Interest on 'sticky' advances taxable as income under mercantile system; section 119 cannot amend the Act

SC held that interest accruing on "sticky" advances is taxable as income under the mercantile system; the majority view that such accruals are not merely hypothetical was affirmed and appeals dismissed. The court rejected reliance on administrative circulars to override the statute, observing section 119 cannot amend the Act. It noted that if an advance later becomes a bad debt, the taxpayer may claim refund of tax paid on previously accrued interest in accordance with law.

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Issues:
Taxation of interest accruing on "sticky advances" under the Income-tax Act, 1961.

Analysis:
The Supreme Court was tasked with determining how interest accruing on "sticky advances" should be taxed under the Income-tax Act, 1961. The court referenced the case of State Bank of Travancore to establish a foundation for its decision. "Sticky advances" are loans with highly doubtful recovery prospects, and the interest accrued on such advances is typically credited to a separate account rather than the profit and loss account. The court considered arguments from legal experts like Shri Palkhivala, Shri Desai, and Dr. Pal to address the issue.

The majority view, led by Mukharji J., emphasized that real income must be taxed when it accrues, and the determination of real income should consider various factors. Eight key propositions were formulated to guide the assessment of whether income has truly accrued to the assessee. The court highlighted the importance of the method of accounting in computing income under section 28 of the Act and stressed that the method chosen by the assessee impacts the taxability of income.

Tulzapurkar J. presented a dissenting view, arguing that only the accrual of real income should be taxable, and interest on "sticky loans" should be considered hypothetical income. However, the majority's stance was deemed more logical and fair, as it accounted for potential injustice and allowed for deductions in cases where debts turn bad.

The court also addressed the significance of circulars issued under section 119 of the Act, concluding that such circulars cannot override the Act's provisions. The judgment affirmed the majority view from the State Bank of Travancore case, holding that interest accrued on "sticky advances" is taxable income. If an advance is proven to be a bad debt, the taxpayer is entitled to a refund of the tax paid on the interest.

In conclusion, the appeals were dismissed as the judgments aligned with the majority's position in the State Bank of Travancore case. The court emphasized that if an advance is later classified as a bad debt, the taxpayer can claim a refund of the tax paid on the interest.

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