STATE BANK OF TRAVANCORE v. COMMISSIONER OF INCOME TAX, KERALA

A

JANUARY 8, 1986 B [V, D, TULZAPURKAR, SABYASACIU MUKHARJI AND RANGAl'IATH MISRA, JJ, ]

Income Tax Act, 1961:

Sections 28, 29 & 145 - Banking Company - Advances con- sidered doubtful of recovery-interest on such 'sticky' advan- c ces not carried in 'Profit and Loss Account' - Credited to separate account - 'Interest suspense ac;count' - Accrual of income - Whether arises - Interest amount - Whether exemption frorn tax. - Concept and notion of real income - Explained. Hethod of account;i.ng - How far relevant for computa- tion of income, prof.its and gains - Mercantile and cash D systems of accounting - Oif fererice between. Devaluation of Indian Rupee - Exchange difference aris- ing therefrom - Whether income assessable to tax.

The assessee, a subsidiary bank of the State Bank of India, used to maintain in the accounting years 1964, 1965 and E 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 accqunt called 'Interest Suspense Account' as the principal amounts of these 'stic~y advances' themselves had become not bad or irrecoverable, but extremely doubtful of ' recovery. In its returns th~ 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 H

26 SUPREME COURT REPORTS (1986] 1 s.c.R.

A exchm\ge by way of cash balances available with their foreign ·i 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 de- valuation rates gave rise to a profit of 57.5% in the transac- tion; the assessee bank-credited this surplus to an account designated "Provision for Contingencies". In the Assessment B Year 1967-i>B 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.

E In the appeals to this Court on behalf of the assessee- bank it was contended: (l) 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 prof its 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 princi- P. ples and realities of the situation it will be clear that in

p. 27 Copy page pinpoint

~-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 oil sticky advances and the debit entries made in re>1pect of such interest in the respective accounts Of the concerned debtors B 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 remit- c tance 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 D 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 E 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 mercantiie 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 F 'Cand 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 Instruc- tions contained in Vartous Circulars were in consona~ce with the accepted principle that what was charg~abie under ~he '< Income Tax Act was the teal inconie of an assessee but these instructions which held field for over 53 years were changed, though wrongly, under fresh -circulars issued by the Central

281 SUPREME COURT REPORTS [1986] t s.c.R.

A 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 regu- larly 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 B 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 mercan- ;; tile 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 c 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 charge- 1J ability must attach to real profits and gains arfaiitg 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 thes~ 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 I'

p. 29 Copy page pinpoint

C.l.T. v. ~ Line Ltd., 46 I.T.R. 590 referred to. H

30 SUPREME COURT REPORTS [1986] l s.c.R.

A Per ltd<harji, 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 B attracted even in cases where an assessee followed the mercan- tile system of accounting. However, in examining any transac- tion or situation, the court would have mre regard to the r rea1ity of t.he situation rather than purely theoretical or doctrinaire aspect, (92 A; 86 F-G] · 2, The profits and gains chargeable to tax under the Act c are those which have been either received by the assessee or have accrued to the assessee during the period be,tween the first and the last day of the year of a.ccount and are receiv- able, Income received or income accrued are both chargeable to tax under section 28 of the Act. [74 C] 3, By and large, two syst,ems of account keeping are followed one is the cash and the other, mercantile. The cash ) system postulate actual receipt of mney; 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 afid/or debit. A sum of mney, 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 mney is yet to be paid. (72 B-C]

G 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 '!' H then have to be determined. The circulars being executive in

p. 31 Copy page pinpoint

A ~ character cannot alter the provisions of the Act and being in the nature of concessions could always be prospectively with- drawn. [ 75 A-B] Comnissiooer of :iru:c--tax, Madras v; K.ll.11.T.T. 'lbiaga- raja Oietty & Co., 24 I.T.R. 525, illakeshvar Prasad Narain Singh v. Comniasiooer of Income Tax, Bihar & Orissa, 4 I. T. R. B 71 at 74, C<nnlsaiooer of Income-tax v. Sbrlmati Singari Bai, 13 I.T.R. 224 & Coamissiooer of :IncoE-tax, Madras v. A. -., Krisbnaswami MiidaHar 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 c assessee. After debiting the debtor's account and not revers- ing 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 ,t; particular situation makes an income not to accrue, then very D 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]

Catholic Bank of India (In liquidation) v. Comnissiooer E of Income-tax, Kerala, Ernalmlam, 1964 K.L.T. 653 = 1965 (1) I.T, Journal 355, Coamissiooer of Income-tax, Bombay I v. Confinance Ltd., 89 I,T.R, 292 and James Finlay & Co. v. Coamissioner 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 taxa~ tion 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 circumstan- ces 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 impro- bability of realisation in a realistic manner and dovetailing H

32 SUPREME COURT REPORTS [1986] l s.c.R.

of these factors together, but once the accrual takes place on -< A 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 B must be applied in appropriate cases but with circumspection " and must n~t 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 c 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]

D 9. Once the accrual takes place and income accrues, the same cannot be defeated hy 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 ot the term can be brought into play, but the notion of real income cannot be brought into play where income haa accrued according to the accounts of assessee and there is no indication by the assessee to treat the SIIklunt as not having accrued. Suspended animation followinr inclusion of the SIIklunt 7 in suspense account does not negate accrual and after the event of accrual, corroborated by appropriate entry in the F 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 Ll:d. v. Coamissioner of Income-Tax (eelltral), Calcutta, 82 I.T.R. 835 and Calcutta Co. Ltd. v. c.-1.ssioner of Income-Tax, West Beugal, 37 I.T.R, l relied upon. G Collllllssioner of Income-Tax, llo<>bay Cit:y, I v. llessrs. Shoorji Vallabhdas and Co., 46 I.T.1'. 144, Coamissioner of ) Income-tax, llombay North Kutch and f.aurashtra, Ahmedabad v. Cbamanlal Hangaldas &: Co .. , 29 I~T.R. 987, &rvi lndustrU-S

STATt: ~ANK v. C.1. T. 33

·~ Ltd. v. Coamissioner of ~ (Central) Calcutta, 82 A I.T.R. 835, H.M. Kashiparekh & Co. U:d.'s case, 39 I.T.R. 706, Colllnissioner of Income-Tax, West Bengal, 11 v. llirla Gwalior (P) Ltd., 89 I.T •. R. 266, .Conmi.ssioner of Iru:ome-cax, Tamil Nadu-V v. Motor Credit Co. (P) Ltd., 127 l,T,R, 572, Coomi.ssioner of ~. Madras Central v. Devi Films (P) Ltd., 143 I.T.R. 386 and Que:l.ssioner of Income-Tax, B Amritsar-11 v. Ferozepur Fi.oance {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 ) ~ eve~t 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 C in the suspense account. Extension of the concept of real income to this field to negate after the aioount 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 0 income' is well recognised one, it cannot be introduced as an outlet of income fr~m 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, E injustice or anomaly do not afford justification for extempt- ing income from taxation. [93 C-il]

Mapp v. Oram, 1969 (Vol.Ill) All E.R. 219 (H.L.) "" referred to. F Per Tulzapurkar, J. - (dissenting)

1Copy pinpoint1. 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 G mere non-receipt of income, when it is reasonably realisable, will not affect accrual but factual or practical unrealis-, ability thereof may prevent its accrual depending upon the facts and circumstances attending upon the transaction. (59 F-G] H

34 SUPREME COURT REPORTS [1986] 1 S.C.R.

2Copy pinpoint2. 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-11]

3Copy pinpoint3. 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 B accrual of interest thereon as real income and would have the effect of rendering such income hypothetical and t!le same cannot be brought to tax. (59 E-F]

4Copy pinpoint4. 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 c income or the ambit of taxation. In other words, any hypo- thetical income which may have theoretically 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 account- ing and makes entries in his books in regard to such 0 hypothetical income. (47 F-<;] I

5Copy pinpoint5. The method of accounting regularly employed by an assessee is rel¢vant ' 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 E method of accounting determines the mode o>f computing taxable income but it does not determine or even effect the range of taxable income or ambit of taxation. (49 C-D] ·

6Copy pinpoint6. 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' F instead of to "Interest Account' or 'Profit and Loss Account' is a well recc;>gnised and accepted practice of col!lllercial accountancy, th'1t it is wholly consistent with mercantile method of accow\ting and that i t prevents the wrong crediting and improper and illegal distribution or remittance of inflated and unreal profits. (52 D-E]

7Copy pinpoint7. Under s. 5 taxability is attracted not merely when G 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 receiv~d or not and 'accrued income' is that income which 'the assessee has a legal right to receive.' (52 F-<;] H

STATE BANK v. C.I.T. 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 B 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 asses see' s books maintained in the mercantile system. [55 C-0]

9Copy pinpoint9. Even under the mercantile system of accounting when- ever adopted it is only the accrual of real income which is c 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 reali- ties and specialities of the situation and cannot be deter- mined by adopting purely theoretical or doctrinaire or legali- D stic approach. [58 H; 59 A]

Catholic Baolt of India (In Liquidation) v. Comissiooer 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.l.T., 137 I.T.R. 698 overruled. E C.l.T. v. Motor Credit Co. (P) Ltd., 127 I.T.R. 572, C.l.T. v. Devi Fillls (P) Ltd., 143 I.T.R. 386, C.l.T. v. Ferozepur Finance (P) Ltd., 124 I.T.R. 619, lllakesvar Prasad Narain singh v. Commissioner of Income Tax, 4 I.T.R. 71 at 74 & H.K. Kashiparekh Co. 's case, 39 I.T.R. 706 approved. F C.I.T. v. Sarangpur Cotton Mfg. Co., 6 I.T.R. 36 at 40, C.l.T. v. Singari Bai, 13 I.T.R. 224 at 227, c.1.T. Ksdras v. A. Krislmaswa.t lludaliar & Ors., 53 I.T.R. 122, c.r.T. v. Shoorji Vallabhdas & Co. 46 I. T.R. 144, C.l.T. v. Birla Gwalior (P) Ll:d., 89 I. T.R. 266 and Kohler's Dictionary for Accountants 3rd Edn. relied on. G

C.I.T. v. Thiagaraja Chetty, 24 I.T.R. 525 at 531, llorvi Industries Ltd. v. C.l.T. Calcutta, 82 I.T.R. 835 at 840, C.l.T. v. Barivallabhadas Kalida& & Co., 39 I.T.R. 1, C.I.T. Ksdhya Pradesh v. Kaloor811l Govindr&lll, 57 I.T.R. 630, Poona Electric Supply Co. Ltd. v. C.I.T. llollbay, 57 I.T.R. 521, H C,I.T, v. Sir S.K. Cidtnavis, 6 I.T. Cases 453 Shukla and Grewal referred to.

36 S~PREME COURT REPORTS [1986] 1 s.c.R.

A CIVIL APPELi.ATE 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, . i v.s. Desai, B,B, Ahuja and Miss A, Subhashini for the R Respondent. '

N,A, Palkhiwala, S.E, Dastur, M/s. J.B. Dadachanji, Mrs. - A.K. Verma a~d D.N. Mishra, for the Intervenors (M/s. Grindlays Bank, Calcutta and State Bank of Travancore), c Dr. P. Pal and D,N, Gupta for the Intervenor (Chartered Bank), .. I F.N. Kai<'\, Mr. S.E. llastur, C,S, Shroff, S.S. Shroff and S,A, Shroff for the Intervenor (Industiral Credit & Invest- ment Corpn. , & American Express International Bank and City ... D 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 follol.ing Judgments were delivered

TULZAPURKAR, J, These appeals by certificate from the , High Court raise the following two interesting questions of law for our determination:

( l) Whether on the facts and in the circumstances of the case the addition of the sum of Rs, 67,170, Rs, ~7,777 and Rs, 57,889, representing interest on 'sti~ky 1 advances, as income for the. assessment years 1965-66, 1966-67 an4 1967-68 respectively was justified in law?

(2) Whether on the facts and in the circumstances of the case the exchange difference of Rs. l,66, 128 H

STATE liANK v. C. l, T, [TULZAPURKAR, J,] 37

arising· on devaluation of the Indian rupee on A

6. 6.1966 was rightly treated as income for the assessment year 1967-t>S? The facts giving rise to the first question He 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 ca~endar B year as its previous year and the calendar years 1964, 1965 an<! 1966 are respectively the relevant previous years for the assessment years 1965-66, 1966-<>7 and 1967-<>8 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 c Loss Account' er.edited the same to a separate account styled 'Interest Suspense AccoW1t' as the principal amounts of these stickly a~vances themselves had become, not bad or irrevocer- able 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' INere Rs. 67,170 Rs. 47,777 and Rs. 57,889 for the assessment years 1965-{)6, 1966-<>7 and 1967-{)8 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 F 'Interest Suspense Account' so as to avoid showing inflated prof its 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 G 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 H

38 SUPREME COURT REPORTS [1986] I S.C.R.

A year the assel='see could in that year. tr.eat it. as such and clailil deducticif wider s. 36 (1) (vii) of the Income Tax Act

1961. In holding that these three sums were taxable as income in the hands df the assessee for the concerned years the High 1 Court followed , its ear lier decision in the, case of Catholic Banlt of India !(In IJ.quidation) v. Coami.ssioner of Income-tax, Kerala, (1964]', K.L.T. 653 = (1965] l Income-tax Journal 355 B where despite the dir.ective isSued by the Reserve Bank of India to the assessee-bank. not to carry interest on such sticky advances to 'Profit and Loss Accowit' and despite the fact that the assessee-bank had in pursuance thereof ommitted - such interest from its 'Profit and Loss Accowit' the Court had taken the view that such interest was taxable as income in the c hands of the assessee-bank because of the mercantile system of accowiting 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 r D 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 dir.ecti ve fr.om 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 accowiting 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 i decision herein, took a similar view and answered a similar question against the assessee for the subsequent yea~ 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 cowisel for the assessee raised a two-fold contention in support of his plea that the three sums r.epr.esenting inter.est on 'sticky' advances, i.e. G advances in respect whereof there was high impr.obability of recovery of even the principal amowits 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

.. STATE HANK v. c. r. T. [TULZAPURKAR, J.] 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 commer- . cial 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 c 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 distri- bution 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 llaryana High Court in C.I.T. v. Ferozepur Finance (P) U;cl. 124 I.T.R. 619 where a view has been taken that it will be totally unrealis- '· tic 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 whicn a G high degree of improbability of recovery attaches in a parti- cular 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 H

40 ~UPREME COURT REPORTS [1986] 1 s.c.R.

impugned decision herein as also the further decision in 110 A ITR 336 were rendered by the Kerala High Court in 197 3 and ,I 1975 respectiveiy the aforesaid distinction between an irre- ~ coverable, 104n and a stickly loan was recognised ·by the Central Board of P.evenue 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 mercan- tile system of accounting and he further pointed out that B Instructions had been issued not to treat the unrealised interest on such sticky loan as income by carrying it to 1

'Profit and Loss Account' so that the figure of distributable .,,, profits should not get inf lated and preferably to credit the same to a special account such as 'Interest Suspense Account' and that if the banks, financial institutions and money c lenders, who' kept their accounts on mercaritile system, maintained such a suspense account in which the unrealised interest was entered, the same should not be included in the <>ssessee's taxable income, if the Income Tax Officer was satisfied that there was really little probability of the loans being jrepaid. (Vide C.B.R. Circular No. 37 /54 dated D 25.8.1924, No. 4l(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 1contained in these Circulars were in consonance with the. accepted principle that what was chargeable under the E Income Tax Act was the real income of an assessee but accord- ing 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 DirJct Taxes whereunder such interest on doubtful or sticky loans became includible in the assessable income of the F 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 G for Doubtful Int~rest 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 accoun- . ting the Income Tax Officer was bound to give effect to it " under ~. 145 of the Act, and, therefore, the treatment of the H three sums representing interest on sticky loans as the

STATE BANK v. C.I.T. [TULZAPURKAR, J,] 41

assessee's income for the concerned assessment years would be unsustainable in law; and in this behalf counsel placed A !>- 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 poli~ies of server.al financial institutions including foreign panks, six B interverners, ruimely, American Express Inter.national Banking Corpn., Mercantile Bank Limited through its successors ~ Hongkong & Shenghai Banking Corporation, Citi Bank N.A., Chartered Bank, Gr.indlays Bank and Industrial Credit & Invest- ment 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 c 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 D regularly on mercantile system each one of these institutions in the matter of inter.est on doubtful or sticky loans invari- ably 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 E Account' or 'Reserve for Doubtful Interest Account' and only upon realisation the same is er.edited 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 Intervener.a that they have .an elaborate and well controlled y system of evaluation for the purposes of assessing the F recoverab'ility 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 tr.eating the laons as sticky, Counsel reiterated on behalf of the Inter.veners that the benefit under the earlier G Circulars of C.B.R. and R.B.l. 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. H

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 there- G !~~:nd:~g:~ ~:a~o ~~~~ud~h~~:, ~~r~::~i;~;":uchh~~~~men~d~ 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 accrue4 income and not adyisable ,.. H because if done it will apply to all cases and not merely to cases of interest accruing !o banks and financial

STATE BANK v. c.1.r. [TULZAPURKAR, J,] 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.l. 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 b<>s been effected prospectively from the assessment year, 1979-80. c 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 con8tit.ute real income of the assessee for the concerned assessment.years? Had D such income really accrued to the assessee ·for· those years? Does r.eal accrual of income deperid 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 E mercantile) relevant for dec,iding 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 F because of high improbability of recovery attaching to it in the concerned accounting year or years? We would like to deal with these questions 'iri the light, of ·decided cases. The _matetial ProV1sions 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) G 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 SUPREME COURT REPORTS [1986] 1 S.C.R. A

computed in accordance with the provisions contained in as. -', 30 ti> 43A, ,that is to say after making allowances and deduc- tions mentioned in those sections. Section 145 (I) provides that .income chargeable under the head 'Profits and Gains of Business' shall be computed in accordance with the method of B 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 deter- c mine; but where he is not satisfied about the correctness or completeness of the account.~ of the asses see, 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 D 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 there- from.· •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 what- ever 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 taxabi Uty 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 theore- tically 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 indi- cate 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 bear- ing on the question of real accrual of income. In llhakeswar

STATE BANK v. C.I.T. [TULZAPURKAR, J.] 45

/ Prasad Narain Singh v. r.....iHiooer of 1""'*' :ru, 4 I.T.R. 71 A 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, entrie~ being made only when money is actually collected or disbursed and if the profits of the business are accounted in B 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, other- wise known as the 'book profits system of accountancy' or the 'wmplete double entry book-keeping' has .been described by Sir Iqbal Aluned, C.J. in C.I.T. v. Singari Bai, 13 I.T.R. 224 c at 227, as follows: "Under this system the net profit of loss is cal- culated 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. ~ Krishoaswami 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; G 11 Amang· Indian businessmen, as elsewhere, there are current two principal systems of book keeping. There is, firstly, the cash system in which a

46 SUPREME COURT REPORTS [19861 l s.c.R.

recbrd is maintained of actual receipt and actual A 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 incµrred, irrespective of the date of payments. For B exai\iple, 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 goo~s; 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 c 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 D 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 bal~nce thus arising, there is added the amount of the I outstandings not collected at the end of the year and from this is deducted the liabilities· E 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 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 thejcash system is adopted, there is no question of bad' debts or out standings at all, in the case of mercantile system against the book prof it some of the bad debts may have to be set off when they are H foUrul to be irrecoverable. Besides the cash system

STATE BANK v. C.l,T; [TULZAPURKAR, J,] 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 obser- vation at page 128 of the Report: "But the section (section 13 of the 1922 Act equi- valent 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 c 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 H

48 SUPREME COURT REPORTS [1986] l s.c.R.

its books pursuant to the mercantile system of accounting regularly adopted by it. Indisputably, the three suma in 4 question repre~ented the assessee's income by way of interest on advances ~de by it to some of its customers but having regard to t~e deteriorating financial position of the concerned parties and the history of their accounts the asses- see felt tha' the advances had become sticky during the concerned accounting years inasmuch as even the recovery of II 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 lo its profit and loss account but credited the same to a sepl).rate account styled 'Interest Suspense Account' so as to avoid showing unreal or inflated prof its and claimed c that it was dot 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 1 such interest had not materialised or resulted to the assessee in those yeans were not disputed but as stated earlier the claim was neg~tived by the taxing authorities and the Tribunal ,. D 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 mercan- tile 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 1

E the concerned parties by making debit entries in their accounts. The High Court also affirmed the view that there had been accrual 1of the income at the Jnd of each accounting year and in that behalf laid emphasis on the fact that the assessee had been regularly adopting the mercantile system of account- 7 F ing and obsetved that the assessee 1 s income will have to be determined ii\ 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 .:ax the taxing 1

authorities, the Tribunal and the High Court, relying on the mercantile system employed by the assessee, adopted a G legalistic approach and took the view that because such interest had.fal~en due and become legally recoverable by the assessee at .the end of each of the accounting years it had accrued to l.t, though by rea•on of the stickiness of the ..,, advances or .loans such interest had ia fact not resulted or materialised but remained its hypothetical income. Two H questions arise: Should such legalistice approach prevail Cl"er

STATE BANK v. C.I.T. [TULZAPIJ!lKAR, J.] 49

A 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 con- tained in the Income Tax Act 1961, in accordance with the accounts regularly maintained by it." I have already indicated c above that the illethod 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. ln other words simply because the assessee has been regularly employing the mercan• tile system of accounting it would not mean that any hypothe- tical 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 concer.ned debtors and had designedly cr.e4ited it to 'Interest Suspense Account' instead of carrying it to G 'Profit and Loss A:!count' 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 pend- ing their final disposition; it does _not appear in financial statements" (vide Kohler's Dictionary for Accountants, l'hird F.dition). Since the final disposition of the sums in question H was uncertain and hung in balance these items were properly

50 SUPREME COURT REPORTS (1986] 1 s.c.R.

A carried to 'Int~rest 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 simul- B taneously such interest was credited to Interest Suspense Account and not to Profit and Loss Account. The tSJ<ing 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 demonstr- c ably shown an intention to treat such interest as its hypothe- tical 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, wa~ to make a systematic record of business transactions in,a manner which must show the correct financial position of a lmsiness house at a given point of time and reflect the real and true profits of the business done by it during the year i of account and contended that in treating the three sums in guestion I in the manner done the assessee had merely followed: a universally recognised practice invariably adopted by bank$ 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 'Iaterest 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. fr.om the standard text books on accountancy. For instance, in the treatise 'Advanced Accounts' G 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 H credited to Interest Account. Instead it should be I

STATE BANK v. C. I. T. [TULZAPURKAR, J. ] 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 a11XJUnt should be closed by transfer to the Loan Account. This treat- B ment 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. 11 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 c 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 t.he true profits. The relevant passai:te occurring at pages 186-187 runs thus: D "Where interest has not_ been paid, it is sometimes left out of account altogether. This prevents the possibility of irrecoverable interest being credit- ed 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 a11XJunt 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 'Inter- national Accounting Standard 18'. (Supplement to 'The Manage- ment Accountant', December 1982) a publication of the Inter- national Accounting Standards Committee. The concept of revenue recognition is explained thus in para 5:" G "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. H

52 SUPREME COURT REPORTS [1986] l S.C.R. A

Whe!]. uncertainties exist regarding the detennina- tion 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 B set out in paragraphs 16 to 27 and para 25 is material which runs thus: "Revenues arising from the use by others of enter- prise rescftlrces yielding interest, royalties and dividends should only be recognised when no signi- ficant uncertainty as to measurability or c 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 commer- cial 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 infla- ted and unreai 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 it.a hypothetical income and not real income. F Turning ~o the first question it is true that under s. 5 taxabillity i$ attracted not merely when income is actually , received but ~lso when it has 'accrued' and it is also true, as has been <µ<plained by this Court in Thiagaraja <lletty' s case (supra) :and Morvi Industries' case (supra) that income G accrues when it 'falls due', that is to say when it becomes legally recoverable irrespective of whether it is actually received or. not and 'accru~d 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 H , doctrine of real income could arise; for., in the former case '-:"

STATE BANK v. c.r.T. [TULZAPURKAR, J,] 53 A 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 pend- ing settlement of a dispute in regard to another debt owed to it by the managing agents (which proposed settlement was ulti- B mately rejected) and the Court held that such keeping it .in the suspense account pending settlement of another in,debte.d- ness would not pr.ev~nt 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 c 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 CSDllOt be a tax, even though in book-keeping, an entry is made about a hypothetical income, which does not materi- alise. 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, 00...,ver, the income CBI\ be said not to have resulted at all, there is obviously neither accrual nor receipt of income, even though sn 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 asseasee-firm was the managing agent of two shipp- ing 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 er.edited 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 SUPREME COURT .REPORTS [1986] 1 s.c.R. A

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 JO per cent had already accrued to the B assessee in the year of account which ended on March 31, 1948 and the agreerltent in December 1948, after the close of the pt'evious 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 c 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 D Court relied upon the fact that the assessee had in fact received only 'he lesser amount in spite of the entries in the accounts books'I and held that such lesser amount alone was taxable. , A large !lumber 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 b¢ decided on commercial principles having regard to the business character of the transactions and the reali- ties 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 ~heoretically accrued and (b) cases where these haa 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 atttlntion to the decision of this Court it will suffice to indicate that in the former group fall the follow- ing decisions, namely C.I.T. v. Bari Vallabhadas Kal.idas & Co., 39 I.T.R. I, C.I.T. v. Qumian!al Mangaldas & Co. and

STATE BANK v. C.I.T. [TULZAPURKAR, J.] 55

C.I.T. v. Mangaldas Girdhardas. Parekh Ltd., 39 I.T.R. 8, A • 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 B 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 unUaterally or as a result of. bilateral arrangement, voluntary relinquished or surrendered c 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 • D ...,. 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 i.n the mercantile system, was the managing ~gent 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 E managed company were not sufficient to pay a divident of 6 per cent; 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 F ' 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 tax- able income, On a Reference, the High Court held that it was G 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 'r- fact that the asses see followed mercantile system of account ' dld not have any bearing. The Court further held that the H

56 SUPREME COURT REPORTS (19861 i s.c.R. A

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 B 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 hear- ing of the Reference counsel for the re.venue raised a conten- tion that even if the amount of Rs. 57785 had been foregone by c the assessee company on grounds of commercial expediency that was riot 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 lJ could not avail of the benefit of the doctrine of real income where the income by way of the managing agency commission had y 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 surr.ender was not ma.de 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 (J 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 7 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 7' concepts underlying the two rules. In.our judgment,

STATE BANK v. C. I. T. [TULZAPURKAR, J.] 57

they permit of harmonious application, though the application is to a degree rust de?end on the circumstances of each case. Some propositions could be forrulated but whether a general forrula appli- B cable to all circumstances could be hit on we rather doubt.

1bough it may not be possible to prescribe a general forrula which successfully compose every conflicting situatlon, the position in law seems clear to us that in applying the two rules to c particular transactions regard rust 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 she'er adherence to one rule and discounting of the other." 0

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 rust have been entries in the books E 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 F '<.would not be justified in attaching any particular importance· in this case to the fact that the company followed the mercantile system of account. 1bat 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 Comnissioner of G 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 th~ real nature of what happened; a mere book entry is not conclusive ~ of the question whether the assessee had become entitled to the H

58 SUPREME COURT REPORTS [1986] 1 s.c.R. A

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, therefor-e, is whether the two facts, one the amount of Rs. 1,17,644.4 annas which B 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 c 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 D Tribunal, that the surrender was made bona fide and on grounds solely of commercial expediency, it 'I' 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, F agreed to or given up on grounds of commercial expediency, simply because it takes place some time after the close of the7 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 gr.eater 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 i t is only the accrual -.... H of real income which is chargeable to tax, that accrual is a ' matter of substance and that it is to be decided on commercial

STATE BANK v. C.I.T, [TULZAPURKAR, J,] 59

A principles having regard to the business character of the transactions and the realities and specialities of the situa- tion 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 B the transactions and the realities and specialities of the situation in preference to theoretical, doctrinaire or legal- istic 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 inc6me? Tii.ere is no reason why the factum of stickiness of loans operating throughout the accounting c period or periods, not on the basis of mere lpse dixit of the assessee but on being objectively established to the satis- faction of the taxing authorities by ref,erence to the facts showing the deteriorating financial position of the conc~rned 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 sti.ckiness of loans objectively established should not prevent accrual of interest thereon as real incorre. In fact in the former case considerations of cormnercial 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 lnterest thereon as real income and would have the effect of rendering such lncome 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 reallsable during the accounting year or years. In other words merP. non-receipt of income, when it is reasonably realisable, ., will not affect accrual but factual or practical unrealis- ability thereof may prevent its accrual depending upon the facts and circumstances attending upon the transaction. H

60 SUPREME COURT REPORTS [ 1986] 1 S, C.R. A

Counsel for the revenue raised two objections to extend ! the theory of real income so as to E!Xclude from chargeability the interest on sticky loans merely because it suffers from high improbability of recovery, j:n the first place he urged that the Act contains no provision excluding or deducting such B 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 c as sought would entrench upon s. 36 (1) (vi), Secondly, it was urged that such extension will be ill-advised inasmuct, 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. 1' (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 intro- duced in the income tax law (the 1922 Act) fot 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.K. QU.tna- G vis, 6 I.I. 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 pdnciples 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 dtduction is .,,. H 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

STATE llANK v. C.I.T. [TULZAPURKAR, J,] 61 A account must necessarily be t.aken of all losses incurred, otherwise you would not ·arrive at the true porfits and gains." Moreover, there is a clear distinction between an irrecover- able loan and a Sticky lo.an; 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 B deduction under s. 36 (1) (vii) while the latter is a loan to whl.ch a high degree of improbability of recovery attaches in a particular year or years due to which inter.est 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 c 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 D 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 E. 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 F 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 G II dated 16.4.1973 and RBI Circular IFD No. 0,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 Y rejected. H I may now deal with the decisions of the High Courts, Directly on the point at issue there are five decisions which

62 SUPREME COURT REPORTS [1986] 1 s.c.R. A

we need consider. Out of these counsel for. the assessee relied upon three decisions , two of the Madras High Court in lk>tor 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 hypo- B thetical and not real income should be excluded from the computation of the assessee 's· income while counsel for. the r.evenue relied upon two decisions one of the Bombay High Court in C.I.T. v. Confinance Ltd. 89 l,T,R, 292 and the other of the Calcutta High Court in James Finlay & Co. v. C.l.T. 137 I. T. R. 698 as both these apparently seem to take a contrary c view. I shall first deal with two decisl.ons on which counsel for the revenue placed rell.ance. In C.l.T. v. Confinance Ltd. the assessee was carrying on money lending business and bank- ing business and followed mercantile system of accounting. For the accounting year ending March 31, 1959 the assessee stated that no credit was taken in it,s balance-sheet in respect of inter.est on several loans advanced by it as inter.est 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 inter.est was not disput- F ed were circumstances which by themselves were in sufficient to support the conclusion that there was no real income in 7 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 e~pounded in·Kashiparekh's case to the facts of the case but the High Court declined to do so by adopting a legal- isti~ 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

STATE BANK v. C.I.T, [TULZAPURKAR, J,] 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 furl:her 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 loa~ B 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 qn 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 C 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 theie was no change in the mercantile system .of account- ing that had all along been empolyed by the assessee, that the D ..,. .transfer of items of interest to Suspense Ac.count 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 diffi- culty in realising the interest in the year of account there was no material to show that there was any agreement 'with the E 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 F ~ came to -the conclusion that it was not applicable inasmuch as the claim for interest had not been reUnquished 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 hypo- G thetical 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 H

64 SUPREME COURT REPORTS [1986] l s.c.R. A

firms having been taken over by the State transpor.t Corpora- ,. tion,· the firms defaulted in making payments of hir.e purchase instalments, and consequently the buses were seized. As the assessee company was advised that there was no prospect of r.ecover.ing even the principal amount it did not er.edit the B interest on the outstandings fr.om 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 intetest on the amounts outstanding fr.om these two fir.ms, The AAC deleted the addition. The Tribunal held that the assessee >- could not have expected to get any interest income on the c outstandings found due from two firms and it would be wholly unrealistic on the part of the assessee to take credit fr.om the 'interest income and consequently confirmed the AAC 's· order. On a reference at the instance of the Collllllissioner the Madras High court held that the Tr.ibunal was right in its conc1;,..ion that though the assessee had adopted the mer.cantile system of accounting no interest income could be assessed in its hands on accrual basis and it would be ver.y unrealistic on the part of the assessee to take credit for the highly >' illusory interest. Following the decision of this Court in Sboorji Vallabhdas Co's case and of the Bombay High Court in Kasbiparekh's case the High Court took the view that the regular. mode ·of accounting merely detennl.ned 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. lt further observed that it was not the hypothetical accrual of income based on the mer.cantile system of accounting follow- F ed l>y the sssessee that had to be taken into account but what should be considered was whether the income had really materialised or. r.esulted 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 r.ef~rence to his system of accounting and G held that since there was not even the r.emotest possibility of any inter.est 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 ar.e the other two decisions in Devi Films case and Ferozepur Finance case. I H approve these three decisions. v In view of my collclusiOil that th1s theory of real income could be and should be extended to interest on sticky loans and