Venugopal, J.:— The assessee is a private limited company carrying on business as financiers for purchase of motor vehicles on hire-purchase agreement. Under the hire-purchase agreement it advanced money to M/s. P.N Swamy Naidu and Company and M/s. Prakash Transports. At the beginning of the accounting year relevant to the assessment year 1973-74, a sum of Rs. 5,30,113 was outstanding as against M/s. P.N Swamy Naidu and Company and a sum of Rs. 34,000 was found outstanding as against M/s. Prakash Transports. The assessee did not account for any interest either on accrual or receipt basis from these two firms on the ground that it was not possible even to recover the capital from these two firms. The ITO did not accept the assessee's contention and included a sum of Rs. 56,163 by way of accrued interest on the amounts outstanding from these two firms. On appeal, the AAC held that though under the mercantile system of accounting accrued interest should be treated as income, in the peculiar facts and circumstances of the case, even where the capital was not capable of being realised, there was no point in making a debit entry in respect of a hypothetical unrealised interest and on this ground, he deleted the addition of Rs. 56,163. On further appeal to the Tribunal it was contended for the revenue that as the assessee was following the mercantile system of accounting it was bound to account for accrued interest even though nothing was received during the year of account and it is always open to the assessee to write off such of the interest as became irrecoverable in the year in which it was found to be so. The Tribunal, rejecting the contention, held that on the facts and circumstances of the case the assessee could not have expected to get any interest income on the outstandings found due from these two firms and it would be wholly unrealistic on the part of the assessee to take credit for a highly illusory interest income and the Tribunal, accordingly, confirmed the order passed by the AAC.

2. At the instance of the revenue, the following question of law has been referred to this court for opinion under s. 256(1) of the I.T Act, 1961:

“Whether, on the facts and in the circumstances of the case, the sum of Rs. 56,163 was assessable as income on the basis that it constitutes accrued interest?”

3. The learned counsel for the revenue contended that once the assessee had chosen the mercantile system of accounting for an assessment and has regularly employed that system, it is not open to the assessee unilaterally at any time during a subsequent accounting year to change that system and it is not open to the assessee to say that he would not debit in his account the interest which had accrued under the hire-purchase agreements executed with the two firms and so long as the interest income has accrued it has to be included in the income of the assesee even though the assessee may not be able to actually realise the interest from the two firms on account of their financial position and it is always open to the assessee to write off the interest in any year in which it became irrecoverable.

4. In support of this contention, the learned counsel for the revenue relied on a decision in Shiv Prasad Ram Sahai v. Commissioner Of Income-Tax, Uttar Pradesh., [1966] 61 ITR 124 (All) and the decisions of the Supreme Court in CIT v. Thiagaraja Chetty & Co., [1953] 24 ITR 525 and Morvi Industries Ltd. v. Commissioner Of Income Tax (Central) Calcutta, [1971] 82 ITR 835.

5. In H.M Kashiparekh & Co. Ltd. v. CIT, [1960] 39 ITR 706 (Bom), the assessee was maintaining its accounts on the mercantile system. Under the managing agency agreement, it was under a duty to forgo up to one-third of its commission where the profits of the managed company were not sufficient to pay a dividend of 6 per cent, and in pursuance of that agreement, the assessee, for the relevant year in question, had forgone a sum of Rs. 97,000. The question arose whether the income forgone by the assessee could be the real income of the assessee for the accounting year. The contention of the revenue was that the assessee was maintaining its accounts on the basis of the mercantile system of accounting and the income must be held to have accrued at the end of the accounting year. Rejecting this contention, the Bombay High Court held (p. 720);

“Even so (the failure to produce account books), we shall proceed on the footing that the assessee-company having followed the mercantile system of account, there must have been entries made in its books in the accounting year in respect of the amount of the commission. In our judgment, we would not be justified in attaching any particular importance “in this case to the fact that the company followed the mercantile sytem of account. That would not have any particular bearing in applying the principle of real income to the facts of this case.”

6. The decision was cited with approval by the Supreme Court in Poona Electric Supply Co. Ltd. v. CIT, [1965] 57 ITR 521, 529 and the Supreme Court observed:

“‘The principle of real income is not to be so subordinated as to amount virtually to a negation of it when a surrender or concession or rebate in respect of manging agency commission is made, agreed to or given on grounds of commercial expediency, simply because it takes place some time after the close of an accounting year. In examining any transaction and situation of this nature the court would have more regard to the reality and speciality of the situation rather than the purely theoretical or doctrinaire aspect of it. It will lay greater emphasis on the business of the matter viewed as a whole when that can be done without disregarding statutory language.’”

7. The Supreme Court in CIT v. Shoorji Vallabhdas and Co., [1962] 46 ITR 144 held (headnote):

“Income-tax is a levy on income. Though the Income-tax 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, yet 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.”

8. In the mercantile system of accounting credit entries are made in respect of amounts as soon as they became legally due and even before they are actually received and similarly the expenditure for which legal liability has been incurred, are immediately debited even before the amounts in question, are actually disbursed. The point of time at which tax liability is attracted depends upon the system of accounting regularly employed by the assessee and in the case of mercantile system of accounting, liability to tax is attracted as soon as the income accrued. Regular mode of accounting only determines the mode of computing taxable income and the point of time at which the tax liability is attracted. It cannot determine or affect the range of taxable income or the ambit of taxation. 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. 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 a hypothetical income. It is not the hypothetical accrual of income based on the mercantile system of accounting followed by the assessee that has to be taken into account but, what should be considered is, whether the income has really materialised or resulted to the assessee. 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. In the present case, the routes in which the buses of the two firms, M/s. P.N Swamy Naidu and Company and M/s. Prakash Transports, were plying were taken over by the Cheran Transport Corporation Ltd. It is on account of the taking over of the routes by the Cheran Transport Corporation Ltd. that the two firms defaulted in making the payment of the hire-purchase instalments and this has led to the seizure of the buses by the assessee. The legal opinion taken by the assessee also indicated that there was no prospect of any recovery of the amount lent to these two firms by initiating legal proceedings against them. When the facts and circumstances of the case clearly indicated that there is not even the remotest possibility of any interest income materialising in favour of the assessee in respect of the outstandings for the accounting year relevant to the assessment year in question, no liability to tax can be imposed on the ground that interest has accrued because of the mercantile system of accounting employed by the assessee. The mercantile system of accounting can be relevant only to determine the point of time at which tax liability is attracted and it cannot be relied on to determine whether income has, in fact, resulted or materialised in favour of the assessee. Merely because the assessee has been maintaining his accounts on the basis of mercantile system of accounting, the interest income on the outstandings in the two firms cannot be held to have accrued at the end of the accounting year. Viewed against the background of commercial and business realities of the situation in which the assessee was placed, the Tribunal came to the conclusion that it would be very unrealistic on the part of the assessee to take credit for a highly illusory interest. The Tribunal was fully justified in arriving at this conclusion. The question referred to us is answered in the affirmative and in favour of the assessee. The assessee is entitled to costs. Counsel's fee Rs. 500.