2008 (1) TMI 491 - AT - Income Tax

Accrual of income - The books are maintained on accrual basis except in the case of income from interest on seed money loans (including penal interest) which is accounted for on cash basis - Permitted to Government companies engaged in the promotion and development of industries Method of Accounting Mercantile or Cash ? - Best judgement assessment u/s 144 - HELD THAT - we are of the considered view even when an assessee is following mercantile method of accounting it is indeed possible and at times even necessary that depending upon the probability or improbability of being able to recover the amounts revenues which legally accrue to an assessee may not be taken into account for the purpose of income recognition. To that extent it is still possible for an assessee to recognize certain revenues due to their peculiar nature. on receipts basis. The only change that has been brought about by amendment in s. 145 is that while prior to the amendment there was no need to justify such an accounting treatment on merits and it was possible for the assessee to argue that as long as a method has been consistently followed no objection can be taken to the same the situation post amendment is that any non recognition of revenue has to be justified by the assessee on merits. Post amendment it is also necessary for the assessee to demonstrate that even under the mercantile method of accounting there are good reasons for not recognizing the revenues in question on accrual basis and that facts and circumstances of the case warrant that such revenues are recognized only when the same are received. That will essentially depend on facts of each case. The facts of the case before us do indeed justify that even under mercantile method of accounting revenues in question i.e. accrued interest on seed money loans are recognized only when the same are actually received by the assessee. No doubt there is a legal right to receive the interest but there are also ground realities which do not permit strict enforcement of this right. In our considered opinion any other view of the matter will result in distortion in the financial results disclosed by the books of accounts maintained by the assessee. It is also important to remain alive to the fact that the provisions of s. 145(1) are subject to inter alia mandate of AS-1 which also prescribes that Accounting policies adopted by an assessee should be such so as to represent a true and fair view of the state of affairs of the business profession or vocation in the financial statements prepared and presented by on the basis of such accounting policies. In the name of compliance with s. 145(1) it cannot be open to anyone to force adoption of accounting policies which result in a distorted view of the affairs of the business. We therefore uphold the claim of the assessee that even under the mercantile method of accounting and on peculiar facts of this case the assessee is justified in following the policy of not recognizing these interest revenues till the point of time when the uncertainty to realize the revenues vanishes. There is one more aspect of the matter. Let us assume for a minute that the method of accounting followed by the assessee is indeed contrary to the provisions of s. 145(1) but then the AO is not entitled to make adjustments in those books of accounts to bring the same in conformity with the provisions of s. 145(1). All that he can do in such a situation is to lean on s. 145(3) which permits him to make a best judgment assessment under s. 144. A notification issued by the Government of India cannot be taken lightly nor can the AO be simply dismissive about it. In our considered view this notification is sound basis to come to the conclusion that the revenues in question can be treated as income only when the revenues are realized. A best judgment assessment is also required to be a sound and rationale judgment about the income of the assessee. From this point of view also the assessee cannot be forced to pay tax on the interest accrued on seed money loans. Thus we are of the considered view that the CIT(A) was not justified in confirming the addition on account of accrued interest on seed money loans. We therefore direct the AO to delete this addition. The assessee gets the relief accordingly. In the result the appeals allowed.

Issues Involved:
1. Justification of CIT(A) in confirming the addition of Rs. 2,77,26,740 on account of accrued interest on seed money loans.
2. Applicability of the amended Section 145 of the IT Act, 1961.
3. Relevance of the Government of India notification dated 10th September 1990.
4. Interpretation and application of Accounting Standards, particularly AS-1.
5. Concept of 'real income' and 'prudence' in revenue recognition under mercantile accounting.

Issue-wise Detailed Analysis:

1. Justification of CIT(A) in Confirming the Addition of Rs. 2,77,26,740 on Account of Accrued Interest on Seed Money Loans:
The core issue in this appeal was whether the CIT(A) was justified in confirming the addition of Rs. 2,77,26,740 on account of accrued interest on seed money loans. The assessee, a government-owned corporation, argued that interest on seed money loans should be accounted for on a cash basis due to the low likelihood of recovery. The AO, however, rejected this approach, insisting on the mercantile method. The Tribunal found that even under the mercantile method, it is permissible to recognize revenue only when there is a reasonable certainty of its realization. Thus, the CIT(A)'s confirmation of the addition was not justified.

2. Applicability of the Amended Section 145 of the IT Act, 1961:
The AO noted that post-1997, Section 145 of the IT Act mandates that income must be computed in accordance with either the cash or mercantile system of accounting, and the hybrid method is no longer permissible. The Tribunal acknowledged this change but emphasized that the provisions of Section 145(1) are subject to Section 145(2), which refers to the Accounting Standards notified by the Central Government. Therefore, the notified Accounting Standards, which may allow deviations from strict cash or mercantile accounting, take precedence.

3. Relevance of the Government of India Notification Dated 10th September 1990:
The assessee relied on a Government of India notification allowing government companies engaged in industrial promotion to account for interest on seed money loans on a cash basis. The CIT(A) dismissed this notification as outdated post-amendment of Section 145. However, the Tribunal found that this notification still holds relevance and supports the assessee's method of accounting, especially in the context of best judgment assessment under Section 144.

4. Interpretation and Application of Accounting Standards, Particularly AS-1:
The Tribunal examined AS-1, which emphasizes 'prudence', 'substance over form', and 'materiality' in accounting policies. The Tribunal found that these principles support the assessee's approach of recognizing interest revenue only when received, as it provides a true and fair view of the state of affairs. The CIT(A)'s interpretation that AS-1 does not permit a change in the method of accounting was found to be too restrictive.

5. Concept of 'Real Income' and 'Prudence' in Revenue Recognition Under Mercantile Accounting:
The Tribunal underscored the principle that only 'real income' should be brought to tax, as distinguished from hypothetical income. It cited the Supreme Court's decision in Godhra Electricity Co. Ltd. vs. CIT, which held that income must be recognized in light of the probability of its realization. The Tribunal concluded that the assessee's method of recognizing interest on seed money loans only upon receipt was justified under the principles of prudence and real income.

Conclusion:
The Tribunal concluded that the CIT(A) was not justified in confirming the addition of Rs. 2,77,26,740 on account of accrued interest on seed money loans. The Tribunal directed the AO to delete this addition, allowing the appeal in favor of the assessee.

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