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:
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
