I.T.A. NO.550/KB OF 1991-92, DECIDED ON 10TH APRIL, 1994. VS I.T.A. NO.550/KB OF 1991-92, DECIDED ON 10TH APRIL, 1994.
1995 P T D (Trib.) 401
[Income-tax Appellate Tribunal Pakistan]
Before Muhammad Mujibullah Siddiqui, Judicial Member
and Asad Arif, Accountant Member
I.T.A. No.550/KB of 1991-92, decided on 10/04/1994.
Income Tax Ordinance (XXXI of 1979)---
----Third Sched., R. 8(5)(a)---Sale and lease back transaction ---Concept-- Determination of fair market value by Assessing Officer---Procedure and considerations---Rule 8(5)(a) of the Third Sched., Income Tax Ordinance, 1979 when attracted.
Sale and lease back transaction have been recognised as a combination of sale by a company and subsequent transaction of lease agreement in respect of the same plant or machinery. It has been recognised as a mode of financing as well and thus, such transaction envisaged two aspects, one for the purposes of law and the other for the purposes of accountancy and financing. Viewed from the point of law the transaction envisages an actual sale in which all the ingredients of a legal, valid, actual sale are found. The title in the property is transferred, consideration is received and all the incidents of a sale are fulfilled. The parties are then by virtue of another agreement transposed to the status of lessor and lessee and another transaction is concluded. So far the civil law of the land is concerned, the intention of the parties in selling the property and then leasing the same is absolutely immaterial. For the purpose of accountancy the transaction is entered into as a mode of financing. For the purpose of accountancy and financing it is immaterial whether the sale consideration is according to tire fair value or not and it only deals as to how the profit or loss if any is to be treated for the purpose of accountancy. At this juncture the law of taxation comes into play for its own purpose if depreciation has been claimed on such capital assets and at this stage the provisions contained in Third Schedule of the Income Tax Ordinance, 1979 become relevant.
In a sale and lease back transaction there is a combination of two transactions. The first transaction is of sale and the second transaction is of lease back to the seller by the buyer. The second transaction is in fact a mode of financing.
If the plant and machinery has been acquired on lease by the seller, it does not change the complexion of transaction of the sale of assets.
The sale of entire class of assets and obtaining the same on lease rental by seller are two distinct and independent transactions.
Any sale and lease back arrangement the sale price is determined keeping in view the rental schedule. Since the sale is made in special circumstances which is coupled with a mode of financing; therefore, the sale price is determined by the parties keeping in view the requirements of finances by the sellers and the rate of rent agreed between the parties. Thus, it may be more than the fair market value, equal to the fair market value and even less than the fair market value.
For the purpose of Rule 8(5)(a) of the Third Schedule to the Income Tax Ordinance, 1979 the Assessing Officer should determine the fair market value. However, the fair market value is to be determined keeping in view all the attending circumstances and without losing sight of the fact that in a sale and lease back arrangement no open market is available. In International Accounting Standard also the fair value has been defined to mean an amount which a knowledgeable willing buyer shall pay to a knowledgeable willing seller. The determination of fair market value of an asset is always a difficult exercise particularly in the case of a sale and leaseback. It is a very cumbersome and difficult proposition as all the attending circumstances are to be considered on their own merits in each case. As the circumstances and terms and conditions agreed between the parties may differ from case to case, therefore, no hard and fast rule can be laid down for determining a fair market value in a case of sale and lease back arrangement. The formula adopted by the Assessing Officer is particularly bound to cause serious injustice to the assessee, as the entire formula is imaginary as well as arbitrary. Although the Assessing Officer is empowered to determine the fair market value by resort to Rule 8(5)(a) of the Third Schedule to the Income Tax Ordinance but the formula adopted is not to be arbitrary and harsh.
Since it is a highly technical job which an Assessing Officer is not supposed to perform on his own according to the dictates of justice, therefore, determination of the fair market value of the machinery should be referred to the valuers under section 67 of the Income Tax Ordinance, 1979. The valuers should determine the market value of the machinery on the date of sale transaction keeping in view the special nature of transaction which is involved the sale and lease back arrangement. The terms and conditions of the lease should also be kept in view while determining the fair market value of the machinery. After receiving report from valuers the Assessing officer should give his finding on merits as deemed fit.
It is not right to say that Rule 8(5)(a) of the. Third Schedule applied to an actual sale which does not cover an arrangement of sale and lease back.
Leaseback transaction being a case of actual sale the provisions contained in Rule 8(5)(a) of the Third Schedule are applicable.
Modern Accounting by Sidney Davidson and International Accountant Standard No. 17 ref.
Ali Nasir Bokhari, D.R. for Appellant.
Nasim Hyder, C.A. for Respondent.
Date of hearing: 29th November, 1993.
ORDER
MUHAMMAD MUJIBULLAH SIDDIQUI (JUDICIAL MEMBER).--- This appeal at the instance of department is directed against the order dated 7-8-1991 by the learned O.T.(A), Zone-VI, Karachi in ITA No.439/A VI/1991.
2. The sole objection raised on behalf of the department is that the learned C.I.T.(A) was not justified in deleting the addition of Rs.49,40,978 which was made by estimating profit on sale of machinery on the basis of fair market value.
3. Briefly stated the relevant facts are that the respondent is a private limited company engaged in the manufacturing and sale of carpet yam. During the year under consideration the respondent-company disposed of the entire class of assets, i.e., plant and machinery to M/s. First Grindlays Modaraba for Rs.41,07,014 and claimed loss of Rs.1,56,070 as the written down value of the said assets was Rs.42,63,084. The respondent-company thereafter obtained the said plant and machinery on lease rental from M/s. First Grindlays Modaraba and claimed an amount of Rs.5,28,913 as lease rental expenses during the year under consideration. The respondent-company was asked by the assessing officer to explain and furnish the evidence of transaction of sale of plant and machinery and lease agreement with M/s. First Grindlays Modaraba. It was explained on behalf of the respondent-company that financing for plant and machinery during the current year has been obtained under lease finance and consequently the title of the entire plant and machinery has been transferred to the lessor at tax purpose written down value. Consequently though there was loss on sale of assets to the extent of Rs.24,98,163.75, as per book value, yet this loss has not been considered for, while computing the taxable income for the current year. It was contended that for tax purposes there is neither a gain nor loss. The assessing officer observed that the entire class of assets has been sold by the respondent-company for Rs.41,07,014 and, therefore, in order to assess the profit the value is to be determined under Rules 7 and 8 of the Third Schedule to the Income Tax Ordinance read with section 29(3) of the Income Tax Ordinance, 1979. The respondent was called upon to explain as to why the profit arising after determining the fair market value should not be taxed as deemed income. It was explained on behalf of the respondent that the plant and machinery was sold with a leaseback arrangement for which purposes the value was fixed at Rs.41,07,014. It was further explained that in order to finalize the leaseback arrangement the First Grindlays Modaraba paid a sum of Rs.41,07,014 to the respondent-company which was accounted for in the books of accounts as sale proceeds of the plant and machinery and thereafter a lease was signed and for the purposes of lease the value of machinery was fixed at Rs.41,07,014. It was further explained that the financial consequences of the arrangement has been disclosed in the Financial statements where the value of plant and machinery has been excluded from fixed assets and at the same time lease rental accrued has been instituted. It was further explained that since the accounting loss on deletion of machinery is not an allowable deduction the same has been added in the computation of income. At the same time since the entire class of assets was disposed of the loss of Rs.1,56,070 has been claimed in view of the provisions of clause 7(c).of Third Schedule to the Ordinance. It was further stated that the cumulative effect of the entire arrangement was that the company was able to get release of the fund which was blocked in the capital value of fixed assets and the funds which were badly needed to augment the working capital requirement of the company were arranged. The appellant further took plea that Rule 8(5)(a) of the Third Schedule to the Ordinance defines sale proceeds to be the sale price of the assets or its fair market value whichever is higher. In the instant case the assets have been sold at a value which also is the fair market value since in the subsequent transaction, First Grindlays Modaraba (the buyer) listed the said assets at the same value. In the circumstances the declared sale price of the plant and machinery being the fair market value of the same should be accepted.
4. The above explanation of the respondent-company was not accepted by the assessing officer who observed that the explanation simply confirmed that the disposal of entire class of assets has been made during the year under consideration for Rs.41,07,014 against the written down value of the said assets which stood at Rs.42;63,084 as on 1st July, 1988 and the assessee company sustained and claimed the loss amounting to Rs.1,56,070 on account of disposal of said assets as provided under clause 7(c) of the Third Schedule to the Income Tax Ordinance, 1979. The assessing officer further refused to accept the plea that the entire transaction of sale of machinery was for obtaining the same on lease rental and to obtain financial assistance for working capital requirement because the respondent should have obtained loan against mortgage of the said plant and machinery instead of selling the same to a leasing company. The contention that the selling price of the assets in question was the fair market value was also discarded. The assessing officer thereafter called upon the respondent to furnish the details/documents for the purpose of determining the fair market value. The documents/details called for by the assessing officer were invoices, bill of entry and other expenses incurred in case machinery was imported and in case of purchase of second hand machinery the documentary evidence regarding the purchase alongwith the written down value in the hand of seller and original cost thereof. The current market rate of new machinery was also sought from the respondent. The respondent company furnished details as required. It was urged on behalf of the respondent company that the sale price declared is the fair market value which may be accepted. It was contended that the proposed fair market value has not been confronted which plea was accepted by the assessing officer and, therefore, vide letter dated 20-2-1991 the assessing officer confronted the respondent company with the basis for determining the fair market value as follows:
"(a) By making addition on account of inflationary rate prevailing during theperiod of purchase of machinery and disposal thereof which is between 10 to 15 % per year.
(b) By making suitable addition on account of the depreciation allowed during the entire period i.e. date of purchase of machinery and date of sales thereof as the statutory allowance does not necessarily depreciate the machinery in accordance with the rate of depreciation allowed during the entire period.
(c) The machinery purchased by you from M/s. Sanaullah Woollen Mills (Pvt.) Ltd. for total consideration of Rs.21,00,000 had the W.D.V. in the hands of the said company at Rs.18,895 only. This clearly reflects that the appreciation for such an old machinery having the W.D.V. of Rs.18,895 only would that the price of Rs.21,00,000. As such this principle will be applied, in determining fair market value of this machinery purchased by you from your sister concern as well as other machinery including in the class of assets disposed of by you during the year under consideration."
5. The respondent-company furnished explanation which reads as follows:
"We refer to your Letter No. ITO/Cir-07/Cos.III 1990-91, dated 20-2-1991. You have asked us to furnish explanation on your intended action of estimating the fair market value of the assets sold by the Company during the above assessment year under a sale and lease back arrangement.
You have not doubted the veracity of the transaction entered into by the Company except that you feel that the transaction due to its special situation of sale and lease back has not been consummated at a 'fair market value'. The basis of determining the fair market value as given in your aforesaid letter shows that you intend to make a valuation of assets which has been sold by the Company instead of determining a 'fair market value'. We are of the opinion that 'valuation' and 'fair market value' are not synonymous and there exists a suitable difference between the two. The taxing statute requites as a fundamental principle that wherever possible estimates based on rate of inflation and the like should be avoided because such an exercise is not free from incorrect conclusions: In determining the 'fair, market value' the market itself should be determining factor and not inflation indexes.
We also have serious reservation in the context of valuation of plant, regarding your statement that depreciation is only a statutory allowance. There is no doubt that such is the case but one cannot disregard the fact that 'depreciation' in accounting terms mean the allocation of the depreciable amount of an asset over its estimated useful life. Depreciation is provided not only to take into account the physical wear and tear of the assets but also for obsolescence arising from technological changes and improvements in production method. You would appreciate that an asset does depreciate in value after use over a number of years. To disregard depreciation of asset would, therefore, unjustified W.D.V. and any resultant valuation would be arbitrary and without any lawful basis.
We would like to submit that an important point which you seem to have not been able to comprehend is that the law requires you to determine fair market value and such determination can only be with reference to the market. Fair market value would mean the value at which any article can be bought and sold freely in a open market situation. In this context, therefore, your intention of making a valuation based on rate of inflation is transgressing the limits propounded by tax, statute. Your intended action would be unreasonable and without any lawful basis.
In conclusion we would like to suggest you to consider the following facts
In a sale and lease back arrangement the seller continues to enjoy the use of assets and make profit therefrom.
As opposed to obtaining finance against mortgage of assets, sale and lease back arrangement has been considered Islamic and an acceptable mode of financing.
Had the company obtained finances against mortgage of assets, you would have allowed interest without any question. An adverse inference being drawn from the sale and lease back arrangement entered into by the company is inequitable and not justified."
The contentions raised on behalf of the respondent were not accepted by the assessing officer who held that the determination of fair market value of the assets as well as computation of profit as per sub-clause (b) of Third Schedule cannot be avoided for the reason that the transaction of sale of assets is of a special nature as the said assets was obtained on lease from the purchaser. The plea that the machinery depreciates due to use was accepted but with the observation that wear and tear of the asset do not result exactly at the rate of depreciation allowed by the department. It was held that the appreciation in the value of asset is directly related to the rate of inflation which is a determining factor to arrive at the fair market value of a particular asset. The assessing officer was further of the view that the admitted fact is that the respondent Company had sold entire class of assets and if the plant and machinery has been acquired on lease does not change the complexion of transaction of sale or assets. He further held that the sale of entire class of assets and obtaining the same from First Girndlays Modaraba on lease rental are two distinct and independent transactions. He, therefore, with the approval of I.A.C. determined the fair market value of the assets sold. In doing so the sole criterion applied by the assessing officer was the rate of inflation to the original value since 1981 to the assessment year under consideration when the assets were sold.
He further observed that although the rate of inflation over these years have been fluctuating between 10 % to 15 % but in order to be fair and reasonable he was applying rate of inflation at 10% per year. He further observed that the depreciation is allowed by the department at 20 % but the actual wear and tear is less and that is why book value rate of depreciation charged by the respondent Company was 10 %. However, the assessing officer observed that he will allow depreciation at 20% in order to be just and fair to the respondent-Company. He cited an example whereby the respondent-company purchased a second hand machinery having written down value of Rs.18,895 at Rs.21,,00,000. The assessing officer ultimately determined the fair market value of the plant and machinery at Rs.92,04,062 and worked out the profit at Rs.49,40,978 which was added to the total income. The working of the assessing officer is as follows:
"Assessment year 1989-90(30-6-1989). | Original Cost | Appreciation |
Plant and Machinery purchased during the year. Appreciation @ 10% inflation per annum. | 21,00,000 | Nil |
Since the machinery has been purchased and sold during the year under consideration and also due to the fact that the appreciation has already taken place for W.D.V. of Rs,18,895 to Rs.21 lacs, therefore, no appreciation in value is taken. | 21,00,000 | |
Asstt. Year 1988-89(30-6-1988) | | |
| Plant and machinery purchased during the year. Less: Deletions. Appreciation (& 10 % inflation per annum for one year. | 91,758 15,000 76,758 | 7, 676 |
| Asstt. Year 1987-88(30-6-1987) | | |
| Plant and machinery purchase during the year. Appreciation @ 10 % inflation per annum for 2 years. | 16,79,884 | 3,35,977 |
| Asstt. Year 1986-87(30-6-1986) | | |
| Plant and machinery purchased during the year. Appreciation @ 10 % inflation per annum for 3 years. | 1,29,579 | 38,874 |
| Asstt. Year 1985-86(30-6-1985) | | |
| Plant and machinery purchased during the year. Appreciation @ 10 % inflation per annum for 4 years. | 1,11,000 | 44,400 |
| Asstt.Year 1984-85 (30-6-1984) | | |
| Plant and machinery purchased during the year. Appreciation @ 10 % inflation per annum for 5 years. | 1,98,000 | 99,000 |
| Asstt. Year 1983-84 (30-6-1983) | | |
| Plant and machinery purchased during the year. Less: Deletion Appreciation (2 10 % inflation per anum for 6 years | 14,49,000 72,900 13,76,100 | 8,25,660 |
| Asstt. Year 1982-83(30-6-1982) | | |
| Plant and machinery purchased during the year. Appreciation (2 10 % inflation per annum for 7 years. | 4,72,770 | |
| Asstt.Year 1981-82(30-6-1981) | | |
| Plant and machinery during the year. Appreciation @ 10 % inflation per annum for 8 years. | 17,27,690 | 13,82,152 |
| Asstt.Year 1980-81(30-6-1980) | | |
| Plant and machinery purchased during the year. Appreciation at 10 % inflation per annum for 9 years. | 20,78,850 | 18,70,963 |
| (i) Total original cost ofMachinery | 99, 50, 631 | |
| (ii) Total appreciation due to 10% rate of inflation. | | 49,35,643 |
| Present value of machinery during the year under consideration would be (i) + (ii) | 99,50,631 49.35,643 1,48,86,274 |
| " Less:--Depreciation allowed @ 20% for the assessment year 1980-81 up to the Asstt. year 1989-90. | 56.82,212 |
| Fair Market Value | 92,04,062 |
| Less: W.D.V. as on 30-6-1989 | 42.63,084 |
| | 49,40,978 |
Profit on sale of plant and machinery taxable under the head "Income From Business" or profession" as per Rule 7 of the Third Schedule read with section 29 (3) of the Income Tax Ordinance, 1979."
6. Being aggrieved with the ignoring of loss on sale of fixed assets and addition of profit as worked out above the respondent preferred appeal before the learned C.I.T.(A) assailing the addition of Rs.50,97,048. The same contentions as agitated before the assessing officer were reiterated. The method f working out the fair market value of the plant and machinery by using the rate of inflation at 10% per annum was also assailed and it was urged that the "sale proceeds" as used in Third Schedule to the Income Tax Ordinance means actual sale when fair market value can judicially be ascertained and that the fair market value means value at which any article can be bought and sold freely in the open market. It was further contended that sale and lease back is not an actual sale as in a sale and lease back arrangement the seller continues to enjoy the use of assets and make profit therefrom. It was urged that transfer of assets does not take place in such a case as physical possession remains with the seller and thus no transfer takes place. In support of the contention the following paragraph from a book on sale and lease back arrangement was produced;
"The firm may sell property and immediately lease it back from its new owner. The terms of the combined sale and lease back make the deal equivalent to outright borrowing with the asset as collateral. "
7. It was further contended that the sale and lease back arrangement is a mode of financing which has not been discussed in the Income Tax Ordinance and the situation visualized under Rule 8(5) of the Third Schedule to the Ordinance are not attracted to the case of the respondent. The situation was analyzed in the following manner:
| "SITUATION AS PER RULE 8(5) | CASE OF YOUR APPELLANT |
| (a)Where the asset is actually sold. | --- Plant has not actually been sold as discussed above |
| (b) Where the asset is transferred by way of exchange | --- Transfer of asset has not taken place. |
| (c) Where the asset is transferred otherwise by way of sale or exchange. | --- Transfer of asset has not taken place. |
| (d) Other situations as per Rule 8(5) to (j). | --- No such situation applied. |
8. Finally it was argued that since the sale and lease back situation is not visualized in the Ordinance, therefore, the question of adopting fair market value under Rule 8(5) of the Third Schedule does not arise.
9. The learned C.I.T.(A) accepted the contentions and deleted the addition with the following findings:
"(i) I agree with the contention of the A.R. that sale and lease back arrangement is not an actual sale but a mode of financing facility since in this type of arrangement physical possession, right to use the said plant and machinery and all the risks and rewards incidental to ownership remains with the appellant. This pertinent fact has not been appreciated by the learned Income-tax Officer. What is more is that the continued use of property is under the vested tutelage of the purchaser and as per Article 16 of the lease agreement there are as many as 17 stipulated conditions with reference to which the sold and leased assets have to be used all under the supervision of the First Grindlays Modaraba (the buyer) with the additional condition in Article 18.08 under which, after cessation of the lease, if the property is sold to a third party, 95 % of sale proceeds of the leased property revert to the assessee appellant.
These are conditions for the use and sale and reversion of the property as such under which grim situation there was no 'open market' with reference to which the price of the assets could be, with any logical reference, estimated particularly in view of the fact that the specialized type of second hand assets in use of the assessee has no 'open market' 0ith many buyers and many sellers.
Consequently I have to observe that the transaction under dispute was not 'sale' but 'conditional sale' and as such clearly outside the purview of Rule 8(5) of the IIIrd Schedule while the provisions of section 29 were not attracted being property on which depreciation was exigible.
Even if the same is considered intra vires, the onus to chow higher market than the documented price, within the meaning of Rule 8(5) read with Rule 7 of the IIIrd Schedule, was clearly upon the officer that has not been sufficiently discharged as modus. vivendi of approximating the market was purely imaginary.
(ii) I also agree with the contention of the A.R. that 'sale proceeds' of the assets sold have been defined in the first place to be the actual sale price thereof and the fair market value can if more than the sale proceeds, be adopted only in situations stated in Rule 8(5) of the Third Schedule.
The wordings used in Rule 8(5)(a) of the Third Schedule are as under:----
Where the asset is actually sold, the sale price thereof or the fair market value, whichever is the higher.
I agree with the contention of the A.R. that the words 'Actually sold' used in Rule 8(5)(a) do not cover an arrangement of sale and lease back which to my mind is only a mode of financing.
(iii) However, if this issue is looked at from a different angle and if it is assumed that 'fair market value is to be adopted even then the law has defined the term fair market value as the price which the asset would ordinarily fetch on sale in the open market on the relevant date. The application of inflationary rates for estimation of fair market value is to say the least an arbitrary manner of determining fair market value. Such a method does not necessarily help in arriving at the 'fair market value since it does not take into account the nature and condition of the assets, decrease in the value of specific asset due to technical advancement etc. Considering the above facts I am of the considered opinion that the additions made by the learned Income-tax Officer on account of sale of plant and machinery do not have any legal or even theoretical justification and, therefore, I direct that the addition of Rs.49,40,978 be deleted. "
10. This time the department felt dissatisfied and hence this second appeal before us. We have heard Mr. Ali Nasir Bukhari, learned representative for the department and Mr. Nasim Hyder, C. A., learned representative for the respondent.
11. The learned D.R. has submitted that the finding of the learned C.I.T.(A) that the transaction of sale and lease back is not an actual sale but a mode of financing facility only, is not correct in accordance with the general law of contract, the transfer of property, Sale of Goods Act and the law of lease as prevailing for the time being in Pakistan. He has contended that the sale and lease back arrangement is combination of two independent and separate transactions whereby in the first instance a transaction of sale is concluded between a seller and buyer and on conclusion of sale and transfer of ownership the seller acquires the lease right on payment of lease money. He has argued that so far the other stipulations contained in the lease agreement are concerned, to which the learned C.I.T.(A) has referred, they do not alter the nature of transactions, as the lease agreement is subject to the conditions agreed upon between the parties which is executed after the conclusion of sale. He has further submitted that so far the financing facility is concerned it is the effect of lease agreement only and has nothing to do with the initial transaction which is an outright sale. He has contended that the learned C.I.T.(A) has further misdirected in holding that the initial transaction between the seller and buyer was not a sale but conditional sale and thus, outside the purview of Rule 8(5) of the Third Schedule. The learned D.R. has next argued that the learned C.I.T.(A) has wrongly held that the words, "actually sold" used in Rule 8(5)(a) of the Third Schedule do not cover an arrangement of sale and lease back and it is only a mode of financing. The learned D.R. has further submitted that the learned C. I. T. (A) was not justified in discarding the method adopted by the assessing officer for working the fair market value of the machinery sold.
12. On the other hand, Mr. Nasim Hyder, C. learned representative for the respondent has reiterated his contentions raised before the learned two officers below. His main contention is that the sale and lease back arrangement is not an actual sale but it is merely a recognized mode of financing which is adopted as a substitute for financing on interest which is un-Islamic. He has submitted that even after the conclusion of sale and lease back arrangement the respondent/seller remained owner of the machinery as it remained in physical possession of respondent and was being used by them. In support of his contention Mr. Nasim Hyder has placed reliance on certain observations from the Book "Hand Book of Modern Accounting" by Sidney Davidson." In Chapter 25 under the heading "leases" it has been observed on page 18 as follows:
"The lease transaction is primarily a financial one; this being the case, the lessor entered into the transaction for the interest rewards, and the present value of the future lease payments would be equal to his purchase price. The amount to be capitalized by the lessee would be the cost of the property. The interest rate implicit in the transaction could be derived from the cost and rental schedule. The lessee would rarely be ignorant of the purchase price paid by the lessor. Second, in the case of a sale and lease back, the purchase price certainly is apparent to the lessee. Third, when property is purchased from an outsider, the lessee may have been a participant in the negotiations, but even if he was not, he is likely to know an approximate price from his alternative decision analysis."
13. On the same page under the sub-heading "sale and lease back" the learned author has observed as follows:
"Occasionally, companies sell property and promptly lease it back. The terms of the lease back are usually such that the transaction is equivalent to an outright borrowing. The lessee is to pay maintenance, insurance, and taxes. Rental payments are set to repay the buyer-lessor his purchase price plus interest. At termination, the lessee is entitled to residual rights for a nominal lumpsum payment or is entitled to continued occupancy for a minimal rental. The transaction should be handled by the financing method. In the current economic era of rising prices, it is likely that the sale price exceeded the seller's original cost less accumulated depreciation.
14 The learned authors have further stated as follows:
"The Accounting Principles Board covered these matters in its opinion No. 5:
The Board is of the opinion that the sale and the lease back usually cannot be accounted for as independent transactions. Neither the sale price nor the annual rental can be objectively evaluated independently of the other. Consequently, material gains or losses resulting from the sale of properties which are the subject of sale and leaseback transactions, together with the related tax effect, should be amortized over the life of the lease as an adjustment of the rental cost (or, if the leased property is capitalized, as an adjustment of depreciation).
The FASB concurred in this general view that all gains and losses on sale lease back transactions should be amortized over the life of the lease (the one exception arises if the fair value of the property sold is less than its undepreciated cost, in which case the loss would be recognized immediately up to the amount of the difference between undepreciated cost and fair value. The FASB also held that where the lease is a capital lease, as will usually be the case, the deferred profit shall be deducted in the balance-sheet from the asset recorded under the capital lease. "
15. I have carefully considered the contentions raised on behalf of the learned representatives for the parties. The points which require consideration are as follows:
(a) Whether the sale and lease back transaction is merely a mode of financing and the transaction does not amount to be sale or it is a combination of two independent transactions though concluded immediately one after the other. The first being sale transferring the title in the property and the second being in the nature of lease transposing the buyer as a lessor and the seller as a lessee.
(b) If the sale and leaseback arrangement envisage actual sale and thereafter execution of lease agreement, whether Rule 8(5)(a) of the Third Schedule of the Income Tax Ordinance is applicable and if so whether the method adopted by the assessing officer for determining the fair market value is justified.
16. For the purpose of determining the first issue I have carefully read the citations from the Book of Sidney Davidson produced by Mr. Nasim Hyder. I have already reproduced the relevant citations from the Book. The learned author has observed that, "in the case of sale and lease back the purchase price certainly is apparent to the assessee". Thus, it is evident that the author is referring to the purchase price which is an incident and attribute of the sale transaction. Again the said author has observed that, "occasionally companies sell property and promptly lease it back." This observation also lends support to the contention of learned D. R. that the sale and leaseback arrangement is a combination of two independent transactions to wit, sale and lease. The author has again observed that, "in the current economic era of rising prices it is likely that the sale prices exceeded the seller's original cost less accumulated depreciation". The author has again used he expression "sale price" and the 'seller' meaning thereby that the transaction is primarily a sale transaction though it may be entered into with the purpose of raising the finances and thus in terms of accountancy it may be deemed to be a very prudent and beneficial mode of financing but it will not change the nature of transaction in the field of law and for the purpose of taxation. It is not necessary that the Accountant's view, the jurist's view and the view for the purpose of taxation may be similar or same in respect of a particular transaction. The views may differ and every group shall be justified in holding its view with reference to its particular field of consideration. In this behalf I would like to refer to International Accounting Standard No. 17. Under the heading sale and lease back it is stated as follows:
"33. A sale and lease back transaction involves the sale of an asset by the vendor and the leasing of the same asset back to the vendor. The rentals and the sale price are usually interdependent 'as they are negotiated as a package and need not represent a fair value. The accounting system of a sale and lease back transaction depends upon the type of lease involved.
34. If the lease back is a finance lease, the transaction is a means whereby the lessor provides finance to the lessee, with the asset as security. For this reason it is not proper to record an excess of sale proceeds over the carrying amount as a realized profit. Such excess, if recognized, is deferred and amortized over the lease term.
35. If the lease back is an operation lease, and the rentals and the sale price are established at fair value, there has in fact been a normal sale transaction and any profit or loss is normally recognized immediately.
36. If the lease back is an operating lease and the sale price is below fair value any profit or loss is recognized immediately except that, if the, loss is compensated by future rentals at below market price, it is deferred and amortized in the proportion to the rental payments over the period for which the asset is expected to be used. If the sale price is above fair value, the excess over fair value & deferred and amortized over the period for which the asset is expected to be used.
37. For operating leases, if the fair value at the time of transaction is less than the carrying amount, a loss equal to the amount of difference between the carrying amount and fair value is recognized immediately. For finance leases, no such adjustment is necessary unless there has been a permanent impairment in value in which case the carrying amount is reduced to recoverable amount in accordance with the International Accounting Standard 16, accounting for property plant and equipment."
In accounting standard 16 and 17 the fair value has been defined as, "the amount for which an asset could be exchanged between a knowledgeable willing buyer and a knowledgeable willing seller in an arms length transaction".
17. A perusal of the above principles contained in the International Accounting Standard 17 shows that the sale and lease back transaction have been recognized as a combination of sale by a company and subsequent transaction of lease agreement in respect of the same plant or machinery. It has been recognized as a mode of financing as well and thus, such transaction envisages two aspects; one for the purposes of law and the other for the purposes of accountancy and financing. Viewed from the point of law the transaction envisages an actual sale in which all the ingredients of a legal, valid, actual sale are satisfied. The title in the property is transferred, consideration is received and all the incidents of a sale are fulfilled. The parties are then by virtue of another agreement are transposed to the status of lessor and lessee and another transaction is concluded. So far the civil law of the land is concerned the intention of the parties in selling the property and then leasing the same is absolutely immaterial. For the purpose of accountancy the transaction is entered into as a mode of financing. For the purpose of accountancy and financing it is immaterial whether the sale consideration is according to the fair value or not and it only deals as to how the profit or loss if any is to be treated for the purpose of accountancy. At this juncture the law of taxation comes into play for its own purposes if depreciation has been claimed on such capital assets and at this stage the provisions contained in Third Schedule of the Income Tax Ordinance, 1979 become relevant.
18. Now we revert particularly to the facts of the present case to examine as to what treatment the seller/lessee and buyer/lessor have given themselves to the transaction between them. A copy of the lease agreement is available on record and in the recital part thereof it is stated as follows:
"Whereas, being owner of the machinery and equipment and other property described in the First Schedule hereto attached, the lessee has sold the same to the Modzraba; and Whereas the lessee is desirous of taking on lease from the Modaraba the said machinery, equipment and other property, and the Modaraba has agreed to provide the same on lease to the lessee."
19. In Article 1, clause (d) it is stated that, "the lease property forms part of the exclusive assets of the Modaraba". In clause (e) of the same Article, it is stated that, "supplier" shall mean the supplier from whom the lease property was purchased by the lessee before its sale to the Modaraba as referred to in the preamble to this lease agreement". Again in clause 6.03, para. (e) it has been stated that, "as between the, Modaraba and the lessee and their respective successors in title, the lease property shall remain personal property of and shall continue to be in the ownership of the Modaraba". In clause 10.01 it has been stipulated as follows:
"As the owner of the lease property, the Modaraba shall procure comprehensive insurance cover in respect of the same and maintain it throughout the lease period and the period of any renewal thereof. Prior to delivery of the lease property or the commencement of the lease, a copy of the insurance policy shall be provided by the Modaraba to the lessee. Premium and other charges for such policy shall be paid by the Modaraba and immediately reimbursed by the lessee upon demand by the Modaraba. "
20. In Article 12 of the Lease Agreement under the heading "Title" it is provided as follows:
All rights, title and exclusive ownership of the lease property shall at all times remain vested in the Modaraba and the lessee covenants and agrees not to do anything or perform any act prejudicial thereto .it is clarified that this lease agreement is not and shall not be construed as an agreement of hire purchase or an agreement conferring on the lessee any ownership or proprietary right in the lease property except as a lessee as contemplated under this lease agreement.
Again in Article 14.06 it is stipulated that:
"As between the Modaraba and the lessee the lease property shall remain personal or movable property and shall continue in the ownership of the Modaraba notwithstanding that the same they have been affixed to any land or building. "
In Article 18.03 it is clarified that:
"Since the lessee is not the owner of the lease property, the lessee shall not claim any relief by way of any deduction, allowance or grant available to the Modaraba as the owner of the lease property under the income-tax or other laws or rules or regulations and shall not do anything by which Modaraba may be deprived of such allowance or grant. "
Article 18.08 which has been referred by the learned C.I.T.(A) reads as follows:
"After the expiry of the lease period, or any extension thereof, the Modaraba shall sell the lease property in such manner and to such person(s) as the Modaraba shall deem fit or expedient and at the best possible price as the Modaraba shall be able to procure for the lease property. Subject to the faithful and satisfactory performance by the lessee of the duties and obligation on the part of the lessee to be performed and observed under this lease agreement during the entire lease period, and any extension thereof, the Modaraba shall pay to the lessee, after the sale of the lease property as above stated, an amount equivalent to 95 % of the sale proceeds of the lease property realized by the Modaraba after paying off all the expenses and taxes incidental to the sale by way of rebate of rentals on account of good performance. The lessee shall not have the right to challenge or question the amount of sale proceeds realized as aforestated, and the certificate of the Modaraba in regard thereto shall be accepted by the lessee as correct and reflecting the true position. "
It is provided in Article 18.09 that:
"After the sale of the lease property as aforesaid, the Modaraba shall pay to the lessee an amount equivalent to 95 % of the sale proceeds of the lease property realized by the Modaraba after paying off all expenses and taxes incidental to the sale by way of rebate of rentals for the unexpired period of the lease. Where the lessee did not hand over possession of the lease property to the Modaraba neither paid to the Modaraba nor assisted the Modaraba in recovering the amounts specified in clause 16.04 and the lease property sold by the Modaraba, the lessee shall have no right to receive any amount of the sale proceeds of the lease property as a rebate of rentals"
21. The above-cited stipulations agreed in the lease agreement leave no room for any doubt that the plant and machinery has been sold to the Modaraba and it is an outright sale. The learned C.I.T.(A) without examining all the contents of the lease agreement has observed that, "the additional condition in Article 18.08 under which, after cessation of lease, if the property is sold to a third party 95 % of sale proceeds of the leased property revert to the assessee/appellant". On perusal of the terms and conditions agreed between the parties it is abundantly clear that the observation of the learned C.I.T.(A) is not correct and he has further fallen in error in observing that the transaction under dispute was not sale but conditional sale and as such clearly outside the purview of Rule 8(5) of the Third Schedule. The learned C.I.T.(A) has further fallen in error in observing that Rule 8(5)(a) of the Third Schedule applied to an actual sale which does not cover an arrangement of sale and lease back. It appears that the learned C.I.T.(A) was very much impressed with the fact that the sale and lease back arrangement was a mode of financing. No doubt, it involved a mode of financing but the fact remains that the machinery has been sold by the appellant to the First Grindlays Modaraba.
22. Consequent to above discussion it is held that in a sale and lease back transaction there is a combination of two transactions. The first transaction is of sale and the second transaction is of lease back to the seller by the buyer. The second transaction is in fact a mode of financing. The learned I.T.O. was, therefore, justified in holding that the appellant sold entire class of assets and if the plant and machinery has been acquired on lease it does not change the p complexion of transaction of the sale of assets. The I. T. O. was further justified in holding that the sale of entire class of assets and obtaining the same from First Grindlays Modaraba on lease rental are two distinct and independent transactions. On the other hand, the learned C. I. T. (A) has misdirected in coming to the contrary conclusion. The impugned finding of learned C.I.T.(A) on the point of sale of machinery is, therefore, vacated and the finding of I.T.O. is restored.
23. As a result of above finding the question arises whether Rule 8(5)(a) of the Third Schedule is applicable and if so weather the method adopted by the I.T.O. is correct or not. After the detailed discussion as above we hold without any hesitation that it being a case of actual sale the provisions contained in Rule 8(5)(a) of the Third Schedule are applicable. We have already cited observations from the Hand Book of Modern Accounting by Sidney Davidson from which it could be inferred that arty sale and lease back arrangement the sale price is determined keeping in view the rental schedule. Since the sale is made in special circumstances which is coupled with a mode of financing, therefore, the sale price is determined by the parties keeping in view the requirements of finances by the seller and the rate of rent agreed between the parties. Thus, it may be more than the fair market value, equal to the fair market value and even less than the fair market value, The same inference can be drawn from the contents of International Accounting Standard 17, the relevant provisions whereof have been cited above. It is, therefore, necessary that for the purpose of Rule 8(5)(a) of the Third Schedule to the Income Tax Ordinance, 1979 the I.T.O. should determine the fair market value. However, the fair market value is to be determined keeping in view all the attending circumstances and without losing sight of the fact that in any sale and lease back arrangement no open market is available as rightly observed by the learned C.I.T.(A). In international Accounting Standard also the fair value has been defined to mean an amount which a knowledgeable willing buyer shall pay to a knowledgeable willing seller. The determination of fair market value of an asset is always a difficult exercise particularly in the case of a sale and lease back. It is a very cumbersome and difficult proposition as all the attending circumstances are to be considered on their own merits in each case. As the circumstances and terms and conditions agreed between the parties may differ from case to case, therefore, no hard and fast rule can be laid down for determining a fair market value in a case of sale and leaseback arrangement, The formula adopted by the assessing officer is particularly bound to cause serious injustice to the assessees as the entire formula is imaginary as well as arbitrary. It is, therefore, held that although the assessing officer is empowered to determine the fair market value by resort to Rule 8(5)(a) of the Third Schedule to the Income Tax Ordinance but the formula adopted is arbitrary and harsh. The finding of learned C.I.T.(A) deleting the addition is, therefore, vacated and the finding of I.T.O. determining the fair market value on the formula of adding inflationary rate is hereby set aside. Since it is a highly technical job which an Assessing Officer is not supposed to perform on his own according to the dictates of justice, therefore, it is directed that the question of determining the fair market value of the machinery should be referred to the market valuers under section 67 of the Income Tax Ordinance, 1979. The valuers should determine the market value of the machinery on the date of sale transaction keeping in view the special nature of transaction, which is involved, in the sale and lease back arrangement. The terms and conditions of the lease should also be k6pt in view while determining the fair market value of the machinery. After receiving report from valuers the assessing officer should give his finding on merits as deemed fit.
24. The appeal is allowed as above.
M.B.A./677/T Appeal allowed.