By TIOL News Service

NEW DELHI, MAR 24, 2015: THE issue before the Bench is - Whether the liability of assesee to pay the interest upfront to the debenture holder can be fully claimed for deduction in the first year itself, if the liability is fully discharged in such AY. And the verdict favours the assessee.

Facts of the case

The assessee company is engaged in the business of manufacturing hammer, wrench & other hand tools, automotive tools, drift pin, sockets & pipe wrenches. The assessee while filing its return, had had claimed deduction of revenue expenditure on account of interest payment in the sum of 2,72,25,000/- paid to one M/s. Maliram Makharia Stock Brokers Pvt. Ltd. and Rs. 55,00,000/- on account of interest payment given to M/s. Sharp Knife Company Pvt. Ltd. This was on account of upfront payments of interest given to the said two debenture holders in the A.Ys 1996-97 and 1997-98 respectively. Insofar as the assessee's claim for deduction of premium payable on redemption was concerned, the same was claimed in the return on a spread over basis covering a period of five years. The AO however, treated it as the 'deferred revenue expenditure', to be written off over a period of five years and, therefore, in these A.Ys, he allowed only 1/5th of the payment made, though the entire payment was made in the A.Y 1996-97. On appeal, the CIT(A) confirmed the order of the AO. On further appeal, the Tribunal as well as the jurisdictional High Court upheld the order of CIT(A) maintaining the method of deduction adopted by the AO.

Having heard the parties, the Supreme Court held that,

++ it is seen that the assessee maintains its accounts on mercantile basis. Further, the entire amount for which deduction was claimed was, in fact, actually paid to the debenture holder as upfront interest payment. It is also a matter of record that this amount became payable to the debenture holder in accordance with the terms and conditions of the non-convertible debenture issue floated by the assessee, on the exercise of option by the aforesaid debenture holders, which occurred in the respective A.Ys in which deduction of this expenditure was claimed. As per section 36(1)(iii), any amount on account of interest paid becomes an admissible deduction u/s 36 if the interest was paid on the capital borrowed by the assessee and this borrowing was for the purpose of business or profession. There is no quarrel, in the present case, that the money raised on account of issuance of the debentures would be capital borrowed and the debentures were issued for the purpose of the business of the assessee. In such a scenario when the interest was actually incurred by the assessee, which follows the mercantile system of accounting, on the application of this statutory provision, on incurring of such interest, the assessee would be entitled to deduction of full amount in the assessment year in which it is paid. While examining the allowability of deduction of this nature, the AO is to consider the genuineness of business borrowing and that the borrowing was for the purpose of business and not an illusionary and colourable transaction. Once the genuineness is proved and the interest is paid on the borrowing, it is not within the powers of the AO to disallow the deduction either on the ground that rate of interest is unreasonably high or that the assessee had himself charged a lower rate of interest on the monies which he lent. In the instant case, the AO did not dispute that the non-convertible debentures were issued and money raised for business purposes. The AO did not even dispute the genuineness of clause relating to upfront payment of interest in the first year itself as per the option to be exercised by the debenture holder. Therefore, there is no dispute that interest has, in fact, been 'paid' during the year of accounting. Definition of 'paid' is contained u/s 43(ii) to mean actually paid or incurred according to the method of accounting. As per the said definition, even if the amount is not actually paid but 'incurred', according to the method of accounting, the same would be treated as 'paid'. Since the assessee was following mercantile system of accounting, the amount of interest could be claimed as deduction even if it was not actually paid but simply 'incurred'. However, in the instant case, it is not in dispute that the amount of interest was actually paid as well in the assessment year in which it was claimed;

++ the only reason which persuaded the AO to stagger and spread the interest over a period of five years was that the term of debentures was five years and that the assessee had itself given this very treatment in the books of accounts, viz, spreading it over a period of five years in its final accounts by not debiting the entire amount in the first year to the P&L A/c and it has, in fact, debited 1/5th of the interest paid to the P&L A/c from the second year onwards. Insofar as the first reason, namely, non-convertible debentures were issued for a period of five years is concerned, that is clearly not tenable. While taking this view, the AO clearly erred as he ignored the terms on which debentures were issued. As noted, there were two methods of payment of interest stipulated in the debenture issued. Debenture holder was entitled to receive periodical interest after every half year @ 18% per annum for five years, or else, the debenture holder could opt for upfront payment of 55 percent debenture towards interest as one time payment. By allowing only 1/5th of the upfront payment actually incurred, though the entire amount of interest is actually incurred in the very first year, the AO, in fact, treated both the methods of payment at par, which was clearly unsustainable. By doing so, the AO, in fact, tampered with the terms of issue, which was beyond his domain. It is obvious that on exercise of the option of upfront payment of interest by the subscriber in the very first year, the assessee paid that amount in terms of the debenture issue and by doing so he was simply discharging the interest liability in that year thereby saving the recurring liability of interest for the remaining life of the debentures because for the remaining period the assessee was not required to pay interest on the borrowed amount;

++ the next question which arises for consideration is as to whether the assessee was estopped from claiming deduction for the entire interest paid in the year in which it was paid merely because it had spread over this interest in its books of account over a period of five years. It is found that the High Court has taken into consideration the provisions of Section 36(1)(iii) and the conditions which are to be fulfiled for allowing the deduction on this account. However, the High Court chose to decline the whole deduction in the year of payment, thereby affirming the orders of the authorities, by invoking the 'Matching Concept'. It is observed by the High Court that under the mercantile system of accounting, book profits are liable to be taxed and in order to determine the net income of an Accounting Year, the revenue and other incomes are to be matched with the cost of resources consumed. For this reason, in the opinion of the High Court, this matching concept is required to be done on accrual basis. This court is of the opinion that it is here the High Court has gone wrong and this approach resulted in wrong application of Matching Concept. It is emphasized once again that as per the terms of issue, the interest could be paid in two modes. As per one mode, interest was payable every year and in that case it was to be paid on six monthly basis @ 18% per annum. In such cases, the interest as paid was claimed on yearly basis over a period of five years and allowed as well and there is no dispute about the same. However, in the second mode of payment of interest, which was at the option of the debenture holder, interest was payable upfront, which means insofar as interest liability is concerned, that was discharged in the first year of the issue itself. By this, the assessee had benefited by making payment of lesser amount of interest in comparison with the interest which was payable under the first mode over a period of five years. This court is, therefore, of the opinion that in order to be entitled to have deduction of this amount, the only aspect which needed examination was as to whether provisions of Section 36(1)(iii) r/w/s 43(ii) were satisfied or not. Once these are satisfied, there is no question of denying the benefit of entire deduction in the year in which such an amount was actually paid or incurred;

++ the High Court has also observed that it was a case of deferred interest option. However, it is clear that there is no concept of deferred revenue expenditure in the Act except under specified sections, i.e. where amortization is specifically provided, such as Section 35-D. What is to be borne in mind is that the moment second option was exercised by the debenture holder to receive the payment upfront, liability of the assessee to make the payment in that very year, on exercising of this option, has arisen and this liability was to pay the interest @ 55 per debenture. It is also clear that not only the liability had arisen in the A.Y in question, it was even quantified and discharged as well in that very accounting year. In the instant case, the assessee did not want spread over of this expenditure over a period of five years as in the return filed by it, it had claimed the entire interest paid upfront as deductible expenditure in the same year. In such a situation, when this course of action was permissible in law to the assessee as it was in consonance with the provisions of the Act which permit the assessee to claim the expenditure in the year in which it was incurred, merely because a different treatment was given in the books of accounts cannot be a factor which would deprive the assessee from claiming the entire expenditure as a deduction. It has been held repeatedly by this Court that entries in the books of accounts are not determinative or conclusive and the matter is to be examined on the touchstone of provisions contained in the Act. In view of these discussion, this court is of the opinion that the judgment and the orders of the High Court and the authorities do not lay down correct position in law.

(See 2015-TIOL-25-SC-IT)