By Kirit S. Sanghvi
Chartered Accountant
ABC Ltd. commenced
development of a real estate project in F.Y. 2019-20. It proposes to enter into
agreements for sale of units under construction.
ABC Ltd. has
borrowed capital of Rs. 100.00 crores from financial institutions. The yearly
borrowing cost (interest) is Rs. 12.00 crores. The capital is borrowed for
construction of units which, as on 31st March, 2020 are in the state
of work-in-progress (WIP).
The company is
finalising its accounts for F.Y. 2019-20. It has capitalised interest in the
books of accounts in conformity with the Accounting Standard-16 on ‘Borrowing
Costs’ (AS-16). The accountant of the company raises an issue about the claim
for deduction in respect of the interest paid on the borrowing, for he wants to
know whether provision for taxation in the accounts of F.Y. 2019-20 should be
based on the profit as per the profit and loss account or should be based on such
profit as reduced by the amount of interest that is otherwise capitalised. The
company approaches you for guidance.
IDENTIFICATION
OF ISSUES
The central issue
for consideration is whether or not interest paid on borrowing used in
construction of real estate for sale is allowable, particularly in the light of
the proviso to section 36(1)(iii) as amended from A.Y. 2016-17.
The following
issues require consideration:
(i) Scope of proviso to section
36(1)(iii): Whether, on the basis of the facts and circumstances, interest on
the borrowing used for construction of WIP would be an allowable expense
particularly in the light of the proviso to section 36(1)(iii) of the
Income-tax Act, 1961 (the Act)?
(ii) Income Computation and Disclosure Standard
(ICDS): How will the provisions of ICDS-IX relating to the ‘Borrowing Cost’
impact the claim for deduction for interest in this case?
(iii) Can the treatment of interest in own books of
accounts be ignored? Whether a claim for deduction in respect of interest can
be made when the assessee has himself capitalised such interest in the books of
accounts?
Scope of proviso to section 36(1)(iii)
Section 36(1) in
its main part provides for allowance of the interest in respect of capital
borrowed for the purpose of business. However, the proviso carves out an
exception to the general provisions. The proviso reads as, ‘Provided
that any amount of the interest paid, in respect of capital borrowed for
acquisition of an asset (whether capitalised in the books of accounts or not),
for any period beginning from the date on which the capital was borrowed for
acquisition of the asset till the date on which such asset was first put to
use, shall not be allowed as deduction.’
The proviso
provides for disallowance of interest when the following circumstances exist
cumulatively:
(a) interest is paid in respect of borrowing;
(b) the borrowing is used for acquisition of an
asset;
(c) there is a time gap between the date on which
capital was borrowed and the date on which such asset was put to use.
If these conditions
are fulfilled, interest for the period from the date of borrowing till the time
the asset is put to use will be disallowed.
In this case, the
company has used borrowed capital on construction which is in the stage of WIP.
The proviso prescribes, under certain circumstances, disallowance of
interest if the borrowed capital is used for acquisition of an ‘asset’. In this
case, therefore, the question of disallowance of interest attributable to WIP
should arise provided it is shown first that ‘WIP’ is contemplated in the
meaning of the term ‘asset’. The language of the proviso does not
provide a straight answer. Therefore, the language of the proviso has to
be carefully considered to find out whether interest attributable to
‘inventory’, or ‘WIP’ is in contemplation of the proviso.
Two things stand
out from a reading of the proviso. It applies if there is an
‘acquisition’ of an asset, and two, that the asset is such as is capable of
being ‘put to use’. When the proviso is read in the context of interest
attributable to WIP, the ‘asset’ referred to in the proviso is WIP. In
order to find out whether WIP is contemplated as an ‘asset’ in the proviso,
we can test it by rephrasing the proviso thus: ‘…interest paid in
respect of capital borrowed for acquisition of WIP for any period beginning
from the date on which the capital was borrowed till the date on which such WIP
was first put to use…’
WIP in a case such
as this one is said to be ‘constructed’ and not ‘acquired’. The expression ‘WIP
is acquired’ has a completely different meaning from the meaning of the expression
‘WIP is constructed’. Random House Webster’s Unabridged Dictionary defines
‘acquisition’ as ‘act of acquiring or gaining possession, e.g., the acquisition
of real estate’. Black’s Law Dictionary defines ‘acquisition’ as ‘the gaining
of possession or control over something’. The word ‘acquire’ is defined in the
same dictionary as ‘to get possession or control of; to get; to obtain’. One
can see that the normal meaning of ‘acquisition’ carries in it a sense of a
thing that exists and the act of gaining possession of or control over that
thing is called ‘acquisition’.
With this
understanding of the term ‘acquisition’, let us rephrase the proviso to
see whether the language sounds natural when the proviso is sought to be
applied to the borrowing costs attributable to construction of WIP. The
rephrased proviso will read as ‘…interest paid in respect of capital
borrowed for acquisition of WIP…’. If this is the sentence, the usual sense
that is conveyed is that the person gains possession of or control over an asset
which so far existed, but its possession was not with him. When a builder
constructs units which are in the state of WIP, does the builder describe his
activities as amounting to ‘acquisition’ of WIP? Isn’t the builder more
accurate in describing his activities as amounting to ‘construction’ of WIP?
Thus, the use of the word ‘acquisition’ and the absence of the word
‘construction’ in the proviso is the first indication that WIP is not
contemplated as an ‘asset’ to which the proviso should apply.
There is one more
reason, and perhaps more indicative than the first reason, showing that WIP is
not contemplated in the meaning of the term ‘asset’ in the proviso. This
second reason is that the proviso prescribes the date on which the asset
was first ‘put to use’ as the terminus for capitalisation of interest. It
follows logically that if WIP is deemed to be contemplated in the meaning of
the term ‘asset’, then capitalisation of interest will cease on the date on
which the WIP is ‘put to use’. Now, one hardly ‘puts WIP to use’; what one
ordinarily does with WIP is to make it ready for sale. Thus, WIP or the units
constructed for sale do not have a date on which they are ‘put to use’. How
does one then decide the point of cessation of capitalisation of interest if
the proviso is applied to the interest attributable to the WIP?
Reference should be made here to paragraph 8(b) of the ICDS-IX which prescribes
the point of time when capitalisation of interest attributable to inventories
will cease. According to this paragraph, one arrives at this point of time
‘when substantially all the activities necessary to prepare such inventory for
its intended sale are complete’. Thus, it may be argued that even for ICDS-IX
the concept of ‘put to use’ is not relevant when it is dealing with
capitalisation of interest attributable to WIP; instead, the ICDS prescribes a
new terminus for capitalisation of interest while dealing with interest
attributable to WIP. The terminus prescribed by ICDS-IX is different from the
one that is prescribed in the proviso.
Two things can be
said about this inconsistency. One, this part of ICDS-IX which prescribes a new
terminus exceeds the scope laid down by the proviso; there is conflict
between the ICDS and the statutory provision. The conflict is that the law
amply indicates by its language that it is not intended to apply to interest
attributable to inventories, whereas the ICDS-IX ropes in such interest by
using a different language. Therefore, to that extent, the statutory provision
should prevail. Two, the framers of ICDSs believe that the concept of ‘put to
use’ insofar as WIP is concerned is not relevant, or else, they would not have
changed the terminus for capitalisation of interest attributable to WIP from
what is prescribed in the proviso.
Impact of ICDS-IX on Section 36(1)(iii)
As seen above, the proviso
uses the expression ‘acquisition of an asset’ which, as shown above, does not
serve well if the meaning that is intended to be conveyed is ‘construction of
an asset’. One may argue here that though the word ‘construction’ is not used
in the proviso, it is used in ICDS-IX. Therefore, interest on borrowing,
directly or indirectly attributable to WIP, should be disallowed if not under
the proviso then under ICDS-IX. To this argument, it may be said that
the argument would be valid if ICDS’s were allowed to exceed the statutory
provision which the ICDS’s find themselves in conflict with. Quite to the
contrary, the preamble to ICDS-IX states that in case there is a conflict
between the provisions of the Act and the ICDS, the provisions of the Act shall
prevail to that extent.
Therefore, when
ICDS-IX uses the words ‘construction’ and ‘production’ in addition to the term
‘acquisition’, it is in acknowledgement of the fact that ‘construction’ has a
distinct meaning different from the meaning of the term ‘acquisition’.
Therefore, when interest attributable to WIP is sought to be disallowed by
taking resort to ICDS-IX it should be recognised that ICDS-IX exceeds the scope
assigned to it by section 36(1)(iii). Therefore, to that extent, the provisions
of the Act shall prevail.
In the above
discourse, considerable emphasis is placed on the meaning of certain terms,
like ‘acquisition’ and ‘put to use’ and their usage in section 36(1)(iii)in
order to decipher the scope of the proviso. This approach of inferring a
meaning of a statutory provision is acceptable when the positive use of a word
or non-use of specific words can help decide an issue. A good example
deciphering meaning is provided by the Bombay High Court’s decision in the case
of CIT vs. Jet Airways (I) Ltd. (2011) 331 ITR 236 in which the
use of a pair of words ‘and also’ helped decide the issue.
Can the treatment of interest in
own books of accounts be ignored?
The allowability of
interest in a case like this should be decided independently and if the law is
found to allow such deduction, then it does not matter that the accounting
policy provides otherwise. As for the importance of accounts in determining
taxable income, the Supreme Court said in Taparia Tools Ltd. vs. CIT 372
ITR 605 (SC), ‘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’.
As to the
relationship between the accounting policy and a provision of law, the Supreme
Court held in Tuticorin Alkali & Fertilizers Ltd. vs. CIT 227 ITR 172
(SC) that ‘It is true that the Supreme Court has very often referred to
accounting practice for ascertainment of profit made by a company or value of
the assets of a company. But when the question is whether a receipt of money is
taxable or not, or whether certain deductions from that receipt are permissible
in law or not, the question has to be decided according to the principles of
law and not in accordance with accountancy practice. Accounting practice cannot
override section 56 or any other provision of the Act.’
OTHER POINTS
There is one more
reason to hold the view that the meaning of ‘asset’ in the proviso does
not contemplate ‘WIP’. This will be clear from a reading of the proviso
before it was amended by the Finance Act, 2015 effective from A.Y. 2016-17
which, when unamended, read as, ‘Provided that any amount of the interest paid,
in respect of capital borrowed for acquisition of an asset for extension of
existing business or profession (whether capitalised in the books of accounts
or not), for any period beginning from the date on which the capital was
borrowed for acquisition of the asset till the date on which such asset was
first put to use, shall not be allowed as deduction.’
The amendment has
not affected the meaning of the word ‘asset’; it has dropped the words, ‘for
extension of existing business or profession’. When these words formed part of
the proviso, it was hardly anybody’s case that interest on capital
borrowed for construction of WIP should be disallowed, because construction of
WIP would ordinarily not result in ‘extension of business’, and therefore,
interest was not disallowable. Now, with the removal of the words, ‘for
extension of existing business or profession’ from the proviso, the
interest attributable to an asset which interest earlier escaped disallowance
on account of the fact that the asset was acquired but not for extension of
business, will also be roped in for capitalisation. For example, a company buys
a machine which is put to use after 12 months from the time the capital for its
acquisition was borrowed. Interest paid for such period will be disallowed in
spite of the fact that the machine may not have been acquired for extension of
existing business.
A useful reference
may be made here to the Circular No. 19/2015 dated 27th November,
2015 explaining the amendment brought in by the Finance Act, 2015. The relevant
parts of the Circular are reproduced below:
‘16.1 The Income
Computation and Disclosure Standards (ICDS)-IX relating to borrowing costs
provides for capitalisation of borrowing costs incurred for acquisition of
assets up to the date the asset is put to use. The proviso
to clause (iii) of sub-section (1) of section 36 of the Income-tax Act provided
for capitalisation of borrowing costs incurred for acquisition of assets for
extension of existing business up to the date the asset is put to use. However,
the provisions of ICDS-IX do not make any distinction between the asset
acquired for extension of business or otherwise.
16.2 Therefore, there was an inconsistency between
the provisions of proviso
to clause (iii) of sub-section (1) of section 36 of the Income-tax Act and the
provisions of ICDS-IX. The general principles for capitalisation of borrowing
cost requires capitalisation of borrowing cost incurred for acquisition of an
asset up to the date the asset is put to use without making any distinction
whether the asset is acquired for extension of existing business or not. The
Accounting Standard Committee, which drafted the ICDS, also recommended that
there is a need to carry out suitable amendments to provisions of the proviso
to clause (iii) of sub-section (1) of section 36 of the Income-tax Act for
aligning the same with the general capitalisation principles.
16.3 In view of
the above, the provisions of proviso to clause
(iii) of sub-section (1) of section 36 of the Income-tax Act have been amended
so as to provide that the borrowing cost incurred for acquisition of an asset
shall be capitalised up to the date the asset is put to use without making any
distinction as to whether an asset is acquired for extension of existing
business or not.’
It can be seen from
the contents of the Circular that the purpose of the amendment was to remove
inconsistency between the provisions of the proviso and the provisions
of ICDS-IX. However, when the proviso requires capitalisation of that
interest which is directly or indirectly attributable to the acquisition,
construction and production of a qualifying asset, ICDS-IX requires
capitalisation of interest even in cases where the qualifying asset is
constructed or produced, whereas the proviso mandates capitalisation of
interest in the cases where the qualifying asset was acquired. The Act
recognises the difference in the connotations of the terms ‘acquired’ and
‘constructed’ by using both in section 24(b). Thus, the provisions of ICDS-IX
in this regard exceed the scope of the statutory provision to which the
provisions of ICDSs have to yield.
A reference may be
made here to the decision of the Bombay High Court in the case of CIT vs.
Lokhandwala Construction Ind. Ltd. (2003) 260 ITR 579. The assessee had
used borrowed capital on construction of buildings which were WIP. The
Commissioner invoked his powers u/s 263 and directed the interest to be
disallowed on the ground that it was incurred in relation to acquisition of a
capital asset and therefore the interest expenditure was capital in nature. The
High Court held otherwise and directed the interest to be allowed.
It is true that the
assessment year involved in this case is such that the proviso in any
shape was not on the statute book. However, the decision explains an important
principle of accountancy, which is that interest paid on capital borrowed and
used for construction, acquisition or production of inventory is expenditure of
revenue in nature. This principle should hold good even in the present times as
‘true income’ cannot be computed ignoring such principles of accountancy.
CONCLUSION
The accountant may
consider the interest capitalised in the books of accounts as deductible for
the purpose of computation of taxable income, and may provide for taxation
accordingly with a clear understanding that this may lead to litigation arising
mainly on account of inconsistency between the proviso to section
36(1)(iii) and ICDS-IX. The company has a good, arguable case on hand.
