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TMI Blog2003 (1) TMI 83X X X X Extracts X X X X X X X X Extracts X X X X ..... is matter, we are concerned with computation of taxable income and, therefore, the true accounting principles will have to be taken into account. - IT APPEAL NOS. 88, 89, 90, 155, 180 AND 181 OF 2001 - - - Dated:- 8-1-2003 - Judge(s) : S. H. KAPADIA., J. P. DEVADHAR. JUDGMENT The judgment of the court was delivered by S.H. KAPADIA J.-The above six appeals have come before this court under section 260A of the Income-tax Act, 1961. Income-tax Appeals Nos. 88 of 2001, 89 of 2001 and 90 of 2001 are filed by the assessee whereas, Income tax Appeals Nos. 155 of 2001, 180 of 2001 and 181 of 2001 are filed by the Department. For the sake of convenience and brevity, the facts in Income-tax Appeal No. 89 of 2001 are hereinafter mentioned. Facts: During the assessment year 1996-97, the assessee issued non-convertible debentures aggregating to Rs. 6,00,00,000 on a private placement basis. The face value of the debenture was Rs. 100 each. As regards payment of interest on debentures, the debenture-holders were at their option either periodically receiving interest on half-yearly basis at 18 per cent. per annum for five years or one year up-front payment of Rs. 55 per debenture. T ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... r cent. and credited as reserve on the liabilities side of the balance-sheet. However, in its returns for the accounting year ending March 31, 1996, the assessee claimed the entire up-front payment of Rs. 2,72,25,000 to Maliram Makharia Stock Brokers Private Limited as fully deductible expenditure though the assessee did not debit the full amount or any part thereof to its profit and loss account. Similarly, the assessee claimed full deduction for Rs. 55,00,000 in its return for the year ending March 31, 1997. The Assessing Officer disallowed the claim of the assessee for full deduction of Rs. 2,72,25,000 and Rs. 55,00,000 on the ground that the entire liability regarding discounted interest paid up-front has not been incurred in the accounting year ending March 31, 1996, and March 31, 1997. It was also disallowed on the ground that the approximate income which the assessee would have earned by utilisation of Rs. 495 lakhs and Rs. 100 lakhs , which the assessee borrowed by way of non-convertible debentures, was not offered for taxation. The Assessing Officer also relied upon the judgment of the Supreme Court in the case of Madras Industrial Investment Corporation Ltd. v. CIT [1997] ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... spread over basis over the life of the debentures?" Arguments: Mr. Dastur, learned senior counsel appearing on behalf of the assessee, in support of the assessee's appeals contended that under the terms of issue, two options were given to the lenders. Under the interest option, the assessee offered to pay half-yearly interest at 18 per cent. per annum till redemption. Whereas, under the deferred interest option, up-front payment of Rs. 272,25,000 was offered and paid by the assessee to the lender in the year of allotment. He contended that on March 29, 1996, the assessee received from Maliram Makharia Stock Brokers Private Limited Rs. 4,95,00,000 and on the same day under the terms of the contract, the assessee repaid interest of Rs. 2,72,25,000. He contended that if Rs. 100 was received by the assessee on March 29, 1996, then the assessee, under the terms of the contract, became liable to pay to Maliram Makharia Stock Brokers Private Limited Rs. 55 on March 29, 1996, itself. He contended that under the terms of the contract Rs. 100 was received by the assessee which was repaid after five years. He, therefore, contended that the up-front payment of Rs. 55 on March 29, 1996, wa ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... oration Ltd.'s case [1997] 225 ITR 802 (SC), the premium amount was payable after five years and, therefore, the Supreme Court has allowed amortisation. He contended that in the present case, liability to pay interest arose in the first year ending March 31, 1996, and it was also discharged in the first year. He contended that the assessee was maintaining the mercantile system of accounting and under the terms of the issue, the amount became a liability in the first year itself and, therefore, the Assessing Officer erred in spreading the liability to pay interest over five years. Mr. Dastur further contended that in the case of Madras Industrial Investment Corporation Ltd. [1997] 225 ITR 802 (SC), the liability to pay interest continued for five years. However, in the present case, the liability to pay interest stood discharged in the very first year. He contended that in the case of Madras Industrial Investment Corporation Ltd. [1997] 225 ITR 802 (SC), the liability was a continuing liability, which is not the case in the present matter. He further pointed out from the judgment of the Supreme Court in Madras Industrial Investment Corporation Ltd.'s case [1997] 225 ITR 802, that th ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... v. Buckau Wolf New India Engineering Works Ltd. [1986] 157 ITR 751. In that case, the amount was payable in instalments and yet, the Bombay High Court has ruled that the deduction for the entire amount should be given in the first year because, the liability accrued in the first year. He, therefore, contended that Madras Industrial Investment Corporation Ltd.'s case [1997] 225 ITR 802 (SC) has no application to the facts of the present case. He contended that the liability to pay interest did not stretch for five years because, it was paid in the very first year. He further contended that in this case, the assessee was required to pay interest of Rs. 4,45,50,000 but, by paying in the first year Rs. 2,72,25,000. Up-front, the assessee has been able to save payment of interest to the tune of Rs. 1,73,25,000. Mr. Dastur contended that even according to the Department, Rs. 55 equal to Rs. 2,72,25,000 should not be spread over. However, by reason of the assessee making payment of Rs. 2,72,25,000 in the first year, the assessee is put to a disadvantage as the assessee is paying the interest for five years in the very first year. He contended that in this case, the Department has given d ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... and its liability to pay interest accrued in the very first year. It was thus contended that had the assessee paid Rs. 55 at the end of five years and if the assessee was c aiming deduction in t e first year, then the Department would have been right in refusing deduction. However, in this case, the assessee has paid Rs. 55 in the first year itself and, if so, the assessee was entitled to deduction in the first year itself for two reasons, viz., that the assessee is maintaining its accounts on the accrual system and, secondly, the liability has been discharged in the very first year. It was contended that there was no provision under the Act under which the liability incurred by the assessee could be reduced. That, Rs. 55 had gone out of the pocket of the assessee for all times and, therefore, the assessee was entitled to claim deduction for the entire Rs. 55 in the first year. It was urged that the analogy of deep discount bonds did not apply to this case as in this case, the liability arose in the first year and it was paid in the first year whereas, in the case of deep discount bonds, the liability to pay arises in the fifth year. Mr. Dastur, next contended that in the present ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... hat in absolute terms, the Assessing Officer has given to the assessee more deduction but not in terms of the present value. He contended that the present value was Rs. 4,45,50,000 spread over five years which was the same as Rs. 2,72,25,000 in the first year. Therefore, there is no loss to the Revenue. Therefore, the entire question is academic. Mr. Dastur contended that it was not open to the Assessing Officer to insist on the spread over particularly when the liability under the contract arose to the assessee in the first year unless the Assessing Officer holds that the contract was a sham. However, in this case there is no such finding and, therefore, the Assessing Officer was not entitled to change the terms of the contract. In the circumstances, the Assessing Officer was bound to proceed on the footing that the liability had accrued in the assessment year in question, i.e., the assessment year 1997-98. That, if the assessee pays rent in advance in the first year under a contract which states that there shall be no refund of the rent paid then the assessee must get deduction in the first year itself and, therefore, the only question which the Assessing Officer was required to ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... s re-written the contract by obliterating the option given to the lenders-Maliram Makharia Stock Brokers Private Limited and Sharp Knife Company Private Limited. Mr. Dastur next contended that in the present matter, the Tribunal has held that the expenditure must relate to the income in the assessment year and that the benefit was spread over for a period of five years and, therefore, the expenditure must also be spread over. However, Mr. Dastur argued that the Tribunal erred in introducing the matching concept referred to above. He submitted that in the present case the liability accrued in the first year and, therefore, as held by the Supreme Court in the case of Mysore Spinning and Mfg. Co. Ltd. v. CIT [1966] 61 ITR 572, the assessee was entitled to full deduction in the first year and, therefore, the question of co-relating the expenditure to income/benefit for five years does not arise. Mr. Dastur next contended that on the contrary in this case if the assessee had adopted the said amortisation, the Department would have told the assessee that it was not entitled to deduction in the second year as no liability accrued in the second year and as no payment was made in the se ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ars. However, the same was paid in the first year by the assessee and, therefore, the Assessing Officer was right in coming to the conclusion that the principle of amortisation was applicable to the facts of this case. Mr. R.V. Desai, learned senior counsel for the Department, next contended in support of the appeals filed by the Department that the Tribunal has failed to appreciate that the total borrowed capital on March 29, 1996, was Rs. 4,95,00,000 out of which, Rs. 2,72,25,000 was repaid on the same day as up-front fee and, therefore, the actual borrowed capital left with the assessee was only Rs. 2,22,75,000 which was used for business and, since part of the borrowed capital came to be refunded to the subscribers on the same day, the actual borrowed capital remaining with the assessee was only Rs. 2,22,75,000 and, therefore, the total borrowed capital of Rs. 4,95,00,000 in the first year was not utilised for the purpose of the business and, therefore, the assessee was not entitled to claim deduction under section 36(i)(iii). He further contended that the entire scheme of non-convertible debentures was a device to defeat the collection of tax revenue. That, in the present ca ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... r itself whereas according to the Assessing Officer, it was deferred revenue expenditure (DRE) and, therefore, apportionable over five years. A. Matching concept: The mercantile system of accounting is based on accrual. Basically, it is a double entry system of accounting. Under the mercantile system of accounting, profits arising or accruing at the date of the transaction are liable to be taxed notwithstanding the fact that they are not actually received or deemed to be received under the Act. Under the mercantile system of accounting, therefore, book profits are liable to be taxed. The profits earned and credited in the books of account constitute the basis of computation of income. The system postulates the existence of tax in so far as monies due and payable by the parties to whom they are debited. Therefore, under the mercantile system of accounting, in order to determine the net income of an accounting year, the revenue and other incomes are matched with the cost of resources consumed (expenses). Under the mercantile system of accounting, this matching is required to be done on accrual basis. Under this matching concept, revenue and income earned during an accounting peri ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... e spread over a number of years even if the assessee has written it off in his books, over a period of years. However, the facts may justify an assessee who has incurred expenditure in a particular year to spread and claim it over a period of ensuing years. In fact, allowing the entire expenditure in one year might give a very distorted picture of the profits of a particular year. Issuing debentures is an instance where, although the assessee has incurred the liability to pay the discount in the year of issue of debentures, the payment is to secure a benefit over a number of years. There is a continuing benefit to the business of the company over the entire period. The liability should, therefore, be spread over the period of the debentures." Therefore, the matching concept, which we have referred to is well recognised by various judgments of the Supreme Court. In this case, the issue is whether the entire expenditure distorts the profits of a particular year. In this case, we are concerned with the computation of income and, therefore, the method of accounting followed by the assessee is relevant because accrual of income is to be seen in the light of the method of accounting. W ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... aid profit of Rs. 1,86,34,016. This is how the profit got distorted. In the annual report, the assessee has conceded that Rs. 2,72,25,000 was deferred revenue expenditure to be written off over five years. In his order, the Assessing Officer has recorded a finding of fact which categorically brings out the matching concept. He has stated that for the accounting year March 31, 1996, profit after tax increased to Rs. 1,86,34,016 from Rs. 50 lakhs in the last year ending March 31, 1995. Therefore, the Assessing Officer was right in apportioning the expenditure at 18 per cent. per annum on Rs. 495 lakhs amounting to Rs. 74,250 for three days because only then the estimated expenditure could match with income of Rs. 1,86,34,016. If the expenditure was Rs. 2,72,25,000, the net profit cannot be Rs. 1,86,34,016. The assessee followed the mercantile system of accounting. In their annual accounts, the assessee has shown Rs. 2,72,25,000 as deferred revenue expenditure. Therefore, in our view, the expenditure of Rs. 2,72,25,000 though paid was not incurred and, in fact, what was incurred was Rs. 74,250 for year ending March 31, 1996. To put it in a different way, the annual accounts show that ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... imited and Sharp Knife Company Private Limited, respectively, had to be discounted as the said two payments were deferred revenue expenditure. Therefore, the Assessing Officer was required to apply a yardstick/measure in order to compute the estimated expenditure. The Assessing Officer has applied the rate of 18 per cent. per annum on Rs. 495 lakhs and on Rs. 100 lakhs. and has accordingly worked out the deduction. This rate of 18 per cent. is the discount rate. On that basis, for the year ending March 31, 1996, the Assessing Officer has worked out the deduction amounting to Rs. 74,250 which is interest at 18 per cent. per annum on Rs. 495 lakhs for three days. Similarly, calculations are made in respect of Rs. 100 lakhs borrowed by the assessee during the year ending March 31, 1997, from Sharp Knife Company Private Limited, which are as follows: Statement showing the interest payment claimed as deduction by the assessee as against interest payment granted by the Assessing Officer: --------------------------------------------------------------------------- Sr. Assessment Amount Interest payment Interest payment No. Year borrowed claimed by the ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... books at Rs. 11,00,000, which comes to 11 per cent. on Rs. 100 lakhs, whereas, the Assessing Officer has estimated the expenditure at Rs. 18,00,000 which is 18 per cent. on Rs. 100 lakhs. It is vehemently urged on behalf of the assessee that the Assessing Officer has re-written the contract by applying the rate of 18 per cent. per annum while calculating deduction. It was pointed out that this rate of 18 per cent. was applicable to the option under clause 3(a) and not to the option under clause 3(b) of the terms of the issue which dealt with up-front payment. We do not find any merit in this argument. Firstly, 18 per cent. is a yardstick/measure which is taken into account for calculating deduction. As stated above, 11 per cent. per annum has been taken into account by the assessee as a yardstick whereas, the Assessing Officer has taken 18 per cent. per annum. In the case of option under clause 3(a), the actual amount of interest paid to the lender and debited to the profit and loss account has been treated as deduction whereas, in the present case which falls under the deferred interest option, the Assessing Officer has not taken the actual debited amount calculated at 11 per cent ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... nder the caption "debenture interest deferral amount". It is shown as an asset. It is shown as an asset because, it represented interest for five years which has been paid by the assessee in the first year ending March 31, 1996. In the first year, there is no amount debited to the profit and loss account. The balance-sheet refers to notes on accounts. Under the caption "major accounting policies", note "L" reads as follows: "up-front payment on non-convertible debentures has been treated as deferred revenue expenditure which is not refundable and which is to be written off over a period of debentures". Therefore, reading the balance-sheet, it is clear that Rs. 2,72,25,000 represented deferred interest of five years paid in the first year. Therefore, in the first year, profits of Rs. 1,86,34,016 is without debit. The Assessing Officer has estimated however the expenditure at 18 per cent. per annum amounting to Rs. 74,250 for three days (i.e., Rs. 89.10 lakhs per annum) to earn the above profit after tax. (b) Income-tax Appeal No. 88 of 2001 concerns the accounting year ending March 31, 1997, corresponding to the assessment year 1997-98. In the year ending March 31, 1997, the asses ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... tion reserve and, similarly, the premium at 10 per cent. payable in the fifth year under the terms of the issue has been paid from debenture premium reserve which has been created by appropriating one-fifth of Rs. 60,00,000 each year to the reserve. The above analysis indicates two things. Firstly, in the accounts, the up-front payment has been treated as deferred expenditure by the assessee which is written off over the period of debentures. The assessee created an asset on the basis of interest for five years being paid in advance in the first year and, thereafter, the said asset is being written off over the period of debentures for five years. Therefore, the entire amount of Rs. 55 per NCD equal to the total amount of Rs. 2,72,25,000 cannot be treated as expense in the first year. It would result in distortion as stated above. Secondly, the accounts show that the premium payable by the assessee at the end of five years was Rs. 60,00,000 and each year 20 per cent. of Rs. 60,00,000 i.e., Rs. 12,00,000, has been charged to the profit and loss account. This is of some consequence. If the assessee's argument is to be accepted, it would mean that in the first year ending March 31, 19 ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ads from income, profits and gains would differ according to the system of accounting adopted by the assessee. For that purpose, one has to estimate the expenditure by applying the matching concept and a proper discount rate. This rate is required to be applied as in this case the Assessing Officer was required to estimate DRE for the purposes of computing a proper deduction under section 36(1)(iii). In the case of CIT v. A. Krishnaswam Mudaliar [1964] 53 ITR 122, it has been laid down by the Supreme Court that in computing the balance of profits and gains for the purposes of income-tax, two principles have to be kept in mind. Firstly, the profits of any particular year or accounting period must be taken to consist of the difference between receipts from the trade or business during the year and the expenditure laid out to earn those receipts. Secondly, the account of profit and loss to be made out for the purposes of ascertaining that difference must be framed in accordance with the ordinary principles of commercial accounting so far as applicable. For example, under the ordinary principles of commercial accounting, the values of stock-in-trade at the beginning and at the end of t ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... e of the asset and, therefore, the method of accounting followed by the assessee becomes relevant. Therefore, there is no merit in the argument advanced on behalf of the assessee that good accounting is not necessarily good law. In the case of Tuticorin Alkali Cheinicals and Fertilizers Ltd. [1997] 227 ITR 172 (SC), one of the points which arose for determination was whether interest received by the assessee on short-term deposits during pre-commencement of business could be capitalised as accretion to capital and, therefore, non-taxable. Therefore, in the case, the issue was on the nature of the receipt. Hence, that case has no application. On the contrary, it has been held that the accounting principles are relevant for ascertainment of profits made by a company or for ascertainment of value of assets of the company but, not for determining the nature of receipt. Therefore, the said judgment supports the view which we have taken as in this case, we are concerned with computation of income. It is important to note that the deferred revenue expenditure is of revenue nature but, because of its special features, it is spread over a number of years during which the benefit of expendit ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... partment against the order of the Tribunal on the ground that up-front payments represented repayment of the borrowed capital and, therefore, the assessee was not entitled to deduction under section 36(1)(iii). As stated in our judgment hereinabove, the Assessing Officer has recorded the finding of fact, which has been confirmed by the Tribunal that up-front payments were on revenue account. Therefore, we have decided these matters on the basis of that finding of fact. Therefore, the questions raised in the appeals filed by the Department are not answered. Consequently, there will be no order in Income-tax Appeal No. 155 of 2001, Income-tax Appeal No. 180 of 2001 and Income-tax Appeal No. 181 of 2001. Conclusion: In this case, we are concerned with deferred revenue expenditure, which is a special type of asset. In this case, we are not concerned with the nature of profits. In this case, we are concerned with the ascertainment of true profits under the Income-tax Act and in order to ascertain such profits, we have to follow the true accounting principles and we have to apply those principles in the light of the method of accounting followed by the assessee. In cases involving sp ..... X X X X Extracts X X X X X X X X Extracts X X X X
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