Up front interest on bonds and debentures allowed on mercantile basis in spite of matching principal followed in accounts

[CA DEV KUMAR KOTHARI]

Relevant links and references:

Section 36 (1) (iii)  and 145 of Income-tax Act, 1961.

Taparia Tools Limited Versus Joint Commissioner Of Income Tax 2015 (3) TMI 853 - SUPREME COURT

Bharat Earth Movers v. Commissioner of Income Tax 2000 (8) TMI 4 - SUPREME Court

Madras Industrial Investment Corporation Limited v. Commissioner of Income Tax 1997 (4) TMI 5 - SUPREME Court

Hindustan Aluminium Corporation Ltd. vs. CIT, 1982 (4) TMI 12 - CALCUTTA High Court

Kedarnath Jute Manufacturing Co. Ltd. v. Commissioner of Income Tax (Central), Calcutta 1971 (8) TMI 10 - SUPREME Court;

Tuticorin Alkali Chemicals & Fertilizers Ltd., Madras v. Commissioner of Income Tax, Madras 1997 (7) TMI 4 - SUPREME Court;

Sutlej Cotton Mills Ltd. v. Commissioner of Income Tax, Calcutta 1978 (9) TMI 1 - SUPREME Court;

 United Commercial Bank, Calcutta v. Commissioner of Income Tax, WB-III, Calcutta 1999 (9) TMI 4 - SUPREME Court.

Terms and conditions in case of debentures, bonds and similar debt securities/ instruments:

Terms relating to interest payable on debt securities are decided between issuer of security and subscriber of security. The T & C relating to interest and payment include inter alia the following:

1. Rate of interest – it can be fixed or variable linked with PLR or some other basis.
2. Compounding of interest- it can be monthly, quarterly half yearly or yearly or some other basis as may be agreed,
3. Payment of interest, or accumulation of interest.
4. Redemption of debenture it will depend on term for which security is issued.

Rate of interest will be lower in case interest is paid upfront for a longer duration. Even in cases where say interest is paid in advance every quarter , interest payable will be lower than  when it is payable  after each quarter. These are based on concept ‘there is cost of money for every day’.

When differential terms and conditions prevail in respect of various securities or lots of securities issued, the accrual and playability of interest will be determined vis a vis applicable and agreed terms and conditions in respect of each such  security or lot of security.

Upfront payment:

In case, T & C are for upfront payment, the interest accrues and become payable on the occasion of issue of such security or on security holder exercising his option to receive interest upfront. This will depend on actual facts and circumstances of the case.

In case of upfront payment for a longer duration, it is true that interest is paid for a longer duration, but it is also equally true that for such payment in advance or upfront basis, the security issuer saves interest due to lower rate of interest agreed and also because compounding of interest does not take place.

Matching principal:

Matching principal is to match costs to revenue. In case of periodical costs, the expenses may be spread over the period of definite or likely period over which benefit will accrue. However, this does not affect accrual of expenses. An expenditure accrue on accrual date this may not be on first day of previous year, it can be on any day. Applying matching principal, expenses may be spread over a period of more than one year, however, on accrual basis, the expenses accrues on accrual date. Many expenses which are generally treated as expenditure and a part as prepaid expenditure, can be claimed fully in one year based on mercantile basis. However, because the amount involved are not higher and by matching principal expenditure is debited in more than one year ( generally two years in case of normal expenses  incurred based on annual or half yearly contracts).

However, when amount is large and upfront payment is also to cover a longer duration, then claim in first year vis a vis a longer duration of many years become important.

Case of Debentures issued by Taparia Tools:

Assesse had issued debentures on different terms and conditions. Two debenture holders opted for upfront payment of interest. The assessee, paid full interest in first year but debited interest over period of debentures (five years) in P & L account. However, following mercantile basis assessee claimed entire amount of interest which was paid to two debenture holders who opted for upfront payment, assessee claimed the full amount in its computation of income and return of income. The AO, CIT(A), Tribunal and High Court all denied such claim and allowed deductions only as per matching principals followed in P & L account.

The assessee appealed before the Supreme Court. The Supreme Court, on consideration of terms and conditions, and facts that interest was fully accrued and was also actually paid in year of issue of debentures issued with option of upfront payment accepted by debenture holder, the entire interest was to be allowed in first year because it was accrued, and allowable under mercantile basis. The court also reaffirmed law earlier laid down that the book entries are not conclusive, the claim is to be allowed if allowable as per law.

The judgment:

Taparia Tools Limited Versus Joint Commissioner Of Income Tax 2015 (3) TMI 853 - SUPREME COURT