1986 (1) TMI 1 - SC - Income Tax

Bank interest on sticky advances and foreign exchange gains from rupee devaluation ruled taxable income

The SC held that interest on sticky advances debited to customers but credited to suspense accounts constitutes assessable income for tax purposes. The ... Accrual of income - mercantile system of accounting - doctrine of real income - interest on doubtful or 'sticky' advances - Interest Suspense Account - deduction for bad debts under section 36(1)(vii) - exchange difference on devaluation as business income - stockintrade treatment of foreign currencyInterest on doubtful or 'sticky' advances - doctrine of real income - mercantile system of accounting - Interest Suspense Account - deduction for bad debts under section 36(1)(vii) - Whether the amounts representing interest on sticky advances were includible in the assessee's income for the relevant assessment years - HELD THAT: - The majority concluded that accrual under the Incometax Act is governed by legal entitlement and the substantive charging provisions and that the doctrine of 'real income' must be applied with circumspection. While the mercantile system determines the mode and timing of computation, it does not alter the content or range of taxable income. Once interest has legally accrued and been treated as accrued in the books, mere transfer to an Interest Suspense Account, or subjective improbability of recovery, does not by itself negate accrual. The appropriate statutory machinery for dealing with unrealisable debts is the deduction for bad debts under section 36(1)(vii) (subject to its conditions) and not a broad extension of the realincome doctrine to convert accrued items into nonincome on the basis of mere improbability of recovery. Considerations of commercial reality may prevent accrual in exceptional facts (for example where income has been given up or where there is a statutory diversion at source), but the mere existence of doubtful recovery-absent objective material showing relinquishment, writeoff, or other controlling circumstances-does not prevent accrual. Accordingly the additions were held to be taxable. The Court rejected the view that keeping interest in a suspense account in itself established that the interest had not accrued as real income. [Paras 68, 70, 72]Addition of the interest on sticky advances was held to be includible in the assessee's income (answered in favour of the Revenue).Exchange difference on devaluation as business income - stockintrade treatment of foreign currency - accrual of income - Whether the exchange difference arising on devaluation of the rupee constituted income of the bank for the assessment year 1967-68 - HELD THAT: - All judges agreed that foreign currency held by a bank in the course of its foreignexchange business is stockintrade and that appreciation arising from devaluation, when realised or treated as resulting from trading operations, constitutes business income. On the facts the bank had held foreign exchange immediately prior to devaluation and revalued the cost in rupees by crediting the surplus to a 'Provision for contingencies' account. Factual findings by the tax authorities that the foreignexchange assets were acquired and sold or used in the ordinary banking operations supported treating the surplus as a trading receipt. The Court therefore upheld the inclusion of the exchange difference in taxable business profits for 196768. [Paras 28, 29, 72]Exchange difference arising on the devaluation was held to be taxable business income (answered in favour of the Revenue).Final Conclusion: By majority the appeals were dismissed: the additions of interest on the disputed 'sticky' advances were held to be includible in the assessee's income for the assessment years in question, and the exchange gain on the 1966 devaluation was upheld as taxable business income for 1967-68. ISSUES: Whether interest on 'sticky' advances-advances with high improbability of recovery but not written off as bad debts-accrued as real income and was taxable under the Income-tax Act for the assessment years 1965-66, 1966-67, and 1967-68. Whether the exchange difference arising from the devaluation of the Indian rupee on June 6, 1966, constituted taxable income for the assessment year 1967-68. RULINGS / HOLDINGS: On the first issue, the majority held that the sums representing interest on sticky advances constituted 'hypothetical income' and not 'real income' and therefore could not be brought to tax for the concerned assessment years; the accrual of income requires that it be 'factually and practically realisable' and mere legal recoverability or debit entries under the mercantile system do not suffice to establish accrual of real income. The dissenting judgment held that interest on sticky advances had accrued under the mercantile system of accounting and was taxable income; the method of accounting regularly employed determines the mode of computing income and the accrual of income is a matter of legal right to receive, not subject to the theory of real income to exclude accrued but doubtful income. On the second issue, all judges agreed that the exchange difference arising on devaluation of the Indian rupee was taxable income for the assessment year 1967-68, as it arose from the assessee's business of buying and selling foreign exchange and was properly treated as business profits. RATIONALE: The court applied the provisions of the Income-tax Act, 1961, especially sections 5, 28, 29, 36(1)(vii), and 145(1), to determine the timing and nature of income accrual and taxability. Section 145(1) mandates computation of income according to the method of accounting regularly employed, but this method 'cannot enlarge or restrict the content of the taxable income' under the Act. The majority emphasized the doctrine of 'real income,' as expounded in prior Supreme Court decisions, which requires that only income which has 'really accrued or arisen' and is 'factually and practically realisable' be taxed; hypothetical or unrealised income entries in the books do not constitute taxable income. The mercantile system of accounting recognizes income on accrual (legal right to receive), but the court held that accrual for tax purposes must consider commercial realities and the business character of transactions, not merely legalistic or doctrinaire entries. The practice of carrying interest on sticky loans to an 'Interest Suspense Account' instead of crediting it to the profit and loss account is a 'universally recognised practice' consistent with mercantile accounting principles and prevents showing inflated profits or illegal distribution of unrealised income. The court distinguished between bad debts (irrecoverable loans) deductible under section 36(1)(vii) and sticky loans (loans with high improbability of recovery), holding that interest on sticky loans is hypothetical income and not taxable unless realised. The dissenting opinion stressed that once income has legally accrued (i.e., has fallen due or become payable), it is taxable income, regardless of improbability of recovery, and that the theory of real income cannot be extended to exclude such accrued income; the statutory provisions for deduction of bad debts under section 36(1)(vii) are the proper mechanism for dealing with unrecoverable amounts. Regarding the exchange difference, the court applied the principle that profits arising from the business of buying and selling foreign exchange, including gains from currency devaluation, constitute business income taxable under the Act; a mere book appreciation without sale does not constitute income, but the facts showed the foreign exchange stock was sold or used, confirming the taxable nature of the gain. The court noted that earlier circulars of the Central Board of Revenue and Reserve Bank of India, which allowed exclusion of unrealised interest on sticky loans from taxable income, were executive concessions and could be withdrawn prospectively without altering the statutory provisions.