State Bank of Travancore Vs.
Commissioner of Income Tax, Kerala [1986] INSC 4 (8 January 1986)
TULZAPURKAR, V.D.
TULZAPURKAR, V.D.
MUKHARJI, SABYASACHI (J) MISRA RANGNATH
CITATION: 1986 AIR 757 1986 SCR (1) 25 1986
SCC (2) 11 1986 SCALE (1)34
CITATOR INFO :
RF 1991 SC1806 (6,13)
ACT:
Income Tax Act, 1961:
Sections 28, 29 & 145 - Banking Company -
Advances considered doubtful of recovery-interest on such 'sticky' advances not
carried in 'Profit and Loss Account' - Credited to separate account - 'Interest
suspense account' - Accrual of income - Whether arises - Interest amount -
Whether exemption from tax - Concept and notion of real income - Explained.
Method of accounting - How far relevant for
computation of income, profits and gains - Mercantile and cash systems of
accounting - Difference between.
Devaluation of Indian Rupee - Exchange
difference arising therefrom - Whether income assessable to tax.
HEADNOTE:
The assessee, a subsidiary bank of the State
Bank of India, used to maintain in the accounting years 1964, 1965 and 1966,
its accounts in mercantile system making entries and calculating income and
loss on accrual basis and adopted the calendar year as its previous year. The
assessee, in the course of its banking business, used to charge interest on
advances considered doubtful of recovery termed as 'sticky advances' by
debiting the concerned parties but instead of carrying the same to its 'Profit
& Loss Account', credited the same to a separate account called 'Interest
Suspense Account' as the principal amounts of these 'sticky advances'
themselves had become not bad or irrecoverable, but extremely doubtful of
recovery. In its returns the assessee disclosed such interests separately and
claimed that the same were not taxable in its hands as income for the concerned
years.
The business of the assessee bank also
included buying and selling of foreign exchange and before devaluation of the
Indian Rupee on August 6, 1966, the assessee bank held foreign 26 exchange by
way of cash balances available with their foreign correspondents, forward
contracts, items in transits, etc. in U.S. Dollars and in Sterling, which on
devaluation of the Indian Rupee when converted back to rupees at the post
devaluation rates gave rise to a profit of 57.5% in the transaction; the
assessee bank-credited this surplus to an account designated "Provision
for Contingencies". In the Assessment Year 1967-68 the assessee bank
claimed that profit by way of exchange difference on devaluation should not be
taxed as it was of a casual and non-recurring nature.
The claim of the assessee bank on both these
aspects was rejected by the Income-tax Authorities, Income-tax Appellate
Tribunal and the High Court. The High Court held:
(a) the assessee was following the mercantile
system of accounting; such interest, therefore, had accrued to the assessee at
the end of the accounting year; and (b) the assessee itself had treated such
income as accrual of interest by charging the same to the parties concerned by
making debit entries in their respective accounts. However, if any part of
these debits had later on become irrecoverable in any year, the assessee could
have, in that year, treated the same as such and claimed deduction under
section 36(1)(vii) of the Income Tax Act, 1961.
In the appeals to this Court on behalf of the
assessee bank it was contended: (1) that the three sums representing interest
on 'sticky' advances, i.e. advances in respect where of there was high
improbability of recovery of even the principal amounts, ought not to have been
subjected to tax as income under the Act; that what are chargeable to
income-tax in respect of a business are profits and gains actually resulting
from the transaction of the previous year, that is to say, the real profits and
gains and not hypothetical profits or gains on a doctrinaire theory of accrual;
that even under the mercantile system of accounting regularly adopted by an
assessee it is only the acrual of "real income" in the commercial
sense which is chargeable to tax, that accrual is a matter of substance to be
decided on commercial principles having regard to business character of the
transaction and the realities of the situation and cannot be determined on any
abstract theory of accrual or by adopting a legalistic approach and that if regard
is had to the commercial principles and realities of the situation it will be
clear that in 27 the case of banks, financial institutions and money-lenders,
whose bulk profits mainly consist of interest earned by them, there is no
accrual of real income so far as interest on sticky advances and the debit
entries made in respect of such interest in the respective accounts of the
concerned debtors following the mercantile system of accounting merely
reflected hypothetical income that does not materialise in the concerned
accounting year or years during which the advances remain sticky and hence it
is but proper to carry such interest to "Interest Suspense Account' as
carrying the same to 'Profit and Loss Account' would result in showing inflated
profits and might even lead to improper and illegal distribution or remittance
thereof; (2) that there is a clear distinction between an irrevocable loan and
a sticky loan; the former is a bad debt in respect whereof the chance of
recovery is nil and as such can outright form the subject matter of deduction
under section 36(i)(vii) of the Act while the latter is a loan to which a high
degree of improbability of recovery attaches in a particular year or years
depending upon the financial position of the concerned debtor due to which
interest thereon becomes hypothetical income during such year or years and, as
such, the same, not being real income, cannot be brought to tax; (3) that right
from August 1924 onwards till the decision of the High Courts distinction between
an irrecoverable loan and a sticky loan was recognised by the Central Board of
Revenue as also by the Reserve Bank of India in their diverse Circulars in the
case of banks, financial institutions and money-lenders regularly following the
mercantile system of accounting and that Instructions had been issued not to
treat the unrealised interest on sticky loans as income by carrying it to
'Profit and Loss Account' so that the figure of distributable profits should
not get inflated and preferably to credit the same to a special account
'Interest Suspense Account' and that if the banks, financial institutions and
money-lenders, who kept their accounts on mercantile system, maintained a
suspense account in which the unrealised interest was entered, the same should
not be included in the assessee's taxable income, if the Income Tax Officer was
satisfied that there was really probability of the loans being repaid; (4) that
the Instructions contained in various Circulars were in consonance with the
accepted principle that what was chargeable under the Income Tax Act was the
real income of an assessee but these instructions which held field for over 53
years were changed, though wrongly, under fresh circulars issued by the Central
28 Board of Direct Taxes whereunder interest on doubtful or sticky loans became
includible in the assessable income of the assessee with effect from the
assessment year 1979-80, and (5) that in the case of banks and financial
institutions who regularly adopted mercantile system of accounting the practice
of carrying interest on such sticky loans to 'Interest Suspense Account' or
'Reserve for Doubtful Interest Account' in stead of crediting the same to
'Interest Account' or 'Profit and Loss Account' is a universally recognised
practice invariably adopted by them and being wholly consistent with the
mercantile system of accounting the Income Tax Officer was bound to give effect
to it under section 145 of the Act and, therefore, the treatment of the three
sums representing interest on sticky loans as the assessee's income for the
concerned years would be unsustainable in law.
On behalf of the Revenue it was contended:
(1) that though it is the real income that is chargeable to tax under the Act
and not any hypothetical income of an assessee and that under section 28 in
respect of a business the chargeability must attach to real profits and gains
arising from the transactions of the previous year, but under section 5 read
with section 28 of the Act the liability attaches to profits which have been either
received by the assessee or which have accrued to him during the year of
account and that income accrues when it "falls due", i.e.
becomes legally recoverable irrespective of
whether actually received or not and "accrued income" is that income
which "the assessee has a legal right to receive" and since the
assessee has been maintaining its accounts on mercantile basis the three sums
being interest on loans, whether doubtful or sticky, fell due and became
payable to the assessee at the end of each of the three accounting years and
constituted its accrued income and, therefore, justifiably brought to tax in
the concerned assessment years; (2) that though, while imposing the tax
liability under the Act, the Courts have recognised the theory of real income
by having regard to the business character of the transactions and realities of
the situation but these aspects have been taken into account for the purpose of
determining whether the income could be said to have legally accrued or not and
once it is found to have legally accrued it is brought to tax and that the
theory of real income has been invoked and confined only to two types of cases
(a) where there has been a surrender of income which may in theory have
accrued, and (b) where there has been diversion of income at source either 29
under a statute or by over riding title but in none of the cases has the aspect
of high improbability of recovery been regarded as sufficient to prevent
accrual; therefore the theory of real income should not be extended so as to
exclude from chargeability such income which has accrued but merely suffers
from high improbability of recovery, because such extention would be neither
permissible nor advisable - not permissible because it goes against the very
concept of accrued income and not advisable because if done it will apply to
all cases and not merely to cases of interest accruing to banks and financial
institutions. Such extension will moreover entrench upon section 36(1) (vii)
which provides for deductions of a debt or part thereof on its becoming bad on
fulfilment of certain conditions specified in sub-section (2) thereof; for
these reasons the extension of the theory of real income so as to take within
its ambit the consideration of high improbability of recovery is not warranted.
As regards the Circulars of C.B.R. and R.B.I., it was submitted that these
merely granted a concession to and conferred no right in favour of the assessee
which could be and has been withdrawn later by issuing fresh Circulars but
since the benefit or the concession in favour of the assessee could not be
withdrawn retrospectively, the withdrawal of concession has been effected
prospectively from the assessment year 1979-80.
Dismissing the appeals, ^
HELD: Per Tulzapurkar, Mukharji and Ranganath
Misra, JJ. (concurring).
The principle that if the stock-in-trade
remains unused or unsold the mere book appreciation in the value thereof cannot
be brought to tax is well accepted. However, in the instant case, the assessee
bank by carrying the surplus resulting from the devaluation of the Indian rupee
to an account designated 'Provision for Contingencies' could be said to have
clearly treated such surplus as its business income. Further, the Appellate
Assistant Commissioner in his appellate order recorded a categorical finding
that the stock in trade in terms of foreign currency was sold and used by the
assessee in its normal business. Having regard to this factual position the
exchange difference arising out of devaluation of the Indian rupee was rightly
treated as income of the assessee in the assessment year 1967-68. [65 C; 66
G-H; 67 A & D] C.I.T. v. Mughal Line Ltd., 46 I.T.R. 590 referred to.
30 Per Mukharji, J. (1) It is the income
which has really accrued or arisen to the assessee that is taxable. Under
Income-tax law, receipt of income, either actual or deemed, is not a condition
precedent to the taxability. These were assessable if these had arisen or
accrued or deemed to have accrued or arisen under the Act. This principle would
be attracted even in cases where an assessee followed the mercantile system of
accounting. However, in examining any transaction or situation, the court would
have more regard to the reality of the situation rather than purely theoretical
or doctrinaire aspect. [92 A; 86 F-G]
2. The profits and gains chargeable to tax
under the Act are those which have been either received by the assessee or have
accrued to the assessee during the period between the first and the last day of
the year of account and are receivable. Income received or income accrued are
both chargeable to tax under section 28 of the Act. [74 C]
3. By and large, two systems of account
keeping are followed one is the cash and the other, mercantile. The cash system
postulate actual receipt of money; and for exigibility of income tax, such
receipt from business, profession or vocation or from other sources has to be
actual in the relevant year of account. The mercantile system is one where
accounts are maintained on the basis of entitlement to credit and/or debit. A
sum of money, as soon as it becomes payable, is taken into account without
reference to actual receipt and a debit becomes admissible when liability to
pay is created even though the sum of money is yet to be paid. [72 B-C]
Dhakeshwar Prasad Narain Singh v. Commissioner of Income Tax, Bihar &
Orissa, 4 I.T.R. 71 at 74, Commissioner of Income Tax, Bombay v. Sarangpur
Cotton Manufacturing Co.
Ltd., 6 I.T.R. 36, Commissioner of Income-tax
v. Shrimati Singari Bai, 13 I.T.R. 224 and Commissioner of Income-tax, Madras
v. A. Krishnaswami Mudaliar and Ors., 53 I.T.R. 122 referred to.
4. The income of the assessee will have to be
determined according to the provisions of the Act in consonance with the method
of accountancy regularly employed by the assessee. The method of accounting
regularly employed by the assessee helps computation of income, profits and
gains under section 28 of the Act and the taxability of that income under the
Act, will then have to be determined. The circulars being executive in 31 character
cannot alter the provisions of the Act and being in the nature of concessions
could always be prospectively withdrawn. [75 A-B] Commissioner of Income-tax,
Madras v. K.R.M.T.T.
Thiagaraja Chetty & Co., 24 I.T.R. 525,
Dhakeshwar Prasad Narain Singh v. Commissioner of Income Tax, Bihar &
Orissa, 4 I.T.R 71 at 74, Commissioner of Income-tax v. Shrimati Singari Bai,
13 I.T.R. 224 & Commissioner of Income-tax, Madras v. A. Krishnaswami
Mudaliar and Ors., 53 I.T.R. 122 referred to.
5. Mere improbability of recovery, where the
conduct of the assessee is unequivocal cannot be treated as evidence of the
fact that income has not resulted or accrued to the assessee. After debiting
the debtor's account and not reversing that entry - but taking the interest merely
in suspense account cannot be such evidence to show that no real income has
accrued to the assessee or treated as such by the assessee. If the actuality of
a situation or the reality of a particular situation makes an income not to
accrue, then very different considerations would apply. But where interest has
accrued and the assessee has debited the account of the debtor, the difficulty
of the recovery would not make the accrual non-accural of interest. [92 C-D; 89
B- C] Catbolic Bank of India (In liquidation) v. Commissioner of Income-tax,
Kerala, Ernakulam, 1964 K.L.T. 653 = 1965 (1) I.T. Journal 355, Commissioner of
Income-tax, Bombay I v. Confinance Ltd., 89 I.T.R. 292 and James Finlay &
Co. v. Commissioner of Income Tax, 137 I.T.R. 698 approved.
6. An acceptable formula of co-relating the
notion of real income in conjunction with the method of accounting for the
purpose of computation of income for the purpose of taxation is difficult to
evolve. Besides, any straight- jacket formual is bound to create problems in
its application to every situation. It must depend upon the facts and
circumstances of each case. It would be difficult and improper to extent the
concept of real income to all cases depending upon the ipse dixit of the
assessee which would then become a value judgment only. What has really accrued
to the assessee has to be found out and what has accrued must be considered
from the point of view of real income taking the probability or improbability
of realisation in a realistic manner and dovetailing 32 of these factors
together, but once the accrual takes place on the conduct of the parties
subsequent to the year of closing, an income which has accrued cannot be made
"no income". The conduct of the parties in treating the income in a
particular manner is material evidence of the fact whether income has accrued
or not. [91 B-C; E-F; 92 C]
7. The concept of real income is a well
accepted one and must be applied in appropriate cases but with circumspection
and must not be called in aid to defeat the fundamental principles of
income-tax as developed. [92 F]
8. The concept of real income would apply
where there has been a surrender of the income which in theory may have accrued
but in the reality of the situation no income has resulted because the income
did not really accrue. Where a debt has become bad and deduction in compliance
with the provisions of the Act should be claimed and allowed. If there is any
diversion of income at source under any statute or by overriding title then
there is no income to the assessee. [92 A-C]
9. Once the accrual takes place and income
accrues, the same cannot be defeated by any theory of real income. In some
limited fields where something which is the reality of the situation prevents
the accrual of the income, then the notion of the real income i.e. making the
income accrue in the real sense of the term can be brought into play, but the
notion of real income cannot be brought into play where income has accrued
according to the accounts of assessee and there is no indication by the
assessee to treat the amount as not having accrued. Suspended animation
following inclusion of the amount in suspense account does not negate accrual
and after the event of accrual, corroborated by appropriate entry in the books
of account on the mere ipse dixit of the assessee, no reversal of the situation
can be brought about. [88 D; 81 B-D] Morvi Industries Ltd. v. Commissioner of
Income-Tax (Central), Calcutta, 82 I.T.R. 835 and Calcutta Co. Ltd. v. Commissioner
of Income-Tax, West Bengal, 37 I.T.R. 1 relied upon.
Commissioner of Income-Tax, Bombay City, I v.
Messrs.
Shoorji Vallabhdas and Co., 46 I.T.R. 144,
Commissioner of Income-tax, Bombay North Kutch and Sturashtra, Ahmedabad v. Chamanlal
Mangaldas & Co., 29 I.T.R. 987, Morvi Industries 33 Ltd. v. Commissioner of
Income-Tax (Central) Calcutta, 82 I.T.R. 835, H.M. Kashiparekh & Co. Ltd.'s
case, 39 I.T.R.
706, Commissioner of Income-Tax, West Bengal,
II v. Birla Gwalior (P) Ltd., 89 I.T.R. 266, Commissioner of Income-tax, Tamil
Nadu-V v. Motor Credit Co. (P) Ltd., 127 I.T.R. 572, Commissioner of
Income-Tax, Madras Central v. Devi Films (P) Ltd., 143 I.T.R. 386 and
Commissioner of Income-Tax, Amritsar-II v. Ferozepur Finance (P) Ltd., 124
I.T.R. 619 distinguished.
10. The concept of real income cannot be so
used as to making accrued income, non-income simply because after the event of
accrual, the assessee neither decides to treat it as bad debt nor claims
deduction under section 36(2) of the Act, but still enters the same with a
diminished hope of recovery in the suspense account. Extension of the concept
of real income to this field to negate after the amount had become payable is
contrary to the postulates of the Act. [82 B-C] Per Ranganath Misra, J.
(concurring) Section 36(2) of the Act covers the entire field regarding
deduction for bad debt. Though the concept of 'real income' is well recognised
one, it cannot be introduced as an outlet of income from taxman's net for
assessment on the plea that though shown in the account book as having accrued,
the same became a bad debt and was not earned at all. The citizen is entitled
to the benefit of every ambiguity in a taxing statute but where the law is
clear considerations of hardship, injustice or anomaly do not afford justification
for extempting income from taxation. [93 C-D] Mapp v. Oram, 1969 (Vol.III) All
E.R. 219 (H.L.) referred to.
Per Tulzapurkar, J. - (dissenting)
1. Under the Income Tax Act in order that
income should accrue it should not merely fall due or become legally
recoverable but should also be factually and practically realisable during the
accounting year or years. In other words mere non-receipt of income, when it is
reasonably realisable, will not affect accrual but factual or practical
unrealisability thereof may prevent its accrual depending upon the facts and
circumstances attending upon the transaction. [59 F-G] 34
2. This theory of real income could be and
should be extended to interest on sticky loans and that on principle such
interest being hypothetical cannot be brought to tax.
[64 G-H]
3. That the stickiness of advances or loans
objectively established to the satisfaction of the taxing authorities by
producing proper material, is sufficient to prevent the accrual of interest
thereon as real income and would have the effect of rendering such income
hypothetical and the same cannot be brought to tax. [59 E-F]
4. Under section 145 the assessee's regular
method of accounting determines the mode of computing the taxable income but it
does not determine or even affect the range of taxable income or the ambit of
taxation. In other words, any hypothetical income which may have theoretically
accrued but has not truly resulted or materialised in the concerned accounting
year cannot be brought to change simply because the assessee has been regularly
employing the mercantile system of accounting and makes entries in his books in
regard to such hypothetical income. [47 F-G]
5. The method of accounting regularly
employed by an assessee is relevant only for the purpose of computation of
income, profits and gains under s. 28 of the Act and that it cannot enlarge or
restrict the content of the taxable income under the Act and that under s. 145
the assessee's regular method of accounting determines the mode of computing
taxable income but it does not determine or even effect the range of taxable
income or ambit of taxation. [49 C-D]
6. In the case of interest on sticky loans
the practice of debiting the accounts of the concerned debtors with such
interest and carrying the same to 'Interest Suspense Account' instead of to
"Interest Account' or 'Profit and Loss Account' is a well recognised and
accepted practice of commercial accountancy, that it is wholly consistent with
mercantile method of accounting and that it prevents the wrong crediting and
improper and illegal distribution or remittance of inflated and unreal profits.
[52 D-E]
7. Under s. 5 taxability is attracted not
merely when income is acutally received but also when it has 'accrued' and
income accrues when it 'falls due', that is to say when it becomes legally
recoverable irrespective of whether it is actually received or not and 'accrued
income' is that income which 'the assessee has a legal right to receive.' [52
F-G] 35
8. Where income or part thereof has
theoretically accrued but has been, either unilaterally or as a result of
bilateral arrangement, voluntary relinquished or surrendered by the assessee
before its accrual the same cannot be regarded as real income of the assessee
and cannot be brought to tax. Such conclusion is reached having regard to the
business character of the transactions and the realities of the situation
notwithstanding that some entries have been made in the assessee's books
maintained in the mercantile system. [55 C-D]
9. Even under the mercantile system of
accounting whenever adopted it is only the accrual of real income which is
chargeable to tax, that accrual is a matter of substance and that is to be
decided on commercial principles having regard to the business character of the
transactions and the realities and specialities of the situation and cannot be
determined by adopting purely theoretical or doctrinaire or legalistic
approach. [58 H; 59 A] Catholic Bank of India (In Liquidation) v. Commissioner
of Income-tax, Kerala, 1964 K.L.T. 653 = 1965 (1) Income-tax Journal 355,
C.I.T. v. Confinance Ltd., 89 I.T.R. 292 & James Finlay & Co. v.
C.I.T., 137 I.T.R. 698 overruled.
C.I.T. v. Motor Credit Co. (P) Ltd., 127
I.T.R. 572, C.I.T. v. Devi Films (P) Ltd., 143 I.T.R. 386, C.I.T. v.
Ferozepur Finance (P) Ltd., 124 I.T.R. 619,
Dhakeswar Prasad Narain singh v. Commissioner of Income Tax, 4 I.T.R. 71 at 74
& H.M. Kashiparekh Co.!s case, 39 I.T.R. 706 approved.
C.I.T. v. Sarangpur Cotton Mfg. Co., 6 I.T.R.
36 at 40, C.I.T. v. Singari Bai, 13 I.T.R. 224 at 227, C.I.T. Madras v. A.
Krishnaswami Mudaliar & Ors., 53 I.T.R. 122, C.I.T. v.
Shoorji Vallabhdas & Co. 46 I.T.R. 144,
C.I.T. v. Birla Gwalior (P) Ltd., 89 I.T.R. 266 and Kohler!s Dictionary for
Accountants 3rd Edn. relied on.
C.I.T. v. Thiagaraja Chetty, 24 I.T.R. 525 at
531, Morvi Industries Ltd. v. C.I.T. Calcutta, 82 I.T.R. 835 at 840, C.I.T. v.
Harivallabhadas Kalidas & Co., 39 I.T.R. 1, C.I.T. Madhya Pradesh v.
Kalooram Govindram, 57 I.T.R. 630, Poona Electric Supply Co. Ltd. v. C.I.T.
Bombay, 57 I.T.R.
521, C.I.T. v. Sir S.M. Cnitnavis, 6 I.T.
Cases 453 Shukla and Grewal referred to.
36
CIVIL APPELLATE JURISDICTION : Civil Appeal
Nos. 1860- 62 (NT) of 1973.
From the Judgment and Order dated 22.3.1973
of the Kerala High Court in I.T.R. Nos. 27 to 29 of 1971.
N.A. Palkhiwala, S.E. Dastur, M/s.
J.B.Dadachandji, Ravinder Narain, Mrs. A.K. Verma and Jeol Peres for the
Appellant.
V.S. Desai, B.B. Ahuja and Miss A. Subhashini
for the Respondent.
N.A. Palkhiwala, S.E. Dastur, M/s. J.B.
Dadachanji, Mrs. A.K. Verma and D.N. Mishra, for the Intervenors (M/s.
Grindlays Bank, Calcutta and State Bank of
Travancore).
Dr. P. Pal and D.N. Gupta for the Intervenor
(Chartered Bank).
F.N. Kaka, Mr. S.E. Dastur, C.S. Shroff, S.S.
Shroff and S.A. Shroff for the Intervenor (Industiral Credit & Invest-ment
Corpn., & American Express International Bank and City Bank Banking Corpn.)
S.E. Dastur, S.N. Talwar and H.S. Parihar for the Intervenor (Mercantile Bank
Ltd.).
K. Ram Kumar, K. Ram Mohan and Mrs. J.
Ramachandran for the Intervenor (Indian Overseas Bank, Madras).
The following Judgments were delivered
TULZAPURKAR, J. These appeals by certificate from the High Court raise the
following two interesting questions of law for our determination:
(1) Whether on the facts and in the
circumstances of the case the addition of the sum of Rs. 67,170, Rs. 47,777 and
Rs. 57,889, representing interest on !sticky! advances, as income for the
assessment years 1965-66, 1966-67 and 1967-68 respectively was justified in
law? (2) Whether on the facts and in the circumstances of the case the exchange
difference of Rs.
1,66,128 37 arising on devaluation of the
Indian rupee on 6.6.1966 was rightly treated as income for the assessment year
1967-68? The facts giving rise to the first question lie in a narrow compass
and are these. The assessee is a subsidiary of the State Bank of India; it
maintains accounts on mercantile system making entries on accrual basis; it
adopts the calendar year as its previous year and the calendar years 1964, 1965
and 1966 are respectively the relevant previous years for the assessment years
1965-66, 1966-67 and 1967-68 to which the question relates. In the course of
its banking business the assessee charged interest on advance considered
doubtful of recovery otherwise called sticky advances by debiting the concened
parties but instead of carrying it to its !Profit and Loss Account! credited
the same to a separate account styled !Interest Suspense Account! as the
principal amounts of these stickly advances themselves had become, not bad or
irrevocerable but extremely doubtful of recovery. However, in its returns the
assessee disclosed such interest separately and claimed that the same was not
taxable in its hands as income for the concerned years. The amounts so charged
to the concerned parties but credited to the !Interest Suspense Account! were
Rs. 67,170 Rs. 47,777 and Rs. 57,889 for the assessment years 1965-66, 1966-67
and 1967-68 respectively.
Before the taxing authorities as also before
the Tribunal and the High Court the assessee raised the contention that having
regard to the deteriorating financial position of the concerned parties and
history of their accounts, the recovery of even the principal amounts had
become highly improbable and extremely doubtful rendering the advances !sticky!
and as such the interest thereon, though debited to them, was, following a well
recognised principle of commercial accountancy, taken to !Interest Suspense
Account! so as to avoid showing inflated profits by including hypothetical
income and since such interest was not its real income, the same was not
taxable in its hands.
The contention was rejected at all the levels
principally on two grounds - (a) since admittedly the assessee was following
the mercantile system of accounting such interest had accrued to it at the end
of each accounting year and (b) the assessee had itself shown the accrual of
such interest by charging the same to the concerned parties by making debit
entries in their accounts. It was observed that if any part of the debts later
became irrecoverable in any 38 year the assessee could in that year treat it as
such and claim deduction under s. 36 (1) (vii) of the Income Tax Act 1961. In
holding that these three sums were taxable as income in the hands of the
assessee for the concerned years the High Court followed its earlier decision
in the, case of Catholic Bank of India (In Liquidation) v. Commissioner of
Income-tax, Kerala, [1964] K.L.T. 653 = [1965] 1 Income-tax Journal 355 where
despite the directive issued by the Reserve Bank of India to the assessee-bank
not to carry interest on such sticky advances to !Profit and Loss Account! and
despite the fact that the assessee-bank had in pursuance thereof ommitted such
interest from its !Profit and Loss Account! the Court had taken the view that
such interest was taxable as income in the hands of the assessee- bank because
of the mercantile system of accounting that had been regularly employed by it,
which had not been changed even after receiving the directive from the Reserve
Bank.
The High Court was of the view that the facts
of the instant case were indistinguishable from those obtaining in the Catholic
Bank's case except that there was a directive from the Reserve Bank of India to
the Catholic Bank which was absent in the case before it but in its opinion the
presence or absence of such directive from the Reserve Bank could not determine
the question whehter there was accrual of income or not and that in the case
before it also there was accrual of income to the assessee considering the
mercantile method of accounting that had been regularly adopted by it. In this
view of the matter the High Court answered the question against the assessee
and in facour of the revenue.
Incidentally it may be stated in the case of
this very assessee the High Court, following the decision herein, took a
similar view and answered a similar question against the assessee for the
subsequent year 1968-69 which decision rendered in 1975 is reported in 110 ITR
336. The assessee has challenged this view before us in these appeals.
Mr. Palkhivala the learned counsel for the
assessee raised a two-fold contention in support of his plea that the three
sums representing interest on !sticky! advances, i.e.
advances in respect whereof there was high
improbability of recovery of even the principal amounts ought not to have been
subjected to tax as income under the Act. In the first place he contended that
what are chargeable to income tax in respect of a business are profits and
gains actually resulting from the transactions of the previous year, that is to
say, the real profits and gains and not hypothetical profits or gains 39 on a
doctrinaire theory of accrual, that even under the mercantile system of
accounting regularly adopted by an assessee it is only the accrual of real
income in the commercial sense which is chargeable to tax, that accrual is a
matter of substance to be decided on commercial principles having regard to
business character of the transactions and the realities of the situation and
cannot be determined on any abstract theory of accrual or by adopting a
legalistic approach and that if regard is had to commercial principles and
realities of the situation it will be clear that in the case of banks, financial
institutions and money lenders, whose bulk profits mainly consist of interest
earned by them, there is no accrual of real income so far as interest on sticky
advances is concerned, and the debit entries made in respect of such interest
in the respective accounts of the concerned debtors following the mercantile
system of accounting merely reflect hypothetical income that does not
materialise in the concerned accounting year or years during which the advances
remain sticky and hence it is but proper to carry such interest to !Interest
Suspense Account! as carrying the same to !Profit and Loss Account! would
result in showing inflated profits and might even lead to improper and illegal
distribution or remittance thereof. In this behalf counsel cited several
decisions of this Court as also of the High Courts where the principle of real
income has been recognised and invoked while considering the tax liability
under the Act and in particular strong reliance was placed on two decisions of
the Madras High Court in C.I.T. v. Motor Credit Co.(P) Ltd., 127 I.T.R. 572 and
C.I.T. v. Devi Films (P) Ltd. 143 I.T.R. 386 and one decision of the Punjab and
Haryana High Court in C.I.T. v.
Ferozepur Finance (P) Ltd. 124 I.T.R. 619
where a view has been taken that it will be totally unrealistic to treat
interest on sticky loans as income and the same was excluded from computation
of the assessee!s income. According to Counsel there is a clear distinction
between an irrecoverable loan and a sticky loan; the former is a bad debt in
respect whereof the chance of recovery is nil and as such can out right form
the subject matter of deduction under s. 36 (1) (vii) of the Act while the
latter is a loan to which a high degree of improbability of recovery attaches
in a particular year or years depending upon the financial position of the
concerned debtor due to which interest thereon becomes hypothetical income
duringsuch year or years and, as such, the same, not being real income, cannot
be brought to tax. Counsel pointed out that right from August 1924 onwards till
the 40 impugned decision herein as also the further decision in 110 ITR 336
were rendered by the Kerala High Court in 1973 and 1975 respectively the
aforesaid distinction between an irrecoverable loan and a stickly loan was
recognised by the Central Board of Revenue as also by the Reserve Bank of India
in their diverse Circulars in the case of banks, financial institutions and
money lenders regularly following the mercantile system of accounting and he
further pointed out that Instructions had been issued not to treat the
unrealised interest on such sticky loan as income by carrying it to !Profit and
Loss Account! so that the figure of distributable profits should not get
inflated and preferably to credit the same to a special account such as
Interest Suspense Account! and that if the banks, financial institutions and
money lenders, who kept their accounts on mercantile system, maintained such a
suspense account in which the unrealised interest was entered, the same should not
be included in the assessee!s taxable income, if the Income Tax Officer was
satisfied that there was really little probability of the loans being repaid.
(Vide C.B.R.
Circular No. 37/54 dated 25.8.1924, No.
41(V-6) D of 1952 dated 6.10.1952, CBDT!s Letter F.No. 207/10/73 ITA II dated
16.4.1973 and RBI Circular IFD No. O.P.R. 1076/1(5) to SFCs dated 21.11.1973,
copies whereof were furnished to the Court). Counsel urged that such
Instructions contained in these Circulars were in consonance with the accepted
principle that what was chargeable under the Income Tax Act was the real income
of an assessee but according to him these Instructions which held field for
over 53 years were changed, though wrongly, under fresh Circulars dated June
20, 1978 and October 9, 1984 issued by the Central Board of Direct Taxes
whereunder such interest on doubtful or sticky loans became includible in the
assessable income of the assessee (subject to some relief specified therein)
with effect from the assessment year 1979-80. Secondly, counsel contended that
in any view of the matter in the case of banks and financial institutions who
regularly adopt mercantile system of accounting the practice of carrying
interest on such sticky loans to !Interest Suspense Account! or !Reserve for
Doubtful Interest Account! instead of crediting the same to !Interest Account!
or !Profit and Loss Account! is a universally recoginsed practice invariably
adopted by them and being wholly consistent with the mercantile system of
accounting the Income Tax Officer was bound to give effect to it under s. 145
of the Act, and, therefore, the treatment of the three sums representing
interest on sticky loans as the 41 assessee!s income for the concerned
assessment years would be unsustainable in law; and in this behalf counsel
placed reliance on the standard text books of accountancy of authors like
Spicer and Pegler, Shikla and Grewal and the Approved Text of International
Accounting Standard 18.
Since the issues raised before us have a
vital bearing upon the tax liability and business interests and policies of
serveral financial institutions including foreign banks, six interverners,
namely, American Express International Banking Corpn., Mercantile Bank Limited
through its successors Hongkong & Shenghai Banking Corporation, Citi Bank
N.A., Chartered Bank, Grindlays Bank and Industrial Credit & Investment
Corpn. of India sought our permission to intervene in these appeals and we
granted the requisite permission in view of the importance of the issues involved
and it may be stated that Counsel appearing for the interveners have adopted
the arguments of Mr. Palkhiwala and generally supported the submissions made by
him on behalf of the assessee in these appeals; but special mention may be made
of the fact that in the written submissions filed on their behalf it has been
categorically asserted that while maintaining their accounts regularly on
mercantile system each one of these institutions in the matter of interest on
doubtful or sticky loans invariably follow the practice of debiting such
interest to the account of concerned borrower but instead of crediting it to
!Interest Account! or !Profit and Loss Account! the same is carried to a
special account styled !Interest Suspense Account! or !Reserve for Doubtful Interest
Account! and only upon realisation the same is credited to Interest Account and
Profit and loss Account in the year of realisation and is offered for taxation.
It is also claimed by some of the Interveners that they have an elaborate and
well controlled system of evaluation for the purposes of assessing the
recoverability and position of various accounts of their borrowers and the
financial condition of each borrower is periodically reviewed by Senior
Management Personnel on the basis of detailed reports and data collected in
regard to each before treating the laons as sticky. Counsel reiterated on
behalf of the Intervenees that the benefit under the earlier Circulars of
C.B.R. and R.B.I. did not depend upon the ipse dixit of the assessee but was available
only if the safeguards specified therein were observed and the taxing authority
was satisfied on objective materials that the loan had become sticky and there
was really little probability of the same being repaid.
42 On the other hand, counsel for the Revenue
pressed for our acceptance the view taken by the High Court. He fairly conceded
that it is the real income that is chargeable to tax under the Act and not any
hypothetical income of an assessee and that under section 28 in respect of a
business the chargeability must attach to real profits and gains arising from
the transactions of the previous year but he contended that under section 5
read with section 28 of the Act the liability attaches to profits which have
been either received by the assessee or which have accured to him during the
year of account and it is well settled that inncome accrues when it "falls
due", i.e., becomes legally recoverable irrespective of whether actually
received or not and "accrued income" is that income which "the assessee
has a legal right to receive": vide C.I.T. v. Thiagaraja Chetty, 24 I.T.R.
525 at 531 and Morvi Industries Ltd. v. C.I.T.
Calcutta, 82 I.T.R. 835 at 840 and since
admittedly the assessee has been maintaining its accounts on mercantile basis
the three sums being interest on loans, whether doubtful or sticky, fell due
and became payable to the assessee at the end of each of the three accounting
years and constituted its accrued income and were, therefore, justifiably
brought to tax in the concerned assessment years. Counsel for the revenue
fairly conceded that Courts have, while imposing the tax liability under the
Act, recognised the theory of real income by having regard to the business
character of the transactions and realities of the situation but these aspects
have been taken into account for the purpose of determining whether the income
could be said to have legally accrued or not and once it is found to have
legally accrued it is brought to tax. He pointed out that all the decisions of
this Court show that this theory has been invoked and confined only to two
types of cases (a) where there has been a surrender of income which may in
theory have accrued, and (b) where there has been diversion of income at source
either under a statute or by over-riding title but in none of these cases has
the aspect of high improbability of recovery been regarded as sufficient to
prevent accrual; counsel therefore urged that this theory of real income should
not be extended so as to exclude from chargeability such income which has
accrued but merely suffers form high improbability of recovery. Counsel
submitted such extension would be neither permissible nor advisable - not
permissible because it goes against the very concept of accrued income and not
adyisable because if done it will apply to all cases and not merely to cases of
interest accruing to banks and financial 43 institutions. Moreover, such
extension will entrench upon section 36 (1) (vii) which provides for deduction
of a debt or part thereof on its becoming bad on fulfilment of certain
conditions specified in sub-section (2) thereof. For these reasons counsel
submitted that the extension of the theory of real income so as to take within
its ambit the consideration of high improbability of recovery is not warranted.
As regards the earlier Circulars of C.B.R. and R.B.I. On which reliance was
placed by the assessee, counsel for the revenue submitted that these merely
granted a concesssion to and conferred no right in favour of the assessee which
could be and has been withdrawn later by issuing fresh Circulars but since the
benefit or the concession in favour of the assessee could not be withdrawn
retrospectively, the withdrawal of concession has been effected prospectively
from the assessment year, 1979-80.
Having regard to the rival contentions urged
before us by counsel on either side it is clear that the following questions do
arise for our serious consideration on the first issue raised for determination
in these appeals. Did the three sums representing interest on sticky loans
constitute real income of the assessee for the concerned assessment years? Had
such income really accrued to the assessee for those years? Does real accrual
of income depend on its falling due by mere lapse of requisite contractual period
at the end of which it becomes legally payable or upon the business character
of the transaction and the realities of the situation? How far is the method of
accounting regularly adopted by the assessee (here mercantile) relevant for
deciding the question of real accrual? What is the effect of making debit
entries in respect of such interest in the respective accounts of the concerned
debtors under the mercantile system of accounting? And lastly, can and should
the theory of real income be extended so as to exclude a particular income from
chargeability under the Act because of high improbability of recovery attaching
to it in the concerned accounting year or years? We would like to deal with
these questions in the light of decided cases.
The material provisions in regard to the
computation of income of an assessee under the head !Profits and Gains of
Business! are to be found in sections 28 (i) 29 and 145 (1) but these have to
be read subject to sec. 5 of the Act.
Section 28 (i) taxes the profits and gains of
any business carried on by the assessee at any time during the previous year
and such profits and gains are, under sec. 29 to be 44 computed in accordance
with the provisions contained in ss.
30 to 43A, that is to say after making
allowances and deductions mentioned in those sections. Section 145 (1) provides
that income chargeable under the head !Profits and Gains of Business! shall be
computed in accordance with the method of accounting regularly employed by the
assessee, provided that, in any case where the accounts are correct and
completed to the satisfaction of the Income-Tax Officer but the method is such
that, in his opinion, the income cannot be properly deduced therefrom then the
computation shall be made upon such basis and in such manner as the Income-Tax
Officer may determine; but where he is not satisfied about the correctness or
completeness of the accounts of the assessee, or where no method of accounting
has been regularly employed by the assessee, he can proceed to make the assessment
to the best of his judgment. It is well-settled, as a result of the
Privy-Council decision in C.I.T. v. Sarangpur Cotton Mfg. Co., 6 I.T.R. 36 at
40 that the section clearly makes such regularly employed method of the opinion
of the Income tax Officer, the income, profits and gains cannot properly be
deduced therefrom.
Though these provisions provide for charging
the income by way of profits and gains of business and prescribe the manner of
computation the question as to at what point of time its chargibility arises is
answered by s. 5 of the Act which states that the total income of a resident
assessee from whatever source derived becomes chargeable either when it is
received by him or when it accrues or arises to him during the previous year.
In other words taxability is attracted even when income has accrued and it is
clear that the receipt of income is not the sole test of taxability under the
Act; but whether on receipt basis or accrual basis it is the real income and
not any hypothetical income which may have theoretically accrued that is
subjected to tax under the Act and this latter aspect arising under our Act is
well settled by decisions of this Court and the High Court to which I will
presently refer.
However, before referring to the decisions
which deal with the doctrine of real income it will be desirable to indicate
the main difference between the two methods of accounting that are usually
employed by business men as also to deal with the aspect as to how far and to
what extent a method of accounting - particularly the mercantile method - has a
bearing on the question of real accrual of income. In Dhakeswar 45 Prassad
Narain Singh v. Commissioner of Income Tax, 4 I.T.R.
71 at 74 Sir Courtney Terrell, C.J. described
the 'cash system' in these words:
"According to the system a record is
kept of actual receipts and actual payments, entries being made only when money
is actually collected or disbursed and if the profits of the business are
accounted in this way the tax is payable on the difference between the receipts
and the disbursements for the period in question." On the other hand the
'mercantile accountancy system, otherwise known as the 'book profits system of
accountancy' or the 'complete double entry book-keeping' has been described by
Sir Iqbal Ahmed, C.J. in C.I.T. v. Singari Bai, 13 I.T.R. 224 at 227, as
follows:
"Under this system the net profit of
loss is calculated after taking into account all the income and all the
expenditure relating to the period, whether such income has been actually
received or not and whether such expenditure has been actually paid or not.
That is to say, the profit computed under this system is the profit actually
earned, though not necessarily realized in case, or the loss computed under the
system is loss actually sustained, though not necessarily paid in cash. The
distinguishing feature of this method of accountancy is that it brings into
credit what is due immediately it becomes legally due and before it is actually
received; and it brings into debit expenditure the amount for which a legal
liability has been incurred before it is actually disbursed." The
distinction between these two accounting systems has been adverted to by this
Court in several of its decisions but I need refer only to one decision in
C.I.T. Madras v. A.
Krishnaswami Mudaliar & Others, 53 I.T.R.
122 where the distinction has been elaborately brought out by Shah J (as he
then was) in the following passage occurring at pages 129-130 of the Report;
"Among Indian businessmen, as elsewhere,
there are current two principal systems of book keeping.
There is, firstly, the cash system in which a
46 record is maintained of actual receipt and actual disbursements, entries
being posted when money or money's worth is actually received, collected or
disbursed. There is, secondly, the mercantile system, in which entries are
posted in the books of account on the date of the transaction, i.e., on the
date on which rights accrue or liabilities are incurred, irrespective of the
date of payments. For example, when goods are sold on credit, a receipt entry
is posted as of the date of sale, although no cash is received immediately in
payment of such goods; and a debit entry is similarly posted when liability is
incurred although payment on account of such liability is not made at the time.
There may have to be appropriate variations when this system is adopted by an
assessee who carries on a profession.
Whereas under the cash system no account of
what are called the outstandings of the business either at the commencement or
at the close of the year is taken, according to the mercantile method actual
cash receipts during the year and the actual cash outlays during the year are
treated in the same way as under the cash system, but to the balance thus arising,
there is added the amount of the outstandings not collected at the end of the
year and from this is deducted the liabilities incurred or accrued but not
discharged at the end of the year. Both the methods are somewhat rough. In some
cases these methods may not give a clear picture of the true profits earned and
certainly not of taxable profits. The quantum or allowances permitted to be
deducted under diverse heads under section 10 (2) from the income, profits and
gains of a business would differ according to the system adopted. This is made
clear by defining in subsection (5) the word 'paid' which is used in several
clauses of sub-section (2) as meaning actually paid or incurred according to
the method of accounting upon the basis of which the profits or gains are
computed under section 10. Again where the cash system is adopted, there is no
question of bad debts or outstandings at all, in the case of mercantile system
against the book profit some of the bad debts may have to be set off when they
are found to be irrecoverable.
Besides the cash system 47 and the mercantile
system, there are innumerable other systems of accounting which may be called
hybrid or heterogeneous - in which certain elements and incidents of the cash
and mercantile systems are combined." On the aspect as to how far and to
what extent a method of accounting has a bearing on the question of real
accrual of income the Court has made the following significant observation at
page 128 of the Report:
"But the section (section 13 of the 1922
Act equivalent to section 145 of the 1961 Act) only deals with a computation of
income, profits and gains for the purposes of sections 10 and 12 (sections 28
and 56 of the 1961 Act) and does not purport to enlarge or restrict the content
of taxable income, profits and gains under the Act." Obviously for the
content of taxable income one must have regard to the substantive charging
provisions of the Act.
This decision, in my view, has emphasised two
important aspects in regard to the two methods of accounting usually employed
by business men. In the first place the Court has pointed out that both the
methods are somewhat rough and in some cases these methods may not give clear
picture of the true profits earned and certainly not of taxable profits;
and secondly, whatever be the method
regularly employed by an assessee the same has to be adopted as the basis and
is relevant only for the purpose of the computation of income, profits and
gains under sections 28 and 56 of the Act but it cannot enlarge or restrict the
content of the taxable income, profits and gains under the Act. It is thus
clear that, under section 145, the assessee's regular method of accounting
determines the mode of computing the taxable income but it does not determine
or even affect the range of taxable income or the ambit of taxation. In other
words, any hypothetical income which may have the oretically accrued but has
not truly resulted or materialised in the concerned accounting year cannot be
brought to charge simply because the assessee has been regularly employing the
mercantile system of accounting and makes entries in his books in regard to
such hypothetical income.
In the light of above I would recapitulate
the admitted facts and the manner in which the assessee treated or dealt with
the three sums representing interest on sticky loans in 48 its books pursuant
to the mercantile system of accounting regularly adopted by it. Indisputably,
the three sums in question represented the assessee's income by way of interest
on advances made by it to some of its customers but having regard to the
deteriorating financial position of the concerned parties and the history of
their accounts the assessee felt that the advances had become sticky during the
concerned accounting years inasmuch as even the recovery of the principal
amounts had become highly improbable and extremely doubtful in those years;
therefore, though it charged such interest by debiting the concerned parties it
did not carry it to its profit and loss account but credited the same to a
separate account styled 'Interest Suspense Account' so as to avoid showing
unreal or inflated profits and claimed that it was not taxable in its hands as
real income had not accrued to it. The facts that the advances or loans had,
during the concerned accounting years, become sticky and that such interest had
not materialised or resulted to the assessee in those years were not disputed
but as stated earlier the claim was negatived by the taxing authorities and the
Tribunal on the ground that the advances or loans had not been treated as
irrecoverable or bad debts under s. 36 (1) (vii), that the aspect that the
advances or loans had become sticky was irrelevant, that since the assessee was
following the mercantile system of accounting such interest has accrued to it
at the end of each accounting year and that the assessee had itself shown the
accrual of interest by changing the same to the concerned parties by making
debit entries in their accounts. The High Court also affirmed the view that
there had been accrual of the income at the end of each accounting year and in
that behalf laid emphasis on the fact that the assessee had been regularly
adopting the mercantile system of accounting and observed that the assessee's
income will have to be determined in accordance with that method. In other
words it is clear that in coming to the conclusion that the three sums in
question were liable to be brought to tax the taxing authorities, the Tribunal
and the High Court, relying on the mercantile system employed by the assessee,
adopted a legalistic approach and took the view that because such interest had
fallen due and become legally recoverable by the assessee at the end of each of
the accounting years it had accrued to it, though by reason of the stickiness of
the advances or loans such interest had in fact not resulted or materialised
but remained its hypothetical income. Two questions arise: Should such
legallstics approach prevail over 49 the doctrine of real income that has been
recognised and invoked by Courts while imposing tax liability under the Act?
Secondly, can the mercantile system of accounting, though regularly employed,
'determine' accrual of real income? Since the answer to the second question has
been already indicated in the earlier part of our judgment we shall dispose of
second question first. As regards the mercantile system of accounting regularly
employed by the assessee there are two aspects which we like to stress.
First, the High Court, in my view, was in
error in observing that the assessee's income "will have to be determined
pursuant, to the provisions contained in the Income Tax Act 1961, in accordance
with the accounts regularly maintained by it." I have already indicated
above that the method of accounting regularly employed by an assessee is
relevant only for the purpose of computation of income, profits and gains under
s. 28 of the Act and that it cannot enlarge or restrict the content of the
taxable income under the Act and that under s. 145 the assessee's regular
method of accounting determines the mode of computing taxable income but it
does not determine or even effect the range of taxable income or ambit of
taxation. In other words simply because the assessee has been regularly
employing the mercantile system of accounting it would not mean that any
hypothetical income which may have theoretically accrued but has not truly
resulted to him in the concerned accounting year can be brought to charge and,
therefore, the question whether the three sums representing interest on sticky loans
had really accrued to the assessee or not would be a matter of substance and
cannot be determined by merely having regard to the method of accounting (here
mercantile system) adopted by the assessee. Secondly it will have to be borne
in mind that this is not a case where the assessee had ignored or failed to
make any entries at all in regard to such interest on advances or loans which
had become sticky in its books maintained on mercantile system but it had
charged such interest by debiting the accounts of concerned debtors and had
designedly credited it to 'Interest Suspense Account' instead of carrying it to
'Profit and Loss Account' with a view to avoid showing unreal or inflated
profits. A 'suspense account' in book-keeping means "an account in which
items are temporarily carried pending their final disposition; it does not
appear in financial statements" (vide Kohler's Dictionary for Accountants,
Third Edition).
Since the final disposition of the sums in
question was uncertain and hung in balance these items were properly 50 carried
to 'Interest Suspense Account' and could not and did not find a place in the
financial statement like the Profit and Loss Account. From the mere fact that
such interest was charged to the concerned debtors by making debit entries in
their respective accounts no inference could be drawn that the assessee had
regarded it as accrued income because simultaneously such interest was credited
to Interest Suspense Account and not to Profit and Loss Account. The taxing
authorities, the Tribunal and the High Court clearly erred in drawing such
inference against the assessee. In fact by making the aforesaid entries and
treating the three sums in the manner done the assessee must be regarded as
having demonstrably shown an intention to treat such interest as its
hypothetical and not real income.
Counsel for the assessee pointed out that
after all the primary purpose of book-keeping, whatever be the method of
accounting, was to make a systematic record of business transactions in a manner
which must show the correct financial position of a business house at a given
point of time and reflect the real and true profits of the business done by it
during the year of account and contended that in treating the three sums in
question in the manner done the assessee had merely followed a universally
recognised practice invariably adopted by banks and financial institutions who
maintain their accounts on mercantile system and what was more this practice
accorded with the principle that no item should be treated as income unless it
has been actually received or has accrued in the sense that there is reasonable
certainty that it will be realised. I find considerable force in this
contention of counsel for the assessee. That the practice of carrying interest
on such sticky loans to 'Interest Suspense Account' instead of crediting the
same to 'Interest Account' or to 'Profit and Loss Account' is a universally
recognised practice and is wholly consistent with the mercantile system of
accounting will be clear from the standard text books on accountancy.
For instance, in the treatise 'Advanced
Accounts' by Shukla and Grewal (Ninth Revised and Enlarged Edition 1981) a
clear reference to such practice finds a place in the following paragraph
occurring at page 1089 under the heading 'Interest on doubtful debts':
"Interest on doubtful debts should be
debited to the loan account concerned but should not be credited to Interest
Account. Instead it should be 51 credited to Interest Suspense Account. To the
extent the interest is received in cash, the Interest Suspense Accounts should
be transferred to Interest Account; the remaining amount should be closed by
transfer to the Loan Account. This treatment accords with the principle that no
item should be treated as income unless it has been received or there is a
reasonable certainty that it will be realised." Similarly in Spicer and
Pegler's 'Practical Auditing' by W.W. Bigg (Fourth Indian Edition by S.V.
Ghatalia) the learned author has suggested that instead of leaving
irrecoverable interest on doubtful loans out of account altogether the practice
of charging such interest to the parties concerned but crediting it to the
Interest Suspense Account is more appropriate for reflecting the correct state
of affairs and the true profits. The relevant passage occurring at pages
186-187 runs thus:
"Where interest has not been paid, it is
sometimes left out of account altogether. This prevents the possibility of
irrecoverable interest being credited to revenue, and distributed as profit. On
the other hand, this treatment does not record the actual state of the loan
account, and in the case of banks and other concerns whose business it is to
advance money, it is usual to find that interest is regularly charged up, but
when its recovery is doubtful, the amount thereof is either fully provided
against or taken to the credit of an Interest Suspense Account and carried
forward, and not treated as profit until actually received." Reference may
also be made to the Approved Text of the 'International Accounting Standard 18'
(Supplement to 'The Management Accountant', December 1982) a publication of the
International Accounting Standards Committee. The concept of revenue
recognition is explained thus in para 5:" "Revenue recognition is
mainly concerned with when revenue is recognised in the income statement of an
enterprise. The amount of revenue arising on a transaction is usually
determined by agreement between the parties involved in the transaction.
52 When uncertainties exist regarding the
determination of the amount, or its associated costs these uncertainties may
influence the timing of revenue recognition." The effect of uncertainties
on revenue recognition has been set out in paragraphs 16 to 27 and para 25 is
material which runs thus:
"Revenues arising from the use by others
of enterprise resources yielding interest, royalties and dividends should only
be recognised when no significant uncertainty as to measurability or
collectability exists." In other words according to International
Accounting Standard 18 if significant uncertainty as to collectability of
interest exists such revenue should not be recognised. In view of what has been
stated in the standard books on accountancy as also in the International
Accounting Standard 18 I am clearly of the view that in the case of interest on
sticky loans the practice of debiting the accounts of the concerned debtors
with such interest and carrying the same to 'Interest Suspense Account' instead
of to 'Interest Account' or 'Profit and Loss Account' is a well recognised and
accepted practice of commercial accountancy, that it is wholly consistent with
mercantile method of accounting and that it prevents the wrong crediting and
improper and illegal distribution or remittance of inflated and unreal profits
and by making the appropriate entries following such practice the assessee had
clearly indicated that the three sums in question being interest on sticky
loans constituted its hypothetical income and not real income.
Turning to the first question it is true that
under s.
5 taxabillity is attracted not merely when
income is actually received but also when it has 'accrued' and it is also true,
as has been explained by this Court in Thiagaraja Chetty's case (supra) and
Morvi Industries' case (supra) that income accrues when it 'falls due', that is
to say when it becomes legally recoverable irrespective of whether it is
actually received or not and 'accrued income' is that income which 'the
assessee has a legal right to receive'.
Incidentally it may be stated that in both of
these cases, where the legal aspect of accrual has been explained, no question
of applying the doctrine of real income could arise; for, in the former case 53
after the commission payable to the managing agents had accrued at the end of
the accounting year the managed company had, instead of paying it, kept it in a
suspense account pending settlement of a dispute in regard to another debt owed
to it by the managing agents (which proposed settlement was ultimately rejected)
and the Court held that such keeping it in the suspense account pending
settlement of another indebtedness would not prevent its accrual to the
managing agents, while in the other case a unilateral relinquishment of the
commission by the managing agents was after its accrual and hence the Court
ruled that it could not escape liability to tax. While the legal aspect of
accrual thus holds good this Court in C.I.T. v. Shoorji Vallabhdas & Co. 46
I.T.R. 144 has enuciated the doctrine of real income in these terms:
"Income-tax is a levy on income. No
doubt, the Income-tax Act takes into account two points of time at which the
liability to tax is attracted, via., the accrual of the income or its receipt;
but the substance of the matter is the
income. If income does not result at all, there cannot be a tax, even though in
book-keeping, an entry is made about a hypothetical income, which does not
materialise. Where income has, in fact, been received and is subsequently given
up in such circumstances that it remains the income of the recipient, even
though given up, the tax may be payable. Where, however, the income can be said
not to have resulted at all, there is obviously neither accrual nor receipt of
income, even though an entry to that effect might, in certain circumstances,
have been made in the books of account." (Emphasis supplied) The above
observations were made in the context of these facts. The assessee-firm was the
managing agent of two shipping companies; between April 1, 1947 and December
31, 1947 an amount of Rs. 1,71,885 from one company and Rs.2,56,815 from the
other company became due to the assessee as commission @ 10 per cent under the
managing agency agreement and in its books the assessee had credited these
amounts to itself and debited them to the managed companies. In November, 1947
the assessee desired to have the managing agency transfered to two private
limited companies and in this connection agreed in 54 December 1948 to accept
2-1/2 per cent as commission and gave up 75 per cent of its earnings. The
department sought to assess the amounts of Rs. 1,36,903 and Rs. 2,00,625 being
the 75 per cent which the assessee have given up, on the ground that commission
at 10 per cent had already accrued to the assessee in the year of account which
ended on March 31, 1948 and the agreement in December 1948, after the close of
the previous year, to give up a portion of income could not save that portion
from liability to income-tax. Negativing the contention this Court, in
agreement with the High Court's view, held that the subsequent agreement has
altered the rate of commission in such a way as to make the income which really
accrued to the assessee different from what had been entered in the books of
account and that this was not a case of a gift by the assessee to the managed
companies of a portion of income which had already accrued, but an agreement to
receive a lesser remuneration than what had been agreed upon. The Court relied
upon the fact that the assessee had in fact received only the lesser amount in
spite of the entries in the accounts books and held that such lesser amount
alone was taxable.
A large number of decisions rendered by this
Court as well as by the High Courts were cited at the bar by Counsel on the
either side in which this aforesaid theory of real income has been invoked and
applied and in some of them emphasis has been laid on the aspect that accrual
is the matter of substance to be decided on commercial principles having regard
to the business character of the transactions and the realities of the
situation. After having gone through these decisions I am in agreement with the
submission of the learned counsel for the revenue that these decisions
involving the application of the concept fall into two groups: (a) cases where
there has been a surrender or relinquishment of income that may have
theoretically accrued and (b) cases where these has been diversion of income at
source either under a statute or by over riding title; but in both types of
cases the Court's endeavour was to determine whether there was accrual of real
income having regard to the realities or specialities of the situation. It is
not necessary to deal with each and every decision falling under either one or
the other group but confining attention to the decision of this Court it will
suffice to indicate that in the former group fall the following decisions,
namely C.I.T. v. Hari Vallabhadas Kalidas & Co., 39 I.T.R. 1, C.I.T. v.
Chamanlal Mangaldas & Co. and 55 C.I.T. v. Mangaldas Girdhardas Parekh
Ltd., 39 I.T.R. 8, C.I.T. v. Messrs Shoorji Vallabhadas and Co. (supra), C.I.T.
Madhya Pradesh v. Kalooram Govindram, 57
I.T.R. 630 and C.I.T. v. Birla Gwalior (P) Ltd., 89 I.T.R. 266, while the
decision in Poona Electric Supply Co. Ltd. v. C.I.T. Bombay, 57 I.T.R. 521, falls
in the latter group. Since the instant case is not one of diversion of income
at source either under a statute or by over-riding title I need dilate only on
the decisions in the former group.
As regards the decisions falling in group (a)
I would like to point out that the ratio of all these decisions clearly is that
where income or part thereof has theoretically accrued but has been, either
unilaterally or as a result of bilateral arrangement, voluntary relinquished or
surrendered by the assessee before its accrual the same cannot be regarded as
real income of the assessee and cannot be brought to tax, and such conclusion
has been reached having regard to the business character of the transactions
and the realities of the situation notwithstanding that some entries have been
made in the assessee's books maintained in the mercantile system. The decision
of the Bombay High Court in H.M. Kashiparekh Co.'s case 39 I.T.R. 706 is a
typical instance in point. The assessee, which maintained its accounts in the mercantile
system, was the managing agent of a paper mill company; under the managing
agency agreement it was under a duty to forego up to one-third of its
commission where the profits of the managed company were not sufficient to pay
a divident of 6 percent; for the accounting year ending March 31, 1950 the
assessee earned a commission of Rs. 1,17,644 but as a result of resolutions
passed by the managed company and the assessee company the assessee gave up a
sum of Rs. 97,000 (Rs.57785 over and above Rs. 39215 which it was bound to
forego) in December 1950. Though the Appellate Tribunal found that the excess
amount of Rs. 57785 had also been given up for reasons of commercial expediency
it held that the maximum amount which could be foregone by the assessee was
only Rs. 39215 and therefore included the excess amount of Rs. 57785 in the
taxable income. On a Reference, the High Court held that it was the real income
of the assessee company for the accounting year that was liable to tax, that
the real income could not be arrived at without taking into account the amount
foregone by the assessee and that in ascertaining the real income of the fact
that the assessee followed mercantile system of account did not have any
bearing. The Court further held that the 56 accrual of commission, the making
of the accounts, the legal obligation to give up part of the commission and the
foregoing of the commission at that time of the making of the accounts were not
disjointed facts; there was a dovetailing about them which could not be ignored
and therefore the real income of the assessee was Rs.27644 and the amount of
Rs.97000 foregone by the assessee could not be included in the real income of
the assessee for the accounting year.
It will be significant to mention that during
the hearing of the Reference counsel for the revenue raised a contention that
even if the amount of Rs. 57785 had been foregone by the assessee company on
grounds of commercial expediency that was not done in the accounting year which
ended on March 31, 1950 but it was done in December 1950 as a result of two
resolutions, one passed by the managed company and the other passed by the
assessee company and that since admittedly the assessee was following the
mercantile system of accounting it could not avail of the benefit of the
doctrine of real income where the income by way of the managing agency
commission had been credited in the books in the year of account and had been
surrendered by it in the next year; in other words it was specifically urged
that if the surrender was not made and entered in the books in the same year no
question of real income could arise and in this behalf counsel relied upon the
well- settled rule that for purposes of income-tax each year was required to be
regarded as a distinct and self-contained unit. Apropos this contention the
Court observed thus:
"The two rules that income-tax is annual
in its structure meaning thereby that for computation each year is a distinct
self-contained unit and the other that the income to be taxed is the real
income of the assessee do not seem to us to be incompatible or irreconcilable.
Mr. Joshi (counsel for the revenue) also is not prepared to go so far as that
and has fairly stated that there is no antithesis between the two rules. The
facts of a case may present some difficulty in applying the rules by the
conflict would, in our opinion, be rather apparent than real. The facts of a
given case may create the impression of a discrepant situation but the apparent
discrepancy can be solved in a manner not inconsistent with the basic concepts
underlying the two rules. In our judgment, 57 they permit of harmonious
application, though the application is to a degree must depend on the
circumstances of each case. Some propositions could be formulated but whether a
general formula applicable to all circumstances could be hit on we rather
doubt.
Though it may not be possible to prescribe a
general formula which successfully compose every conflicting situation, the
position in law seems clear to us that in applying the two rules to particular
transactions regard must be had to the true legal rights and the true
situation. A fair interpretation of the transaction and the situation would
lead to a preferable and, if we may say so, a correct solution than sheer adherence
to one rule and discounting of the other." At page 720 of the Report the
Court went on to observe thus:
"In the course of his argument, learned
counsel for the Revenue stated that there must have been entries in the books
of the managed company and the managing company in consonance with clause 5 of
the managing agency agreement.............. we shall proceed on the footing
that, the assessee company having followed the mercantile system of account,
there must have been entries made in its books in the accounting year in
respect of the amount of the commission. In our judgment, we would not be
justified in attaching any particular importance in this case to the fact that
the company followed the mercantile system of account.
That would not have any particular bearing in
applying the principle of real income to the facts of this case.
Incidentally, we may observe that we
ourselves pointed out in the case of Commissioner of Income-tax v. Shoorji
Vallabhadas & Co. that the question whether the income accrued or not is
not a mere matter of cogency of the entries made in the account books of the
assessee but is essentially one of substance and of the real nature of what
happened; a mere book entry is not conclusive of the question whether the
assessee had become entitled to the 58 sums or not. It may also be mentioned
that in that case we were dealing with an assessee who followed the mercantile
system of account. The crucial question before us, therefore, is whether the
two facts, one the amount of Rs. 1,17,644.4 annas which would have become
payable to the managing company but for the surrender and the factus of
surrender, are to be isolated or treated as of cogency in determining the
actual accrual of income, by which we mean the real income of the assessee
company. If the fact of foregoing or surrendering the amount of Rs. 57,000 odd
is to be regarded as of cogency in the context of the present point of real
income and if it be remembered that the surrender was made at the time of
ascertaining the quantum of the commission payable to the assessee company and
further if it be remembered, as now found by the Tribunal, that the surrender
was made bona fide and on grounds solely of commercial expediency, it seems
very difficult to us to see how the Revenue is justified in contending that the
real income of the assessee was something different than the amount of Rs.
20,000. (Sic R.27644) which was shown by it at the time of assessment as its
income from managing agency commission." The Court further expressed the
view that the principle of real income was not to be so subordinated as to
amount virtually to a negation of it when a surrender or concession or rebate
in respect of managing agency commission is made, agreed to or given up on
grounds of commercial expediency, simply because it takes place some time after
the close of the accounting year and that in examining any transaction and
situation of this nature the Court would have more regard to the reality and
speciality of the situation rather than the purely theoretical or doctrinaire
aspect of it and it will lay greater emphasis on the business aspect of the
matter viewed as a whole when that can be done without disregarding the
decision of the Bombay High Court has been fully approved by this Court in Birla
Gwalior (P) Ltd.'s case (supra).
It will thus be clear that even under the
mercantile system of accounting whenever adopted it is only the accrual of real
income which is chargeable to tax, that accrual is a matter of substance and
that it is to be decided on commercial 59 principles having regard to the
business character of the transactions and the realities and specialities of
the situation and cannot be determined by adopting purely theoretical or
doctrinaire or legalistic approach. If, therefore, for the purpose of
determining whether there has been accrual of real income or not regard is to
be had to the business character of the transactions and the realities and
specialities of the situation in preference to theoretical, doctrinaire or
legalistic approach I fail to appreciate why interest on sticky loans, which
has theoretically accrued but has not factually resulted or materialised at all
to an assessee hypothetical income and not real income? There is no reason why
the factum of stickiness of loans operating throughout the accounting period or
periods, not on the basis of mere ipse dixit of the assessee but on being
objectively established to the satisfaction of the taxing authorities by
reference to the facts showing the deteriorating financial position of the
concerned debtors and the history of their accounts should not have the effect
of preventing the accrual of interest thereon as real income to the assessee?
If voluntary relinquishment or surrender of income done unilaterally or as a
result of bilateral arrangement can prevent its real accrual there is no reason
why the factum of stickiness of loans objectively established should not
prevent accrual of interest thereon as real income. In fact in the former case
considerations of commercial expediency could be a motivating force behind such
voluntary relinquishment or surrender of the income resulting in its
non-accrual but in the latter case the non-accrual would be due to
circumstances beyond the assessee's control. I am, therefore, clearly of the
view that the stickiness of advances or loans objectively established to the
satisfaction of the taxing authorities by producing proper material, is
sufficient to prevent the accrual of interest thereon as real income and would
have the effect of rendering such income hypothetical and the same cannot be
brought to tax. In my view under the Income Tax Act in order that income should
accrue it should not merely fall due or become legally recoverable but should
also be factually and practically realisable during the accounting year or
years.
In other words mere non-receipt of income,
when it is reasonably realisable, will not affect accrual but factual or
practical unrealisability thereof may prevent its accrual depending upon the
facts and circumstances attending upon the transaction.
60 Counsel for the revenue raised two
objections to extend the theory of real income so as to exclude from
chargeability the interest on sticky loans merely because it suffers from high
improbability of recovery. In the first place he urged that the Act contains no
provision excluding or deducting such interest from computation of income and
the only provision for deduction of debts is to be found in s. 36 (1) (vii)
where under debts which are established to have become irrecoverable and bad in
the previous year are permitted to be deducted on fulfilment of certain
conditions specified in sub-section (2) and as such the extension of the theory
of real income as sought would entrench upon s.
36 (1) (vi),Secondly, it was urged that such
extension will be ill-advised inasmuch as, if done, it will apply to cases of
interest accruing to all money-lenders and not merely to cases of interest
accruing to banks and financial institutions. As regards the first objection
the argument amounts to saying that the exclusion or deduction in respect of
irrecoverable and bad debts under s. 36 (1) (vii) read with the conditions
mentioned in sub-sec. (2) proceeds on the basis that in substance such debts do
not constitute real income of the assessee and therefore exclusion of interest
on sticky loans from computation of income for which there is no provision in
the Act and that too without any conditions would impinge upon the specific
provision contained in s. 36 (1) (vii) read with sub-section (2). The answer to
this objection is that it is not as if that in the absence of some specific
provision exclusion of hypothetical income cannot be done; in fact such
exclusion rests not upon any slippery or slushy ground but upon the principle
that under the Act chargeability is attracted only to real income and in this
behalf it will be pertinent to mention that the provision for exclusion or
deduction of bad debts was introduced in the income tax law (the 1922 Act) for
the first time in 1939 but even prior to the insertion of such provision in the
1922 Act the Privy Council in C.I.T. v. Sir S.M. Chitnavis, 6 I.T. Cases 453
had, on the basis of ss. 10 and 13 of the 1922 Act, ruled that such bad debts
were necessarily allowable as deduction on grounds of first principles of
accountancy. At page 457 of the Report the Privy Council have observed:
"Although the Act nowhere in terms authorises the deduction of bad debts
of a business, such a deduction is necessarily allowable. What are chargeable
to income-tax in respect of a business are the profits and gains of a year; and
in assessing the amount of the profits and gains of a year 61 account must
necessarily be taken of all losses incurred, otherwise you would not arrive at
the true porfits and gains." Moreover, there is a clear distinction
between an irrecoverable loan and a sticky loan; the former would be a bad debt
in respect whereof the chances of recovery are almost nil having been written
off the same can form the subject matter of a deduction under s. 36 (1) (vii)
while the latter is a loan to which a high degree of improbability of recovery
attaches in a particular year or years due to which interest thereon becomes
hypothetical income and not real income during the said year or years and
therefore, it cannot be brought to tax, though if realised subsequently the
same could be and ought to be brought to tax, if this distinction is borne in
mind no question of impinging upon the provision contained in s. 36 (1) (vii)
read with sub- section (2) can arise by extending the theory of real income to
the interest on sticky loans.
As regards the second objection, if on
principle interest on sticky loans is merely hypothetical income and is not
real income and is on that account to be excluded from computation of income we
fail to see why the benefit of this principle under the theory of real income
should not be available to private money-lenders. The theory of real income
must apply to all cases irrespective of who the assessee is. All that is
required to be ensured is that like the banks and financial institutions the
money-lenders must also establish to the satisfaction of the taxing authority
that the loans in question had in fact become sticky during the concerned year
or years by producing proper material and that they have invariably followed
the practice of carrying the interest of such loans to Interest Suspense
Account in stead of crediting the same to Interest Account or Profit & Loss
Account with the additional safeguard of offering the same for taxation if and
when it is subsequently realised.
It will be pertinent to mention in this
connection that the earlier Circulars issued by the Central Board of Revenue
and Reserve Bank of India (vide C.B.R. Circular No. 37/54 dated 25.8.1924, No.
41 (V-6) D of 1952 dated 6.10.1952, CBDT's Letter F.No. 207/10/73 ITA II dated
16.4.1973 and RBI Circular IFD No. O.P.R. 1076/1 (5) to SFCs dated 21.11.1973)
which conferred the benefit of excluding such interest on sticky loans albeit
by way of concession were applicable to private money lenders also. In the
circumstances both the objections are liable to be rejected.
I may now deal with the decisions of the High
Courts.
Directly on the point at issue there are five
decisions which 62 we need consider. Out of these counsel for the assessee
relied upon three decisions, two of the Madras High Court in Motor Credit Co.
case, and Devi Films case and one of the Punjab & Haryana High Court in
Ferozepur Finance case (supra) where a view has been taken that interest on
sticky loans being hypothetical and not real income should be excluded from the
computation of the assessee's income while counsel for the revenue relied upon
two decisions one of the Bombay High Court in C.I.T. v. Confinance Ltd. 89
I.T.R. 292 and the other of the Calcutta High Court in James Finlay & Co.
v. C.I.T. 137 I.T.R. 698 as both these apparently seem to take a contrary view.
I shall first deal with two decisions on
which counsel for the revenue placed reliance. In C.I.T. v. Confinance Ltd. the
assessee was carrying on money lending business and banking business and
followed mercantile system of accounting. For the accounting year ending March
31, 1959 the assessee stated that no credit was taken in its balance- sheet in
respect of interest on several loans advanced by it as interest had remained
unpaid from March 31, 1956. For the assessment years 1959-60 and 1960-61
interest in respect of amounts due by debtors amounting to Rs. 9,275 and Rs.
13,033 respectively was brought to tax by the I.T.O. and A.A.C. The Tribunal
reversed the orders on the ground that the records showed that there had hardly
been any receipts of interest for a number of years past. On a reference, the
High Court reversed the Tribunal's view and held that the facts that there were
hardly any receipts in respect of items of interest or that the bona fides of
the assessee in not charging interest was not disputed were circumstances which
by themselves were in sufficient to support the conclusion that there was no
real income in respect of items of interest inasmuch as none of the debts due
by the several debtors was written off by the assessee and no evidence was
produced to show that interest in respect of the debts was given up and
therefore the two sums were properly includible in the total income of the
assessee for the two assessment years respectively. From the judgment we find
that counsel for the assessee sought to apply the doctrine of real income as
expounded in Kashiparekh's case to the facts of the case but the High Court
declined to do so by adopting a legalistic approach that the assessee had been
following mercantile system of accounting that the interest had accrued and
further laid considerable emphasis on two aspects, namely, that none of the
debts due by the several debtors was written off by the 63 assessee and no
evidence was produced to show that interest in respect of the debts was given
up. In my view the High Court failed to appreciate that the method of
accounting employed by an assessee merely determined the mode of computing the
income and not the range of taxable income and further failed to notice that
there could be and was a clear distinction between an irrecoverable or a bad
debt on the one hand the sticky loan on the other to which we have adverted
earlier.
In James Finlay's case decided by the
Calcutta High Court the items of interest receivable from two parties on
advances made to them were sought to be excluded from computation of income of
the assessee for 1970-71 on the ground that since 1.1.1968 the assessee had
decided to change its method of accounting in respect of interest, which was
doubtful of recovery, by crediting the same to the Suspense Account and also on
the ground that before the closing of the books of account of the relevant
accounting year the assessee had adbandoned its claim for such interest. The
High Court held that there was no change in the mercantile system of accounting
that had all along been empolyed by the assessee, that the transfer of items of
interest to Suspense Account could not be termed as a change in the method of
accounting and therefore the amounts were assessable on accrual basis; as
regards the other ground the High Court held that though there was difficulty
in realising the interest in the year of account there was no material to show
that there was any agreement with the debtors to waive the interest or to keep
it in the Suspense Account and hence the claim for interest had not been given
up. In our view the decision mainly turned upon whether the assessee had
changed its method of accounting or not and the finding was it has not and as
far as the theory of real income is concerned the Court did not reject the same
but on facts came to the conclusion that it was not applicable inasmuch as the
claim for interest had not been relinquished or given up.
On the other hand in the three decisions on
which counsel for the assessee relied two High Courts have invoked and applied
the theory of real income to cases of interest on sticky loans and taken the
view that such interest being hypothetical and not real is not includible in
the assessable income of the assessee. Only one decision may be referred to in
detail. In the Motor Credit Co's case the assessee in the course of its
business as financiers for purchase of motor vehicles advanced, under a hire
purchase agreement, moneys to two firms which were plying buses. The routes of
these two 64 firms having been taken over by the State Transport Corporation,
the firms defaulted in making payments of hire purchase instalments, and consequently
the buses were seized. As the assessee company was advised that there was no
prospect of recovering even the principal amount it did not credit the interest
on the outstandings from the two firms even though it was adopting the
mercantile system of accounting. The ITO, however, included a sum of Rs. 56,163
by way of accrued interest on the amounts outstanding from these two firms, The
AAC deleted the addition. The Tribunal held that the assessee could not have
expected to get any interest income on the outstandings found due from two
firms and it would be wholly unrealistic on the part of the assessee to take
credit from the interest income and consequently confirmed the AAC's order. On
a reference at the instance of the Commissioner the Madras High court held that
the Tribunal was right in its conclusion that though the assessee had adopted
the mercantile system of accounting no interest income could be assessed in its
hands on accrual basis and it would be very unrealistic on the part of the assessee
to take credit for the highly illusory interest.
Following the decision of this Court in
Shoorji Vallabhdas Co's case and of the Bombay High Court in Kashiparekh's case
the High Court took the view that the regular mode of accounting merely
determined the mode of computing the taxable income and the point of time at
which the tax liability was attracted and it could not determine or affect the
range of taxable income or the ambit of taxation. It further observed that it
was not the hypothetical accrual of income based on the mercantile system of
accounting followed by the assessee that had to be taken into account but what
should be considered was whether the income had really materialised or resulted
to the assessee and that question had to be considered with reference to
commercial and business realities of the situation in which the assessee had
been placed and not with reference to his system of accounting and held that
since there was not even the remotest possibility of any interest income materialising
in favour of the assessee in respect of the outstandings for the accounting
year relevant to the assessment year in question no liability to tax could be
imposed on the assessee. To the same effect are the other two decisions in Devi
Films case and Ferozepur Finance case. I approve these three decisions.
In view of my conclusion that this theory of
real income could be and should be extended to interest on sticky loans and 65
that on principle such interest being hypothetical cannot be brought to tax it
is unnecessary to deal with the earlier Circulars of the Central Board of
Revenue and the Reserve Bank of India all of which were in the nature of
concession granted to an assessee according to counsel for the revenue.
Having regard to the above discussion it is
clear that the three sums representing interest on sticky advances in the
instant case being hypothetical and not real income of the assessee could not
be brought to tax for the three concerned assessment years and we answer the
first question in the negative in favour of the assessee and against the
revenue. Of course it goest without saying that if and when these sums or any
part thereof are realised subsequently the same could be brought to tax in the
year of realisation.
The second question raised for our
determination in these appeals relates to the taxability of Rs. 1,66,128 which
represents the exchange difference arising on devaluation of the Indian Rupee
on August 6, 1966 and the question relates to the assessement year 1967-68
only. The facts giving rise to the question are these. Admittedly the business
of the assessee-bank included buying and selling of foreign exchange and
therefore any foreign currency held by it would be its stock-in-trade and if
foreign currencies bought at the predevaluation rate of exchange were sold at
post devaluation rate of exchange resulting in a surplus the same would be its
business receipt or revenue receipt and therefore liable to tax as part of
business profits.
Indisputably, just before the devaluation of
the Indian Rupee on August 6, 1966 the assessee-bank held foreign exchange by
way of cash balances available with their foreign correspondents, forward
contracts, items in transit etc., amounting to L-33,780,76 in US Dollars and
L-9552.0.2 in Sterling which when converted back to Rupees at the post
devaluation rates gave rise to a profit of 57.5% or Rs.
1,66,128 in the transaction; the
assessee-bank credited this surplus to an account designated "Provision
for Contingencies". It was contended on behalf of the assessee before the
lower taxing authorities that this profit should not be taxed as it was of a
casual and nonrecurring nature.
The contention was negatived by the
authorities on the ground that even assuming, without conceding, that it was a
windfall and, therefore, of a casual nature the same had arisen from the
business activities of the assessee-bank and, therefore, was not exempt but was
liable to tax. Before the Appellate Tribunal an attempt was made by counsel for
the assessee-bank to contend that the cash balance in terms of 66 dollars and
sterlings at the end of the accounting period, i.e., on December 31, 1966 was
higher than that as existed on the crucial date, namely, August 6, 1966 and,
therefore, this precluded any inference that the stock of dollars and sterlings
that existed on the devaluation date had been converted into Indian currency
thus resulting in profits.
The Tribunal rejected the contention as being
without force inasmuch as the assessee-bank had revalued the cost of foreign
exchange in terms of rupees as on the date of devaluation to bring it on par
with the post-devaluation rate by giving a corresponding credit to the
"Provision for Contingencies" thus treating the surplus resulting
from the fluctuation of exchange rate as its income and the mere fact that the
same had been carried to the account style "Provision for
Contingencies" did not alter the true character of the transaction. The
High Court confirmed the ultimate conclusion of the Tribunal by answering the
relevant question referred to it in favour of the Revenue.
Counsel for the assessee fairly conceded two
positions arising in the case. In the first place he conceded that foreign
exchange was held by the assessee-bank as its stockin-trade and he further
conceded that any sale of such stock-in-trade must result in business income
but he urged that if the stock-in-trade remains unused and unsold its notional
appreciation or book appreciation in value does not result in taxable profit
(vide C.I.T. v. Mughal Line Ltd. 46 I.T.R. 590, and according to him this is
what had happened in the instant case. According to counsel the fact that the
stock-in-trade in terms of foreign currency that was held by the assessee just
prior to the date of devaluation was shown not to have been depleted between
the date of devaluation and December 31, 1966 (the end of accounting period)
clearly suggested that the stock-in-trade initially held had remained unused
and unsold during this entire period, especially when the stock-in-trade held
on December 31, 1966 was shown to be higher than the one held just prior to the
devaluation date; and therefore it was a case of a mere nominal appreciation or
book appreciation in the value of the stock and as such the same could not be
brought to tax.
There can be no dispute with regard to the
principle that if the stock-in-trade remains unused or unsold the mere book
appreciation in the value thereof cannot be brought to tax but on the facts
requisite to sustain the proposition the assessee-bank does not seem to stand
on any firm footing. In the first place by carrying the surplus resulting 67
from the devaluation of the Indian rupee to an account designated
"Provision for Contingencies" the assessee bank itself could be said
to have clearly treated such surplus as its business income. Secondly, the AAC
in his appellate order has recorded a categorical finding that the stock in
trade in terms of foreign currency was sold and used by the assessee in its
normal banking business. This is what the AAC has observed:
"What is important is that the profit on
account of the difference in exchange rate should have arisen in the course of
trading operations of the bank. There is no dobut that it did so arise in the
instant case. The bank acquired and sold the foreign exchange assets in course
of its normal banking business and therefore, the profit arising out of the
fluctuation in exchange rates, however, large and however unexpected any
particular fluctuation may be, arose in the course of and incidental to such business
of the bank." Having regard to the aforesaid factual position I confirm
the High Court's view that the second question has to be answered in the
affirmative in favour of the Revenue and against the assessee.
In the result I would allow the appeals in so
far as the first question is concerned and dismiss the same as regards the
second question. In the circumstances there will be no order as to costs.
SABYASACHI MUKHARJI,J. These appeals by
certificate arise from the decision of the High Court of Kerala in respect of
the assessment years 1965-66, 1966-67 and 1967-68 relating to the previous
calendar year 1964, 1965 and 1966 respectively. The following two questions are
involved in these appeals:
(1) Whether, on the facts and in the
circumstances of the case, the addition of the sums of Rs.67,170. Rs. 47,777.
and Rs. 57,889 representing interest on 'sticky' advances as income for the
assessment years 1965-66, 1966-67 and 1967-68 respectively was justified in
law? (2) Whether on the facts and in the circumstances of the case, the
exchange difference of Rs.
68 1,66,128 arising on revaluation of the
Indian rupee on 6.6.1966 was rightly treated as income of the assessment year
1967-68? In view of the categorical findings of fact recorded by the Tax authorities
and the Tribunal and mentioned in the judgment of Tulzapurkar, J., I am in
respectful agreement with the opinion of Tulzapurkar, J. that the High Court
was right and the second question must be answered in the affirmative and in
favour of the revenue, and the appeals on this aspect must be dismissed.
With regard to the first question, with
respect, it is not possible to agree with the reasoning and the conclusions
arrived at by Tulzapurkar, J., in the judgment. It is necesary for this reason
to reiterate in brief the facts relating to the first question. The assessee is
a subsidiary bank of the State Bank of India. It used to maintain in the
relevant accounting years its accounts in mercantile system;
therefore, entries were made and income and
loss were calculated on accrual basis. The assessee in the course of its
banking business used to charge interest on advances, including even those
which it considered doubtful of recovery and which the assessee termed as
'sticky advances' by debiting the concerned parties but in stead of carrying
the same to its 'Profit & Loss Account', credited the same to a separate
account called 'Interest Suspense Account'.
According to the assessee the principal
amounts of these advances labelled as 'sticky advances' had become not bad or
irrecoverable, but extremely doubtful of recovery. In its returns the assessee
had disclosed such interests separately and claimed that the sums were not
taxable as income of the concerned years. In view of the relevant years
involved, the question must be considered in the light of the provisions of the
Income Tax Act, 1961 (hereinafter called the 'Act').
Before the Taxing Officers, the Tribunal and
the High Court, the assessee's contention was that having regard to bad and
deteriorating financial conditions of the parties concerned as well as history
of their accounts, the recovery of even the principal debts had become
improbable and doubtful, thereby making these loans or advances as the assessee
called 'sticky' and, as such interest on these though debited to the respective
debtors was taken to 'Interest Suspense Account'. This, according to the
assessee, became necessary 69 to avoid showing inflated profits by including
hypothetical and unreal income and, such income, according to the assessee, was
not his real income. It was contended by the assessee that the said sums namely
the interest on the so called 'sticky' loans was not taxable in its hands. This
contention was, however, rejected by the Income-tax authorities as well as the
High Court.
The following were the grounds for such
rejection:
(a) The assessee was following the mercantile
system of accounting; such interest, therefore, had accrued to the assessee at
the end of the accounting year.
(b) The assessee itself had treated such
income as accrual of interest by charging the same to the parties concerned by
making debit entries in their respective accounts.
It was pointed out that if any part of these
debits had later on become irrecoverable in any year, the assessee could have,
in that year, treated the same as such and claimed deduction under section
36(1)(vii) of the Act.
Reliance was placed by the High Court on an
earlier decision of the same High Court in the case of Catholic Bank of India
(In liquidation) vs. Commissioner of Income-Tax, Kerala, Ernakulam., [1964]
K.L.T. 653 = [1965] 1 I.T. Journal 355.
In that case in spite of the directions
issued by the Reserve Bank of India to the assessee bank not to carry interest
of such sticky advances to 'Profit and Loss Account' and also in spite of the
fact, that the assessee bank in pursuance of these directions omitted their
interest from its 'Profit and Loss Account', the court took the view that such
interest was taxable as income in the hands of the assessee bank because the
mercantile system of accounting had been regularly followed by the bank and
that had not been changed even after receiving directions from the Reserve Bank
of India. The Kerala High Court had relied upon certain observations in the
commentary on the Income Tax Act, 1961, by Kanga, 5th Edn. Vol. I, page 665
wherein the learned author has stated:
"The assessee cannot escape liability to
tax by omitting to make an entry or making a wrong entry in the accounts. The
date of taxability of income 70 is the date when the appropriate entries are
made or should be made in the accounts in accordance with the method of
accounting regularly employed by the assessee. The substantive part of the
section makes it clear that the income is to be computed' in according with the
method of accounting regularly employed.' The Income-tax Officer may include in
the computation of income an amount which does not figure in the accounts but
the inclusion of which is required by the assessee's method of accounting; that
is to say, the Income-tax officer may without deviating from the assessee's
method, make such adjustments in the profit and loss account as are necessary
for giving full and true effect to that method itself.
Having adopted a regular method of
accounting, the assessee cannot be allowed to change it or depart from it for a
particular year or for part of the year or in respect of particular
transactions." The High Court of Kerala was of the view that the facts of
the instant case out of which these appeals arise being the same as those in
Catholic Bank's case except that there was a direction from the Reserve Bank of
India to Catholic Bank, which is absent in the instant case before us, the same
conclusion must follow. In the opinion of the High Court, the presence or absence
of such direction from the Reserve Bank was not determinative of the question.
There was accrual of income to the assessee considering the fact that the
assessee had been following the mercantile method of accounting which had been
regularly adopted by the assessee and accepted by the taxing authorities. The
High Court in that view of the matter answered the question in favour of the
revenue. For subsequent years 1968-69 in respect of the same assessee, an
identical view was reiterated by the said High Court in the assessment year
1968-69 as reported in 110 I.T.R. 336. The correctness of this view is under
challenge in these appeals before us.
The assessee indubitably maintained its
accounts on mercantile basis and had regularly adopted it. The assessee claimed
that the three sums represented interests on what it called 'sticky' loans in
its books of account but having regard to the deteriorating financial position
of the concerned debtors and the history of these accounts, the assessee was of
the view that in the relevant years the advances had become 71 so 'sticky' that
even the recovery of the principal amounts had become highly improbable and
extremely doubtful.
Therefore, though the assessee charged such
interests by debiting the concerned parties (emphasis supplied) yet it credited
the said amounts to a separate account styled as 'Interest Suspense Account'.
This the assessee claimed on the theory that it was to avoid showing unreal or
inflated profits. The assessee claimed that it was not taxable as real income
had not accrued to it. It was, however, disallowed on the ground that the
advances had not been treated as irrecoverable or bad debts in terms of section
36(1)(vii) of the Act. In coming to the conclusion that these sums were
taxable, the taxing authorities, the Tribunal and the High Court proceeded on
well-settled principles pertaining to the mercantile system and took the view
that such interest had fallen due and became legally recoverable in accordance
with the system of accounting during each of the relevant accounting years.
In support of the assessee's contention
learned counsel contended before us that what are chargeable to income-tax in
respect of a business, are profits and gains of that business actually
resulting from the transactions of the previous year. It was submitted that
even under the mercantile system of accounting accrual or "real
income" in the commercial sense only was chargeable to tax and this must
accrue in substance according to the realities of the situation. It was
submitted that if regard is had to realities of the situation as well as the
actual commercial principles, it would be evident that in cases of banks,
financial institutions and money-lenders bulk of the income is usually earned
by way of interest and as such there cannot be any accrual of real income from
interest on doubtful advances or sticky advances and, therefore, the entries
made in respect of such accounts in case of all such traders following the
mercantile system of accounting only reflected hypothetical income which does
not materialise in income. It was submitted that, therefore, it was proper to
carry such interest to 'Interest Suspense Account' as carrying the same to
'Profit and Loss Account' would amount to showing an unreal and inflated profit
and thereby lead to improper and illegal distribution or remittances thereof.
Therefore, the question, is, whether on the
theory of real income, interests which had accrued legally to an assessee - in
this case banking institution following the mercantile system of accountancy
can be kept out of the net of 72 taxation. How far does the concept of real
income defeat accrual of income in any particular case according to the
well-recognised theory of accounting principles which are accepted by the legal
standards so far followed? In this country, by and large, two systems of
account keeping are followed - one is the cash and the other, mercantile.
Plainly speaking, the cash system postulates actual receipt of money; and for
exigibility of income tax, such receipt from business, profession or vocation
or from other sources has to be actual in the relevant year of account. The
mercantile system, on the other hand, is one where accounts are maintained on
the basis of entitlement of credit and/or debit. A sum of money, as soon as it
becomes payable, is taken into account without reference to actual receipt and
a debit becomes admissible when liability to pay is created even though the sum
of money is yet to be paid.
Several circulars issued by the Central Board
of Taxes were placed before us in course of the hearing. One such was C.B.R.
Circular No. 37/54 dated 25th August, 1924. There the Central Board had said
that it accepted the conclusion reached at the Conference of Income-tax
Commissioners held in August, 1924 that if a money-lender who kept his accounts
on the commercial system maintained a suspense account in which he entered
loans which in his opinion were extremely unlikely to be recoverable though he
did not yet wish actually to write them off, interest accruing on such loans
need not be included in the assessee's taxable income, if the Income-tax
officer was satisfied that there was little provability of recovery of the
loan. This was obviously on the footing that the last ray of hope of recovery
had not been extinguished and the stage for write off had not come.
The second circular is one dated 6th October,
1952, which is Circular No. 41(V-6)D of 1952 dealing with the subject of bad
and doubtful debts - irrecoverable loans or bank interest on such debts. It was
indicated therein that when there was unlikelihood of loans being recovered,
interests from such loans need not be included in the taxable income if the
Income-tax Officer was satisfied that there was really little possibility of
the loans being repaid. But an account was to be maintained for future
allowances for taxation of recoveries in subsequent assessment years. There is
also a letter dated 16th April, 1973, from the Under Secretary, Central Board
of Direct Taxes referring to D.O.
letter dated 15th March, 1973 reiterating
that the 73 amounts kept in suspense account under those circumstances would
not be taxable. The assessee was, however, required to maintain a systematic
method of accounting in respect of dobutful debts subject to checks and
counter-checks. By the letter dated 21st November, 1973, the Reserve Bank of
India wrote that there was no uniformity in the practice followed by State
Financial Corporations on sticky loans were the same position was reiterated. A
letter was written on 20th June, 1978, by the Central Board of Direct Taxes to
the Commissioner of Income-tax soon after the decision rendered in the
assessee's case in 110 I.T.R. 336 referred to hereinbefore. In that letter
reference was made to the previous circulars and it was pointed out that the
stand taken in these circulars was not acceptable to the Revenue Audit
Department and it had objected to the exclusion of such amounts of interest
from the total income. The Board advised that where accounts were kept on mercantile
basis, interest was taxable irrespective of whether the same was credited to
suspense account or to interest account.
Reference was made to the decision of the
Kerala High Court in 110 I.T.R. 336 which has been followed in the instant
case. The Central Board, therefore, directed that such interests should be
includible in the taxable income, and all pending cases should be disposed of
keeping the present instructions in view. It was further directed that
immediate review should be undertaken under section 147(b) or section 263 of
the Act in respect of assessments which had been completed in accordance with
the Board's earlier directions.
In the last letter, the same position was
reiterated but it was further clarified as to future course of action. In these
appeals we are not concerned with the actual effect of these Circulars and
these need not be set out and examined.
Several financial institutions sought to
intervene as the question involved herein is of some importance to them.
We have allowed them to make their
submissions and taken them into consideration. It was urged that the
instructions contained in these circulars noted before were in consonance with
the accepted principles of accountancy and these instructions have held the
field for over 53 years. It was also submitted that as such claims have been
allowed to be exempted for more than half a century, and the practice had
transformed itself into law, this position should not have been deviated from.
This submission, of course, cannot be accepted. The question of how far the
concept or real income enters into the question of taxability in the facts and
circumstances of this 74 case and how far and to what extent the concept of
real income should inter-mingle with the accrual of income will have to be
judged in the light of the provisions of the Act, the principles of accountancy
recognised and followed and the feasibility. The earlier circulars being
executive in character cannot alter the provisions of the Act. These were in
the nature of concessions and could always be prospectively withdrawn. However,
on what lines the rights of the parties should be adjusted in consonance with
justice inview of these circulars is not a subject matter to be adjudicated by
us and as rightly contended by counsel for the revenue, the circulars cannot
detract from the Act.
The profits and gains chargeable to tax under
the Act are those which have been either received by the assessee or have
accrued to the assessee during the period between the first and the last day of
the year of account and are receivable. Income received or income accrued are
both chargeable to tax under section 28 of the Act. The computation of this
income is provided for in section 29 of the Act. While we are on the sections,
it may be appropriate to refer to section 36 also. Section 36(a) provides for
certain deductions from the computation of income and sub- section (vii)
thereof deals with bad debts in these terms:
"(vii) subject to the provisions of
sub-section (2), the amount of any debt, or part thereof, which is established
to have become a bad debt in the previous year." Section 36(2) prescribes
the conditions to be satisfied for earning deduction for a bad debt. There is
no dispute in these appeals that such conditions are not satisfied.
Section 56 of the Act deals with income from
other sources and section 57 deals with deductions in computation of income
from other sources. Section 145 deals with the method of accounting.
Sub-section (1) of the said section provides that income chargeable under the
head "Profits and gains of business or profession" or "Income
from other sources" shall be computed in accordance with the method of
accounting regularly employed by the assessee. The proviso in certain
eventualities permits the Income-tax Officer to adopt the mode for computation
of income. Similar too is the position of sub-section (2).
75 It is settled that the income of the
assessee will have to be determined according to the provisions of the Act in
consonance with the method of accountancy regularly employed by the assessee.
The method of accounting regularly employed by the assessee helps computation
of income, profits and gains under section 28 of the Act and the taxability of
that income under the Act will then have to be determined. The question, is,
whether the income which has been computed according to the method of
accounting followed regularly by an assessee can be diminuted or diminished by
any notion of real income. This has to be judged in the light of the well-
settled principles.
In Commissioner of Income-tax, Madras, v.
K.R.M.T.T.
Thiagaraja Chetty & Company, 24 I.T.R.
525, this Court as early as 1953 reiterated that once the sum of Rs. 2,26,850
in that case was arrived at as income that had accrued to the assessee, it did
not cease to be the income by reason of the fact that it was carried to the
suspense account by a resolution of the directors and that it was, therefore,
assessable to tax. The assessee firm therein was a managing agent of a limited
company. Under the managing agency agreement the assessee was entitlted to a
certain monthly remuneration - a commission of ten per cent on the net profits
of the company and a small percentage on sales and purchases. The agreement
further provided that the assessee was at liberty to retain, reimburse and pay
themselves out of the funds of the Company all moneys expended on its behalf
and all sums due to them for commission or otherwise.
During the year of account ending 31st March,
1942, the assessee had become entitled to a commission of Rs.
2,26,850. On 30th March, 1942, the assessee
wrote to the company requesting that a certain debt, which the assessee owed to
the company for along time past, should be written off. The directors by their
resolution, passed on the same debt, refused to write off the amount without
consulting the general body of shareholders and pending the settlement of the
dispute resolved to keep the sum of Rs. 2,26,850 was debited as a revenue
expenditure of the company and was allowed as deduction in computing the
profits of the company for the purpose of income-tax. The question was whether
in the assessment year 1942-43, the assessee was liable to pay tax on the sum
of Rs. 2,26,850. The Tribunal held that the assessee was being assessed on cash
basis in previous years, that the income had not accrued to the assessee and
that the sum of Rs. 2,26,850 should be excluded from taxation as not having
been received in the accounting year. The High Court came to 76 the conclusion
that there was no material for the Tribunal's finding that the assessee was
being assessed on cash basis in the previous years but held (Satyanarayana Rao,
J., confirming the decision of the Appellate Tribunal;
Viswanatha Sastri, J., contra) that the sum
of Rs. 2,26,850 was not liable to tax, inasmuch as it was not income of the
assessee which had accrued or arisen in the accounting year.
This Court in appeal held that the High Court
was right in its conclusion that there was no material for the Tribunal's
finding that the assessee was being assessed on cash basis on the sums
mentioned which had accrued to the assessee and it did not cease to be income.
In this connection, this Court at page 531 of the Report referred to the
observations of Viswanatha Sastri, J. wherein the learned judge had stated:
"The sum had irrevocably entered the debit side of the company's account
as a disbursement of managing agency commission to the firm and had been
appropriated to the firm's dues and same could not again be entered in a
suspence account at a later date. The sum, therefore, belonged to the firm and
had to be included in the computation of the profits and gains that had accrued
to it unless the firm had regularly kept its accounts on a cash basis, which is
not the case here." This problem may be better looked into if the question
of difference between the mercantile system and cash system is examined in a
little detail.
Sir Courtney Terrel, C.J. delivering the
judgment of the Patna High Court in Dhakeshwar Prasad Narain Singh v.
Commissioner of Income Tax, Bihar &
Orissa, 4 I.T.R. 71 at 74., noted the difference between the two methods of
accounting for income, profits and gains of business. The learned Chief Justice
observed at page 74 of the report:
"Now, there are two methods of accounting
for the income, profits and gains of a business which are generally referred to
as the cash basis and the mercantitle basis. According to the former a record
is, as in this case, kept of actual receipts and actual payments, entries being
made only when money is actually collected or disbursed and if the profits of
the business are accounted for in this way the tax is payable on the difference
between the receipts and the disbursements for the period in question. There
is, secondly, the mercantile 77 system under which a profit and loss account is
maintained. At the end of the financial year the assets and liabilities are
valued and entered in the account and the difference between the two is the
profit upon which the tax is paid." The Commissioner of Income Tax, Bombay
v. Sarangpur Cotton Manufacturing Co. Ltd., 6 I.T.R. 36. Lord Thankerton,
speaking for the Judicial Committee after referring to section 13 of 1922 Act
which was more or less similar to section 145 of the present Act observed at
page 40 as follows:
"Their Lordships are clearly of opinion
that the section relates to a method of accounting regularly employed by the
assessee for his own purposes - in this case for the purposes of the Company's
business - and does not relate to a method of making up the statutory return of
assessment to income-tax. Secondly, the section clearly makes sucha method of
accounting a compulsory basis of computation unless in the opinion of the
Income-tax Officer, the income, profits and gains cannot properly be deduced
therefrom. It may well be that, though the profit brought out in the accounts
is not the true figure for income-tax purposes the true figure can be
accurately deduced therefrom. The simplest case would be where it appears on
the face of the accounts that a stated deduction has been made for the purpose
of a reserve. But there may will be more complicated cases in which
nevertheless, it is possible to deduce the true profits from the accounts, and
the judgment of the Income-tax Officer under the proviso must be properly
exercised. It is misleading to describe the duty of the Income-tax Officer as a
discretionary power." Iqbal Ahmad, C.J. has aptly described in
Commissioner of Income Tax v. Shrimati Singari Bai, 13 I.T.R. 224, the
mercantile system of accountancy and has observed at page 227 of the report as
follows:
"The distinguishing feature of this
method of accountancy is that it brings into credit what is due immediately it
becomes legally due and before it is actually received; and it brings into debit
78 expenditure the amount for which a legal liability has been incurred before
it is actually disbursed.
The 'mercantile accountancy system' is the
opposite of the 'cash system' of book-keeping' under which a record is kept of
actual cash receipts and actual cash payments, entries being made only when
money is actually collected or disbursed." In Commissioner of Income-Tax,
Madras v. A.
Krishnaswami Mudaliar and Others, 53 I.T.R.
122, this Court had to refer to the distinction between mercantile system and
cash system. Referring, however, to the relevant section appropriate to section
145 of the present Act, this Court observed that the section did not compel the
Income-tax Officer to accept a balance-sheet of cash receipts and outgoings
prepared from the books of account: it was for him to compute the income in
accordance with the method of accounting regularly employed by the assessee.
Referring to the prevalent system of book-keeping in India, Shah, J.
speaking for this Court observed at pages
129-130 of the report as follows:
"Among Indian businessmen, as elsewhere,
there are current two principal systems of book-keeping.
There is, firstly, the cash system in which a
record is maintained of actual receipt and actual disbursements, entries being
posted when money or money's worth is actually received, collected to
disbursed. There is, secondly, the mercantile system, in which entries are
posted in the books of account on the date of transaction, i.e., on the date on
which rights accrue or liabilities are incurred, irrespective of the date of
payment. For example, when goods are sold on credit, a receipt entry is posted
as of the date of sale, although no cash is received immediately in payment of
such goods; and a debit entry is similarly posted when a liability is incurred
although payment on account of such liability is not made at the time.
There may have to be appropriate variations
when this system is adopted by an assessee who carries on a profession. Whereas
under the cash system no account of what are called the outstandings of the
business either at the commencement or at the close of the year is taken,
according to the mercantile method actual cash receipts during the year and the
79 actual cash outlays during the year are treated in the same way as under the
cash system, but to the balance thus arising, there is added the amount of
outstandings not collected at the end of the year and from this is deducted the
liabilities incurred or accrued but not discharged at the end of the year. Both
the methods are somewhat rough. In some cases these methods may not give a
clear picture of the true profits earned and certainly not of taxable profits.
The quantum of allowances permitted to be deducted under diverse heads under
section 10(2) from the income, profits and gains of a business would differ
according to the system adopted. This is made clear by defining in sub- section
(5) the word "paid" which is used in several clauses of sub-section
(2) as meaning actually paid or incurred according to the method of accounting
upon the basis of which the profits or gains are computed under section 10.
Again where the cash system is adopted, there is no question of bad debts or
outstanding at all, in the case of mercantile system against the book profits
some of the bad debts may have to be set of when they are found to be
irrecoverable.
Besides the cash system and the mercantile
system, there are innumerable other systems of accounting which may be called
hybrid or heterogeneous - in which certain elements and incidents of the cash
and mercantile systems are combined." For the content of the taxable
income, one has to refer to the substantive provisions of the Act, mainly
section 5 of the Act read with other relevant sections.
In Commissioner of Income-Tax, Bombay City I
v. Messrs.
Shoorji Vallabhdas and Co., 46 I.T.R. 144,
this Court discussed the concept of real income. There the relevant fact was
that before the close of the relevant accounting year which was from 1st April,
1947 to 31st December, 1947, in November, 1947 the assessee had desired to have
the managing agency transferred to two private companies and this was
transferred by a subsequent agreement after the close of the year. The assessee
in that case in fact received only the lesser amount in spite of the entries in
the account books, and it was held that this lesser amount alone was taxable.
It 80 was reiterated by Hidayatullah J. as the learned Chief Justice then was,
that income-tax is a levy on income and the Income-tax Act took into account two
points of time at which the liability to tax was attracted viz., the accrual of
the income or its receipt; yet the substance of the matter was income. If
income did not result at all, there could not be any tax, even though in
book-keeping, an entry was made about a "hypothetical income" which
did not materialise. Where income has, in fact, been received and is
subsequently given up, in such circumstances that it remains the income of the
recipient, even though given up, the tax might be payable. Where, however, the
income can be said not to have resulted at all, there was obviously neither
accural nor receipt of income, even though an entry to that effect might, in
certain circumstances, have been made in the books of account. This decision
and the use of the expression that entry of the 'hypothetical income' is often
misunderstood in the sense that after the accrual if the income did not
materialise then on the basis of the actuality or reality of the situation it
should not be considered to be income at all. But the significant fact which is
often lost sight of is that within the relevant accounting year viz. 1st April,
1947 and 31st December, 1947, in November, 1947 the assessee had desired to
have the managing agency transferred to two private companies and the
subsequent agreement in the following year viz. December, 1948 was merely
fructification or carrying into effect of that desire and as a result of the
same, the income did not accrue. That this was the basis for the ratio of the
decision of this Court would be clear because this Court referred to and relied
on the decision of the Bombay High Court in Commissioner of Income-tax, Bombay
North, Kutch and Saurashtra, Ahmedabad v. Chamanlal Mangaldas & Co., 29
I.T.R. 987 in this respect. That was also a case of managing agency company's
entitlement to receive commission at a certain rate. By another agreement, in
the case of commission earned by the managing agent for the calender year 1950
was reduced to Rs. 1 lakh. That agreement i.e. the subsequent agreement took
place during the previous year, and the resolution of the board of the director
of the managed company was also in the previous year but it was, however, made
final on 8th April, 1951, at a meeting of the board of directors but at a time
beyond the previous year. The High Court had taken the view that by reason of
the resolution during the currency of the previous year, the right of the
assessee to commission ceased to be under the original agreement and dependent
upon and arose only after the decision of 81 the board of directors to reduce
the commission. The assessee was, therefore, held not liable on the larger sum
as it was only a hypothetical income which it might have earned if the old
agreement had subsisted. This Court found that the facts of that case were
almost identical with the facts in Shoorji Vallabdas's case. Therefore Shoorji
Vallabhdas's case must be understood on the footing that because of the desire
in November, 1947, the commission did not accrue at the end of the accounting
year. In that sense there was no accrual of the income. It may be reiterated
that in some limited fields where something which is the reality of the
situation prevents the accrual of the income, then the notion of real income
i.e. making the income accrue in the real sense of the term can be brought into
play but the notion of real income as it shall presently be indicated cannot be
brought into play, where income has accrued according to the accounts of the
assessee and there is no indication by the assessee to treat the amount as not
having accrued. Suspended animation following inclusion of the amount in the
suspense account does not negate accrual and after the event of accrual,
corroborated by appropriate entry in the books of account, on the mere ipse
dixit of the assessee, no reversal of the situation can be brought about.
Morvi Industries Ltd. v. Commissioner of
Income-Tax (Central), Calcutta, 82 I.T.R., 835., was also a case of giving up
the commission which had accrued though in that case the payment had been
deferred till after the accounts had been passed in the meetings of the managed
company. This Court held that such a situation did not affect the accrual of
the income. This Court found that the amounts of income for the relevant years
were given up unilaterally by the assessee after these had accrued and it could
not escape liability to tax on those amounts. This Court reiterated that income
accrued when it became due. The postponement of the date of payment did not
affect the accrual of income.
The fact that the amount of the income was
not subsequently received by the assessee would not also detract from or affect
the accrual of the income although non-receipt may in appropriate cases be a
valid ground for claiming deduction.
This Court reiterated that the mercantile
system of accounting differed substantially from the cash system of
book-keeping. Under the cash system, it was only actual cash receipts and
actual cash payments that were recorded as credits and debits; whereas, under
the mercantile system, credit entries were made in respect of amounts due
immediately they became legally payable 82 and before they were actually
received. Similarly, the expenditure items for which legal liability had been
incurred were immediately debited even before the amounts in question were
actually disbursed. This position was reiterated by this Court in 1971 after
taking into consideration various decisions of this Court. In our view,
therefore, the concept of real income cannot be so used as to make accrued
income non-income simply because after the event of accrual, the assessee
neither decides to treat it as bad debt nor claims deductions under section
36(2) of the Act, but still enters the same with a diminished hope of recovery
in the suspense account. Extension of the concept of real income to this field
to negate accrual after the amount had become payable is contrary to the
postulates of the Act.
It may be mentioned that before the decision
of the Bombay High Court in H.M. Kashiparekh & Co. Ltd.'s case, 39 I.T.R.
706., rendered on 1st and 2nd April, 1960, a decision having relevance on the
concept of real income and about whose important facts we shall advert later,
this Court in February, 1960 in Commissioner of Income-Tax Bombay North v.
Chamanlal Mangaldas & Co. (supra) had to
consider some of these aspects. In that case there was provision for reduction
of commission where profits were insufficient in case of the managing agent.
There was modification of the commission before the end of the year. The amount
was given up by the managing agent. The question that arose was whether the
income had accrued and what was the effect of the entries made in the books of
account. It was held by this Court that the agreement was an integrated and
indivisible one and the managing agent's commission was only determinable and
accrued when the year was over. It was further held that the fact that the
amounts of commission were credited in the books of the managed company every
six months only meant that as an interim arrangement the accounts of all sales
were made up at the end of six months also. But this did not affect the
construction of the clause containing the terms for payment of commission nor
the deduction made therein as a result of the modified arrangement. The amount
which arose or accrued and which the managing agent had the right to receive
was not affected by the manner in which the entry was made. The managing agent
was entitled to receive as commission only a sum of Rs.
4,11,875 and that amount alone accrued to the
managing agent. This Court reiterated the principle that the amount which would
83 arise or accrue to the managing agent and the managing agent would have a
right to receive would not be affected by the manner in which entry was made. The
existence of the right to receive i.e. accrual, is important and that is a
matter of the reality of the situation keeping the terms and conditions and the
conduct of the parties. In Kashiparekh's case (supra), the Division Bench of
the Bombay High Court dealt with an assessee firm which had maintained its
account in the mercantile system. The assessee was the managing agent of a
paper mill company. Under the managing agency agreement, it was under a duty to
forgo upto one-third of its commission when the profits of the managed company
were not sufficient to pay the dividend of 6 per cent. For the accounting year
ending on 31st December, 1950, the assessee had earned a commission of Rs.
1,17,644 but as a result of the resolutions passed by the managed company and
the assessee company the assessee gave up a sum of Rs. 97,000 in December,
1950. The Appellate Tribunal held that the maximum amount the assessee was
bound to forgo was only Rs. 39,215 and included the balance of amount forgone
viz. Rs. 57,785 in the taxable income. The Tribunal, however, found that the
sum of Rs. 57,785 was also given up for reasons of commercial expediency. The
Division Bench of the Bombay High Court held that it was the real income of the
assessee company for the accounting year that was liable to tax and that the
real income could not be arrived at without taxing into the account the amount
forgone by the assessee. In ascertaining the real income the fact that the
assessee followed the mercantile system of accounting did not have any bearing.
The accrual of the commission, the making of the accounts, the legal obligation
to give up part of the commission and the forgoing of the commission at the
time of the making of the accounts were not disjointed facts: there was a
dovetailing about them which could not be ignored (emphasis supplied). The real
income of the assessee, it was further held, was Rs.27,644 and the amount of
Rs. 97,000 forgone by the assessee could not be included as the real income of
the assessee for the accounting year. The two rules that income-tax is annual
in its structure, and, therefore, the computation for each year is a distinct
self- contained unit and the other that the income to be taxed is the real
income of the assessee are not incompatible or irreconcilable; they admit of
harmonious application. The principle of real income is not to be so
subordinated to virtually amount to a negation of it when a surrender or
concession or rebate in respect of managing agency commission is made, agreed
to or given on grounds of 84 commercial expediency, simply because it takes
place some time after the close of an accounting year. In examining any
transaction and situation of this nature, the court would have more regard to
the reality and speciality of the situation rather than the purely theoretical
and doctrinaire aspect of it. It laid great emphasis on the business aspect of
the matter viewed as a whole when that could be done without disregarding the
language of the statute. It may be pointed out that the decision in
Kashiparekh's case (supra) has received approval of this Court in Commissioner
of Income-Tax, West Bengal II v. Birla Gwalior (P) Ltd., 89 I.T.R. 266., but in
our opinion it is necessary to reiterate the real facts and the basic
principles of Kashiparekh's case. It is true that the concept of real income
will have its effect also in mercantile system of accounting. There the
accounting year was ending 31st March, 1950. For the account year 31st March,
1950 the assessee had earned commission but as a result of resolutions passed,
the assessee company gave up Rs. 97,000 in December, 1950.
The question involved, was, whether the
accrued interest in the accounting year could be given up subsequently or not.
Now looked at from the proper perspective, the Court was of the view, as we
read it, that the right to the commission arose under the managing agency
agreement. Under the agreement there was a duty to forgo upto one-third of the
commission where profit of the managed company was not sufficient to pay a divident
of 6 per cent.
It is in the peculiar situation arising out
of the managing agency agreement that subsequently a sum of Rs. 97,000 was
given up in December, 1950. In this context the fact of surrender and the
concept of real income must be viewed. It was really to implement the
obligation under the managing agency agreement that the giving up took place.
Therefore, the accrual of commission, the making of the accounts, the legal
obligation to give up part of the commission and the forgoing of the commission
at the time of the making of the accounts were considered not to be disjointed
facts. There was dovetailing about these which in reality of the situation
could not be ignored. This is not a case where there being no previous
obligation after interest having been earned in the sense of having accrued
according to the mercantile system of accounting, the assessee after the close
of the accounting year without giving up the interest which the assessee could
have as a bad debt, did not offer it for taxation but carried it to 'interest
suspense account'.
85 Carrying certain amount which had accrued
as interest without treating it as bad debt or irrecoverable interest but
keeping in suspense account would be repugnant to section 36(1)(vii) read with
section 36(2) of the Act. The concept of real income must not be so read as to
defeat the object and the provision of the statutory enactment. In that view of
the matter Kashiparekh's case would not be of any assistance to the assessee
for the contentions it sought to urge before this Court in the instant case.
As mentioned hereinbefore this Court in Birla
Gwalior (P) Ltd.'s case (supra) had dealt with Kashiparekh's case.
That decision before the court was an appeal
from the decision of the Calcutta High Court (78 I.T.R. 788) in which delivered
the judgment. It was felt by the High Court that reading the order of the
Tribunal as a whole though various contentions were raised before the Tribunal,
the Tribunal had mainly decided the question applying the theory of real income
and held that these amounts did not form the real income of the assessee,
inasmuch as, according to the Tribunal, the remunerations were forgone on
grounds of commercial expediency. The High Court held that once it was decided
that these amounts did not form part of the real income of the assessee which
was liable to tax, the question of deduction under section 10(2)(xv) of the
1922 Act became irrelevant. There the question really was when did the income
really accrue - whether at the end of the accounting year or upon the making up
of the accounts, in case of the entitlement of commission of the assessee in
the managing agency commission and office allowance. This Court (at page 270 of
89 I.T.R.) noted that the date for payment of the commission was stipulated in
the managing agency agreement.
The accounting year of the assessee as well
as the managed companies was the financial year. The respondent gave up the
managing agency commission from both the managed companies, for the assessment
years 1954-55 to 1956-57, after the end of the relevant financial years but
before the accounts were made up by the managed companies. This Court
emphasised that as the managing agency commission receivable could have been
ascertained only after the managed company had made up its accounts and the
assessee had given up the commission even before the managed company made up
its accounts, and no date had been fixed in the agreement for the payment of
the commission, the mere fact that the respondent was maintaining its accounts
on the mercantile system did not lead to the conclusion that the 86 commission
had accrued to it by the end of the relevant accounting year. The commission
given up by the respondent could not be considered to be its real income. It is
clear that the fact of the case was that the managing agency commission
receivable by the assessee could have been ascertained only after the managed
company had made up its accounts and as it had not made up its accounts, the
commission did not accrue to the assessee company and therefore the giving up
which was for valid reasons was not given up after the accrual of income.
Dealing with Kashiparekh's case this Court
observed that an argument was advanced before this Court that as the assessee
was maintaining its accounts on mercantile basis, the commission had accrued.
This contention did not find favour with this Court, because this Court noted
that no due date was fixed for payment of the commission under the managing
agency agreement. Therefore, whether in a particular case managing agency
commission had accrued or not would depend upon various factors and there is a
dovetailing of these factors. It is in this light that this Court understood
Kashiparekh's case and approved that decision at page 270 of the report. In my
opinion, this approval by this Court on this basis does not help the assessee
in the present appeals before us. It has to be pointed out that the facts in
Kashiparekh's case were peculiar and the court wanted to relieve the assessee
from the undue hardship of tax liability. The ratio of a case with such special
features may not be available for general application.
The Bombay High Court in Commissioner of
Income-tax, Bombay I v. Confinance Ltd., 89 I.T.R. 292, held that under the
income-tax law receipt of income, either actual or deemed, is not a condition
precedent to taxability. These were assessable if these had arisen or accrued
or deemed to have accrued or arisen under the Act. This principle would be
attracted even in cases where an assessee followed the mercantile system of
accounting. However, in examining any transaction or situation, the Court would
have more regard to the reality of thesituation rather than purely theoretical
or doctrinaire aspect. It was held in that case after discussing the facts that
there were hardly any receipts in respect of items of interest or that the bona
fides of the assessee in not charging interest were not disputed, were
circumstances which were by themselves insufficient to support the conclusion
that 87 there was no real income in respect of the items of interest as none of
the debts due by the several debtors was written off by the assessee and no
evidence was produced to show that interest in respect of the debts was given
up. The High Court, therefore, held that there was no giving up and these
incomes were assessable. I am in respectful agreement with the conclusion of
the Bombay High Court. In the instant case before us the facts are still worse.
The assessee has not only not written off, but it is still treating loans as
alive by keeping them in suspense account. Kantawala, J., as the Chief Justice
then was, followed the correct principle therein after considering
Kashiparekh's case (supra). The principles enunciated therein are in consonance
with the decision of the Calcutta High Court in James Finlay & Co. v.
Commissioner of Income Tax., 137 I.T.R. 698,
where all these relevant authorities including Kashiparekh's case as well as
Birla Gwalior (P) Ltd.'s case have been discussed and analysed. In that case
the accounts of the assessee company for the year 1970-71 included an amount of
8,264 from B & G and Rs. 55,920 from S.P. Ltd. receivable as interest. The
interest due from B & G were on advances made in 1966 and that from S.P.
Ltd. were on advances made in 1965. The assessee was following the mercantile
system of accounting and the Income-tax Officer treated both the items of
interest as the assessee's income for 1970-71. The assessee used to credit the
interest to its profit and loss account.
It urged that it had decided to change w.e.f.
1st January, 1968, its method of accounting in respect of interest which was
doubtful of recovery, and that such interest was thence forward credited to the
suspense account. The Tribunal held that there was no change in the method of
accounting and that before the closing of the books of account of the relevant
accounting year, the assessee had not abandoned its claim of interest and as
such the amounts were assessable on accrual basis. On a referene, the High Court
held that the alteration of practice in book-keeping and transfer of amounts to
the suspense account could not be termed as a change in the method of
accounting. In the instant appeals before us, the position is still worse for
the assessee.
There is no claim that there was any change
in the method of accounting. The High Court further held in James Finlay's case
that though there was difficulty in realising the interests in the year of
account, there was no material to show that there was any agreement with the
debtors to waive the interest or to keep these in suspense account. Hence, the
claim for interest had not been given up. The amounts accrued 88 and continued
to remain accrued and were therefore income assessable to tax.
Our attention was drawn to certain passages
in some recognised text books on accountancy. Reference was made to
"Advanced Accounts" by Shukla and Grewal (Ninth Revised and Enlarged
Edition 1981) as well as to Spicer and Pegler's "Practical Auditing"
by W.W. Bigg (Fourth Indian Edition by S.V. Ghatalia) where it has been
suggested that doubtful debts might be carried to interest suspense account.
Reference was also made to the Approved Text
of the "International Accounting Standard 18". Relevant passages from
these books have been set out in the judgment of our learned brother
Tulzapurkar, J. No useful purpose will be served by repeating these. Even if in
a given circumstance, the amounts may be treated as interest suspense account
for accountancy purpose that would not affect the question of taxability as
such. This must be determined by well-settled legal principles and principles
of accountancy which have been referred to hereinbefore.
The concept of reality of the income and the
actuality of the situation are relevant factors which go to the making up of
the accrual of income but once accrual takes place and income accrues, the same
cannot be defeated by any theory of real income. Reference may be made to
Calcutta Co. Ltd. v.
Commissioner of Income-Tax, West Bengal, 37
I.T.R. 1.
Three decisions, two of the Madras High Court
and one of the Punjab and Haryana High Court, which shall presently be noticed,
were pressed into service on behalf of the assessee to suggest that the concept
of real income can be so applied as to make, where the chances of realisation
of accrued income are less it non est.
In Commissioner of Income-tax, Tamil Nadu-V
v. Motor Credit Co. Pvt. Ltd., 127 I.T.R. 572, the assessee, a private company,
was carrying on business as financier for purchase of motor vehicles on hire
purchase. It advanced under hire purchase agreements monies to two firms which
were plying buses. The routes of these two firms having been taken over by a
State Transport Corporation following nationalisation, the firms defaulted in
making payment of the hire purchase instalments, and consequently the buses
were seized. As the assessee-company was advised that there was no prospect of
recovering even the principal amount, the assessee-company did 89 not credit
the interest on the outstandings from the two companies even though it was
adopting the mercantile system of accounting. The Income-tax Officer, however,
included a sum of Rs. 56,163 by way of accrued interest on the amounts
outstanding against these two firms. There in fact no interest accrued in view
of the facts because there was hire purchase and the State transport
corporation had taken over the firms. Therefore, there was no question of
paying any hiring charges or interest. In that view it was considered to be
unrealistic that income accrued. If the actuality of situation or the reality
of a particular situation makes an income not to accrue, then very different
considerations would apply. But where interest has accrued and the assessee has
debited the account of the debtor the difficulty of the recovery would not make
the accrual non-accrual of interest.
In Commissioner of Income-Tax, Madras Central
v. Devi Films (P) Ltd., 143 I.T.R. 386, the Madras High Court held that the
regular mode of accounting only determined the mode of computing the taxable
income and the point of time at which the tax liability was attracted. It would
not determine or affect the range of taxable income or the ambit of taxation.
It was further held that where no income had resulted, it could not be said that
income had accrued merely on the ground that the assessee had been following
the mercantile system of accounting. Even if the assessee made a credit entry
to that effect still no income could be said to have accrued to the assessee
according to the Madras High Court. If no income had materialised, it was
pointed out, there could be no liability to tax on any hypothetical accrual of
income based on the mercantile system of accounting followed by the asessee
that had to be taken into account, but what should be considered was whether
the income had really materialised or resulted to the assessee.
The question whether real income had
materialised to the assessee had to be considered with reference to commercial
and business realities of the situation. In that case the assessee company had
entered into an agreement with M who was producing a Kannada film. The film was
in the process of production and the producer wanted finance to complete the
picture and approached the assessee and offered the exclusive distribution
rights of the picture in certain areas in Karnataka State. The assessee agreed
to advance a sum of Rs. 2,80,000. Under the agreement the assessee as
distributor could deduct the commission and appropriate the balance 90 towards
the discharge of the amount advanced to the producer and after the advance was
completely adjusted, the distributor had to remit to the producer the
realisactions after deducting the commission. The distribution commission was
to be calculated at 35% of the net realisation on the picture. The producer
undertook to complete and deliver the prints for the release of the picture
failing which the producer under took to pay damages together with interest for
the amount received at 12% per annum from the date of default to the date of
delivery of the prints and also provided certain sum for certain contingency.
It is not necessary to set out in detail the further facts. It was held that
the assessee was in a position to realise only Rs.
3,47,000 approximately during the three years
in question as against a total sum or Rs. 4,37,828 incurred as the cost of
production. The Tribunal was justified in the High Court's view that having
regard to the terms of the agreement entered into between the parties and in
the light of the entries contained in the accounts, the commission could not be
said to have accrued in favour of the assessee, as commission could be earnt
only after the entire advance had been realised. The decision, as is apparent
from its tenor rested upon the peculiar facts. As the advances could not be
realised because of the contingencies that happened in that case, the
commissions did not accrue or could not be said to have actually accrued. As
mentioned before, the concept of real income may have to be given precedence in
computation of income in a particular case but accrued income cannot be waived
as not having accrued to the assessee. Sethuraman, J.
who delivered the judgment of the bench noted
the distinction between the James Finlay's case and the case before him in the
Madras High Court. Dealing with the Calcutta case, Sethuraman, J. observed at
page 395 that the waiver of interest would be inconsistant with the entries in
the books, since the interest had been credited to the suspense account. As in
the instant case before us in these appeals the learned judges of the Madras
High Court also referred to Morvi Industries Ltd. (supra) where affirming the
Calcutta High Court decision, it was found that the relinquishment by the
assessee of its remuneration after it had become due was of no effect and that
the amount was liable to be taxed. The Madras High Court felt that this Court
had considered only in the light of the system of accounting followed by the
assessee and further observed that this Court in the aforesaid decision had not
been referred to the notion of real income. It is unfortunate that the High 91
Court chose to side-track a binding decision of this Court on a wholly
untenable ground.
In Commissioner of Income-Tax, Amritsar-II v.
Ferozepur Finance (P) Ltd. 124 I.T.R. 619., the facts were different and the
Punjab and Haryana High Court hald that that even in the mercantile system of
accountancy an assessee could forgo the whole or part of a debt, which was
irrecoverable. There the court came to the conclusion that there was no income
in view of the particular facts and circumstances of the case.
An acceptable formula of co-relating the
notion of real income in conjunction with the method of accounting for the
purpose of computation of income for the purpose of taxation is difficult to
evolve. Besides any straight jacket formula is bound to create problems in its
application to every situation. It must depend upon the facts and circumstances
of each case. When and how does an income accrue and what are the consequences
that follow from accrual of income are wellsettled. The accrual must be real
taking into account the actuality of the situtation. Whether an accrual has
taken place or not must in appropriate cases be judged on the principles of
real income theory. After accrual non- charging of tax on the same because of
certain conduct based on the ipse dixit of a particular assessee cannot be
accepted. In determining the question whether it is hypothetical income or
whether real income has materialised or not, various factors will have to be
taken into account.
It would be difficult and improper to extend
the concept of real income to all cases depending upon the ipse dixit of the
assessee which would then become a value judgment only.
What has really accrued to the assessee has
to be found out and what has accrued must be considered from the point of view
of real income taking the probability or improbability of realisation in a
realistic manner and dovetailing of these factors together but once the accrual
takes place, on the conduct of the parties subsequent to the year of closing an
income which has accrued cannot be made "no income".
The extension of such a value judgment to
such a field is a pregnant with the possibility of misuse and should be treated
with caution; otherwise one would be on sticky grounds. One should proceed
cautiously and not fall a prey to the shifting sands of time.
As a result of the aforesaid discussion, the
following propositions emerge;
92 (1) It is the income which has really accrued
or arisen to the assessee that is taxable. Whether the income has really
accrued or arisen to the assessee must be judged in the light of the reality of
the situation. (2) The concept of real income would apply where there has been
a surrender of income which in theory may have accrued but in the reality of
the situation no income had resulted because the income did not really accrue.
(3) where a debt has become bad deduction in compliance with the provisions of
the Act should be claimed and allowed. (4) Where the Act applies the concept of
real income should not be so read as to defeat the provisions of the Act. (5)
If there is any diversion of income at source under any statute or by
over-riding title then there is no income to the assessee. (6) The conduct of
the parties in treating the income in a particular manner is material evidence
of the fact whether income has accrued or not. (7) Mere improbability of
recovery, where the conduct of the assessee is unequivocal, cannot be treated
as eivdence of the fact that income has not resulted or accrued to the
assessee. After debiting the debtor!s account and not reversing that entry -
but taking the interest merely in suspense account cannot be such evidence to
show that no real income has accrued to the assessee or treated as such by the
assessee. (8) The concept of real income is certainly applicable in judging
whether there has been income or not but in every case it must be applied with
care and within well-recognised limits.
We were invited to abandon legal
fundamentalism. With a problem like the present one, it is better to adhere to
the basic fundamentals of the law with clarity and consistency than to be
carried away by common cliches. The concept of real income certainly is a
well-accepted one and must be applied in appropriate cases but with
circumspection and must not be called in aid to defeat the fundamental
principles of law of income-tax as developed.
For the reasons aforesaid, with respect, it
is not possible for me to agree with the answer proposed by my learned brother,
Tulzapurkar, J. on the first question. In the premises question number (1)
should be answered in the affirmative and in favour of the revenue and question
number (2) must also, in respectful agreement with my learned brother, be
answered in the affirmative and in favour of the revenue. The appeals therefore
must fail and are dismissed.
But in view of 93 the facts and circumstances
of these cases, parties will bear their own costs throughout.
RANGANATH MISRA, J. I have had the advantage
of reading the two separate judgments by my learned brothren .Tulzapurkar and
Mukharji, JJ.
I am in agreement with both of them that the
second question had been correctly answered in favour of the Revenue by the
High Court and the appeals are to be dismissed on affirmation of that
conclusion so far as that aspect is concerned.
In regard to the answer proposed for the
first question, I have bestowed my careful consideration and I am in agreement
with the reasonings and conclusions reached by my learned Brother Mukharji, J.
I am of the view that section 36(2) of the Income Tax Act covers the entire
field regarding deduction for bad debt. Though the concept of !real income! is
well recognised one, it cannot be introduced as an outlet of income from
taxman!s net for assessment on the plea that though shown in the account book
as having accrued, the same became a bad debt and was not earned at all. It is
well settled that the citizen is entitled to the benefit of every ambiguity in
a taxing statute but where the law is clear considerations of hardship,
injustice or anomaly do not afford justification for exempting income from
taxation (see Mapp v. Oram., [1969] (vol.III) All Eng. Reports 219 (H.L.) The
appeals shall stand dismissed with the direction that the parties shall bear
their own respective costs throughout.
ORDER In view of the majority judgments
appeals are dismissed.
A.P.J.
Back
