Sham finance lease treated as advance; lessor denied depreciation as transaction found tax-avoidance masquerading as lease

ITAT MUMBAI (AT) held against the assessee, denying depreciation to the lessor. Although the agreement bore hallmarks of a finance lease and Supreme Court authority treats genuine finance leases as conferring ownership rights (and depreciation to the lessee), the Tribunal found the arrangement a sham intended to masquerade an advance/loan to the lessee and to improperly claim tax benefit. Because there was no genuine leasing (neither operating nor finance) the lessor cannot claim depreciation; the transaction was treated as tax avoidance and disallowed.

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Issues: (i) Whether the lease agreement in question was a finance lease or an operating lease; (ii) Whether depreciation was admissible to the lessor on the leased asset if the arrangement was a genuine finance lease.

Issue (i): Whether the lease agreement in question was a finance lease or an operating lease.

Analysis: The distinction between finance lease and operating lease was examined on the basis of commercial indicators, accounting guidance, and judicial principles. A finance lease was treated as one where the lessor merely finances the acquisition, recovers its investment with return through fixed rentals, and the risks and rewards of ownership substantially vest with the lessee. The agreement showed a non-cancellable fixed-term arrangement, recovery of the full investment with interest, transfer of residual value at the end of the term, and allocation of maintenance, insurance, taxes, and operational risks to the lessee. Applying the doctrine of pith and substance, the formal clauses suggesting ownership in the lessor were treated as cosmetic and insufficient to change the real character of the arrangement.

Conclusion: The agreement was held to be a finance lease and not an operating lease in a genuine commercial sense; on the facts of the case, it was ultimately treated as a loan transaction dressed as a lease, against the assessee.

Issue (ii): Whether depreciation was admissible to the lessor on the leased asset if the arrangement was a genuine finance lease.

Analysis: Depreciation under section 32 requires ownership and user for business purposes. In a genuine finance lease, the lessor's title is only symbolic and the lessee is the real owner for practical purposes because it controls the asset, bears the risks and rewards, and enjoys exclusive use. The reasoning drawn from the broader concept of ownership under the Act led to the conclusion that, where the arrangement is truly a finance lease, depreciation belongs to the lessee and not the lessor. The assessee's reliance on authorities concerning operating leases and sale-and-lease-back transactions was distinguished.

Conclusion: Depreciation was held not admissible to the lessor; the claim failed against the assessee.

Final Conclusion: The questions referred were answered against the assessee, with the result that the impugned depreciation claim was rejected on the footing that the transaction did not entitle the lessor to depreciation under the Income-tax Act.

Ratio Decidendi: In a finance lease, the real owner for depreciation purposes is the lessee, because the lessor's title is only symbolic and the lessee bears the essential incidents of ownership; where the transaction is in substance a loan rather than a genuine lease, the lessor is not entitled to depreciation.

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