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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 ..... y 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. The option in respect of payment of interest was to be exercised within 30 days of the date of allotment. Under the terms of the issue, the debentures could be redeemed at par along with 10 per cent. redemption premium at any time after the end of the fifth year but not beyond the seventh year. The debentures were allotted to the following parties on the dates indicated hereinbelow : --------------------------------------------------------------------------- Party Amount Date of allotment (in lakhs) --------------------------------------------------------------------------- 1. Maliram Makharia Stock Brokers Pvt. &nbs ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... s "deferred revenue expenditures" and written off over a period of five years. Similarly, premium of Rs. 60 lakhs was proportionately debited to each year's profit and loss account at 20 per 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 ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ase and in law, the Tribunal was right in holding that even though, the liability of payment of interest stood liquidated in the first year itself, such liability had to be allowed on a 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 und ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ned with the interest which became payable to the lenders amounting to Rs. 55 in the very first year ending March 31, 1996, whereas, in the case of Madras Industrial Investment Corporation 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 ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... at the rate of 18 per cent. per annurn, which was not permissible under the terms of the issue Mr. Dastur relied upon the judgment of the Bombay High Court in the case of Addl. CIT 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 ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... s not debited Rs. 55 in the first year, it is entitled to claim deduction for Rs. 55 paid in the first year. That, the assessee was maintaining the mercantile system of accounting 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 ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... but it constituted revenue expenditure. Therefore, the Assessing Officer has given to the assessee deduction of a larger amount by Rs. 1,73,25,000. However, Mr. Dastur concedes that 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 ther ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... on the judgment in the case of Addl. CIT v. Buckau Wolf New India Engineering Works Ltd. [1986] 157 ITR 751 (Bom). Mr. Dastur contended that in this case the Assessing Officer has 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 ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... therefore, contended that the amortisation principle was applicable to both the options. He, therefore, contended that even Rs. 55 was payable by way of interest for five years. 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 unde ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... he liability of Rs. 55 (Rs. 2,72,25,000) in the first year of allotment of NCD itself and, therefore, the entire amount of Rs. 2,72,25,000 was allowable in that year 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 mercan ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... expenditure which is incurred wholly and exclusively for the purpose of business must be allowed in its entirety in the year in which it is incurred. It cannot be 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 a ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... after tax was Rs. 1,86,34,016. Now if the expenditure incurred was Rs. 2,72,25,000 as submitted by the assessee then the assessee could never have earned the said 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 p ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... urn used in present value calculations. According to the Assessing Officer, Rs. 2,72,25,000 and Rs. 55,00,000 paid to Maliram Makharia Stock Brokers Private Limited 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: ------------------------------------------- ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... three days, i.e., from March 29, 1996, to March 31, 1996. Rs. 89,10,000 is annual interest at 18 per cent. per annum on Rs.4,95,00,000. Rs. 14,10,410 is the interest at 18 per cent. per annum on Rs. 1,00,00,000 for the period from June 19, 1996, to March 31, 1997 ; and Rs. 18,00,000 is annual interest at 18 per cent. per annum on Rs. 1,00,00,000. At this point, it is important to note that the rate of 18 per cent. per annum represents the measure/yardstick, which the Assessing Officer has arrived at on the basis of an analogy contemplated by clause 3(a) of the terms of the issue quoted hereinabove. In this case, we are concerned with the deferred interest option. However, as stated above, under clause 3(a), there was one more option under which interest was payable at 18 per cent. per annum over a period of five years, which has been debited to the profit and loss account year-wise. Therefore, the Assessing Officer has taken a clue from that option and he has estimated the deduction on yearly basis at the rate of 18 per cent. per annum. Therefore, the contract is not re-written as alleged by the assessee. In fact, according to the assessee's books of account, every year an amo ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... s. 55 up-front. He may show that amount as a liability in his balance-sheet and every year a part of that amount would be reflected on the credit side of the profit and loss account on which he was required to pay tax. In case of deferred revenue income, an estimation would have to be made by applying the interest rate to calculate the present value. In other words, the rate of 18 per cent. is the discount rate applied to estimate the deduction/expense for the purpose of section 36(1)(iii) of the Act. In this case, therefore, if one keeps these two concepts in mind, viz., matching concept and discount rate, then, the matter stands resolved in law. In the light of what is stated above, we are now required to examine the annual accounts of the assessee: (a) Income-tax Appeal No. 89 of 2001 concerns financial year ending March 31, 1996 corresponding to the assessment year 1996-97. Under Schedule "C" to the balance-sheet, under the caption "secured loans", the assessee is shown to have received Rs. 4,95,00,000. The assessee had issued 4,95,000 secured non-convertible redeemable debentures of Rs. 100 each. As stated above, Maliram Makharia Stock Brokers Private Limited had opted for ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... debentures of Rs. 100 each amounting to Rs. 6,00,00,000. In other words, during the accounting year ending March 31, 1998, no fresh loans came to be raised and, therefore, the figure of Rs. 6,00,00,000 is the same as for the accounting year ending March 31, 1997. The balance-sheet for the year March 31, 1998, shows that the asset which stood at Rs. 2,64,12,055 during the accounting year ending March 31, 1997, is reduced to Rs. 1198,67,055. In other words, the asset has been written off by debiting Rs. 65,45,000 to the profit and loss account for the year ending March 31, 1998 under the caption "deffered debenture interest written off". In other words, in the annual accounts, one-fifth of Rs. 55 is written off by the assessee and the asset is accordingly reduced during the year ending March 31, 1998. Now, in this year, the assessee has not claimed any deduction but the Assessing Officer has given deduction of Rs. 1,07,10,000, i.e., at 18 per cent. per annum on Rs. 595 lakhs. (d) This writing off of the assets thereafter continues for the accounting year ending March 31, 1999 ; March 31, 2000 and March 31, 2001. Finally, in the accounting year ending March 31, 2001, the assessee's ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ue expenditure. That, the assessee has treated the up-front payments as deferred revenue expenditure to be written off over the period of debentures. Under section 36(1)(iii) of the Income-tax Act, interest on borrowed capital paid by the assessee is allowable as a deduction. In this case, the assessee follows the mercantile system of accounting. Therefore, the word " paid" in section 36(1)(iii) is to be read in the context of system of accounting followed by the assessee. In this case, in the first year the assessee claims to have incurred liability of Rs. 55 but no amount is debited to the profit and loss account. Similarly, the assessee paid Rs. 55 for the year ending on March 31, 1997, to Sharp Knife Company Private Limited but in the profit and loss account, the assessee has debited only Rs. 11 thereby creating an asset for the balance amount of Rs. 44, which asset is written off each year by debiting Rs. 11 to the profit and loss account for five years. Therefore, if one reads section 36(1)(iii) with section 43(2) of the Income-tax Act, it is clear that the payment of interest on borrowed capital for business purpose is a borrowing cost. Such borrowing costs has been capitali ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... s then, it is the duty of the Assessing Officer to make appropriate adjustments and deduce the true profits. This judgment of the Supreme Court in A. Krishnaswami Mudaliar's case [1964] 53 ITR 122, also lays down the difference between the cash and the mercantile systems of accounting. It also invokes the matching concept. In this judgment, it has been held that when goods are sold on credit and the assessee follows the mercantile system of accounting, a receipt entry is posted as on the date of sale, although no cash is actually received on that day and a debit entry is posted when liability is incurred although payment on account of such liability is not made. That, in appropriate cases, the Assessing Officer may have to make appropriate variations where the system adopted by the assessee does not indicate the profits. The Supreme Court has further laid down that according to the mercantile system of accounting, actual cash received during the year and actual cash outlays are treated in the same way as under the cash system of accounting but, to the balance thus arising, there is added an amount of outstanding not collected at the end of the year and from which the liabilities in ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ses cited. Lastly, we may mention that in this case, the deduction has been calculated at 18 per cent. per annum whereas, if one goes by the books, it is at 11 per cent. per annum. Therefore, the assessee has got higher deduction. Consequently, the above question framed by this court is answered in the affirmative, i.e., in favour of the Department and against the assessee. In this case, the assessee has claimed Rs. 55 (Rs. 2,72,25,000) as a deduction in the first year of payment to Maliram Makharia Stock Brokers Private Limi ted and Rs. 55 lakhs as payment of interest to Sharp Knife Company Private Limited in the accounting year ending March 31, 1997, without applying the matching concept. At the same time the assessee is also claiming deduction to the extent of Rs. 12 lakhs being one-fifth of Rs. 60 lakhs payable as premium on the NCD.in the fifth year on spread over basis. If the assessee's contention was to be accepted, then it would result in distortion of net income. In the cir cumstances, the Assessing Officer was right in spreading the deductions over the period of five years qua up-front payments. Therefore, the assessee's appeals being Income-tax Appeal No. 88 of 2001, I ..... X X X X Extracts X X X X X X X X Extracts X X X X
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