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CBDT clarifies on tax depreciation on leasing, post accounting standard

By Vinod Kothari

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Central Board of Direct Taxes (CBDT) has issued a Circular dated 9th Feb., 2001 which clarifies one of the basic, but most disturbing doubt that the Indian leasing industry had: the change of accounting standards will not by itself lead to a change in tax treatment of lease transactions.

We must, loud and clear, cheer the CBDT for this prompt clarification. After all, the accounting standard came only in the January issue of Chartered Accountant. And believe it, many of the leasing companies have themselves not even read the accounting standard as yet. And here comes the clarification from CBDT - that prompt and that friendly ! Normally, matters lie the grey zone for years before the CBDT is prodded several times by all concerned to clarify. Hats off to the CBDT chairman!

Accounting standard:

The accounting standard on lease accounting AS 19 issued by the ICAI is effective from 1st April 2001 and requires finance leases to be capitalised in the books of the lessee. Most of the leases in India are finance leases, and by capitalisation of the lease by the lessee is meant that the leased asset will be reflected on books of the lessee as the lessee's fixed asset, with a corresponding liability equal to the discounted value of lease rentals. In the books of the lessor, a lease appears as a current asset, similar to the way hire purchase assets accounted for today.

With this accounting standard, most lessors in India feared that tax depreciation to the lessor will also be disallowed. Some people feared the accounting standard as the end of leasing for India, while some others preferred to take the matter to Courts.

CBDT clarifies:

CBDT has, however, in the 9th Feb. circular, set matters at rest, by clarifying that by itself, the changed accounting standard will have no impact on the tax treatment of lease transactions. The following is what the circular means and implies, both in the lines and between the lines:

The circular, read with the accounting standard leads to a new era of dichotomy between accounting standards and tax treatment. While we have all lived with distinction between tax depreciation and book depreciation, here is a new angle to the dichotomy: a distinction between tax ownership and accounting ownership. In terms of accounting standards, the leased asset is deemed owned by the lessee, who is though not its legal owner. As for accounting purposes, however, sec. 32 will continue to allow depreciation to the legal owner of the asset, which is the lessor. In other words, the lessor will claim depreciation for tax purposes while the lessee will capitalise and depreciate the asset for accounting purposes on the lessee's books.
Tax rules as of now make a distinction between lease and hire purchase transactions. In case of hire purchase, where also the legal ownership is retained by the financier, tax depreciation is allowed to the user, viz., the hirer. This is based on a 1943 circular of the Department, and further buttressed by the recent ruling of the Supreme Court in First Leasing Company of India. Apparently, this distinction will continue in the changed regime as well. In other words, in case of hire purchase transactions, the tax owner as well as the accounting owner of the asset will be the hirer, not the lessor.
CBDT's circular also says that in cases where the leased asset does not exist and is created by hawala transactions (should be read as bogus transactions - hawalas mean something different), there is no question of allowing depreciation.
CBDT's circular also says that in case of sale and leaseback transactions, the allowability will be examined based on whether the transaction can be regarded as a colourable device or a sham based on Supreme Court ruling in McDowell' case. This also, however, is a factual issue and can be adjudged only on facts of the case. There cannot be any contention that all sale and leaseback transactions are shams, because there are so many rulings where such transactions have been allowed.
As for other lease transactions, the CBDT circular leaves the matter to be investigated by the assessing officer. The lines of investigation are guided by the CBDT circular of Dec. 31, 1999. This circular, by itself, is not at all clear. It points to several issues to be investigated, but does not indicate what will be result of such investigation. For example, one issue to be investigated is whether the cost of repairs or damages to the asset was borne by the lessee. But the circular gives no guidance as to what will be the outcome, if the answer is one way or the other. Obviously, there is no suggestion that where the cost of damage to the asset is borne by the lessee, the lessor cannot be regarded as the owner. For a brief comment by Vinod Kothari on the circular, refer to our news page here.
The big question is: where will this Circular lead us to in terms of the pending appeals and assessments of lease transactions? A combined reading of the Feb. 9, 2001 circular and that of Dec. 31, 99 makes it obvious that the CBDT does not intend to make a finance lease/ operating lease distinction for tax purposes. If the basic requisites of legal and beneficial ownership are satisfied, the tax laws will continue to allow depreciation to the lessor. There are hundreds of assessments and appeals, at various stages, all over the country, where leases have been considered as financial transactions and held ineligible for depreciation. With the 9th Feb. circular, the contention that the lease is a finance lease and hence not eligible for tax depreciation, does not remain. Therefore, it is hoped that the pending appeals will be settled at the earliest and the bleeding leasing industry will be able to breathe some oxygen in.

Comparative view of lease and hire purchase
	*Legal ownership*	*Tax laws*	*Accounting standards*
Financial lease	Lessor	Lessor	Lessee
Operating lease	Lessor	Lessor	Lessor
Hire purchase with bargain option to buy	Lessor	Lessee	Lessee
Hire purchase with substantial option to buy	Lessor	Lessee	Lessor

What about the lessee:

The CBDT circular of 9th Feb is completely silent on the tax treatment for the lessees. Under the current prevailing law, lease rentals as paid by the lessee are also accounted for as expenses by him, and are claimed as fully expensed for tax purposes.

Under the new accounting standards, the lessee will not expense out the rentals for accounting purposes: he will be required to split the two and report as expense only the interest fraction of the rentals.

Presumably, as the CBDT holds that the accounting standard will not be relevant for tax purposes, a lessee may not be debiting the full amount of rentals for accounting purposes, but nevertheless will claim the rentals as expense for tax purposes, as he does today. At the same time, a lessee might be capitalising and depreciating the leased asset for accounting purposes, but will not do the same for tax purposes.

In other words, a lessor will depreciate what he does not account for, and a lessee will not depreciate what he does.

The MAT matter:

While the CBDT circular on tax depreciation will be relevant for tax computation, it is accounting standards which are relevant for minimum alternative tax (MAT) purposes, as MAT is imposed on book profits. In other words, for MAT purposes, it is the lessee who will depreciate the asset and apportion the rentals into interest and principal, with only the former going to revenue statement.

CBDT clarification regarding accounting standard