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Mr. Palkhivala the learned counsel for the assessee raised a two-fold contention in support of his plea that the three sums representing interest on !sticky! advances, i.e. advances in respect whereof there was high improbability of recovery of even the principal amounts ought not to have been subjected to tax as income under the Act. In the first place he contended that what are chargeable to income tax in respect of a business are profits and gains actually resulting from the transactions of the previous year, that is to say, the real profits and gains and not hypothetical profits or gains on a doctrinaire theory of accrual, that even under the mercantile system of accounting regularly adopted by an assessee it is only the accrual of real income in the commercial sense which is chargeable to tax, that accrual is a matter of substance to be decided on commercial principles having regard to business character of the transactions and the realities of the situation and cannot be determined on any abstract theory of accrual or by adopting a legalistic approach and that if regard is had to commercial principles and realities of the situation it will be clear that in the case of banks, financial institutions and money lenders, whose bulk profits mainly consist of interest earned by them, there is no accrual of real income so far as interest on sticky advances is concerned, and the debit entries made in respect of such interest in the respective accounts of the concerned debtors following the mercantile system of accounting merely reflect hypothetical income that does not materialise in the concerned accounting year or years during which the advances remain sticky and hence it is but proper to carry such interest to !Interest Suspense Account! as carrying the same to !Profit and Loss Account! would result in showing inflated profits and might even lead to improper and illegal distribution or remittance thereof. In this behalf counsel cited several decisions of this Court as also of the High Courts where the principle of real income has been recognised and invoked while considering the tax liability under the Act and in particular strong reliance was placed on two decisions of the Madras High Court in C.I.T. v. Motor Credit Co.(P) Ltd., 127 I.T.R. 572 and C.I.T. v. Devi Films (P) Ltd. 143 I.T.R. 386 and one decision of the Punjab and Haryana High Court in C.I.T. v. Ferozepur Finance (P) Ltd. 124 I.T.R. 619 where a view has been taken that it will be totally unrealistic to treat interest on sticky loans as income and the same was excluded from computation of the assessee!s income. According to Counsel there is a clear distinction between an irrecoverable loan and a sticky loan; the former is a bad debt in respect whereof the chance of recovery is nil and as such can out right form the subject matter of deduction under s. 36 (1) (vii) of the Act while the latter is a loan to which a high degree of improbability of recovery attaches in a particular year or years depending upon the financial position of the concerned debtor due to which interest thereon becomes hypothetical income duringsuch year or years and, as such, the same, not being real income, cannot be brought to tax. Counsel pointed out that right from August 1924 onwards till the impugned decision herein as also the further decision in 110 ITR 336 were rendered by the Kerala High Court in 1973 and 1975 respectively the aforesaid distinction between an irrecoverable loan and a stickly loan was recognised by the Central Board of Revenue as also by the Reserve Bank of India in their diverse Circulars in the case of banks, financial institutions and money lenders regularly following the mercantile system of accounting and he further pointed out that Instructions had been issued not to treat the unrealised interest on such sticky loan as income by carrying it to !Profit and Loss Account! so that the figure of distributable profits should not get inflated and preferably to credit the same to a special account such as Interest Suspense Account! and that if the banks, financial institutions and money lenders, who kept their accounts on mercantile system, maintained such a suspense account in which the unrealised interest was entered, the same should not be included in the assessee!s taxable income, if the Income Tax Officer was satisfied that there was really little probability of the loans being repaid. (Vide C.B.R. Circular No. 37/54 dated 25.8.1924, No. 41(V-6) D of 1952 dated 6.10.1952, CBDT!s Letter F.No. 207/10/73 ITA II dated 16.4.1973 and RBI Circular IFD No. O.P.R. 1076/1(5) to SFCs dated 21.11.1973, copies whereof were furnished to the Court). Counsel urged that such Instructions contained in these Circulars were in consonance with the accepted principle that what was chargeable under the Income Tax Act was the real income of an assessee but according to him these Instructions which held field for over 53 years were changed, though wrongly, under fresh Circulars dated June 20, 1978 and October 9, 1984 issued by the Central Board of Direct Taxes whereunder such interest on doubtful or sticky loans became includible in the assessable income of the assessee (subject to some relief specified therein) with effect from the assessment year 1979-80. Secondly, counsel contended that in any view of the matter in the case of banks and financial institutions who regularly adopt mercantile system of accounting the practice of carrying interest on such sticky loans to !Interest Suspense Account! or !Reserve for Doubtful Interest Account! instead of crediting the same to !Interest Account! or !Profit and Loss Account! is a universally recoginsed practice invariably adopted by them and being wholly consistent with the mercantile system of accounting the Income Tax Officer was bound to give effect to it under s. 145 of the Act, and, therefore, the treatment of the three sums representing interest on sticky loans as the assessee!s income for the concerned assessment years would be unsustainable in law; and in this behalf counsel placed reliance on the standard text books of accountancy of authors like Spicer and Pegler, Shikla and Grewal and the Approved Text of International Accounting Standard 18.

On the other hand, counsel for the Revenue pressed for our acceptance the view taken by the High Court. He fairly conceded that it is the real income that is chargeable to tax under the Act and not any hypothetical income of an assessee and that under section 28 in respect of a business the chargeability must attach to real profits and gains arising from the transactions of the previous year but he contended that under section 5 read with section 28 of the Act the liability attaches to profits which have been either received by the assessee or which have accured to him during the year of account and it is well settled that inncome accrues when it "falls due", i.e., becomes legally recoverable irrespective of whether actually received or not and "accrued income" is that income which "the assessee has a legal right to receive": vide C.I.T. v. Thiagaraja Chetty, 24 I.T.R. 525 at 531 and Morvi Industries Ltd. v. C.I.T. Calcutta, 82 I.T.R. 835 at 840 and since admittedly the assessee has been maintaining its accounts on mercantile basis the three sums being interest on loans, whether doubtful or sticky, fell due and became payable to the assessee at the end of each of the three accounting years and constituted its accrued income and were, therefore, justifiably brought to tax in the concerned assessment years. Counsel for the revenue fairly conceded that Courts have, while imposing the tax liability under the Act, recognised the theory of real income by having regard to the business character of the transactions and realities of the situation but these aspects have been taken into account for the purpose of determining whether the income could be said to have legally accrued or not and once it is found to have legally accrued it is brought to tax. He pointed out that all the decisions of this Court show that this theory has been invoked and confined only to two types of cases (a) where there has been a surrender of income which may in theory have accrued, and (b) where there has been diversion of income at source either under a statute or by over-riding title but in none of these cases has the aspect of high improbability of recovery been regarded as sufficient to prevent accrual; counsel therefore urged that this theory of real income should not be extended so as to exclude from chargeability such income which has accrued but merely suffers form high improbability of recovery. Counsel submitted such extension would be neither permissible nor advisable - not permissible because it goes against the very concept of accrued income and not adyisable because if done it will apply to all cases and not merely to cases of interest accruing to banks and financial institutions. Moreover, such extension will entrench upon section 36 (1) (vii) which provides for deduction of a debt or part thereof on its becoming bad on fulfilment of certain conditions specified in sub-section (2) thereof. For these reasons counsel submitted that the extension of the theory of real income so as to take within its ambit the consideration of high improbability of recovery is not warranted. As regards the earlier Circulars of C.B.R. and R.B.I. On which reliance was placed by the assessee, counsel for the revenue submitted that these merely granted a concesssion to and conferred no right in favour of the assessee which could be and has been withdrawn later by issuing fresh Circulars but since the benefit or the concession in favour of the assessee could not be withdrawn retrospectively, the withdrawal of concession has been effected prospectively from the assessment year, 1979-80.

Counsel for the revenue raised two objections to extend the theory of real income so as to exclude from chargeability the interest on sticky loans merely because it suffers from high improbability of recovery. In the first place he urged that the Act contains no provision excluding or deducting such interest from computation of income and the only provision for deduction of debts is to be found in s. 36 (1) (vii) where under debts which are established to have become irrecoverable and bad in the previous year are permitted to be deducted on fulfilment of certain conditions specified in sub-section (2) and as such the extension of the theory of real income as sought would entrench upon s. 36 (1) (vi),Secondly, it was urged that such extension will be ill-advised inasmuch as, if done, it will apply to cases of interest accruing to all money-lenders and not merely to cases of interest accruing to banks and financial institutions. As regards the first objection the argument amounts to saying that the exclusion or deduction in respect of irrecoverable and bad debts under s. 36 (1) (vii) read with the conditions mentioned in sub-sec. (2) proceeds on the basis that in substance such debts do not constitute real income of the assessee and therefore exclusion of interest on sticky loans from computation of income for which there is no provision in the Act and that too without any conditions would impinge upon the specific provision contained in s. 36 (1) (vii) read with sub-section (2). The answer to this objection is that it is not as if that in the absence of some specific provision exclusion of hypothetical income cannot be done; in fact such exclusion rests not upon any slippery or slushy ground but upon the principle that under the Act chargeability is attracted only to real income and in this behalf it will be pertinent to mention that the provision for exclusion or deduction of bad debts was introduced in the income tax law (the 1922 Act) for the first time in 1939 but even prior to the insertion of such provision in the 1922 Act the Privy Council in C.I.T. v. Sir S.M. Chitnavis, 6 I.T. Cases 453 had, on the basis of ss. 10 and 13 of the 1922 Act, ruled that such bad debts were necessarily allowable as deduction on grounds of first principles of accountancy. At page 457 of the Report the Privy Council have observed: "Although the Act nowhere in terms authorises the deduction of bad debts of a business, such a deduction is necessarily allowable. What are chargeable to income-tax in respect of a business are the profits and gains of a year; and in assessing the amount of the profits and gains of a year account must necessarily be taken of all losses incurred, otherwise you would not arrive at the true porfits and gains." Moreover, there is a clear distinction between an irrecoverable loan and a sticky loan; the former would be a bad debt in respect whereof the chances of recovery are almost nil having been written off the same can form the subject matter of a deduction under s. 36 (1) (vii) while the latter is a loan to which a high degree of improbability of recovery attaches in a particular year or years due to which interest thereon becomes hypothetical income and not real income during the said year or years and therefore, it cannot be brought to tax, though if realised subsequently the same could be and ought to be brought to tax, if this distinction is borne in mind no question of impinging upon the provision contained in s. 36 (1) (vii) read with sub- section (2) can arise by extending the theory of real income to the interest on sticky loans.

The assessee indubitably maintained its accounts on mercantile basis and had regularly adopted it. The assessee claimed that the three sums represented interests on what it called 'sticky' loans in its books of account but having regard to the deteriorating financial position of the concerned debtors and the history of these accounts, the assessee was of the view that in the relevant years the advances had become so 'sticky' that even the recovery of the principal amounts had become highly improbable and extremely doubtful. Therefore, though the assessee charged such interests by debiting the concerned parties (emphasis supplied) yet it credited the said amounts to a separate account styled as 'Interest Suspense Account'. This the assessee claimed on the theory that it was to avoid showing unreal or inflated profits. The assessee claimed that it was not taxable as real income had not accrued to it. It was, however, disallowed on the ground that the advances had not been treated as irrecoverable or bad debts in terms of section 36(1)(vii) of the Act. In coming to the conclusion that these sums were taxable, the taxing authorities, the Tribunal and the High Court proceeded on well-settled principles pertaining to the mercantile system and took the view that such interest had fallen due and became legally recoverable in accordance with the system of accounting during each of the relevant accounting years.