1985 (12) TMI 71 - AT - Income Tax

Summary

Issues Involved:
1. Chargeability of income from interest to tax.
2. Financial condition of debtors (Bhadohi Cold Storage and Carpet Traders) and its impact on interest accrual.
3. Existence of an agreement for charging interest.
4. Change in the method of accounting from mercantile to cash system.
5. Allegation of colorable transactions to reduce tax liability.
6. Disallowance of car expenses.

Detailed Analysis:

1. Chargeability of Income from Interest to Tax:
The primary contention in these appeals was whether the income from interest was chargeable to tax. The assessee, engaged in the manufacture and export of carpets, had not charged interest from its sister concerns, Bhadohi Cold Storage and Carpet Traders, for the assessment years in question. The IAC included the interest as income based on the mercantile system of accounting. The Commissioner (Appeals) corrected the IAC's figures and determined that only a portion of the interest could be included in the assessment. The Tribunal set aside the Commissioner (Appeals)' order, directing a fresh examination of the facts and the application of the Supreme Court's principles in Morvi Industries Ltd. v. CIT.

2. Financial Condition of Debtors:
The financial condition of Bhadohi Cold Storage and Carpet Traders was a significant factor. The Commissioner (Appeals) initially held that no interest could be charged from Bhadohi Cold Storage due to its poor financial condition and the doubtful recovery of the principal amount. This decision was challenged, and the Tribunal directed a re-examination. Upon review, it was found that Bhadohi Cold Storage's financial position was indeed poor, with substantial arrears and no realistic prospect of recovering even the principal amount. This finding was supported by letters from the assessee to the IAC and the fact that the debtor's financial condition had deteriorated significantly.

3. Existence of an Agreement for Charging Interest:
The Commissioner (Appeals) initially ignored an affidavit stating there was no agreement for charging interest, as the deponent was not produced. He concluded there was an implied agreement for charging interest based on past practices. However, the Tribunal found that the financial condition of the debtors justified the non-charging of interest, aligning with the principles laid down in Ferozepur Finance (P.) Ltd. v. CIT and Motor Credit Co. (P.) Ltd. v. CIT, which emphasized that no tax could be levied on hypothetical income if the financial condition of the debtor made recovery unlikely.

4. Change in Method of Accounting:
The assessee argued for a change from the mercantile system to the cash system of accounting for interest. The Tribunal agreed that the assessee was justified in not charging interest given the debtors' financial conditions, and this change in accounting method was permissible under the circumstances.

5. Allegation of Colorable Transactions:
The departmental representative alleged that the non-charging of interest was a colorable transaction since the directors of the assessee were partners in the debtor concerns. However, the Tribunal found no evidence to support this allegation and noted that the transactions were at arm's length. The decision in Govan Bros. v. CIT was deemed inapplicable as the issue of colorable transactions was not raised at earlier stages.

6. Disallowance of Car Expenses:
The ITO disallowed Rs. 10,000 out of the car expenses claimed by the assessee, citing personal use by the directors. The Commissioner (Appeals) enhanced this disallowance to Rs. 17,845. The Tribunal found no justification for this enhancement, noting that the IAC's original disallowance was based on reasonable satisfaction of partial personal use. The Tribunal deleted the additional disallowance of Rs. 7,845.

Conclusion:
The Tribunal concluded that no interest accrued to the assessee from Bhadohi Cold Storage or Carpet Traders for the assessment years 1978-79 and 1979-80, except for the already taxed amount of Rs. 4,500. Consequently, the additions of Rs. 37,776 for 1978-79 and Rs. 10,500 and Rs. 21,060 for 1979-80 were deleted. The disallowance of Rs. 7,845 in car expenses was also deleted, resulting in the appeal for 1978-79 being partly allowed and the appeal for 1979-80 being fully allowed.