COMMISSIONER OF INCOME TAX-VI versus VIRTUAL SOFT SYSTEMS LTD.

Citation: [2018] 5 S.C.R. 595 · Decided: 24-04-2018 · Supreme Court of India · Bench: R.K. AGRAWAL · Disposal: Appeal(s) allowed

Judgment (excerpt)

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COMMISSIONER OF INCOME TAX-VI
v.
VIRTUAL SOFT SYSTEMS LTD.
(Civil Appeal No. 4358 of  2018)
APRIL 24, 2018
[R. K. AGRAWAL AND ABHAY MANOHAR SAPRE, JJ.]
Income Tax Act, 1961 –  Deduction on account of lease
equalization charges from lease rental income – Entitlement for –
Held: 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, there is
no express bar in the IT Act which bars the bifurcation of the lease
rental – This bifurcation is analogous to the manner in which a
bank would treat an EMI payment made by the debtor on a loan
advanced by the bank – The repayment of principal would be a
balance sheet item and not a revenue item – Only the interest earned
would be a revenue receipt chargeable to income tax – Hence,  whole
revenue from lease would not be subjected to tax under the IT Act –
Respondent is entitled for bifurcation of lease rental as per the
accounting standards prescribed by the ICAI – Chartered
Accountants Act, 1949.
Chartered Accountants Act, 1949 –  Guidance note issued by
the Institute of Chartered Accountants of India (ICAI) – Reliability
of – Held: ICAI is a recognized expert body vested with the
authority to recommend accounting standards – The method of
accounting followed, as derived from the ICAI’s Guidance Note, is
a valid method of capturing real income based on the substance of
finance lease transaction.
Companies Act, 1956 –  s.211 – Accounting standards as
prescribed by ICAI to prevail until the accounting standards are
prescribed by the Central Government.
   [2018] 5 S.C.R. 595
  595
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SUPREME COURT REPORTS
[2018] 5 S.C.R.
Disposing of the appeals, the Court
HELD: 1.1 The ICAI is an expert body, created by the
Parliament under the Chartered Accountants Act, 1949. The
ICAI’s publication on the subject indicates that the Guidance
Note on Accounting for Leases was issued by it for the first time
in 1988 which was later on revised in 1995. The Guidance Note
reflects the best practices adopted by the accountants throughout
the world. The ICAI is a recognized body vested with the
authority to recommend accounting standards for ultimate
prescription by the Central Government in consultation with the
National Advisory Committee of Accounting Standards for the
presentation of true and fair financial statements. [Para 8]
[601-C-D]
1.2 Section 211 of the Companies Act, 1956 as it stood
before the amendment dealt with “the Form and contents of
balance-sheet and profit and loss account”. Sub clause (3C) of
Section 211 was added vide 1999 amendment with retrospective
effect.  The purpose behind the amendment in Section 211 of the
Companies Act, 1956 was to give clear sight that the accounting
standards, as prescribed by the ICAI, shall prevail until the
accounting standards are prescribed by the Central Government
under this sub-section. The purpose behind the accounting
standards was to arrive at a computation of real income after
adjusting the permissible deprecation. It is not disputed that these
accounting standards are made by the body of experts after
extensive study and research. [Paras 9, 10] [601-E; 602-A-B]
2.1 The method of accounting provided in the Guidance
Note of 1995, on the one hand, adjusts the inflated cost of interest
of the assets in the balance sheet. Secondly, it captures “real
income” by separating the element of capital recovery (essentially
representing repayment of principal amount by the lessee, the
principal amount being the net investment in the lease), and the
finance income, which is the revenue receipt of the lessor as
remuneration/reward for the lessor’s investment. As per the
Guidance Note, the annual lease charge represents recovery of
the net investment/fair value of the asset lease term. The finance
income reflects a constant periodic rate of return on the net
investment of the lessor outstanding in respect of the finance
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lease. While the finance income represents a revenue receipt to
be included in income for the purpose of taxation, the capital
recovery element (annual lease charge) is not classifiable as
income, as it is not, in essence, a revenue receipt chargeable to
income tax. [Para 12] [604-C-E]
2.2 The method of accounting followed, as de

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