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Depreciation on leasing ? An ageing puzzle
September, 03rd 2007
Under the Income Tax law, two most important conditions for tax depreciation claim pertain to ownership and usage of the asset. As is the case on any other contentious matter, history is replete with judicial pronouncements by courts on this subject. Though the condition on usage is more or less a settled issue, ownership condition still continues to keep the judiciary engaged particularly as new models of businesses are evolving. Entitlement of depreciation in a lease transaction has witnessed the maximum debate in recent times. The moot question being who shall be eligible to claim depreciation in a lease transaction whether the lessor (person who hires or leases the asset for a consideration ) or the lessee (who hires for business use).
Before we dwell on leasing transactions, I must add that the issue on hire purchase is a law which has been settled way back in 1943. An administrative circular clarifies that where the terms of agreement provide that the asset shall eventually become the property of the hirer or confer on the hirer an option to buy the asset, the transaction shall be regarded as one of hire-purchase and he would be entitled to depreciation. The administrative guideline was predominantly dealing with a situation of a movable asset, though, without any specific reference.
On the other hand, a land mark Supreme Court judgement in 1999 in the case of Mysore Minerals clarified that the condition of ownership must be assigned a wider meaning any one in possession of property in his own title exercising such dominion over the property as would enable others being excluded and having right would be the owner. The fact that a formal deed was not executed and registered under the law would not be of relevance. In one stroke, the apex court diluted the definition of ownership and took a liberal view. Of course, the law was subsequently amended to provide that insofar as the condition for legal ownership of an immovable property is concerned.
In common parlance, a lease is understood as hiring of an asset for a periodic payment; parties involved in the transaction are classified as lessor and lessee whilst the periodic payment to be made by lessee is termed as lease rental. From an accounting standpoint, simplistically, lease can be classified in three forms finance lease, operating lease and hire purchase. A lease is classified as a finance lease if it is for the entire economic life of the asset and under the lease arrangement all risks and rewards incidental to the ownership of the asset is transferred to the lessee.
The International Accounting Standards Committee defines finance lease as an arrangement where all the risks and rewards incident to ownership of an asset are with the lessee. Any lease other than a finance lease is operating lease. On the other hand, if under the lease agreement, the lessee/hirer has an option to acquire the asset at the end of the identified lease period, such arrangement shall classify as hire purchase. Interestingly, the last part of definition is in conformity with the 1943 Board guideline, thereby suggesting the wisdom of the Indian administration.
Admittedly, the line of distinction between a finance lease and a hire purchase is blurred and leaves a lot to interpretation. Interestingly, the interpretation of various forms of lease has been ratified and applied by different courts from time to time; the determination of whether a lease is a finance lease or operating lease or is in the nature of a hire purchase arrangement depends on the facts and substance of the transaction rather than the form of such arrangement. Indian Accounting Standard 19 on Leases provide that in case of an operating lease, the lessor shall be eligible to claim depreciation in respect of leased asset; whereas in a finance lease the lessee becomes the economic owner of the asset and, therefore, should be entitled to claim depreciation on the leased asset.
Under the Income tax Act, 1961, a tax payer is eligible to claim depreciation on an asset provided the asset is owned by such person and is being used for the purpose of his business. There is plethora of precedents where the claim of depreciation has been denied by tax authorities in case either or both of these tests are not met.
The twin tests of ownership and use for claiming depreciation become even more critical in lease transactions, wherein the owner of the assets foregoes the possession and use of the asset; whilst the assets is used by lessee for his business.
The principles governing eligibility of lessor to claim tax depreciation under the lease arrangement is enunciated by administrative guidance issued by the CBDT in circulars 9/1943 and 2/2001. These circulars do not distinguish between the two kinds of lease arrangements and provides that in a lease, other than a hire purchase, the lessor is eligible to claim depreciation, provided the tests of ownership and use of the asset are satisfied. The circulars indirectly shows the thumbs down to accounting treatment of lease by providing that classification of asset in accordance with Accounting Standard 19 will not have implications on the allowance of depreciation to the lessor under the income tax laws.
After the issuance of administrative guidance on depreciation in leasing transcations, there is no ambiguity insofar as depreciation in an operating lease situation is concerned. On the contrary, in case of finance lease there has been prolonged controversy over the determination of ownership of the leased asset and therefore the eligibility of lessor to claim depreciation on the asset leased under a finance lease arrangement.
The principles for claiming tax depreciation provided unique planning opportunity to taxpayers and throw the issue open for varying interpretation.
Increasingly, finance companies began funding purchase of asset under a finance lease arrangement. This mechanism enabled the financing companies to reduce their taxable income base by claiming depreciation as deduction against the income.
In other instances, the owner of the assets resorted to sale-and-lease back mechanism with the objective of realising value from tax depreciation on the asset by enabling the buyer (or lessor) claim depreciation on inflated cost of asset.
However, in most such instances, the courts have held the transaction was a colourable device to evade taxes and disallowed the deprecation claim. Though the eligibility of a lessor to claim depreciation in finance lease has been a matter of debate courts have become increasingly alert on misuse of tax depreciation shield under the garb of finance lease.
In a recent landmark decision of Marico Industries, a Mumbai Tribunal held that in a finance lease it is the lessee who becomes the owner of the assets for all economic purposes and therefore the depreciation on the leased asset shall be available to the lessee and not the lessor.
The Tribunal applied the principles enunciated by the Apex court in Asea Brown Boveris case ( though not on a tax related matter ) wherein the court held that a finance lease is essentially a financing arrangement whereby the lessee assumed the ownership of the asset in as much as it is the borrower who chooses the property to be purchased, takes delivery, enjoys the use of occupation of the property, bears the wear and tear and takes the risk of loss or damage.
The decision of the Tribunal could well prove to be a turning point insofar as the claim of depreciation in a finance lease in concerned. Though the decision of Tribunal is not the last word on the question of law; nevertheless the ruling could take away the heat from long drawn debate over availability of depreciation in a finance lease
Whilst the finality on the issue would need more time, tax payers and tax advisers would anxiously await the Supreme Courts decision, which is soon expected to hear a sizeable bundle of appeals arising out of inconsistent High Court decisions. I would hope that the court would lay down principles, taking into consideration the inconsistency in the past decisions and align the decision (to some extent) with definitions under the Indian and International accounting standards. Of course, the facts of each individual case would be the deciding factor in each judgment.
Mukesh Butani
The author is Tax practice leader of BMR Advisors and views expressed herein are personal.
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