this case was that the breakers were given on
lease before the end of previous year and therefore, the same should be
considered as "used" for the purpose of business. Assessee admittedly had
Depreciation dichotomy between Accounting Standard and Tax Laws on
Financial Lease Transaction
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supplied the machinery before the end of the financial year and the assessee had
received the lease rentals for the same. The fact whether the lessee had put to
use the leased equipment would be irrelevant as long as the machinery in fact
had been given on lease before the end of the financial year and hence revenue's
appeal was dismissed. The Bombay High Court relied on the judgment of the
Supreme Court in MCorp Global Pvt. Ltd. vs. CIT (Civil Appeal No. 955 of 2009)
and held that the Tribunal is right in allowing the assesses claim of deprecation.
•
Commissioner of Income Tax vs. Vepar Private
(TAXAP/1391/2010 4/ 4) on 4 July, 2011 (Gujarat High Court)
Limited
Assessee claimed depreciation on factory premises. Assessing Officer disallowed
a portion of depreciation claimed on the ground that such portion of the building
was not occupied by the assessee but was leased out to the subsidiary company.
The assessee carried the issue before the CIT [A] who deleted such
disallowances on the ground that in the present case also the factual position
available on records clearly shows that part of the business premises was made
available to the subsidiary company under business compulsion and on account
of commercial expediency for the simple reason that part of the stitching process
had to be carried out under the direct technical supervision of the assessee
company which was not possible if this work would have been carried out by the
subsidiary company elsewhere. Accordingly, the business premises were fully
used for the business purposes of the assessee company and for no other
purpose and therefore the assessee company is clearly eligible for grant of
depreciation in respect of the whole business premises. The Tribunal set-aside
the order of the CIT[A]. A rectification application u/s. 254 of the Income Tax
Act, 1961 was filed before the Tribunal. The Tribunal corrected its mistake and
rectified the said order saying that the business premises were fully used for the
business purposes of the assessee company and for no other purpose and
therefore the assessee company is clearly eligible for grant of depreciation in
respect of the whole business premises.
The Gujarat High Court held that the Tribunal has exercised power of review and
it had only corrected an error which was apparent on the face of the record. Tax
Appeal stands dismissed.
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Cases decided on question of law:
•
M/S. First Leasing Company Of India Ltd vs The Assistant Commissioner
of Income tax on 21 February, 2010 (Tax Case Appeal Nos.1071 of 2007
and 589 of 2008) (Madras High Court)
The appellant is a leasing company. It entered into a Sale and Lease Back (SLB)
Agreement in respect of certain assets with the Tamil Nadu Electricity Board
(TNEB). As per the SLB Agreement, the appellant purchased certain assets from
TNEB and leased them back to it. Apart from the above, in respect of four other
leases with M/s. Kedia Distilleries, Prakash Industries Ltd., Prestige Corporation
Ltd. and Suckchain Cements Ltd., the lease period was over and as per the lease
agreements, the appellant had to take back the leased assets. The appellant did
not take back the assets, but claimed depreciation. All the SLBs were entered on
30.3.2001 and the leases were all created on 31.3.2001. Out of 25 such SLBs, two
of the assets were purchased by the TNEB on 7.11.2000 and 16.12.2000 and the
rest of the assets were all purchased between 18.1.2001 and 14.3.2001. All the
assets sold and leased back were entitled for 100% depreciation. There was no
actual delivery on sale by the TNEB to the appellant nor was there re-delivery
pursuant to the lease. The written down value of the assets was not made. As per
the lease back agreement, the ownership always remained with the appellant.
Pursuant to the SLB, the appellant was entitled for only 50% of depreciation in
that Assessment Year as the use of the assets did not exceed 182 days. Apart
from the lease back agreement which provided for payment of the installments
from the collection of current consumption charges by way of priority, it was
also supported by the State Government guarantee numbering several
thousands. The assets were not physically identified as it was impossible of
identification at the time when the sale was said to have been created and the
lease back agreement was entered into. While all the assets were already owned
by the TNEB at the time of the SLB, Clause 15(a) of the agreement stipulated that
the appellant as lessor was to purchase the machinery/equipment selected by
the lessee/TNEB from the supplier designated by the TNEB. The transaction,
namely the lease back agreement, was treated as sale and the liability to sales tax
was to be borne by the TNEB.
Inspite of such sharp facts, Madras high court held that the transaction cannot be
a loan agreement on the basis that the agreement provided for the deduction of
the lease installment from the current consumption charges by the way of
priority. The assets were not used for more than 182 days; hence it is eligible for
50% depreciation. On the applicable rate of depreciation the whole transaction
Depreciation dichotomy between Accounting Standard and Tax Laws on
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cannot be held doubtful as the transaction between the parties was carried out
in accordance with law. As far as the four other leases with M/s. Kedia
Distilleries, Prakash Industries Ltd., Prestige Corporation Ltd. and Suckchain
Cements Ltd. are concerned, it was concluded with the view of the Commissioner
of Income Tax (Appeals) that the appellant was not able to collect any lease rent
and was also not able to take possession of those assets, but since the assets
continued to remain with the lessors, viz. the appellant, it will have to be
presumed that the equipments were used in the business of the appellant.
Consequently, the appellant was entitled for the depreciation.
The substantial questions of law framed for consideration in both the appeals
are answered in favour of the assessee-appellant and the appeals are accordingly
allowed. The order of the Income Tax Appellate Tribunal as well as that of the
Assessing Officer is set aside and the order of the Commissioner of Income Tax
(Appeals) stands restored.
•
Gujarat High Court’s ruling in case of Commissioner of Income Tax vs
Sandesh Limited on 15 March, 2011 [TAXAP/1620/2009 4/4 ORDER]
Here, the assessee, Sandesh Limited (lessor), had entered into a sale and lease
back transaction with Rajasthan State Electricity Board (RSEB) in respect of Gas
Booster Compressors & Fuel Oil Handling System and had claimed depreciation.
The assessing officer had treated it as a hire purchase transaction and
accordingly disallowed depreciation claim of the assessee on the same. The
Gujarat High Court relied on the judgment as held in the case of CIT vs. Rajasthan
State Electricity Board (2006)204 CTR (Raj) 415 wherein the question before the
Rajasthan High Court was in relation to disallowance of payment of lease rentals
on the transaction of sale-cum-lease back agreement and Rajasthan High Court
has found that the Tribunal had rightly appreciated the facts and correctly found
the transaction to be genuine and such a finding could not be treated to be
perverse. It was held that sale-cum-lease back agreements entered by the
appellant board were not sham/non-genuine transactions. And hence in the
present case also, the tribunal’s judgement was upheld and the appeal was
dismissed.
Concept of Tax Shelter and Sham
In a situation of sale and lease back transaction treated as being sham/ nongenuine, the lessee could be denied the deduction of lease rentals paid to the
lessor. In this situation, as the lessee should then be regarded as the owner of the
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Depreciation dichotomy between Accounting Standard and Tax Laws on
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asset in question, depreciation on the written down value thereof should be
certainly allowable to the lessee.
So, there is a need to look into what is sham/ non-genuine transaction and
before that one must also understand the concept of tax shelter.
Tax shelters are any method of reducing taxable income resulting in a reduction
of the payments to tax collecting entities, including state and federal
governments. Tax shelters have existed for ages, and have been well recognized
in almost all jurisdictions. Famous dicta exist from English and Indian courts
respecting a man’s right to so organize his affairs that his taxes are minimized. In
the USA, a famous line from Judge Learned Hand said in Helvering v. Gregory, 69
F.2d 809, 811 (2nd Cir. 1934), aff’d, 293 U.S. 465 (1935) is often cited:
“Any one may so arrange his affairs that his taxes shall be as low as possible;
he is not bound to choose that pattern which will best pay the Treasury;
there is not even a patriotic duty to increase one’s taxes.”
However, it is a classic paradox in tax literature as to when does a tax shelter
becomes a sham. A sham transaction is a transaction that is otherwise devoid of
economic reality and is entered into merely for the sake of avoiding tax.
According to a landmark case of Snook vs. London and West Riding Investments
Ltd. [1967] 2 QB 786 (CA) it was stated that a sham transaction is one in which
the parties intend to create one set of rights and obligations but perform acts or
enter into documents that they intend should give third parities, often Revenue
and Customs or the court, the appearance of creating different rights and
obligations. That is, the outer appearance of the transaction and the inner reality
are different.
In the case of Vodafone International Holdings B.V., Netherlands vs Union Of India
& Anr on 8 September, 2010 (VBC 1 wp1325.10), it was held by the Bombay High
Court that tax planning is legitimate so long as the assessee does not resort to a
colourable device or a sham transaction with a view to evade taxes. In UOI Vs
Azadi Bachao Andolan, AIR 2004 SC 107, the view was reiterated that the
assessee was entitled to arrange his affairs to reduce tax liability, without
violating the law. It would be redundant to get into the long chain of rulings
whereby courts have discussed shams and genuine tax shelters.
In a situation of sale and lease back transaction treated as being non-genuine,
the lessee could be denied the deduction of lease rentals paid to the lessor. In
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Depreciation dichotomy between Accounting Standard and Tax Laws on
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this situation, as the lessee should then be regarded as the owner of the asset in
question, depreciation on the written down value thereof should be certainly
allowable to the lessee.
Summing Up
Post DTC regime also, it is expected that there will not be a parity between the
tax laws and the accounting norms in respect of classifying a transaction as a
financial lease because of the defects in the definition of financial lease as per
DTC. However, the theory of substance over form will always be a guiding factor
i.e. one has to look into the reality rather than the glamour. It is expected from
the income tax law makers to make a little more effort in defining the financial
lease transaction so that the dichotomy that existed for several years can be
resolved and there will be a certainty with regard to taxation laws for Leasing
industry.