Indian
Supreme Court ruling – Tax depreciation should be available to the lessor in a
finance lease transaction
The recent ruling of
the Supreme Court of India in the case of ICDS Ltd (‘ICDS’) is an important
ruling as it establishes that tax depreciation on a finance lease transaction
should be available to the lessor, as the lessor qualifies as the ‘owner’
of the asset and is using the asset for the ‘purpose of
business’.
Background
1.
ICDS, a RBI registered
non-banking financial company (‘NBFC’), was engaged in the business of hire
purchase, leasing, real estate etc. ICDS purchased vehicles (ie, trucks)
directly from manufacturers and leased them out to its customers on a finance
lease basis. The vehicles were registered in the name of the lessee, as was
required under the Motor Vehicles Act, 1988 (‘MV Act’).
2.
As per the lease
agreement executed between ICDS and its customers, (i) ICDS was to remain the
exclusive owner of the leased vehicles at all points in time and the lessee had
no right, title or interest to mortgage, hypothecate, or sell the vehicles as a
bailee, (ii) ICDS was permitted to repossess the vehicle if the lessee were to
default in lease payments, (iii) at the conclusion of the lease period, the
lessee was obliged to return the vehicle to ICDS and ICDS could choose to sell
the vehicle at one percent of the original cost of the vehicle to the lessee,
and (iv) ICDS had the right to inspect the vehicle at all
times.
3.
In its income-tax
returns for Assessment Years (‘AYs’) 1991‑1992 to 1996-1997, ICDS claimed tax
depreciation on the leased vehicles on the basis that it owned the vehicles and
used the vehicles for the purpose of its business. The entire lease rentals
that were earned by ICDS from lease of the vehicles were reported to tax as
business income. The tax depreciation was claimed at a higher rate of
50 percent for AY 1991-92 and 40 percent for AYs 1992-93 to 1996-97, (instead of
the normal tax depreciation rate of 20 percent that was prescribed for motor
cars) on the basis that the vehicles were used in the business of running on
hire.
4.
The assessing officer
disallowed the tax depreciation claim of ICDS on the basis that (i) ICDS was
merely leasing the vehicles out and it was not actually running the vehicles in
the business of hire, and (ii) ICDS had merely financed the purchase of the
vehicles and was not the ‘owner’ of the vehicles. On appeal, the
Commissioner of Income-tax (Appeals) [‘CIT(A)’] allowed ICDS to claim tax
depreciation on the leased vehicles at the normal rate of 20 percent instead of
the higher rate of tax depreciation. On further appeal, the Income-tax
Appellate Tribunal (‘ITAT’) ruled the matter entirely in favour of ICDS and
allowed ICDS to claim higher tax depreciation.
5.
The Karnataka High
Court overturned the ruling of the ITAT on the basis that the vehicles were
registered in the name of the lessees and ICDS had merely financed the
transaction; thus, ICDS could not be held as the ‘owner’ of the leased
vehicles. The matter was litigated further to the Supreme
Court.
The ruling of the
Supreme Court
6.
The Supreme Court
ruled in favour of ICDS and held that the Company was eligible to claim tax
depreciation on the leased vehicles, as it qualified as the ‘owner’ of
the vehicles and had used the vehicles for the ‘purpose of business’.
The Supreme Court also upheld ICDS’ claim for higher tax depreciation, as the
leased vehicles had been used in the business of running them on hire. The
reasoning of Supreme Court for reaching the above conclusions has been discussed
in the ensuing paragraphs.
7.
The Supreme Court
observed that section 32 of the Income-tax Act, 1961 (‘Act’) imposes a twin
requirement of (i) ownership, and (ii) usage for business, for a successful
claim for tax depreciation under section 32 of the Act.
The ownership
test
8.
The Supreme Court
analyzed the term ‘owner’, as is used under section 32 of the Act, though
is not defined under the Act, and observed that the concept of tax depreciation
legitimately belongs to the person who has invested in the asset; is utilizing
the asset and is thereby gradually losing the value of investment on account of
wear and tear of the asset and would need to replace the asset which has eroded
in value over a period of time. It further observed that ownership is a
function of legal right or title against the rest of the world; the meaning of
the term is to be gathered from the connection in which it is used and from the
subject matter to which it is applied.
9.
A scrutiny of the
material facts in ICDS’s case raised a presumption of ownership in favour of
ICDS given the manner in which the lease agreement (discussed in point 2 above)
was drafted. The clues qua ownership of the vehicles were contained in the
lease agreement itself, which clearly pointed in favour of ICDS.
10.
The Supreme Court
agreed with the observations of the ITAT that leasing of vehicles was akin to
hiring of vehicles. A hiring arrangement or lease, unlike a hire purchase
agreement, is a contract of bailment – plain and simple with no element
of sale inherent. Bailment, as defined under the Indian Contract Act, 1872,
means the delivery of goods by one person to another for some purpose upon a
contract that once the purpose has been accomplished, the goods shall be
returned or otherwise disposed off according to the directions of the person
delivering them. The transactions entered into by ICDS were in the nature of
lease transactions and not hire purchase transactions.
11.
The Supreme Court
disagreed with the primary argument of the Indian Revenue authorities to contend
ownership of the vehicles. The Revenue authorities had contended that section
2(30)[1] of the MV Act defines the term
‘owner’ of a motor vehicle as the one in whose name the vehicle is
registered and in case of lease transactions, the lessee in
possession of the vehicle. The Revenue’s argument was that the test of
ownership is the registration of the vehicle. Since the vehicles were
registered in the name of the lessees and not ICDS, the lessees would be the
rightful owners of the vehicles and accordingly, the ones entitled to claim tax
depreciation.
12.
However, the Supreme
Court was not convinced with the above argument of the Indian Revenue
authorities and held that section 2(30) of the MV Act is a deeming provision
that creates a legal fiction of ownership in favour of the lessee only
for the purpose of the MV Act; it is not a statement of law on ownership in
general. The MV Act mandates that during the period of lease, the vehicle be
registered in the name of the lessee and after conclusion of the lease period,
in the name of the lessor; it leaves the lessor with no option but to register
the vehicles in the name of the lessee[2].
Thus, no inference could be drawn from the registration certificate to determine
legal title of the vehicles. Even the invoices issued by the manufacturer
(which were in the name of the lessee) were held to be inconsequential to
determine the ownership of the leased vehicles given the lease agreements and
other related factors considered by the Supreme Court.
13.
If the lessee were in
fact the true owner of the vehicle, he would have claimed tax depreciation on
the same, which was not done in the present case. The Supreme Court also
observed that it would be a strange situation to have no claim of tax
depreciation due to a vacuum of ownership.
14.
Lastly, the Supreme
Court ruled that the lease rentals received by ICDS were assessed in its hands
as business income and the entire lease rentals were to be treated as deductible
revenue expenditure in the hands of the lessee. This reaffirmed the position
that ICDS was in fact the ‘owner’ of the leased vehicles.
Usage for Business and
higher tax depreciation on leased vehicles
15.
The Supreme Court did
not agree with the second contention of the Revenue authorities that the lessees
were actually using the vehicles in the business of running them on hire and
hence, the lessees were eligible to claim tax depreciation on the leased
vehicles.
16.
The Supreme Court held
that section 32 of the Act requires that for the purpose of claiming tax
depreciation, an assessee must use the asset for the ‘purpose of
business’. The section does not mandate actual usage of the asset by the
assessee itself. The vehicles were utilized for the business of ICDS, ie
leasing out of trucks purchased by ICDS. Hence, so long as the vehicles were
used for the purpose of business of ICDS of leasing them out, the requirement
under section 32 of the Act stood satisfied.
17.
The Supreme Court
relied on its erstwhile rulings in the cases of Shaan Finance and Castle Rock
Fisheries[3], which were passed
in the context of sections 32A (Investment Allowance) and 33 (Development
Rebate) of the Act, respectively, for analyzing whether ICDS had used the
vehicles for the ‘purpose of business’. In the case of Shaan Finance,
the Supreme Court had observed that section 32A(2)(b) of the Act refers to the
various uses that a machinery can be put to use for; the section however does
not mandate that the assessee himself should use the machinery for the purposes
specified in section 32A(2)(b) of the Act. Further, in the case of Castle Rock
Fisheries, the Supreme Court had observed that where the business of the
assessee consists of hiring out of machinery and where the income derived from
hiring of the machinery is business income, the assessee must be considered as
having used the machinery for the purposes of its business.
18.
ICDS was a leasing
company which leased out vehicles that it purchased. Hence, the income derived
from leasing of vehicles was taxable in the hands of ICDS as its business income
or income derived in the course of business and was assessed as such. Thus,
ICDS was held to have fulfilled the requirement under section 32 of the Act of
using the asset for the ‘purpose of business’.
19.
As regards ICDS’s
claim for higher tax depreciation on the leased vehicles, the Supreme Court
observed that once again, the words ‘purpose of business’ gained
significance. ICDS had already satisfied the condition of using the vehicles
for the ‘purpose of business’ and hence, was entitled to a higher tax
depreciation on the leased vehicles.
20.
The observations of
the ITAT in relation to Circular No 652 dated June 14, 1993 (‘Circular’) were
held to be the clincher in favour of ICDS. The ITAT had observed that the
Circular had clarified that the higher rate of depreciation of 40 percent (as
was applicable in earlier AYs) in case of lorries etc plying on hire was not
applicable if the vehicles were used in a non-hiring business of the assessee;
the ITAT further specified that the Circular should not be read out of context
to deny higher tax depreciation in case of leased vehicles when the actual use
was in the hiring business. Hence, reading the Circular along with the
decisions of the Supreme Court in the case of Shaan Finance, ICDS was entitled
to a higher rate of tax depreciation on the leased vehicles.
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