The Supreme Court, in Commissioner of Income Tax vs. Virtual Soft Systems Ltd. held that deduction on account of lease equalization charges from lease rental income can be allowed under the Income Tax (IT) Act, 1961, on the basis of Guidance Note issued by the Institute of Chartered Accountants of India (ICAI).
In the instant case, the Respondent-assessee filed the return of income declaring loss of Rs.70.24 Lacs. They claimed a deduction of Rs.1.65 Crores as lease equalization charges. However, the Assessing Officer (A.O.) disallowed the claim of deducting the lease equalization charges. He added the same to the income of the respondent. Aggrieved, the respondent filed an appeal before the Commissioner of Income Tax (Appeals) (CIT(A)). CIT(A) dismissed the appeal and upheld the order of the A.O. Thereafter, an appeal was filed before the Tribunal. Setting aside the orders of the A.O and the CIT(A) the Tribunal, allowed the appeal. Revenue, being dissatisfied, approached the High Court against the order of the Tribunal. The revenue’s appeal was rejected. Finally, the Revenue approached the Supreme Court.
The Counsel for the Revenue contended that there is no concept of deduction regarding the lease equalization charges under the Income Tax Act,1961 and that the deduction cannot be allowed. Lease equalization charge is an additional deduction debited to Profit and Loss Account (P&L) in addition to the depreciation claimed in books so as to make it equal to capital recovery.
The Counsel for the Respondent-Assessee argued that it is a settled principle that a Guidance Note issued by the ICAI carries great weight and by adopting a method of accounting prescribed in such a Guidance Note, in order to compute real income and offering the same for taxation, cannot be disregarded by the A.O unless such action falls within the scope and ambit of Section 145(3) of the Income Tax Act,1961. He further submitted that the lease equalization charge is a method of adjusting the depreciation claimed in the books of accounts to enable the Respondent to represent its real income by adopting an accounting methodology prescribed by the ICAI.
The Court found that the method of accounting as derived from ICAI’s Guidance Note is a valid method of capturing real income based on the substance of finance lease transaction. The bench reminded that it is a cardinal principle of law that the difference between capital recovery and interest or finance income is essential for accounting for such a transaction with reference to its substance. It further noted that, if the same was not carried out, the Respondent would be assessed for income tax not merely on revenue receipts but also on non-revenue items which are completely contrary to the principles of the IT Act and to its Scheme and spirit.
Relying on the decision of the Court in the case of Commissioner of Income Tax vs. Punjab Stainless Steel Industries, the bench comprising of Justice R.K Agrawal & Justice Abhay Manohar Sapre observed “The bifurcation of the lease rental is, by no stretch of imagination, an artificial calculation and, therefore, lease equalization is an essential step in the accounting process to ensure that real income from the transaction in the form of revenue receipts only is captured for the purposes of income tax. Moreover, we do not find any express bar in the IT Act which bars the bifurcation of the lease rental. To sum up, we are of the view that the Respondent is entitled to the bifurcation of lease rental as per the accounting standards prescribed by the ICAI. Moreover, there is no express bar in the IT Act regarding the application of such accounting standards.”
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