Income-tax---

----Income---Accounting---Real income principle---Mercantile system of accounting---Mere posting of entry in accounts maintained on mercantile system---Not sufficient---Amount claimed by assessee from provincial Government over and above the price tentatively agreed and entered in accounts maintained on mercantile system---Provincial Government rejecting assessee's claim---Amount entered in accounts not assessable.

In order to tax an income, one has to see whether it is the real income or whether the income has materialised. What is necessary to be considered is the true nature of the transaction and whether in fact the transaction has resulted in profit or loss to the assessee. Once accrual takes place and income accrues, the same cannot be defeated by any theory of real income. Even under, the mercantile system of accounting, it is only the accrual of real income which is chargeable to tax. The income should not be hypothetical income, but real income. If income is given up unilaterally by the assessee after it had accrued, he could not escape liability to tax. When income is in fact received but subsequently given up, it remains the income of the recipient and tax is payable. When income has not resulted at all, there is neither accrual nor receipt of income even if there is an entry to that effect in the books of account. Mere posting of an entry in the account books would not always supply conclusive evidence on the question whether the disputed amount has accrued to the assessee or not. Mere effort on the part of the assessee to realise the amount by sending a bill or making a claim or filing a suit for recovery would not, in law, make it income which has accrued in the year in question. The transfer of the amount to the profit and loss account is bereft of my significance.

The assessee was a public sector undertaking engaged in the manufacture and sale of pharmaceutical products. The entire production of the assessee was supplied to the Kerala Government. There was an agreement between the assessee and the State Government that if the price structure fixed by the Government was lower than the price fixed by the assessee, the excess payment would be adjusted against future supplies. If the price fixed was higher, a claim could be preferred for the balance. During the accounting year relevant to assessment year 1978-79, the assessee preferred a claim for Rs.41,86,349 as excess amount receivable over and above the price tentatively agreed for the products supplied. The claim was not accepted by the Government and the Joint Secretary of the Industries Department turned down the claim. The amount had been shown in the profit and loss account as amount receivable and the original return had been filed by the assessee on this basis. In the course of proceedings under section 144B, the company filed a revised return claiming exclusion of this amount from the total receipts. By that time, the Government had already turned down the assessee's claim. The Income-tax Officer was not willing to accept the assessee's claim for exclusion. However, the Tribunal accepted the assessee's claim. On a reference:

Held, that the price of drugs supplied by the assessee was only tentative. The entries made in the accounts represented mere claims and did not represent any income accrued or received. The excess amount credited in the accounts of the assessee was not assessable as its income.

Chowringhee Sales Bureau Pvt. Ltd. v. C.I.T. (1973) 87 ITR 542 (SC); C.I.T. v. Burlop Commercial Pvt. Ltd. (1988) 173 ITR 522 (Cal.); C.I.T. v. Kameshwar Singh (1933) 1 TTR 94 (PC); C.I.T. v. Kerala Financial Corporation (1985) 155 ITR 228 (Ker.); C.I.T. v. Krishnaswami Mudaliar (A) (1964) 53 TTR 122 (SC); C.I.T. v. Motor Credit Co. Pvt. Ltd. (1981) 127 ITR 572 (Mad.); C.I.T. v. Nadiad Electric Supply Co. Ltd: (1971) 80 ITR 650 (Bom.); C.I.T. v. Planters Co. Pvt. Ltd. (1980) 123 ITR 648 (Mad.); C.I.T. v. Shoorji Vallabhdas & Co. (1962) 46 ITR 144 (SC); C.I.T. v. Western India Engineering Co. (1971) 81 ITR 712 (Guj.); Morley (Inspector of Taxes) v. Tattersall (1939) 7 ITR 316 (CA); Morvi Industries Ltd. v. C.I.T. (1971) 82 ITR 835 (SC); Pioneer Consolidated Co. of India Ltd. v. C.I.T. (1972) 85 ITR 410 (All.); State Bank of Travancore v. C.I.T. (1986) 158 ITR 102 (SC) and Sutlej Cotton Mills Ltd. v. C.I.T. (1979)116 ITR 1(SC) ref.

P.K.R.Menon and N.R.K.Nair for the Commissioner.

B.S.Krishnan for the Assessee.

JUDGMENT

K.P. BALANARAYANA MARAR, J. --At the instance of the Revenue, the following question has been referred to this Court for decision:

"Whether, on the facts and in the circumstances of the case and considering the mercantile system of accounting followed by the assessee and also considering that the reopening of accounts is impermissible under Indian law, the Tribunal is right in holding--

(i) that the amount credited as the price of medicine supplied to Government does not represent accrued income or income received?

(ii) that entries made in accounts represent mere claims?"

The respondent-assessee is a public sector undertaking of the Government bf Kerala and the subsidiary of the Kerala State Industrial Enterprises Ltd. It is engaged in the manufacture and sale of pharmaceutical products. We are concerned with the assessment year 1978-79 for which the corresponding previous year ended on March 31,1978.

The entire production of the assessee is supplied to the Health Services Department of the Kerala Government. The Government had been sanctioning ad hoc advances to be adjusted later against the supplies. Some difficulties arose in following this practice and the Director of Health Services pointed out to the Government that adjustment of advances could not be made because the prices of the items have to be fixed by the Government of India. Further advance could not be made to the assessee-company and that created a grave financial situation for the assessee. The Director of Health Services, therefore, suggested to the Government that the advances already paid may be adjusted on the basis of the tentative price approved by the firm and further advances may be sanctioned so as to enable them to continue further production. An indemnity bond was executed by the chairman of the company to the effect that if the price structure fixed by the Government is lower than the rate fixed by the firm, the excess payment would be adjusted against future supplies. If the price fixed was higher, a claim could be referred for the balance amount. This proposal was agreed to by the Government.

During the accounting year under consideration, the assessee, preferred a claim for Rs.41,86,349 as excess amount receivable over and above the price tentatively agreed for the products supplied. The claim was not accepted by the Government and the Joint Secretary of the Industries Department turned down the claim. The amount had been shown in the profit and loss account as amount receivable and the original return has been filed by the assessee on this basis. In the course of proceedings under section 144-B, the company filed a revised return claiming exclusion of this amount from the total receipts. By that time, the Government had already turned down the assessee's claim. The Income-tax Officer was not willing to accept the assessee's claim for exclusion. According to him, the assessee was following the mercantile system of accounting and credit once taken cannot be excluded on a re-consideration of finalised accounts. On appeal, the Commissioner of Income?-tax (Appeals) held that the claim was unilateral and a mere claim cannot have the characteristics of income. According to him the amount claimed had not become the income of the assessee at any point of time and he, therefore, held that this amount should be deleted. On further appeal before the Income-tax Appellate Tribunal, the appellate authority came to the conclusion that the price of the products supplied was fixed only tentatively and was subject to ultimate fixation by the Government of India. The Tribunal observed that the price initially charged did not represent the correct price of the product supplied and a mere claim made cannot be equated with the incurring of liability or a receipt. Relying on the decision of the Supreme Court in Shoorji Vallabhdas & Co. (1962) 46 ITR 144 and the decision of the Gujarat High Court in Western India Engineering Co. (1971) 81 ITR 712, the Tribunal agreed with the view of the Commissioner of Income-tax ( Appeals).

The reference application by the Commissioner of Income-tax was originally disposed of by the Tribunal by drawing up a statement of the case on January 31, 1986, referring one question out of the two questions suggested by the Department. In respect of the question which was not referred, the Department moved this Court by O.P. 8758 of 1986. This Court directed the Tribunal to refer that question also. It was thereafter that the aforesaid question was referred to this Court for decision.

It is urged on behalf of the Revenue that the assessee is following the mercantile system of accounting and credit once taken cannot be excluded on a reconsideration of finalised accounts. This contention found favour with the assessing authority who refused to exclude the amount as required by the assessee. It is settled law that the income of the assessee will have to be determined according to the provisions of the Income-tax Act and in consonance with the method of accounting followed by the assessee. The precise question which we are called upon to consider in this reference is whether the amount sought to be excluded is the real income of the assessee. To ascertain whether it is real income or not, it is advantageous to look into the distinguishing feature of the mercantile system of accountancy from the other system, viz., cash system of accounting. Two broad systems of accounting to determine the profits and gains of a business are referred to as "cash basis" and "mercantile basis". The distinction between the mercantile system and the cash system has been explained by the Supreme Court in CIT v, A.Krishnaswami Mudaliar (1964) 53 ITR 122. The Supreme Court observed (p. 129):

"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 receipts 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 accure or liabilities are incurred, irrespective of the date of payment. For example, when goods are sold on credit, a receipt entry is posted as on the date of sale, although no cash is received immediately in payment for 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."

On the cash system of accounting, the Supreme Court observed (p. 129):

"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?.

It is true that the assessee is following the mercantile system of accounting; but even then it is only the accrual of real income which is chargeable to tax. We have, therefore, to ascertain whether the amount sought to be excluded is the real income of the assessee. Income-tax is a tax on the income and the Income-tax Act takes into account two points of time at which the liability to tax is attracted, viz., the accrual of income or its receipt. Section 4 of the Act charges every person in respect of his total income and the gamut of the total income is defined in section 5 of the Act. The total income of any previous year of a person who is a resident includes all income from whatever source derived which (a) is received or is deemed to be received in India in such year by or on behalf of such person; or (b) accrues or arises or is deemed to accrue or arise to him in India during such year; or...?

Liability to tax is, therefore, attracted only if income accrues or if income is received. The Supreme Court in CIT v. Shoorji Vallabhdas & Co. (1962) 46 ITR 144, held that 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 (emphasis supplied). The Supreme Court further held that if 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. But, in cases where the income can be said not to have resulted at all, there is obviously neither accrual nor receipt of income, even though an entry is made to that effect in certain circumstances in the books of account.

In Morvi Industries Ltd. v. CIT (1971) 82 ITR 835 the Supreme Court observed that the relinquishment by the assessee of its remuneration after it had become due was of no effect and that the amount was liable to be taxed,

The question that arises for consideration in this reference is whether the amount sought to be excluded had already accrued and subsequently been given up by the assessee. A claim was no doubt made by the assessee on the basis of the agreement entered into between the assessee and the Government by which the Government had undertaken to pay the difference between the advance already paid and the price fixed by the Government which necessitated the exclusion of this amount from the profit and loss account to which the claim had already been credited. Mere sending of a bill or the making of a claim will not create an enforceable right. The Bombay High Court had occasion to consider this aspect in CIT v. Nadiad Electric Supply Co. Ltd. (1971) 80 ITR 650. It was held that sending the bills amounted merely to making a claim for the amounts mentioned in the bill and that mere sending of bills did not create a legal enforceable right in the assessee-company, nor a corresponding legal enforceable obligation on the municipality in that case.

In CIT v. Western India Engineering Co. (1971) 81 ITR 7 2, the Gujrat High Court was dealing with a case where the mercantile system of accounting was followed by the assessee. It was observed that this system of accounting brings into credit what is due, immediately it becomes legally due and before it is actually received, and it brings into debit expenditure the amount for which a, legal liability has been incurred before it is actually disbursed. It undoubtedly furnishes prima facie evidence to shoo whether the amount has accrued or not. It was held that the mere posting of an entry in the account books of the assessee would not always supply conclusive evidence on the question whether the disputed amount has accrued to the assessee or not. It was further observed that the question as to what income has accrued or arisen to the assessee during a particular year is essentially a question of fact and that should be decided with reference to the particular facts and circumstances of each case. The Calcutta High Court is also of the same view. In CIT v. Burlop Commercial Pvt. Ltd. (1988) 173 ITR 522 (Cal.), it was held that mere effort on the part of the assessee to realise the amount by sending the bill or filing a suit for its recovery would not in law make it an income which had accrued in the year in question. It was also observed that the fact that the assessee followed the mercantile system of accounting is not relevant.

The Madras High Court in CIT v. Motor Credit Co. P. Ltd. (1981) 127 ITR 572, held that the question whether real income has materialised to the assessee has to be considered with reference to commercial and business realities of the situation in which the assessee has been placed and not with reference to his system of accounting. It was held that where no income has resulted, it cannot be said that income has accrued merely on the ground that the assessee has been following the mercantile system of accounting. It was further observed that even if the assessee makes a debit entry to that effect, still no income can be said to have accrued to the assessee. If no income has materialised, there can be no liability to tax on a hypothetical income.

This Court also had occasion to consider this aspect in CIT v. Kerala Financial Corporation (1985) 155 ITR 228. There it was held that if, on the construction of the transaction, income is found not to have arisen or accrued, any entry in the books of account showing accrual of income would not attract tax merely by reason of such entry.

The Supreme Court in Sutlej Cotton Mills Ltd. v. CIT (1979) 116 ITR 1, observed that the way in which entries are made by an assessee in his books of account is not determinative of the question whether the assessee has earned any profit or suffered any loss. The assessee may be making entries which are not in conformity with the proper principles of accountancy. The assessee may conceal profit or show loss. The Supreme Court held that the entries made by the assessee cannot be regarded as conclusive one way or the other. It was observed that what is necessary to be considered is the true nature of the transaction and whether in fact it has resulted in profit or loss to the assessee. A three-judge Bench of the Supreme Court had again considered this matter in State Bank of Travancore v. CIT (1986) 158 ITR 102. His Lordship, Justice Sabyasachi Mukharji (as His Lordship then was), speaking for the majority, held that even under the mercantile system of accounting, it is only the accrual of the real income which is chargeable to tax. The accrual is a matter of substance and it is to be decided on commercial principles having regard to the business character of the transactions and the realities and specialities of the situation and cannot be determined by adopting a purely theoretical or doctrinaire or legalistic approach. It was further held that there can be no dispute with regard to the principle that if the stock-in-trade remains unused or unsold, the mere book appreciation in value thereof cannot be brought to tax. At the same time it was held that the concept of reality of the income and the actuality of the situation are relevant. factors which go to the making up of the accrual of income and once accrual takes place and income accrues, the same cannot be defeated by any theory of real income. The following propositions were laid down by the Supreme Court in that decision (headnote)

(1) It is the income which has really accrued or arisen to the assessee that is taxable. Whether the income has really accrued or arisen to the assessee must be judged in the light of the reality of the situation.

(2) The concept of real income would apply where there has been a surrender of income which, in theory, may have accrued but, in the reality of the situation, no income had resulted because the income did not really accrue.

(3) Where a debt has become bad, deduction in compliance with the provisions of the Act should be claimed and allowed.

(4) Where the Act applies, the concept of real income should not be so read as to defeat the provision of the Act.

(5) If there is any diversion of income at source under any statute or by overriding title, then there is no income to the assessee.

(6) The conduct of the parties in treating the income in a particular manner is material evidence of the fact whether income has accrued or not.

(7) Mere improbability of recovery, where the conduct of the assessee is unequivocal, cannot be treated as evidence of the fact that income has not resulted or accrued to the assessee. After debiting the debtor's account and not` reversing that entry--but taking the interest merely in suspense account cannot be such evidence to show that no real income has accrued to the assessee or has been treated as such by the assessee.

(8) The concept of real income is certainly applicable in judging whether there has been income or not but, in every case, it must be applied with care and within well-recognised limits.

Learned counsel for the Revenue has a contention that the amount had been transferred to the profit and loss account, and the amount once credited cannot be excluded in view of the method of accounting followed by the assessee. Learned counsel cited the decision of the privy Council in CIT N. Kameshwar Singh (1933) 1 ITR 94. In that case, the assessee had kept his account books on a `hybrid' system. It was held that what the officer was directed to compute is not the assessee's receipts, but the assessee's income and in dubio what the assessee himself chooses to treat as income may well be taken to be the income and to arise when he so chooses to treat it.

The Madras High Court in CIT v. Planters Co. (P.) Ltd. (1980) 123 ITR 648 had to examine the character of the amount in order to find out whether it is income that has accrued to the assessee. It was observed that the sale price is a trading receipt and it accrued at the time when the sale is effected in the mercantile system of accountancy. The Madris High Court referred to the decision of the Supreme Court in Chowringhee Sales Bureau P. Ltd. v. CIT (1973) 87 ITR 542, and observed that the Supreme Court had pointed out that the true nature and quality of the receipts, anal not the head under which they are entered in the account books that would decisive and that if a receipt was a trading receipt, the fact that it is not shown in the account books of the assessee would not prevent the assessing authority from treating it as a trading receipt. The question whether the character of the receipt is changed in any manner by reason of the amount having been appropriated and transferred by the assessee to the profit and loss account was also considered by the Madras High Court. The decision o1 the Court of Appeal in Morley (Inspector of Taxes) v. Tattersall (1939) 7 ITR 316 was also referred to. In that case, the assessee was a firm of auctioneers who did business in the sale of horses. Several sellers of horses failed to claim the balances of purchase monies due to then resulting in large unpaid balances unaccounted by the firm. As per the clause in the deed of partnership, it was provided that all unclaimed balances as on 31st December of the year of account succeeding the six-year period prior to it should be transferred to the credit of the partners. By another clause, it was provided that all liabilities subsisting in reference to the balances should continue to be borne by the partners. The question arose whether the unclaimed balances were trading receipts liable to income-tax. At page 323, Greene M. R. pointed out:

"It seems to me that the quality and nature of a receipt for income-tax purposes is fixed once and for ail when it is received. What the partners did in this case, as I have said, was to decide among themselves that what they had previously regarded as a liability of the firm they would not, for practical reasons, regard as a liability; but that does not mean that at that moment they received something, nor does it mean that at that moment they imprinted upon some existing asset a quality different from what it had possessed before. There was no existing asset at all at that time. All that they did, as I have already pointed out, was to write down a liability item in their balance-sheet, and how in the world by effecting that operation you can be said to have converted a sum received years and years ago into something which it never was is a thing which, with all respect, passes my comprehension."

In the case before the Madras High Court, the amounts were received during 1955 and 1959 as trading receipts. It was observed that the result of the transfer to the profit and loss account is merely to close that particular account and that did not, in any manner, affect either the rights of the assessee or its obligation to the tax department. It was further observed that there has been no accrual of any income by reason of the transfer entry being made from the sales tax account to the profit and loss account of the year. The amount would have been taxed in the years in which the amounts were received. The omission to tax them in the earlier years affords no ground for taxing them in that particular year. Distinguishing the decision of the Allahabad High Court in Pioneer Consolidated Co. of India Ltd. v. CIT (1972) 85 ITR 410, the Madras High Court held that a transfer to the profit and loss account is bereft of significance. With respect, we are inclined to accept this view of the Madras High Court.

From the decisions cited above, the following principles emerge:

In order to tax an income, one has to see whether it is the real income or whether the income has materialised. What is necessary to be considered is the true nature of the transaction and whether in fact the transaction has resulted in profit or loss to the assessee. Once accrual takes place and income accrues, the same cannot be defeated. Even under the mercantile system of accounting it is only the accrual of real income which is chargeable to tax. The income should not be hypothetical income but real income. If income is given up unilaterally by the assessee after it had accrued, it could not escape liability to tax. When income is in fact received but subsequently given up it remains the income of the recipient and tax is payable. When income has not resulted at all, there is neither accrual nor receipt of income even if there is an entry to that effect in the books of account. Mere posting of an entry in the account books would not always supply conclusive evidence on the question whether the disputed amount has accrued to the assessee or not. Mere effort on the part of the assessee to realise the amount by sending a bill or making a claim or filing a suit for recovery would not in law make it an income which has accrued in the year in question. The transfer of the amount to the profit and loss account is bereft of any significance.

Viewed in the light of the principles enunciated above, the Tribunal was right in agreeing with the Commissioner of Income-tax (Appeals) in holding that the assessing authority was wrong in refusing to exclude the amount of Rs. 41,86,349 from the total receipts. The amount represented the amount claimed by the assessee from the Government towards the price of medicines supplied to the Director of Health Services during 1974-75 and 1975-76. That claim was made in accordance with the Government Order G. O. Rl-34 dated October 10, 1975. The Government order was issued in pursuance of an indemnity bond executed by the assessee to the effect that, if the price structure fixed by the Government of India is lower than the rate now fixed by the firm, the excess payments will be adjusted against future supplies and if, on the contrary, the price fixed is higher, the balance amount can be claimed by the firm from the Government. It was on the basis of this indemnity bond and subsequent order of the Government that the assessee made the claim which was turned down by the Government. By that time, the amount had been included in the profit and loss account. In the proceedings under section 144-B, the assessee filed a revised return claiming exclusion on the basis of the Government Order rejecting the claim. In these circumstances, the Commissioner of Income-tax was right in observing that a mere claim cannot clothe the expectation with the character of income and that the treatment given by the assessee in his accounts in regard to a receipt or a payment is not conclusive about its real character. The Commissioner has rightly held that the amount should have been excluded from the total income of the year under consideration. The Appellate Tribunal, while concurring with the order of the Commissioner of Income-tax (Appeals), observed that the price of drugs supplied by the assessee-company to the Health Service Department was only tentative, but was not fixed by contract or otherwise. The entries made in the accounts represented only mere claims and did not represent any accrued income or income received. It was for these reasons that the Tribunal agreed with the view of the Commissioner of Income-tax (Appeals). No error of law has been committed by the Appellate Tribunal.

The question referred to us for decision is, therefore, answered in the affirmative, i.e., in favour of the assessee and against the Revenue.

A copy of this judgment under the seal of the Court and the signature of the Registrar will be forwarded to the Income-tax Appellate Tribunal, Cochin Bench.

M.B.A./1255/P??????????????????????????????????????????????? Question answered in the affirmative.