Court Upholds Assessee's Accounting Method for Membership Fees, Rejects Revenue's Appeal

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

Case Name:

Commissioner of Income Tax vs Winner Business Link (P) Ltd.(High Court of Gujarat)

Tax Appeal No. 1159 of 2006

Date: 18th December 2014

Key Takeaways:

1. The court affirmed that income should be recognized in accordance with the matching principle and accrual concept of accounting.

2. When services are rendered partially over time, revenue should be shown proportionate to the degree of completion of the service.

3. The Assessing Officer must compute income based on the accounting method regularly used by the assessee, making adjustments only if it fails to show true profits.

4. The court emphasized the importance of following accounting standards notified by the government.

Issue:

Whether the Income Tax Appellate Tribunal was justified in accepting the assessee's method of accounting for membership fees and related expenses by spreading them over the period of membership, rather than recognizing the full amount in the year of receipt as contended by the Revenue department

Facts:

- The assessee company provides discount cards to members on payment of a non-refundable membership fee.

- Membership periods vary from 1 to 30 years.

- The assessee prepares accounts on an accrual basis, apportioning membership fees over the entire membership period.

- The Assessing Officer rejected this method, invoking Section 145(3) (of Income Tax Act, 1961) to tax the full pre-received fees in the year of receipt.

- The Commissioner of Income Tax (Appeals) and ITAT ruled in favor of the assessee's accounting method.

- The Revenue department appealed against these orders in the High Court.

Arguments:

Revenue's Arguments:

1. The assessee does not provide continuous service after card sale, so there's no basis for spreading income.

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

3. The assessee's method would show losses throughout.

Assessee's Arguments:

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

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

3. The method aligns with mandatory accounting standards.

Key Legal Precedents:

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

Emphasized the matching principle in mercantile 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):

Clarified the concept of income accrual and the right to receive income.

Judgement:

1. The High Court dismissed the Revenue's appeals and upheld the ITAT's orders.

2. The court found no infirmity in the Tribunal's decision, agreeing that the assessee's accounting method correctly determined profit for each year.

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

4. The assessee was justified in spreading the membership fee income and related expenses over the membership period.

5. The court affirmed that 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 the assessee's method aligned with accounting principles like the matching concept and provided a more accurate picture of yearly profits.

Q2: What is the significance of this judgment for businesses with long-term service contracts?

A2: It supports recognizing revenue over the service period rather than upfront, which can better reflect the economic reality of long-term contracts.

Q3: How does this ruling impact the interpretation of Section 145(3) (of Income Tax Act, 1961)?

A3: It suggests that the Assessing Officer should not reject an accounting method that accurately reflects profits, even if it differs from immediate recognition of income.

Q4: What role did accounting standards play in this decision?

A4: The court emphasized the importance of following accounting standards notified by the government, which supported the assessee's method.

Q5: How might this judgment affect similar cases in the future?

A5: It may serve as a precedent for other cases involving the recognition of income from long-term service contracts or membership fees.

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 deleting the addition

made by the Assessing Officer invoking the provisions of

Section 145(3) (of Income Tax Act, 1961), towards membership fees. The

questions of law raised in each appeal is reproduced

hereunder:

TAX APPEAL NO. 1159 OF 2006

Whether the Appellate Tribunal was right in

law and on facts in accepting the method of

accounting followed by the assessee ignoring

the fact that during the regular assessment

proceedings for A.Y.1997-98 the method of

accounting followed by the asseessee was

rejected by the Assessing Officer?

TAX APPEAL NO. 1375 OF 2006

A. Whether the Appellate Tribunal was right in

law and on facts in quashing the order u/s.263 (of Income Tax Act, 1961)

of the I.T. Act passed by the CIT and in reaching

the conclusion that the assessment order passed

by the Assessing Officer in respect of the block

period was not erroneous and that the order of

the Assessing Officer merged with the order of

the CIT(A) ignoring the explanation (c) to

Section 263(1) (of Income Tax Act, 1961)?

B. Whether the Appellate Tribunal was right in

law and on facts in accepting the method of

accounting followed by the assessee ignoring

the fact that during the regular assessment

proceedings for A.Y.1997-98 the method of

accounting followed by the asseessee was

rejected by the Assessing Officer?

TAX APPEAL NOS. 1376 TO 1380 OF 2006

Whether the Appellate Tribunal was right in law

and on facts in accepting the method of

accounting followed by the assessee ignoring

the fact that during the regular assessment

proceedings for A.Yr.1997-98 the method of

accounting followed by the asseessee was

rejected by the Assessing Officer?

TAX APPEAL NO. 1443 OF 2011

[A] Whether the Appellate Tribunal is right in

law and on facts in deleting the addition of Rs.

4,31,95,051/= rejecting the accounting policies?

TAX APPEAL NO. 1444 OF 2011

Whether the Appellate Tribunal is right in law

and on facts in deleting the addition of Rs.

16,38,89,666/= made by the Assessing Officer

invoking the provisions of Section 145(3) (of Income Tax Act, 1961) of the

Act, towards the membership fees ?

2. The assessee company is engaged in the business of

providing discount 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 thirty 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 Assessing Officer concluded that the method of

accounting followed by the assesee was not correct as the

amount of total membership fees had accrued in the

accounting year in which the members were enrolled and the

liability for the expenses relating thereto by way of

commission and insurance premium had been incurred in that

very year. The Assessing Officer therefore invoked the

provisions of Section 145(3) (of Income Tax Act, 1961) and rejected the method of

accounting of the assessee and taxed the pre-received

membership fees less pre-paid commission and insurance

premium. The assessee preferred an appeal before the

CIT(A) and the CIT(A) allowed the assessee’s appeals and

directed the Assessing Officer to follow the method of

accounting regularly followed by the assessee. The revenue

therefore challenged the orders passed by CIT(A) before the

Tribunal and the Tribunal vide impugned orders dismissed the

appeals and upheld the orders passed by CIT(A). Being

aggrieved by the said order, the revenue is in appeal before

us.

3. Mr. Manish Bhatt, learned Senior Standing Counsel

appearing on behalf of Ms. Mauna Bhatt, learned Standing

Counsel 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.

3.1 Mr. Bhatt 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.

3.2 Mr. Bhatt 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.

4. Mr. R.K. Patel, 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 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

makes 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)