Interest income not taxable when principal recovery uncertain due to debtor insolvency except TDS amount

ITAT Mumbai ruled on accrual of interest income from unsecured inter-corporate deposit where debtor company underwent insolvency proceedings. Tribunal held that interest income cannot be deemed accrued when principal recovery is uncertain due to debtor's insolvency and insufficient assets. However, interest income equivalent to TDS amount deducted was held taxable since assessee effectively received that portion through tax credit. Addition sustained only to extent of TDS amount (Rs. 32,85,608) with corresponding TDS credit allowed. Appeal partly allowed.

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The primary issue presented for consideration is whether the interest income on unsecured inter-corporate deposits placed with a company undergoing insolvency proceedings can be said to have accrued to the assessee for the purpose of taxation, especially when the principal amount itself is doubtful of recovery. Additionally, the question arises regarding the entitlement of the assessee to claim credit for tax deducted at source (TDS) on such interest income, which was deducted and remitted by the Interim Resolution Professional during the insolvency process.

Regarding the core legal questions:

• Whether interest income on unsecured inter-corporate deposits with a company under insolvency proceedings accrues to the assessee under the mercantile system of accounting and is taxable despite uncertainty of receipt.
• Whether the assessee is entitled to claim credit for TDS deducted on such interest income, despite non-recognition of the income in its books.
• Whether future interest receipts, if any, should be offered to tax in the year of receipt.

The Tribunal undertook a detailed issue-wise analysis as follows:

Accrual of Interest Income on Unsecured Inter-Corporate Deposits Amid Insolvency Proceedings

The legal framework revolves around the mercantile system of accounting, which recognizes income on accrual rather than receipt, and the "real income theory," which mandates that income must be real and not hypothetical to be taxable. Precedents cited include decisions of the Tribunal and the Hon'ble Delhi High Court, which emphasize that income accrual must be coupled with reasonable certainty of realization.

The assessee's contention was that since the company in which the inter-corporate deposits were made had entered insolvency proceedings and the assets were insufficient to cover secured creditors, the claim of unsecured creditors (including the assessee) was not admissible. Consequently, there was no certainty of receipt of either principal or interest, and hence the interest income could not be recognized or taxed.

The Tribunal examined a precedent from the Pune bench of the Tribunal involving a defunct bank where interest income was not taxed due to the impossibility of realization, despite accrual under mercantile accounting. The Tribunal quoted extensively from that decision, which held that income accrual without reasonable certainty of receipt does not attract tax liability. The Tribunal also relied on the Delhi High Court judgment which held that even under mercantile accounting, the real accrual of income must be considered with the probability of realization. The Supreme Court's guidance was noted, emphasizing that hypothetical income entries that do not materialize are not taxable.

The Tribunal found the facts of the instant case analogous to these precedents. The assessee had not recognized the interest income in its books and had written off the principal amount as bad debt. The insolvency proceedings and the insufficiency of assets to cover unsecured creditors underscored the uncertainty of realization. Therefore, the Tribunal concluded that the interest income, beyond the amount reflected by TDS deduction, had not accrued to the assessee in a real sense and was not taxable for the year under consideration.

Entitlement to TDS Credit on Deducted Tax

It was undisputed that the Interim Resolution Professional had deducted TDS on the interest income purportedly payable to the assessee and remitted the same to the government. The Tribunal reasoned that to the extent of TDS deducted, the assessee could be deemed to have received interest income. Therefore, the interest income corresponding to the TDS amount was taxable, and the assessee was entitled to claim credit for the TDS deducted.

The Tribunal accordingly upheld the addition of interest income to the extent of the TDS amount and directed the assessing officer to grant credit for the TDS against the tax liability.

Taxation of Future Interest Receipts

Both parties agreed that any interest income received in future should be offered to tax in the year of receipt. The Tribunal directed the assessee to comply with this principle, thereby ensuring that any subsequent realization of interest income would be appropriately taxed.

In addressing competing arguments, the Revenue contended that since the company was part of the assessee's group, the interest income should be considered accrued and taxable. They also submitted reports suggesting unsecured creditors were being compensated, implying some certainty of receipt. The Tribunal found these arguments unpersuasive in light of the insolvency proceedings, the insufficiency of assets, and the legal principles governing income accrual and taxation. The Tribunal emphasized the necessity of certainty and real accrual, not mere book entries or group affiliations.

The Tribunal's conclusions on the issues are as follows:

• The interest income on unsecured inter-corporate deposits with a company undergoing insolvency proceedings does not accrue to the assessee for tax purposes when there is no reasonable certainty of its receipt.
• The interest income to the extent of TDS deducted and remitted by the Interim Resolution Professional is deemed to have accrued and is taxable. The assessee is entitled to claim credit for the TDS amount.
• The assessee must offer any future interest income received on such deposits to tax in the year of receipt.

Significant holdings from the judgment include the following verbatim excerpts that encapsulate the core principles:

"The concept of accrual of income needs to be considered in the hue of the 'real income theory'. Where accrual of an income takes place but its realisation becomes impossible, such hypothetical income cannot be charged to tax. In the case of mercantile system of accounting, an accruing income can be charged to tax only when it is likely to be received under the given circumstances."

"Income-tax is a levy on income. No doubt, the Income-tax Act takes into account two points of time at which the liability to tax is attracted, viz., the accrual of the income or its receipt; but the substance of the matter is the income. If income does not result at all, there cannot be a tax, even though in book-keeping, an entry is made about a hypothetical income, which does not materialise."

"The question whether there was real accrual of income to the assessee-company... has to be considered by taking the probability or improbability of realisation in a realistic manner... it is not possible to hold that there was real accrual of income... which were added by the Income-tax Officer."

These principles affirm that mere accounting recognition of income is insufficient for taxability unless there is a reasonable certainty of receipt, particularly when the principal is doubtful or irrecoverable.

In conclusion, the Tribunal partly allowed the appeal by excluding the interest income from taxation except to the extent of TDS deducted, and directed the grant of corresponding TDS credit. It also mandated that any future interest income received be taxed in the year of receipt, thus aligning tax liability with actual realization and receipt of income.

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