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

STATE BANK v. C.I.T. [TULZAPURKAR, J,] 65

that on principle such interest being hypothetical cannot be brought to tax it ts unnecessary to deal with the earlier Circulars of the Central Board of Revenue and the Reserve Bank of India all of which were in the nature of concession granted to an assessee according to counsel fo_r the revenue. 1 Having regard to the above discussion i.t is clear that the three sums representing interest on sticky advances in the instant case being hypothetical and not real income of the assessee could not be brought to tax for the three concerned assessment years and we answer the first question in the negative in favour of the assessee and against the. revenue. Of course it goest without saying that if and when these SUlllS or any part thereof- are realised subsequently the same could be brought to tax in the year of realisation. c The second question raised for our determination in these appeals relates to the taxability of Rs •. 1,66,128 which represents the exchange difference arising:' on devaluation of the Indian Rupee on August 6, 1966 and the question relates to the assessement year 1967-68 only. The facts giving rise to the question are these. Admittedly the . business of the assessee-bank included buying and selling of foreign exchange and therefore any foreign currency held. by it would be its · stock-in-trade and if foreign currencies bought ·at the 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 August 6, 1966 the assessee-bank held foreign exchange by way of cash balances available with their foreign correspondents, forward contracts, items in transit etc., amounting to L-33,780,76 in US Dollars and L-9552.0.2 in Sterling which when converted back to Rupees at the post devaluation rates gave rise to a profit of 57.5% or Rs. 1,66,128 in the transaction; the assessee-bank·credited thiS surplus to an account designated "Provision for Contingencies". It was contended on behalf of the assessee before the lower taxing authorities that this profit should not be taxed as it was of a casual and non- G recurring nature. 'nle contention was negatived by the authori- ties on the ground that even assuming, without conceding, that it was a windfall and, therefore, of a casual nature the same had arisen from the business activities of the assessee-bank and, therefore, was not exempt but was liable to tax. Before the Appellate Tribunal an attempt was made by counsel for the H assessee-bank to contend that the cash balance in terlllS of

66 SUPREME COURT REPORTS (1986] 1 s.c.R. A

dollars and sterlings at the end of the accounting period, i.e., on December 31, 1966 was higher than that as existed on the crucial date, namely, August 6, 1960 and, therefore, this precluded any inference that the stock of dollars and ster- lings that existed on the devaluation date had been converted B into Indian currency thua resulting in profits. The Tribunal rejected the contention as being without force inasmuch as the assessee-bank had revalued the cost of foreign exchaiige in terms of rupees as on the date of devaluation to bring it on par with the post-devaluation rate by giving a corresponding credit to the "Provision for Contingencies" thus treating the c surplus resulting from the fluctuation of exchange rate as its income and the mere fact that the same had been carried to the account style·"Provision for Contingencies" did not alter the true character of the transaction. The High Court confirmed the ultimate conclusion of the Tribunal by answering the relevant question referred to it in favour of the Revenue. D Counsel for the assessee fairly conceded two positions arising in the case. In the first place he conceded that foreign exchange was held by the assessee-bank as its stock- in-trade and he further conceded that any sale of such stock- in-trade must result in business income but he urged that if the stock-in-trade remains unused and unsold its notional appreciation or book appreciation in value does not result in taxable profit (vide C.I.T. v. ll!ghal Line Lt:d. 46 I.T.R. 590, arid according to him thl.s is what had happened in the instant case. According to counsel the fact that the stock-in-t·rade 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 sotck-in-tr.ade held on December 31, 1966 was shown to be higher. than the one held just prior to the devaluation date; and therefore it was G a case of a mer.e nominal appreciation or. book appreciation in the value of the stock and as such the same could not be brought to tax. There can be no dispute with regard to the principle that if the stock-in-trade remains unused or unsold the mere book appreciation in the value thereof cannot be brought to tax but on the facts requisite to sustain the pro- H position the assessee-bank does not seem to stand on any firm footing. In the first place by carrying the surplus resulting

STATE BANK·v. C.I,T. [SABYASACHI MllKHARJI, J, J 67 A from the devaluation of the Indian rupee to an account desig- -1, nated "Provision for Contingencies" the assessee bank itself could be said to have clearly treated such surplus as its business income. Secondly, the AAC in his appellate order has recorded a categorical finding that the stock in trade in terms of foreign currency was sold and used by the assessee in B its normal banking business. This is what the AAC has observed:

''What is important is that the profit on account of the difference in exchange rate should have arisen in the course of trading operationa of the bank. There is no dobut that it did so arise in ·the instant case. The bank acquired and sold the c foreign exchange assets in course of its normal banking business and therefore, the profit arising out of the fluctuation in exchange rates, however, large and however unexpected any particular fluctu- ation may be, arose in the course of and incidental to such business of the bank." Having regard to the aforesaid factual position I confirm the High Court's view that the second question has to be answered in the affirmative in favour of the Revenue and against the assessee. In the result I would allow the appeals in so far as the first question is concerned and dismiss the same as regards the second question. In the circumstances there will be no order as to costs. SABYASACHI MllKHARJI,J. These appeals by certificate arise from the decision of the High Court of Kerala in respect of the assessment years 1965-66, 1966-67 and 1967-68 relating to the previous ·calendar year 1964, 1965 and 1966 respectively. " The following two questions are involved in these appeals:

(1) Whether, on the facts and in the circumstances of the case, the addition of the sums of Rs.67,170. Rs, 47,777. and Rs. 57,889 representing interest on G 'sticky' advances as income for the assessment years 1965-66, 1966-67 and 1967-68 respectively was justified in law?

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

68 SUPREME COURT REPORl'S [19861 i s.c.R• .A 1,66,128 arising on revaluation of the Indian rupee on 6. 6.1966 was rightly treated as income of the assessment year 1967-<>8? In view of i:he categorical findings of fact recorded by the Tax au.thorities and the Tribunal and mentioned in the jildgment of tulzapurkar, J., I am in respectful agreement with B the opinion of tulzapurkar, J. that the High Court was right 4nd the ·second question lllU8t be answered in the· affirmative and .in favour of the revenue, and the appeals on this aspect must be'd1Bliitssed. With. regard· to the first question, with respect, it is not paaiible to agree with 'the reasoning and the conclusions c arrived at by tulzapurkar, J., in the judgment. It is necesary for tlite reason to re.iterate in brief the facts relating to the first que~tion. The assessee is a subsidiary bank of the State ·ililik of India. It used to maintain in the relevant accounting years its accounts in mercantile system; therefore, entries ifare made and· income and loss were calculated on D acerual bBsis. The assessee in the course of its banking buaine~s \Hied to charge interest on advances, including even those '1!Uch it con1idered cioubtful of recovery and which the allaesa..e tenied as i1ticky advances' by debiting the concerned pat~i·~· Ii~~ 'in atead of carrying. the sama to its 'Profit & toa& Account' , credited the same i:-o. a aeparate acccount called E 'lnt.erest S11Spense Acc!luii:t '. Accord~ng ·co the aStlessee the principal amounts of theae . adVlli:tceli label.led as 1 sticky advances' had become not :bed or irre.:.averable, but extremely doubtful of recovery. In its ret•1rns the assessee had disclos- e! silch inter~ata separately and claimed that the SUlllS were not taxable as income of the concerned years. In view of the F · relev~t y!Jar.• ~nvolyed, tba 'iue&tion must be considered in ,. thfi lisht iif the provisiona of tlte Income ?ax Act, 1961 (here- inafter called the : 'Act');> . Blifor~ the taxing Officera, the Tribunal and the High Gourt .~ .the aaaeHee 'e, contention waa that having regard to bad alld deterl.oratina financial conditions of the parties conaernad •• llell .as history of their accounts. the recovery of even the prilleipal debts ha~ become improbable and doubt- ful, the~eby makinil these loans or advances as the assessee called 'sticky' and, as such interest on these though debited t.o the respective debtors was taken to 'Interest Suspense H Account'. 'lh.is 1 according to the assessee, became necessary •

STATE BANK v. C.I.T. [SABYASACHI MUKHARJI, J.] 69

A to avoid showing inflated profits by including hypothetical and unreal income and, such income, according to the assessee, was not his real income. It was· contended by the assessee that the said sums namely the interest on the so called 'sticky' loans was not taxable in its hands. This. contention was, how- ever, rejected by the Income-tax authorities as well as the B High Court. The following were the grounds for such rejection: (a) The assessee was following the mercantile system of accounting; such interest, therefore, had accrued to the assessee at the end of the account- ing year. c (b) The assessee itself had treated such income as accrual of interest by charging the same to the parties concerned by making debit entries in their tespective accounts•

---<: · It was pointed out that if any part of these debits had D later on ·become irrecoverable in any year, the assessee could have, in that year, treated the . same as such and claimed deduction under section 36(l)(vil.) of the Act. Reliance was placed by the High Court on an earlier decision of the same High Court in the case of CatbOllc Bank of India (In liqui- dation) vs. Cocimissioner of 1--'?ex, lerala, Emalml . . ., E [1964] K.L.T. 653 ~ [1965] 1 I.T. Journal 355. In that case in spite of the directions issued by the Reserve Bank of India to the assessee bank not to carry interest of such sticky advances to 'Profit and Loss Account' and also in.spite of the fact, that the assessee bank in pui:susnce of these directions '\ omitted their interest from its 'Profit and Loss Account', the F court took the view that such interest was taxable as income in the hands of the assessee l>ank because the mercantile system of accounting had been.regularly followed by the bank and that had not been changed even after receiving directions from the Reserve Bank of India, The Kerala High Court had relied upon certain observations in the commentary on the G Income Tax Act, 1961, by Kanga, 5_th Edn. Vol. I, page 665 wherein the learned author has stated:

"The a_asessee cannot escape liabl.lity to. tax by omit~ing to make an entry or making a wrong entry in tlie acccounts•; The date of. taxability of income H

70 SUPREME COURT REPORTS [1986] I S.C.R. A

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' B in according with the method of accounting regular- ly 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 ac~ounting; that is to say., the Income-tax officer may without c deviating from the assessee's method, make such adjustments in the profit and loss account as are necessary for giving full and true effect. to that method itself. Having adopted a regular method of accounting, the assessee cannot be allowed to change it or depart from it for a particular year or for part of the year or in respect of particular transactions." The High Court. of Kerala was of the view that the facts of the instant case out of which these appeals arise being the same as those in Catholic Bank's case except that there was a direction from the Reserve Bank of India to Catholic Bank, E which is absent in the instant case before us, the same con- clusion must follow. In the opinion of the High Court, the presence or absence of such direction from the Reserve Bank was not determinative of the question. There was accrual of income to the assessee considering the fact that the assessee had been following the mercantile method of accounting which had been regularly adopted by the assessee and accepted by the taxing authorities. The High Court l.n that view of the matter 7· answered the question in favour of the revenue. For subsequent years 1968-69 in respect of the same asses see, an identical view was reiterated by the said High Court in the ~ssessment year 1968-69 as reported in 110 I.T,R. 336. The correctness of this view is under challenge in these appeals before us. The assessee indubitably maintained its accounts on mer- cantile basis and had regularly adopted it. The assessee claimed that the three sums represented interests on what it called 'sticky' loans in its books of account but having regard to the deteriorating financial position of the concern- ..,, H ed debtors and the history of these accounts, the assessee was of the view that in the relevant years the advances had become

STATE BANK v. C.I.T. [SABYASACHI MUKHARJI, J.] 71

A so 'sticky' that even the recovery of the principal amounts had become highly improbable and extremely doubtful. There- fore, though the assessee charged such interests by debiting the concerned parties (emphasis supplied) yet it credited the said amounts to a separate account styled as 'Interest Suspense Account' • This the assessee claimed on the theory B that it was to avoid showing unreal or inflated profits. The assessee claimed that it was not taxable as real income had not accrued to it. It was, however·, disallowed on the ground that the advances had not been treated as irrecoverable or bad debts in terms of section 36(l)(vii) of the Act. In coming to the conclusion that these sums were taxable, the taxing authorities, the Tribunal and the High Court proceeded on c 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 account- ing 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 6£ a business, are profits and gains of that business actually resulting from the transactions of the previous year. It was submitted that even under the mercantile system of accounting accrual or "real income" in the commercial sense only was chargeable to tax and this mst acc·rue in substance according to the realities of the situation. It was submitted that if regard is had to realities of the situation as well as the actual commercial principles, it would be evident that in '' cases of banks, financial institutions and money-lenders bulk of the income is usually earned by way of interest and as such there cannot be any accrual of real income from interest on doubtful advances or sticky advances and, therefore, the entries made in respect of such accounts in case of all such traders following the mercantile system of accounting only reflected hypothetical income which does not materialise in income. It was submitted that, therefore, it was proper to carry such interest to 'Interest Suspense Account' as carrying the same to 'Profit and Loss Account' would amount to showing an unreal and inflated prof.it and thereby lead to imp~oper and illegal distribution or remittances thereof. Therefqre, the question, ls, whether on the theory of real income, interests which had accrued legally to an assesse~ - in this case banking institution following the mercantile system of accountancy can be kept out of the net of H

72 SUPREME COURT REPORTS [1986] 1 s.c.R.

A taxation. How far does the concept of real ·income defeat accrual of income in any particular case according to the well-recognised theory of accounting principles which are accepted by the legal standards so far followed? In this country, by and large, two systems of account keeping are followed - one is the cash and the other, mercan- B tile. .Plainly speaking, the cash system postulates actual receipt of money; and for exigibili ty of income tax, such receipt from buainess, profession or vocation or from other sources has to be actual in the relevant year of account. The mercantile system, on the other hand, is one where accounts are maintained on the basis of entitlement of credit and/or c debit. A sum of nx>ney, as soon as it becomes payable, is taken into account without reference to actual recceipt and a debit becomes admissible when liability to pay is created even though the sum of nx>ney l.s yet to be paid. Several circulars issued by the Central Board of Taxes were placed before ua in course of the hearl.ng. One such was D C.B.R, Circular No. 37/54 dated 25th August, 1924. There the Central Board had aaid that it accepted the conclusion reached at the Conference of Income-tax Commissioners held l.n August, 1924 that if a money-lender who kept hl.s accounts on the ~ommercial system maintained a suspense account in which he entered loans which in his opinion were extremely unlikely to be recoverable though he did not yet wish actually to write them off, interest accruiiig on such loans need not be included in the assessee' s taxable income, if the Income-tax officer was satisfied that there was little provabl.lity of recovery of the loan. This was obviously on the footing .that the last ray of hope of recovery had not been extinguished and the stage for write off had not come. The second circular is one dated 6th October, 1952, which is Circular No. 41(V-ii)D of 1952 dealing with · the subject of bad and doubtful debts - irre- coverable loans or bank interest on such debts. It was indica- ted therein that when there was unll.kelihood of loans being revcovered, inter.eats from such loans need not be included in ·G the taxable income if the Income-tax Officer was satisfied that there was really little possl.bility 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 dsted 16th April, 1973, from the Under Secretary, Central Board of Direct Taxes referring to H D.O. letter dated 15th March, 1973 reiterating that the

STATE BANK v. C.I.T. [SABYASACHI MUKllARJI, J.] 73

A .C. amounts kept ip suspense account under those circumstances would not be taxable. The assessee was, however, required to maintain a systematic method of accounting i.n respect of dobutful debts subject to checks and counter-checks. By the letter dated 21st November, 1973, the Reserve Bani< of India wrote that there was no unif orml.ty in the practice followed by B State Fi.nancl.al Corporati.ons on sticky loans wehre the same position was reiterated. A letter was written ·on 20th June, 1978, by the Ce.ntral Board of Direct Taxes to the Coonnissi.oner of Income-tax soon after the decision rendered in the assessee's case i.n 110 I.T.R. 336 referred to hereinbefore. In that letter. reference was made to the previous circulars and it was pointed out that the stand taken in these cl.rculars was c not acceptable to the Revenue Audit Department and i.t had objected to the exclusion of such amounts of interest from the total income. The Board advised that where accounts were kept on mercantile basis, interest was taxable irrespective of whether the same was credited to suspense· account or to interest account .. Reference was· made to the decision of the D ·-< Kerala High Court in 110 I.T.R. 336 which has been followed in the instant case. The Central Board, therefore, di.rected that such interests should be i.ncludible in the taxable income, and all pending cases should be disposed of keeping the present instructions in view. It was. further directed that immediate review should be undertaken under sectl.on 147(b) or sectin 263 E of the Act in respect of assessments which had been completed in accor.dance with the Board's earli.et directions. In the last letter., the same position was reiterated but :1.t was further clarified as to future course of action. In these appeals we are not concerned with the actual effect of these Circulars and these need not be set out .and examined. F Several financl.al institutions sought to Intervene as the question involved herein i.s of some importance to them. We have allowed them to make their submissions and taken them into consideration. It was urged that the Instructions contained in these circulars noted before were in consonance with the accepted prl.nciples of accountancy and these Instruc- G tions have held the field for over 53 years. It was also submitted that as such claims have been allowed to be exempted for more than half a century, and the pract:l.ce had tr.ans formed itself into law, this posi.tion should not have been deviated from. This submi.ssion, of course, cannot be accepted. The question of how far the concept or real income enters J.nto the H question of taxability in the facts and cir.clllDStances of thi.s

74 SUPREME COURT REPORTS [1986] l s.c.R. A case and how far and to what extent the concept of real > income should inter-ntl.ngle with the accrual of Income will have to be judged J.n the light of the provisions of the Act, the principles of accountancy recognised and followed and the feasibl.lity, The earlier circulars being executive in character cannot alter the provisl.ons of the Act. These were B in the nature of concessions ~nd could always be prospectively withdrawn.. However, on what lines the r:f.ghts of the parti.es should be adjusted in consonance with justice J.nview of these cJ.rculars is not a subject matter to be adjudJ.cated by us and - as rightly contended by counsel for the revenue, the cl.rculars cannot detract from the Act. c 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 durl.ng the period between the fl.rat 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 D provl.ded for J.n sectJ.on 29 of the Act. WhHe we are on the sections, it may be appropriate to refer to section 36 also. >- Section 36(a) provides for certain deductions from the compu- > tation of income and sub-section (vii) thereof deals with bad debts in these terms:

E "(vii.) subject to the provl.sions of sub-section (2), the amount of any debt, or part thereof, which is establi.shed to have become a bad debt J.n the previous year."

Section 36(2) prescribes the conditions to be satisfied for earning deduction for a bad debt. There J.s no dispute in these appeals ·that such conditi.ons ar.e not satisfied. )' Section 56 of the Act deals with 1.ncome from other sources and sectl.on 57 deals with deductions in computation of income from other sources. Section 145 deals with the method of accountl.ng, Sub-sectl.on (1) of the sal.d sectl.on provides that income chargeable under the head "ProfJ.ts and gaJ.ns of business or profession" or "Income from other sources" shall be computed l.n accordance wl.th the method of accounting regularly employed by the assessee. The provl.so Jn certain eventuali.tl.es perml.ts the Income-tax Offl.cer to adopt the mode for computatlm; of income. SJ.mliar too J.s the positi.on of >' H sub-section (2).

STATE BANK v. C.l.T. [SABYASACHI MUKHAR.JI, J.] 75

A It is settled that the income of the assessee will have, to be determined according to the provisions of the Act in consonance with the method of accountancy regularly employed by the assessee. The method of accounting regularly employed by the assessee helps computation of income, prof its and gains under section 28 of the Act and the taxability of that income B under the Act will then have to be determined. The question, is, whether the income which has been computed according to the method of accounting followed regularly by an assessee can be diminuted or diminished by any notion of real income. This has to be judged in the light of the well-settled principles. In Conlmissioner of Income-tax, Madrast v. K.R.M~T.T. Thiagaraja Chetty & Company, 24 l.T.R. 525,. this Court as early as 1953 reiterated that once the Slllll of Rs. 2,26,850 in c that case was arrived at as income that had accrued to the assessee, it did not cease to be the income by reason of the fact that it was carried to the suspense account by a resolu- tion of the directors and that it was, therefore, ·assessable ---\ to tax. The assessee firm therein was a managing agent of a D limited company. Under the managing agency agreement the assessee was entitlted to a certairi mOnthly remuneration - a commission of ten per cent on the net profits of the company and a ~mall percentage on sales and purchases. The agreement further provided that the assessee was at liberty to retain, reimburse and pay themselves out of the funds of the Company E all moneys expended on its behalf and all sums due to them for commission or otherwise. During the year of account ending 31st March, 1942, the assessee had become entitled to a commission of Rs. 2,26,850. On 30th March, 1942, the assessee wrote to the company requesting that a certain debt, which the '( assessee owed to the company for along time past, should be written off, The directors.by their resolution, passed on the same debt, refused to write off the amount without consulting the general body of shareholders and pending the settlement of the dispute resolved to keep the sum of Rs. 2,26,850 was debited as a revenue expenditure of the company and was allowed as deduction in computing the profits of the company for the purpose of income-tax. The question was whether in the assessment year 1942-43, the assessee was liable to pay tax on the sum of Rs. 2,26,850. The Tribunal held that the assessee was being assessed on cash basis in previous years, that the income had not accrued to the assessee and that the sum of Rs. 2,26,850· should be excluded from taxation as not having H .been received in the accounting year. The High Court came to

A 76 SUPREME COURT REPORTS [19861 i s.c.R.

the conclusion that there was no mated.al for the 'rrl.bunal' s finding that the assessee was being assessed on cash basl.s in the previous years but held (Satyanarayana Rao, J,, confl.rming the decisi.on of the Appellate Trl.bunal; VJ.swanatha Sastrl., J., l! contra) that the sum of Rs. 2,26,850 was not liable to tax, inasmuch as it was not Income of the assessee whi.ch had accrued or arl.sen in the accountl.ng year. Thl.s Court J.n appeal held that the llJ.gh Court was d.ght J.n its conclusl.on that there was no mated.al for the Trl.bunal' s fl.nding that the assessee was beJ,ng assessed on cash basi.s on the sums c mentl.oned whl.ch had accrued to the assessee and J.t did not cease to be Income. In thl.s connectl.on, this Court at page 531 of the Report referred to the observati.ons of VJ.swanatha Sastrl., J, wherei.n the learned judge had stated: "The sum had Irrevocably entered the debl.t sl.de of the company's account as a disbursement of managl.ng agency commJ.ssi.on to the fl.rm and D had been approprfated to the fl.rm' s dues and same could not agai.ri be entered i.n a suspence account at a later date. The sum, therefore, belonged to the fl.rm and had to be Included i.n the computatl.on of the prof! ts and gal.us that had accrued to J.t unless the flrm had regularly kept j ts accounts on a cash basi.s, wh:J.ch i.s not the case here." E Thl.s problem may be better looked into J.f the questl.on of dl.fference between the mercantl.le system and cash system J.s examined J.n a Uttle detal.l. Si.r Courtney Terrel, C,J, dell.verl.ng the judgment of the Patna High Court l.n lllakeshwar Prasad Narain Singh v. Commissioner of Income Tax, llihar & OrJ.ssa, 4 I. T.R. 71 at F 74., noted the difference between the two methods of account- ing for Income, prof!. ts and gal.ns of busi.ness. The learned Chl.ef Justice observed at page 74 of the report: "Now, there are two methods of accounti.ng for the income, profl.ts and gal.ns of a busl.ness whl.ch are generally referred to as the cash basJ.s and the G mercantl.tle basl.s. Accordl.ng to the former a record J.s, as J.n thl.s case, kept of actual recel.pts and actual payments, entri.es bei.ng made only when money J.s actually collected or dl.sbursed and J.f the pr.ofi.ts of the business are accounted for i.n thi.~ way the tax J.s . payable on the dl.fference between II the recel.pts and the dl.sbursements for the perl.od J.n questl.on. There J.s, secondly, the mercantl.le

STATE BANK v. C.I.T. [SABYASACHI MUKHARJI, J.] 77

system under whl.ch a profi.t and loss account is maintai.ned. At the end of the fi.nancjal year the assets and li.abiliti.es are valued and enter.ed in the account and the dl.fference between the i:wo is the proHt upon which the tax is paid." B The Coamissioner of Income Tax, Bombay v. Sarangpur Cotton Manufacturi.ng Co. Lt:d., 6 I. T.R. 36. Lord Thankerton, speaking for the Judi.cial Commi.ttee after referring. to secti.on ·~ .\ 13 of 1922 Act whi.ch was more or less similar to secti.on 145 of the present Act observed at page 40 as follows: "Thei.r Lordshi.ps are clearly of opini.on that the secti.on relates to a method of accounti.ng reglllarly c employed by the assessee for his own purposes - in thl.s case for the purposes of the Company's business - and does not relate to a method of making up the statutory return of assessment to income-tax. Secondly, the secti.on clearly makes sucha method of accounting a compulsory basis of D ·" computation. unless i.n the opini.on of the Income-tax Offi.cer, the income, proHts and gains cannot properly be deduced therefrom. It may well be that, though the profi.t brought out in the accounts i.s not the true fi.gure for income-tax purposes the true Hgure can be accurately deduced therefrom. E The simplest case would be where it appears on the face of the accounts that a stated deductl.on has been made for the pur.pose of a reserve. But there may will be more complicated cases in whl.ch never- theless, it is possible to deduce the true profi.ts from the accounts, and the judgment of the Income- F ·~. tax OfHcer under the proviso must be properly exerci.sed. It is misleading to describe the duty of the Income-tax Officer as a discretionary power." Iqbal Ahmad, C.J. has aptly descri.bed in Coolllissioner of Income ·rax v. Shrimat:i Sini!arl Bai, 13 I.T.R. 224, the mercan- ti.le system of accountancy and has _observed at page 227 of the G report as follows:

"The distingui.shi.ng feature of this method of accountancy is that i.t bri.ngs into credi.t what is due immediately i.t becomes legally due and before it is actually received; and it bri.ngs into debit H

78 SUPREME COURT REPORTS [1986] 1 s.c.R.

A expenditure the amount for which a legal liability has been incurred before it is actually disbursed. The 'mercantile accountancy system' _is the opposite of the 'cash system' of book-keeping' under which a recordis kept of actual .cash receipts and actual cash payments, entries being made only when money B is actually collected or disbursed." In Commissioner of Income.-Tax 9 Madras v. A. ICrl.slmaswaml Mudaliar and Others, 53 I.T.R. 122, this Court had to refer to the distinction between mercantile system and cash system. r Referring, however, to the relevant section appropriate to ,•'

section 145 of the present Act, this Court observed that the c section did not compel the Income-tax Officer to accept a balance-sheet of cash receipts and outgoings prepared from the books of account: it was for him to compute the income in accordance with the method of accounting regularly employed by the assessee. Referring to the prevalent system of book-keep- ing in India, Shah, J. speaking for this Court observed at D pages 129-130 of the report as follows: "Among Indian businessmen, as elsewhere, there are current two principal systems of book-keeping. There is, firstly, the cash system in which a record is maintained of actual receipt and actual disbursements, entries being posted when money or E 100ney's worth is actually received, collected to disbursed. There is, secondly, the mercantile system, in which entries are posted in the books of account on the date of transaction, i.e., on the date on which rights accrue or liabilities are incurred, irrespective of the date of payment. For F 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 G may have to be appropriate var.iations 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 colllllencement or at the close of the year is taken, according to the mercantile H method actual cash receipts during the year and the

STATE BANK v. C.I.T. [SABYASACHI MUKHARJI, J.] 79

, A actual cash outlays during the year are treated in the same way as under the cash system, but t0 the balance thus arising, there is added the amount of outstandinge not collected at the end of the year and from this is deducted the liabilities incurred or accrued but not discharged at the end of the B 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 tax- able profits. The quantum of allowances permitted to be deducted under diverse heads under section 10(2) from the income, profits and gains of a business would differ according to the system c 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 pai<! or incurred according to the method of accounting upon the basis of which the prof its or gains are computed under section 10. Again where the cash system is adopted, there is no question of bad debts or outstanding at all, in the case of mercantile system against the book profits some of the bad debts may have to be set of when they are found to be irrecoverable. Besides the cash system and the mercantile system, there are innumerable other systems of accounting which may be called hybrid or heterogeneous - in which certain elements and incidents of the cash and mercantile systems are combined. 11 For the content of the taxable income, one has to refer v to the substantive provisions of the Act, mainly section 5 of F 1 the Act read with other relevant sections. In Commissioner of Income-Tax, Bombay City I v. lless:rs. Sboorji Vallabhdas and Co., 46 I. T.R. 144, this Court discussed the concept of real income. There the relevant fact was that before the close of the relevant accounting year which was from 1st April, 1947 to 31st December, 1947, in G November, 1947 the 'assessee had desired to hRve the managing agency transferred· to two private companies _and this was transferred by a subsequent agreement after the c.lose of the year. The assessee in that case in fact received only the lesser amount in spite of the entries in the account books, and it was held that this lesser amount alone was taxable. It H

80 SUPREME COURT REPORTS [1986] 1 s.c.R. A was reiterated by Hidayatullah J, as the learned Chief Justice ,~ then was, that income-tax is a levy on income and the Income- tax Act took into account two points of time at which the liability to tax was attracted viz., the accrual of the income or its receipt; yet the substance of the matter was income. If income did not result at all, there could not be any tax, even B though in book-keeping, an entry was made about a "hypotheti- cal income" which did not materialise. Where income has, in fact, been received and is subsequently given up, in such r circumstances that it remains the income of the recipient, even though given up, the tax might be payable. Where, how- ever, the income can be said not to have resulted at all, c there was obviously neither accural nor receipt of income, even though an entry to that effect might, in certain circum- stances, have been made in the books of account. This decision and the use of the expression that entry of the ;hypothetical income' is often misunderstood in the sense that after the accrual if the income did not materialise thefi on the basis of D the actuality or reality of the situation it should not be >- considered to be income at all. But the significant fact which is often lost sight of is that within the relevant accounting year viz. 1st April, 1947 and 31st December, 1947, in Novem- ber, 1947 the assessee had desired to have the managing agency transferred to two private companies and the subsequent agree- E ment in the following year viz. December, 1948 was merely fructif ication 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 Conmissioner of Income- F tax,' Bombay North, Kutch and Saurashtra, Ahmedabad v. Chaman- > lal Mangaldas & Co., 29 I.T.R. 987,in this respect. That was also a case of managing agency company's entitlement to re- ceive commission at a certain rate. By another agreement, in the case of commission earned by the managing agent for the calender year 1950 was reduced to Rs. 1 lakh. That agreement G i.e. the subsequent agreement took place during the previous year, and the resolution of the board of the director of the managed company was also in the previous year but it was, however, made final on 8th April, 1951, at a meeting of the board of directors but at a time beyond the previous year. The -~ High Court had taken the view that by reason of the resolution H during the currency of the previous year, the right of the assessee ·to commission ceased to be under the original agree- ment and dependent upon and arose only after the decision of

STATE BANK v. C.I.T. [SABYASACHI MUKHARJI, J,] 81

A 4 the board of directors to reduce the commission. The assessee was, therefore, held not ·liable on the larger sum as it was only a hypothetical income which it might have earned if the old agreement had subsisted. This Court. found that the facts of that case were almost identical with the facts in Shoorji Vallabdas's case. Therefore Shoorji Vallabhdas's case must be understood on the footing that because of the desire in November, 1947, the commission did not accrue at the end of the accounting year. In that sense there was no accrtlal of the income. It may be reiterated that in some limited fields where something which is the reality of the situation prevents the accrual of the income, then the notion of real income i.e. making the income accrue in the real sense of the term can be brought into play but the notion of real income as it shall presently be indicated cannot be brought into play, where income ·has accrued ~ccording to the accounts of the assessee and there is no ind~cation by the assessee to treat the amount as not having accrued. Suspended animation following inc.lusion -~ of the amount in the suspense account does not negate accrual and after the event of accrual, corroborated by appropriate entry in the books of acco4nt, on the mere ipse dixit of the assessee, no reversal of the situation can be brought about. Morvi Industries Ltd. v. Commissioner of Income-Tax (Central), Calcutta, 82 I.T.R., 835., was also a case of giving up the commission which had accrued though in that case the payment had been deferred till after the accounts had been passed in the meetings of the managed company •.This Court held that such a situation did not affect the accrual of the income. This Court found that the amounts of ·income for the relevant years were given up unilaterally by the assessee ·~ after these had accrued and it could not escape liability to tax on those amounts. This Court reiterated that income accrued when it became due. The postponement of the date of payment did not affect the accr~al of income. The fact that the amount of the income was not subsequently received by the asse~see would not also detract from or affect the accrual of the income although non-receipt may in appropriate cases be a G valid ground for claiming deduction. This Court 'reiterated that the mercantile system of accounting differed substantial- ly from the cash system of book-keeping. Under the cash system, it was only actual cas~ receipts and actual cash pay- ments that were recorded as credits and debits; whereas, under the mercantile system, credit entries were made in H respect of amounts due immediately they became legally payable

82 SUPHEME COUKT HEPORTS [1986] l s.c.R. A and before they were actually received. Similarly, the expen- diture items for which legal liability had been incurred were immediately debited even before the amounts in question were actually disbursed. This position was reiterated by this Court in 1971 after taking into consideration various decisions of this Court. In our view, ·therefore, the concept of real income B cannot be so used as to make accrued income non-income simply because after the event of accrual, the assessee neither decides to treat it as bad debt nor claims deductions under section 36(2) of the Act, but still enters the same with a diminished hope of recovery in the suspense account. Extension of the concept of real income to this field to negate accrual c after the amount had become payable is contrary to the postu- lates of the Act. It may be mentioned that before the decision of the Bombay High Court in H.M. Kashiparekh & Co. Ltd.'s case, 39 I.T.R. 706., rendered on 1st and 2nd April, 1960, a decision having relevance on the concept of real income and about whose important facts we shall advert later, this Court in February, 1960 in Coumrl.ssioner of -Income-Tax Bombay North v. Chamanlal llaogaldas & Co. (supra) had to consider some of these aspects. In that case there was provision for reduction of collllllission where profits were insufficient in case of the managing agent. There was modificatior. of the commission before the end of the year. The amount was given up by the managing agent. The question that arose was whether the income had accrued and what was the effect of the entries made in the books of account. It was held by this Court that the agreement was an integrated and indivisible one and the managing agent's commission was only determinable and accrued when the year was over. It was further held that the fact that the amounts of commission were credited in the books of the managed company every six months only meant that as an interim arrangenlent the accounts of all sales were made up at the end of six months also. But this did not affect the construction of the clause containing the terms for payment of commission nor the deduction made therein as a result of the modified arrangement. The amount which arose or accrued and which the managing agent had the right to receive was not affected by the manner in which the entry was made. The managing agent was entitled to receive as commission only a sum of Rs. 4,11,875 and that amount alone accrued to the managing agent. This H Court reiterated the principle that the amount which would

STATE BANK v. C.I.T. [SABYASACHI MUKHARJI, J.] 83

A arise or accrue to the managing agent and the managing agent '°" would have a right to receive would not be affected by the manner in which entry was made. The existence of the right to receive i.e. accrual, is important and that is a matter of the reality of the situation keeping the terms and conditions and the conduct of the parties. In Kashiparekh·'s case (supra), the B Division Bench of the Bombay High Court dealt with an assessee firm which had maintained its account in the mercantile system. The assessee was the managing agent of a paper mill company. Under the managing agency agreement, it was under a duty to forgo upto one-third of its commission when the prof its of the managed company were not sufficient to pay the dividend of 6 per cent. For the accounting year ending on 31st December, 1950, the assessee had earned a comnission of Rs. c l, 17, 644 but as a result of the resolutions passed by the managed company and the assessee company the assessee gaVe up a sum of Rs. 97,000 in December, 1950. The Appellate Tribunal held that the maximum amount the assessee was bound to forgo was only Rs. 39,215 and included the balance of amount forgone D -{ viz. Rs. 57,785 in the taxable income. The Tribunal, however, found that tha sum of Rs.57,785 was also given up for reasons of commercial expediency. The Division Bench of the Bombay High Court held that it. was the real income of the assessee company for the accounting year that was liable to tax and that the real income could not be arrived at without taxing E into the account the amount forgone by the assessee. In ascer- taining the real income the fact that the assessee followed the mercantile system of accounting did not have any bearing. The accrual of the commission, the making of the accounts, the legal obligation to give up part of the COlllllission and the forgoing of the commission at the time of the making of the F x accounts were not disjointed facts: there was a dovetailing ' about them which could not be ignored (emphasis supplied). The real, income of the assessee, it was further held, was Rs. 2 7, 644 and the amount of Rs. 97, 000 forgone by the assessee could not be included as the real income of the assessee for the accounting year. The two rules that income-tax is annual G in its structure, and, therefore, the computation for each year is a distinct self-contained unit and the other that the income to ~ taxed is the real income of the assessee are not incompatible or irreconcilable; they admit of harmonious application. The principle of real income is not to be so subordinated to virtually amount to a negation of it when a H surrender or concession or rebate in respect of managing agency commission is made, agreed to or given on grounds of

84 SUPREME COURT REPORTS [1986] l s.c.R. A commercial expediency, simply because it takes place some time ,>-- afte'r the close of an accounting year. In examining any transaction and situation of this nature, the court would have more regard to the reality and speciality of the situation rather than the purely theoretical and doctrinaire aspect of it. It laid great emphasis on the business aspect of the B matter viewed as a whole when that could be done without disregarding the language of the statute. It may be pointed out that the decision in Kashiparekh 's case (supra) has r received approval of this Court in Commissioner of Income-Tax, West Bengal II v. Birla Gwalior (P) Ltd., 89 I.T.R. 266., but in our opinion it is necessary to reiterate the real facts and c the basic principles of Kashiparekh's case. It is true that the concept of real income will have its effect also in mercantile system of accounting. There the accounting year was ending 31st March, 1950. For the account year 31st March, 1950 the assessee had earned connnission but as a result of resolu- tions passed, ·the assessee company gave up Rs. 97 ,000 in D 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 E there was a duty to forgo upto one-third of the commission where profit of the managed company was not sufficient to pay a di vident of 6 per cent. It is in the peculiar situation arising out of the managing agency agreement that subsequently a suin of Rs. 97 ,000 was given up in December, 1950, In this context the fact of surrender and the concept of real income F DllSt be viewed. It was really to implement the obligation , under the managing agency agreement that the giving up took place. Therefore, the accrual of commission, the making of.the accounts, the legal obligation to give up part of ·the commission and the forgoing of the commission at the time of the making of the accounts were considered not to be disjoin- G ted facts. There was dovetailing about these which in reality of the situation could not be ignored. This is not a case where there being no previous obligation after interest having been earned in the sense of having accrued according to the mercantile system of accounting, the assessee after the close of the accounting year without giving up the interest which ~ H the assessee could have as a bad debt, did not offer it for taxation but carried it to 'interest suspense account'.

STATE BANK v. C.I.T. [SABYASACHI MUKHARJI, J,] 85

A Carrying certain amount which had accrued as interest without treating it as bad debt or irrecoverable interest but keeping in suspense account would be repugnant to section 36(l)(vii) read with section 36(2) of the Act. The concept of real income must not be so read as to defeat the object and the provision of the statutory enactment. In that "view of the matter B Kashiparekh' s case would not be of any assistance to the assessee for the contentions it sought to urge before this Court in the instant case. As mentioned hereinbefore this Court in Birla Gwalior

- (P) Ltd. 's case (supra) had. dealt with Kashiparekh's case. That decision before the court was an appeal from the decision of the Calcutta High Court (78 I.T.R. 788) in which I c delivered the judgment. It was felt by the High Court that reading the order of the Tribunal as a whole though various contentions were raised before the Tribunal, the Tribunal had mainly decided the question applying the theory of real income and held that these amounts did not form the real income of the · assessee, inasmuch as, according to the Tribunal, the remunerations were forgone on grounds of commercial expe- diency. The High Court held that once it was decided that these amounts did not form part of the real income of the assessee which was liable to tax, the question of deduction under section 10(2)(xv) of the 1922 Act became· irrelevant. There the question really was ·when did the income really accrue - whether at the end of the accounting year or upon the making up of the accounts, in case of the entitlement of commission of. the assessee in the managing agency commission and office allowance. This .Court (at page 270 of 89 I. T.R.) noted that the date for payment of the commission was s tipu- ~ lated 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 assess- ment 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 it.s accounts and the assessee had given up the commission even before the managed company made up its accounts, and no date had been fixed in the agreement for the payment of the commission, the mere fact that the respondent was maintaining its accounts on the mercantile system did not lead to the conclusion that the

86 SUPREME COURT REPORTS (19861 1 s.c.R.

A 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 ascer- tained only after the managed company had made up its accounts B and as it had not made up its accounts, the commission did not accrue to the assessee company and therefore the giving up which was for valid reasons was not given up after the accrual )-- of income. Dealing with Kashiparekh's case this Court observed that an argument was advanced before this Court that as the c assessee was maintaining its accounts ori mercantile basis, the commission had accrued. This contention did not find favour with this Court, because this Court noted that no due date was fixed for payment of the.commission under the managing agency agreement. Therefore, whether in a particular case managing agency commission had accrued or not would depend upon various factors and there is a dovetailing of these factors. It is in ~ D this light that this Court understood Kashiparekh' s case and approved that decision at page 270 of the report. In my opinion, this approval by this Court on this basis. does not help the assessee in the present appeals before us. It has to be pointed out that the facts in Kashiparekh's case were peculiar and the court wanted to relieve the assessee from the undue hardship of tax liability. The ratio of a case with such special features may not be available for general application. The Bombay High Court in Collllilissioner of Income-tax, Bombay Iv. Confinance Ltd., 89 I.T.R. 292, held that under the income-tax law receipt of income, either actual or deemed, y is not a condition precedent to taxability. 'Ihese were assess- able if these had arisen or accrued or deemed to have accrued or arisen under the Act. This principle would be attracted even in cases where an assessee followed the mercantile system of accounting. However, in examining any transaction or situa- G tion, the Court would have more regard to the reality of the situation rather than purely theoretical or doctrinaire aspect. It was held in that case after discussing the facts that there were hardly any receipts in respect of items of interest or that the bona f ides of the assessee in not charg- ing interest were not disputed, Were circumstances which were -f H by themselves insufficient to support the conclusion that

STATE BANK v. C.I.T. [SABYASACHI MUKHARJI, J,] 87

there was no real income in respect of the items of interest A ""- as none of the debts due by the several debtors was written .off by the assessee and no evidence was produced to show that interest in respect of the debts was given up. The High Court, therefore, held that there. was no giving up and these incomes were assessable. I am in respectful agreement with the con- clusion of the Bombay High Court. In the instant case before B us the facts are still worse. The assessee has not only nOt. written off, but it is still treating loans as alive by_ keeping them in suspense account. Kantawala, J., as the Chief Justice then was, followed the correct principle therein after consid~.ring Kashiparekh 's case (supra). The principles enun- ciated therein are in consonance with the decision of the Calcutta High Court in James Finlay & Co. v. Commissioner of c Income Tax., 137 I.T.R. 698, where all these relevant autho- rities including Kashiparekh's case as well as Birla Gwalior (P) Ltd.'s case have been discussed and analysed. In that case the accounts of the assessee company for the year 1970-71 included an amount of 8,264 from B & G and Rs. 55,920 from S.P. Ltd. receivable as interest. The interest due from B & G D were on advances made in 1966 and that from S.P. Ltd. were on advances made in 1965, The assessee was following the mercan- tile system of accounting and the Income-tax Officer treated both the items of interest as the assessee's income for 1970-71. The assessee used to credit the interest to its profit and loss account. It urged that it had decided to E change w.e.f. 1st January, 1968, its method of accounting in respect of inter.est which was doubtful of recovery, and that such interest was thence forward credited to the suspense account. The Tribunal held that there was no change in the method of .accounting and that before the closing of the books -;,- of account of the relevant accounting year, the assessee had F " not abandoned its claim of interest and as such .the amounts were assessable on accrual basis. On a referene ,_ the High Court held that the alteration ·of practice in ·book-keeping and transfer of amounts to the suspense account could not be termed as a change in the method of accounting. In the instant appeals before us, the position is still worse for the assessee. There is no claim that there was any change in the method of accounting. The High Court further held in James Finlay's case that though there was difficulty in realising the interests in the year of account, there was· no inaterial to show that there was any agreement with the debtors to waive the interest or to keep these in suspense account. HenCe, the claim for interest had not been given up. The amounts accrued

88 SUPREME COURT REPORTS (19861 l s.c.R. A

and continued to remain accrued and were therefore income )i assessable to tax. Our attention was drawn to certain passages in some • recognised tex~ books on accountancy. Reference was made to "Advanced Accounts" by Shukla and Grewal (Ninth Revised and B Enlarged Edition 1981) as well as to Spicer and Pegler's "Practical Auditing" by W.W. Bigg (Fourth Indian Edition by S.V. Ghatalia) where it has been suggested that doubtful debts might be carried to interest suspense account. Reference was also made to the Approved Text of the "International Account- ing Standard 18". Relevant passages from these books have been c set out in the judgment of our learned brother Tulzapurkar, J. No useful purpose will be served by repeating these. Even if in a given circumstance, the amounts may be treated as int~re.st suspense account for accountancy purpose th~t would not affect the question of taxability as such. This must he determined by well-settled legal principles and principles of D accountancy which have been ref erred to hereinbef ore. , The concept of reality of the income and the actuality of the situation are relevant factors which go to the making .up at the accrual of income but once accrual takes place and income accrues, the same carmot be defeated by any theory of real income. Reference may be made to Calcutta Co. Ltd. v. E Commissioner of Income-Tax, West Bengal, 37 I.T.R. 1.

Three decisions, two of the Madras High Court and one of the Punjab and Haryana High Court, which shall presently be noticed, were pressed into service on behalf of the assessee to suggest that the concept of real income can be so applied as to make, where the chances of realisation of accrued income are less it non est. ---- In Commissioner of Income-tax, Tamil Nadu-V v. Motor Credit Co. Pvt. Ltd., 127 I.T.R. 572, the assessee, a private company, was carrying on business as financier for purchase of motor vehicles on hire purchase. It advanced under hire purchase agreements monies to two firms which were plying buses. The routes of these two firms having been taken over by a State Transport Corporation following nationalisation, the firms defaulted in making payment of the hire purchase instal- ments, and consequently the buses were seized. As the assessee-company was advised that there was no prospect of ·--,I H recoVeriilg even the principal pmount, the assessee-company did

STATE BANK v. C.I.T. [SABYASACHI MUKHARJI, J,] 89

A '- ' -I. not credit the interest on the outstandings from the two companies even though it was adopting the mercantile system of accounting. The Income-tax Officer, however, included a sum of Rs. 56,163 by way of accrued interest on the amounts outstand- ing against these two firms. There in fact no interest accrued in view of the facts because there was hire purchase and the B State transport corporation had taken over the firms. There- fore, there was no question of paying any hiring charges or ~. interest. In that view it was considered to be unrealistic that income accrued. If the actuality _of situation or the reality of a particular situation makes an income not to accrue, then very different considerations would apply. But where interest has accrued and the assessee has debited the c account of the debtor the difficulty of the recovery would_ not make the accrual non-accrual of interest.

In Colllllissioner of Income-Tax, Madras Central· v. ·Devi Films (P) Ltd., 143 I. T. R. 386, the Madras High Court held ~ that the regular mode of accounting only determined the mode of computing the taxable income and the point of time at which the tax liability was attracted. It would not determine or affect the range of taxable income or the ambit of taxation. It was further held that where no income had resulted,. it could not be said that income had accrued merely on the ground that the assessee had been following the mercantile system of accounting. Even if the assessee made a credit entry to that effect still no income could be said to have "accrued to the assessee according to the Madras High Court. If no income had materialised, it was pointed out, there could be no liability to tax on any hypothetical accrual of income based on _the , mercantile system of accounting followed by the asessee that F · had to be taken into account, but what should be considered was whether the income had really materialised or resulted to the assessee. The question whether real income had materialis- ed to the assessee had to be considered with reference to commercial and business realities of the situation. In that case the assessee company had entered into an agreement with M G who was producing a Kannada film. The film was in the process of production and the producer wanted finance to complete the picture and approached the assessee and offered the exclusive distribution rights of the picture in certain areas in Karnataka State. The assessee agreed to advance a sum of Rs. 2,80,000. Under the agreement the assessee as distributor H could deduct the commission and appro~riate the balance

90 SUPREME COURT REPORTS [1986] I S.C.R. A

towards the discharge of the amount advanced to the producer r and after the advance was completely adjusted, the distributor had to remit to the producer the realisactions after deducting the colllllission. The distribution colllllission was to be calcula- ted at 35% of the net realisation on the picture. The producer B undertook to complete and deliver the prints for the release of the picture.failing which the producer under took to pay damages together with interest for the amount received at 12% per annum from the date of default to the date of deli very of ,_ the prints and also providi!d certain sum for certain contin- gency. It is not necessary to set out in detail the further c facts, It was held that the assessee was in a position to realise only Rs. 3,47,000 approximately during the three years in question as against a total sum or Rs. 4,37,828 incurred as the cost of production. The Tribunal was justified in the High Court's view that having regard to the terms of the agreement entered into between the parties and in the light of the entries contained in the accounts, the commission could not be said to have accrued in favour of the assessee, as commission ~ could be earnt only after the entire advance had been realised. The decision, as is apparent from its tenor rested upon· the peculiar facts. As the advances could not be realised because of the contingencies that happened in that case, the commissions did not accrue or could not be said to have actually accrued. As mentioned before, the concept of real income may have to be given precedence in computation of income in a particular case but accrued income cannot be waived as not having accrued to the assessee. Sethuraman, J, who delivered the judgment of the bench noted the distinction between the James Finlay's case and the case before him in the Madras High Court. Dealing with the Calcutta case, Sethuraman, • J, observed at page 395 that the waiver of interest would be inconsistent with the entries in the books, since the interest had been credited to the suspense account. As in the instant case before us in these appeals the learned judges of the G Madras High Court also ref erred to llorvi Iru!uatriea Ltd. (supra) where affirming the Calcutta High Court decision, it was found that the relinquishment by the assessee of its remu- neration after it had become due was of no effect and that the an.>unt was liable to be taxed. The Madras High Court felt that this Court had considered only in the light of the system of H accounting followed by the assessee and further observed thst './ this Court in the aforesaid decision had not been referred to the notion of real income. It is unfortunate that the High

STATE BANK v. C.I.T. [SABYASAC.'H,l MUKHARJI, J. J 91

A Court chose to side-track a binding decision of this Court on a wholly untenable ground. In Commissioner of Income-Tax, Amritsar-II v. Ferozepur Finance (P) Ltd. 124 I.T.R. 619., the facts were different and the Punjab and Haryana High Court hald that that even in the mercantile system of accountancy an assessee could forgo B the whole or part of a .debt, whi_ch was irrecoverable. There the court came to the. conclusion that there was no income in view of the·particular facts and circumgtances of the case. An acceptable formula of co-relating the notion of real income in conjunction with the method of accounting· for the purpose of computation of income for the purpose of taxation is difficult to evolve. Besides any straight jacket formula is c bound to create pi"oblems in its application to every situa- tion. 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 situtation. Whether an accrual has taken place or not must in appropriate cases be judged on the principles of real income theory. After accrual non-charging of tax on the same because of certain conduct based on the ipse dixit of a particular assessee cannot be accepted. In determining the question whether it is hypothetical income or whether real income has materialised or not, various factors will have to be taken into account. It would be difficult and improper to extend the concept of real income to all cases depending upon the ipse dixit of the assessee _which would then become a value judgment only. \/hat has really accrued to the assessee has to be found out and what has accrued must be considered from the point .of view of real income taking the probability or improbability of realisation in a realistic manner and dovetailing of these factors .together but once the accrual takes place, on the conduct of the par.'ties subsequent to the year of closing an income which baS accrued cannot be made "no income'.'. The extension of such a value judgment to .such a field is a pregnant with the possibility of mis'Use and should be treated with caution; otherwise one would be on sticky grounds. One should proceed cautiously and not fall a prey to the shifting sands of time. ·- As a result of the aforesaid discussion, the following propositions emerge; H

92 SUPREME COURT REPORTS [1986'1 .1 s.c.R; A (l) It is the income which has really accrued or .arisen to the assessee that is taxable. Whether .the income has really accrued or arisen to the assessee lllllSt be judged· in the light of the reality of the situation. (2) ,The concept of real income would apply where there has been ~ surrender of income which in theory may' have accrued but in the reality of the B situation no income had resulted because the income did not really accrue. (3) where a' debt has bedome bad c!edtiction in compliance with the provisions of the Act should be. claimed and allowed. ( 4) Where the Act applies the concep~. of real income should not be so read as to defeat the provisions of the Act. (5) If there is any diversion of income at source c under any statute or by over-riding title then there is no income to the assessee. (6) The conduc.t of the parties tn treating the income in a particular manner is material evidence of the fact whether income has accrued or not. (7) Mere improbability of recovery, where. the conduct of the assessee is unequivocal, cannot be treate;d as eivdence _of the fact that income has not resulted or accrued to the ·.assessee. After debiting the debtor's account and not reversing that entry - but taking the interest merely in suspense account cannot be such evidence to show that no real income has accrued to the assessee or treated as such by the assessee. (8) The concept of real income is certainly applicable in judging whether there has been income or not but in every case ·it lllllst be applied with care and within well-recognised limits. We were invited to abandon legal fundamentalism. With a problem like the present one, it· is better to adhere to the basic fundamentals of the law with clarity and consistency than to be carried away by common cliches, The concept of real income certainly is a well~accepted one and lllllSt be applied in appropriate cases but with circumspection and lllllst not be called in aid to defeat the fundamental principles of .law of income-tax as developed. - For the reasons aforesaid, with respect, it is not possible for me to agree with the answer proposed by my learn.- ed brother, Tulzapurkar, J, on the first questiol), In th,e premises question number (1) should be answered in the affir~ mative 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 H appeals therefore must fail and are dismissed. But in view of

STATE BANK v. C,l.T. [RANGANATH MISRA, J.] 93

the facts and circumstances of these cases, parties will bear A their own costs throughout. RANGANATH MISRA, J, ·I have had the advantage of reading the two separate judgments by my learned brothren • Tulzapurkar and Mukharji, JJ, I am in agreement with both of them that the second .B question had been correctly answered in favour of the Revenue by the High Court and the appeals are to be dismissed on affirmation of that. conclusion so far as that aspect is concerned. In regard to the answer proposed for the first question, I have bestowed my careful consideration and I am in agreement c with the reasonings and conclusions reached by my lear.ned Brother Mukharji, J, I am of the view that section 36(2) of the Income Tax Act covers the entire field regarding deduction for bad debt. Though the concept of 'real income' is well recognised.one, it cannot be introduced aB an outlet of income 'from taxman's net for assessment on the plea that though shown in the account book as having accrued, the same became a bad D debt and was not earned at all. It is well settled that the citizen is entitled to the benefit of every ambiguity in a taxing statute but where the law is clear considerations of hardship, injustice or anomaly do not afford justification for exempting income from taxation (see Mapp v. Oram., [1969] ~ (vol.Ill) All Eng. Reports 219 (H.L.) E The appeals shall stand dismissed with the direction that- the parties shall bear their own re&pective costs throughout.

ORDER F In view of the majority judgments appeals are dismissed.

A.P.J.