1.22     Query

Accounting for interest earned on fixed deposits.

1.A private limited company owns one hotel premises. Due to difficulties of management, the hotel premises were given on lease to another person for running it as a hotel. The agreement to this effect, inter alia, provided that the duration of agreement will be for a total period of 15 years, starting from 1.1.1988 and that a minimum payment of Rs. 1.00 lakh per annum will become due to the lessor. The lessor is also entitled to share in the profits of the business to be so run by the lessee, if such profits exceed a sum of Rs. 5.00 lakhs per annum.

2.One of the conditions of the agreement is that at the beginning of the each block of 5 years, the lessee will pay to the lessor in advance the minimum guaranteed lease payment for 5 years. Accordingly, the lessor has received a sum of Rs. 5.00 lakhs on 1.1.1988 towards the lease rent @ Rs. 1.00 lakh for each of the years 1988,’89,’90,’91 and ’92. The lessor has deposited this amount in long term fixed deposit on which interest is being credited in their account of lessor every half year. If the lease arrangement is terminated by the lessee, then he is not entitled to claim the refund of advance lease considerations so paid.

3.In view of above facts, the querist has referred the following issues for the opinion of Expert Advisory Committee:

(a) Whether the lessor company can postpone revenue recognition on fixed deposit interest on the sum of Rs. 4.00 lakhs, while preparing its financial accounts for the year 1988, on the ground that when the original income has not accrued in respect of the years 1989,’90,’91 and ’92 (Rs. 1.00 lakh each year), the benefit arising from or attributable to such unaccrued income will also not accrue to it as on 31.12.1988. If the lessor company accounts for as income the whole of the interest received on the total deposit of Rs. 5.00 lakhs in the year 1988, would it tantamount to not keeping the books of account on accrual basis, as contemplated in sub-section (3) of section 209 of the Companies Act?

(b) Notwithstanding the accounting treatment given for such interest income (attributable to the advance amount of Rs. 4.00 lakhs) in the accounts of the company, whether the lessor company can plead in income-tax assessments that having regard to section 5 read with section 9 of the Income-tax Act, the interest though received should not taxable in the previous year 1988, but should be taxed in the respective year/s when the principal income of lease rent would become due.

                                                                                        Opinion                                                        January 23, 1990

1.The Committee is of the view that it is not necessary that an income should arise only out of the investment of resources which have been earned by an entity. For instance, if an entity earns an income out of the investment made by it from borrowed funds, the nature of income and its accounting do not change.

2. The Committee is, therefore, of the opinion that the company should account for, in the accounts pertaining to financial year 1988, the interest on the entire sum of Rs. 5.00 lakhs for the year 1988 since the right to receive the said interest income vests with lessor company, notwithstanding the fact that Rs. 4.00 lakhs represents the unearned income. In the opinion of the Committee, this treatment would be in accordance with the accrual concept of accounting as contemplated in sub-section (3) of the section 209 of the Companies Act, 1956. (‘Interest accrues on time basis’, as per para 3.10 of the ‘Guidance Note on Accrual Basis of Accounting’, issued by the Research Committee of the Institute of Chartered Accountants of India).

3.The Committee also notes that section 5 of the Income-tax Act, 1961, prescribes, inter alia:

“5(1) Subject to the provisions of this Act, the total income of any previous year of a person who is a resident includes all income from whatever source derived which-

(a) is received or is deemed to be received in India in such year by or on behalf of such person; or

(b) accrues or arises or is deemed to accrue or arise to him in India during such year; ………….”

4.The Committee is of the opinion that section 5 of the Income-tax Act does not preclude the interest earned on investments made out of unearned sources from the scope of total income. The interest on the entire Rs. 5.00 lakhs due/received in the year 1988 belongs to the lessor and is consequently covered by section 5. In the opinion of the Committee, the said interest will be taxable in the assessment year relevant to the previous year 1988.

5.The Committee notes that section 9 of the Income-tax Act, 1961, specifies the incomes which are deemed to accrue or arise in India. Since, in the present case, the question as to whether the income has arisen or accrued in India or outside India is not there, the provisions of section 9 are irrelevant.

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