2020 (10) TMI 459 - HC - Income Tax

Method of accounting - receipt basis or accrual basis (mercantile system) - income received in advance in the nature of interest income on discounting of bills against letter of credit - HELD THAT - It cannot be disputed that discounting of bills is being done in one of the modes of finance and the Assessing Officer accepted that the assessee received the amount of interest which represented interest pertaining to a subsequent year. In such cases if the assessee is not permitted to debit interest related to the period beyond the closing date from the interest received account and credited in the advance account then it would fall foul of the mercantile system of accounting. In case of pre-payment of usance import bills remittances may be made only after reducing the proportionate interest for the unexpired portion of usance at the rate at which interest has been claimed and in cases where interest is not separately claimed or expressly indicated remittances may be allowed after deducting the proportionate interest for the unexpired portion of usance at the prevailing LIBOR of the currency of invoice. The above directions issued by the RBI would also come to the aid and assistance of the assessee. We hold that the Assessing Officer the CIT(A) and the Tribunal fell in error while considering the issue framed before us as a substantial question of law.

Issues Involved:
1. Taxation of income received in advance.
2. Interpretation of Section 5(1)(a) and Section 145 of the Income Tax Act.
3. Applicability of mercantile system of accounting.
4. Tribunal's findings on the liability to repay interest on discounted bills.
5. Relevance of matching concept and accounting principles.
6. Compliance with Foreign Exchange Association of India Rules and RBI Master Directions.

Issue-wise Detailed Analysis:

1. Taxation of Income Received in Advance:
The core issue in this appeal is whether the income received in advance, specifically interest income on discounting of bills against letters of credit, should be taxed on a receipt basis or an accrual basis. The Assessing Officer included the interest received in advance in the taxable income for the year under consideration, arguing that it was received during that year. The assessee contended that the interest income should be taxed based on the accrual system since they follow the mercantile system of accounting.

2. Interpretation of Section 5(1)(a) and Section 145 of the Income Tax Act:
The Assessing Officer referred to Section 5(1)(a) to justify taxing the interest income in the year it was received. However, the assessee argued that under Section 145, which deals with the method of accounting, the income should be computed according to the mercantile system they regularly employ. The judgment emphasizes that income should be recognized based on the method of accounting followed by the assessee, which in this case is the mercantile system.

3. Applicability of Mercantile System of Accounting:
The Tribunal's decision was based on the premise that the interest received on purchase and discount of bills may not need to be repaid, thus treating it as income for the year it was received. The judgment refutes this, highlighting that under the mercantile system, income is recognized on an accrual basis. This means that income is taxed when the right to receive it is established, not necessarily when it is received. The judgment cites the case of Siam Commercial Bank PCL Vs. DDIT, which clarifies that under the mercantile system, income is recognized when it accrues, irrespective of actual receipt.

4. Tribunal's Findings on the Liability to Repay Interest on Discounted Bills:
The Tribunal's observation that the interest on discounted bills may not need to be repaid was found to be factually incorrect. The judgment points out that if bills are honored within the discount period, proportionate interest for the remaining period must be refunded. This contradicts the Tribunal’s conclusion and supports the assessee's position that the interest should not be taxed in the year of receipt if it pertains to a subsequent period.

5. Relevance of Matching Concept and Accounting Principles:
The judgment underscores the importance of the matching concept, which aligns revenues with corresponding expenses. It explains that under the mercantile system, income and expenses are recognized when they accrue. The decision quotes the Mumbai Tribunal's explanation in the case of Siam Commercial Bank PCL, emphasizing that income should be taxed when it accrues, not when it is received. This principle supports the assessee's method of accounting for interest received in advance as a liability until it accrues as income.

6. Compliance with Foreign Exchange Association of India Rules and RBI Master Directions:
The judgment references Rule 2.2(c) of the Foreign Exchange Association of India Rules and RBI Master Directions, which mandate refunding interest for the unexpired period in case of early realization of discounted bills. These regulations support the assessee's practice of treating interest received in advance as a liability until it accrues, reinforcing the argument against taxing it on a receipt basis.

Conclusion:
The judgment concludes that the Assessing Officer, CIT(A), and the Tribunal erred in their interpretation and application of the relevant provisions and accounting principles. The appeal is allowed, and the substantial question of law is answered in favor of the assessee, affirming that the interest received in advance should be taxed based on the accrual system as per the mercantile method of accounting.

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