Depreciation On Leased Assets

Hi Mr Ravi,

You haven't said if it's a Finance Lease or an Operating Lease. AS 19 defines a Finance lease as the one in which substantially all risks and rewards emanating from the ownership of the asset are transferred to the lessee. An Operating lease is defined negatively as the one that isn't a Financial lease—that is in an Operating lease substantially all risks and rewards of ownership aren't passed to the lessee. You need to go through para 8 of AS 19 that lays down tests to determine whether a lease constitutes a finance lease. The first test is: Will the ownership of the leased out assets be transferred to the lessee at the end of the lease term? However I think if the primary test of risks and rewards associated with owning an asset being passed on to the lessee is satisfied in your case, it'd be a finance lease. The lessee in its Balance Sheet recognizes an asset held under finance lease by creating a corresponding liability in respect of future lease rentals. Since your question seems to relate to depreciation under the Income Tax Act, I shall examine this issue from the taxation angle only. In terms of claiming depreciation u/s 32 of the I T Act, there are numerous case laws, decided by the Supreme Court no less, where it's been held that the legal ownership of the asset is not necessary to be eligible to claim depreciation on it. In Mysore Minerals Ltd. v. CIT [1999] 106 Taxman 166 (SC), the Apex court said the following:[Building owned by the assessee the expression as occurring in section 32(1) of the Income-tax Act means that the person who having acquired possession over the building in his own right uses the same for the purposes of the business or profession though a legal title has not been conveyed to him consistently with the requirements of laws such as the Transfer of Property Act, the Registration Act, etc., but nevertheless is entitled to hold the property to the exclusion of all others.]Let's see how the CBDT deals with the issue of depreciation on finance leases. In its Circular No 2/2001 dated February 9, 2001, it says:[1 Under the Income-tax Act in all leasing transactions, the owner of the asset is entitled to depreciation if the same is used in the business, under section 32 of the Income-tax Act. The ownership of the asset is determined by the terms of the contract between the lessor and the lessee.2. [….]3. It has come to the notice of the Board that the New Accounting Standard on `Leases' issued by the Institute of Chartered Accountants of India requires the capitalization of the asset by the lessees in finance lease transaction. By itself, the accounting standard will have no implication on the allowance of depreciation on assets under the provisions of the Income-tax Act."]Clearly the CBDT and the chartered accountants are at loggerheads on this issue. But it seems we have the law on our side. Recently in a decision in Asea Brown Boveri Ltd. v. Industrial Finance Corpn. of India Ltd. [2004] 56 SCL 21/[2006] 154 Taxman 512 (SC), the Supreme Court has endorsed the ICAI's perspective on the treatment of assets being used under a finance lease. I quote below from the judgement:[In our opinion, financial lease is a transaction current in the commercial world, the primary purpose whereof is the financing of the purchase by the financier. The purchase of assets or equipments or machinery is by the borrower. For all practical purposes, the borrower becomes the owner of the property, inasmuch as it is the borrower who chooses the property to be purchased, takes delivery, enjoys the use and occupation of the property, bears the wear and tear, maintains and operates the machinery/equipment , undertakes indemnity and agrees to bear the risk of loss or damage, if any. He is the one who gets the property insured. He remains liable for payment of taxes and other charges and indemnity. He cannot recover from the lessor, any of the above-mentioned expenses. The period of lease extends over and covers the entire life of the property for which it may remain useful, divided either into one term or divided into two terms with a clause for renewal. In either case, the lease is non-cancellable. ]So the final interpreter of the law in India, the Supreme Court, has recognized that a finance lease is nothing but a loan in disguise. The lessee is just a borrower who would have the asset legally transferred in his name after he's paid out all the lease rentals. Actually to call those periodical payouts "rentals" is a misnomer—they're more in the nature of part principal repayments of loan and part interest. Never mind the CBDT in its FBT circular wants the lessee to pay FBT on the entire lease rentals on car!The above decision of the SC was in the context of the Companies Act and not the Income tax law. But that's no reason to brush it under the carpet. But why, we even have Income tax judgements disallowing depreciation to lessors. Since either of two parties has to claim depreciation, by implication, the lessee CAN claim depreciation u/s 32. The Delhi Tribunal in Industrial Finance Corpn. of India v. Dy. CIT [2005] 4 SOT 223 (Delhi), held that:[If the lessor in terms of the agreement provides only the right to use to the lessee during the period of lease, retaining the rights as an `owner' with itself [i.e., operating lease as defined by Notified AS-19], in such a case the lessor would be regarded as the owner for the purposes of claim of depreciation.If the leasing arrangement is a mere financing arrangement, whereby the lessor, in reality is only providing funds for acquisition of the asset and the asset leased out for all intents and purposes, becomes the property of the lessee (i.e., finance lease in terms of Notified AS-19), then in such situation benefit of the depreciation would not be available in the hands of the lessor]Of course in this case the plaintiff, the IFCI, happened to be a financier, which was in the business of financing assets. Still, I think the reasoning can be applied to a situation where the lessor isn't a registered financier, but is in the "business" of leasing out assets. It's difficult to see how the CBDT's circular of February 9, 2001 can be applied to finance leases in the light of the above judgements. As far operating leases are concerned, what the CBDT says doesn't militate against what the judicial forums say. There'd be a whole lot of issues involved in this transaction. What about TDS on lease rent u/s 194-I? If we say not the whole of lease rentals constitute income in the hands of the lessor as they're merely components of principal and interest camouflaged as lease rentals, would the lessee still need to make TDS on the lease rentals? In the ABB decision, the Supreme Court has given explicit recognition to the accounting concept of Substance over Form—-we should look at the substance or essence of the transactions and not merely their form or the legal clothing the parties dress them up in.As we've seen, a finance lease is bristled with legal difficulties right from the word go. If you'd rather not get entangled in all these issues, it's better to define the lease as an Operating lease and let your client, the lessor, claim depreciation on it. Thanks,CA Sanjeev Bedi--- In ICAI_CIRC_MEERUT_ CA@yahoogroups. com, selvaganapathy ravichandran wrote:>> Dear Friends,> > One of our client has leased out Land , Building & Machinery etc to another person for the purpose of Carring out Business. The lease rental is Rs. 1 lAKH per Month as lease rental . Who should claim the depriciation Lessor/Lessee?> I persume only the Lessor is entitled to claim the Depriciation . Kindly clarify.> > Regards,> Ravi