Article on depreciation dichotomy between Accounting Standard and Tax laws on financial lease

[NIDHI JAIN]

Depreciation dichotomy between Accounting Standard and Tax Laws on Financial Lease Transaction

 

-By Nidhi Jain

nidhijain@vinodkothari.com

 

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 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.

 

o 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.

 

o 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.

 

o 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.

 

o 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.

 

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 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 25-03-2009 (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 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 Limited (TAXAP/1391/2010 4/ 4) on 4 July, 2011 (Gujarat High Court)

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.

 

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 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/ non-genuine, 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 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 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.