Itta/10/2000 Of Srichakara Financial Services P Ltd v. Commissioner Of Income Tax/Bangalore

THE HON’BLE THE CHIEF JUSTICE SHRI MADAN B.LOKURANDTHE HON’BLE SHRI JUSTICE SANJAY KUMAR I.T.T.A.NO.10 OF 2000 DATED 7THFEBRUARY, 2012 Between Sri Chakra Financial Services Limited(Formerly known as PriyadarshiniLeasing and Finances Limited, Hyderabad),Represented by its whole time DirectorSri N.Krishna Mohan. …Appellant And The Commissioner of Income-tax,Central, Bangalore. ...Respondent THE HON’BLE THE CHIEF JUSTICE SHRI MADAN B.LOKURANDTHE HON’BLE SHRI JUSTICE SANJAY KUMAR I.T.T.A.NO.10 OF 2000 JUDGMENT(Per Sri Justice Sanjay Kumar) The issue for consideration in this assessee’s appeal underSection 260-A of the Income Tax Act, 1961 (hereinafter, ‘the Act’) is asto the methodology of computation of the assessee’s income fromfinance charges. The assessee is a public limited company engaged in thebusiness of leasing, hire purchase and finance. For the assessmentyear 1987-88, it admitted a loss of Rs.7,09,738/-. The AssistantCommissioner of Income Tax, Central Circle-III, Hyderabad, howeverassessed the income of the assessee at Rs.6,77,460/-. Thisassessment was based on disallowance of deductions andconsequential additions in connection with finance charges, loss onrevaluation of shares and notional interest on interest free loans givenby the assessee. Finance charges represent the interest component of the hirepurchase monthly instalments paid by hirers to the assessee. Theassessee had itself credited Rs.12,33,700/- under this head in its profitand loss account. However, in its return of income the finance chargeswere reduced to Rs.6,71,326/- on the ground that the amount ofRs.5,62,374/- did not accrue as income though credited as such in theprofit and loss account during the assessment year. The AssessingOfficer (AO) however did not accept this deduction and took into account the credited amount of Rs.12,33,700/- while computing theincome under this head. The AO also disallowed the deductions onthe other two counts. Dissatisfied with this assessment, the assessee filed an appealbefore the Commissioner of Income Tax (Appeals) III, Andhra Pradesh,Hyderabad. By order dated 30.11.1990, the Commissioner acceptedthe stand of the assessee and allowed the appeal. Aggrieved, theRevenue carried the matter in appeal before the Income Tax AppellateTribunal, Hyderabad Bench ‘A’, Hyderabad, in I.T.A.No.463/Hyd/91.The two issues raised before the Tribunal related to the financecharges and the loss on revaluation of its shares. By order dated30.12.1998, the Tribunal allowed the Revenue’s appeal and reversedthe order passed by the Commissioner. Consequently, this appeal bythe assessee. Though the aspect of the alleged loss on revaluation of theshares held by the assessee was also sought to be raised, this Court,while admitting the appeal, framed only one substantial question oflaw: “We are of the view that the first question as to themethodology of computing the income representingreceipts on account of finance charges and interestraises a substantial question of law to be decided inthe appeal. As regards the second question, i.e., loss claimed onaccount of re-valuation of shares, we do not find anyarguable question of law and the reasoning given bythe Tribunal is based on appreciation of facts. The appeal is admitted as regards the first questionindicated above.” The scope of this appeal is therefore limited to the methodologyof computation of the assessee’s income from finance charges earnedthrough its hire purchase and leasing operations. It is not in dispute that the assessee credited Rs.12,33,700/-towards finance charges in its books of account. This figure was “We are of the view that the first question as to themethodology of computing the income representingreceipts on account of finance charges and interestraises a substantial question of law to be decided inthe appeal. As regards the second question, i.e., loss claimed onaccount of re-valuation of shares, we do not find anyarguable question of law and the reasoning given bythe Tribunal is based on appreciation of facts. The appeal is admitted as regards the first questionindicated above.” The scope of this appeal is therefore limited to the methodologyof computation of the assessee’s income from finance charges earnedthrough its hire purchase and leasing operations. It is not in dispute that the assessee credited Rs.12,33,700/-towards finance charges in its books of account. This figure was arrived at by adopting the ‘Indexing’ or ‘Sum of Digits’ (SOD) system ofaccounting. However, while offering income under this head in itsreturn of income, the assessee followed the mercantile system ofaccounting and reduced the income on this count to Rs.6,71,326/-. Theorders of the authorities below reflect that the hire purchaseagreements entered into by the assessee with its customers requiredfinance charges to be paid at the rate of 15% per annum over a periodof five years. The consolidated Equated Monthly Instalment (EMI)payable by the hirers was detailed in Schedule-II of the agreement andeach composite instalment of the EMI contained two elements – partprincipal and part finance charges. The ‘principal component’constituted capital receipt while the amount collected towards ‘financecharges’ was obviously a revenue receipt. In its books of account, theassessee used the SOD system of accounting and reflected morereceipts on the revenue account and less on the capital account fromout of the EMIs received during the assessment year. While submittingits return of income, the assessee however adopted the mercantilesystem of accounting and showed lesser receipts on the revenueaccount. To understand the difference in the two systems of accounting, itwould suffice to extract the hypothetical example adopted by theCommissioner of Income Tax (Appeals): 6. To illustrate the difference in accounting of incomes as per theindexing method and the mercantile system, a hypothetical transactioninvolving hiring of machinery worth Rs.100/- is taken, on which hire purchasefinance charges recoverable in 5 years is Rs.70/-. The following are theamounts of recovery shown in the books of account and in the computation ofincome as per the return filed. Total value of machinery Rs.100/- Finance charges Rs.70/- Rs.170/- Receipt of finance charges for the first and second years underthe indexing system would thus be far higher than that reflected in themercantile system of accounting. That is what has happened in thepresent case. The issue however is whether the income of theassessee under this head is to be assessed as per the entries in itsown books of accounts or in accordance with the mercantile system ofaccountancy which it chose to adopt in its return of income. The AO, upon a detailed analysis, found that the mercantilesystem of accounting could not be applied to hire purchasetransactions for computing the interest chargeable on the principalloan amount as it would not reflect the true state of affairs. He foundthat the interest component would remain constant in the mercantilesystem despite the outstanding principal amount reducing each year.Consequently, the rate of interest for the later years would work out tobe far higher than the rate stipulated in the agreement. He wastherefore of the opinion that whatever portion of the EMI was treated asinterest/finance charges by the assessee should be held to haveaccrued to the assessee during the assessment year and chargeableto tax. The AO, upon a detailed analysis, found that the mercantilesystem of accounting could not be applied to hire purchasetransactions for computing the interest chargeable on the principalloan amount as it would not reflect the true state of affairs. He foundthat the interest component would remain constant in the mercantilesystem despite the outstanding principal amount reducing each year.Consequently, the rate of interest for the later years would work out tobe far higher than the rate stipulated in the agreement. He wastherefore of the opinion that whatever portion of the EMI was treated asinterest/finance charges by the assessee should be held to haveaccrued to the assessee during the assessment year and chargeableto tax. The AO also pointed out the anomaly which would arise ifdeductions towards finance charges in the hands of the hirers werepermitted on the basis of the indexing system of accounting whileallowing the hiring company/financer to adopt the mercantile system ofaccounting in respect thereof. The AO opined that the assessee couldnot maintain one system of accounting for the purpose of carrying onits business and another system for tax purposes. As the assesseehad itself maintained its books of accounts on the indexing system ofaccounting, the AO held that it was bound to adopt the same for the purpose of the assessment proceedings also. In appeal, the Commissioner of Income Tax (Appeals) observedthat no hypothetical or theoretical income based on mere book entriescould be brought to tax. Dealing with the differential income arising outof the finance charges in the present case, the Commissioner opinedthat the same was neither actually received by the assessee nor did itaccrue to it as per the mercantile system of accounting. The financecharges income arrived at in the books of account following theindexing system of accounting was held to be hypothetical incomewhich did not materialize either by accrual or by actual receipt. TheCommissioner therefore concluded that the income on account offinance charges should be assessed as returned by the assessee andnot as per its books of account. In the second appeal, the Tribunal followed the decision inDEPUTY COMMISSIONER OF INCOME TAX V/s. NAGARJUNA INVESTMENT TRUST LIMITED[[1]], wherein a Special Bench of theTribunal at Hyderabad held that finance charges/interest in relation tohire purchase agreements recognized by the assessee on the basis ofthe method of accounting employed by it and reflected in its books ofaccount has to be considered as the real income which accrued andwhich was liable for assessment. In consequence, the Tribunalaccepted the Revenue’s stand in so far as this aspect was concerned. S r i A.V.Krishna Koundinya, learned counsel for theappellant/assessee, would contend that adoption of the mercantilesystem of accounting for assessment purposes was valid and correctas the same would show the real income that had accrued and arisenon account of finance charges. With regard to the practice of theassessee in resorting to the indexing or SOD system of accounting inits books of account, the learned counsel stated that the same wasdone so as to lift the financial standard of the assessee in the eyes ofthe public, though it did not legitimately receive that much interest. Reliance was placed by the learned counsel on UNITED COMMERCIAL BANK V/s. COMMISSIONER OF INCOME-TAX[[2]]. S r i A.V.Krishna Koundinya, learned counsel for theappellant/assessee, would contend that adoption of the mercantilesystem of accounting for assessment purposes was valid and correctas the same would show the real income that had accrued and arisenon account of finance charges. With regard to the practice of theassessee in resorting to the indexing or SOD system of accounting inits books of account, the learned counsel stated that the same wasdone so as to lift the financial standard of the assessee in the eyes ofthe public, though it did not legitimately receive that much interest. Reliance was placed by the learned counsel on UNITED COMMERCIAL BANK V/s. COMMISSIONER OF INCOME-TAX[[2]]. Therein, the Supreme Court observed that what is taxable under theAct is the really accrued or arisen income and if on the basis of themethod of accountancy regularly employed by the assessee, the realincome is pointed out in the IT Return submitted by the assessee, itcannot be ignored by holding that in a balance sheet which is requiredto be statutorily maintained in a particular form, a different system ofaccounting is adopted. The Supreme Court held that for the purpose ofincome-tax whichever method is adopted by the assessee, a truepicture of the profits and gains, that is to say, the real income is to bedisclosed and for determining the real income, the entries in a balancesheet required to be maintained in the statutory form, may not bedecisive or conclusive. In such a case, the Supreme Court held that it was open to theIncome-tax Officer as well as the assessee to point out the true andproper income while submitting the return. Pertinent to note, theSupreme Court pointed out that the method of accounting adopted bythe tax payer consistently and regularly cannot be discarded by thedepartmental authorities on the view that the assessee should haveadopted a different method of keeping accounts or of valuation. TheCourt also pointed out that whether the income has really accrued orarisen to the assessee must be judged in the light of the reality of thesituation. As pointed out by the Supreme Court in COMMISSIONER OF INCOME-TAX V/s. BRITISH PAINTS INDIA LIMITED[[3]], even if theassessee adopted a regular system of accounting, the AssessingOfficer is under a duty under Section 145 of the Act to considerwhether the correct profits and gains could be deduced from theaccounts so maintained. If not, he is obliged to adopt such method ofcomputation as he deemed appropriate for proper determination of thetrue income of the assessee. In the present case, as the assessee itself adopted two systemsof accounting – one for its books of account and the other forassessment purposes, the AO had to examine as to which of the twosystems reflected the real income of the assessee under the head offinance charges. Section 145 of the Act dealing with the method of accounting reads as under: “Section 145. Method of accounting.—(1) Incomechargeable under the head “Profits and gains ofbusiness or profession” or “Income from othersources” shall, subject to the provisions of sub-section(2), be computed in accordance with either cash ormercantile system of accounting regularly employedby the assessee. (2) The Central Government may notify in theOfficial Gazette from time to time accountingstandards to be followed by any class of assessees orin respect of any class of income. (3) Where the Assessing Officer is not satisfiedabout the correctness or completeness of theaccounts of the assessee, or where the method ofaccounting provided in sub-section (1), or accountingstandards as noticed under sub-section (2), have notbeen regularly followed by the assessee, theAssessing Officer may make an assessment in themanner provided in Section 144.” I n SANJEEV WOOLEN MILLS V/s. COMMISSIONER OF (2) The Central Government may notify in theOfficial Gazette from time to time accountingstandards to be followed by any class of assessees orin respect of any class of income. (3) Where the Assessing Officer is not satisfiedabout the correctness or completeness of theaccounts of the assessee, or where the method ofaccounting provided in sub-section (1), or accountingstandards as noticed under sub-section (2), have notbeen regularly followed by the assessee, theAssessing Officer may make an assessment in themanner provided in Section 144.” I n SANJEEV WOOLEN MILLS V/s. COMMISSIONER OF INCOME-TAX[[4]], the Supreme Court observed that the choice ofmethod of accounting regularly employed by the assessee lies with theassessee but the assessee would be required to show that he hasfollowed the chosen method regularly. The Department is bound bythe assessee’s choice of method regularly employed unless by thismethod the true income or profit of accounts cannot be arrived at. Themethod of accounting cannot be substituted by the Assessing Officermerely because it is unsatisfactory. What is material for the purpose ofSection 145 of the Act is that the method should be such that the realincome, profit and gain can be properly deduced therefrom. If themethod adopted does not afford a true picture of profits, it would be rejected, but such rejection should be based on cogent evidence andwould be done with caution. The power can be exercised by theassessing authority to choose the basis and manner of computation ofthe income but he must exercise his discretion and judgment judiciallyand reasonably. Despite this Court granting time, both sides were unable toproduce a copy of the hire purchase agreement entered into by theassessee with its customers. As the full particulars are not before thisCourt, the observations in this regard of the authorities below assumeimportance. While considering the issue as to what portion of the monthlyinstalment accrued as interest, the AO did not detail the bifurcation, ifany, of the consolidated monthly equated instalment mentioned inSchedule II of the agreement. In appeal, the Commissioner alsoreferred to this aspect but did not elucidate as to whether anyapportionment of the instalment amount is detailed in the saidSchedule towards the principal and interest components. However, the AO while dealing with this aspect observed thatthe most appropriate method of accounting in the case of hirepurchase financing, which would give the correct picture of thecomponents of principal and interest in the instalments paid by thehirer would be the index system of accounting. He further observedthat this was followed by the assessee and all other hire purchasefinanciers. The inference that can be logically drawn from this exerciseby the AO is that there was no apportionment in the assessee’s hirepurchase agreements. In appeal, the Commissioner baldly stated that the financecharges computed by adopting the SOD system of accounting wouldbe hypothetical income and such income did not in fact materializeeither by accrual or by receipt. There is however no basis for thisconclusion of the Commissioner. It was for the assessee to apportionthe EMIs towards the principal and interest components and once such apportionment was voluntarily made by the assessee, it wouldconstitute the ‘real income’ of the assessee. There was nothing‘hypothetical’ about it as the same apportionment was, in fact, shownby the assessee in its books of account. In appeal, the Commissioner baldly stated that the financecharges computed by adopting the SOD system of accounting wouldbe hypothetical income and such income did not in fact materializeeither by accrual or by receipt. There is however no basis for thisconclusion of the Commissioner. It was for the assessee to apportionthe EMIs towards the principal and interest components and once such apportionment was voluntarily made by the assessee, it wouldconstitute the ‘real income’ of the assessee. There was nothing‘hypothetical’ about it as the same apportionment was, in fact, shownby the assessee in its books of account. It may be noticed that unlike in UNITED COMMERCIALBANK[2], the assessee in the present case was not statutorilycompelled to adopt different systems of accounting. As pointed out bythe assessee itself, adopting of dual systems was only for the purposeof building up its public image by boosting its financial strengths. Asthe practice of those involved in hire purchase and leasingtransactions was to account for such income on the basis of theIndexing System of accounting and as such system was voluntarilyadopted and followed by the assessee itself, there was no valid reasonfor it to resort to a different system of accounting only for taxassessment. I n NAGARJUNA INVESTMENT TRUST LIMITED[1], the hirepurchase agreement did not give the apportionment or bifurcation ofeach equated monthly instalment between the principal and interestcomponents. The Special Bench of the Tribunal was of the opinionthat where the debtor/hirer paid an instalment without specifying orearmarking any amounts towards the principal or interest, the creditoris entitled to appropriate the amount of instalment first towards thepayment of interest and the balance amount towards the principal. TheTribunal found that was what had been precisely done by the hiringcompany in that case on the basis of SOD method in its books ofaccount. Reliance in this regard was placed on the Judgment of theSupreme Court in MEGHRAJ V/s. MST. BAYABAI[[5]],wherein it washeld that the normal rule in the case of a debt due with interest is thatany payment made by the debtor is in the first instant to be appliedtowards the satisfaction of the interest and thereafter to the principal. The Tribunal found that the indexing method/SOD method takes intoaccount the reducing principal amount in each EMI and give a realistic,constant and uniform rate of interest which is the real rate of interestimplicit in the hire purchase agreement. The Tribunal therefore concluded that the finance chargesincome/interest income in relation to hire-purchase agreementsrecognized on the basis of SOD method by the assessee in its booksof account represented the real income accrued to the assessee in therelevant previous year and which, having been apportioned from theamount of equated monthly instalment, also represented the incomereceived/receivable in the relevant accounting year as per the terms ofthe respective hire-purchase agreements. Sri Krishna Kaundinya , learned counsel, sought to draw adistinction between the above decision and the case on hand byplacing reliance on ASHOK LEYLAND FINANCE LIMITED V/s. ASSISTANT COMMISSIONER OF INCOME TAX[[6]]. Therein, aDivision Bench of the Madras High Court was dealing with a casewhich was somewhat similar on facts to the present one. The appellantcompany before the Madras High Court was also engaged in thebusiness of hire-purchase and lease financing. Its annual accountswere maintained in so far as finance charges were concerned on thereducing balance method (indexing method). However, the mercantilesystem of accounting was employed for the return of income as in thepresent case. Sri Krishna Kaundinya , learned counsel, sought to draw adistinction between the above decision and the case on hand byplacing reliance on ASHOK LEYLAND FINANCE LIMITED V/s. ASSISTANT COMMISSIONER OF INCOME TAX[[6]]. Therein, aDivision Bench of the Madras High Court was dealing with a casewhich was somewhat similar on facts to the present one. The appellantcompany before the Madras High Court was also engaged in thebusiness of hire-purchase and lease financing. Its annual accountswere maintained in so far as finance charges were concerned on thereducing balance method (indexing method). However, the mercantilesystem of accounting was employed for the return of income as in thepresent case. Faced with a situation where two systems were adopted foraccounting for the income, the Madras High Court held that the right toreceive an amount under a contract accrues or arises depending uponthe terms of the particular contract. In other words, income has to becomputed even under the accrual system of accounting only on thebasis of accrual as provided for in the agreements evidencing thetransactions. In short, there can be no accrual of income de hors theterms and conditions of the agreement. Viewed in this light, the Madras High Court held that the technique of accounting followed by theassessee (Reducing balance method or the SOD method) in its booksof account for recording the transactions cannot determine the accrualof income. The Court held that accrual would depend on the terms andconditions of the contract between the parties, but not at the whims ofeither party. Upon perusing sample copies of the agreements, theMadras High Court held that it was not open to the assessee to adoptthe SOD method or the reducing balance method when the agreementwas to the contrary. Examination of the above judgment reflects that the case beforethe Madras High Court differed from the present one on crucial factualaspects. The Madras High Court found on facts that the terms of theagreement in that case did not permit adoption of the Indexing Systemof accounting and therefore, use of the said system in the books ofaccounts was held to be contrary to the terms of the contract itself. In the present case, however, there is no indication of theassessee’s hire purchase agreements reflecting bifurcation of the EMIsinto principal and interest components. In the absence thereof, thecommon and accepted usage of the Indexing system of accounting inthe hire purchase trade must be held to be valid as otherwise the rateof interest under the mercantile system in so far as the later EMIs areconcerned would be far higher and contrary to the rate prescribed inthe assessee’s agreements. Further, as the assessee had itselfemployed this system of accounting in its books of account, applyingthe law laid down in SANJEEV WOOLEN MILLS[4], the Departmentwas bound to accept the same for the assessment proceedings. Viewed thus, we are of the opinion that the law laid down by theSpecial Bench of the Income Tax Appellate Tribunal at Hyderabad inNAGARJUNA INVESTMENT TRUST LIMITED[1] was correct. In theevent the hire purchase or leasing agreement did not give theapportionment or bifurcation of the EMIs between the principal and interest components, the interest income in relation to suchagreements, recognized on the basis of SOD system of accounting bythe assessee in its books of account, represents the ‘real income’accrued to the assessee. Reliance placed by the Tribunal on thisjudgment while allowing the Revenue’s appeal in the present casewas therefore justified. The substantial question of law is accordinglyanswered upholding the Revenue’s computation of the assessee’sincome from finance charges and in favour of the Revenue and againstthe assessee. In consequence, the ITTA is dismissed, but in thecircumstances, without any order as to costs. --------------------------------MADAN B.LOKUR, CJ. 7 FEBRUARY, 2012.Note: L.R.Copy to be marked. (B/O) PGS ----------------------------SANJAY KUMAR, J. --------------------------------MADAN B.LOKUR, CJ. 7 FEBRUARY, 2012.Note: L.R.Copy to be marked. (B/O) PGS ----------------------------SANJAY KUMAR, J. *THE HON’BLE THE CHIEF JUSTICE SHRI MADAN B.LOKURANDTHE HON’BLE SHRI JUSTICE SANJAY KUMAR I.T.T.A. NO.10 OF 2000 % 07-02-2012 Sri Chakra Financial Services Limited(Formerly known as PriyadarshiniLeasing and Finances Limited, Hyderabad),Represented by its whole time DirectorSri N.Krishna Mohan. …Appellant Vs. $ The Commissioner of Income-tax,Central, Bangalore. ...Respondent <GIST: >HEAD NOTE: ! Counsel for appellant : Sri A.V.Krishna Koundinya ^ Counsel for respondent : Sri J.V.Prasad ? CASES REFERRED: 1) 1998(62) TTJ (HYD) (SB) 33 = 65 ITD 17 (SB)2) (1999) 240 ITR 355 (SC)3) (1991) 188 ITR 444) (2005) 279 ITR 434 (SC)5) AIR 1970 SC 1616) (1979) 59 TTJ (Mad) 736 [1] 1998(62) TTJ (HYD) (SB) 33 = 65 ITD 17 (SB) [2] (1999) 240 ITR 355 (SC) [3] (1991) 188 ITR 44 [4] (2005) 279 ITR 434 (SC) [5] AIR 1970 SC 161 [6] (1979) 59 TTJ (Mad) 736