Hybrid accounting and penal levy treatment: sticky-loan interest taxed on receipt basis, while RBI penal interest was not deductible.

Interest on sticky loans could not be brought to tax on accrual basis where the bank had consistently followed a hybrid method of accounting, under which such interest was recognised on receipt basis and that method had been accepted by the Department; the Court held that, absent rejection of the accounting method on a legally sustainable ground, the income had to be taxed in accordance with the regularly followed system. Penal interest paid to the Reserve Bank of India under the Banking Regulation Act was held to be penal in character rather than a normal business expense, so its deduction was denied under the Income-tax Act as allowing it would sanction a statutory breach and offend public policy.

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Issues: (i) Whether interest on sticky loans, though accrued, could be assessed on receipt basis in view of the assessee-bank's hybrid method of accounting; (ii) Whether penal interest paid to the Reserve Bank of India under the Banking Regulation Act, 1949 was allowable as a deduction under the Income-tax Act, 1961.

Issue (i): Whether interest on sticky loans, though accrued, could be assessed on receipt basis in view of the assessee-bank's hybrid method of accounting.

Analysis: The Court noted that the controversy was not whether the interest had accrued in law, but whether, having regard to the method of accounting regularly followed and accepted by the Department for years, the said interest could be brought to tax in the relevant year on accrual basis. The assessee had consistently followed a hybrid system, under which interest on sticky loans was accounted for on cash basis while other receipts were on mercantile basis, and there was no rejection of that method by the Revenue for want of true profits or any other legally sustainable reason.

Conclusion: The answer was in favour of the assessee and against the Revenue. Interest on sticky loans was not required to be assessed on accrual basis in the relevant year.

Issue (ii): Whether penal interest paid to the Reserve Bank of India under the Banking Regulation Act, 1949 was allowable as a deduction under the Income-tax Act, 1961.

Analysis: The Court held that the levy under section 24 of the Banking Regulation Act, 1949 was not merely compensatory but penal in character. The statutory scheme treated the default as a breach attracting a penalty, and the payment was not a legitimate business outlay incurred in the ordinary course of lawful business. Allowing such a payment as deduction would amount to giving effect to an infraction of law and would be contrary to public policy.

Conclusion: The answer was in favour of the Revenue and against the assessee. The penal interest was not deductible under section 37 of the Income-tax Act, 1961.

Final Conclusion: The reference was answered by upholding non-taxability of sticky-loan interest on accrual basis in the relevant year, while denying deduction for the penal interest paid to the Reserve Bank of India.

Ratio Decidendi: Where the method of accounting regularly followed and accepted by the Department governs the timing of recognition of a particular item of income, that item cannot be forcibly brought to tax on a different basis in the absence of rejection of the accounting method; conversely, a payment exacted for breach of a statutory obligation and bearing penal character is not an allowable business deduction.

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