Contractual source of interest determines taxability: ex gratia interest is not taxable, but security deposit interest remains income.

Interest is taxable when it arises from a contractual or statutory obligation, because it then constitutes revenue income; where no such source exists, a payment made by way of ex gratia compensation is a capital receipt and not chargeable to tax. Applying that principle, interest on the withheld contract amount was treated as non-taxable because the contract did not confer a right to interest on delayed bills, the arbitrator had no authority to award it for the relevant period, and the award itself negatived earlier interest. By contrast, interest on the security deposit was taxable because the contract clause created an implied obligation and corresponding right to receive such interest, bringing it within income.

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Issues: (i) Whether interest awarded on the withheld contract amount, including pendente lite and future interest, was an ex gratia capital receipt not taxable, and (ii) whether interest awarded on the security deposit was attributable to the contract and taxable as income.

Issue (i): Whether interest awarded on the withheld contract amount, including pendente lite and future interest, was an ex gratia capital receipt not taxable.

Analysis: Interest is ordinarily taxable when it arises from a contractual or statutory source, because in that situation it is a revenue receipt. Where neither the contract nor a statute creates a right to receive interest or an obligation to pay it, the payment assumes the character of ex gratia compensation and is not taxable as income. On the facts, the contract did not confer any right to interest on delayed bills, did not authorise the arbitrator to grant such interest for the relevant periods, and the applicable procedural provision was inapplicable to the arbitration proceedings. The award itself also negatived interest for the earlier withholding period, supporting the absence of any contractual entitlement.

Conclusion: The interest awarded on the withheld contract amount was an ex gratia capital receipt and was not taxable.

Issue (ii): Whether interest awarded on the security deposit was attributable to the contract and taxable as income.

Analysis: The contract contained a specific clause permitting adjustment of sums due by reference to the security deposit and the interest arising therefrom. That language was treated as creating an implied contractual obligation to pay interest on the security deposit, with a corresponding right in the assessee to receive it. Interest arising from such a contractual source retains the character of income and is taxable.

Conclusion: The interest on the security deposit was taxable as income.

Final Conclusion: The addition was sustained only to the extent of interest on the security deposit, while the balance interest on the withheld contract amount remained outside tax.

Ratio Decidendi: Interest is taxable when it arises from a contractual or statutory obligation, but where no such source exists and the payment is merely ex gratia, it is a capital receipt not chargeable to tax.

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