2016 (6) TMI 99 - AT - Income Tax

Accrual of income - nature of income - whether right to receive the return (or income) on the shares had accrued to the assessee during the relevant year? - irrevocable option to sell these shares at the option price to AT & T Global (or its affiliates), which had the right to first refusal. The option by either could be exercised on or after three years of investment or the elimination of the Indian Government regulation on foreign equity holding levels, whichever is earlier. The option price for the purpose of the afore-said purchase and sale is defined as the equity contribution plus return at 11% p.a. compounded annually on the said contribution over the period of holding. - The assessee-company is also entitled to, besides option price, so determined, what is termed as call option fee , on each anniversary of the capitalization date @ 5.5% of its equity contribution. - whether the income by way of return on equity accrues to the assessee from day to day, i.e., on the basis of the holding period, for each previous year comprising the holding period, or shall accrue only on the sale of shares, i.e., on the exercise of the put option or, equivalently, call option by AT & T Global Held that - The transfer of shares in the manner including the price determined there-under, is made the essence of the agreement, so that any contravention thereof constitutes a breach thereof, which may result in its termination. The assessee-company, which has no right to management, cannot sell, assign, transfer or otherwise dispose of its shares (or interest therein) in any manner, or otherwise encumber the same in any manner. The assessee s investment in shares, has to be considered in conjunction with the said agreement, being in fact itself only pursuant thereto, i.e., having regard to the reality and the entirety of the facts and circumstances of the case. The same, as evident, is qualitatively very different from the shareholding of, or the rights as a shareholder of, AT&T. The provision of call option fee and compounding in the Agreement are considered inconsistent with investment in shares proper. It is the substance that is to prevail over form. The arrangement is accordingly found to be the only a manner of investment, akin to a financing arrangement, yielding return (income) as a function of time. No doubt or uncertainty with regard to the realization or the ultimate collection of the income by way of option price on transfer of shares, obtaining (i.e., reckoned in a realistic manner), the income (by way of return on investments in shares) is found to have accrued by way of inflow of or giving rise to a receivable. The arrangement is in fact AT & T not requiring any financer, but entering the arrangement all the same only to comply with the GOI policy as to a cap on the foreign equity participation in the telecom sector for the time being, not even a financing arrangement. The agreement and the rights accruing thereby was further examined from the stand point of and in the light of a provision of the compound rate of return (on annualized basis so that the same increases in geometric progression with time); discounting for net present value, only to find further endorsement of the said view and, further, of not impacting the valuation (of the right to receive) or the accrual of the income in any manner. Even de hors the character of the arrangement as a financing arrangement or any other, the nature of the investment would not be of much consequence as long as there is accrual of income in the facts and circumstances of the case, i.e., by way of right to receive a receivable, resulting in a debt, realizable even if in future. The fact that the income is realizable as a part of the sale price of shares, i.e., an investment by the assessee, a investment company, as a part of and in regular course of its business, to fetch return, i.e., along with redemption or liquidation of the investment, as only representing the form in which the income, imbedded in the increased share value, is realized. The same is only a manner of realization of the income, since accrued, as is the case (in other common day examples of) with interest on (cum) debentures or Bank FDR, etc. and, thus, by itself of little moment. Could it be material, one may ask, if the interest of Debenture or FDR stands to be received, over the tenure of the investment, separately, or along with redemption of the investment? The increase in the share price to the defined extent would arise irrespective of the performance of the company during the holding period or its intrinsic value (net worth) at the time of transfer of shares. Would it therefore matter even if (say) some management rights were also attached to the shareholding which we observe as not. In our view not. The investment is in a private company, shares in which are severely restricted for transfer, making it highly illiquid, i.e., but for the arrangement, in pursuance to which only in fact the investment in shares stands made. That is, considerable uncertainty would otherwise exist as to the realizability of the income. The income being also in agreement with the matching principle of accountancy, also judicially approved, is thus found to accrue from year to year, i.e., on time basis and, thus, for the relevant year. The same, further, is only by way of business income, i.e., as assessed, on which we again observe no dispute; rather, the two returns ensuing on investment, i.e., by way of call option fee (returned and assessed as business income) and the annualized return (over the holding period), found to be para materia, forming part of an integrated revenue model and, further, only in the nature of interest income as defined both in the accountancy as well as by statute. There is no law that interest could be assessed only as income from other sources , partake as it does its character from the underlying transaction from which it arises (CIT vs. Govinda Choudhury 1992 (4) TMI 8 - SUPREME Court . The case law cited stands also considered, only to find the same to be in agreement with the view expressed herein, confirming the stand of the Revenue, being essentially a question of fact, to be determined on an appreciation of the facts of the case, with the law being well settled. Finally, we observe the income arising has not been worked out by the A.O. in the manner provided for in the agreement, i.e., @ 11% p.a., compounded annually with reference to the date of the investment. The A.O. shall do so, of-course after allowing opportunity to present its working with regard thereto and consider the same. We consider ourselves competent to issue such a direction - Decided against assessee.

Summary

Issues Involved:
1. Accrual of Income
2. Nature of Income
3. Matching Principle
4. Case Law Analysis

Detailed Analysis:

1. Accrual of Income:
The primary issue is whether the income by way of return on 'equity' accrues to the assessee from day to day or only upon the sale of shares. The assessee argued that the income had not accrued as the option had not been exercised, relying on precedents like E. D. Sassoon and Co. Ltd. vs. CIT and CIT vs. Canara Bank. The Revenue contended that the income accrues on a time basis, citing cases like Madras Industrial Investment Corporation Ltd. vs. CIT and State Bank of Travancore vs. CIT. The tribunal concluded that the income accrues to the assessee on a time basis, reflecting an increase in the option price during the year, thus bringing it to tax.

2. Nature of Income:
The tribunal examined the nature of the right to receive income under the shareholder's agreement. It was determined that the right to an increase in the value of shares, embedded in the option price, accrues over time. The agreement specified a return at 11% p.a. compounded annually, which accrues irrespective of the exercise of the option. The tribunal found that the income, though realized upon the transfer of shares, accrues annually as a function of time, thus constituting business income.

3. Matching Principle:
The tribunal emphasized the importance of the matching principle, which requires that both revenues and costs be accounted for on an accrual basis. The assessee's borrowing costs were allowed as business expenditure, and the corresponding revenue, whether realized or not, was to be recognized as income. This principle ensures that the financial statements reflect a true and fair view of the state of affairs.

4. Case Law Analysis:
The tribunal reviewed various case laws cited by both parties. In A. Gajapathy Naidu, the right to receive compensation arose only upon the government's direction, and thus, the income was taxed in the year it was received. In State Bank of Travancore, the concept of real income was emphasized, but it could not negate accrual where it had already occurred. In E. D. Sassoon and Co. Ltd., the commission accrued only at the end of the year, not apportioned between the assignor and assignee. In Canara Bank, interest was held to accrue only when the securities yielded interest. The tribunal found these precedents consistent with its decision that the income accrues annually on a time basis.

Conclusion:
The tribunal dismissed the assessee's appeal, holding that the income by way of return on investment in shares accrues annually as a function of time, thus constituting business income. The tribunal directed the Assessing Officer to work out the income in the manner provided for in the agreement, ensuring compliance with the matching principle and relevant case laws.