9911796707
TMI Blog2016 (6) TMI 99X X X X Extracts X X X X X X X X Extracts X X X X ..... olding 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 i ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... 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 inte ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ption to increase its holding in AT T India to the extent permissible by laws in India by requiring appellant company to sell shares to it or to its affiliates at the option price. Similarly, the appellant company also has an 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. For the period of holding beyond the anniversary date, proportionate fees calculated at the said rate is to be allowed. That is, for the broken period since the last anniversary, the assessee is entitled to a fee on a proportionate basis, calc ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... d to fall due (for payment) on each anniversary date (of capitalization), income stands accounted for and disclosed as business income. 4.2 It is, to begin with, important to understand the meaning and connotation of the term accrual , the scope of which is the bone of contention between the parties. Section 5 of the Act, which defines the scope of total income of a resident, provides for it to include income that accrues or arises to the assessee during the year. As a legal concept, the same stands defined per a series of decisions by the Apex Court, as a right to receive. The Hon ble Court in Gajapathy Naidu (supra) succinctly stated the following propositions that are to be considered for the purpose: When an Income-tax Officer proceeds to include a particular income in the assessment, he should ask himself, inter alia, two questions, namely : (i) what is the system of accountancy adopted by the assessee? and (ii) if it is the mercantile system, subject to the deemed provisions, when has the right to receive that amount accrued ? If he comes to the conclusion that such a right accrued or arose to the assessee in a particular accounting year, he shall include the sa ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ssees or in respect of any class of income. The assessee is admittedly following accrual method of accounting which, it being a company, incorporated under the Companies Act, 1956, is even otherwise statutorily obliged to in terms of the provisions of the said governing Act. The Central Government has notified two Accounting Standards (AS-I and AS-II) on 25.1.1996 u/s. 145(2) of the Act. The said Accounting Standards have a legal mandate, so that the word accrual , to which a clear meaning has been assigned, acquires the force of law. The relevant part of AS-I reads as under: ACCOUNTING STANDARDS NOTIFIED UNDER SECTION 145(2) A. Accounting Standard I relating to disclosure of accounting policies: 1. All significant accounting policies adopted in the preparation and presentation of financial statements shall be disclosed. 2 .. 3 .. 4. Accounting policies adopted by an assessee should be such so as to represent a true and fair view of the state of affairs of the business, profession or vocation in the financial statements prepared and presented on the basis of such accounting policies. For this purpose, the major considerations governing the selection and ap ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... India, are also relevant. These Accounting Standards are binding on companies in view of the Companies Act, 1956, so that they again have the force of law (s.209). Rather, as explained by the Apex Court, they represent the crystallized accounting principles as recognized by the accounting policies and, further, those issued by ICAI are required to be followed [ J.K. Industries Ltd. vs. Union of India [2008] 297 ITR 176 (SC)]. They provide discipline and harmonization of concepts and accounting principles; the objective being true and fair accounting. Accounting Standard (AS)-1 issued by ICAI, titled Disclosure of accounting policies , again, enlists accrual, along with Going Concern and Consistency , as fundamental accounting assumptions that underlie the preparation and presentation of financial statements. Substance over form is stated, along with the Prudence and Materiality , as the major considerations for the selection of the accounting policies. AS-9 issued by ICAI is on Revenue Recognition. The same, in it s relevant part, reads as under: Definitions 4. The following terms are used in this Standard with the meanings specified: 4.1 Revenue is the gross ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... hat as judicially explained, i.e., as a legal concept. That is, the word accrual as occurring in section 5 signifies the same meaning as in section 145, per the Accounting Standard notified there-under. The entries that stand to be passed in the books of account, it may be further noted, are akin to that which shall stand to be passed where the funds are invested in interest bearing loan/advance, as (say) a deposit with the bank, with a fixed tenure. We may, for better understanding, illustrate these accounting entries (on (say) a FDR of ₹ 1000/- at 10% p.a., compounded annually), as: (Amt in Rs.) 1) Interest accrued but not due A/c Dr. 100/110/121 To Interest accrued A/c Cr. 100/110/121 (being the amount of interest accrued on FDR No. .. dated .. maturing on .. at % p.a. compounded annually). 2) Now considering that the FDR is for 42 months (say), the entire interest accrued for the first three years (Rs.331/-) shall, along with principal amount (Rs.1000/-), form part of the principal for earning interest for the balance six months, as: Interest accrued but not due A/c Dr. 133 To Interest accrued A/c Cr. 133 (being the amount of interest ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... would be no difference between cash and accrual method of accounting, or determination of income, i.e., speaking in the context of tax laws, or section 145 of the Act. In particular, which in fact only endorses and subscribes the accounting principles of income recognition as prescribed by AS-9 (of ICAI), which again has statutory force u/s. 209 of the Companies Act, 1956. These entries, are not only in accord and harmony with the principles of commercial accounting, well established, the prime objective of which is to reflect the true state of affairs of the reporting enterprise and, thus, in the absence of anything to the contrary in law, applicable, but also, as shall be seen, consistent with the accounting standards, legally mandated, so that the same have the force of law. 4.3 As the right to the assessee arises on the basis of the Agreement, we next examine the nature of this right, i.e., on facts. The right to call or put, in exercise of the option, is a right separate and distinct from the right to an increase in the value of the shares the subject matter of call and put option, over time. In fact, it is the two rights, the right to an enhancement in the value of t ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ant to the terms of this Agreement and based on the nature of global telecommunications services and the financial prospects of AT T India, ML will realize in almost all cases an equity return equal to the Option Price and Call Option Fee and further acknowledge that the cost structure of AT T India is dependent upon allocations of expenses across AT T s global operations, which allocations shall be made by AT T in a commercially reasonable manner without specific regard to the profitability or un-profitability of AT T India. The Sponsors acknowledge that the Option Price plus the Call Option Fee represents a reasonable return on equity investment in the company . The difference of the return (to the extent of 11%) getting paid only on the transfer of shares, i.e., on divesture, along with the return of capital, is on account of the very nature of the agreement. The same only represents the form in which the return gets received by the assessee (ML), without in any manner impacting the substance of the agreement, i.e., to secure investment for a certain period of time at a prescribed rate of return. How could then, we wonder, the assessee object to the Revenue regarding the tw ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... es, thus, represent only a medium and manner in which the investment takes place, which is regarded as parking of funds by the investor, calculated to yield a definite and stipulated rate of return . The terms of the agreement, when read as a whole, make this abundantly clear, with the agreement in fact making no bones about it. Reference in this context be made to, inter alia , clauses 2.5, 2.6, 4.9, 6.11, 6.13, 6.15, 6.16, 7.3, 7.4, 8.4, 8.5, 8.8, 8.13 8.15, 9, 17.2 (c), 17.3 (c), 17.4-17.5 of the Agreement, some of which we reproduce as under: 6.13 Subject to the provisions of the Act, the Board of Directors shall determine all matters by simple majority vote, which majority shall include at least two (2) directors nominated by AT T. 7.3 Subject to the provisions as contained in the Articles and the Act any resolution at a duly constituted General Meeting shall be adopted by a simple majority vote of the total votes validly cast at such General Meeting which majority shall include affirmative vote of AT T. 7.4 At a General Meeting the Parties shall cause their votes in respect of their respective Shares to be cast on the matters before the meeting in a manner so to ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... inate this Agreement by a written notice of thirty (30) days to AT T: (c) if ML, subject to Section 9.1 of the Agreement, is prohibited from holding some or all of the shares in the Company due to any reason whatsoever, not directly attributable to the actions of ML. 17.4 On termination of this Agreement, as aforesaid, shall not relieve any Party of any obligations or liabilities accrued to it prior to the date of termination and the provisions of Sections 13, 16.1, 17.4 and 24 shall survive termination of this Agreement. Further notwithstanding anything contained in this Agreement: 17.4.1 On termination of this Agreement by AT T (i) pursuant to Section 17.2(a) or (b) AT T may elect to require ML to sell its entire shares at their par value, to a person resident in India or other eligible person identified by AT T and in the event of such election the sale and purchase of shares shall be completed within a period of 120 (one hundred twenty) days from the date of the written notice for termination; or (ii) pursuant to Section 17.2(c) AT T shall offer to sell to ML such number of shares in the Company that it can not hold at the Option Price and if ML does not exercis ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... s.110 - - 11 11 121 Total 100 110 121 - 1331 [@: at the end of third year; TR =} total return (exclusive of the amount considered as reinvested and, therefore, not forming part of the principal); GA = Gross Amount; figures in brackets denote negative sums, being notionally received back for reinvestment] The return for the first year (Rs.100/-) yields ₹ 10/- each for the second and the third year, with ₹ 10/- for the first year yields Re.1/- for the third year. Similarly, the return of ₹ 100 for the second year yields a return of ₹ 10/- for the third year, taking the total return for that year to ₹ 21/-. Compounding, as afore explained, involves the concept of merger of principal and return thereon, i.e., capital and income, at defined intervals of time. Clearly, the return for the first and the second year gets included in the principal amount (notionally) for the second and the third year respectively, obliterating the conceptual difference between the p ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... manifestation of a right. It cannot be that though a right exists, or has come into existence, there is no corresponding debt , which is thus to be understood as implying a receivable, even if realizable at a future date. The same does not imply and is not to be confused with a debt in praesenti , i.e., so that the amount is due for payment , often referred to as the due date . The debt accruing is a debt realizable at a later, subsequent date. We have already, per the accounting entries pertaining to transactions of interest on deposit and sale of goods, sought to emphasize and explain the difference between accrual and due (for payment). Rather, how can, it may be asked, an amount which is itself periodically, i.e., at intervals of time, reinvested, or regarded as so, fetching returns, be due for payment in the interim period. Further, it does not and need not, in order to signify accrual or of having arisen, imply a debt legally enforceable as soon as the right is created. It would though be incorrect to say that the debt so arising is not a legally enforceable debt the debt, with all its attributes, including as to its realizability and legal enforceability, accrues ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... interest on deposit (say, with a bank) or sale of goods. Though the reference point thereat was the depositor or the seller, the said entries or, rather, the mirror image of those entries, would be equally valid for the corresponding party, i.e., the person incurring the corresponding expenditure, even as indicated thereat, being the depositee (bank) or the purchaser of goods (or recipient of services) in the present case. In either case, the expenditure and the corresponding liability, even if payable in future, stands incurred. We may for better comprehension, state the relevant entries as under: (Amt. in Rs.) 1) Interest A/c Dr. 100/110/121 To Interest accrued but not due A/c Cr. 100/110/121 (to amount of interest account on loan of ₹ 1000 for year 1/2/3) 2) Interest accrued and due Dr. 331 To interest accrued but not due Cr. 331 (being amount of interest accrued on FDR, transferred to due account on maturity of the FDR) 3) FDR A/c Dr. 1000 Interest accrued and due A/c Dr. 331 To bank account Cr. 1331 (to the maturity proceeds of FDR transferred to the saving bank account of the depositor on its maturity) 4) Purchase A/c Dr. 1000 To Bill ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... e assessee-company? The assessee-company also does not partake of any (higher) return, and in case the value of shares at the time of divesture, on the basis of intrinsic value, is higher, the assessee would be entitled only to pre-determined price, which in that case due to legal restrictions, be purchased by a Qualified Investor (QI) specified by AT T (clause 8.13). The investment thus can only be regarded or euphemistically termed as in equity shares, and for all intents and purposes, or in substance, is an investment held in the form of shares for a definite period at a particular return cost to the transferee of shares, toward the time value of the funds . The transfer of shares is, thus, only the manner in which either party exercises the right, being the right to receive and, correspondingly, the right to acquire shares - nothing more and nothing less. Till then, it is an open contract, and the income shall continue to accrue to the assessee by elapse of time. We do not, when we state so, in any manner, hold or mean that the investment in shares is not to be regarded as such. But only that, nevertheless, the right to receive the income, which stands to be embedded in ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... y after the lock-in period is or, at the option of the parties, convertible into a due date. Nature of Income 4.10 A question may arise as to the nature of income. Income is a term of wide amplitude, so that anything that can conforms to the notion of a gain or benefit, i.e., that appeals to the concept thereof, is income, as used or understood in the common parlance, with the Act only listing down, per the defining section (s. 2(24)), inexhaustively, the various types of income. Reference in this context be made to Emil Webber vs. CIT [1993] 200 ITR 483 (SC). The nature of income which falls to arise to the assessee is to be in the facts and circumstances of the case, including the fact that the investment under reference only represents an opportunity to the assessee to earn income from an investment, made in the course of its business as an investment company, returning the income by way of call option fee as business income, only business income. There is, in fact, no question of the assessee earning or being entitled to call option fee otherwise, where it acquires the shares in the investeecompany as a stakeholder (promoter) . We have, further, found the two r ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... he corresponding expenditure are accounted for on accrual basis, it automatically gives rise to the matching principle, so that it is nothing but an accounting expression for both revenues and costs, being accounted for on accrual basis. In the facts of the case, the assessee has incurred borrowing cost ranging from 10% to 14% per annum, which in fact led the AO to ascertain the assessee s revenue model and the corresponding income streams. Clearly, the assessee stands allowed all interest incurred in relation to the borrowed capital for the purpose of the investment under consideration as business expenditure. The corresponding revenue, whether realized during the current year or not, is liable to be recognized as income. Of course, there must be no significant uncertainty as to its ultimate collection, and which does not exist being not contended at any stage in the present case. We do not, when we say so, mean that in every case of accrual of income and the corresponding expenditure (or vice versa), the same would lead to a matching. But only that, firstly, the said accounting concept stands statutorily accepted, being only being only an expression of a recognized principle of ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... oss stood already set off against the income accruing, which is as much the operating result of the enterprise as would be a positive income. The right to compensation arose in a subsequent year and is distinct from incurring the loss itself. The position would be different had the Government been contracted and, accordingly, obliged to compensate the assessee for the loss, if any, arising to it on the relevant supplies. In State Bank of Travancore (supra) another three member constitution decision, the Apex Court, in ratio, clarified that whether the income had really accrued or arisen to the assessee must be judged in the light of the reality of the situation, including the conduct of the parties. Further, the concept of real income, which is certainly applicable, cannot be extended to negate accrual, particularly where it has already accrued, i.e., is to be applied with care and within well recognized limits. The terms of the contract are plain and clear. There is also nothing inconsistent in the conduct of the parties therewith. In the reality of the situation, regard for which it is to be made, the assessee is irrevocably entitled to transfer, and AT T Global irrevocabl ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... se only to the assignee-company on the conclusion of the calendar year 1943; the calendar year being the accounting year. The moment it is realized that the managing agency agreement, where-under the income by way of agency commission accrues on the rendering of the services, and the assignment agreement where-under the office of the managing agency a business, stands assigned, are separate and distinct agreements, it shall become plain that no part of the income under the former (managing agency agreement) could enure to the assignor of the managing agency business. The said decision is not applicable. In Canara Bank (supra), the assessee, a banking company, closing its accounts on December 31 every year, reflected interest accrued as on December 31, 1981, as interest relatable to the relevant period. The interest was, however, payable only after December 31, 1981. The same was held as not accrued for the relevant year, following Vijaya Bank Ltd. vs. CIT [1991] 187 ITR 541 (SC), in which case the appellant bank purchased securities, the price of which was contended as determined with reference to their actual value as well as the interest that had accrued on the securitie ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... gally mandated. Only to find a complete harmony between the two, i.e., as judicially explained and as defined in accountancy, the commercial principles of which would even otherwise hold in the absence of anything to the contrary under the statute. The question to examine is if the right to receive the return (or income) on the shares had accrued to the assessee during the relevant year. The same flowing from the shareholder s agreement entered into by it with a parent (foreign) company of the investee-company, a resident, the said agreement stands examined in detail, even as no dispute or doubt with regard to the scope or meaning of its provisions is available on record, i.e., only with a view to ascertain the nature of the rights accruing to or vesting in the assessee per the same. The Agreement was found to unequivocally and unambiguously convey the right to receive the return on its investment (in shares) to the assessee-company and, further, that income therefore accrued to it in the same manner and to the same extent as the increase in the value of its share holding in the investee-company, at a defined rate per unit of time over the holding period, which was further fixed a ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... g 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 right to receive, if construed as a right to receive in praesenti , it may be appreciated, would obliterate the difference between the right to receive and due for payment . Or, in fact, between accrual and receipt , used in contradistinction, even as explained in Ashokbhai Chimanbhai (supra). It is only the realizability of the right accrued that is postponed to a later, defined date, signif ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... 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 ..... X X X X Extracts X X X X X X X X Extracts X X X X
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