Income Tax Appellate Tribunal - Pune
Western Maharashtra Development ... vs Deputy Commissioner Of Income Tax on 31 January, 2008
Equivalent citations: (2008)114TTJ(PUNE)54
ORDER
Pramod Kumar, A.M.
1. The short issue that we are required to adjudicate in this appeal is whether or not the CIT(A) was justified in confirming the addition of Rs. 2,77,26,740 on account of accrued interest on seed money loans. The assessment year involved is 2002-03 and the impugned assessment is framed under Section 143(3) of the IT Act, 1961.
2. The assessee before us is a corporation wholly owned by the Government of Maharashtra. The assessee is engaged in various activities aimed at development of industries and promotion of industrialization in western region of the Maharashtra State. In the course of scrutiny assessment proceedings, the AO noticed that while the assessee had maintained books of accounts on accrual basis in respect of all items of accounts, the assessee has accounted for interest on seed money loan/assistance on cash basis. The AO also noted that this factual position is admitted by the assessee in the notes attached to, and forming part of the annual accounts which, inter alia, state as follows:
The books are maintained on accrual basis, except in the case of income from interest on seed money loans (including penal interest) which is accounted for on cash basis. This is permitted to Government companies engaged in the promotion and development of industries, vide Government of India, Ministry of Industry, Department of Company Affairs Notification GSR No. 770(E) dt. 10th Sept., 1990....
3. The AO, based on the details collected in respect of seed money loans/assistance, quantified the amount of accrued interest at Rs. 2,77,26,740. The assessee was required to show cause as to why the said amount of Rs. 2,77,26,740, being amount includible in income of the assessee computed on mercantile basis, not be added to the income of the assessee. It was explained by the assessee that the interest in question is in respect of the loans given to educated unemployed persons, which are not on commercial terms. It was submitted that in such cases, even the likelihood of receipt of principal, leave aside interest, was rather low. It could not thus be said that any real income accrued to the assessee. The basic purpose of this type of lending was contributing to development of the State and it was not a commercial exercise. It was assessee's contention that on materially identical facts, Tribunal has all along held that the assessee was permitted to account for interest income on cash basis. The matter has travelled upto Supreme Court by way of SLP, and Hon'ble Supreme Court has dismissed Revenue's Special I eave Petition against Hon'ble High Court declining Revenue's reference application under Section 254(2) of the Act. It was submitted that, the assessee was all along following this method of accounting, and the Government of India, vide Notification dt. 10 Sept., 1990, has permitted so. It was also pointed out that, "even under the mercantile method of accounting, it is the real income as distinguished from hypothetical income which can be brought to tax" and that "in case of Godhra Electricity Co. Ltd. v. CIT (1997) 139 CTR (SC) 564 : (1997) 225 1TR 746 (SC) wherein it has been held no real income had accrued to assessee company since the assessee was not (likely to be) able to recover the interest".
4. None of these submissions, however, impressed the AO. He observed that w.e.f. the asst. yr. 1997-98, there is a major change in the provision of Section 145 of the Act. The amended section provides that income under the head 'Profits and gains from business or profession' or 'Income from other sources' could only be computed in accordance with "either cash or mercantile system of accounting regularly employed by the assessee". It was thus concluded that 'hybrid' method of accounting was no longer a permissible system of accounting; the assessee had to either choose 'mercantile' system of accounting in respect of all transactions or 'cash' system of accounting. It was also noted that the assessee, on the facts of the present case, was following the cash system of accounting so far as income from interest was concerned, but the assessee preferred to follow 'accrual' method of accounting in respect of all other transactions. The AO also noted that the reasoned decision of the Tribunal was in the context of the pre-amendment legal position, as applicable for asst. yr. 1996-97 and assessment years prior thereto, and the CIT(A) clearly erred in not taking note of the amended legal position when following the same decision for the postamendment years. The CIT(A)'s decision in favour of the assessee for the asst. yr. 1997-98, which was apparently relied upon by the assessee, was thus unacceptable. It was in the backdrop of this discussion that the AO rejected the method of accounting followed by the assessee, and added the amount of Rs. 2,77,26,740 on account of accrued interest on seed money loans, to the income of the assessee.
5. Aggrieved by the stand so taken by the AO, the assessee carried the matter in appeal before the CIT(A), but without any success. Learned CIT(A) did take note of the fact that the provisions of Section 145(1) are subject to the provisions of Section 145(2) which, in turn, refer to the Accounting Standards notified by the Government of India. He, however was of the view that none of the notified Accounting Standards also come to the rescue of the assessee. He was fair enough to take on record the fact that the Accounting Standards 1 (AS-1) does lay emphasis on 'prudence', 'substance over form' and 'materiality' as considerations governing the selection and application of accounting policies, but he added that 'a closer reading of the AS-1 would indicate that it does not permit change of method of accounting altogether' and that 'it merely permits certain provision to be made, such as for known liabilities, losses etc. from the incomes which is otherwise to be accounted for on accrual basis'. According to the learned CIT(A), the assessee's case clearly did not come under AS-1, and that the assessee could not, therefore, 'claim a departure from income recognition provided under Section 145(1) by referring to any Accounting Standard'. Learned CIT(A) also referred to and relied upon Hon'ble Supreme Court's decisions in the cases of UCO Bank v. CAT and State Bank of Travancore v. CIT . As for the Hon'ble Supreme Court's decision in the case of Godhra Electricity Co. Ltd. v. CIT , learned CIT(A) distinguished the same on facts. As for the Gol notification, the learned CIT(A) noted that the same was issued prior to amendment in Section 145 of the IT Act and was, therefore, no longer good in law, and that, in any event, such a notification could not override Section 145 of the Act. On the basis of these, and other propositions, the learned CIT(A) upheld, and in fact further fortified, the addition made by the AO. The assessee is not satisfied even by the order of the OT(A), and is in further appeal before us.
6. When this appeal came up for hearing before us on 1st Jan., 2008, there was a request for adjournment of the case for want of availability of the counsel. Having given our careful consideration to the assessee's request, we deemed it fit and proper to reject the request and proceeded ex parte qua the assessee. The assessee's representative, who had come to seek adjournment, was, however, advised to file a written note and other relevant documents that the assessee would seek to rely upon. We have heard Shri Srinivasan, learned Departmental Representative, at considerable length, perused the material on record and duly considered factual matrix of the case as also the applicable legal position.
7. We find that as Section 145(1) unambiguously provides the profits of business are to be computed in accordance with 'either cash or mercantile system of accounting, regularly employed by the assessee'. However, rider is that the provisions of Section 145(1) are subject to the provisions of Section 145(2) which, in turn, provide that the Accounting Standards, as may be notified by the Central Government from time to time, are to be followed by any class of assessee or in respect of any class of income. In other words, therefore, the notified Accounting Standards are to be followed by an assessee even if these Accounting Standards provide for an accounting treatment contrary to the mercantile system of accounting or cash system of accounting as may be regularly followed by the assessee. To that extent, the notified Accounting Standards are to have precedence.
8. One of these notified Accounting Standards, i.e., AS-1, inter alia, provides as follows:
(4) Accounting policies adopted by an assessee should be such so as to represent a true and fair view of the state of affairs of the business, profession or vocation in the financial statements prepared and presented by on the basis of such accounting policies. For this purpose, the major considerations governing the selection or application of accounting policies are following:
(i) Prudence : Provisions should be made for all known liabilities and losses even though the amount cannot be determined with certainty and represents only a best estimate in the light of available information.
(ii) Substance over form : The accounting treatment and presentation in financial statements of transactions and events should be governed by their substances and not merely by the legal form.
(iii) Materiality : Financial statements should disclose all the material items, the knowledge of which might influence the decision of the user of the financial statements.
9. A plain reading of the above extracts from the notified Accounting Standard would show that irrespective of whatever be the method of accounting employed by the assessee, it is sine qua non that the financial statements prepared on the basis of such method of accounting must represent a true and fair view of the state of affairs of the business. To that extent, the method of accounting employed by the assessee has to give way to the; accounting policies aimed at true and fair view of the affairs of the business. One of the major considerations for having such accounting policies is 'prudence'. What follows is that the considerations of prudence have to be blended with the strict principles of mercantile or cash method of accounting, even when an assessee is following mercantile or cash method of accounting, and an improvised method of mercantile or cash method of accounting, which may result from such a blending of considerations of prudence with the strict principles of mercantile or cash method of accounting, meets the requirements of Section 145 of the Act.
10. The concept of 'prudence' as one of the basic considerations in deciding accounting policies is not of a recent origin. It is one of the fundamental principles of accounting that, as a measure of prudence and following the principle of conservatism, the incomes are not taken into account till the point of time that there is a reasonable degree of certainty of its realization, while all anticipated losses are taken into account as soon as there is a possibility, howsoever uncertain, of such losses being incurred. A Co-ordinate Bench of this Tribunal, in the case of Mashreq Bank v. Dy. Director of IT (2007) 18 SOT 233 (Mumbai) has, while dealing with a somewhat connected issue, made following observations:
...The accountancy principle of conservatism, which has been duly recognized by the Courts, mandates that anticipated losses are to be provided for in the computation of income but it does not permit anticipated profits to be taken into account till the profits actually arise. That is the underlying reason that in the case of unsold stock, when market rate is higher than the purchase price, the market price is ignored in computation of value of stock, and, as a result, anticipated profit on sale of such stock is ignored. However, when the market price of stock is lower than the purchase price, the market price is taken into account, and, accordingly, anticipated loss is taken into account. These dual standards in recognizing anticipated losses and anticipated profits are accepted accounting norms. In the case of Chainrup Sampatram v. CIT , Hon'ble Supreme Court took note of this position and observed that 'while anticipated loss is taken into account anticipated profit is not brought into account as no prudent trader would care to show increased profit before its actual realisation. This is the theory underlying the rule that the closing stock is to be valued at cost or market price whichever is lower, and it is now generally accepted as an established rule of commercial practice and accountancy'. No doubt these observations were made in the context of valuation of stock but what is material is the theory underlying the principle of valuing closing stock at cost or market price whichever is lower and the fact that such a theory has the acceptance of the Hon'ble Supreme Court....
11. In the case of Godhra Electricity Co. Ltd. (supra), a somewhat identical issue came up before the Hon'ble Supreme Court. The assessee in that case was admittedly following mercantile method of accounting, and yet the assessee did not recognize certain revenues which the assessee was legally entitled to receive, as the assessee was not, for good and valid reasons, hopeful of being able to recover. The question arose whether there was any real accrual of income which could be brought to tax. It was in this backdrop that the Hon'ble Supreme Court observed that "the question whether there was a real accrual of income to the assessee company...has to be considered in the light of probability or improbability of realization in a realistic manner". It would thus follow that even when an assessee is following mercantile method of accounting, it is not always necessary that all the Revenues legally arising in the relevant period are to be recognized for income accrual purposes. In other words, revenue recognition, even under accrual method of accounting, may have to be deferred in view of improbabilities of being able to recover the revenues so accrued.
12. The proposition so laid down by the Hon'ble Supreme Court is in harmony with the well recognized accounting principles.
13. Let us take a look at the connotations of expression 'mercantile method of accounting'. 'Guidance Note on Terms Used in Financial Statements', issued by the ICAI, describes the said method as follows:
Accrual basis of accounting The method of recording transactions by which revenues, costs, assets and liabilities are reflected in the books of accounts in the period in which they accrue. The accrual basis of accounting includes considerations relating to deferrals, allocations, depreciation and amortization. This basis of accounting is also referred to as mercantile basis of accounting.
14. No doubt, as a general principle of the mercantile method of accounting, revenues are reflected in the books of accounts of the period in which revenues accrue, and revenue is recognized as it is earned. However, there are exceptions to this principle and such exceptions are warranted by the considerations of 'prudence' which, in any event, override the strict principles of mercantile method of accounting. In this light, let us take a look at the following extracts from 'Guidance note on accrual basis of accounting', issued by the ICAI, which unambiguously demonstrate the rationale of such exceptions:
Revenue recognition:
3.2 Recognition of revenue requires that revenue is measurable and that at the time of sale of or the rendering of service or use of resources of the enterprise by others, it would not be unreasonable to expect ultimate collection.
3.10 (i) interest accrues, in most circumstances, on the time basis determined by the amount outstanding and the rate applicable.
...
3.11 When interest, royalties and dividends from foreign countries require exchange permission and when uncertainty in remittance is anticipated, revenue recognition may need to be postponed."
(Emphasis by underlining, italicised in print, supplied by us)
15. While these Guidance Notes issued by the ICAI are not binding under the IT Act but, these authoritative pronouncements by the premier accounting body in India do throw light on the nature and principles of 'mercantile method of accounting' which is not defined under the IT Act. It is well settled in law that in legislation relating to a particular trade, business or profession, words having special meaning in that context are understood in that sense. The provisions of Section 145 pertain to the accounting aspects, and, therefore, any expressions finding place therein are to be construed in the manner in which these are construed in the accounting profession. The authoritative pronouncements made by the ICAI, therefore, must be given due consideration when examining connotations of an accounting expression i.e. mercantile method of accounting, and particularly when there is nothing to the contrary in the tax legislation. As a matter of fact, as we have seen in the preceding discussions, judicial pronouncements support and approve these accounting principles.
16. In the light of the above discussions, we are of the considered view even when an assessee is following mercantile method of accounting, it is indeed possible, and at times even necessary, that depending upon the probability or improbability of being able to recover the amounts, revenues which legally accrue to an assessee may not be taken into account for the purpose of income recognition. To that extent, it is still possible for an assessee to recognize certain revenues, due to their peculiar nature, on receipts basis. The only change that has been brought about by amendment in Section 145 is that while prior to the amendment, there was no need to justify such an accounting treatment on merits and it was possible for the assessee to argue that as long as a method has been consistently followed, no objection can be taken to the same, the situation post amendment is that any non recognition of revenue has to be justified by the assessee on merits. Post amendment, it is also necessary for the assessee to demonstrate that even under the mercantile method of accounting, there are good reasons for not recognizing the revenues in question on accrual basis and that facts and circumstances of the case warrant that such revenues are recognized only when the same are received. That will essentially depend on facts of each case.
17. The facts of the case before us do indeed justify that even under mercantile method of accounting, revenues in question, i.e. accrued interest on seed money loans, are recognized only when the same are actually received by the assessee.
18. There is no dispute about the fact that the assessee company is a Government corporation wholly owned by the Government of Maharashtra, and is engaged in various activities aimed at development of industries and promotion of industrialization in western region of the Maharashtra State. These activities are surely not on commercial lines and the predominant purpose of these activities is to promote growth and development in the target area. When seed money is given to an entrepreneur, the purpose of this advance is to enable him to start his business and even the repayment process starts only after the entrepreneur is able to repay the commercial loan for the purpose of business. It is more of a venture capital than a commercial funding, and let us also not lose sight of the fact that this venture capital is extended to the sections of society which are not only underprivileged but are least safe from the commercial point of view. In these circumstances, the approach of the assessee in recognizing the revenue, by way of interest on seed loans, only when received cannot be said to be unjustified. It is also important, to bear in mind that even after the amendment in Companies Act, which, post amendment, permits accounting only on mercantile basis, the Government of India issued a notification for relaxing the norms and permitting the assessee company to book the revenues in question only when actually received. This fact aptly demonstrates the bona fides of the approach of the assessee, and justifies delayed recognition of revenue on account of interest on seed loans. It is also beyond dispute or controversy that the recoveries of interest on seed money are extremely low and the possibilities of recovering these amounts somewhat remote. No doubt, there is a legal right to receive the interest, but there are also ground realities which do not permit strict enforcement of this right. In our considered opinion, any other view of the matter will result in distortion in the financial results disclosed by the books of accounts maintained by the assessee. It is also important to remain alive: to the fact that the provisions of Section 145(1) are subject to, inter alia, mandate of AS-1 which also prescribes that "Accounting policies adopted by an assessee should be such so as to represent a true and fair view of the state of affairs of the business, profession or vocation in the financial statements prepared and presented by on the basis of such accounting policies". In the name of compliance with Section 145(1), it cannot be open to anyone to force adoption of accounting policies which result in a distorted view of the affairs of the business. We, therefore, uphold the claim of the assessee that even under the mercantile method of accounting, and, on peculiar facts of this case, the assessee is justified in following the policy of not recognizing these interest revenues till the point of time when the uncertainty to realize the revenues vanishes.
19. There is one more aspect of the matter. Let us assume for a minute that the method of accounting followed by the assessee is indeed contrary to the provisions of Section 145(1) but then the AO is not entitled to make adjustments in those books of accounts to bring the same in conformity with the provisions of Section 145(1). All that he can do in such a situation is to lean on Section 145(3) which permits him to make a best judgment assessment under Section 144. In the best judgment assessment, he has to take into account all such material as he has gathered in the course of assessment proceedings. This material obviously includes the Government of India notification which, despite the fact that all companies are required to follow accrual basis of accounting, specifically directs the assessee company to book interest income on seed money loans only when the same is actually received. A notification issued by the Government of India cannot be taken lightly nor can the AO be simply dismissive about it. In our considered view, this notification is sound basis to come to the conclusion that the revenues in question can be treated as income only when the revenues are realized. A best judgment, assessment is also required to be a sound and rationale judgment about the income of the assessee. From this point of view also, the assessee cannot be forced to pay tax on the interest, accrued on seed money loans.
20. For the detailed reasons set out above, we are of the considered view that the CIT(A) was not justified in confirming the addition of Rs. 2,77,26,740 on account of accrued interest on seed money loans. We, therefore, direct the AO to delete this addition. The assessee gets the relief accordingly.
In the result, the appeal is allowed.