The Judgment of the Court was delivered by

Ajit K. Sengupta, J.:— In this reference under section 256(2) of the Income-tax Act, 1961, for the assessment year 1973–74, the following question of law has been referred to this court:

“Whether, on the facts and in the circumstances of the case, the Tribunal was right in upholding the order of the Income-tax Officer in estimating the interests income of the assessee?”

2. The facts, shortly stated, are that the assessee derives income from interest and director's remuneration. The assessee had advanced a loan of over Rs. 2 lakhs in 1959 to his father, Sri Manik Chand Bagri, who was carrying on business in export of gunny bags. The loan amount had touched the figure of Rs. 3,45,400 in the year 1965. At the beginning of the present year, i.e, 1st January 1972, the debit balance in the account of Sri Manik Chand Bagri was Rs. 1,27,444. The assessee had charged interest in this account up to the year 1970 but from January 1, 1971, the assessee did not charge any interest in this account. In the return of income filed for the assessment year 1973–74, for which the relevant accounting period ended on December 31, 1972, the assessee had not shown any interest income received or receivable from Sri Manik Chand Bagri. In response to a query made by the Income-tax Officer as to why no interest income was shown in the assessment year 1973–74 on investment with Sri Manik Chand Bagri, the assessee through his representative's letter dated March 25, 1976, explained that the business of his father, Sri Manik Chand Bagri, had received a setback and that the said Manik Chand Bagri was not in a position to repay even the principal sum not to speak of interest and that there was an unwritten agreement and understanding between the assessee and his father, Sri Manik Chand Bagri, to the effect that his father would repay the whole amount standing to his debit as soon as possible provided no further interest would be charged from January, 1971. It was submitted by the assessee that, as a result of the understanding between the assessee and his father, Sri Manik Chand Bagri, no interest was charged on the outstanding. The assessee also pointed out that, as per mutual agreement, Sri Manik Chand Bagri liquidated the entire loan. In the course of the assessment proceedings, the assessee had also filed a confirmatory statement in respect of the loan transactions with the said Sri Manik Chand Bagri duly confirmed by the said debtor to show that the said debtor had also not provided for any interest in his books. However, the Income-tax Officer observed that, in view of the fact that the assessee was following the mercantile system of accounting, the interest income, whether received or not, would be taxed and, accordingly, he included a sum of Rs. 14,868 being interest at 12 per cent.

3. The assessee went up in appeal and the Appellate Assistant Commissioner accepting the contentions of the assessee, deleted the addition of Rs. 14,868. The Appellate Tribunal, however, accepted the appeal of the Department and restored the order of the Income-tax Officer, thereby confirming the addition of Rs. 14,868.

4. It has been contended by Mr. Roy Chowdhury, learned advocate appearing on behalf of the assessee, that there was no expectation of receiving any interest from the father. The genuineness of the transaction has not been disputed in this case either. The undisputed facts of this case are that there was no agreement for payment of interest by and between the creditor and the debtor. But interest was duly credited to the account in the books of the assessee till the year 1970. Thereafter, on account of shortage of working capital and loss, the assessee's father, the debtor, was not in a position to repay even the capital sum, not to speak of interest. The debtor was only repaying the principal amount to the creditor and was not charged any interest. From 1971, interest was not credited to the account and the debit balance was carried forward from year to year until-the principal amount was paid off by the debtor.

5. The Tribunal was of the view that the crux of the problem is whether, on the facts and in the circumstances of the present case, it can be said that interest income had accrued to the assessee in respect of the aforesaid advance given to Sri Manick Chand Bagri. The Tribunal held that, apart from those circumstances mentioned hereinbefore, there was no other material or circumstantial evidence to indicate that interest in respect of the aforesaid debt had been given up by the assessee. The Tribunal held that, in the absence of any contemporaneous evidence to show that interest in respect of the aforesaid debt had been given up by the assessee, it must be held that interest had accrued to the assessee. The assessee had merely not charged the same for the year of account.

6. The real question is whether the assessee has given up or forgone the interest. The mercantile system of accounting is relevant only to determine the point of time at which tax liability is attracted and whether the income has accrued or not. It cannot be relied on to determine whether the income has, in fact, resulted or materialised in favour of the assessee. It is true that the assessee has been maintaining his accounts on the basis of the mercantile system of accounting. The interest income may have accrued according to the mercantile system. In our view, this issue has to be viewed in the context of commercial and business realities of the situation. Reference may be made to the decision of the Supreme Court in Poona Electric Supply Co. Ltd. v. CIT, [1965] 57 ITR 521, where the Supreme Court observed (at page 529):

“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 managing 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 aspect of the matter viewed as a whole when that can be done without disregarding statutory language.”

7. Reference may also be made to the judgment of the Supreme Court in the case of CIT v. Shoorji Vallabhdas and Co., [1962] 46 ITR 144, where the Supreme Court 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. The fact in this reference remains that from the year, 1970 onwards, the assessee did not receive any interest as the debtor was unable to pay any interest. Income by way of interest was not, in fact, realised by the debtor and has not become his income in the real sense.

9. Our attention has been drawn to a decision of the Madras High Court in the case of CIT v. Motor Credit Co. P. Ltd., [1981] 127 ITR 572. There, the assessee, a private company, which was carrying on business as financiers for purchase of motor vehicles on hire purchase, advanced, under hire purchase agreements, monies to two firms which were plying buses. The routes of these two firms having been taken over by a State Transport Corporation, the firms defaulted in making payments of the hire purchase instalments, and, consequently, the buses were seized. As the assessee-company was advised that there was no prospect of recovering even the principal amount, the assessee-company did not credit the interest on the outstandings from the two companies even though it was adopting the mercantile system of accounting. The Income-tax Officer, however, included a sum of Rs. 56,163 by way of accrued interest on the amounts outstanding from these two firms. The Appellate Assistant Commissioner deleted the addition. The Tribunal held that the assessee could not have expected to get any interest income on the outstandings found due from the two firms and it would be wholly unrealistic on the part of the assessee to take credit for the interest income and, consequently, confirmed the Appellate Assistant Commissioner's order. In these facts, the Madras High Court held that the Tribunal was correct in its conclusion that though the assessee had adopted the mercantile system of accounting, no interest income could be assessed in its hands on accrual basis as it would be very unrealistic on the part of the assessee to take credit for a highly illusory interest. The court held thus (headnote):

“The regular mode of accounting determines only the mode of computing the 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 had 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 on 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.”

10. Our attention has also been drawn to a decision of the Punjab and Haryana High Court in the case of Commissioner Of Income-Tax, Amritsar-Ii v. Ferozepur Finance (P.) Ltd., [1980] 124 ITR 619. There also, the assessee was maintaining accounts on mercantile basis. It was found that the condition of the debtor was bad and interest was not charged on account of the financial position of the debtor. It was held that, even in the mercantile system of accountancy, an assessee could forgo the whole or part of a debt, which was irrecoverable, and the same could not be added to the income of the assessee. There, the court held that since it was not possible for the assessee to recover the amount, the assessee was justified in not charging interest thereon and the interest was rightly forgone by it. In this case also, as we have already indicated, the assessee was not able to recover the principal and, accordingly, the charge of interest in such a case would have only inflated the income of the assessee and the assessee would have been liable to pay tax on such hypothetical income, when it is not the real income of the assessee and when it really was not reflected in the accounts of the assessee.

11. For the reasons aforesaid, the question in this reference is answered in the negative and in favour of the assessee. There will be no order as to costs.

Bhagabati Prasad Banerjee, J.:— I agree.