Thursday, December 19, 2013

Concept of Real Income Section 5


Concept of Real Income Section 5

Sometimes we may argue We are not going to receive this income it cannot be taxed”.
While it looks correct because of the perception of the person. He thinks what I may not earn I will not pay Income Tax on that part.
But in the view and interpretation of the law something which you might have not received can be taxed. And here comes the section 5.
Scope of total income.
5. (1)     Subject to the provisions of this Act,
 the total income of any previous year of a person
who is a resident includes all income from whatever source derived which—
(a)  is received or is deemed to be received in India in such year by or on behalf of such person ; or
(b)  accrues or arises or is deemed to accrue or arise to him in India during such year ; or
(c)  accrues or arises to him outside India during such year :

Although the concept of real income is well-accepted yet it gives rise to some confusion about what is real income & what is hypothetical income.
The law is very clear about what should be “Income” what we should understand is the meaning of certain words used in the section 5.
(i)     Accrue
(ii)   Arises
The word “Accrue” means to come as an accession, increment or produce, to fall to one by way of advantage, to fall due, to fall as natural growth or increment.

The word “Arise” means to spring up, to come into existence.

The words “Accrue” or “Arise” have been used in the section as contradiction to the word “Received”. And so these does not mean actual receipt of any gain or profit. If an assessee acquires the right to receive the income though received later on said to accrue to him. Unless and until there is created a debt due by somebody in favour of the assessee, it can not be said that he has acquired a right to receive the income or that income has accrued to him.

“When the right to receive the income becomes vested in the assessee, it is said to accrue or Arise.”

It can be said the decisive test as to what is real income one must check thoroughly the contractual obligation of the parties with respect to each transaction.

To clarify the concept elaborately following judgements (Source Taxmann website) are worth noting for the concept of real income:

1        Service charges on delayed payment payable as per contract between parties is liable to tax even if waived of in following accounting year.
Growth Leasing & Finance Ltd. v.Income-tax Officer  [1998] 066 ITD 0067 (AHD.)
Section 5, of the Income-tax Act, 1961 - Income - Accrual of - Assessment year 1988-89 - Assessee-company provided a machinery on lease/with and deferred financing facilities, to Nirlon - Payments were to be made by instalments - As per agreement assessee was entitled to claim service charges on delayed/non-payment of instalments - Nirlon could not pay a number of instalments due to its adverse financial position - Assessee, employing mercantile system of accounting, accounted for instalments amounts on accrual basis but did not account for any service charges - Only after expiry of relevant accounting year assessee-company waived such service charges by entering into another agreement with Nirlon - Whether income on account of service charges due for delayed/non-payment of instalments was taxable on accrual basis - Held, yes

2        Interest on loan along with penal interest on the same are liable to tax even if are due for payment after accounting period.
Tamil Nadu Small Industries Development Corpn. Ltd. v. Commissioner of Income-tax  [2003] 128 TAXMAN 510 (MAD.)
Section 5 of the Income-tax Act, 1961 - Income - Accrual of - Assessment year 1978-79 - Whether in view of clear finding of fact by Tribunal that assessee was following mercantile system of accounting, accrued interest on hire purchase of machinery on loans and penal interest were liable to be included in total income of assessee notwithstanding fact that due dates of payment fell after 31st of March of relevant previous year - Held, yes

3        Doubtful recovery will not conclude that in reality income has not accrued.
S.R. Doshi Finance & Investment (P.) Ltd. v. Assistant Commissioner of Income-tax  [2000] 75 ITD 434 (MUM.) (SMC-III
Section 5 of the Income-tax Act, 1961 - Income - Accrual of - Assessment year 1991-92 - Assessee did not credit lease rentals accrued to it from a lessee along with interest on overdue rentals - Assessee had neither surrendered or given up such income - Whether assessee having accepted that income had accrued but its recovery was doubtful, mere doubt about recovery would not lead to conclude that in reality income had not accrued to assessee when assessee was following mercantile method of accounting - Held, yes - Whether, therefore, addition of lease rentals and interest was justified - Held, yes

4        Subsequent waiver does not stop accrual of income.
H.P. Mineral & Ind. Development Corpn. v.Commissioner of Income-tax  [2008] 302 ITR 120 (HP)
Where assessee was following mercantile system of accounting, interest accrued to it on advance was chargeable on accrual basis and merely because it was waived by a resolution of Board passed after close of accounting year, that would not stop its accrual on basis of real income thereof.

5        Interest on default of payment of instalment chargeable as per agreement between the parties not waived off during the accounting period is accrued income to the assessee and taxable.
Naik Wvg. Mills v. Income-tax Officer  [2000] 74 ITD 401 (PUNE)
Section 5 of the Income-tax Act, 1961 - Income - Accrual of - Assessment year 1990-91 - Assessee-firm was following mercantile system of accounting - It entered into a development agreement with a party in respect of a plot - Consideration was to be paid in instalments and clause 6 of aforesaid agreement provided that in case of default in payment of instalment, interest was to be paid to assessee - Other party committed a default in payment of instalment due to be paid during accounting year relevant to assessment year 1990-91 - Assessee did not include interest accrued in respect of such instalment in its income shown for assessment year 1990-91 - Whether as there was neither any request for waiver of interest from other party nor decision was taken by assessee to waive such interest income before end of relevant accounting period, it could be said that interest income accrued to assessee for period of default and same was assessable in its hands in assessment year 1990-91 - Held, yes

6        Interest on doubtful advances is realincome as have been accrued to the assessee and liable to tax.
SUPREME COURT OF INDIA State Bank of Travancore v.Commissioner of Income-tax [1986] 24 TAXMAN 337 (SC)
Section 5, read with section 145, of the Income-tax Act, 1961 - Income - Accrual of -Assessee-bank, following mercantile system of accounting, charged interest on advances considered doubtful of recovery, called sticky advances by debiting concerned parties but, instead of carrying it to profit and loss account, credited it to separate account styled 'Interest suspense account' In its return assessee disclosed such interest separately and claimed that same was not taxable in its hands as income of concerned years - Whether in view of concept of real income, impugned interest, which had accrued to assessee, could be excluded from assessee's taxable income of concerned years - Held, no

In the above decision of the supreme court the court in case of SB of Travancore the concept of real income has been thoroughly elaborated and established following conclusions (extracts of various para of the decision):

1        The question of how far the concept of real income entered into the question of taxability in the facts and circumstances of this case and how far and to what extent the concept of real income should intermingle with the accrual of income will have to be judged in the light of the provisions of the Act, the principles of accountancy recognised and followed the feasibility. The earlier circulars, being executive in character, could not alter the provisions of the Act. An acceptable formula of correlating the notion of real income in conjunction with the method of accounting for the purpose of computation of income for the purpose of taxation is difficult to evolve. Besides, any strait-jacket formula is bound to create problems in its application to every situation. It must depend on the facts and circumstances of each case when and how income accrues and what consequently follow from the accrual of income. Whether an accrual has taken place or not must, in appropriate cases, be judged on the principles of real income theory.
2        After accrual, non-charging of tax on the same because of certain conduct based on the ipse dixit of a particular assessee cannot be accepted.
3        In determining the question whether it is hypothetical income or whether real income has materialised or not, various factors will have to be taken into account…, but once the accrual takes place, on the conduct of the parties subsequent to the year of closing, an income which has accrued cannot be made 'no income'.
4        It is the income which has really accrued or arisen to the assessee that is taxable. Whether the income has really accrued or arisen to the assessee must be judged in the light of the reality of the situation.
5         The concept of real income would apply where there has been a surrender of income which in theory may have accrued but in the reality of the situation no income had resulted because the income did not really accrue.
6         Where a debt has become bad, deduction in compliance with the provisions of the Act should be claimed and allowed.
7         Where the Act applies, the concept of real income should not be so read as to defeat the provisions of the Act.
8         If there is any diversion of income at source under any statute or by overriding title, then there is no income to the assessee.
9        The conduct of the parties in treating the income in a particular manner is material evidence of the fact whether income has accrued or not.
10     Mere improbability of recovery, where the conduct of the assessee is unequivocal, cannot be treated as evidence of the fact that income has not resulted or accrued to the assessee. After debiting the debtor's account and not reversing that entry, but taking the interest merely in suspense account, cannot be such evidence to show that no real income has accrued to the assessee or has been treated as such by the assessee.
11    The concept of real income is certainly applicable in judging whether there has been income or not, but in every case it must be applied with care and within well-recognised limits, and must not be called in aid to defeat the fundamental principles of law of income-tax as developed.

The above discussions elaborate a very simple concept of Real income and how it can affect taxability due to some contractual obligations.

Hence some contractual obligations yet not meant to earn a direct income but made for efficient recovery or mode of penal charges for delay payments or deferment due to uncertainty might trigger the concept of real income and one might hive to charge the same as income even if it has not been received by the assessee. ____________________________________________________________________
For suggestions and feedback please feel free to contact us via e-mail; dhruvjainassociates@yahoo.co.in or you can log on to our website: http://dhruvjainassociates.in/contact
___________________________________________________________________________________
This blog is the property of Dhruv Jain & Associates. Any form of reproduction, dissemination, copying, disclosure, modification, distribution and/or publication of the content of blog or of the blog itself  without the prior written consent of the author of this blog is strictly prohibited and doing so will attract legal proceedings. Any views or opinions presented in this blog post are solely those of the author and for informative purpose only and should not be treated /used as guiding rule or professional consultancy in any case. The matter of discussion is highly sensitive to the amendments made by the government under various laws and may not be updated as per the changes. Readers are suggested to take prior professional consultancy of experts before using the blog or its material in any way.
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Tuesday, July 2, 2013

Section 36(1)(vii) Bad Debts, Provisions and NBFCs


Section 36(1)(vii) Bad Debts, Provisions and NBFCs

Deduction of Bad Debts under income tax Act is a very simple issue yet it gets complex for various entities. Mostly complexity arises when it is confused with the term “Provision”.

Section 36(1)(vii):-

Subject to sub-section (2)

The amount of

ANY BAD DEBT or

Part Thereof

Which is written off as irrecoverable

In the Accounts of the assessee

FOR the Previous year.

Explanation:-

Any bad debt or part thereof written off

SHALL NOT include

Any PROVISION for bad & doubtful debts.

The section itself specifically excludes the amount of Provision to be allowed as deduction.

However section 36(1)(viia) allows the deduction for any provision for bad & doubtful debt for a specified amount but only for:
·        Schedule Banks (not being incorporated outside India), Non-schedule Bank(under banking regulation Act, 1949), Co-operative Bank other than primary agricultural society or a primary co-operative agricultural & rural development bank.
·        Bank incorporated outside India
·        Public Financial Institution, State Financial corporation, State industrial investment corporation.

Here conflict arises for NBFC’s. Since section 36(1)(viia) does not include NBFCs and Explanation to section 36(1)(vii) squarely applies hence NBFCs are not entitled to deduction of any provision created for bad and doubtful debts, no matter such provision is created based on the guidelines issued by the RBI.

The issue whether NBFCs are allowed deduction for provision of bad debts has been debated for long. But there are various judgments clarifying the issue.

In the case of Art Leasing Ltd. v. Commissioner of Income-tax*, Kottayam [2010] 187 Taxman 29 (KER)/[2010] 229 CTR 272 (KER) the same issue was discussed in detail and held as below:

“Section 36(1)(vii) of the Income-tax Act, 1961 - Bad debts - Assessment years 1997-98 to 2000-01 – Whether Parliament is well aware of risk undertaken by banks in making advance to rural sector in terms of guidelines issued by Government and RBI and only such cases are treated as exceptions to general provision contained in Explanation to section 36(1)(vii), which prohibit granting of deduction of any provision for bad and doubtful debts - Held, yes –

Whether NBFCs are not covered by section 36(1)(viia) and, therefore, they are not entitled to deduction of any provision created for bad and doubtful debts, no matter such provision is created based on guidelines issued by RBI - Held, yes

Section 45Q of the Reserve Bank of India Act, 1934 - Chapter III-B to override other laws - Whether ‘any other law’ referred to in section 45Q does not cover Income-tax Act which applies to all assessees in computation of taxable income - Held, yes
….                                       …..                                           …..                   ……

“…..In fact, section 36(1)(viia) is a complete answer to this query raised by the appellant wherein special provisions are made in the Income-tax Act for allowing provision for bad and doubtful debts of scheduled banks, non scheduled banks, co-operative banks, etc., to the extent permissible there under. In fact, under section 36(1)(viia), the eligible Banks are authorised to create provision subject to certain limits in respect of rural advances and other loans referred to therein and claim deduction of the same. This provision clearly indicates that Parliament is well aware of the risk undertaken by the Banks in making advance to the rural sector in terms of the guidelines issued by the Government and the RBI and only such cases are treated as exception to the general provision contained in Explanation to section 36(1)(vii), which prohibits granting of deduction of any provision for bad and doubtful debts. Unfortunately, for the appellant NBFCs are not covered by section 36(1)(viia) of the Income-tax Act and so much so, Explanation to section 36(1)(vii) squarely applies or in other words, the appellant NBFCs are not entitled to deduction of any provision created for bad and doubtful debts, no matter such provision is created based on the guidelines issued by the RBI..

Further in the leading decision of the case of Southern Technologies Ltd. v.Joint Commissioner of Income-tax* , Coimbatore [2010] 187 TAXMAN 346 (SC) the issues related to provision for doubtful debts were discussed in depth and held as under concluding that provision of bad debts is not allowable deduction for NBFCs.

“Section 36(1)(vii) of the Income-tax Act, 1961, read with the NBFCs Prudential Norms (Reserve Bank) Directions, 1998 - Bad debts - Whether 1998 Directions deal only with presentation of NPA provisions in balance sheet of a NBFC and they have nothing to do with computation or taxability of provisions for NPAs under Income-tax Act - Held, yes –

Whether provision for NPAs in terms of 1998 Directions constitutes expense on basis of which deduction can be claimed by NBFCs under section 36(1)(vii) - Held, no –

Whether even applying theory of real income, a debit, which is expressly disallowed by Explanation to section 36(1)(vii), if claimed, has got to be added back to total income of assessee, because Act seeks to tax ‘real income’ which is income computed according to ordinary commercial principles but subject to provisions of Act - Held, yes

Section 36(1)(vii), read with section 43D, of the Income-tax Act, 1961 - Bad debts - Whether sections 36(1)(vii) and 43D are violative of articles 14 and 19 of Constitution - Held, no
Section 37(1) of the Income-tax Act, 1961 - Business expenditure - Allowable as - Whether section 37 applies only to items which do not fall in sections 30 to 36; if a provision for doubtful debt is expressly excluded from section 36(1)(vii), then such a provision cannot be claimed as a deduction under section 37 even on basis of ‘real income theory’ - Held, yes” 

    
After going through the above cases, situation gets clear that provision for bad debts is not allowable deduction.

Now for the clarity of accounting treatment differentiating between provision & bad debts write off, some more judgements have been reproduced below:

The writing off of the bad debts, without charging the same in the profit & loss account is not writeoff at all- CIT V. Hotel Ambassador 2002 121 taxmann 437 (Ker.)

Where the amount has been claimed as provision for bad and doubtful debt and is not written off in the accounts of various persons, the same would not be allowable as deduction. Even RBI Guidelines would not override this provision of income tax Act- ITO v. Maruti Countrywide Auto financial services P Ltd. 2008, 20 SOT 237 (Delhi)

It is not obligatory for assessee to place demonstrative proof for establishing a debt as bad- Ajitkumar C. Kamdar v. CIT 2005, 1 SOT 183 (MUM)

Hence with the above detailed discussion following checks can be concluded for bad debts:

·        There must be a debt i.e. existence of relationship of debtor & creditor.
·        Debt must be incidental to the business or profession of the assessee
·   Debt must have been taken into account in computing assessable income [This condition is not relevant if bad debts represent money lent in the ordinary course of money-lending or banking business sec 36(2)(i)].
·        Entire debt need not to be considered.
·        Debt must have been actually written off in the books of accounts of the assessee.
·        No allowance for Bad debt of a business which has been discontinued before the commencement of the previous year.
____________________________________________________________________
For suggestions and feedback please feel free to contact us via e-mail; dhruvjainassociates@yahoo.co.in or you can log on to our website: http://dhruvjainassociates.in/contact
___________________________________________________________________________________
This blog is the property of Dhruv Jain & Associates. Any form of reproduction, dissemination, copying, disclosure, modification, distribution and/or publication of the content of blog or of the blog itself  without the prior written consent of the author of this blog is strictly prohibited and doing so will attract legal proceedings. Any views or opinions presented in this blog post are solely those of the author and for informative purpose only and should not be treated /used as guiding rule or professional consultancy in any case. The matter of discussion is highly sensitive to the amendments made by the government under various laws and may not be updated as per the changes. Readers are suggested to take prior professional consultancy of experts before using the blog or its material in any way.
___________________________________________________________________________________

Wednesday, May 8, 2013

2(22)(e) Deemed Dividend a Study


Section 2 (22) (e) Deemed Dividend a Study

2 (22) (e)  "dividend" includes—
any payment by
a company, not being a company in which the public are substantially interested,
of any sum
by way of advance or loan
to a shareholder
who is the beneficial owner of shares
(not being shares entitled to a fixed rate of dividend whether with or without a right to participate in profits)
holding not less than ten per cent of the voting power,
or to any concern
in which such shareholder is a member or a partner
and in which he has a substantial interest ie. entitled to not less than 20% of the income)
or any payment
by any such company
on behalf, or for the individual benefit
of any such shareholder
to the extent to which the company in either case possesses accumulated profits

but "dividend" does not include

(ii)  any advance or loan made to a shareholder  [or the said concern] by a company in the ordinary course of its business, where the lending of money is a substantial part of the business of the company ;

The plain reading of the section brings the taxability of accumulated profits which are distributed by closely held companies to its shareholders in form of loans and advances. The intent of the section is to curb the practice adopted by closely held companies of avoiding tax on dividend in the hands of the share holders by giving them as loans & advances.

But the section alone is not as clear as it seems, for following reasons:

Definition of Loan?
Definition of Advance?   
Type of Loan?
Period for taxation?

If the section is applied without through understanding of above terms the section can include a lot of transactions as deemed dividend which actually should not be so treated. Since the terms have not been defined in the act the meaning for the same & intent of the legislature has to be construed from various judicial pronouncements as summarised here under.
  
LOAN & ADVANCE

A Loan is defined by the Oxford English Dictionary as " a thing lent; something the use of which is allowed for a time, on the understanding that it shall be returned or an equivalent given ; esp., a sum of money lent on these conditions and usually with interest."

In Suradindu Sekhar v. Lalit Mohan Mazumdar money was due to the plaintiff and the defedant had executed a bond in respect thereof. The defendat claimed relief under the Bengal Money Lenders Act. The Court said, "leaving the purchase money unpaid is leaving a debt unpaid. Every loan is a debt but every debt is not a loan. The purchase money due to the plaintiff is a debt due to the plaintiff but is not a loan or a transaction which is in substance a loan"

Similarly in the case of Dr. Fredie Ardheshir Mehta v. Union of India [1991] 70 Comp. Cas.
210 (Bom) it was decided that  The essential requirement of a loan is the advance of money (or of some article) upon the understanding that it shall be returned, and it may or may not carry interest.

Therefore there should be actual flow of money along with the understanding that it should be paid back. Also interest on loan should not be considered as loan.

The term Advance has undoubtedly a wide meaning depending on the context in which it is used. In its widest meaning it may or may not include lending or obligation of repayment.

In the case of CIT v Raj Kumar [2009] 181 taxman 155/318 ITR 462 (delhi) the answer was given in detail by applying rule of noscitur a sociis it is a legitimate rule of construction to construe words in an Act of Parliament with reference to words found in immediate connection with them".

Hence the word advance which is in with the word loan could only mean such advance which bear with it an obligation of repayment.

Type of Loan

Loan can be in kind also. M.D. Jindal v. CIT [1986] 28 Taxman 509 (cal.)

Period for Taxation

As per section 8(a) deemed Dividend accrues in the previous year in which the payment is made. Hence payments made in current year are covered and any outstanding balances have to be ignored.  

Various Judicial Pronouncements for Better Understanding

There should be actual outflow of money as loan or advance from the company, mere creation of debtor & creditor relationship between company and the assessee will not be enough. CIT v. G. Venkataraman [1975] 101 ITR 673 (Mad.)

Actual amount received as loan alone is taxable as dividend. CIT v Parle Plastics Ltd. [2011] 196 taxman 62 (Bom.)

Trade Advances are not covered. CIT v. Raj Kumar [2009] 181 taxman 155/318 itr 462 (delhi).

Payments made towards personal liability of the shareholder are also covered. CIT v. K. Srinivasan [1963] 59 ITR 788 (Mad.)

Inter-corporate deposits shall not be treated as deemed dividend. Bombay Oil Industries Ltd. v. DCIT (2009) 28 SOT 383 (Mum)

If the amount does not bear the characteristic of loan and advance section 2(22)(e) shall not be applicable. CIT v. creative Dyeing & Printing P Ltd [2009] 184 Taxman 483 (Delhi).

Share Application money received by closely held company can not be treated as deemed dividend. Ardee Finvest P Ltd. V. CIT [2001] 79 ITD 547 Delhi).

Loan on behalf of the assessee are also assessable as deemed dividend. L. Alagusundaram Chettiar v. CIT [2002] 121 Taxman 587 (SC).

Payment on Behalf of Shareholders are also covered. CIT v. K. Srinivasan [1963] 50 ITR 788 (Mad.).
____________________________________________________________________
For suggestions and feedback please feel free to contact us via e-mail; dhruvjainassociates@yahoo.co.in or you can log on to our website: http://dhruvjainassociates.in/contact
___________________________________________________________________________________
This blog is the property of Dhruv Jain & Associates. Any form of reproduction, dissemination, copying, disclosure, modification, distribution and/or publication of the content of blog or of the blog itself  without the prior written consent of the author of this blog is strictly prohibited and doing so will attract legal proceedings. Any views or opinions presented in this blog post are solely those of the author and for informative purpose only and should not be treated /used as guiding rule or professional consultancy in any case. The matter of discussion is highly sensitive to the amendments made by the government under various laws and may not be updated as per the changes. Readers are suggested to take prior professional consultancy of experts before using the blog or its material in any way.
___________________________________________________________________________________