One of the most
important deductions permissible under income tax law in relation to capital
assets is depreciation. Under the general scheme of the Income tax Act, particularly
section 32, depreciation is allowed to an assessee who is the owner of a
capital asset used for the purposes of business. The criterion of “ownership”
is given a slightly more liberal scope under tax law. Assessees can make
use of this relaxed understanding in structuring their transactions so as to
gain the benefit of depreciation. One such device used is that of sale and
lease back transactions. Such transactions often come under the scrutiny of revenue
authorities as being not genuine. In this context, the question of claim of
depreciation in the case of leasing transactions assumes importance. A couple
of recent decisions have provided some measure of clarity in this regard.
important deductions permissible under income tax law in relation to capital
assets is depreciation. Under the general scheme of the Income tax Act, particularly
section 32, depreciation is allowed to an assessee who is the owner of a
capital asset used for the purposes of business. The criterion of “ownership”
is given a slightly more liberal scope under tax law. Assessees can make
use of this relaxed understanding in structuring their transactions so as to
gain the benefit of depreciation. One such device used is that of sale and
lease back transactions. Such transactions often come under the scrutiny of revenue
authorities as being not genuine. In this context, the question of claim of
depreciation in the case of leasing transactions assumes importance. A couple
of recent decisions have provided some measure of clarity in this regard.
In IndusInd Bank v. ACIT, ITA 6566/Mum/2002,
a Special Bench of the Tribunal had to consider whether depreciation would be
allowed to the lessor or to the lessee. The facts were that the assessee, a
bank, entered into an agreement with another company under which the assessee
was lease out a boiler to the company for a specific fixed period, subject to
payment of lease rent. After the expiry of the period, the asset was to be sold
to the company. The assessee bank claimed depreciation on the boiler. The Assessing
Officer did not accept this claim on the ground that the transaction was merely
a paper transaction. At best, according to the assessing officer, the transaction
could be categorized as a finance lease and not an operating lease.
The Special Bench noted that in substance, a finance lease is akin to a loan
from the lessor to the lessee. After examining the decision of the Supreme
Court in Asea Brown Boveri v. IFCI 54
Taxman 512 (SC), and Association of Leasing
& Financial Services Companies v. Union of India , and relying on Accounting
Standard – 19, the Special Bench noted the broad features of a finance lease as
under (para 5.14 of the order of the Bench):
–
A finance lease is non-cancelable, and there is a fixed
obligation on the lessee for payment of lease rent for the period of the lease.
If the lease is terminated prematurely by the lessee, the lessor is entitled to
recover his investment along with expected interest.
A finance lease is non-cancelable, and there is a fixed
obligation on the lessee for payment of lease rent for the period of the lease.
If the lease is terminated prematurely by the lessee, the lessor is entitled to
recover his investment along with expected interest.
–
A finance lease is always for a fixed period. This
period is calculated by taking into consideration the economic life of the
asset; and is settled in such a way so as to fully recover the investment of
the lessor together with interest.
A finance lease is always for a fixed period. This
period is calculated by taking into consideration the economic life of the
asset; and is settled in such a way so as to fully recover the investment of
the lessor together with interest.
–
The lessor is interested in the recoupment of his
investment with interest in
the shape of rentals over the period of lease, and not really with the asset itself
or its user.
The lessor is interested in the recoupment of his
investment with interest in
the shape of rentals over the period of lease, and not really with the asset itself
or its user.
–
The lessee bears the responsibility of costs of
insurance, repairs, maintenance etc. The features of bailment are absent. An
operating lease, on the other hand, has the features of bailment. In a finance
lease, the responsibility of the lessee is not restricted only to taking “as
much care as a man of ordinary prudence would” as warranted under section 151
of the Contract Act, but extends beyond this threshold.
The lessee bears the responsibility of costs of
insurance, repairs, maintenance etc. The features of bailment are absent. An
operating lease, on the other hand, has the features of bailment. In a finance
lease, the responsibility of the lessee is not restricted only to taking “as
much care as a man of ordinary prudence would” as warranted under section 151
of the Contract Act, but extends beyond this threshold.
–
The equipment is chosen by the lessee, but the payment
to the supplier is made by the lessor. Thus, the lessee chooses the assets,
takes delivery, enjoys the
use of the asset, and bears the risks and costs of its wear and tear, taxes/charges
in relation to the asset etc. The risks and rewards incidental to ownership vest
with the lessee and not with the lessor. The lessor simply holds the title of asset
by way of security for recouping the investment and interest.
The equipment is chosen by the lessee, but the payment
to the supplier is made by the lessor. Thus, the lessee chooses the assets,
takes delivery, enjoys the
use of the asset, and bears the risks and costs of its wear and tear, taxes/charges
in relation to the asset etc. The risks and rewards incidental to ownership vest
with the lessee and not with the lessor. The lessor simply holds the title of asset
by way of security for recouping the investment and interest.
The Special
Bench further noted that in the case of an operating lease, a lessor can claim
depreciation; however, in the case of a finance lease, only the lessee would be
entitled to claim depreciation. The Tribunal noted that even for the purposes of
tax law, “In a lease transaction also
there can be only one owner of the asset, that is, either the lessor or lessee
and not both of them or either of them at their discretion. Whereas in the case
of operating lease, it is the lessor who is the real owner of the asset, but in
case of finance lease, it is the lessee who is to be regarded as the real owner
of the asset. Ex consequenti only the lessor can claim depreciation in case of
an operating lease and the lessee, as to who should be conferred the benefit of
deprecation allowance.”
Bench further noted that in the case of an operating lease, a lessor can claim
depreciation; however, in the case of a finance lease, only the lessee would be
entitled to claim depreciation. The Tribunal noted that even for the purposes of
tax law, “In a lease transaction also
there can be only one owner of the asset, that is, either the lessor or lessee
and not both of them or either of them at their discretion. Whereas in the case
of operating lease, it is the lessor who is the real owner of the asset, but in
case of finance lease, it is the lessee who is to be regarded as the real owner
of the asset. Ex consequenti only the lessor can claim depreciation in case of
an operating lease and the lessee, as to who should be conferred the benefit of
deprecation allowance.”
Further
examining the terms of the agreement between the parties, the Special Bench held
that the lease agreement was a paper transaction to cover up the reality. The
bench noted, following the decision of the Supreme Court in Sundaram Finance Limited v. State of Kerala
AIR 1966 SC 1178, “The true effect of a
transaction may be determined from the terms of the agreement considered in the
light of the surrounding circumstances. In each case the Court has, unless
prohibited by the statute, power to go beyond the document and to determine the
nature of transaction, whatever may be the form of the document…”
examining the terms of the agreement between the parties, the Special Bench held
that the lease agreement was a paper transaction to cover up the reality. The
bench noted, following the decision of the Supreme Court in Sundaram Finance Limited v. State of Kerala
AIR 1966 SC 1178, “The true effect of a
transaction may be determined from the terms of the agreement considered in the
light of the surrounding circumstances. In each case the Court has, unless
prohibited by the statute, power to go beyond the document and to determine the
nature of transaction, whatever may be the form of the document…”
The Delhi High
court also recently considered the question of when an agreement should be
considered as a finance lease and when it should be considered as an operating
lease. The Court reaffirmed that the question could not be decided by merely looking
at the title, nomenclature or label given to the agreement: the terms and conditions
of the Agreement are relevant but not conclusive. Surrounding circumstances can
look at. The court followed Sundaram
Finance, which in turn had relied on the following observation of Lord
Esher MR in Re Watson “…When the transaction is in truth merely a
loan transaction, and the lender is to be repaid his loan and to have a
security upon the goods, it will be unavailing to cloak the reality of the transaction
by a sham purchase and hiring. It will be a question of fact in each case
whether there is a real purchase and sale complete before the hiring agreement.
If there be such a purchase and sale in fact and afterwards the goods are
hired, the case is not within the Bills of Sale Act. The document itself must
be looked at as part of the evidence, but it is only part, and the Court must
look at the other facts and ascertain the actual truth of the case.”
court also recently considered the question of when an agreement should be
considered as a finance lease and when it should be considered as an operating
lease. The Court reaffirmed that the question could not be decided by merely looking
at the title, nomenclature or label given to the agreement: the terms and conditions
of the Agreement are relevant but not conclusive. Surrounding circumstances can
look at. The court followed Sundaram
Finance, which in turn had relied on the following observation of Lord
Esher MR in Re Watson “…When the transaction is in truth merely a
loan transaction, and the lender is to be repaid his loan and to have a
security upon the goods, it will be unavailing to cloak the reality of the transaction
by a sham purchase and hiring. It will be a question of fact in each case
whether there is a real purchase and sale complete before the hiring agreement.
If there be such a purchase and sale in fact and afterwards the goods are
hired, the case is not within the Bills of Sale Act. The document itself must
be looked at as part of the evidence, but it is only part, and the Court must
look at the other facts and ascertain the actual truth of the case.”
At the same
time, these observations must not be treated as giving complete freedom to the
revenue to ignore the wording of the contract between the parties: the Madras
High Court recently clarified (CIT v. M/s
High Energy Batteries, T.C. 579/2005, decided on 17th April,
2012; a decision in the context of a reopening of assessment where the Revenue’s
stance was that a sale and lease back transaction was not genuine), “Given the freedom to enter into agreements
with parties and guided by commercial considerations, even to invoke the theory
of tax evasion, the Revenue must have sufficient material to draw an inference
of what had been shown as an understanding on an agreement between the parties,
is not, in fact, so.”
time, these observations must not be treated as giving complete freedom to the
revenue to ignore the wording of the contract between the parties: the Madras
High Court recently clarified (CIT v. M/s
High Energy Batteries, T.C. 579/2005, decided on 17th April,
2012; a decision in the context of a reopening of assessment where the Revenue’s
stance was that a sale and lease back transaction was not genuine), “Given the freedom to enter into agreements
with parties and guided by commercial considerations, even to invoke the theory
of tax evasion, the Revenue must have sufficient material to draw an inference
of what had been shown as an understanding on an agreement between the parties,
is not, in fact, so.”
It is thus clear from these decisions that the distinction between operating
leases and finance leases (clarified by the Supreme Court in ABB’s case) is relevant in income tax law
as well, and suitable care needs to be taken in structuring transactions and
drafting the agreements to avail of appropriate tax benefits.
Excellent analysis Mihir.
In the cited Madras HC case, the issue whether on the facts it was a financelease or opertaing lease does not appear to have been gone into. The decision in assessee's favour is on different grounds.
Briefly commented @ http://vswaminathan-vswaminathan-swamilook.blogspot.in/2012/05/voda-once-more.html
(may be contd.)
(
Thanks for your comments.
Regarding the Madras High Court decision, it turns on a finding that the reopening was based on a change of opinion, and therefore not sustainable. However, after giving the finding on change of opinion, the High Court says, "Quite apart from this aspect, we have no hesitation in rejecting the Revenue's appeal on the merits of the reassessment relating
to the assessment year 1995-96 as well as in respect of the assessment years 1996-97 and
1997-98."
Thus, the High Court did consider the merits too, and considered the genuineness of the leasing transaction. The High Court has also considered the effect of several Supreme Court judgments (including Vodafone) on 'sham transactions'.
The concluding statement of the High Court reads, "On
a perusal of the documents produced, we have no hesitation in confirming the order of the
Tribunal, both on the question of jurisdiction to reopen the assessment for the assessment
year 1995-96 and on the merits of the claim in respect of the three assessment years viz.,
1995-96 to 1997-98."
Thus, the primary ground (change o0f opinion) as well as on the merits – regarding sham transaction – the issue was decided in favour of the assessee.
But there are tons of High Court judgments (Guj, Orissa, Kolkata, Madras) on sale-and-lease back transactions which hold that the lessor is entitled to depreciation as long as it is not a sham transaction… Does this judgment consider those?
I think the SB's holding would be read as meaning that a finance lease is not really a lease in the sense of the cases where the lessor is allowed depreciation.
High Court judgments (Guj, Orissa, Kolkata, Madras) on sale-and-lease back transactions which hold that the lessor is entitled to depreciation as long as it is not a sham transaction .This judgment is considerable now