Court Upholds Assessee's Method of Spreading Membership Fees Over Service Period

Get the full picture - access the original judgement of the court order here.

Case Name:

Commissioner of Income Tax vs Unique Mercantile Service (P) Ltd. (High Court of Gujarat)

Tax Appeal No. 1471 of 2005

Date: 18th December 2014

Key Takeaways:

1. The court upheld the assessee's method of accounting, which spread membership fees and expenses over the service period.

2. The judgment emphasizes the importance of matching revenue with expenses to accurately reflect profits.

3. The court ruled that income should be recognized as services are rendered, not when fees are received.

Issue:

Was the Income Tax Appellate Tribunal justified in setting aside the order of the Commissioner of Income Tax passed under Section 263 (of Income Tax Act, 1961), and accepting the assessee's method of accounting for membership fees and related expenses?

Facts:

1. The assessee company provides facility cards to members for a one-time, non-refundable membership fee.

2. Membership periods vary from one to fifteen years.

3. The assessee apportioned membership fees over the entire period of membership.

4. The Assessing Officer initially rejected this method for the 1997-98 assessment year but accepted it for 1998-99.

5. The Commissioner of Income Tax (CIT) set aside the 1998-99 assessment under Section 263 (of Income Tax Act, 1961).

6. The Income Tax Appellate Tribunal ruled in favor of the assessee's accounting method.

Arguments:

Revenue's Arguments:

1. The Tribunal erred in quashing the CIT's order under Section 263 (of Income Tax Act, 1961).

2. The assessee doesn't provide continuous service after card sale, so all revenue should be recognized immediately.

3. Postponing revenue while claiming immediate expenses distorts financial results.

Assessee's Arguments:

1. The accounting method is recognized and determines true and fair profit for each year.

2. The company provides various facilities to cardholders/members over time.

Key Legal Precedents:

1. Taparia Tools Ltd. vs. Jt. CIT, [2003] 260 ITR 102 (Bombay High Court):

Emphasized matching principle in accounting.

2. Rakesh Shantilal Mardia vs. Deputy Commissioner of Income-tax [2012] 210 Taxman 565 (SC):

Affirmed the matching principle for determining real income.

3. Commissioner of Income-Tax vs. Dinesh Kumar Goel [2011] 331 ITR 10 (Delhi High Court):

Discussed the concept of income accrual and the importance of rendering services.

4. Snesh Resort Pvt. Ltd vs. Dy. CIT (Tax Appeal No. 113 of 2004):

Supported the concept of revenue recognition based on service rendering.

Judgement:

1. The High Court dismissed the revenue's appeals, affirming the Tribunal's decision.

2. The court held that the assessee's method of spreading membership fees and expenses over the service period was justified.

3. The court emphasized that when services are rendered partially, revenue should be shown proportionate to the degree of service completion.

4. The Tribunal was correct in setting aside the CIT's order under Section 263 (of Income Tax Act, 1961).

FAQs:

Q1: Why did the court favor the assessee's accounting method?

A1: The court found that this method more accurately reflected the true profits by matching revenue with the related expenses over the service period.

Q2: What is the significance of the "matching principle" in this case?

A2: The matching principle ensures that revenues and expenses are recognized in the same accounting period, providing a more accurate picture of the company's financial performance.

Q3: How does this judgment impact businesses with long-term service contracts?

A3: It supports the practice of recognizing revenue over the service period rather than upfront, which can lead to more stable and accurate financial reporting.

Q4: What would have been the consequence if the revenue's argument was accepted?

A4: It would have led to inflated profits in the year of receiving membership fees, followed by losses in subsequent years when expenses were incurred without corresponding revenue.

Q5: Does this judgment apply to all types of membership fees?

A5: While the principle may be broadly applicable, each case would need to be evaluated based on the specific nature of services provided and the terms of the membership agreement.

1. Being aggrieved and dissatisfied with the impugned judgment and order passed by the Income Tax Appellate Tribunal, Ahmedabad Bench (hereinafter referred to as ‘the Tribunal’), the revenue has preferred the present Tax Appeals assailing the following orders.

1.1 These matters were admitted by this Court for

consideration of the substantial question of law as to whether

the Appellate Tribunal was justified in setting aside the order

of the CIT passed under Section 263 (of Income Tax Act, 1961),

1961 (hereinafter referred to as ‘the Act’).

2. The assessee company is engaged in the business of

providing facility cards to the members on payment of

prescribed fees which is called membership fees which is a

one-time fee and is non-refundable. The period of

membership varies between one to fifteen years. It is the case

of the assessee that the payment of the membership is non-

transferable. The accounts of the assessee had been prepared

on accrual basis and accordingly it had apportioned the

membership fees received from the members enrolled in a

particular accounting year over the entire period of their

membership.

2.1 The assessment year 1997-98 was the first assessment

year in which the Assessing Officer rejected the method of

accounting followed by the assessee and he considered the

receipt in the year in which the cards were issued and

similarly the deduction for expenditure was also allowed in

the year in which they were paid irrespective of the number of

years for which insurance cover was taken. In the assessment

year 1998-99 the Assessing Officer accepted the assessee’s

method of accounting to be correct. However, the CIT(AP set

aside the order of the Assessing Officer u/s 263 (of Income Tax Act, 1961).

Similarly, in the other remaining years under consideration in

these appeals, the Assessing Officer rejected the assessee’s

method of accounting. Therefore, the revenue in all these

appeals appealed before the Tribunal and the Tribunal vide

impugned order held that the period/years wherein the

Assessing Officer has accepted the assessee’s method of

accounting was neither erroneous nor prejudicial to the

interest of revenue. The order u/s 263 (of Income Tax Act, 1961) was also set

aside. Being aggrieved by the said order, the revenue is in

appeal before us.

3. Mr. Nitin Mehta, learned advocate appearing for the

revenue submitted that the Tribunal has committed an error

in quashing the order u/s 263 (of Income Tax Act, 1961) passed by the CIT and

in reaching the conclusion that the assessment order passed

by the A.O by accepting the assessee’s method of accounting

was neither erroneous nor prejudicial to the interests of

revenue. He submitted that the Tribunal has ignored the fact

that the A.O had not followed the assessment order passed by

his predecessor for A.Y 1997-98 wherein the method of

accounting followed by the assessee was rejected.

3.1 Mr. Mehta has drawn our attention to the decision of

ITAT, Hyderabad Bench which was relied upon by the

Tribunal in the case of Treasure Island Resorts (P) Ltd vs.

DCIT reported in 84 TTJ 820 considering the facts in both the

cases to be similar. He submitted that the facts in both the

cases are not identical but altogether different and therefore

the decision reached by the Tribunal is factually as well as

legally incorrect.

3.2 Mr. Mehta submitted that since discount is given by the

shop keepers and insurance facility is provided by the

Insurance Company, the assessee does not provide any

service to the card holders after sale of card and therefore

there is no question of providing service on continuous basis

for the period of card. He further submitted that by

postponing the revenue and two items of expenses, the

assessee has claimed all other expenses for sale of cards in

the first year and is giving distorted picture of the working

results since the expenses have been claimed but the income

is postponed. He submitted that in such a scenario, the

assessee will be showing loss all throughout.

4. Mr. B.S. Soparkar, learned advocate appearing for the

assessee supported the impugned order passed by the

Tribunal and submitted that no interference is called for in the

same. He submitted that except for the year 1998-99

wherein the Assessing Officer accepted the assessee’s method

of accounting to be correct and CIT(A) set aside the order of

the Assessing Officer u/s 263 (of Income Tax Act, 1961), the CIT(A) allowed in

favour of the assessee. He submitted that the method of

accounting followed by the assessee is a recognized method

and true and fair profit of each assessment year is determined

through the same. He further submitted that the assessee

company provides various facilities to the card

holders/members.

5. We have heard learned advocates for both the sides and

perused the materials on record. The main dispute in all

these appeals is with regard to the correctness of the method

of accounting of the assessee company for recording the

receipt by way of membership fee and the expenses by way of

commission and insurance premium. The assessee company

is following mercantile system of accounting but the dispute is

when the assessee has issued the facility card for a number of

years, whether the membership fee received for number of

years accrues in the year in which the card is issued or

whether it should be spread over to the number of years for

which the card is issued.

5.1 In this regard it shall be relevant to peruse the

Notification No. S.O. 69(E) dated 25.01.1996 wherein the

Central Government has notified Accounting Standard-1,

more particularly, the expression ‘accrual’ which has been

defined as under:

“(b) “Actual” refers to the assumption that

revenues and costs are accrued, that is, recognized

ad they are earned or incurred (and not as money

is received or paid) and recorded in the financial

statements of the periods to which they relate;”

5.2 The assessee has accordingly recorded the revenue as

well as expenditure in the financial statement of period to

which they relate. We find that the Tribunal has rightly

observed as under in para 8 as under:

“... When the assessee issued facility cards for

number of years,t he assessee has received

entrance fee as well as membership fee. Entrance

fee is recorded in the year of receipt while the

membership fee is spread over to the period to

whichthe membership relates. Similarly, the

assessee pays insurance premium for the number

of years for which the card is issued because the

assessee has to provide the accidental insurance

for the entire period of the card. Such expenditure

is also spread over to the period for which the card

is issued. The Revenue has claimed that the

receipt of membership fee as well as the

expenditure on the commission and the insurance

premium is to be recorded in the year in which

they are received and paid. The stand of the

Revenue is contrary to the definition of accrual as

provided in the Accounting Standard specified by

the Central Government which is mandatory to be

followed by the income tax assessee.”

5.3 We find that the Tribunal has rightly relied upon the

decision of Hyderabad Bench in the case of Treasure Island

(supra) and concluded as under:

“The above finding of the ITAT would be squarely

applicable to the case under consideration before

us as the facts in both the cases are identical. In

the case under appeal before us also, the assessee

is under an obligation to provide the services on

continuous basis for the period for which the card

is issued. The assessee has spread over the receipt

as well as expenditure as per Accounting Standard

– 9 and the same is disclosed by the assessee by

way of Note in the audited accounts. If the

contention of the Revenue is accepted and the

entire memebership fee collected is taxed in the

year of receipt then in the subsequent year when

the assessee will incur the expenditure there will

be loss. That would give distorted picture of the

working result of the assessee. In view of the

above, we respectfully following the above decision

of ITAT, Hyderabad Bench in the case of Treasure

Island (P) Ltd (supra) hold that the method of

accounting followed by the assessee was proper

and correct method and the Assesing Officer has

wrongly rejected the same.”

6. In this regard we are supported by the decisions of the

Apex Court as well as this Court, Bombay and Delhi High

Courts. The Bombay High Court in the case of Taparia

Tools Ltd. vs. Jt. CIT, [2003] 260 ITR 102 has observed

that in order to determine the net income of an accounting

year, the revenue and other incomes are matched with the

cost of resources consumed. Under the Mercantile System of

Accounting, this Matching is required to be done on accrual

basis. Under this Matching concept, revenue and income

earned during an Accounting Period, irrespective of actual

cash in-flow, is required to be compared with expenses

incurred during the same period, irrespective of actual out-

flow of cash. It has been further held that the Income Tax Act

make no provision with regard to valuation. It charges for

payment of tax, the income which is to be computed in the

manner provided by the Act and that it is the duty of the

Assessing Officer to deduce a proper taxable income. It is held

that the Assessing Officer is required to compute the income

in accordance with the method of accounting regularly

employed by the assessee and if the system adopted by the

assessee does not result in ascertainment of proper profits

then, it is the duty of the assessing officer to make

appropriate adjustments and deduce true profits.

6.1 The Apex Court in the case of Rakesh Shantilal

Mardia vs. Deputy Commissioner of Income-tax reported

in [2012] 210 Taxman 565 (SC) considering the decision of

the Bombay High Court in the case of Taparia Tools Ltd.

(supra) has held that matching principle is required to be

followed in order of arrive at the real income of the assessee.

6.2 Similarly, in the case of Commissioner of Income-Tax

vs. Dinesh Kumar Goel reported in [2011] 331 ITR 10

(Delhi), the Delhi High Court has held as under:

“... even when the income accrues or arises or is

deemed to accrue or arise to the assessee in India

during previous year, that is to be taxed in that

year. It is important, therefore, that receipt of a

particular amount in the relevant year should be an

“income” under the aforesaid provision. What is the

relevant yardstick is the time of accrual or arisal

for the purpose of its taxation, viz., in order to be

chargeable, the income should accrue or arise to

the assessee during the previous year. If income

has accrued or arisen, even if actual receipt of the

amount is not there, it would be chargeable to tax

in the said year. Though the amount may be

received later in the succeeding year, the income

would be said to accrue or arise if there is a debt

owed to the assessee by somebody at that moment.

From this, it follows that there must be the “right

to receive the income on a particular date, so as to

bring about a creditor and debtor relationship on

the relevant date”. The Court further explained

that a right to receive a particular sum under the

agreement would not be sufficient unless the right

accrued by rendering of services and not by

promising for services and where the right to

receive is interior to rendering of service, the

income, therefore, would accrue on rendering of

services.”

6.3 This Court has also taken the same view in a recent

decision in the case of Snesh Resort Pvt. Ltd vs. Dy. CIT

rendered in Tax Appeal No. 113 of 2004 on 18.11.2014.

This Court has observed as under:

“6.2 Similarly in the case of Bilahari Investment

P. Ltd (supra) the Apex Court has held that since

from the various statements produced, the entire

exercise arising out of the change of method from

the completed contract method to deferred

revenue expenditure was revenue neutral, the

completed contract method was not required to be

substituted by the percentage of completion

method.

7. Considering the aforesaid observations of the

Tribunal as well as the decisions relied upon by

learned advocate for the assessee, we are of the

opinion that the Tribunal has committed an error in

passing the impugned order so far as considering

the membership fees as income when the assessee

had not resumed giving the services of the water

park to its members. Under such circumstances,

the amount received by way of membership fees

was required to be considered as an advance and

thereafter as and when the business commenced

the amount of liability was required to be taxed

over a period of time proportionately. The amount

of membership fees would be considered as income

from the year the business of the assessee

commenced. We therefore answer the questions

raised in the negative i.e. against the revenue and

in favour of the assessee.”

7. In view of the aforesaid discussion, we do not find any

infirmity in the order passed by the Tribunal. The Tribunal

has rightly considered that the method of accounting should

be such from which the correct profit of each year can be

deducted and that as per the method adopted by the Revenue,

the profit in the year in which the card is issued would be

more resulting in loss/less profit in the year in which the

services will be rendered by the assesseee. We are of the

opinion that when the services are rendered partially, revenue

is to be shown proportionate to the degree of completion of

the service and therefore the assessee was justified in

spreading over the amount of membership fee and expenses.

8. Therefore, the Tribunal is justified in setting aside the

order of the CIT passed under Section 263 (of Income Tax Act, 1961). We,

accordingly, answer the question of law raised in the present

appeals in the affirmative i.e in favour of the assessee and

against the revenue. The impugned order passed by the

Tribunal is hereby confirmed. Appeals are dismissed

accordingly.

(K.S.JHAVERI, J.)

(K.J.THAKER, J)