AI Drafter 
TaxTMI 
TaxTMI 
TaxTMI 
2016 (6) TMI 99
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.... Ltd. (AT & T India), a company under the Companies Act, 1956 promoted by AT & T Global, upto 26% of the equity capital of the former, i.e., AT & T India. The balance 74% was to be held by AT & T Global, i.e., to the extent of the cap on the foreign direct investment (FDI) under the extant policy regime of the Government of India (GOI) for the telecommunication sector. The date/s of investment is termed as a capitalization date/s. AT & T Global had under the agreement an irrevocable call option to increase its' holding in AT & T India to the extent permissible by laws in India by requiring appellant company to sell shares to it or to its' affiliates at the option price. Similarly, the appellant company also has an irrevocable option to sell these shares at the option price to AT & T Global (or its affiliates), which had the right to first refusal. The option by either could be exercised on or after three years of investment or the elimination of the Indian Government regulation on foreign equity holding levels, whichever is earlier. The option price for the purpose of the afore-said purchase and sale is defined as the equity contribution plus return at 11% p.a. compounded annually ....
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....no relaxation in the policy guidelines by the GOI prescribing a cap on the Foreign Direct Investment (FDI) in the telecommunication ('telecom') sector at 74%. Ex-consequenti, there is no transfer of shares, in the increased value of which, realizable on their transfer, the impugned income is embedded. To the extent of call option fees, defined again in terms of a rate per unit of time - on the investment (i.e., at 5.5% p.a.), which stands allowed and, further, prescribed to fall due (for payment) on each anniversary date (of capitalization), income stands accounted for and disclosed as business income. 4.2 It is, to begin with, important to understand the meaning and connotation of the term 'accrual', the scope of which is the bone of contention between the parties. Section 5 of the Act, which defines the scope of 'total income' of a resident, provides for it to include income that accrues or arises to the assessee during the year. As a legal concept, the same stands defined per a series of decisions by the Apex Court, as a right to receive. The Hon'ble Court in Gajapathy Naidu (supra) succinctly stated the following propositions that are to be considered for the purpose: ....
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.... that the income chargeable under the heads of income 'Profits and gains of business or profession' (PGBP) or 'Income from other sources' (IFOS) shall, subject to the provision of sub section (2), be computed in accordance with either cash or mercantile system of accounting regularly employed by the assessee. Sub-section (2) thereof further provides that the Central Government may notify from time to time income computation and disclosure standards to be followed by any class of assessees or in respect of any class of income. The assessee is admittedly following accrual method of accounting which, it being a company, incorporated under the Companies Act, 1956, is even otherwise statutorily obliged to in terms of the provisions of the said governing Act. The Central Government has notified two Accounting Standards (AS-I and AS-II) on 25.1.1996 u/s. 145(2) of the Act. The said Accounting Standards have a legal mandate, so that the word 'accrual', to which a clear meaning has been assigned, acquires the force of law. The relevant part of AS-I reads as under: 'ACCOUNTING STANDARDS NOTIFIED UNDER SECTION 145(2) A. Accounting Standard I relating to disclosure of account....
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....rded as its' income. Equally, there has to be a clear nexus with the time of accrual, so that the income has to be for a particular period. Continuing further, the Hon'ble Apex Court has time and again clarified that in the absence of any specific provision, it is the principles of commercial accounting that would hold (viz. Challapalli Sugars Ltd. vs. CIT [1975] 98 ITR 167 (SC)). Accounting Standards issued by the Institute of Chartered Accountants of India (ICAI), which is the regulatory body for the profession of accountancy in India, are also relevant. These Accounting Standards are binding on companies in view of the Companies Act, 1956, so that they again have the force of law (s.209). Rather, as explained by the Apex Court, they represent the crystallized accounting principles as recognized by the accounting policies and, further, those issued by ICAI are required to be followed [J.K. Industries Ltd. vs. Union of India [2008] 297 ITR 176 (SC)]. They provide discipline and harmonization of concepts and accounting principles; the objective being true and fair accounting. Accounting Standard (AS)-1 issued by ICAI, titled 'Disclosure of accounting policies', again, enlists ac....
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.... period. And further, that substance over form should govern the accounting policies to be followed for the same. The third aspect we observe is that both sets of Accounting Standards (i.e., as notified by the Board and as issued by ICAI) also indicate the manner in which the relevant income is to be recognized, i.e., as it is earned (AS-I), and on time basis, i.e., as it accrues (per AS-9). Equally importantly, accrual as an accounting concept is in agreement with that as judicially explained, i.e., as a legal concept. That is, the word 'accrual' as occurring in section 5 signifies the same meaning as in section 145, per the Accounting Standard notified there-under. The entries that stand to be passed in the books of account, it may be further noted, are akin to that which shall stand to be passed where the funds are invested in interest bearing loan/advance, as (say) a deposit with the bank, with a fixed tenure. We may, for better understanding, illustrate these accounting entries (on (say) a FDR of Rs. 1000/- at 10% p.a., compounded annually), as: (Amt in Rs.) 1) Interest accrued but not due A/c Dr. 100/110/121 To Interest accrued A/c Cr. 100/110/121 ....
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....unts reflecting the following entries: (Amt. in Rs.) 1) Trade/Bills Receivable A/c Dr. 1000 (say) To Sale A/c Cr. 1000 (the value of the goods sold to ... vide bill no...... dated ......, due for payment on .......) 2) Customer (by name) A/c Dr. 1000 To trade/bills receivable A/c Cr. 1000 (to bill no....... dated ....... on becoming due for payment) 3) Bank A/c Dr. 1000 To Customer A/c Cr. 1000 (on receipt of payment vide cheque no..... dated..... against bill no....... dated.........). In fact, if this basic difference (between debt in praesenti and debt in futuro) is ignored, there would be no difference between 'cash' and 'accrual' method of accounting, or determination of income, i.e., speaking in the context of tax laws, or section 145 of the Act. In particular, which in fact only endorses and subscribes the accounting principles of income recognition as prescribed by AS-9 (of ICAI), which again has statutory force u/s. 209 of the Companies Act, 1956. These entries, are not only in accord and harmony with the principles of commercial accounting, well established, the prime objective of which is to re....
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....ms of the agreement, pari materia, with one getting paid, and the other taken into account for computing the price calculated to yield a return at the prescribed rate for each future period/s, with the holding period in either case being determined likewise, i.e., the date of investment (capitalization date) to the date of divesture. Why, the sponsors, implying the assessee (ML) and the parent company (AT & T) collectively, themselves regard the 'option price' and the 'call option fee' as constituting a reasonable return on investment, for which reference be made to clause 2.6 of the Agreement, which reads as under: '2.6 The Sponsors acknowledge that pursuant to the terms of this Agreement and based on the nature of global telecommunications services and the financial prospects of AT&T India, ML will realize in almost all cases an equity return equal to the Option Price and Call Option Fee and further acknowledge that the cost structure of AT&T India is dependent upon allocations of expenses across AT&T's global operations, which allocations shall be made by AT&T in a commercially reasonable manner without specific regard to the profitability or un-profitability of AT&T In....
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.... divesture, at the same (defined) rate. Couple this with the fact that the fair price is independent of the actual value of the shares or the performance of the company during the holding period, or on the date of divesture (refer clauses 2.6, 8.13 of the Agreement), and the picture is complete. The future price would depend not on the performance of the company, and predetermining the same, which is of essence (to the agreement) lends it with a character of a financial instrument toward earning income at a defined (agreed) rate, rather than a promoter investing in an enterprise in a defined business, i.e., acquiring a stake in a particular business. Shares, thus, represent only a medium and manner in which the investment takes place, which is regarded as parking of funds by the investor, calculated to yield a definite and stipulated rate of return. The terms of the agreement, when read as a whole, make this abundantly clear, with the agreement in fact making no bones about it. Reference in this context be made to, inter alia, clauses 2.5, 2.6, 4.9, 6.11, 6.13, 6.15, 6.16, 7.3, 7.4, 8.4, 8.5, 8.8, 8.13 - 8.15, 9, 17.2 (c), 17.3 (c), 17.4-17.5 of the Agreement, some of which we repr....
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.... on the Board of Directors to) support the same. The price per share for the Buy Back shall be equal to the Option Price. If another price is required to be paid by the Laws of India then the Company may elect to cancel such Buy Back. Above purchases of shares shall be made in Indian Rupees. 17.2 In the following cases, AT&T shall have the right and option to terminate this Agreement by a written notice of thirty (30) days to ML: (c) if AT&T is prohibited from holding some or all of the shares in the Company, as provided in this Agreement, due to any reason whatsoever, not directly attributable to the actions of AT&T. 17.3 In the following case, ML shall have the right and option to terminate this Agreement by a written notice of thirty (30) days to AT& T: (c) if ML, subject to Section 9.1 of the Agreement, is prohibited from holding some or all of the shares in the Company due to any reason whatsoever, not directly attributable to the actions of ML. 17.4 On termination of this Agreement, as aforesaid, shall not relieve any Party of any obligations or liabilities accrued to it prior to the date of termination and the provisions ....
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....facts of the case. This is as, as afore-stated, compounding envisages a notional receipt, which is then reinvested at the stipulated rate, as we may seek to demonstrate per a table, giving rise to secondary, tertiary, etc. income streams, i.e., the income for the intervening period, as: [Givens - Principal Amount: Rs. 1000/-, Rate: 10% p.a.] Investment/Yr. 1 2 3 TR(@) GA(@) Rs.1000 (100) (100) 100 100 1100 Rs.100 - (10) 10 10 110 Rs.110 - - 11 11 121 Total 100 110 121 - 1331 [@: at the end of third year; TR =} total return (exclusive of the amount considered as reinvested and, therefore, not forming part of the principal); GA = Gross Amount; figures in brackets denote negative sums, being notionally received back for reinvestment] The return for the first year (Rs.100/-) yields Rs. 10/- each for the second and the third year, with Rs. 10/- for the first year yields Re.1/- for the third year. Similarly, the return of Rs. 100 for the second year yields a return of Rs. 10/- for the third year, taking the total return for that year to Rs. 21/-. Compounding, as afore ....
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....so emphasized earlier, is not dormant. No adjustment in the value is accordingly called for, i.e., in the right to receive. c) The increased value of the holding, so that the income is realised only on it's liquidation, is admittedly business income. Coming back to our earlier discussion, the debt only implies the manifestation of a right. It cannot be that though a right exists, or has come into existence, there is no corresponding 'debt', which is thus to be understood as implying a receivable, even if realizable at a future date. The same does not imply and is not to be confused with a debt in praesenti, i.e., so that the amount is due for payment, often referred to as the 'due date'. The debt accruing is a debt realizable at a later, subsequent date. We have already, per the accounting entries pertaining to transactions of interest on deposit and sale of goods, sought to emphasize and explain the difference between 'accrual' and 'due' (for payment). Rather, how can, it may be asked, an amount which is itself periodically, i.e., at intervals of time, reinvested, or regarded as so, fetching returns, be due for payment in the interim period. Further, it does not and ne....
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....nt liability which may have to be discharged in future cannot be considered as expenditure.' Further, accrual cannot be in vacuum. Just as in the case of income, the expenditure has to be 'incurred' or 'sustained' by a 'person'. We have already explained the issue with reference to and by taking some common day examples of interest on deposit (say, with a bank) or sale of goods. Though the reference point thereat was the depositor or the seller, the said entries or, rather, the mirror image of those entries, would be equally valid for the corresponding party, i.e., the person incurring the corresponding expenditure, even as indicated thereat, being the depositee (bank) or the purchaser of goods (or recipient of services) in the present case. In either case, the expenditure and the corresponding liability, even if payable in future, stands incurred. We may for better comprehension, state the relevant entries as under: (Amt. in Rs.) 1) Interest A/c Dr. 100/110/121 To Interest accrued but not due A/c Cr. 100/110/121 (to amount of interest account on loan of Rs. 1000 - for year 1/2/3) 2) Interest accrued and due Dr. 331 To interest accrued but ....
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.... intrinsic or the market value of its shares as on the date of transfer, the assessee is to, on the exercise of the option, or alternatively by AT&T, entitled to a (contractually agreed) price calculated to give a predetermined yield. That is, the said option is inconsistent with investment in risk capital? Then, again, why, for example, should the parent AT&T Global, a shareholder itself, bear the risk of the fall in the price of the shareholding of the assessee-company? The assessee-company also does not partake of any (higher) return, and in case the value of shares at the time of divesture, on the basis of intrinsic value, is higher, the assessee would be entitled only to pre-determined price, which in that case - due to legal restrictions, be purchased by a Qualified Investor (QI) specified by AT & T (clause 8.13). The investment thus can only be regarded or euphemistically termed as in equity shares, and for all intents and purposes, or in substance, is an investment held in the form of shares for a definite period at a particular return - cost to the transferee of shares, toward the time value of the funds. The transfer of shares is, thus, only the manner in which either par....
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....sessee's option and, therefore, it is only where it is so chooses that it shall stand not to be realized (during a particular period). The question, in the given facts of the case, of non realization of right by definite date does not arise. Rather, the correct way to interpret this is to say that the right to receive can be fructified, realizing the income on every single day after the completion of three years of the holding period. That is, each day after the lock-in period is or, at the option of the parties, convertible into a due date. Nature of Income 4.10 A question may arise as to the nature of income. Income is a term of wide amplitude, so that anything that can conforms to the notion of a gain or benefit, i.e., that appeals to the concept thereof, is income, as used or understood in the common parlance, with the Act only listing down, per the defining section (s. 2(24)), inexhaustively, the various types of income. Reference in this context be made to Emil Webber vs. CIT [1993] 200 ITR 483 (SC). The nature of income which falls to arise to the assessee is to be in the facts and circumstances of the case, including the fact that the investment under reference only r....
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....first blush, fails on judicial scrutiny. Firstly, the principles of commercial accounting, as explained with reference to the decisions by the Hon'ble Apex Court, shall hold for tax purposes, that is, for the purposes of the Act as well in the absence of any specific prescription to the contrary therein. Two, accrual method of accounting is legally mandated under AS-I notified under section 145(2) of the Act. When both the income and the corresponding expenditure are accounted for on accrual basis, it automatically gives rise to the matching principle, so that it is nothing but an accounting expression for both revenues and costs, being accounted for on accrual basis. In the facts of the case, the assessee has incurred borrowing cost ranging from 10% to 14% per annum, which in fact led the AO to ascertain the assessee's revenue model and the corresponding income streams. Clearly, the assessee stands allowed all interest incurred in relation to the borrowed capital for the purpose of the investment under consideration as business expenditure. The corresponding revenue, whether realized during the current year or not, is liable to be recognized as income. Of course, there must be no ....
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.... represent two separate and distinct events. What the matching principle, on the other hand, postulates is that both the income and expenditure relating to a particular period are taken into account so as not to reflect a distorted picture - the benefit of the expenditure arising, or the expenditure referable to the benefit, in measurable terms, spreading, across years. In this case, the excess expenditure resulting in loss stood already set off against the income accruing, which is as much the operating result of the enterprise as would be a positive income. The right to compensation arose in a subsequent year and is distinct from incurring the loss itself. The position would be different had the Government been contracted and, accordingly, obliged to compensate the assessee for the loss, if any, arising to it on the relevant supplies. In State Bank of Travancore (supra) another three member constitution decision, the Apex Court, in ratio, clarified that whether the income had really accrued or arisen to the assessee must be judged in the light of the reality of the situation, including the conduct of the parties. Further, the concept of real income, which is certainly applicab....
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....ation. Profits, it explained, can only be ascertained by comparing the value of the assets of the business at two dates, the increase shown at the later date representing the profits of the business during the year. This is precisely what was reiterated and elaborated by the Hon'ble Court in Ashokbhai Chimanbhai (supra). The commission at a defined rate (7 ½ %) of the annual net profit of the U company, thus, arose only to the assignee-company on the conclusion of the calendar year 1943; the calendar year being the accounting year. The moment it is realized that the managing agency agreement, where-under the income by way of agency commission accrues on the rendering of the services, and the assignment agreement where-under the office of the managing agency - a business, stands assigned, are separate and distinct agreements, it shall become plain that no part of the income under the former (managing agency agreement) could enure to the assignor of the managing agency business. The said decision is not applicable. In Canara Bank (supra), the assessee, a banking company, closing its accounts on December 31 every year, reflected interest accrued as on December 31, 1981, as i....
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....lowing the accrual method of accounting for finalizing its accounts as well as reporting income - being in fact legally obliged to do so, the said concept, i.e., accrual, a fundamental accounting assumption - so that the accounts cannot be considered as reflecting a true and fair state of affairs until the same is adopted, was examined in light of the judicial precedents and Accounting Standards, since legally mandated. Only to find a complete harmony between the two, i.e., as judicially explained and as defined in accountancy, the commercial principles of which would even otherwise hold in the absence of anything to the contrary under the statute. The question to examine is if the right to receive the return (or income) on the shares had accrued to the assessee during the relevant year. The same flowing from the shareholder's agreement entered into by it with a parent (foreign) company of the investee-company, a resident, the said agreement stands examined in detail, even as no dispute or doubt with regard to the scope or meaning of its provisions is available on record, i.e., only with a view to ascertain the nature of the rights accruing to or vesting in the assessee per the sam....
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....d in a realistic manner), the income (by way of return on investments in shares) is found to have accrued by way of inflow of or giving rise to a receivable. The arrangement is in fact - AT & T not requiring any financer, but entering the arrangement all the same only to comply with the GOI policy as to a cap on the foreign equity participation in the telecom sector for the time being, not even a financing arrangement. The agreement and the rights accruing thereby was further examined from the stand point of and in the light of a provision of the compound rate of return (on annualized basis - so that the same increases in geometric progression with time); discounting for net present value, only to find further endorsement of the said view and, further, of not impacting the valuation (of the right to receive) or the accrual of the income in any manner. Even de hors the character of the arrangement as a financing arrangement or any other, the nature of the investment would not be of much consequence as long as there is accrual of income in the facts and circumstances of the case, i.e., by way of right to receive - a receivable, resulting in a debt, realizable even if in future. Th....
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....e case (in other common day examples of) with interest on (cum) debentures or Bank FDR, et. al. and, thus, by itself of little moment. Could it be material, one may ask, if the interest of Debenture or FDR stands to be received, over the tenure of the investment, separately, or along with redemption of the investment? The increase in the share price to the defined extent would arise irrespective of the performance of the company during the holding period or its' intrinsic value (net worth) at the time of transfer of shares. Would it therefore matter even if (say) some management rights were also attached to the shareholding - which we observe as not. In our view - not. The investment is in a private company, shares in which are severely restricted for transfer, making it highly illiquid, i.e., but for the arrangement, in pursuance to which only in fact the investment in shares stands made. That is, considerable uncertainty would otherwise exist as to the realizability of the income. The income being also in agreement with the matching principle of accountancy, also judicially approved, is thus found to accrue from year to year, i.e., on time basis and, thus, for the relevant year. ....