2015 (8) TMI 1596 - AT - Income Tax

Interest income contingent on borrower's tax assessment outcome cannot be taxed due to collection uncertainty

ITAT Lucknow dismissed revenue's appeal regarding disputed interest income accrual. The tribunal held that where a borrower company's resolution made ... Accrual of income - Scope of real income theory - collection of the disputed amount of interest income HELD THAT:- There is no embargo on the assessee to give loan to the present borrower company interest free or at lesser rate of interest. The resolution of the borrower company with which the assessee also agreed amounts to granting loan to the borrower company at lesser interest for the time being but it may go up in case the borrower company gets deduction in its income tax assessment. Hence, in our considered opinion, it cannot be termed as a colourable device. As per the board resolution of the borrower company dated 01.04.2007 with which the assessee also agreed, the collection of the disputed amount of interest income is uncertain as it depends on the income tax assessment of the borrower company which cannot be final in the present year and therefore, the same is not taxable in view of real income theory as approved in this judgment of Hon’ble apex court in Southern Technologies Ltd [2010 (1) TMI 5 - SUPREME COURT] Therefore, we find no infirmity in the order of CIT (A). Hence, we decline to interfere in his order. Appeal of the revenue is dismissed. 1. ISSUES PRESENTED and CONSIDEREDThe core legal questions considered by the Tribunal in this appeal are:- Whether the deletion of addition of Rs. 35,62,864/- by the CIT(A) was legally and factually justified, given the facts brought on record by the Assessing Officer (AO) during assessment proceedings.- Whether the Board Resolution dated 01.04.2007 passed by the borrowing company, which was relied upon by the assessee and accepted by the CIT(A), is a genuine arrangement or a colourable device designed to circumvent the provisions of the Income Tax Act and defer tax liability.- Whether the resolution signed only by one director of the borrowing company and agreed by the assessee in the capacity of depositor is valid and binding for tax purposes, or whether it was executed merely to evade tax liability.- Whether the accounting method adopted by the assessee was mercantile or cash, and the implications thereof on recognition of interest income for the assessment year in question.- Whether the addition made by the AO should be restored or the deletion by the CIT(A) upheld.2. ISSUE-WISE DETAILED ANALYSISIssue 1: Legitimacy of Deletion of Addition of Rs. 35,62,864/- by CIT(A)Relevant Legal Framework and Precedents: The Tribunal and CIT(A) relied heavily on the principles established in two Supreme Court decisions: Southern Technologies Ltd. vs JCIT and CIT vs Hindustan Housing and Land Development Trust Ltd. These cases clarified the distinction between accrual and collectability of income under the mercantile system of accounting and the Income Tax Act.Specifically, Southern Technologies Ltd. emphasized that collectability of interest income is distinct from its accrual, and that income should not be recognized if there is uncertainty in its collection. The Court held that under the mercantile system, income accrues with time, but taxability depends on whether the right to receive income is certain. The Hindustan Housing case further held that an inchoate right to income does not result in taxable income.Court's Interpretation and Reasoning: The CIT(A) examined the Board Resolution dated 01.04.2007 passed by the borrowing company, which effectively curtailed the assessee's right to receive the disputed interest amount during the year. The resolution provided that the assessee would receive the balance interest amount only if the borrowing company was allowed deduction of the interest expenditure in its income tax assessment. This conditional right created uncertainty in collection.The CIT(A) concluded that since the right to receive the interest income was contingent upon the borrowing company's tax assessment outcome, the income was neither accrued nor received in the relevant year. Therefore, inclusion of the disputed interest income in the assessee's taxable income for the year was not justified.Key Evidence and Findings: The primary evidence was the Board Resolution of the borrowing company, which was also agreed to by the assessee. This resolution explicitly deferred the right to receive interest income based on the borrowing company's tax position. The AO had treated this arrangement as a colourable device, but the CIT(A) found it to be a bona fide arrangement affecting the right to receive income.Application of Law to Facts: The Tribunal agreed with the CIT(A)'s application of the real income theory and mercantile accounting principles. The conditional nature of the right to receive interest income meant that the income had not accrued in the year under assessment. The Tribunal held that the Board Resolution was not a sham or colourable device but a legitimate commercial arrangement affecting accrual of income.Treatment of Competing Arguments: The revenue argued that the resolution was a colourable device to defer tax liability and that the accounting method was mercantile, requiring recognition of income on accrual basis. The Tribunal rejected this, noting that the resolution was signed by the borrowing company's director and agreed by the assessee, and that the uncertainty in collection was genuine and legally significant. The Tribunal found no merit in the revenue's contention that the resolution was executed merely to evade tax.Conclusions: The deletion of the addition by the CIT(A) was upheld. The Tribunal held that the disputed interest income was not taxable in the assessment year as the right to receive it was uncertain and contingent on future events.Issue 2: Validity and Effect of the Board Resolution as a Binding DocumentRelevant Legal Framework and Precedents: The issue involved principles relating to the binding nature of corporate resolutions and their effect on rights to income. The Tribunal considered the resolution in light of the Income Tax Act and accounting principles.Court's Interpretation and Reasoning: The Tribunal noted that the resolution was duly passed by the borrowing company's Board of Directors and signed by the director. The assessee was also a signatory, indicating acceptance of the terms. The resolution effectively modified the right to receive interest income, making it conditional.Key Evidence and Findings: The resolution dated 01.04.2007 was the critical document. The Tribunal found no evidence that the resolution was forged, invalid, or executed solely for tax evasion. The fact that only one director signed was not determinative against its validity.Application of Law to Facts: The Tribunal applied the principle that parties can agree to defer or modify income rights, and such agreements affect the timing of income recognition. The resolution was a legitimate instrument altering the accrual of interest income.Treatment of Competing Arguments: Revenue's argument that the resolution was a colourable device was rejected as speculative and unsupported by evidence. The Tribunal emphasized that the resolution was a bona fide commercial arrangement.Conclusions: The Board Resolution was valid and binding, and its effect on the right to receive interest income was legally effective for tax purposes.Issue 3: Accounting Method Adopted by the Assessee and Its Tax ImplicationsRelevant Legal Framework and Precedents: The debate centered on whether the assessee followed mercantile (accrual) or cash system of accounting. Under mercantile system, income is recognized when it accrues, whereas under cash system, income is recognized on receipt.Court's Interpretation and Reasoning: The CIT(A) acknowledged that the assessee followed the mercantile system but clarified that even under mercantile system, income is not recognized if there is uncertainty in its collection. The Tribunal concurred, relying on Supreme Court precedents that collectability is a distinct concept from accrual.Key Evidence and Findings: The Board Resolution demonstrated that the right to receive interest income was conditional and uncertain, thus justifying non-recognition of income even under mercantile accounting.Application of Law to Facts: The Tribunal held that the assessee's accounting treatment was consistent with mercantile principles, given the specific facts of uncertainty in collection.Treatment of Competing Arguments: Revenue's contention that mercantile accounting mandated recognition of interest income on accrual basis was rejected because the condition precedent to accrual-the right to receive income-was not satisfied.Conclusions: The accounting method adopted by the assessee was appropriate, and the non-recognition of disputed interest income was justified.3. SIGNIFICANT HOLDINGS- 'Collectability is different from accrual and the assessee has to prove that interest is not recognized or taken into account due to uncertainty in collection of the income.'- 'When an assessee is following mercantile method of accounting and has not recognized certain revenues on accrual basis, it is necessary for the assessee to demonstrate that even under mercantile method, there are good reasons for not recognizing revenues in question on accrual basis and that facts and circumstances of case warrant that such revenues are recognized only when the same are received.'- 'In case of an inchoate right to receive income, it does not result in income.'- The Board Resolution dated 01.04.2007, which conditioned the right to receive interest income on the borrowing company's tax deduction of interest expenditure, created genuine uncertainty in collection, thereby justifying non-recognition of income for the assessment year.- The resolution was not a colourable device but a bona fide commercial arrangement affecting the timing of income recognition.- The addition of Rs. 35,62,864/- made by the AO was rightly deleted by the CIT(A), and the Tribunal declined to interfere with this order.