2006 (5) TMI 60 - SC - Income Tax

Whether two separate limits apply for the purposes of computing disallowance u/s 40A(5) where an employee retires and ceases to be in employment during the previous year, so that one limit will apply in respect of the amounts and benefits received by him as an employee and another for the amounts and benefits received by him as a former employee - held that only one limit is prescribed for deduction on account of salary whether paid to an employee in service or a retired employee

Summary

Issues Involved:
1. Taxability of interest on doubtful advances credited to the interest suspense account under the Income-tax Act, 1961.
2. Applicability of separate limits for computing disallowance under section 40A(5) of the Income-tax Act, 1961, when an employee retires during the previous year.

Issue-wise Detailed Analysis:

1. Taxability of Interest on Doubtful Advances:

The first issue pertains to whether the appellant is liable to be taxed on the interest on doubtful advances credited to the interest suspense account. The High Court had ruled in favor of the Revenue, relying on the decision in *State Bank of Travancore v. CIT [1986] 158 ITR 102; [1986] 2 SCC 11*. In this case, the majority opinion held that carrying certain amounts accrued as interest without treating them as bad debts or irrecoverable interest but keeping them in a suspense account would be repugnant to section 36(1)(vii) read with section 36(2) of the Act. Therefore, under the mercantile system of accounting, the amounts accrued on loans were assessable to tax.

However, a subsequent judgment in *UCO Bank v. CIT [1999] 237 ITR 889* affirmed the minority view in *State Bank of Travancore*, stating that if the interest on loans was doubtful and not realized, it should not be brought to tax. This method was in accordance with established accounting practice and supported by the Central Board of Direct Taxes (CBDT) circulars dated October 6, 1952, and October 9, 1984, which were binding under section 119(1) of the Act. The court in *UCO Bank* emphasized that these circulars could mitigate the rigour of a particular section for the benefit of the assessee and should be followed by the departmental authorities.

Given that the assessment year in question was 1978-79, the Department should have adhered to the 1952 circular, which stated that interest on doubtful loans should not be taxed. Therefore, the High Court's decision based on *State Bank of Travancore* was incorrect in light of the *UCO Bank* judgment.

2. Separate Limits for Disallowance under Section 40A(5):

The second issue concerns whether separate limits apply for computing disallowance under section 40A(5) when an employee retires during the previous year. Section 40A(5) limits the deduction of expenditure on salaries, specifying different limits for current and former employees.

The Calcutta High Court in *Hindustan Motors Limited v. CIT [1985] 156 ITR 223* held that payments made to an employee while in service and after retirement should be treated separately, each within their respective limits. This interpretation would allow an employer to claim deductions up to Rs. 60,000 for payments made to a former employee and Rs. 5,000 per month for an employee in service.

Contrarily, the Bombay High Court disagreed, asserting that the status of the employee on the last day of the previous year should be considered for fixing the limit of deduction. It held that there was only one limit of Rs. 60,000 for salary, whether paid to a current or former employee. The court reasoned that allowing separate limits would render the section's purpose meaningless and enable employers to manipulate the timing of payments to avoid the ceiling.

The Supreme Court agreed with the Bombay High Court's view, emphasizing that the legislative intent was to fix a single limit for deductions under section 40A(5). The term "salary" as defined in section 17 includes various components like wages, pension, and gratuity, which should be considered collectively for the deduction limit. The court noted that the use of the word "aggregate" in other provisions was specific to different kinds of payments, whereas section 40A(5)(c) referred to a single "amount" of salary, indicating a unified limit.

Thus, the Supreme Court affirmed the High Court's decision that only one limit of Rs. 60,000 applies for deductions on account of salary, whether for a current or retired employee, in any given previous year.

Conclusion:

The appeal was partially allowed. The Supreme Court overturned the High Court's decision on the first issue, ruling that the interest on doubtful loans should not be taxed in accordance with the 1952 CBDT circular. On the second issue, the Supreme Court upheld the High Court's decision, confirming that only one limit applies for salary deductions under section 40A(5), regardless of whether the payments are made to a current or former employee. No order as to costs was made.