2006 (6) TMI 59 - HC - Income Tax

Chit dividend should be assessd as income of that year, in which it is accrued if assessee is following mercantile system of accounting discount loss could be spread over the remaining period of chit & had to be allowed in the year of its accrual.

Issues Involved
1. Method of accounting for chit dividend and loss.
2. Applicability of principles of deferred expenditure to chit discount.
3. Adherence to Central Board of Direct Taxes (CBDT) instructions on taxability of dividend and allowance of chit loss.

Issue-wise Detailed Analysis

1. Method of Accounting for Chit Dividend and Loss:

The assessees, private limited companies involved in chit fund activities, maintained their accounts on a mercantile basis and computed profit or loss at the end of the chit period using the completed contract method. They argued that the discount incurred by a prized subscriber was a single liability that crystallized at the moment of bidding and should not be spread over the remaining period of the chit.

The Assessing Officer (AO) rejected this method, taxing the dividend in the year of receipt and allowing chit loss on a proportionate time basis. The Commissioner of Income-tax (Appeals) upheld the AO's decision on taxing the dividend but allowed the chit loss deduction in the year of bid.

The Income-tax Appellate Tribunal (ITAT) supported the AO's view, relying on CBDT instructions and the Supreme Court decision in *Madras Industrial Investment Corporation Ltd. v. CIT* [1997] 225 ITR 802, which involved spreading the discount on debentures over the life of the debentures.

The High Court, however, distinguished the facts of the present case from the *Madras Industrial Investment Corporation* case, noting that chit transactions involve a promise to pay future installments, unlike debentures, which involve a continuing liability. The Court concluded that the dividend income should be taxed in the year of accrual, aligning with the mercantile system of accounting.

2. Applicability of Principles of Deferred Expenditure to Chit Discount:

The assessees argued that the discount should be allowed in full in the year it occurred, as it was a one-time liability incurred at the moment of bidding. The AO and ITAT, however, treated the discount as a deferred expenditure to be spread over the remaining period of the chit.

The High Court disagreed with this approach, emphasizing that in chit transactions, the discount is not a deferred expenditure but a business loss incurred in the year of bidding. The Court referred to the Andhra Pradesh High Court decision in *CIT v. Kovur Textiles and Co.* [1982] 136 ITR 61, which allowed the discount as a business loss in the year it occurred.

The Court concluded that the discount should be allowed in full in the year of accrual, rejecting the ITAT's decision to spread it over the remaining period of the chit.

3. Adherence to CBDT Instructions on Taxability of Dividend and Allowance of Chit Loss:

The assessees contended that the ITAT failed to follow CBDT instructions dated May 16, 1978, which addressed the taxability of dividend and allowance of chit loss. The Court, however, deemed this question academic and did not provide a detailed analysis.

Conclusion

The High Court held that:
1. The dividend income should be taxed on the basis of its accrual, favoring the Revenue.
2. The discount loss should be allowed in the year of its accrual, favoring the assessees.
3. The third question regarding CBDT instructions was academic and not addressed.

The appeals were ordered accordingly, with no costs.

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