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Issues involved: Assessment of accrued interest income under the mercantile system of accounting.
Summary: The High Court of Madras considered the case of a private limited company engaged in hire-purchase financing for motor vehicles. The company did not account for accrued interest income from two firms due to doubts about recovering the principal amounts. The Income Tax Officer (ITO) included the accrued interest in the company's income, but the Appellate Assistant Commissioner (AAC) disagreed, citing the impracticality of recognizing unrealized interest. The Tribunal upheld the AAC's decision, emphasizing the unrealistic nature of expecting interest income from the two firms. The revenue challenged this decision, arguing that under the mercantile system of accounting, accrued interest must be recognized. The revenue relied on legal precedents to support their position. However, the Tribunal's decision was upheld by the High Court, which emphasized that the mercantile system of accounting should not lead to taxing hypothetical income. The Court considered the commercial realities of the situation, where recovery of interest was deemed highly unlikely. Therefore, the Court ruled in favor of the assessee, concluding that no liability to tax accrued interest existed based on the mercantile accounting system. The Court highlighted that the timing of tax liability is determined by the accounting system, but the actual realization of income is crucial in assessing tax liability. In a separate judgment, the Court referenced legal precedents to support the view that income tax is levied on actual income, not hypothetical or unrealized income. The Court emphasized that the mercantile system of accounting determines the timing of tax liability, but the actual materialization of income is essential for taxation. The Court considered the business realities of the situation, where the assessee faced challenges in recovering interest income due to external factors. Ultimately, the Court ruled in favor of the assessee, highlighting that no tax liability existed for the accrued interest income based on the mercantile accounting system and the commercial circumstances of the case.
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