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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.

The distinction between these two accounting systems has been adverted to by this Court in several of its decisions but I need refer only to one decision in C.I.T. Madras v. A. Krishnaswami Mudaliar & Others, 53 I.T.R. 122 where the distinction has been elaborately brought out by Shah J (as he then was) in the following passage occurring at pages 129-130 of the Report;

"Among Indian businessmen, as elsewhere, there are current two principal systems of book keeping. There is, firstly, the cash system in which a record is maintained of actual receipt and actual disbursements, entries being posted when money or money's worth is actually received, collected or disbursed. There is, secondly, the mercantile system, in which entries are posted in the books of account on the date of the transaction, i.e., on the date on which rights accrue or liabilities are incurred, irrespective of the date of payments. For example, when goods are sold on credit, a receipt entry is posted as of the date of sale, although no cash is received immediately in payment of such goods; and a debit entry is similarly posted when liability is incurred although payment on account of such liability is not made at the time. There may have to be appropriate variations when this system is adopted by an assessee who carries on a profession. Whereas under the cash system no account of what are called the outstandings of the business either at the commencement or at the close of the year is taken, according to the mercantile method actual cash receipts during the year and the actual cash outlays during the year are treated in the same way as under the cash system, but to the balance thus arising, there is added the amount of the outstandings not collected at the end of the year and from this is deducted the liabilities incurred or accrued but not discharged at the end of the year. Both the methods are somewhat rough. In some cases these methods may not give a clear picture of the true profits earned and certainly not of taxable profits. The quantum or allowances permitted to be deducted under diverse heads under section 10 (2) from the income, profits and gains of a business would differ according to the system adopted. This is made clear by defining in subsection (5) the word 'paid' which is used in several clauses of sub-section (2) as meaning actually paid or incurred according to the method of accounting upon the basis of which the profits or gains are computed under section 10. Again where the cash system is adopted, there is no question of bad debts or outstandings at all, in the case of mercantile system against the book profit some of the bad debts may have to be set off when they are found to be irrecoverable. Besides the cash system and the mercantile system, there are innumerable other systems of accounting which may be called hybrid or heterogeneous - in which certain elements and incidents of the cash and mercantile systems are combined."

In the light of above I would recapitulate the admitted facts and the manner in which the assessee treated or dealt with the three sums representing interest on sticky loans in its books pursuant to the mercantile system of accounting regularly adopted by it. Indisputably, the three sums in question represented the assessee's income by way of interest on advances made by it to some of its customers but having regard to the deteriorating financial position of the concerned parties and the history of their accounts the assessee felt that the advances had become sticky during the concerned accounting years inasmuch as even the recovery of the principal amounts had become highly improbable and extremely doubtful in those years; therefore, though it charged such interest by debiting the concerned parties it did not carry it to its profit and loss account but credited the same to a separate account styled 'Interest Suspense Account' so as to avoid showing unreal or inflated profits and claimed that it was not taxable in its hands as real income had not accrued to it. The facts that the advances or loans had, during the concerned accounting years, become sticky and that such interest had not materialised or resulted to the assessee in those years were not disputed but as stated earlier the claim was negatived by the taxing authorities and the Tribunal on the ground that the advances or loans had not been treated as irrecoverable or bad debts under s. 36 (1) (vii), that the aspect that the advances or loans had become sticky was irrelevant, that since the assessee was following the mercantile system of accounting such interest has accrued to it at the end of each accounting year and that the assessee had itself shown the accrual of interest by changing the same to the concerned parties by making debit entries in their accounts. The High Court also affirmed the view that there had been accrual of the income at the end of each accounting year and in that behalf laid emphasis on the fact that the assessee had been regularly adopting the mercantile system of accounting and observed that the assessee's income will have to be determined in accordance with that method. In other words it is clear that in coming to the conclusion that the three sums in question were liable to be brought to tax the taxing authorities, the Tribunal and the High Court, relying on the mercantile system employed by the assessee, adopted a legalistic approach and took the view that because such interest had fallen due and become legally recoverable by the assessee at the end of each of the accounting years it had accrued to it, though by reason of the stickiness of the advances or loans such interest had in fact not resulted or materialised but remained its hypothetical income. Two questions arise: Should such legallstics approach prevail over the doctrine of real income that has been recognised and invoked by Courts while imposing tax liability under the Act? Secondly, can the mercantile system of accounting, though regularly employed, 'determine' accrual of real income?

"Among Indian businessmen, as elsewhere, there are current two principal systems of book-keeping. There is, firstly, the cash system in which a record is maintained of actual receipt and actual disbursements, entries being posted when money or money's worth is actually received, collected to disbursed. There is, secondly, the mercantile system, in which entries are posted in the books of account on the date of transaction, i.e., on the date on which rights accrue or liabilities are incurred, irrespective of the date of payment. For example, when goods are sold on credit, a receipt entry is posted as of the date of sale, although no cash is received immediately in payment of such goods; and a debit entry is similarly posted when a liability is incurred although payment on account of such liability is not made at the time. There may have to be appropriate variations when this system is adopted by an assessee who carries on a profession. Whereas under the cash system no account of what are called the outstandings of the business either at the commencement or at the close of the year is taken, according to the mercantile method actual cash receipts during the year and the actual cash outlays during the year are treated in the same way as under the cash system, but to the balance thus arising, there is added the amount of outstandings not collected at the end of the year and from this is deducted the liabilities incurred or accrued but not discharged at the end of the year. Both the methods are somewhat rough. In some cases these methods may not give a clear picture of the true profits earned and certainly not of taxable profits. The quantum of allowances permitted to be deducted under diverse heads under section 10(2) from the income, profits and gains of a business would differ according to the system adopted. This is made clear by defining in sub- section (5) the word "paid" which is used in several clauses of sub-section (2) as meaning actually paid or incurred according to the method of accounting upon the basis of which the profits or gains are computed under section 10. Again where the cash system is adopted, there is no question of bad debts or outstanding at all, in the case of mercantile system against the book profits some of the bad debts may have to be set of when they are found to be irrecoverable. Besides the cash system and the mercantile system, there are innumerable other systems of accounting which may be called hybrid or heterogeneous - in which certain elements and incidents of the cash and mercantile systems are combined."