Direct Taxes

Questions & Answers

14th National Tax Convention - 2007 at New Delhi

Q.1 An assessee company is engaged in the business of real estate, investment in a partnership firm, investment in shares and also in financing business. As part of its real estate business, it has undertaken the development of certain properties. It had about 7 such development projects in its hand during the relevant previous year. As far as the development and construction of properties are concerned, the assessee company is following the completed contract method for recognizing its income/loss. The assessee has taken loan from banks for development and construction of properties.

1. Whether the assessee company can claim the deduction for the entire interest payable to the bank in one year though the income from the sale of flats will be shown in subsequent year(s) since it is not declaring any income on yearly basis?

2. Whether the method of accounting followed by the assessee company can be characterized as the proper method of accounting keeping in the Accounting Standard and the provisions of the Income tax Act?

3. Has the Institute of Chartered Accountants of India issued any guidelines in this respect and are they mandatory?

Ans. The Assessee is engaged in the business of real estate development and is following project – completion method of accounting. Further the assessee was simultaneously constructing multiple projects. The Assessee has borrowed funds for these projects.

Accounting Standard 7 was revised in 2002. Pre - revised AS 7 covered persons engaged in real estate development business. Revised AS 7 does not apply to real estate developers. ICAI has issued a guidance note on Recognition of Revenue by Real estate developers in 2006. Accordingly, the revenue shall be recognized when all significant risk and rewards of ownership are transferred. This guidance note does not deal with the method of accounting of costs incurred by real estate developers during the period of construction. The Company can rely upon guidance note issued by ICAI on the treatment of expenditure during Construction period. Finance expenses of large capital projects which involve a prolonged period of construction can be considered as part of the project. Also according to pre-revised AS 7 finance cost which is specifically attributable to a particular project can be included as part of the total project. It may be noted that once the Assessee is following the project completion method the interest has to be added in the work – in – progress. The Appellate Tribunal Special bench in case Wall Street Construction Ltd. vs. JCIT 101 ITD156 (Mum)(SB) has held that where an assessee is following project completion method of accounting, the interest identifiable with that project should be allowed only in the year when the project is completed and the income from that project is offered for taxation. As far as the method of accounting is concerned various Benches of the Income Tax Appellate Tribunal have taken the view that the method of accounting to bring into accounts profits only when entire project has been completed in the cases of property developers is a well recognized method. Reference can be made to the following :

1. D.K. Enterprises vs ITO 39 ITD 394 (Mum)

2. S.K. Estates Pvt. Ltd. vs. ACIT 60 ITD 621 (Mum)

3. Presepolis Construction Co. Pvt. Ltd. vs. ACIT 99 TTJ 92 (Mum)

4. CIT vs. Lokhandwala Constructions Inds. Ltd. 260 ITR 579

5. Shri Nirmal Commercial Ltd. vs CIT 193 ITR 694

6. CIT vs. V.S.Dempo & Co. P. Ltd. (1996) 131 CTR 203 (Bom)

As mentioned above the ICAI has issued guidance notes but they are not mandatory.

Conclusion :

Hence, completed contract method of accounting is a bonafide method which can be used by the assessee engaged in real estate business for computing income or loss. According to the said method, the finance expenses are to be claimed in the year in which profit of the project is offered for taxation.

Q.2 The Assessee’s land was acquired under the Land Acquisition Act and the compensation was awarded by the Land Acquisition Officer. The said award was not accepted and was challenged before a Civil Court to claim higher compensation. The Civil Court awarded higher compensation along with interest. The decree/order of the Court was challenged by the State Government in appeal before the Hon’ble High Court and therefore, the enhanced compensation could not be treated as final.

1. Whether enhanced compensation and interest awarded by the Civil Court is to be taxed in the year of receipt notwithstanding that its order is challenged before High Court and the litigation is pending?

2. Whether decision of Supreme Court in the case of Hindustan Housing & Land Development Trust Ltd. (1986) 161 ITR 524 still hold good after the insertion of clause (b) of sub-section (5) of section 45 by the Finance Act, 1987 w.e.f. 01.04.1988.

3. If the enhanced compensation and interest is assessed on receipt basis, what will happen if the award for compensation is reduced or annulled by the High Court?
   d) Will it make any difference to the taxability of compensation and interest if the same are received on furnishing of security?

Ans. The Supreme Court in case of Hindustan Housing & Land Development Trust Ltd. (1986) 161 ITR 524 held that, Income did not accrue to assessee where, though the arbitrator awarded enhanced compensation for acquisition of Assessee’s land, the State Government had filed appeal there against as the very right of assessee to receive enhanced compensation was put in jeopardy.

Thereafter the Act was amended to nullify the effect of the aforesaid decision. The amendment was considered by the Delhi Tribunal in case of DCIT vs. Bhim Singh Lather (2006) 99 ITD 46 (Del) (TM). The Third Member held as under, “So far as the receipt of additional compensation by the assessee is concerned, it has to be charged on receipt basis and the A.O., in my opinion, was justified in charging the same and the CIT(A) was not right in deleting the same by relying upon the decision of Supreme Court in the case of Hindustan Housing and Land Development Trust and by stating that no right had accrued to the assessee over the said additional compensation ignoring the provisions of the Act under section 45(5) which has shifted the charge of capital gain tax on receipt basis in so far as the additional compensation received is concerned.”

Further amendment by Finance Act, 2003, by introducing an new sub clause (c) makes things clear.

It may be noted that the Mumbai Tribunal in case of Estate of Late Shri Dharambir Hansraj Aggarwal vs. DCIT (2005) 95 ITD 83 (Mum) for A.Y. 1995-96 held that effect of sub-clause (c) introduced in addition to clause (a) & (b) to section 45(5) w.e.f. 1st April, 2004 by Finance Act, 2003, should not be treated as retrospective in nature. Moreover with the insertion of this clause, now it is evident that the legislature was also aware about such eventualities when the compensation enhanced got reduced. There was a provision in Section 155(7A), according to which where in the assessment for any year the capital gain arising from the transfer of capital asset, being a transfer by way of compulsory acquisition, is computed under section 48 and such compensation is enhanced by any Court or Tribunal, etc., the same can be recomputed in accordance with section 48 by taking the enhanced compensation to be the full value of the consideration received and shall make the necessary amendment. This section has been omitted w.e.f. 1st April, 1992 by the Direct Tax Laws (Amendment) Act, 1987. There is no answer to this query that what will be the fate of all such cases between the period of April ,1992 to April. 2004 because sub-section (7A) of section 155 stood deleted from April, 1992 and sub-cl (c) of section 45(5) was introduced w.e.f. April, 2004. The best and the correct way is to compute the capital gain only when the enhanced compensation gets finally settled to avoid multiplicity of litigation. Otherwise also the provisions of section 153(3)(ii) are very much in statute to give effect to an order of any Court. The overall position emerges on perusal of various provisions of the Act that neither the Revenue nor the assessee are remediless and the enhanced compensation when finally settled is always subject to tax.

Conclusion:

Hence the decision of the Supreme Court in the case of Hindustan Housing & Land Development Trust Ltd. (1986) 161 ITR 524 may not good law after the insertion of clause (b) of sub-section (5) of section 45 by the Finance Act, 1987 w.e.f. 01.04.1988, and the enhanced compensation which is subject matter of appeal may be taxable as per the scheme of subsection (b) & (c) of section 45.

Q.3. The AO for the purpose of determining the book profit under section 115JB of the Income-tax Act, 1961 has to prepare two parallel computations – one for determining the total income in accordance with the provisions of the Income-tax Act and the other for determining the book profit. If the income tax payable on the total income as computed under the Income-tax Act in respect of any previous year, relevant to the assessment year, commencing on or after 1st day of April 2007 is less than 10% of its book profit then such book profit shall be deemed to be the total income of the assessee and the tax payable shall be 10% thereof. As per sub-section (2), the assessee has to prepare the profit and loss account for the relevant previous year in accordance with the provisions of Part-II and Part-III of Schedule-VI of the Companies Act. The Explanation defines the words ‘book profit’ which mean net profit as shown in the profit and loss a/c for the relevant previous year. Such book profit has to be increased by items (a) to (g) of the Explanation if they are debited to the P&L a/c and from such profit items (i) to (vii) of the Explanation are to be reduced. The figure arrived at after this exercise would be the book profit of the assessee for the relevant previous year.

During the previous year relevant to A.Y. 2008-09, the assessee company has debited to its P&L a/c an amount of Rs. 2 crores being provision for bad and doubtful debts which has been added back while determining the total income.

1. Whether the provision for bad and doubtful debts is to be added while computing the book profit for the purpose of section115JB in terms of item (c) of the Explanation which says that the book profit is to be increased by the amount or amounts set aside to provisions made for meeting liabilities, other than ascertained liabilities?

2. Whether the provision for bad and doubtful debts shall be regarded as ascertained liability if such debts have not been actually recovered and written off in the books in subsequent years?

Ans. The issues raised above have been answered in case of JCIT vs. Usha Martin Industries Ltd. (2007) 104 ITD 249 (Kol)(SB). The adjustments required to be made to the net profit disclosed in the P & L A/c for the purpose of Section 349 of the Companies Act are quite different than the adjustments required to be made under Explanation to Section 115JA of the Income Tax Act. Therefore, merely because some item debited to P & L A/c is required to be added to the net profit for the purpose of computing the Director’s remuneration, it is not necessary that the same is to be included in the book profit for the purpose of section 115JA. For the purpose of section 115JA, the A.O. can increase the net profit determined as per P & L A/c prepared as per Parts II and III of Schedule VI. to the Companies Act only to the extent permissible under Explanation thereto. The Explanation has provided six items, i.e. item Nos. (a) to (f) which is debited to the P & L A/c can be added back to the net profit for computing the book profit. The provision for bad and doubtful debt has been debited to the P & L A/c. Therefore, it can be added back to the net profit if it falls within any of the items provided under the Explanation. The Assessee’s case would fall within the ambit of item (c) if (i) the amount is set aside to any provision; (ii) the provision is made for meeting liability; and (iii) the provision should be for other than ascertained liability i.e. it should be for unascertained liability. All the above three ingredients should be satisfied so as to bring the provision within the ambit of item (c) of the Explanation to section 115JA. The provision can be for (i) depreciation; (ii) renewals ; (iii) diminution in the value of assets; and (iv) for any known liability of which the amount cannot be determined with substantial accuracy. The question is whether the provision for bad and doubtful debt is the provision for diminution in the value of assets or for known liability of which the amount cannot be determined with substantial accuracy. The provision for bad and doubtful debt is made when the assessee is of the opinion that its entire debt may not be realized and part of the debt may become irrecoverable. However, when the amount of such irrecoverable debt cannot be ascertained with substantial accuracy, the provision is made for bad and doubtful debt. Debts are of two types. One-debt payable by the assessee i.e. where the assessee has to pay amount to others. This would be asset in the hands of the assessee. Admittedly, the ‘debt’ under consideration is ‘debt receivable’ by the assessee. The provision for bad and doubtful debt would always be made with reference to debt receivable, where there is doubt about full realization of debt. The provision is made to cover up the probable diminution in the value of asset i.e. debt which is amount receivable by the assessee. The provision for bad and doubtful debt is the provision for diminution in the value of asset, i.e. debt. The provision for bad and doubtful debt cannot be said to be a provision for liability, because even if a debt is not recovered, no liability would be fastened upon the assessee. The debt is the amount receivable by the assessee and not any liability payable by the assessee and, therefore, any provision towards irrecovarability of the debt cannot be said to be provision for liability. Once it is held that the provision for bad and doubtful debt is not a provision for any liability, the question whether the liability is ascertained liability or unascertained liability does not arise. Therefore, cl. (c) of the Explanation to Section 115JA may not be applicable in respect of provision for bad and doubt debts.

Conclusion :