Accrual taxation of NPA income and crystallisation of legal expenses shaped the ITAT's mixed outcome on income and deduction claims.

Under the mercantile system, unrealised finance charges, lease rentals and interest on NPAs were held not taxable on accrual where the assessee consistently followed RBI prudential norms, the Revenue had accepted that treatment in earlier years, and recognition of income would be only hypothetical while recovery of principal remained doubtful; the addition was deleted. The question whether unpaid interest from Godavari Capital Limited had been settled and written off required verification of the relevant material, so the matter was remanded to the Assessing Officer. Legal expenses for recovery proceedings were not allowable in the relevant year because they had not crystallised and were not debited to profit and loss, so the disallowance was upheld.

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Issues: (i) Whether unrealised finance charges, lease rentals and interest on non-performing assets could be brought to tax on accrual basis under the mercantile system of accounting; (ii) whether the balance unpaid interest from Godavari Capital Limited required fresh consideration; and (iii) whether legal expenses incurred for recovery proceedings were allowable as business expenditure.

Issue (i): Whether unrealised finance charges, lease rentals and interest on non-performing assets could be brought to tax on accrual basis under the mercantile system of accounting

Analysis: The assessee had consistently followed RBI prudential norms for NBFCs from earlier years, and the same accounting treatment had been accepted by the Revenue in prior assessments. The relevant principles under the Income-tax Act and the notified accounting standards emphasise accrual, consistency and prudence, and income cannot be taxed as a hypothetical accrual when recovery of the principal itself is doubtful. The RBI directions governing income recognition for NPAs supported the conclusion that such income should not be recognised until actually realised, and the method adopted by the assessee did not conflict with the notified accounting standards.

Conclusion: The addition of unrealised finance charges, lease rentals and interest was deleted in favour of the assessee.

Issue (ii): Whether the balance unpaid interest from Godavari Capital Limited required fresh consideration

Analysis: The amount was stated to have been settled and written off, but the document relied upon had not been considered by the lower authorities. Since the factual foundation of the claim required verification of the settlement and its effect on the disputed amount, the matter was not finally determined on merits at this stage.

Conclusion: The issue was remanded to the Assessing Officer for reconsideration in accordance with law.

Issue (iii): Whether legal expenses incurred for recovery proceedings were allowable as business expenditure

Analysis: The assessee had not debited the expenditure to the profit and loss account and had treated it in the accounts as part of the amounts recoverable from debtors. Applying the same principles governing accrual and accounting consistency, the expenditure had not crystallised during the relevant year on the assessee's method of accounting. The assessee was left free to claim the deduction when the liability crystallised in accordance with its regular accounting method.

Conclusion: The disallowance of legal expenses was upheld against the assessee.

Final Conclusion: The appeal succeeded only to the extent of deletion of the NPA-related income addition, was sent back for reconsideration on the Godavari Capital interest issue, and failed on the claim for legal expenses.

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