COMMISSIONER OF INCOME TAX vs RAJASTHAN FINANCIAL CORPORATION.

V. K. SINGHAL, J. :

The Tribunal has referred the following question arising out of its order dt. 23rd April, 1981 in respect of asst. yr. 1977-78 under s. 256(1) of the IT Act :

"Whether, on the facts and in the circumstances of the case, the Tribunal was justified in holding that there was no error prejudicial to the Revenue for the CIT to invoke his powers under s. 263 of the IT Act, 1961 ?"

The facts of the case as found by the Tribunal are that there was a footnote in the printed report of the directors disclosing that the accumulated interest accrued on amounts decreed or under the litigation amounting to Rs. 21,43,395 had not been taken into consideration for the purpose of arriving at the income. This amount included a sum of Rs. 9,85,891 relating to the asst. yr. 1977-78. The ITO did not include the amount of Rs. 9,85,821 in the income of the assessee while passing the assessment order. The CIT issued notice under s. 263 as to why the amount should not be included in the total income of the assessee. The objections were filed by the assessee. The CIT found that the order passed by the ITO is erroneous and prejudicial to the interest of the Revenue by not including the amount of Rs. 9,85,821 in the assessable income of the assessee. The CIT therefore directed the IAC(Asst.) (who then held the jurisdiction over the case) to include the sum of Rs. 9,85,821 in the income of the assessee and to issue revised notice of demand.

The assessee challenged the order of the CIT before the Tribunal and contended that the assessee is maintaining the hybrid system of accounting. It was stated that starting from the very beginning this system was followed and accepted by the Revenue and therefore there was no reason to depart for the asst. yr. 1977-78. The decision in the case of State Bank of Travancore Vs. Commissioner of Income Tax, could not have been the basis for the exercise of the powers under s. 263. According to the CIT, in order to deduce the income properly, it is essential that receipt and payments should be worked out on one and the same basis or same basis of accountancy should be adopted for working out the receipt and expenditure.

According to the system of accounting of the assessee, i.e. accounting for interest on sticky advances on receipt basis while interest on other advances were accounted for on accrual basis, the interest was not being accounted for on mercantile system and hybrid system had been followed since last number of years. Reliance was placed on the Boards Circular No. 41(V-6) D of 1962 dt. 6th Oct., 1962 which was subsequently withdrawn on 20th June, 1978. The Tribunal found that the assessee followed the hybrid system from beginning and no reason has been shown for the departure in the asst. yr. 1977-78. The decision in the case of Commissioner of Income Tax, Tamil Nadu-V Vs. Motor Credit Co. P. Ltd., was also taken into consideration and it was found that in that case the assessee was doing the business of financiers for purchase of motor vehicles on hire purchase. It advanced moneys to two firms whose business was taken over by the State. There was no prospect of recovering even the principal amount, the company did not credit the interest on the outstanding from the two companies although it was following mercantile system of accounting. The accrued interest was added by the ITO but the addition was deleted by the AAC. The Tribunal upheld the order of the AAC. The High Court agreed with the Tribunal holding that no interest income could be assessed in the hands of the company on accrual basis as it would be very unrealistic on the part of the assessee to take credit for highly illusory interest. On the basis of this judgment, it was considered that even if an assessee following the mercantile system of accounting can under certain circumstances need not account for interest on advances considered doubtful. Therefore, the assessee could maintain the hybrid system of accounting.

We have considered over the matter. From the findings which have been recorded by the Tribunal it is evident that the assessee was following the hybrid system of accounting right from beginning which was accepted by the Revenue in the past. The decision which was given by the apex Court in the case of State Bank of Travancore Vs. Commissioner of Income Tax, Kerala, was in respect of a case where the assessee was maintaining the mercantile system of accounting. It has to be seen whether the maintaining of accounts by hybrid system is (i) consistently followed by the assessee and (ii) bona fide action and (iii) system is recognised on the basis of accounting principles. The entire action which has been taken on the basis of the order passed by the CIT under s. 263 of the IT Act wherein it was found that the assessee is a financial corporation and derives income mainly from interest on moneys advanced. The interest payable on loans and deposits is calculated on the basis of mercantile system or on double entry basis. The interest is said to be credited to profit and loss account, but in respect of those cases where litigation proceedings have been initiated the interest is not credited to profit and loss account on the ground that such loans are sticky or doubtful for realisation. It was also found that on finalisation of litigation proceedings from such sticky advances/loans, the interest which accrued due is offered for taxation. The Tribunal has also taken into consideration these findings and found that the assessee was following the hybrid system right from the beginning and was accepted by the Revenue. No reason was given for departure. On the basis of the findings which have been recorded, it is found that the assessee was maintaining the hybrid system of accounting in respect of sticky loans and advances. In the preceding assessments, it was never objected to. The action of the assessee cannot be said to be lacking in its bona fide. The hybrid system of accounting was also recognised system of accountancy and therefore the decision in the case of State Bank of Travancore Vs. Commissioner of Income Tax, and State Bank of Travancore Vs. Commissioner of Income Tax, Kerala, has no application where the decision was given in such a case where the assessee was maintaining mercantile system of accounting. In the case of Commissioner of Income Tax, Bombay City I Vs. Shoorji Vallabhdas and Co., it was observed that -

"income tax is a levy on income. No doubt, the IT Act takes into account two points of time at which the liability to tax is attracted, viz. the accrual of the income or its receipt; but the substance of the matter is the income. If income does not result at all, there cannot be a tax, even though in book-keeping an entry is made about a hypothetical income which does not materialise. Where income has, in fact, been received and is subsequently given up in such circumstances that it remains the income of the recipient, even though given up, the tax may be payable. Where, however, the income can be said not to have resulted at all there is obviously neither accrual nor receipt of income, even though an entry to that effect might in certain circumstances, have been made in the books of account."

If the assessee has continued with the system of accountancy which is a recognised one and has consistently been followed and even accepted by the Revenue and has not been found as lacking in its bona fides, the power under s. 263 cannot be exercised.

In Commissioner of Income Tax Vs. U.P. Financial Corporation, it was held that the interest due on the interest bearing loans did not accrue or arise to the assessee during the accounting year because suits were pending for the recovery of the loans. The fact that the assessee followed the mercantile system of accounting and the loans were interest bearing was irrelevant. In the case of Commissioner of Income Tax Vs. Uttar Pradesh Financial Corporation, it was held that the interest did not accrue because during the whole of the period suits filed for recovery of the loans were pending and the awarding of interest for the period was within the discretion of the Court which was yet to pronounce its judgment. In CIT vs. City Bank N. A. (1994) 208 ITR 830 the Bombay High Court also accepted the principle of hybrid system of accounting by the bank which was following mercantile system, but keeping separate account for problem loans and it was held that the said system of accounting was accepted by the IT authorities in the earlier years and the interest on problem loans credited only on actual receipt, therefore was not assessable on the basis of accrual. Similar view was taken by the Orissa High Court in the case of Commissioner of Income Tax Vs. Orissa State Financial Corporation,

Consequently, we are of the opinion that the Tribunal was justified in holding that there was no error prejudicial to the Revenue for the CIT to invoke his powers under s. 263 of the IT Act, 1961.

Accordingly, the reference is answered in favour of the assessee and against the Revenue. No order as to costs.