Grant-in-aid treatment of interest on surplus funds excluded the board's receipt from taxable income under State-directed investment rules.

Interest earned on surplus funds of a statutory board, when invested under State direction and required to be retained as grant-in-aid, is treated as diverted at source and not as the board's real income. The analysis also states that a board performing municipal development and financial functions on behalf of the State, without a trade or business character, may claim exemption under article 289(1) and section 10(20A). On that reasoning, the interest receipt was treated as non-taxable and the reassessment notices were quashed.

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Issues: (i) Whether interest earned on surplus funds invested by the Board was taxable income or stood diverted at source and treated as grant-in-aid by the State Government. (ii) Whether the Board was entitled to exemption on the footing that it acted on behalf of the State and was not carrying on any trade or business, with the result that article 289(1) and section 10(20A) of the Income-tax Act applied.

Issue (i): Whether interest earned on surplus funds invested by the Board was taxable income or stood diverted at source and treated as grant-in-aid by the State Government.

Analysis: The Board received grants for distribution to local authorities and was required to invest surplus amounts in approved deposits or securities. The State Government had expressly directed that the interest earned on such deposits be retained by the Board as part of the grant-in-aid and, on the later clarification, reiterated that the interest did not belong to the Board. Applying the principle that income is not taxable where it never reaches the assessee as its income and is diverted before accrual in law, the Court treated the interest as a grant-in-aid and not as the Board's real income.

Conclusion: The issue was answered in favour of the assessee: the interest was not taxable income of the Board.

Issue (ii): Whether the Board was entitled to exemption on the footing that it acted on behalf of the State and was not carrying on any trade or business, with the result that article 289(1) and section 10(20A) of the Income-tax Act applied.

Analysis: The Court examined the statutory scheme of the Board, including its duties of distributing grants, advising local authorities, improving municipal finance, and assisting implementation of municipal functions. It held that the Board was an instrumentality acting for and on behalf of the State in aid of municipal development and financial administration, without any commercial or trading character. The activity was characterised as governmental in nature, and the Board's functions were linked with planning, development, and improvement of cities and towns within the statutory and constitutional framework.

Conclusion: The issue was answered in favour of the assessee: the Board's income was covered by the claimed exemption and could not be brought to tax.

Final Conclusion: The notices issued for reassessment were quashed, and the Board succeeded on the merits of its claim that the impugned interest was not taxable.

Ratio Decidendi: Where surplus funds of a statutory body are invested under governmental direction and the resulting interest is directed to be treated as grant-in-aid, the amount is diverted at source and does not constitute taxable income of the body; a body performing governmental functions on behalf of the State without any trade or business character cannot be taxed on such receipt.

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