TMI Blog1986 (1) TMI 1X X X X Extracts X X X X X X X X Extracts X X X X ..... the facts and in the circumstances of the case, the exchange difference of ₹ 1,66,128 arising on devaluation of the Indian rupee on June 6, 1966, was rightly treated as income for the assessment year 1967-68 ? The facts giving rise to the first question lie in a narrow compass and are these. The assessee is a subsidiary of the State Bank of India; it maintains accounts on mercantile system making entries on accrual basis; it adopts the calendar year as its previous year and the calendar years 1964, 1965 and 1966 are, respectively, the relevant previous years for the assessment years 1965-66, 1966-67 and 1967-68 to which the question relates. In the course of its banking business, the assessee charged interest on advances considered doubtful of recovery, otherwise called sticky advances, by debiting the concerned parties but instead of carrying it to its profit and loss account credited the same to a separate account styled Interest Suspense Account as the principal amounts of these sticky advances themselves had become, not bad or irrecoverable but extremely doubtful of recovery. However, in its returns, the assessee disclosed such interest separately and claimed tha ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... of the instant case were indistinguishable from those obtaining in the Catholic Bank's case [1964] KLT 653, except that there was a directive from the Reserve Bank of India to the Catholic Bank which was absent in the case before it, but in its opinion the presence or absence of such a directive from the Reserve Bank could not determine the question whether there was accrual of income or not and that in the case before it also, there was accrual of income to the assessee considering the mercantile method of accounting that had been regularly adopted by it. In this view of the matter, the High Court answered the question against the assessee and in favour of the Revenue. Incidentally, it may be stated that in the case of this very assessee, the High Court, following the decision herein, took a similar view and answered a similar question against the assessee for the subsequent year 1968-69 which decision rendered in 1975 is reported as State Bank of Travancore v. CIT [1977] 110 ITR 336. The assessee has challenged this view before us in these appeals. Mr. Palkhivala, the learned counsel for the assessee, raised a two-fold contention in support of his plea that the three sums ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... t on sticky loans as income and the same was excluded from the 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 outright form the subject-matter of deduction under section 36(1)(vii) of the Act while the latter is a loan to which a high degree of improbability of recovery attaches in a particular year or years depending upon the financial position of the concerned debtor due to which interest thereon becomes hypothetical income during such 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 impugned decision herein as also the further decision in State Bank of Travancore v. CIT [1977] 110 ITR 336, were rendered by the Kerala High Court in 1973 and 1975, respectively, the aforesaid distinction between an irrecoverable loan and a sticky loan was recognised by the Central Board of Revenue as also by the Reserve Bank of India in their diverse circulars in the case of banks, financial institutions and money ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... e for the concerned assessment years would be unsustainable in law; and, in this behalf, counsel placed reliance on the standard text books of accountancy of authors like Spicer and Pegler, Shukla and Grewal and the Approved Text of International Accounting Standard 18. Since the issues raised before us have a vital bearing upon the tax liability and business interests and policies of several financial institutions including foreign banks, six interveners, namely, American Express International Banking Corpn., Mercantile Bank Ltd. through its successors Hongkong Shanghai Banking Corpn., Citi Bank N.A., Chartered Bank, Grindlays Bank and Industrial Credit Investment Corpn. of India, sought our permission to intervene in these appeals and we granted the requisite permission in view of the importance of the issues involved and it may be stated that counsel appearing for the interveners have adopted the arguments of Mr. Palkhivala 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 ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... 40 (SC); and since, admittedly, the assessee has been maintaining its accounts on mercantile basis, the three sums being interest on loans, whether doubtful or sticky, fell due and became payable to the assessee at the end of each of the three accounting years and constituted its accrued income and were, therefore, justifiably brought to tax in the concerned assessment years. Counsel for the Revenue fairly conceded that courts have, while imposing the tax liability under the Act, recognised the theory of real income by having regard to the business character of the transactions and realities of the situation but these aspects have been taken into account for the purpose of determining whether the income could be said to have legally accrued or not and once it is found to have legally accrued, it is brought to tax. He pointed out that all the decisions of this court show that this theory has been invoked and confined only to two types of cases: (a) where there has been a surrender of income which may in theory have accrued, and (b) where there has been diversion of income at source either under statute or by overriding title, but in none of these cases has the aspect of high improba ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... nts of the concerned debtors under the mercantile system of accounting ? And lastly, can and should the theory of real income be extended so as to exclude a particular income from chargeability under the Act because of high improbability of recovery attaching to it in the concerned accounting year or years ? We would like to deal with these questions in the light of decided cases. The material provisions in regard to the computation of income of an assessee under the head Profits and gains of business are to be found in sections 28(i), 29 and 145(1) but these have to be read subject to section 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 section 39, to be computed in accordance with the provisions contained in sections 30 to 43A, that is to say, after making allowances and deductions mentioned in those sections. Section 145(1) provides that income chargeable under the head Profits and gains of business shall be computed in accordance with the method of accounting regularly employed by the assessee, provided that, in any case where the accounts ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... eipts and actual payments, entries being made only when money is actually collected or disbursed and if the profits of the business are accounted for in this way, the tax is payable on the difference between the receipts and the disbursements for the period in question. On the other hand, the mercantile accountancy system , otherwise known as the book profits system of accountancy or the complete double entry book-keeping has been described by Sri Iqbal Ahmad C.J. in CIT v. Singari Bai [1945] 13 ITR 224 at 227 (All), as follows: Under this system, the net profit or loss is calculated after taking into account all the income and all the expenditure relating to the period, whether such income has been actually received or not and, whether such expenditure has been actually paid or not. That is to say, the profit computed under this system is the profit actually earned, though not necessarily realised in cash, or the loss computed under this system is the 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 ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... in sub-section (5) the word paid which is used in several clauses of sub-section (2) as meaning actually paid or incurred according to the method of accounting upon the basis of which the profits or gains are computed under section 10. Again where the cash system is adopted, there is no question of bad debts or outstandings at all; in the case of mercantile system against the book profits some of the bad debts may have to be set off when they are found to be, irrecoverable. Besides the cash system and the mercantile system, there are innumerable other systems of accounting which may be called hybrid or heterogeneous in which certain elements and incidents of the cash and mercantile systems are combined. On the aspect as to how far and to what extent a method of accounting has a bearing on the question of real accrual of income, the court has made the following significant observation at page 128 of the report: But the section (section 13 of the 1922 Act equivalent to section 145 of the 1961 Act) only deals with the computation of income, profits and gains for the purposes of sections 10 and 12 (sections 28 and 56 of the 1961 Act) and does not purport to enlarge or re ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... nterest Suspense Account so as to avoid showing unreal or inflated profits and claimed that it was not taxable in its hands as real income had not accrued to it. The facts that the advances or loans had, during the concerned accounting years, become sticky and that such interest had not materialised or resulted to the assessee in those years were not disputed but as stated earlier, the claim was negatived by the taxing authorities and the Tribunal on the ground that the advances or loans had not been treated as irrecoverable or bad debts under section 36(1)(vii), that the aspect that the advances or loans had become sticky was irrelevant, that since the assessee was following the mercantile system of accounting, such interest had accrued to it at the end of each accounting year and that the assessee had itself shown the accrual Of interest by charging the same to the concerned parties by making debit entries in their accounts. The High Court also affirmed the view that there had been accrual of the income at the end of each accounting year and in that behalf laid emphasis on the fact that the assessee had been regularly adopting the mercantile system of accounting and observed th ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ns 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 the concerned debtors and bad designedly credited it to Interest Suspense Account instead of carrying it to the profit and loss account with a view to avoid showing unreal or inflated profits. A suspense account in book-keeping means an account in which items are temporarily carried pending their final disposition ; it does not appear in financial statements. (vide Kohler's Dictionary for Accountants, Third Edition). Since the final disposition of the sums in question was uncertain and hung in balance, these items were properly carried to Interest Suspense Account and could not and did not find a place in the financial statement like the profit and loss ac ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... extent the interest is received in cash, the Interest Suspense Account should be transferred to Interest account; the remaining amount should be closed by transfer to the Loan account. This treatment accords with the principle that no item should be treated as income unless it has been received or there is reasonable certainty that it will be realised. Similarly in Spicer and Pegler's Practical Auditing by W. W. Bigg (Fourth Indian Edition by S.V. Chatalia), the learned author has suggested that instead of leaving irrecoverable interest on doubtful loans out of account altogether the practice of charging such interest to the parties concerned but crediting it to the Interest Suspense Account is more appropriate for reflecting the correct state of affairs and the true profits. The relevant passage occurring at pages 186-187 runs thus: Where interest has not been paid, it is sometimes left out of account altogether. This prevents the possibility of irrecoverable interest being credited to revenue, and distributed as profit. On the other hand, this treatment does not record the actual state of the loan account, and in the case of banks and other concerns whose business it ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... l income. Turning to the first question, it is true that under section 5, taxability is attracted not merely when income is actually received but also when it has accrued and it is also true, as has been explained by this court in Thiagaraja Chetty's case [1953] 24 ITR 525 (SC) and Morvi Industries' case [1971] 82 ITR 835 (SC), that income accrues when it falls due , that is to say, when it becomes legally recoverable irrespective of whether it is actually received or not and accrued income is that income which the assessee has a legal right to receive . Incidentally, it may be stated that in both of these cases, where the legal aspect of accrual has been explained, no question of applying the doctrine of real income could arise; for, in the former case, after the commission payable to the managing agents had accrued at the end of the accounting year, the managed company had, instead of paying it, kept it in a suspense account pending settlement of a dispute in regard to another debt owed to it by the managing agents (which proposed settlement was ultimately rejected) and the court held that such keeping it in the suspense account pending settlement of anothe ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ot 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 had altered the rate of commission in such a way as to make the income which really accrued to the assessee different from what had been entered in the books of account and that this was not a case of a gift by the assessee to the managed companies of portion of income which had already accrued, but an agreement to receive a lesser remuneration than what had been agreed upon. The court relied upon the fact that the assessee had in fact received only the lesser amount in spite of the entries in the accounts books and held that such lesser amount alone was taxable. A large number of decisions rendered by this court as well as by the High Courts were cited at the bar by counsel on 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 matter of substance to be decided on commercial principles having regard to the business character of the transactions and the realities of the situation. After having gone through ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... uty to forgo up to one-third of its commission where the profits of the managed company were not sufficient to pay a dividend of 6 per cent. ; for the accounting year ending March 31, 1950, the assessee earned a commission of ₹ 1, 17,644 but as a result of resolutions passed by the managed company and the assessee company, the assessee gave up sum of ₹ 97,000 (Rs. 57,785 over and above ₹ 39,215 which it was bound to forgo) in December, 1950. Though the Appellate Tribunal found that the excess amount of ₹ 57,785 had also been given up for reasons of commercial expediency, it held that the maximum amount which could be forgone by the assessee was only ₹ 39,215 and, therefore, included the excess amount of ₹ 57,785 in the taxable income. On reference, the High Court held that it was the real income of the assessee company for the accounting year that was liable to tax, that the real income could not be arrived at without taking into account the amount forgone by the assessee and that in ascertaining the real income, the fact that the assessee followed the mercantile system of accounting did not have any bearing. The court further held that the accru ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... rlying the two rules. In our judgment, they permit of harmonious application, though the application to a degree must depend on the circumstances of each case. Some propositions could be formulated, but whether a general formula applicable to all circumstances could be hit on, we rather doubt. Though it may not be possible to prescribe a general formula which may successfully compose every conflicting situation, the position in law seems clear to us that in applying the two rules to particular transactions, regard must be had to the true legal rights and the true situation. A fair interpretation of the transaction and the situation would lead to a preferable and, if we may say so, a correct solution than sheer adherence to one rule and discounting of the other. At page 720 of the report, the court went on to observe thus: In the course of his argument, learned counsel for the Revenue stated that there must have been entries in the books of the managed company and the managing company in consonance with clause 5 of the managing agency agreement ... We shall proceed on the footing that the assessee-company having followed the mercantile system of account, there must hav ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... kes place some time after the close of the accounting year and that in examining any transaction and situation of this nature, the court would have more regard to the reality and speciality of the situation rather than the purely theoretical or doctrinaire aspect of it and it will lay greater emphasis on the business aspect of the matter viewed as a whole when that can be done without disregarding the statutory language. I may point out that this decision of the Bombay High Court has been fully approved by this court in Birla Gwalior P. Ltd.'s case [1973] 89 ITR 266 (SC). It will thus be clear that even under the mercantile system of accounting whenever adopted, it is only the accrual of real income which is chargeable to tax, that accrual is a matter of substance and that it is to be decided on commercial principles having regard to the business character of the transactions and the realities and specialities of the situation and cannot be determined by adopting purely theoretical or doctrinaire or legalistic approach. If, therefore, for the purpose of determining whether there has been accrual of real income or not, regard is to be had to the business character of the tran ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... n sticky loans merely because it suffers from high improbability of recovery. In the first place, he urged that the Act contains no provision excluding or deducting such interest from the computation of income and the only provision for deduction of debts is to be found in section 36(1)(vii) whereunder debts which are established to have become irrecoverable and bad in the previous year are permitted to be deducted on fulfilment of certain conditions specified in sub-section (2) and, as such, the extension of the theory of real income as sought would entrench upon section 36(1)(vi). Secondly, it was urged that such extension will be ill-advised inasmuch as, if done, it will apply to cases of interest accruing to all money-lenders and not merely to cases of interest accruing to banks and financial institutions. As regards the first objection, the argument amounts to saying that the exclusion or deduction in respect of irrecoverable and bad debts under section 36(1)(vii) read with the conditions mentioned in sub-section (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 the co ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... t on sticky loans is merely hypothetical income and is not real income and is, on that account, to be excluded from the computation of income, I fail to see why the benefit of this principle under the theory of real income should not be available to private money-lenders. The theory of real income must apply to all cases irrespective of who the assessee is. All that is required to be ensured is that like the banks and financial institutions, the money-lenders must also establish to the satisfaction of the taxing authority that the loans in question had in fact become sticky during the concerned year or years by producing proper material and that they have invariably followed the practice of carrying the interest on such loans to Interest Suspense Account instead of crediting the same to interest account or profit and loss account with the additional safeguard of offering the same for taxation if and when it is subsequently realised. It will be pertinent to mention in this connection that the earlier circulars issued by the Central Board of Revenue and the Reserve Bank of India (vide C. B. R. Circular No. 37/54, dated August 25, 1924, No. 41(V-6) D of 1952, dated October 6, 1952, CB ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... e conclusion that there was no real income in respect of items of interest inasmuch as none of the debts due by the several debtors was written off by the assessee and no evidence was produced to show that interest in respect of the debts was given up and, therefore, the two sums were properly includible in the total income of the assessee for the two assessment years respectively. From the judgment, I find that counsel for the assessee sought to apply the doctrine of real income as expounded in Kashiparekh's case [1960] 39 ITR 706 (Bom), to the facts of the case but the High Court declined to do so by adopting a legalistic approach that the assessee had been following the 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 assessee and no evidence was produced to show that interest in respect of the debts was given up. In my view, the High Court failed to appreciate that the method of accounting employed by an assessee merely determined the mode of computing the income and not the range of taxable income and further failed to notice ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... he routes of these two firms having been taken over by the State Transport Corporation, the firms defaulted in making payments of the hire-purchase instalments and consequently the buses were seized. As the assessee-company was advised that there was no prospect of recovering even the principal amount, it did not credit the interest on the outstandings from the two firms even though it was adopting the mercantile system of accounting. The Income-tax Officer, however, included a sum of ₹ 56,163 by way of accrued interest on the amounts outstanding from these two firms. The Appellate Assistant Commissioner deleted the addition. The Tribunal held that the assessee could not have expected to get any interest income on the outstandings found due from the two firms and it would be wholly unrealistic on the part of the assessee to take credit for the interest income and consequently confirmed the Appellate Assistant Commissioner's order. On reference at the instance of the Commissioner, the Madras High Court held that the Tribunal was right in its conclusion that though the assessee had adopted the mercantile system of accounting, no interest income could be assessed in its hand ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... realised subsequently, the same could be brought to tax in the year of realisation. The second question raised for our determination in these appeals relates to the taxability of ₹ 1,66,128 which represents the exchange difference arising on devaluation of the Indian rupee on June 6, 1966, and the question relates to the assessment year 1967-68 only. The facts giving rise to the question are these. Admittedly, the business of the assessee bank included buying and selling of foreign exchange and, therefore, any foreign currency held by it would be its stock-in-trade and if foreign currencies bought at the pre-devaluation rate of exchange were sold at post-devaluation rate of exchange resulting in a surplus, the same would be its business receipt or revenue receipt and, therefore, liable to tax as part of business profits. Indisputably, just before the devaluation of the Indian rupee on June 6, 1966, the assessee-bank held foreign exchange by way of cash balances available with their foreign correspondents, forward contracts, items in transit, etc., amounting to $ 33,780.76 in US dollars and pounds 9552.0.2 in sterling which when converted back to rupees at the post-devaluat ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... -trade in terms of foreign currency that was held by the assessee just prior to the date of devaluation was shown not to have been depleted between the date of devaluation and December 31, 1966 (the end of accounting period), clearly suggested that the stock-in-trade initially held had remained unused and unsold during this entire period, especially when the stock-in-trade held on December 31, 1966, was shown to be higher than the one held just prior to the devaluation date ; and, therefore, it was case of a mere nominal appreciation or book appreciation in the value of the stock and, as such, the same could not be brought to tax. There can be no dispute with regard to the principle that if stock-in-trade remains unused or unsold, the mere book appreciation in the value thereof cannot be brought to tax but on the facts requisite to sustain the proposition, the assessee-bank does not seem to stand on any firm footing. In the first place, by carrying the surplus resulting from the devaluation of the Indian rupee to an account designated Provision for contingencies , the assessee bank itself could be said to have clearly treated such surplus as its business income. Secondly, the Ap ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... this aspect must be dismissed. With regard to the first question, with respect, it is not possible to agree with the reasoning and the conclusions arrived at by Tulzapurkar J. in the judgment. It is necessary for this reason to reiterate in brief the facts relating to the first question. The assessee is a subsidiary bank of the State Bank of India. It used to maintain in the relevant accounting years its accounts on mercantile system ; therefore, entries were made and income and loss were calculated on accrual basis. The assessee in the course of its banking business used to charge interest on advances, including even those which it considered doubtful of recovery and which the assessee termed as sticky advances by debiting the concerned parties but instead of carrying the same to its profit and loss account, credited the same to a separate account called Interest Suspense Account . According to the assessee, the principal amounts of these advances labelled as sticky advances had become not bad or irrecoverable, but extremely doubtful of recovery. In its returns, the assessee had disclosed such interest separately and claimed that the sums were not taxable as income ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... een changed even after receiving directions from the Reserve Bank of India. The Kerala High Court had relied upon certain observations in the Commentary on the Income Tax Act, 1961, by, Kanga, 5th Edn., Vol. I, page 665, wherein the learned author has stated : The assessee cannot escape liability to tax by omitting to make an entry or making a wrong entry in the accounts. The date of taxability of income is the date when the appropriate entries are made or should be made in the accounts in accordance with the method of accounting regularly employed by the assessee. The substantive part of the section makes it clear that the income is to be computed 'in accordance with the method of accounting regularly employed'. The Income-tax Officer may include in the computation of income an amount which does not figure in the accounts but the inclusion of which is required by the assessee's method of accounting; that is to say, the Income-tax Officer, may, without deviating from the assessee's method, make such adjustments in the profit and loss account as are necessary for giving full and true effect to that method itself. Having adopted a regular method of accounting, th ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... es, the Tribunal and the High Court proceeded on well-settled principles pertaining to the mercantile system and took the view that such interest had fallen due and became legally recoverable in accordance with the system of accounting followed during each of the relevant accounting years. In support of the assessee's contention, learned counsel contended before us that what are chargeable to income-tax in respect of a business are profits and gains of that business actually resulting from the transactions of the previous year. It was submitted that even under the mercantile system of accounting, accrual of real income in the commercial sense only was chargeable to tax and this must accrue in substance according to the realities of the situation. It was submitted that if regard is had to the realities of the situation as well as actual commercial principles, it would be evident that in cases of banks, financial institutions and moneylenders, bulk of the income is usually earned by way of interest and as such there cannot be any accrual of real income from interest on doubtful advances or sticky advances and, therefore, the entries made in respect of such accounts in the ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ope of recovery had not been extinguished and the stage for write off had not come. The second circular is one dated October 6, 1952, which is Circular No. 41(V-6) D of 1952 dealing with the subject of bad and doubtful debts-irrecoverable loans or bank interest on such debts. It was indicated therein that when there was unlikelihood of loans being recovered, interest from such loans need not be included in the taxable income if the Income-tax Officer was satisfied that there was really little possibility of the loans being repaid. But an account was to be maintained for future allowances for taxation of recoveries in subsequent assessment years. There is also a letter dated April 16, 1973, from the Under Secretary, Central Board of Direct Taxes, referring to D.O. letter dated March 15, 1973, reiterating that the amounts kept in suspense account under those circumstances would not be taxable. The assessee was, however, required to maintain a systematic method of accounting in respect of doubtful debts subject to checks and counter-checks. By the letter dated November 21, 1973, the Reserve Bank of India wrote that there was no uniformity in the practice followed by the State Financia ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... accrual of income will have to be judged in the light of the provisions of the Act, the principles of accountancy recognised and followed and the feasibility. The earlier circulars being executive in character cannot alter the provisions of the Act. These were in the nature of concessions and could always be prospectively withdrawn. However, on what lines the rights of the parties should be adjusted in consonance with justice in view of these circulars is not a subject-matter to be adjudicated by us and, as rightly contended by counsel for the Revenue, the circulars cannot detract from the Act. The profits and gains chargeable to tax under the Act are those which have been either received by the assessee or have accrued to the assessee during the period between the first and the last day of the year of account and are receivable. Income received or income accrued are both chargeable to tax under section 28 of the Act. The computation of this income is provided for in section 29 of the Act. While we are on the sections, it may be appropriate to refer to section 36 also. Section 36(1) provides for certain deductions from the computation of income and clause (vii) thereof deals wit ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... berty to retain, reimburse and pay themselves out of the funds of the company all moneys expended on its behalf and all sums due to them for commission or otherwise. During the year of account ending March 31, 1942, the assessee had become entitled to a commission of ₹ 2,26,850. On March 30, 1942, the assessee wrote to the company requesting that certain debt, which the assessee owed to the company for a long time past, should be written off. The directors, by their resolution passed on the same date, refused to write off the amount without consulting the general body of shareholders and, pending the settlement of the dispute, resolved to keep the sum of ₹ 2,26,850 in suspense without paying it. The sum of ₹ 2,26,850 was debited as a revenue expenditure of the company and was allowed as deduction in computing the profits of the company for purpose of income-tax. The question was whether in the assessment year 1942-43, the assessee was liable to pay tax on the sum of ₹ 2,26,850. The Tribunal held that the assessee was being assessed on cash basis in previous years, that the income had not accrued to the assessee and that the sum of ₹ 2,26,850 should be ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... secondly, the mercantile system under which a profit and loss account is maintained. At the end of the financial year, the assets and liabilities are valued and entered in the account and the difference between the two is the profit upon which the tax is paid. In CIT v. Sarangpur Cotton Manufacturing Co. Ltd. [1938] 6 ITR 36 (PC), Lord Thankerton, speaking for the judicial Committee, after referring to section 13 of the 1922 Act, which was more or less similar to section 145 of the present Act, observed at page 40 as follows : Their Lordships are clearly of opinion that the section relates to method of accounting regularly employed by the assessee for his own purposes-in this case for the purposes of the company's business-and does not relate to a method of making up the statutory return for assessment to income-tax. Secondly, the section clearly makes such a method of accounting a compulsory basis of computation unless, in the opinion of the Income-tax Officer, the income, profits and gains cannot properly be deduced therefrom. It may well be that, though the profit brought out in the accounts is not the true figure for income-tax purposes, the true figure can be accu ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... pective of the date of payment. For example, when goods are sold on credit, a receipt entry is posted as of the date of sale, although no cash is received immediately in payment of such goods; and a debit entry is similarly posted when a liability is incurred although payment on account of such liability is not made at the time. There may have to be appropriate variations when this system is adopted by an assessee who carries on a profession. Whereas, under the cash system, no account of what are called the outstandings of the business either at the commencement or at the close of the year is taken, according to the mercantile method, actual cash receipts during the year and the actual cash outlays during the year are treated in the same way as tinder the cash system, but to the balance thus arising, there is added the amount of the outstandings not collected, it the end of the year and from this is deducted the liabilities incurred or accrued but not discharged at the end of the year. Both the methods are somewhat rough. In some cases, these methods may not give a clear picture of the true profits earned and certainly not of taxable profits. The quantum of allowances permitted to ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... e was obviously neither accrual nor receipt of income, even though an entry to that effect might, in certain circumstances, have been made in the books of account. This decision and the use of the expression that entry was made of the hypothetical income is often misunderstood in the sense that after the accrual, if the income did not materialise then on the basis of the actuality or reality of the situation, it should not be considered to be income at all. But the significant fact which is often lost sight of is that within the relevant accounting year, viz., April 1, 1947, and December 31, 1947, in November, 1947, the assessee had desired to have the managing agency transferred to two private companies and the subsequent agreement in the following year, viz., December, 1948, was merely fructification or carrying into effect of that desire and as a result of the same, the income did not accrue. That this was the basis for the ratio of the decision of this court would be clear because this court referred to and relied on the decision of the Bombay High Court in CIT v. Chamanlal Mangaldas Co.[1956] 29 ITR 987 (Bom) in this respect. That was also a case of managing agency compa ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... that such a situation did not affect the accrual of the income. This court found that the amounts of income for the relevant years were given up unilaterally by the assessee after these had accrued and it could not escape liability to tax on those amounts. This court reiterated that income accrued when it became due. The postponement of the date of payment did not affect the accrual of income. The fact that the amount of income was not subsequently received by the assessee would not also detract from or affect the accrual of the income although non-receipt may in appropriate cases be valid ground for claiming deduction. This court reiterated that the mercantile system of accounting differed substantially from the cash system of book-keeping. Under the cash system, it was only actual cash receipts and actual cash payments that were recorded as credits and debits ; whereas, under the mercantile system, credit entries were made in respect of the amounts due immediately they became legally payable and before they were actually received. Similarly, the expenditure items for which legal liability had been incurred were immediately debited even before the amounts in question were actually ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... managing agent would have a right to receive would not be affected by the manner in which the entry was made. The existence of the right to receive, i.e., accrual, is important and that is a matter of the reality of the situation keeping the terms and conditions and the conduct of the parties. In Kashiparekh's case [1960] 39 ITR 706, the Division Bench of the Bombay High Court dealt with an assessee-firm which had maintained its accounts on the mercantile system. The assessee was the managing agent of a paper mill company. Under the managing agency agreement, it was under a duty to forgo up to one-third of its commission where the profits of the managed company were not sufficient to pay a dividend of 6 per cent. For the accounting year ending on December 31, 1950, the assessee had earned a commission of ₹ 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 ₹ 97,000 in December, 1950. The Appellate Tribunal held that the maximum amount the assessee was bound to forgo was only ₹ 39,215 and included the balance of the amount forgone, viz., ₹ 57,785, in the taxable income. The Tribun ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... of accounting. There, the accounting year was ending March 31, 1950. For the account year March 31, 1950, the assessee had earned commission but as a result of resolutions passed, the assessee company gave up ₹ 97,000 in December, 1950. The question involved was, whether the accrued interest in the accounting year could be given up subsequently or not. Now, looked at from the proper perspective, the court was of the view, as we read it, that the right to the commission arose under the managing agency agreement. Under the agreement, there was a duty to forgo up to one-third of the commission where profit of the managed company was not sufficient to pay a dividend of 6 per cent. It is in the peculiar situation arising out of the managing agency agreement that subsequently a sum of ₹ 97,000 was given up in December, 1950, for the assessment year ending on March 31, 1950. In this context, the fact of surrender and the concept of real income must be viewed. It was really to implement the obligation under the managing agency agreement that the giving up took place. Therefore, the accrual of commission, the making of the accounts, the legal obligation to give up part of th ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... date for payment of the commission was stipulated in the managing agency agreement. The accounting year of the assessee as well as the managed companies was the financial year. The respondent gave up the managing agency commission from both the managed companies, for the assessment years 1954-55 to 1956-57, after the end of the relevant financial years but before the accounts were made up by the managed companies. This court emphasised that as the managing agency commission receivable could have been ascertained only after the managed company had made up its accounts and the assessee had given up the commission even before the managed company made up its accounts, and no date had been fixed in the agreement for the payment of the commission, the mere fact that the respondent was maintaining its accounts on the mercantile system did not lead to the conclusion that the commission had accrued to it by the end of the relevant accounting year. The commission given up by the respondent could not be considered to be its real income. It is clear that the fact of the case was that the managing agency commission receivable by the assessee could have been ascertained only after the managed c ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... up. The High Court, therefore, held that there was no giving up and these incomes were assessable. I am in respectful agreement with the conclusion of the Bombay High Court. In the instant case before us, the facts are still worse. The assessee has not only not written off, but it is still treating loans as alive by keeping them in the suspense account. Kantawala J., as the Chief justice then was, followed the correct principle therein after considering Kashiparekh's case. The principles enunciated therein are in consonance with the decision of the Calcutta High Court in James Finlay Co. v. ClT [1982] 137 ITR 698, where all these relevant authorities including Kashiparekh's case [1960] 39 ITR 706 (Bom) as well as Birla Gwalior P. Ltd.'s case [1973] 89 ITR 266 (SC), have been discussed and analysed. In that case, the accounts of the assessee company for the year 1970-71, included an amount of ₹ 8,264 from B G and ₹ 55,920 from S. P. Ltd. receivable as interest. The interest due from B G were on advances made in 1966 and that from S. P. Ltd. were on advances made in 1965. The assessee was following the mercantile system of accounting and the Income-tax Off ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... fore. The concept of reality Of the income and the actuality of the Situation are relevant factors which go to the making up of the accrual of income but once accrual takes place and income accrues, the same cannot be defeated by any theory of real income. Reference may be made to Calcutta Co. Ltd. v. CIT [1959] 37 ITR I (SC). Three decisions, two of the Madras High Court and one of the Punjab and Haryana High Court, which shall presently be noticed, were pressed into service on behalf of the assessee to suggest that the concept of real income can be so applied as to make, where the chances of realisation of accrued income are less, it non est. In CIT v. Motor Credit Co. Ltd. [1981] 127 ITR 572 (Mad), the assessee, a private company, was carrying on business as financier for purchase of motor vehicles on hire purchase. It advanced under hire-purchase agreements monies to two firms which were plying buses. The routes of these two firms having been taken over by a State Transport Corporation following nationalisation, the firms defaulted in making payment of the hire-purchase instalments, and, consequently, the buses were seized. As the assessee-company was advised that ther ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... istribution rights of the picture in certain areas in Karnataka State. The assessee agreed to advance a sum of ₹ 2,80,000. Under the agreement, the assessee as distributor could deduct the commission and appropriate the balance towards the discharge of the amount advanced to the producer and after the advance was completely adjusted, the distributor had to remit to the producer the realisations after deducting the commission. The distribution commission was to be calculated at 35% of the net realisation on the picture. The producer undertook to complete and deliver the prints for the release of the picture failing which the producer undertook to pay damages together with interest for the amount received at 12% per annum from the date of default to the date of delivery of the prints and also provided certain sum for certain contingency. It is not necessary to set out in detail the further facts. It was held that the assessee was in a position to realise only ₹ 3,47,000 approximately during the three years in question as against a total sum of ₹ 4,37,828 incurred as the cost of production. The Tribunal was justified, in the High Court's view, that having regard ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... omputation of income for the purpose of taxation is difficult to evolve. Besides, any strait-jacket formula is bound to create problems in its application to every situation. It must depend upon the facts and circumstances of each case. When and how does an income accrue and what are the consequences that follow from accrual of income are well-settled. The accrual must be real taking into account the actuality of the situation. Whether an accrual has taken place or not must, in appropriate cases, be judged on the principles of real income theory. After accrual, non-charging of tax on the same because of certain conduct based on the ipse dixit of a particular assessee cannot be accepted. In determining the question whether it is hypothetical income or whether real income has materialised or not, various factors will have to be taken into account. It would be difficult and improper to extend the concept of real income to all cases depending upon the ipse dixit of the assessee which would then become a value judgment only. What has really accrued to the assessee has to be found out and what has accrued must be considered from the point of view of real income taking the probability or ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... certainly is a well-accepted one and must be applied in appropriate cases but with circumspection and must not be called in aid to defeat the fundamental principles of the law of income-tax as developed. For the reasons aforesaid, with respect, it is not possible for me to agree with the answer proposed by my learned brother, Tulzapurkar J., on the first question. In the premises, question number (1) should be answered in the affirmative and in favour of the Revenue and question number (2) must also, in respectful agreement with my learned brother, be answered in the affirmative and in favour of the Revenue. The appeals, therefore, must fail and are dismissed. But in view of the facts and circumstances of these cases, parties will bear their own costs throughout. RANGANATH MISRA J.-I have had the advantage of reading the two separate judgments by my learned brethren, Tulzapurkar and Mukharji JJ. I am in agreement with both of them that the second question had been correctly answered in favour of the Revenue by the High Court and the appeals are to be dismissed on affirmation of that conclusion so far as that aspect is concerned. In regard to the answer proposed for the ..... X X X X Extracts X X X X X X X X Extracts X X X X
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