2025 (6) TMI 480 - AT - Income Tax

ITAT Mumbai denies lessee's depreciation claim on leasehold assets, applies ownership test from CBDT Circular and Supreme Court precedent

Assistant Commissioner of Income Tax, Circle - 6 (1) (1), Maharashtra Versus M/s Aditya Birla Financial Shared Services Limited And (Vice-Versa)

ITAT Mumbai held that lessee cannot claim depreciation on leasehold assets despite CIT(A) allowing the claim. The tribunal applied ownership test from ... Depreciation on lease-hold asset treating the same as asset owned by the assessee company - Test of ownership - owner of the lease hold asset has also claimed such depreciation, which was allowed to it by the department - CIT(A), deleted the addition by holding that the lessor here had no commercial right, title or interest in the asset, after the termination of lease period, meaning thereby, that this was purely a financial lease - HED THAT:- Hon’ble Apex court in the judgment rendered in the case of ICDS Ltd. [2013 (1) TMI 344 - SUPREME COURT] has held that if the assets in question are utilized for the purpose of business of the assessee, the requirement of the section stands satisfied notwithstanding non usage of the assets itself by the assessee.CBDT Circular No.2 dated 09.02.2001 has clearly mentioned that the claim of depreciation is dependent on the test of ownership. The test of ownership is discernible only on interpretation of various clauses in the lease agreement. Ownership of the asset is determined by the terms of contract and not by accounting entries in the books of account. The assessee company being a lessee, is not eligible to claim the benefit of depreciation. AO had correctly disallowed the same. We therefore, uphold the disallowance and in result, appeal of the Revenue is allowed. 1. ISSUES PRESENTED and CONSIDEREDThe core legal questions considered by the Tribunal are:- Whether the assessee company, as lessee under a lease agreement with Hewlett Packard Financial Services (HPFS), is entitled to claim depreciation under Section 32 of the Income Tax Act, 1961 on leasehold assets when HPFS, the lessor and legal owner, has also claimed depreciation on the same assets.- Whether the lease arrangement between the assessee and HPFS constitutes a finance lease or an operating lease for the purpose of depreciation claim.- Whether the assessee is the 'real owner' of the leased assets, thereby qualifying to claim depreciation despite legal ownership lying with HPFS.- Whether the principal component of lease rentals paid by the assessee can be allowed as a revenue deduction in case the depreciation claim is disallowed.- Whether the assessee was denied a fair and reasonable opportunity of hearing during assessment proceedings, violating principles of natural justice.2. ISSUE-WISE DETAILED ANALYSISIssue 1: Entitlement to Depreciation on Leasehold AssetsLegal Framework and Precedents: Section 32 of the Income Tax Act permits depreciation deduction on assets owned and used for business purposes. The Supreme Court in ICDS Ltd. vs. CIT established that 'ownership' and 'usage for business' are twin requirements for depreciation claim. The Court clarified that 'use' does not necessarily mean physical use by the claimant but use for the purpose of business. The Court further held that the lessor, who retains ownership and leases the asset, is entitled to claim depreciation. The Court relied on the definition of ownership in Black's Law Dictionary and various lease agreement clauses to determine ownership. Other precedents including CIT v. Podar Cement, Mysore Minerals Ltd. v. CIT, Dalmia Cement v. CIT, and Asea Brown Boveri Ltd. v. Industrial Finance Corpn. of India emphasize that the 'real owner' who bears risks and enjoys benefits of the asset is entitled to depreciation.Court's Interpretation and Reasoning: The Tribunal examined the Master Rental and Financing Agreement between the assessee and HPFS, focusing on clauses 7 and 10 which explicitly confirm HPFS as the owner of the equipment at all times. Clause 7 requires the assessee to irrevocably novate all rights, title, and interest in the equipment to HPFS. Clause 10 emphasizes that HPFS is the exclusive owner and the assessee has only lessee rights, with obligations not to contest HPFS's ownership or dispose of the equipment without consent. The equipment remains HPFS's property even if affixed to land. The Tribunal found these contractual terms decisive in establishing that the assessee was not the owner of the assets.The Tribunal also considered the factual matrix: the assessee had to return the equipment or HPFS could repossess it; ownership would transfer only upon termination of the lease and completion of payments. This indicated that the ownership was retained by HPFS during the lease term. The Tribunal distinguished this from a typical loan purchase where ownership vests immediately with the purchaser.Key Evidence and Findings: The lease agreement clauses, the nature of the lease term, and the obligation to return or allow repossession of equipment by HPFS were critical. The Tribunal also noted the prior Tribunal decision allowing depreciation to HPFS for AY 2009-10 and the fact that both parties claimed depreciation on the same assets, which would result in double deduction disallowed under tax law.Application of Law to Facts: Applying the Supreme Court's ICDS Ltd. ruling and other precedents, the Tribunal concluded that since HPFS retained ownership and the assessee's rights were limited to use as a lessee, the assessee did not satisfy the ownership requirement under Section 32. Hence, depreciation claim by the assessee was not permissible.Treatment of Competing Arguments: The assessee argued that the lease was a finance lease, making it the 'real owner' as it selected, insured, maintained, and bore risks of the assets. It relied on Accounting Standard 19 and ICDS-I emphasizing substance over form, and various Tribunal decisions allowing depreciation to lessees under finance leases. The assessee contended that the lease period covered a substantial portion of the asset's economic life and that the assets were scrapped at nominal value after lease expiry, supporting ownership in substance.The Revenue disputed this, relying on the legal ownership clauses, prior Tribunal decision allowing depreciation to HPFS, and the absence of evidence that HPFS did not claim depreciation. The Revenue submitted that two entities cannot claim depreciation on the same asset and that the lease was not a finance lease.The Tribunal found the Revenue's arguments more persuasive, as the contractual terms clearly established legal ownership with HPFS and the lease was not a finance lease in substance. The Tribunal distinguished the assessee's reliance on finance lease accounting standards and prior Tribunal decisions on different facts. It also noted that the CBDT Circular No. 2/2001 emphasized ownership determination by contract terms, not accounting entries.Conclusions: The Tribunal upheld the Assessing Officer's disallowance of depreciation claimed by the assessee on leased assets, holding that the assessee was not the owner under Section 32 and thus not entitled to depreciation.Issue 2: Nature of Lease - Finance Lease or Operating LeaseLegal Framework and Precedents: Accounting Standard 19 and judicial pronouncements distinguish finance leases, where ownership risks and rewards transfer to lessee, from operating leases, where ownership remains with lessor. The substance of the transaction governs classification.Court's Interpretation and Reasoning: The Tribunal analyzed the lease agreement clauses, particularly clauses 7, 8, 10, 11, and 21, which indicated that ownership and associated rights remained with HPFS. The assessee's obligation to return equipment and HPFS's right to repossess negated transfer of ownership risks and rewards. The Tribunal found that the lease was not a finance lease but an operating lease.Key Evidence and Findings: The contractual terms requiring novation of rights to HPFS, repossession rights, and restrictions on disposal or attachment of equipment supported this conclusion.Application of Law to Facts: The Tribunal applied accounting and legal principles to conclude that the lease arrangement was not a finance lease, and hence the assessee could not claim depreciation as owner.Treatment of Competing Arguments: The assessee's contention that the lease was a finance lease based on economic substance was rejected as the legal rights and obligations clearly indicated otherwise.Conclusions: The lease was held to be an operating lease with HPFS as owner; thus, depreciation claim by the assessee was disallowed.Issue 3: Deduction of Principal Component of Lease RentalsLegal Framework and Precedents: Lease rentals may be allowed as revenue expenditure if the lease is operating in nature. The principal component may be treated differently depending on whether the lease is finance or operating. Section 40(a)(ia) provisions regarding withholding tax on payments may also apply.Court's Interpretation and Reasoning: The Assessing Officer disallowed deduction of the principal component of lease rentals, treating the payments as repayment of finance and interest. The assessee claimed alternatively that if depreciation was disallowed, the principal component of lease rentals should be allowed as revenue expenditure.Key Evidence and Findings: The AO noted the absence of details of rent component and the composite nature of payments including principal and interest.Application of Law to Facts: The Tribunal observed that this claim was not adjudicated by the CIT(A) and thus remitted the matter for fresh examination with opportunity to the assessee to furnish details and make submissions.Treatment of Competing Arguments: The Tribunal did not decide on merits but directed fresh consideration.Conclusions: The issue of allowability of principal component of lease rentals as deduction was remitted to the CIT(A) for fresh adjudication.Issue 4: Alleged Violation of Principles of Natural JusticeLegal Framework and Precedents: Principles of natural justice require fair and reasonable opportunity of hearing before adverse orders are passed.Court's Interpretation and Reasoning: The assessee claimed denial of reasonable opportunity during assessment. The Tribunal found no evidence of such denial and dismissed the ground.Conclusions: No violation of natural justice was found.3. SIGNIFICANT HOLDINGS- 'Section 32 of the Income Tax Act lays down twin requirements of 'ownership' and 'usage for business' for a successful claim under Section 32 of the Act.'- 'The income tax law requires the use of the asset by the assessee for 'the purpose of business'; it does not mandate the use of the asset by the assessee itself.'- 'The ownership of the vehicle was transferred to the lessee at the end of the lease term, that too at a nominal value... the assessee has a right to retain the legal title of the vehicle against the rest of the world, it would be the owner of the vehicle in the eyes of law.'- 'Ownership of the asset is determined by the terms of contract between the lessor and the lessee.'- 'Where the business of the assessee consists of hiring out machinery and/or where the income derived by the assessee from the hiring of such machinery is business income, the assessee must be considered as having used the machinery for the purpose of business.'- 'In the facts and circumstances of the present case, the assessee company being a lessee, is not eligible to claim the benefit of depreciation.'- The Tribunal upheld the Assessing Officer's disallowance of depreciation claimed by the assessee on leased assets and allowed the Revenue's appeals for both assessment years.- The Tribunal remitted the issue of allowability of principal component of lease rentals as deduction to the CIT(A) for fresh consideration.