9911796707
TMI Blog1997 (4) TMI 115X X X X Extracts X X X X X X X X Extracts X X X X ..... unt of the company for the year ended on 31st December, 1986 (relevant to the year under appeal for assessment year 1987-88) is Rs. 1,04,10,150. The company has adopted a system of accounting called the "SUM OF DIGITS METHOD" (for short referred to as the 'SOD' method) which is also known as the 'Indexing Method' for recognition of its income from the business of hire-purchase and leasing. According to the SOD method, the company recognises its income on a time proportion basis taking into consideration the amount outstanding from time to time and the rate applicable. The loading of the entire income is apportioned over the period of the contract in proportion to the reducing balances that will be outstanding from time to time after taking into consideration the repayment schedule in the form of monthly equated instalments. According to the 'SOD' method, the income is thus overstated in the earlier years and in the latter years covering the period of Hire Purchase Agreement/lease Agreements, it is understated. 2.2 However, the company, while filing its income-tax return for assessment year 1987-88, as in the earlier years, has claimed deduction for differential income aggregating ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... f the Company is true and fair manner and, hence, rejection of books is not warranted. (iii) The assessee has paid an amount of Rs. 60 lakhs as dividend to the shareholders and created reserve to the tune of Rs. 44 lakhs. Thus, an amount of Rs. 1,04,00,000 is transferred to either capital account or paid as dividend. If the income has not accrued to the assessee to the tune of Rs. 52,83,931 so much of the amount out of the borrowed funds have been paid to the shareholders as dividend. Alternatively, the interest the claim on this amount should not be allowed. However, I am of the view that the assessee-company did receive this much of profit so that they are in a position to pay dividend to the shareholders. (iv) On the above points and also considering that the other companies in this group are claiming various allowances on the basis of book results even though they are following similar method of accounting, the assessee's contention is not accepted and rejected." 4. The company preferred an appeal against the said assessment order before the Commissioner of Income-tax (Appeals)-IV, Andhra Pradesh, Hyderabad [hereinafter referred to as the 'CIT(Appeals)'], who decided the sai ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... of hire purchase agreement should prevail over whatever method the appellant had adopted to account for finance charges. The income in the scheme of a contract accrues on the basis of the terms of agreement or the contract and not on a tortium quid. When the appellant is entitled only to collect whatever is stated in Schedule II of the hire purchase agreement, it cannot be said that the appellant collected more by virtue of book entries made by it following indexing method. Where the parties are governed by the terms of the contract and the contractual obligations, it would be far fetched to state that the right to receive for duties performed in accordance with the terms of the contract was, outside the purview of the contract - Such a proposition would be paradoxical. Accordingly, it would stand to reason that Schedule II of the hire purchase agreement dealing with finance charges would prevail over any other method adopted by the appellant to account for finance charges." He, therefore, held that the finance charges arrived at as per the index system does not definitely represent the amount due to the appellant in a given year. The income due to the appellant for a given year d ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... hould have considered that the assessee's books of account are maintained on the method of accounting followed regularly and recognised internationally and as per provisions of section 145, the book results are not rejected and profits from business are computed on the basis of books of account maintained. 3. The CIT(Appeals) should have considered that the assessee paid dividends to the tune of Rs. 60 lakhs on the basis of the income which are shown in the P & L Account. 4. The CIT(Appeals) should have considered that the assessee has maintained the books of account as per the provisions of company law and the same is submitted to the shareholders also. 5. Any other grounds of appeal that may be urged at the time of hearing." 6.1 The learned Senior Departmental Representative (hereinafter referred to as "Sr. D.R.") at the outset invited our attention towards the decision in the case of Nagarjuna Finance (P.) Ltd. in [IT Appeal Nos. 2777 and 2967 (Hyd.) of 1988 dated' 13-3-1995] in which the Tribunal, on identical facts, decided the similar issue in favour of the Revenue. The Tribunal, in the aforesaid decision, has held that the index/SOD method followed by the assessee in its ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... count prepared in accordance with the books of account maintained by the assessee has been approved by the Board of Directors confirming, inter alia, the fact that the profit and loss gives a true and fair view of the profit for the relevant financial year. The company has approved the said audited accounts in its General Meeting. The auditors have also certified that the profit and loss account give a true and fair view of the profits of the company for the relevant financial year. The learned D.R. invited our attention towards auditors' report to corroborate the aforesaid contention. He submitted that the audited profit and loss account disclose a net profit of Rs. 104. 10 lakhs out of which dividends of Rs. 60 lakhs were declared for payment to shareholders and Rs. 44 lakhs were transferred to reserves. Section 205 of Companies Act provides that dividends can be paid only out of profits. The amount of Rs. 60 lakhs has been paid by way of dividend to the share holders in conformity with the requirement of section 205 of the Companies Act. The assessee has, therefore, treated the book profit of Rs. 104. 10 lakhs as its true and real income. Such amount of book profit of Rs. 104. 1 ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... unal in the case of Nagarjuna Finance (P.) Ltd. He submitted that according to the SOD/indexing method followed by the assessee the interest income is recognised in the books of account in such a manner that the entire amount of interest income covering the period of hire purchase agreement/lease agreement will be apportioned over the period of the contract in proportion to the reducing balances that will be outstanding from time to time. It ensures determination of income at a uniform rate of interest implicit in the hire purchase and lease agreement. Such a method of apportionment of the interest income over the period of the hire purchase agreement/lease agreement represents real and true income of the relevant financial year. If the method adopted by the assessee for the purposes of computing its taxable income is accepted, it will lead to absurd results as has been aptly discussed by the Tribunal in the case of Nagarjuna Finance (P.) Ltd. in para 8 of their order. The examples given in para 8 of the said order indicate that interest income, according to the assessee in the first year of hire purchase agreement will come to 14 per cent, in the second year it will come to 21 per ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... od : Under this method, income from finance charges is treated as accruing uniformly over the life of each agreement. This method automatically creates a provision against bad debts and possible increase in the cost of providing finance, since in the initial years the credit to the profit and loss account will be less than under methods (a) and (b) given above. But this method ignores to a large extent initial expenses interest paid, etc. (d) Direct or arbitrary percentage method : A percentage of the outstanding balance is carried forward as deferred income. For best results, the percentage should be determined annually after considering a good sample of the agreement. 6.6 The learned Sr. D.R. submitted that income by way of financial charges derived by the assessee in relation to a transaction of hire purchase is nothing but interest income. Interest is compensation for use of money. He invited our attention towards the definition of the expression 'interest' as given in various dictionaries: "FROM STROUD'S JUDICIAL DICTIONARY (VOL. 3, FOURTH EDITION). ---------------------------------------------------------------------------------- "Interest 'on the said sum', which sum i ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... . 3,944.44 in the first month and each of the succeeding 35 months. Out of Rs. 3,944.44, there is a principal repayment component and interest component. To calculate the actuarial interest the method takes into account all the factors, viz. (a) Principal amount financed (b) Total interest amount (c) Total period (d) Total number of instalments (e) The fact of reducing principal amount on each successive instalment. (f) To give the result in such a way that the rate of interest is approximately constant throughout to give consistent results. The mechanism is as under: The total interest (Rs. 42,000) is Multiplied by the specific number of instalments which is divided by a particular factor. The factor is calculated by using the formula : N(N+ 1) Note: 'N' is the total number of instalments. ------------- 2 Thus the factor (index) applicable to the examples would be as under : 36 (36 + 1) ------------------- = 666 2 The formula for working out the interest component of a given installment is as under : Total amount of interest X Total number of installments remaining including the present, installment. -------------------------------------------------------- Fac ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... terest rates in accrual method when calculated with reference to the outstanding principal amounts: -------------------------------------------------------------------------------- Year Outstanding Total of Interest in Principal Interest amt at the installments year begin accrual component rate -------------------------------------------------------------------------------- I 1,00,000 47,334 14,000 33,334 14 per cent II 66,666 47,333 14,000 33,330 21 per cent III 33,333 47,333 14,000 33,330 42 per cent ----------------------------------------------------------------------------------- ----------------------------------------------------------------------------------- Thus, in the accrual method sought by the assessee, the interest rate works out to 14 per cent in first year and 42 per cent in 3rd year and, therefore, accrual method does not give correct interest income. Comparison of Index Method With Accrual Method 1. Index method is recommended - Accrual method is not recommended for accounting interest income on Hire Purchase and Lease transactions. Index method is followed in books. 2. Index method gives actuarial results, whereas accrual method gives hypothetical r ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... norms mentioned in International Accounting Standards as well as the accounting standards now issued by the Institute of Chartered Accountants of India. The method chosen by the assessee for showing its taxable income is illogical, incorrect and has been chosen purely for deferment of the tax liability. There is a perpetual postponement of the tax liability, if the method suggested by the assessee for computing its taxable income is accepted. 6.7 The learned Sr. D.R. submitted that income shown by the assessee in its books of account, therefore, clearly comes within the ambit of charging section 5 and it cannot be said that the assessee has accounted for certain hypothetical or extra income, which in fact did not accrue to the assessee in the relevant previous year. 6.8 The learned D.R. further submitted that in the present case, the interest has been accounted for on accrual basis in the books of account and an entry in that regard has already been made on the basis of a recognised, scientific and correct method in relation to accrual of income under the provisions of Company Law, Income-tax Law and all other connected laws and which has also been accepted by the auditors, divi ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... e has not accrued to the assessee in accordance with the charging provisions contained in the Income-tax Act. 7.1 The learned counsel submitted that even if the question whether the income as returned by the respondent is the only income which has accrued is to be regarded as being in issue, the observations made by the CIT(Appeals) at pages 2 and 3 of his order, wherein he has mentioned that the DC(Asstt.) in his remand report dated 3-12-1990 is not opposed to adopting income from leasing on accrual basis, make it clear that the issue will arise only in respect of hire purchase amounts and not lease rentals. The Assessing Officer in his aforesaid remand report has accepted that only income which has accrued in respect of lease rental is that which has been returned by the assessee in its return of income. He submitted that the arguments advanced on behalf of the learned Sr. D.R. were mainly confined to the hire purchase agreements and he has not submitted any arguments in relation to income returned by the assessee in relation to lease rentals. The learned counsel submitted that the lease agreements stand on a different footing and the income which actually accrued to the assesse ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... company are reflected in a true and fair manner and, hence, rejection of books of account is not warranted. The Assessing Officer has further observed that the assessee has paid an amount by way of dividends which is in excess of the amount which it could have paid on the basis of the taxable income declared by it. Lastly, the Assessing Officer has stated that whereas the other companies in the group are claiming various allowances on the basis of book results even though they have for tax purposes taken a lesser income into consideration. The learned counsel submitted that the Assessing Officer has brushed aside the assessee's contention that unless income has accrued to an assessee within the meaning of charging sections 4 & 5 of the Act, namely, it has a right to receive the same, the assessee cannot be assessed to tax and it is the duty of the Assessing Officer to compute the income which has accrued. The learned counsel submitted that the provisions of section 145(1) cannot override section 5 of the Act. If an income has neither been received nor it has accrued, whatever section 145 may say the charging provisions cannot be ignored by section 145. The provisions of section 14 ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... rofits and gains of business' are to be found in sections 28(i), 29 and 14(1) but these have to be read subject to section 5 of the Act. Though these provisions provide for charging the income by way of profits and gains of business and prescribe the manner of computation, the question as to what point of time its chargeability arises is answered by section 5 of the Act which states that the total income of a resident assessee from whatever source derived becomes chargeable either when it is received by him or when it accrues or arises to him during the previous year, In other words, taxability is attracted even when income has accrued and it is clear that the receipt of income is not the sole test of taxability under the Act; but, whether on receipt of basis or on accrual basis, it is the real income and not any hypothetical income which may have theoretically argued that is subjected to tax under the Act and this latter aspect arising under our Act is well-settled by the decisions of this court and the High Courts to which I will presently refer. Obviously, for the content of taxable income one must have regard to the substantive charging provisions of the Act. This decision in m ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... d of accounting regularly employed by the assessee." At page 144, the Hon'ble Court has further observed as under : "For the content of the taxable income, one has to refer to the substantive provisions of the Act, mainly section 5 of the Act read with other relevant sections." 7.7 The learned counsel thereafter invited our attention towards the Commentary (Law and Practice of Income-tax) by Kange and Palkiwala at page 1166 (Eighth edition), Vol. I. It has been mentioned in the said commentary that the assessee's regular method of accounting determines the mode of computing the taxable income but it does not determine or even affect the range of taxable income or the ambit of taxation. The provisions for computation of income contained in section 145 cannot derogate from the provisions of charging section. In other words, the charge on income accruing or received in India, imposed by section 5, cannot be avoided by any method of accounting. 7.8 The learned counsel on the strength of the aforesaid submissions and the judgments submitted that once this contention is accepted that the provisions for computation of income contained in section 145 cannot override the charging sectio ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... st specified in the said hire purchase agreement read along with application given by the client for the said hire purchase agreement. The income as per these two methods, one, namely, index method adopted for maintaining books of account and other, namely, equated method adopted for filing the income-tax return was as under as per the exact detail submitted at page 88 in relation to the specimen hire purchase agreement submitted at page 35 of the compilation. The learned counsel submitted that in the hypothetical example given by the learned DR the income by way of finance charge in relation to hire purchase agreement according to the aforesaid two methods can be briefly illustrated as under : Hire Purchase : Amount Financed is Rs. 100 Period of Agreement (in years) 5 Finance Charges 14 per cent p.a. flat finance charge is Rs. 70 Gross Receivable is Rs. 170 In the hands of Hire Purchase Company depreciation will not be admissible. Income as per two different methods will be as under : Index Years Equated 70 X (5/(5 X 6)/2) 23.33 5 70/5 14.00 70 X (4/(5 X 6)/2) 18.67 4 70/5 14.00 70 X (3/(5 X 6)/2) 14.00 3 70/5 14.00 70 X (2/(5 X 6)/2) 9.3 2 70/5 14.00 70 X (1/(5 X 6) ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... extra income shown on the basis of index method/ SOD method in the books of account cannot be regarded as income accrued to the assessee in the previous year. It may be a good accounting policy but it cannot be regarded as income chargeable to tax within the ambit of section 5 of the Income-tax Act, 1961. 8.2 The learned counsel also submitted that the income from hire purchase agreement shown @ 14 per cent p.a. for income-tax purposes on the basis of rate of interest specified in the agreement is in accordance with the accepted principles and accepted commercial practice as has been approved by the decision by the Bombay High Court in the case of CIT v. Tata Sons Ltd.[1939] 7 ITR 195 at page 198. 9. The learned counsel then explained the basic facts relating to the lease agreement. He once again repeated that the remand report submitted by the Assessing Officer before the CIT(Appeals) which has been quoted at page 2 of the order passed by him clearly indicates that the Assessing Officer had no objection to the adoption of accrual basis so far as lease rental is concerned. Without prejudice to this, the learned counsel submitted that as far as the agreements for lease are concer ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... riod of Contract 8 years 96 months (From Aug. 1984 to July 1992) Monthly Lease Rental is Rs. 7,816.20 Gross Lease Rental is Rs. 7,50,355.20 1. In the hands of Lessor Company : a. Depreciation will be available. b. On sum of Digits Method Rs. 7,50,355.20 Lease Rental will be credited over Eight years - as follows : Year 1 2 3 Finance charges 1,75,018.42 1,51,811.55 28,604.69 4 5 6 7 8 1,05,397.83 82,190.97 58,984.11 35,777.25 12,570.38 Total : Rs. 7,50,355.20 c. On Accrual Method Rs. 93,794.40 per annum as lease rental returned (7816.20 X 12 months) 2. In the hands of Lessee. a. No Depreciation b. Lease Rental of Rs. 93,794.40 per annum will be allowed as deduction." The learned counsel thereafter also submitted a simple illustration to explain the two different systems of recognition of income according to SOD/index method in its books of accounts and equated method for the purposes of income-tax return in a chart submitted at page 93 as under : LEASE Equipment Cost is Rs. 100 Period of Agreement (in years) 5 Annual Lease Rental is Rs. 20 Gross Lease Rental is Rs. 150 Index Years Equated 150 + (5/(5+6/2) 50.00 5 150/5 30.00 150 + (4/(5+6/2) 40.00 4 150/5 30. ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... sales were made up at the end of six months also. But this would not affect the construction of the clause containing the terms for payment of commission nor the reduction made therein as a result of the modified arrangement. The amount which would arise or accrue and the managing agent would have the right to receive cannot be affected by the manner in which the entry was made." 12. The learned counsel further submitted that the mere fact that in the books of account certain income is reflected it does not necessarily follow that the same is assessable. For this purpose, he placed reliance on judgments in the case of Shoorji Vallabhdas & Co. , CIT v. Kerala State Drugs & Pharmaceuticals Ltd.[1991] 192 ITR 1/39 Taxman 515, Pandit Pandurang v. CIT 2 ITC 69 (Nag.) and Sahu Jagmandar Das v. CIT [1935] 3 ITR 140 (All.). 13. The learned counsel submitted that the Assessing Officer has noted in the assessment order that the method of accounting followed by the assessee is mercantile method of accounting. Accordingly, on a combined reading of section 5 and section 145 what can be brought to tax is income that has accrued. What is relevant is the method of accounting and not the actual e ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ons of Income-tax Act. He submitted that even in the guidance note at page 2) of the paper book submitted by the department, it has been clearly indicated in para 27 that the specific treatments for determining taxable income would have to be in accordance with the provisions of the Taxation Laws. Such treatments may differ from the recommendations contained in the guidance note. The learned counsel submitted that there may be various circumstances under which the income recorded in the books of account does not tally with the income chargeable to tax. For this purpose, he invited our attention towards the judgment of Hon'ble Supreme Court in the case of British Paints (India) Ltd. The learned counsel submitted that such a situation may happen on account of certain statutory deductions being available e.g. depreciation in the books may be provided for on a straight line basis but for tax purposes would have to be allowed as a deduction under the written down value method. Even if not provided it would have to be allowed. There are other instances where an account of certain accounting policies adopted the book profits would not tally with the tax profits. For example : (a) certain ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ncement period is for accounting purposes reduced from the cost of assets in accordance with the Guidance Note issued by the Institute but for tax purposes assessed as income (CIT v. Cap Steels Ltd. [1986] 162 ITR 533/29 Taxman 125 (Kar.) at 536; CIT v. Derco Cooling Coils Ltd.[1992] 198 ITR 375 (AP)). 17. The aforesaid judgments clearly and conclusively prove that if an amount which has not accrued as income according to the provision of Income-tax Act but has been included as income in the books of account, it is the duty of the Assessing Officer to exclude such items of income. The Claim of differential income made by the assessee represent the income which did not accrue as per the terms of contract executed with the clients and which cannot be regarded as income chargeable to tax under the provisions of Income-tax Act and therefore, the same ought to have been excluded for the purpose of computing the taxable income. 18. The learned counsel also submitted elaborate arguments as to why the decision of the Tribunal in IT Appeal No. 2067/Hyd/88 in the case of Nagarjuna Finance (P.) Ltd. should not be followed. He also submitted a note in this regard which is reproduced hereunde ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... computed in terms of the accounts presented for the Companies Act would not tally with the tax profits. It is further submitted that, method of accounting adopted by the assessee is not the index method of accounting as held by the Tribunal. The method of accounting adopted by the assessee is admittedly mercantile. It is only for recognising the revenue in its books of account that a particular accounting entry has been passed. 4. As regards (e) and (d) above, it is submitted that it is not even the case of the Revenue that the income reflected in the books of account has in fact been physically received. No sum in excess of the monthly lease rental or the monthly hire purchase payment has been received. The revenue also accepts that the differential income which is the subject-matter of the presents appeal has not accrued. As regards the declaration of dividends, it is submitted that in Sree Meenakshi Mills v. CIT[1957] 31 ITR 28 at 59, the Supreme Court has clearly stated that one must not confuse the accrual of income with its disposal. According to the Court the provisions of the Companies Act as to the disposal of the profits are designed to protect the interest of the share ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... accordance with clause 1.3 read with Schedule II of the agreement for lease. By no accounting entry can any sum in excess of the monthly lease rental accrue. Even IAS 17 does not contemplate a recognition of revenue in excess of what has accrued. 9. The decision in CIT v. Kameshwar Singh is distinguishable inasmuch as in that case the Privy Council upheld the assessability to tax of income which the assessee there had himself disclosed in the return of income. In the instant case, the assessee has not returned the income as assessed. The peculiar facts of that case have to be borne in mind. The decision of the Gujarat High Court in CIT v. Chunilal Kushaldas 93 ITR 369 at 381 makes it clear that the observations in a judgment have to be read in the context of the fact situation prevailing. What is also to be borne in mind is that if the Privy Council had not upheld the revenue's contention certain income would have escaped assessment altogether. That is not so in the assessee's case as is borne out by the illustrations at pages 86-93 of the compilation which disclose that over a period of time the entire lease rentals/hire purchase finance charges have been offered for tax, In tot ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... f account were seeking to be assessed in accordance with the cash method which the High Court as well as the Tribunal held was impermissible. The assessee submits that it has not adopting a different method of accounting for its books as well as for tax purposes. The method of accounting adopted is admittedly the mercantile method. It is only applying certain sophisticated accountancy principles in preparing its financial statements for recognising revenue. That a distinction between the profits and book profits in brought out by the decision of the Privy Council in CIT v. Sarangpur Cotton Co. [1938] 6 ITR 36 at pages 40 and 43. 12. The decision of the Supreme Court in State Bank of Travancore's case is also distinguishable inasmuch as in that case income which admittedly had accrued in accordance with the contract entered into between the parties and which was debited to the borrowers account, was sought to be excluded from the ambit of taxation. It is in these circumstances that the Supreme Court held that income which had really accrued or arisen to the assessee is taxable and whether the income had really accrued or arisen to the assessee must be judged in the light of the rea ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... and loss account of administrative and process charges Rs. 3,17,529 being part of deposit received under the scheme had been erroneously credited to the profit and loss account and that the same be withdrawn since subscription received under the scheme was capital in nature and no part thereof was liable to tax. On behalf of the Department, it was inter alia, argued that nobody else could be a better judge than the businessman who in his prudence thought fit to return a part of the loan or deposit as income under the head Administrative and Process charges, and, therefore, the assessee should not be allowed to go back on its own entries which had been originally returned as income. The Tribunal observed that notwithstanding entries in the books of account; there was a revision of computation of income which could not be ignored by the Assessing Officer while computing the taxable income under the Income-tax Act, 1961. The Tribunal relying upon the judgment of Hon'ble Madras High Court in the case of Indian Overseas Bank and the judgment of Hon'ble Apex Court in the case of CIT v. India Discount Co. Ltd. [1970] 75 ITR 191 observed that the receipt being one, which in law could not b ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... btle distinction between these two expressions and the concept of "true and fair" requires disclosure of real income in the profit and loss account and a true and fair view of the state of affairs as on the date of the Balance Sheet. He submitted that the meaning of term "accrual" under mercantile system of accounting is a same under the provisions of Companies Act as well as under the Income-tax Act. 23.3 The learned D.R. submitted that all the cases cited by the learned counsel for the assessee falls under the exceptions enumerated in the Accounting Standards, which have been carved out to meet particular type of exceptional circumstances and situations. For example, the judgment of Hon'ble Bombay High Court in the case of CIT v. Citi Bank N.A. was considering the question relating to applicability or non-applicability of the proviso to section 145(1) in respect of interest on problem loans credited only on actual receipt. The various Accounting Standards also provide for adopting cash basis for recognising interest income on doubtful loans, etc. All such decisions, which deal with exceptional items, which were excluded or included by invoking the proviso to section 145 cannot b ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... 359/73 Taxman 565. The learned Senior D.R. also placed reliance on judgment of Hon'ble Rajasthan High Court in the case of S.M.S. Investment Corpn. (P.) Ltd. v. CIT [1993] 203 ITR 1001 to support his contention that income had accrued to the assessee as soon as the assessee acquired the right to receive the income under the said agreement. The income covering the entire period of agreements has been apportioned according to SOD method in a rationale, systematic and appropriate method by the assessee in its books of account. 23.5 The learned Sr. D.R. further pointed out that copy of one of the Hire Purchase Agreements executed by the company shows that no rate of interest has been mentioned in the contract. The proposal given by the borrower mentions the flat rate of 14 per cent p.a. The flat rate has no meaning. The Schedule gives the total amount of interest finance charges covering the entire period of contract. The real implicit rate of interest can be precisely and correctly determined only by SOD method. 23.6 The learned Sr. D.R. at one point of time conceded that so far as income by way of lease rental is concerned, income may be taxed as per the lease agreements as per ill ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... cording to the mercantile system. It is well-known that the mercantile system of accounting differs substantially from the cash system of book-keeping. Under the cash system, it is only actual cash receipts and actual cash payments that are recorded as credits and debits whereas under the mercantile system, credit entries are made in respect of accounts due immediately they become legally due and before they are actually received; similarly, the expenditure items for which legal liability has been incurred are immediately debited even before the amounts in question are. actually disbursed. Where accounts are kept on mercantile basis, the profits and gains are credited though they are not actually realised, and the entries thus made really show nothing more than an accrual or arising of the said profits at the material time. The same is the position with regard to debits made." 23.8 The learned Sr. D.R. also invited our attention towards the judgment of Hon'ble Kerala High Court in the case of St. Teresa's Oil Mills v. State of Kerala [1970] 76 ITR 365 in which it was held that rejection of accounts should not be done fight heartedly and the Court has also explained the circumstanc ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... carefully considered the decision of the Division Bench of the Tribunal in the case of Nagarjuna Finance (P.) Ltd. We have also carefully gone through all the judgments relied upon by the learned representatives of both sides, the judgments referred to in the impugned order of the CIT(Appeals), as well all the decisions referred to in the order of the Tribunal in the case of Nagarjuna Finance (P.) Ltd. We have given our thoughtful consideration to all other documents, International Accounting Standards (IAS), and the Guidance Notes issued by the Institute of Chartered Accountants of India to which our attention was drawn during the course of hearing. We have also examined the relevant provisions of Income-tax Act, Companies Act and other relevant laws. 26. The principles of law as enunciated by the various judgments of the Hon'ble Apex Court relied upon by the learned representatives of the parties and as clearly emerging from a plain reading of the relevant provisions of Income-tax Act, 1961 can be summarised as under :--- (a) An analysis of section 4 of Income-tax Act, 1961 (hereinafter referred to as the 'Act'), inter alia, provides that tax will be charged on the total incom ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... income. It does not affect the range of taxable income or the ambit of taxation. The computation provisions cannot enlarge or restrict the content of taxable income. The range of taxable income or ambit of taxation is to be determined in accordance with the charging provisions. (ii) The proviso to section 145(1) does not merely confer a discretionary power upon the Assessing Officer but also imposes a statutory duty on the Assessing Officer to examine in every case whether income, profits and gains chargeable to tax in the relevant year, could properly be deduced from the method of accounting followed by the assessee; (iii) The term "accrual" of income used in the Companies Act, as explained in the various Accounting Standards and as understood for the purposes of taxation laws in certain circumstances may have different meanings depending on the purpose of legislation, the context in which such expression has been used and on the interpretation of the terms of relevant contracts. For tax purposes, the accrual or receipt of income in the relevant previous year will have to be determined in consonance with the ambit of taxable income as per section 5 of the Act on the basis of a c ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ne of the H.P. Agreements and one of the Lease Agreements in the compilation and it was the contention of the learned representatives of both sides that all other Hire Purchase Agreements and Lease Agreements are almost identical and similarly worded. We will, therefore, consider the submissions made by the learned representatives of the parties with regard to the aforesaid two categories of differential income keeping in view these specimen and illustrative Hire Purchase Agreement and Lease Agreement submitted in the compilation. 29. Finance income in relation to Hire Purchase Agreement : The copy of Hire Purchase Agreement submitted at pgs. 35 to 61 of the compilation shows that Sri Kanakadurga Press (hereinafter referred to as 'the Hirer') in terms of the proposal form signed by the Hirer requested the assessee-company (hereinafter referred to as "the owner") for finance of the machinery being imported from England and for that purpose, a Hire Purchase Agreement was executed between them on 28th day of November, 1936. The details of the value of machinery, amount financed by the owner, the schedule of repayment, etc., are as under : (Rs.) Basic Price of the Machine 5,67,000 ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... 8 x 49)/2)) 17142.86 48 420000/48 8750 420000 x (47/(48 x 49)/2)) 16785.74 47 420000/48 8750 420000 x (46/(48 x 49)/2)) 16428.75 46 420000/48 8750 420000 x (45/(48 x 49)/2)) 16071.43 45 420000/48 8750 420000 x (44/(48 x 49)/2)) 15714.29 44 420000/48 8750 420000 x (43/(48 x 49)/2)) 15357.14 43 420000/48 8750 420000 x (42/(48 x 49)/2)) 15000.00 42 420000/48 8750 420000 x (41/(48 x 49)/2)) 14642.86 41 420000/48 8750 420000 x (40/(48 x 49)/2)) 14285.71 40 420000/48 8750 420000 x (39/(48 x 49)/2)) 13928.57 39 420000/48 8750 420000 x (38/(48 x 49)/2)) 13571.48 38 420000/48 8750 420000 x (37/(48 x 49)/2)) 13214.10 37 420000/48 8750 420000 x (36/(48 x 49)/2)) 12857.14 36 420000/48 8750 420000 x (35/(48 x 49)/2)) 12500.00 35 420000/48 8750 420000 x (34/(48 x 49)/2)) 12142.86 34 420000/48 8750 420000 x (33/(48 x 49)/2)) 11785.71 33 420000/48 8750 420000 x (32/(48 x 49)/2)) 11428.75 32 420000/48 8750 420000 x (31/(48 x 49)/2)) 11071.43 31 420000/48 8750 420000 x (30/(48 x 49)/2)) 10714.29 30 420000/48 8750 420000 x (29/(48 x 49)/2)) 10357.14 29 420000/48 8750 420000 x (28/(48 x 49)/2)) 10000.00 28 420000/48 8750 420000 x (27/(48 x 49)/2)) 9642.86 27 420000/48 8750 420000 ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ntative that 'finance charges' are nothing but interest, but when we are applying the theory of appropriation, this distinction, if any, found existing between the finance charges and the interest, assumes significance. The further question would be whether any distinction is to be maintained between the payment of Rs. 4,20,000 and Rs. 7,50,000 while considering the question of appropriation. Though Schedule 11 forming part of the H.P. Agreement specifies that the gross amount of Rs. 11,70,000 will be repaid in 48 monthly instalments of Rs. 24,375 each commencing from 12-12-1986 to 12-11-1990, the Agreement does not give the bifurcation or apportionment of the amount of each EMI of Rs. 24,375 between the principal component and interest component. 32. It is an undisputed fact that the assessee-company is entitled to recover an EMI of Rs. 24,375 p.m. in accordance with the said H.P. Agreement. The EMI of Rs. 24,375 undoubtedly consists of interest component as well as principal component. The agreement as aforesaid does not give the apportionment or bifurcation of each equated monthly instalment of Rs. 24,375 between the principal and interest components. The Hirer in the present c ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... balances that will be outstanding from time to time. A perusal of chart given at page 35 indicates that out of first equated monthly instalment of Rs. 24,375, the assessee-company has appropriated in its books of account a sum of Rs. 17,142.86 towards interest and the balance amount has been appropriated towards repayment of principal. In the second month, interest has been calculated on the reduced amount of principal and interest component has been worked out at Rs. 16,785.74. Thus, each EMI has been apportioned in such a manner that it recognises interest income at a constant and uniform rate of interest on the reducing balance of principal amount outstanding from month to month, which represents the true and real rate of interest implicit in the H.P. Agreement. The amount of EMI Rs. 24,375 is receivable by the assessee every month. The apportionment of interest component in each EMI has been made on the basis of such a recognised appropriate and correct method which is known as SOD method. The apportionment so made by the assessee in its books of account for recognition of interest income reflects the true and correct income accrued and received by the assessee in accordance wi ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ssions made on behalf of the assessee in this regard were repelled. 35. The reliance placed by the learned counsel on the Circular No. 9 dated 23-3-1943 and its reaffirmation vide Instruction No. 1057 dated 19-9-1977 would not in any manner help the assessee. The said circular mainly clarifies that depreciation on plant and machinery purchased on hire purchase system would be admissible to the Hirer (lessee) and that the periodical payments made by the Hirer should for tax purposes be regarded as made up of (i) consideration of hire (interest) and (ii) payment on account of purchase (principal component). It further mentions that allowance for interest/hire should be evenly spread over the term of the agreement for being allowed as deduction in the case of the hirer cannot convert the income accrued in the hands of the financier as income having not accrued. The said circular does not give any guidelines relating to accrual of income in the hands of the financier. The said circular cannot be interpreted to mean that an income which comes within the ambit of charging section should not be charged to tax in the year of accrual of income because deduction by way of hire and depreciat ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... over a period of 96 months come to Rs. 7,816.20 X 96 months Rs. 7,50,355.20. The fixed period of the lease of 96 months was a non-cancellable term of the said agreement. The lessors were entitled to recover the entire amount of the rentals for the fixed period in the event of termination of the agreement on a prior date. The lessor shall remain the owner of the equipment at all times. Upon termination of the agreement by efflux of time or otherwise, the lessee is bound to deliver to the lessor the said equipment in good repair, order and condition subject to normal wear and tear. The lessee also inter alia, agreed not to claim any relief by way of depreciation or other deductions available to the owner of the equipment under the provisions of income-tax Act, 1961. 39. The assessee-lessors in their books of account has recognised the income by way of lease rentals on the basis of SOD method as per chart given at page 40 of this order. However, for tax purposes, the assessee has declared lease rental income @ Rs. 7,816.20 p.m. i.e., Rs. 93,794.40 per annum as per the terms of the lease agreement. As against this, the income recognised in its books of account as per the SOD method du ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... nce, the recognition of finance income should be based on a pattern reflecting at constant periodic rate of return on either the lessor's net Investment outstanding or the net cash investment outstanding in respect of the finance lease. The method used should be applied consistently to lease of a, similar financial character. Operating Leases : Assets held for equating lease should be recorded as property, place and equipment in the balance sheet of leases. Rental income should be recognised on a straight line basis over the lease term, unless another systematic basis is more representative of the time pattern of the earnings process contained in the lease. The depreciation of leased assets should be on a basis consistent with the lessor's normal depreciation policy for similar assets, and the depreciation charge should be calculated on the basis set out in International Accounting Standard 4, Depreciation Accounting." The Institute of Chartered Accountants of India have announced Revised Guidance Notes on Accounting for leases in its monthly journal of September, 1995 to replace the earlier guidance note issued in the year 1988. 41.2 The said Guidance Note, inter alia, defines ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... g entries/disclosures should be made : (a) A separate Lease Equalisation Account should be opened with a corresponding debit or credit to Lease Adjustment Account, as the case may be. (b) Lease Equalisation Account should be transferred every year to the Profit and Loss Account and disclosed separately as a deduction from/addition to gross value of lease rentals shown under the head 'Gross Income'. (c) Statutory depreciation should be shown separately in the profit and loss account. Accumulated statutory depreciation should be deducted from the original cost of the leased asset in the balance sheet of the lessor to arrive at the net book value. (d) Balance standing in Lease Adjustment Account should be adjusted in the net book value of the leased assets. The amount of adjustment in respect of each class of fixed assets may be shown either in the main balance sheet or in the Fixed Assets Schedule as a separate column in the section related to leased assets. (e) the aggregate amount included under Lease Adjustment Account on account of lease equalisation credits should be disclosed separately. The method of income measurement suggested in this paragraph, is in consonance with t ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... apital outlay plus a return on the funds invested during the lease term. Therefore the asset and rentals receivable should be included in income over the lease term. Costs, including depreciation, incurred in earning the rental income should be charged to income. Rental income should normally be recognised on a systematic basis which is representative of the time pattern of the earnings process contained in the lease. In many cases, recognised of rental income on a straight line basis over the lease term would be representative of the time pattern. A leased asset for an operating lease should be depreciated on a basis consistent with the lessor's normal depreciation policy for similar assets. Initial direct costs incurred by lessor in negotiating and arranging the lease should be expensed in the year in which they are incurred. The Institute in the aforesaid guidance note in para 27 has given the following clarification : "Computation of taxable income: It is clarified that the specific treatments for determining taxable income would have to be in accordance with the provisions of the taxation laws; such treatments may differ from the recommendations contained in the Guidance ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... o the assessee in the relevant accounting year. 43. The assessee in its income-tax returns has declared income by way of lease rentals on the basis of lease rent fixed in the respective lease agreements and has claimed the excess amount recognised in the books of account beyond the agreed amount of lease rental, as differential income not liable to tax on the ground that income to that extent has not accrued in the relevant previous year. The assessee in relation to the specimen lease agreement has shown income from lease rental @ Rs. 7,816.20 i.e., Rs. 93,794.40 per annum for tax purposes. The assessee is entitled to receive lease rent @ Rs. 7,816.20 p.m. as the lease agreement and, therefore, the income which can be said to have accrued to the assessee in accordance with the terms of the agreement, which alone comes within the ambit of charging provisions is Rs. 7,816.20 p.m. only and not a pie more even though income higher than that has been accounted for on SOD method/index method in the books of account. 44. In view of the aforesaid discussions, we hold that so far as income by way of lease rental is concerned, the only income which accrues in the relevant year is the month ..... X X X X Extracts X X X X X X X X Extracts X X X X
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