2025 (4) TMI 986 - AT - Income Tax

Disallowance of Lease Equalization Reserve - whether the difference between the actual rent paid and the equated rent is allowable as expenditure? - HELD THAT - There is no bar in claiming the actual rent in the Profit Loss account but the assessee following the principle of consistency and Accounting Standard-19 has claimed the same rent as expenditure for the entire period of lease spanning over more than one year. The quantum of increase in the rent as per the lease agreement has been claimed separately under the head rent/lease equalization reserve in the computation of the income. This method of accounting is being followed consistently over the years and the Revenue is accepting it in some preceding and subsequent years. In principle the same has to be allowed as business expenditure irrespective of nomenclature under which such expenditure is put into. The said head lease/rent equalization reserve is not the contingent liability and a reserve. We are of the considered view that the said disallowance of Lease Equalization Reserve made by the AO and sustained by the Ld. CIT(A) is not genuine. Hence the same is deleted. Disallowance of bad debts written off u/s 36(2) - The said claim as bad debts is nothing but the business loss allowable u/s 37. We are of the considered view that the said disallowance of Lease Equalization Reserve made by the AO and sustained by the Ld. CIT(A) is not genuine. Hence the same is deleted.

Summary

Three core legal issues were considered in this appeal: (i) the disallowance of the lease equalization reserve amounting to Rs. 86,30,697/-; (ii) the disallowance of bad debts written off amounting to Rs. 32,21,200/- under section 36(2) of the Income Tax Act, 1961 (hereinafter, the 'Act'); and (iii) the chargeability of interest under sections 234B and 234C of the Act.

The first issue concerned the deductibility of the lease equalization reserve claimed by the assessee. The assessee, engaged in software development services, had taken office premises on lease across multiple cities and followed Accounting Standard (AS) 19 for lease accounting. AS 19 mandates that lease payments under an operating lease be recognized as an expense on a straight-line basis over the lease term unless another systematic basis better represents the time pattern of the user's benefit. The lease agreements contained escalation clauses causing rentals to increase over the lease period. The assessee computed the aggregate lease rentals over the entire lease term and divided this by the number of months, thereby determining an equalized rent per month. The actual rent paid in the initial years was lower than the equalized rent, while in later years it was higher. The difference between the equalized rent and actual rent paid was reflected as a "rent/lease equalization reserve" in the books and claimed as a deduction while computing total income.

The Assessing Officer (AO) disallowed this deduction on the ground that the reserve was a provision or contingent liability, not an actual expense incurred during the relevant year. The Commissioner of Income Tax (Appeals) [CIT(A)] sustained this disallowance, holding that the assessee failed to establish that the expenditure was incurred in the relevant year. The AO and CIT(A) reasoned that the reserve did not represent an actual outflow of funds but rather a notional allocation, thus not deductible.

The Court analyzed the relevant legal framework, primarily AS 19 and the provisions of the Income Tax Act. It noted that AS 19 requires lease payments to be recognized on a straight-line basis, which the assessee had consistently applied. The Court observed that the entire rent was paid through banking channels with tax deducted at source, and the genuineness of the rent payments was undisputed. The Court emphasized that the dispute was not about the validity of the lease rentals but about the accounting treatment and the head under which the expenditure was claimed.

Applying the law to the facts, the Court found that the lease equalization reserve was not a contingent liability or mere provision but represented the difference arising due to the straight-line method of accounting for lease rentals with escalating payments. The Court highlighted that the assessee had consistently followed this accounting treatment over the years, and the Revenue had accepted it in preceding and subsequent years without objection. The Court held that the nomenclature under which the expenditure was claimed should not be a ground for disallowance if the amount represented genuine business expenditure. It concluded that the disallowance of the lease equalization reserve was not justified and deleted the disallowance.

The second issue related to the disallowance of bad debts amounting to Rs. 32,21,200/- written off by the assessee. The AO disallowed the claim under section 36 of the Act, reasoning that the assessee failed to demonstrate that the advances or deposits were part of taxable income and that these debts had become irrecoverable. The CIT(A) upheld this disallowance.

The assessee contended that these amounts represented securities or advances given for business purposes, including deposits with government authorities and rental deposits for employee accommodations, which had become irrecoverable. The assessee argued that these were business losses and should be allowed under section 37(1) of the Act as business expenditure. The assessee relied on several judicial precedents, including a Supreme Court decision that recognized the allowance of losses incidental to business under general commercial principles, even if not specifically provided for in the statute. Other High Court and Tribunal decisions were cited to support the proposition that bad debts or losses of a revenue nature incurred in the ordinary course of business are allowable deductions.

The Court examined the legal framework, particularly sections 36 and 37 of the Act, and the cited precedents. It acknowledged that while the claim was not for trading loss per se, the bad debts written off were business losses allowable under section 37. The Court found merit in the assessee's submissions and the judicial authorities relied upon. It held that the disallowance of bad debts was not justified and deleted the disallowance accordingly.

The third issue concerned the levy of interest under sections 234B and 234C of the Act, which pertain to interest for defaults in payment of advance tax and deferment of advance tax installments. The Court held that since the interest chargeability was consequential to the assessment, and given the relief granted on the substantive issues, this ground did not merit separate consideration and was dismissed.

Significant holdings of the Court include the following:

Regarding the lease equalization reserve, the Court stated verbatim: "There is no bar in claiming the actual rent in the Profit & Loss account but the assessee, following the principle of consistency and Accounting Standard- 19, has claimed the same rent as expenditure for the entire period of lease spanning over more than one year. The quantum of increase in the rent as per the lease agreement has been claimed separately under the head 'rent/lease equalization reserve' in the computation of the income. This method of accounting is being followed consistently over the years and the Revenue is accepting it in some preceding and subsequent years. In principle, the same has to be allowed as business expenditure irrespective of nomenclature under which such expenditure is put into. The said head 'lease/rent equalization reserve' is not the contingent liability and a reserve."

On the issue of bad debts, the Court observed: "In view of the ratio laid down by the Hon'ble Supreme Court and various Hon'ble High Courts... we are of the considered opinion that the said claim of Rs. 32,21,200/- as bad debts is nothing but the business loss allowable under section 37 of the Act."

In conclusion, the Court allowed the appeal by deleting the disallowance of the lease equalization reserve and bad debts, while dismissing the ground relating to interest. The principles established affirm the permissibility of accounting treatments consistent with AS 19 for lease rentals and recognize the allowance of bad debts as business losses under section 37, even if not routed through the Profit & Loss account, provided they arise in the ordinary course of business and are irrecoverable.