Holding

Interest on sticky advances is real income and taxable, and the exchange difference from the rupee devaluation is also taxable.

Summary

The State Bank of Travancore, a subsidiary of SBI, maintained its books on a mercantile basis and charged interest on advances it deemed "sticky" (highly doubtful of recovery) by debiting borrowers but crediting the amounts to an "Interest Suspense Account" instead of its profit‑and‑loss account. It claimed that such interest, being hypothetical, was not taxable, and also argued that a large exchange gain arising from the 1966 rupee devaluation was a non‑recurring windfall and should not be taxed. The Income Tax authorities, the Tribunal and the Kerala High Court added the interest and the exchange gain to the bank’s taxable income. The Supreme Court examined whether interest on sticky advances constitutes "real income" under sections 5, 28, 29 and 36 of the Income‑Tax Act and whether the method of accounting (mercantile) determines accrual, and also whether the exchange difference is taxable. The Court held that the interest had accrued as real income and was taxable, and that the exchange gain was also taxable as business income. The appeals were dismissed.

Issues considered

Whether interest on "sticky" advances, credited to an Interest Suspense Account, constitutes real income chargeable to tax under the Income‑Tax Act.
Whether the mercantile system of accounting determines the point of accrual for tax purposes.
Whether the doctrine of real income can be extended to exclude hypothetical income arising from doubtful loans.
Whether the exchange difference arising from the 1966 devaluation of the Indian rupee is taxable as business income.

Legislation cited

Income Tax Act, 1961s. 145, s. 28, s. 29, s. 36(1)(vii), s. 36(2), s. 5

Subjects

income taxreal incomesticky loansinterest suspense accountmercantile accountingaccrualexchange differencedevaluationsections 28, 36, 145

Judgment

25

A
STATE BANK OF TRAVANCORE
v.
COMMISSIONER OF INCOME TAX, KERALA

JANUARY 8, 1986
B
[V, D, TULZAPURKAR, SABYASACIU MUKHARJI AND
RANGAl'IATH MISRA, JJ, ]

Income Tax Act, 1961:

Sections 28, 29 & 145 - Banking Company - Advances con-
sidered doubtful of recovery-interest on such 'sticky' advan- c
ces not carried in 'Profit and Loss Account' - Credited to
separate account - 'Interest suspense ac;count' - Accrual of
income - Whether arises - Interest amount - Whether exemption
frorn tax. - Concept and notion of real income - Explained.
Hethod of account;i.ng - How far relevant for computa-
tion of income, prof.its and gains - Mercantile and cash D
systems of accounting - Oif fererice between.
Devaluation of Indian Rupee - Exchange difference aris-
ing therefrom - Whether income assessable to tax.

The assessee, a subsidiary bank of the State Bank of
India, used to maintain in the accounting years 1964, 1965 and E
1966, its accounts in mercantile system making entries and
calculating income and loss on accrual basis and adopted the
calendar year as its previous year. The assessee, in the
course of its banking business, used to charge interest on
~.. advances considered doubtful of recovery termed as 'sticky

-
advances' by debiting the concerned parties but instead of F
carrying the same to its 'Profit & Loss Account', credited the
same to a separate accqunt called 'Interest Suspense Account'
as the principal amounts of these 'stic~y advances' themselves
had become not bad or irrecoverable, but extremely doubtful of
' recovery. In its returns th~ assessee disclosed such interests
separately and claimed that the same were not taxable in its G
hands as income for the concerned years.
_,
'\ The business of the assessee bank also included buying
and selling of foreign exchange and before devaluation of the
Indian Rupee on August 6, 1966, the assessee bank held foreign
H
26 SUPREME COURT REPORTS (1986] 1 s.c.R.

A exchm\ge by way of cash balances available with their foreign ·i
correspondents, forward contracts, items in transits, etc. in
U.S. Dollars and in Sterling, which on devaluation of the
Indian Rupee when converted back to rupees at the post de-
valuation rates gave rise to a profit of 57.5% in the transac-
tion; the assessee bank-credited this surplus to an account
designated "Provision for Contingencies". In the Assessment
B Year 1967-i>B the assessee bank claimed that profit by way of
exchange difference on devaluation should not be taxed as it
was of a casual and non-recurring nature.

The claim of the assessee bank on both these aspects was
rejected by the Income-tax Authorities, Income-tax Appellate
c Tribunal and the High Court. The High Court held: (a) the
assessee was following the mercantile system of accounting;
such interest, therefore, had accrued to the assessee at the
end of the accounting year; and (b) the assessee itself had
treated such income as accrual of interest by charging the
same to the parties concerned by making debit entries in their
D respective accounts. However, if any part of these debits had r
later on become irrecoverable in any year, the assessee could
have, in that year, treated the same as such and claimed
deduction under section 36(l)(vii) of the Income Tax Act,
1961.

E In the appeals to this Court on behalf of the assessee-
bank it was contended: (l) that the three sums representing
interest on 'sticky' advances, i.e. advances in respect where-
of there was high improbability of recovery of even the
principal amounts, ought not to have been subjected to tax as
F
income under the Act; that what are chargeable to income-tax
in respect of a business are prof its and gains actually
,
resulting from the transaction of the previous year, that is
to say, the real profits and gains and not hypothetical -
profits or gains on a doctrinaire theory of accrual; that even
under the mercantile system of accounting regularly adopted by
an assessee it is only the acrual of "real income" in the
G commercial sense which is chargeable to tax, that accrual is a
matter of substance to be decided on commercial principles
having regard to business character of the transaction and the
realities of the situation and cannot be determined on any ,
abstract theory of accrual or by adopting a legalistic ~
approach and that if regard is had to the commercial princi-
P. ples and realities of the situation it will be clear that in
STATE BANK v. C.I.T. 27
A

~-the case of banks, financial institutions and money-lenders,
whose bulk profits mainly consist of interest earned by them,
there is no accrual of real income so far as interest oil
sticky advances and the debit entries made in re>1pect of such
interest in the respective accounts Of the concerned debtors B
following the mercantile system of accounting merely reflected
hypothetical income that does not materialise in the concerned
accounting year or years during which the advances remain
sticky and hence it is but proper to carry such interest to
" "Interest Suspense Account' as carrying the same to 'Profit
and Loss Account' would result in showing inflated profits and
might even lead to improper and illegal distribution or remit- c
tance thereof; (2) that there is a clear,distinction between
an irrevocable loan and a sticky loan; the former is a bad
debt in respect whereof the chance of recovery is nil and as
such can outright form the subject matter of deduction under
section 36(i)(vii) of the Act while the latter is a loan to
which a high degree of improbability of recovery attaches in a D
particular year or years depending upon the financial position
" of the concerned debtor due to which interest thereon becomes
hypothetical income during such year. or years and, as such,
the same, not being real income, cannot be brought to tax; (3)
that right from August 1924 onwards till the decision of the
High Courts distinction between an irrecoverable loan and a E
sticky loan was recognised by the Central Board of Revenue as
also by the Reserve Bank of India in ·their diverse Circulars
in the case of banks, financial institutions and money-lenders
regularly following the mercantiie system of accounting and
that Instructions had been issued not to treat the unrealised
interest on sticky loans as income by carrying it to 'Profit F
'Cand Loss Account' so that the figure of distributable profits
should not get inflated and preferably to credit the same to a
special account 'Interest Suspense Account' and· that if the
banks, financial institutions and money-lenders, who kept
their accounts on mercantile system, maintained a suspense
account in which the unrealised interest was entered, the same G
should not be included in the assessee's taxable income, if
the Income Tax Officer was satisfied that there was really
probability of the loans being repaid; (4) that the Instruc-
tions contained in Vartous Circulars were in consona~ce with
the accepted principle that what was charg~abie under ~he
'< Income Tax Act was the teal inconie of an assessee but these H
instructions which held field for over 53 years were changed,
though wrongly, under fresh -circulars issued by the Central
281 SUPREME COURT REPORTS [1986] t s.c.R.

A Board of Direct Taxes whereunder interest on doubtful or
sticky loans became includible in the assessable income of the·~
assessee with effect from the assessment year 1979-80, and (5)
that in the case of banks and financial institutions who regu-
larly adopted mercantile system of accounting the practice of
carrying interest on such sticky loans to 'Interest Suspense
Account' or 'Reserve for Doubtful Interest Account' in stead
B of crediting the same to 'Interest Account' or 'Profit and
Loss Account' is a universally recognised practice invariably
adopted by them and being wholly consistent with the mercan- ;;
tile system of accounting the Income Tax Officer was bound to
give effect to it under section 145 of the Act and, therefore,
the treatment of the three sums representing interest on
c sticky loans as the assessee's income for the concerned years
would be unsustainable in law.
On behalf of the Revenue it was contended: (1) that
though it is the real income that is chargeable to tax under
the Act and not any hypothetical income of an assessee and
that under section 28 in respect of a business the charge-
1J ability must attach to real profits and gains arfaiitg from the~
transactions of the previous year, but under section 5 read
with section 28 of the Act the liability .attaches to profits
which have been either received by the assessee or which have
accrued to him during the year of account and that income
accrues when it "falls due", i.e. becomes legally recoverable
E irrespective of whether actually received or not and "accrued
income" is that income which "the assessee has a legal right
to receive" and since the assessee has been maintaining its
accounts on mercantile basis the three sums being interest on
loans, whether doubtful or sticky, fell due and became payable
to the assessee at the end of each of the three accounting
F years and constituted its accrued income and, therefore.,
justifiably brought to tax in the concerned assessment years;
(2).that though, while imposing the tax liability under the
Act, the Courts have recognised the theory of real income by
having regard to the business character of the transactions
and realities of the situation but thes~ aspects have been
G taken into account for the purpose of determining whether the
income could be said to have legally accrued or not and once
it is found to have legally accrued it is brought to tax and
that the theory of real income has been invoked and confined
only to two types of cases (a) where there has been a
surrender of income which may in theory have accrued, and (b):>'
where there has been diversion of income at source either
I'
STATE HANK v. C.I.T. 29

A
- under a statute or by over riding title but in none of the
cases has the aspect of high improbability of recovery been
regarded as sufficient to prevent accrual; therefore the
theory of real income should not be extended so as to exclude
from chargeability such income which has accrued but merely
suffers from high improbability of recovery; because such B
extention would be neither permissible nor advisable - not
permissible because it goes against the very concept of
..accrued income and not advisable because if done it will apply
to all cases and not merely to cases of interest accruing to
banks and financial institutions. Such extension will moreover
entrench upon section 36(1) (vii) which provides for deduc-
tions of a debt or part thereof on its becoming bad on fulfil- C
ment of c~rtain conditions specified in su~ection (2) there-
of; for these reasons the extension of the theory of real
income so as to take within its ambit the consideration of
high improbability of recovery is not warranted. As regards
the Circulars of C.B.R. and R.B. I., it was submitted that
these merely granted a concession to and conferred no right in . Ii
favour of the assessee which could be and has been withdrawn
later by issuing fresh Circulars but since the benefit or the
concession in favour of the assessee could not be withdrawn
retrospectively, the withdrawal of concession has been effect-
ed prospectively from the assessment year 1979-80.
Dismissing the appeals, E
lllWl: Per ·Tulzapurkar, Mukharji and Rsnganath Misra,
JJ. (concurring).
The principle that i f the stock-in-trade remains unused
or unsold the mere book appreciation in the value thereof
cannot be brought to tax is well accepted. However, in the
, instant case, the asses see bank by carrying the surplus F
· resulting from the devaluation of the Indian rupee to an
account designated 'Provision for Contingencies' could be said
to have clearly treated such surplus as its business income.
Further, the Appellate Assistant Commissioner in his appellate
order recorded a categorical finding that the stock fn trade
in terms of foreign currency was sold and used by the assessee G
in its normal business. Having regard to this factual position
the exchange difference arising out of devaluation of the
Indian rupee was rightly treated as income of the assessee in
the· assessment year 1967-68. [65 C; 66 G-!I; 67 A & D]

C.l.T. v. ~ Line Ltd., 46 I.T.R. 590 referred to. H
30 SUPREME COURT REPORTS [1986] l s.c.R.

A
Per ltd<harji, J. (1) It is the income which has really.-;
accrued or arisen to the assessee that is taxable. Under
Income-tax law, receipt of income, either actual or deemed, is
not a condition precedent to the taxability. These were
assessable if these had arisen or accrued or deemed to have
accrued or arisen under the Act. This principle would be
B attracted even in cases where an assessee followed the mercan-
tile system of accounting. However, in examining any transac-
tion or situation, the court would have mre regard to the r
rea1ity of t.he situation rather than purely theoretical or
doctrinaire aspect, (92 A; 86 F-G]
· 2, The profits and gains chargeable to tax under the Act
c are those which have been either received by the assessee or
have accrued to the assessee during the period be,tween the
first and the last day of the year of a.ccount and are receiv-
able, Income received or income accrued are both chargeable to
tax under section 28 of the Act. [74 C]
3, By and large, two syst,ems of account keeping are
D followed one is the cash and the other, mercantile. The cash )
system postulate actual receipt of mney; and for exigibility
of income tax, such receipt from business, profession or
vocation or from other sources has to be actual in the
relevant year of account. The mercantile system is one where
accounts are maintained on the basis of entitlement to credit
E afid/or debit. A sum of mney, as soon as it becomes payable,
is taken into account without reference to actual receipt and
a debit becomes admissible when liability to pay is created
even though the sum of mney is yet to be paid. (72 B-C]

Dhakesbwar Prasad Narain Singh v. ('.own! ssioner of Income
F Tax, Bibar & Orissa, 4 I. T, R. 71 at 74, ('.oen! ssioner of Income "
Tax, Bollbay v. Sarangpur Cotton Manufacturing Co. Ltd. , 6 ·
I.T.R. 36, Coamissioner of lnc.--tax v. Shrimati Singari Bai,
13 .I.T.R. 224 and c.-issioner of rnco.a-tax, Madras v. A.
Kriabnaswami MiMlaliar and Ors., 53 I.T.R. 122 referred to.

G 4. The income of the assessee will have to be determined
according to the provisions of the Act in consonance with the
method of accountancy regularly employed by the assessee. The
method of accounting regularly employed by the assessee helps
computation of income, profits and gains under section 28 of
the Act and the taxability of that income under the Act, will '!'
H then have to be determined. The circulars being executive in
STATE BANK v. C.I.T. 31

A
~ character cannot alter the provisions of the Act and being in
the nature of concessions could always be prospectively with-
drawn. [ 75 A-B]
Comnissiooer of :iru:c--tax, Madras v; K.ll.11.T.T. 'lbiaga-
raja Oietty & Co., 24 I.T.R. 525, illakeshvar Prasad Narain
Singh v. Comniasiooer of Income Tax, Bihar & Orissa, 4 I. T. R. B
71 at 74, C<nnlsaiooer of Income-tax v. Sbrlmati Singari Bai,
13 I.T.R. 224 & Coamissiooer of :IncoE-tax, Madras v. A.
-., Krisbnaswami MiidaHar and Ors., 53 I. T.R. 122 referred to.

5. Mere improbability of recovery, where the conduct of
the assessee is unequivocal cannot be treated as evidence of
the fact that income has not resulted or accrued to the c
assessee. After debiting the debtor's account and not revers-
ing that entry - but taking the interest merely in suspense
account cannot be such evidence to show that no real income
has accrued to the assessee or treated as such ·by the
assessee. If the actuality of a situation or the reality of a
,t; particular situation makes an income not to accrue, then very D
different considerations would apply. But where interest has
accrued and the assessee has debited the account of the
debtor, the difficulty of the recovery would not make the
accrual non-accural of interest. [92 C-D; 89 B-C]

Catholic Bank of India (In liquidation) v. Comnissiooer E
of Income-tax, Kerala, Ernalmlam, 1964 K.L.T. 653 = 1965 (1)
I.T, Journal 355, Coamissiooer of Income-tax, Bombay I v.
Confinance Ltd., 89 I,T.R, 292 and James Finlay & Co. v.
Coamissioner of Income Tax, 137 I.T.R. 698 approved.

' 6. An acceptable formula of co-relating the notion of F
real income in conjunction with the method of accounting for
the purpose of computation of income for the purpose of taxa~
tion is difficult to evolve. Besides, any straight-jacket
formual is bound to create problems in its application to
every situation. It must depend upon the facts and circumstan-
ces of each case. It would be difficult and improper to extent G
the concept of real income to all cases depending upon the
ipse dixit of the assessee which would then become a value
judgment only. What has really accrued to the assessee has to
be found out and what has accrued must be considered from the
point of view of real income taking the probability or impro-
bability of realisation in a realistic manner and dovetailing H
32 SUPREME COURT REPORTS [1986] l s.c.R.

of these factors together, but once the accrual takes place on -<
A the conduct of the parties subsequent to the year of closing,
an income which has accrued cannot be made "no income". The
conduct of the parties in treating the income in a particular
manner is material evidence of the fact whether income has
accrued or not. [91 B-C; E-F; 92 C]

7. The concept of real income is a well accepted one and
B must be applied in appropriate cases but with circumspection "
and must n~t be called in aid to defeat the fundamental
principles of income-tax as developed. [92 F]
8. The concept of real income would apply where there
has been a surrender of the income which in theory may have
accrued but in the reality of the situation no income has
c resulted because the income did not really accrue. Where a
debt has become bad and deduction in compliance with the
provisions of the Act should be claimed and allowed. If there
is any diversion of income at source under any statute or by
overriding title then there is no income to the assessee. ,.
[92 A-C]
D 9. Once the accrual takes place and income accrues, the
same cannot be defeated hy any theory of real income~ In some
limited fields where something which is the reality of the
situation prevents the accrual of the income, then the notion
of the real income i.e. making the income accrue in the real
sense ot the term can be brought into play, but the notion of
real income cannot be brought into play where income haa
accrued according to the accounts of assessee and there is no
indication by the assessee to treat the SIIklunt as not having
accrued. Suspended animation followinr inclusion of the SIIklunt
in suspense account does not negate accrual and after the 7
event of accrual, corroborated by appropriate entry in the
F books of account on the mere ipse dixit of the assessee, no
reversal of the situation can be brought about. [88 D; 81 B-D]
Morvi Industries Ll:d. v. Coamissioner of Income-Tax
(eelltral), Calcutta, 82 I.T.R. 835 and Calcutta Co. Ltd. v.
c.-1.ssioner of Income-Tax, West Beugal, 37 I.T.R, l relied
upon.
G
Collllllssioner of Income-Tax, llo<>bay Cit:y, I v. llessrs.
Shoorji Vallabhdas and Co., 46 I.T.1'. 144, Coamissioner of )
Income-tax, llombay North Kutch and f.aurashtra, Ahmedabad v.
Cbamanlal Hangaldas &: Co .. , 29 I~T.R. 987, &rvi lndustrU-S

H
STATt: ~ANK v. C.1. T. 33

·~ Ltd. v. Coamissioner of ~ (Central) Calcutta, 82 A
I.T.R. 835, H.M. Kashiparekh & Co. U:d.'s case, 39 I.T.R. 706,
Colllnissioner of Income-Tax, West Bengal, 11 v. llirla Gwalior
(P) Ltd., 89 I.T •. R. 266, .Conmi.ssioner of Iru:ome-cax, Tamil
Nadu-V v. Motor Credit Co. (P) Ltd., 127 l,T,R, 572,
Coomi.ssioner of ~. Madras Central v. Devi Films (P)
Ltd., 143 I.T.R. 386 and Que:l.ssioner of Income-Tax, B
Amritsar-11 v. Ferozepur Fi.oance {P) Ltd., 124 I, T,R. 619
-,· distinguished.
10. The concept of real income cannot be so used as to
making accrued income, non-income simply because after the
)
~ eve~t of accrual, the assessee neither decides to treat it as
bad debt nor claims deduction under section 36(2) of the Act,
but still enters the same with a diminished hope of recovery C
in the suspense account. Extension of the concept of real
income to this field to negate after the aioount had become
payable is contrary to the postulates of the Act. [82 B-C]
Per Ranganath Misra, J. (concurring) ·
, Section 36(2) of the Act covers the entire field
regarding deduction for bad debt. Though the concept of 'real 0
income' is well recognised one, it cannot be introduced as an
outlet of income fr~m taxman's net for assessment on the plea
that though shown in the account book as having accrued, the
same became a bad debt and was not earned at all. The citizen
is entitled to the benefit of every ambiguity in a taxing
statute but where the law is clear considerations of hardship, E
injustice or anomaly do not afford justification for extempt-
ing income from taxation. [93 C-il]

Mapp v. Oram, 1969 (Vol.Ill) All E.R. 219 (H.L.)
"" referred to.
F
Per Tulzapurkar, J. - (dissenting)

1. Under the Income Tax Act in order that income should
accrue it should not merely fall due or become legally
recoverable but should also be factually and practically
realisable during the accounting year or years. In other words G
mere non-receipt of income, when it is reasonably realisable,
will not affect accrual but factual or practical unrealis-,
ability thereof may prevent its accrual depending upon the
facts and circumstances attending upon the transaction.
(59 F-G]
H
34 SUPREME COURT REPORTS [1986] 1 S.C.R.

A 2. This theory of real income could be and should be
extended to interest on sticky· loans and that on principle
such interest being hypothetical cannot be brought to tax.
(64 G-11]
3. That the stickiness of advances or loans objectively
established to the satisfaction of the taxing authorities by
producing proper material, is sufficient to prevent the
B
accrual of interest thereon as real income and would have the
effect of rendering such income hypothetical and t!le same
cannot be brought to tax. (59 E-F]
4. Under ·section 145 the assessee 's regular method of
accounting determines the mode of computing the taxable income
but it does not determine or even affect the range of taxable
c income or the ambit of taxation. In other words, any hypo-
thetical income which may have theoretically accrued but has
not truly resulted or 'materialised in the concerned accounting
year cannot be brought to charge simply because the assessee
has been regularly employing the mercantile system of account-
ing and makes entries in his books in regard to such
0
hypothetical income. (47 F-<;]
I
5. The method of accounting regularly employed by an
assessee is rel¢vant
' only for the purpose of computation of
income, profits and gains under s. 28 of the Act and that it
cannot enlarge or restrict the content of the taxable income
under the Act and that under s. 145 the assessee's regular
E
method of accounting determines the mode o>f computing taxable
income but it does not determine or even effect the range of
taxable income or ambit of taxation. (49 C-D] ·
6. In the case of interest on sticky loans the practice
of debiting the accounts of the concerned debtors with such
interest and carrying the same to 'Interest Suspense Account'
F
instead of to "Interest Account' or 'Profit and Loss Account'
is a well recc;>gnised and accepted practice of col!lllercial
accountancy, th'1t it is wholly consistent with mercantile
method of accow\ting and that i t prevents the wrong crediting
and improper and illegal distribution or remittance of
inflated and unreal profits. (52 D-E]
7. Under s. 5 taxability is attracted not merely when
G
income is acutally received but also when it has 'accrued' and
income accrues when it 'falls due', that is to say when it
becomes legally recoverable irrespective of whether it is
actually receiv~d or not and 'accrued income' is that income
which 'the assessee has a legal right to receive.' (52 F-<;]
H
STATE BANK v. C.I.T. 35
A

~· 8. Where income or part thereof has theoretically
accrued but has been, either unilaterally or as a result of
bilateral arrangement, voluntary relinquished or surrendered
by the assessee before its accrual the same cannot be regarded
B
as real income of the assessee and cannot be brought to tax.
Such conclusion is reached having regard to the business
character of the transactions and the realities of the
__
....:.,..
situation notwithstanding that some entries have been made in
the asses see' s books maintained in the mercantile system.
[55 C-0]
9. Even under the mercantile system of accounting when-
ever adopted it is only the accrual of real income which is c
chargeable to tax, that accrual is a matter of substance and
that is to be decided on commercial principles having regard
to the business character of the transactions and the reali-
ties and specialities of the situation and cannot be deter-
mined by adopting purely theoretical or doctrinaire or legali-
D
stic approach. [58 H; 59 A]

Catholic Baolt of India (In Liquidation) v. Comissiooer
of Income-tax, Kerala, 1964 K.L.T. 653 = 1965 (1) Income-tax
Journal 355, C.I.T. v. Confinance Ltd., 89 I.T.R. 292 & James
Finlay & Co. v. C.l.T., 137 I.T.R. 698 overruled.
E
C.l.T. v. Motor Credit Co. (P) Ltd., 127 I.T.R. 572,
C.l.T. v. Devi Fillls (P) Ltd., 143 I.T.R. 386, C.l.T. v.
Ferozepur Finance (P) Ltd., 124 I.T.R. 619, lllakesvar Prasad
Narain singh v. Commissioner of Income Tax, 4 I.T.R. 71 at 74
& H.K. Kashiparekh Co. 's case, 39 I.T.R. 706 approved.
F
C.I.T. v. Sarangpur Cotton Mfg. Co., 6 I.T.R. 36 at 40,
C.l.T. v. Singari Bai, 13 I.T.R. 224 at 227, c.1.T. Ksdras v.
A. Krislmaswa.t lludaliar & Ors., 53 I.T.R. 122, c.r.T. v.
Shoorji Vallabhdas & Co. 46 I. T.R. 144, C.l.T. v. Birla
Gwalior (P) Ll:d., 89 I. T.R. 266 and Kohler's Dictionary for
Accountants 3rd Edn. relied on. G

C.I.T. v. Thiagaraja Chetty, 24 I.T.R. 525 at 531, llorvi
Industries Ltd. v. C.l.T. Calcutta, 82 I.T.R. 835 at 840,
C.l.T. v. Barivallabhadas Kalida& & Co., 39 I.T.R. 1, C.I.T.
Ksdhya Pradesh v. Kaloor811l Govindr&lll, 57 I.T.R. 630, Poona
Electric Supply Co. Ltd. v. C.I.T. llollbay, 57 I.T.R. 521, H
C,I.T, v. Sir S.K. Cidtnavis, 6 I.T. Cases 453 Shukla and
Grewal referred to.
36 S~PREME COURT REPORTS [1986] 1 s.c.R.

A CIVIL APPELi.ATE JURISDICTION : Civil Appeal Nos, 1860-62
(NT) of 1973,
From the Judgment and Order dated 22.3.1973 of the
Kerala High Court in I.T.R. Nos. 27 to 29 of 1971.
N,A, Palkhiwala, S,E, Dastur, M/s. J,B,Dadachandji,
Ravinder Narain, Mrs, A, K, Verma and Jeol Peres for the
Appellant, . i
v.s. Desai, B,B, Ahuja and Miss A, Subhashini for the
R
Respondent. '

N,A, Palkhiwala, S.E, Dastur, M/s. J.B. Dadachanji, Mrs.
-
A.K. Verma a~d D.N. Mishra, for the Intervenors (M/s.
Grindlays Bank, Calcutta and State Bank of Travancore),
c Dr. P. Pal and D,N, Gupta for the Intervenor (Chartered
Bank),
.. I
F.N. Kai<'\, Mr. S.E. llastur, C,S, Shroff, S.S. Shroff and
S,A, Shroff for the Intervenor (Industiral Credit & Invest-
ment Corpn. , & American Express International Bank and City
...
D
Bank Banking Corpn.)

S.E. Dastur, S,N, Talwar and H.S. Parihar for the
Intervenor (Mercantile Bank Ltd.).

K, Ram Kumar, .K, Ram Mohan and Mrs, J, Ramachandran for
E
the Intervenor {Indian Overseas Bank, Madras),

The follol.ing Judgments were delivered

TULZAPURKAR, J, These appeals by certificate from the ,
High Court raise the following two interesting questions of
F
law for our determination:

( l) Whether on the facts and in the circumstances
of the case the addition of the sum of Rs, 67,170,
Rs, ~7,777 and Rs, 57,889, representing interest on
'sti~ky 1 advances, as income for the. assessment
G
years 1965-66, 1966-67 an4 1967-68 respectively was
justified in law?

(2) Whether on the facts and in the circumstances
of the case the exchange difference of Rs. l,66, 128
H
STATE liANK v. C. l, T, [TULZAPURKAR, J,] 37

arising· on devaluation of the Indian rupee on A
6. 6.1966 was rightly treated as income for
the assessment year 1967-t>S?
The facts giving rise to the first question He in a
narrow compass and are these. The assessee is a subsidiary of
the State Bank of India; it maintains accounts on mercantile
system making entries on accrual basis; it adopts the ca~endar B
year as its previous year and the calendar years 1964, 1965
an<! 1966 are respectively the relevant previous years for the
assessment years 1965-66, 1966-<>7 and 1967-<>8 to which the
question relates. In the course of its banking business the
assessee charged interest on advance considered doubtful of
recovery otherwise called sticky advances by debiting the
concened parties but instead of carrying it to its 'Profit and c
Loss Account' er.edited the same to a separate account styled
'Interest Suspense AccoW1t' as the principal amounts of these
stickly a~vances themselves had become, not bad or irrevocer-
able but extremely doubtful of recovery. However, in its
returns the assessee disclosed such interest separately and
claimed that the same was not taxable in its hands as income D
for the concerned years. The amounts so charged to the
concerned parties but credited to the 'Interest Suspense
Account' INere Rs. 67,170 Rs. 47,777 and Rs. 57,889 for the
assessment years 1965-{)6, 1966-<>7 and 1967-{)8 respectively.
Before the taxing authorities as also before the Tribunal
and the High Court the assessee raised the contention that E
having regard to the deteriorating financial position of the
concerned parties and history of their accounts, the recovery
of even the principal amounts had become highly improbable and
extremely doubtful rendering the advances 'sticky' and as such
the interest thereon, though debited to them, was, following a
"' well recognised principle of commercial accountancy, taken to F
'Interest Suspense Account' so as to avoid showing inflated
prof its by including hypothetical income and since such
interest was not its real income, the same was not taxable in
its hands. The contention was rejected at all the levels
principally on two grounds - (a) since admittedly the assessee
was following the mercantile system of accounting such G
interest had accrued to it at the end of each accounting year
and (b) the assessee had itself shown the accrual of such
interest by charging the same to the concerned parties by
making debit entries in their accounts. It was observed that
if any part of the debts later became irrecoverable in any
H
38 SUPREME COURT REPORTS [1986] I S.C.R.

A year the assel='see could in that year. tr.eat it. as such and
clailil deducticif wider s. 36 (1) (vii) of the Income Tax Act
1961. In holding that these three sums were taxable as income
in the hands df the assessee for the concerned years the High
1
Court followed , its ear lier decision in the, case of Catholic
Banlt of India !(In IJ.quidation) v. Coami.ssioner of Income-tax,
Kerala, (1964]', K.L.T. 653 = (1965] l Income-tax Journal 355
B where despite the dir.ective isSued by the Reserve Bank of
India to the assessee-bank. not to carry interest on such
sticky advances to 'Profit and Loss Accowit' and despite the
fact that the assessee-bank had in pursuance thereof ommitted
-
such interest from its 'Profit and Loss Accowit' the Court had
taken the view that such interest was taxable as income in the
c hands of the assessee-bank because of the mercantile system of
accowiting that had been regularly employed by it, which had
not. been changed even after receiving the directive from the
Reserve Bank. The High Court was of the view that the facts of
the instant case were indistinguishable from those obtaining
in the Catholic Bank's case except that there was a directive
r
D from the Reserve Bank of India to the Catholic Bank which was
absent in the case before it but in its opinion the presence
or absence of such dir.ecti ve fr.om the Reserve Bank could not
determine the question whehter. there was accrual of income or
not and that in the case before it also there was accrual of
income to the assessee considering the mercantile method of
E accowiting that had been regularly adopted by it. In this view
of the matter the High Court answered the question against the
assessee and in facour Of the revenue. Incidentally it may be
stated in the 'case of this very assessee the High Court,
following the i decision herein, took a similar view and
answered a similar question against the assessee for the
F subsequent yea~ 1968-69 which decision rendered in 1975 is '
reported in 110', ITR 336. The assessee has challenged this view
before us in these appeals.
Mr. Palkhivala the learned cowisel for the assessee
raised a two-fold contention in support of his plea that the
three sums r.epr.esenting inter.est on 'sticky' advances, i.e.
G advances in respect whereof there was high impr.obability of
recovery of even the principal amowits ought not to have been
subjected to tax. as income under the Act. In the first place
he contended that what are chargeable to income tax in respect
of a business are profits and gains actually resulting from
the transactions of the previous year, that is to say, the
H real profits and gains and not hypothetical profits or gains

•
.. STATE HANK v. c. r. T. [TULZAPURKAR, J.] 39

on a doctrinaire theory of accrual, that even under the
mercantile system of accounting regularly adopted by an A
assessee it is only the accrual of real income in the commer-
. cial sense which is chargeable to tax, that accrual is a
matter of substance to be decided on commercial principles
having regard to business character of the transactions and
the realities of the situation and cannot be determined on any,
abstract. theory of accrual or by adopting a legalistic B
approach and that if regard is had to commercial principles
and realities of the situation it will be clear that in the
case of banks, financial institutions and money lenders, whose
bulk profits mainly consist of interest earned by them, there
is no accrual of real income so far as interest on sticky
advances is concerned, and the.debit entries made in respect
of such interest in the respective accounts of the concerned c
debtors following the mercantile system of accounting merely
reflect hypothetical income that does not materialise in the
concerned accounting year or years during which the. advances
remain sticky and hence it is but proper to carry such
interest to '.Interest· Suspense Account' as carrying the same
to 'Profit and Loss Account' would result in showing inflated D
profits and might even lead to improper and illegal distri-
bution or remittance thereof. In this behalf counsel cited
several decisions of this Court as also of the High Courts
where the principle of real income has been recognised and
invoked while considering the tax liability under the Act and
in particular strong reliance was placed on two decisions of E
the Madras High Court in C.I.T. v. Motor Credit Co.(P)
Ltd., 127 I.T.R. 572 and C.I.T. v. Devi Films (P) Ltd. 143
I. T.R. 386 and one decision of the Punjab and llaryana High
Court in C.I.T. v. Ferozepur Finance (P) U;cl. 124 I.T.R. 619
where a view has been taken that it will be totally unrealis-
'· tic to treat interest on sticky loans as income and· the same F
was excluded from computation of the assessee's income.
According to Counsel there is a clear distinction between an
irrecoverable loan and a sticky loan; the former is a bad debt
in respect whereof the chance of recovery is nil and as such
can out right form the subject matter of deduction under s. 36
(1) (vii) of the Act while the latter is a loan to whicn a G
high degree of improbability of recovery attaches in a parti-
cular year or years depending upon the financial position of
the concerned debtor due to which interest thereon becomes
°"" hypothetical income duringsuch year or years and, as .such, the
same, not being real income, cannot be brought to tax. Counsel
pointed out that right from August 1924 · onwards till the H
40 ~UPREME COURT REPORTS [1986] 1 s.c.R.

impugned decision herein as also the further decision in 110
A ITR 336 were rendered by the Kerala High Court in 197 3 and ,I
1975 respectiveiy the aforesaid distinction between an irre- ~
coverable, 104n and a stickly loan was recognised ·by the
Central Board of P.evenue as also by the Reserve Bank of India
in their diverse Circulars in the case of banks, financial
institutions and money lenders regularly following the mercan-
tile system of accounting and he further pointed out that
B Instructions had been issued not to treat the unrealised
interest on such sticky loan as income by carrying it to
1

'Profit and Loss Account' so that the figure of distributable .,,,
profits should not get inf lated and preferably to credit the
same to a special account such as 'Interest Suspense Account'
and that if the banks, financial institutions and money
c lenders, who' kept their accounts on mercaritile system,
maintained such a suspense account in which the unrealised
interest was entered, the same should not be included in the
<>ssessee's taxable income, if the Income Tax Officer was
satisfied that there was really little probability of the
loans being jrepaid. (Vide C.B.R. Circular No. 37 /54 dated
D 25.8.1924, No. 4l(V-6) D of 1952 dated 6.10.1952, CBDT's >-
Letter F.No. 207/10/73 ITA II dated 16.4.1973 and RBI Circular
IFD No. O.P.R. 1076/1(5) to SFCs dated 21.11.1973, copies
whereof were furnished to the Court). Counsel urged that such
Instructions 1contained in these Circulars were in consonance
with the. accepted principle that what was chargeable under the
E Income Tax Act was the real income of an assessee but accord-
ing to him these Instructions which held field for over 53
years were changed, though wrongly, under fresh Circulars
dated June 20, 1978 and October 9, 1984 issued by the Central
Board of DirJct Taxes whereunder such interest on doubtful or
sticky loans became includible in the assessable income of the
F assessee (subject to some relief specified therein) with
effect from the assessment year 1979-80. Secondly, counsel
contended that in any view of the matter in the case of banks
and financial institutions who regularly adopt mercantile
system of accounting the practice of carrying interest on
such sticky loans to 'Interest Suspense Account' or 'Reserve
G for Doubtful Int~rest Account' instead of crediting the same
to 'Interest Account' or 'Profit and Loss Account',. is a
universally recoginsed practice invariably adopted by them and
being wholly consistent with the mercantile system of accoun-
. ting the Income Tax Officer was bound to give effect to it "
under ~. 145 of the Act, and, therefore, the treatment of the
H three sums representing interest on sticky loans as the
STATE BANK v. C.I.T. [TULZAPURKAR, J,] 41

assessee's income for the concerned assessment years would be
unsustainable in law; and in this behalf counsel placed A
!>-
reliance on the standard text books of accountancy of authors
like · Spicer and Pegler, Shikla and Grewal and the Approved
Text of International Accounting Standard 18.
Since the issues raised before us have a vital bearing
upon the tax liability and business interests and poli~ies of
server.al financial institutions including foreign panks, six B
interverners, ruimely, American Express Inter.national Banking
Corpn., Mercantile Bank Limited through its successors
~ Hongkong & Shenghai Banking Corporation, Citi Bank N.A.,
Chartered Bank, Gr.indlays Bank and Industrial Credit & Invest-
ment Corpn. of India sought our permission to intervene in
these appeals and we granted the requisite permission in view
of the importance of the issues involved and it may be stated c
that Counsel appearing for the interveners have adopted the
arguments of Mr. Palkhiwala and generally supported. the
submissions made by him on behalf of the assessee in these
appeals; but special mention may be made of the fact that in
the written submissions filed on their behalf it has been
categorically asserted that while maintaining their accounts D
regularly on mercantile system each one of these institutions
in the matter of inter.est on doubtful or sticky loans invari-
ably follow the practice of debiting such interest to the
account of concerned borrower but instead of crediting it to
'Interest Account' or 'Profit and Loss Account' the same is
carried to a special account styled 'Interest Suspense E
Account' or 'Reserve for Doubtful Interest Account' and only
upon realisation the same is er.edited to Interest Account and
Profit and loss Account in the year of realisation and is
offered for taxation. It is also claimed by some of the
Intervener.a that they have .an elaborate and well controlled
y system of evaluation for the purposes of assessing the F
recoverab'ility and position of various accounts of their
borrowers and the financial condition of each borrower is
periodically reviewed by Senior Management Personnel on the
basis of detailed reports and data collected in regard to each
before tr.eating the laons as sticky, Counsel reiterated on
behalf of the Inter.veners that the benefit under the earlier G
Circulars of C.B.R. and R.B.l. did not depend upon the ipse
dixit of the assessee but was available only if the safeguards
specified therein were observed and the taxing authority was
satisfied on objective materials that the loan had become
sticky and there was really little probability of the same
being repaid. H
42 · ! SUPREME COURT REPORTS [19861 1 s.c.R.
A On the other hand, counsel for the Revenue pressed for
our acceptance the view taken by the High Court. He fairly _.
conceded that it is the real income that is chargeable to tax
under the Act and not any hypothetical income of an assessee
and that. under section 28 in respect of a business the charge-
abi lity must attach to real profits and gains arising from the
transactions of the previous year but he contended that under
B section 5 read with section 28 of the Act the liability
attaches to I profits which have been either· received by the
assessee or. which have accured to him during the year of
account and it is well settled that inncome accrues when it .,..
"falls due", .i.e., becomes legally recoverable irrespective of
whether actlJ!lllY received or not and "accrued income" is that
c income which "the assessee has a ·legal right to receive": vide
C.l.T. v. Thiagaraja Ctetty, 24 I.T.R. 525 at 531 and Morvi
Industries Ltd. v. C.l.T. Cslcutta, 82 I,T,R, 835 at 840 and
since admittedly the assessee has been maintaining its
accounts on inercantile basis the three sums being interest on
I
loans, whether doubtful or sticky, fell due and became payable
D
to .the assessee at· the ~nd of each of the three accounting
Years and constituted its accrued income and were~ therefore, ¥
justifiably brought to tax in the concerned assessment years.
Counsel for: the revenue fairly conceded that Courts have,
while imposing the tax liability under the Act, recognised the
theory of real income by having regard to the business
E character of the transactions and realities of the situation
but these aspects have been taken into account for the purpose
of determining whether the .income could be said to have
legally acctued or not and once it is found to have legally
accrued· it is brought to tax". He pointed -out that all the
decisions of this Court show that this theory has been invoked
F
and confined only to ·two types of cases (3) where there has
been a surrender of income which may in theory have accrued, ?
and (b) where there has been diversion of income at source
either under a statute or by over-riding title but. in none of
these cases has the aspect of high improbability of recovery
been regarded as sufficient to prevent accrual; counsel there-
G
!~~:nd:~g:~ ~:a~o ~~~~ud~h~~:, ~~r~::~i;~;":uchh~~~~men~d~
has accrued but merely suffers form high improbability of
recovery. Counsel submitted such extension Would be neither
permissible nor advisable - not permissible because it goes
against the very concept of accrue4 income and not adyisable ,..
H because if done it will apply to all cases and not merely to
cases of interest accruing !o banks and financial
STATE BANK v. c.1.r. [TULZAPURKAR, J,] 43

institutions. Moreover, such extension will entrench .upon
>- section 36 (1) (vii) which provides for deduction of a debt or A
part thereof on its becoming bad on fulfilment of certain
conditions specified in sub-section (2) thereof, For these
reasons counsel submitted that the extension of the theory of
real income so as to take within its ambit the ·consideration
of high improbability of recovery is not warranted. As regards
the earlier Circulars of C.B.R, and R.B.l. on which reliance B
was placed by the assessee, counsel for the revenue submitted
... that these merely granted a concesssion to and conferred no
right in favour of the assessee which could. be and has been
withdrawn later by issuing fresh Circulars but since the
benefit or the concession in favour. of the assessee could not
be withdrawn retrospectively, the withdrawal of concession b<>s
been effected prospectively from the assessment year, 1979-80. c
Having regard to the rival contentions urged before us by
counsel on either side it is clear that the following
questions do arise for our serious consideration on the first
issue raised for determination in these appeals. Did the three
"'<,
sums representing interest on sticky loans con8tit.ute real
income of the assessee for the concerned assessment.years? Had D
such income really accrued to the assessee ·for· those years?
Does r.eal accrual of income deperid on its falling due by mere
lapse of requisite contractual period at the end of which it
becomes legally payable or upon the business character of the
transaction and the realities of the situation? How far is the
method of accounting regularly adopted by the assessee (here E
mercantile) relevant for dec,iding the question of real
accrual? What is the effect of making debit entries in respect
of such interest in the respective accounts of the concerned
debtors under the mercantile system of accounting? And lastly,
" can and should the theory of real income be extended so as to
exclude a particular income from chargeability under the Act F
because of high improbability of recovery attaching to it in
the concerned accounting year or years? We would like to deal
with these questions 'iri the light, of ·decided cases.
The _matetial ProV1sions in regard· to. the computation of
income of an assessee under the head 'Profits and Gains of
Business' are to be found in sections 28 (i) 29 and 145 (1) G
but these have to be read _subject to sec. 5 of the Act.
Section 28 (i) taxes the profits and gains of any business
carried on by the assessee at any time during the previous
year and such profits and gains are, under sec. 29 to be

H
44 SUPREME COURT REPORTS [1986] 1 S.C.R.
A

computed in accordance with the provisions contained in as. -',
30 ti> 43A, ,that is to say after making allowances and deduc-
tions mentioned in those sections. Section 145 (I) provides
that .income chargeable under the head 'Profits and Gains of
Business' shall be computed in accordance with the method of
B accounting regularly employed by the assessee, provided that,
in any case where the accounts are correct and completed to
the satisfaction of the Income-Tax Officer but the method is
such that, in his opinion, the income cannot be properly ,.,
deduced therefrom.then the computation shall be made upon such
basis and in such manner as the Income-Tax Officer may deter-
c mine; but where he is not satisfied about the correctness or
completeness of the account.~ of the asses see, or where no
method of accounting has been regularly employed by the
assessee, he can proceed to make the assessment to the best of
his judgment. It is well-settled, as a result of the Privy-
-Council decision in C.I.T. v. Sarangpur Cotton Mfg. Co., 6
D I.T.R. 36 at 40 that the section clearly makes such regularly
employed method of the opinion of the Income tax Officer, the
income, profits and gains cannot properly be deduced there-
from.·
•Though these provisions provide for charging the income
by way of profits and gains of business and prescribe the
E manner of computation the question as to at what point of time
its chargibility arises is answered by s. 5 of the Act which
states that the total income of a resident assessee·.from what-
ever source derived becomes chargeable either when it is
received by him or when it accrues or arises to him during the
previous year. In other words taxabi Uty is attracted even
F when income has accrued and it is clear that the receipt of
income is not the sole test of taxability under the Act; but ,
whether on receipt basis or accrual basis it is the real
income and not any hypothetical income which may have theore-
tically accrued that is subjected to tax under the Act and
this. latter aspect arising under our Act is well settled by
G decisions of this, Court and the High Court to which I will
presently refer.
However, before referring to the decisions which deal
with the doctrine of real income it will be desirable to indi-
cate the main difference between the two methods of accounting
that are usually employed by business men as also to deal with
H the aspect as to how far and to what extent a method of ""
accounting - particularly the mercantile method -,has a bear-
ing on the question of real accrual of income. In llhakeswar
STATE BANK v. C.I.T. [TULZAPURKAR, J.] 45

/
Prasad Narain Singh v. r.....iHiooer of 1""'*' :ru, 4 I.T.R. 71 A
at 74 Sir Courtney Terrell, C.J. described the 'cash system'
in these words:
"According to the system a record is kept of actual
receipts and actual payments, entrie~ being made
only when money is actually collected or disbursed
and if the profits of the business are accounted in B
this way the tax is payable on the difference
between the receipts and the disbursements for the
period in question."
On the other hand the 'mercantile accountancy system, other-
wise known as the 'book profits system of accountancy' or the
'wmplete double entry book-keeping' has .been described by Sir
Iqbal Aluned, C.J. in C.I.T. v. Singari Bai, 13 I.T.R. 224 c
at 227, as follows:
"Under this system the net profit of loss is cal-
culated after taking into account all the income
and all the expenditure relating to the period,
whether such income has been actually received or
not and whether such expenditure has been actually D
paid or not. That is to say, the profit computed
under this system is the profit actually earned,
though not necessarily realized in case, or the
loss computed under the system is loss actually
sustained, though not necessarily paid in cash.
'The distinguishing feature of this method of E
accountancy is that it brings into credit what is
• due immediately it becomes legally due and before
it_ is actually received; and it brings into debit
expenditure the amount for which a legal liability
has been incurred before it is actually disbursed."
"' The distinction between these two accounting systems has been F
adverted to by this Court in several of its decisions but I
need refer only to one decision in C.I.T. Madras v. ~
Krishoaswami Mudaliar & Others, 53 I.T.R. 122 where the
distinction has been elaborately brought out by Shah J (as he
then was) in the following passage occurring at pages 129-130
of the Report; G
11
Amang· Indian businessmen, as elsewhere, there are
current two principal systems of book keeping.
There is, firstly, the cash system in which a

H
46 SUPREME COURT REPORTS [19861 l s.c.R.

recbrd is maintained of actual receipt and actual
A
disbursements, entries being posted when money or
money's worth is actually• received, collected or
disbursed. There is, secondly, the mercantile
system, in which entries are posted in the books of
account on the date of the transaction, i.e., on
the date on which rights accrue or liabilities are
incµrred, irrespective of the date of payments. For
B exai\iple, when goods are sold on credit, a receipt
entry is posted as of the date of sale, although no
cash is received immediately in payment of such
goo~s; and a debit entry is similarly posted when
liability is incurred although payment on account
of such liability is not made at the time. There
c may have to be appropriate variations when this
system is adopted by an assessee who carries on a
profession. Whereas under the cash system no
account of what are called the outstandings of the
business either at the commencement or at the close
of the year is taken, according to the mercantile
D method actual cash receipts during the year and the
actual cash outlays during the year are treated in
the same way as under the cash system, but to the
bal~nce thus arising, there is added the amount of
the I outstandings not collected at the end of the
year and from this is deducted the liabilities·
E
incurred or accrued but not discharged at the end
of the year. Both the methods are somewhat rough.
In some cases these methods may not give a clear •
picture of the true profits earned and certainly
not of taxable profits. The quantum or allowances
permitted to be deducted under diverse heads under
F section 10 (2) from the income, profits and gains
of a business would differ according to the system
adopted. This is made clear by defining in sub-
section (5) the word 'paid' ·which is used in
several clauses of sub-section (2) as meaning
actually paid or incurred according to the method
G of accounting upon the basis of which the profits
or gains are computed under section 10. Again where
thejcash system is adopted, there is no question of
bad' debts or out standings at all, in the case of
mercantile system against the book prof it some of
the bad debts may have to be set off when they are
H foUrul to be irrecoverable. Besides the cash system
STATE BANK v. C.l,T; [TULZAPURKAR, J,] 47

and the mercantile system, there are innumerable A
other systems of accounting which may be called
hybrid or heterogeneous - in which certain elements
and incidents of the cash and mercantile systems
are combined."
On the aspect as to how far and to what extent a method of
accounting has a bearing on the question of real accrual of B
income the Court has made the following significant obser-
vation at page 128 of the Report:
"But the section (section 13 of the 1922 Act equi-
valent to section 145 of the 1961 Act) only deals
with a computation of income, profits and gains for
the purposes of sections 10 and 12 (sections 28 and
56 of the 1961 Act). and does not purport to enlarge c
or restrict the content of taxable income, profits
and gains under the Act."
Obviously for the content of . taxable income one must have
regard to the substantive charging provisions of the Act. This
decision, in my view, has emphasised two important aspects in
regard to the two methods of accounting usually employed by D
business men. In the first place the Court has pointed out
that both the methods are somewhat rough and in some cases
these methods may not give clear picture of the true profits
earned and certainly not of taxable profits; and secondly,
whatever be the method regularly employed by an assessee the
same has to be adopted as the basis and is relevant only for E
the purpose of the computation of income, profits and gains
under sections 28 and 56 of the Act but it cannot enlarge or
restrict the content of the taxable income, profits and gains
under the Act. It is thus clear that, under section 145, the
~· assessee's regular. method of accounting determines the mode of
computing the taxable income but it does not determine or even F
affect the range of taxable income or the ambit of taxation.
In other words, any hypothetical income which may have the
oretically accrued but has not truly resulted or materialised
in the concerned accounting year cannot be brought to charge
simply because the assessee has been regularly employing the
mercantile system of accounting and makes entries in his books G
in regard to such hypothetical income.

In the light of above I would recapitulate the admitted
facts and the manner in which the assessee treated or dealt
with the three sums representing interest on sticky loans in
H
48 SUPREME COURT REPORTS [1986] l s.c.R.

its books pursuant to the mercantile system of accounting
A regularly adopted by it. Indisputably, the three suma in 4
question repre~ented the assessee's income by way of interest
on advances ~de by it to some of its customers but having
regard to t~e deteriorating financial position of the
concerned parties and the history of their accounts the asses-
see felt tha' the advances had become sticky during the
concerned accounting years inasmuch as even the recovery of
II the principal! amounts had become highly improbable and
extremely doubtful in those years; therefore, though it
charged such interest by debiting the concerned parties it did
not carry it lo its profit and loss account but credited the
same to a sepl).rate account styled 'Interest Suspense Account'
so as to avoid showing unreal or inflated prof its and claimed
c that it was dot taxable in its hands as real income had not
accrued to it. The facts that the advances or loans had,
during the concerned accounting years, become sticky and that
1
such interest had not materialised or resulted to the assessee
in those yeans were not disputed but as stated earlier the
claim was neg~tived by the taxing authorities and the Tribunal ,.
D on the ground' that the advances or loans had not been treated
as irrecoverable or bad debts under s. 36 (1) (vii), that the
aspect that .the advances or loans had become sticky was
irrelevant, that since the assessee was following the mercan-
tile system of accounting such interest has accrued to it at
the end of each accounting year and that the assessee had
itself shown the accrual of interest by changing the same to
1

E
the concerned parties by making debit entries in their
accounts. The High Court also affirmed the view that there had
been accrual 1of the income at the Jnd of each accounting year
and in that behalf laid emphasis on the fact that the assessee
had been regularly adopting the mercantile system of account- 7
F ing and obsetved that the assessee 1 s income will have to be
determined ii\ accordance with that method. In other words it
is clear that in coming to the conclusion that the three sums
in question were liable to be brought to .:ax the taxing
1

authorities, the Tribunal and the High Court, relying on the
mercantile system employed by the assessee, adopted a
G legalistic approach and took the view that because such
interest had.fal~en due and become legally recoverable by the
assessee at .the end of each of the accounting years it had
accrued to l.t, though by rea•on of the stickiness of the ..,,
advances or .loans such interest had ia fact not resulted or
materialised but remained its hypothetical income. Two
H questions arise: Should such legalistice approach prevail Cl"er
STATE BANK v. C.I.T. [TULZAPIJ!lKAR, J.] 49

A
the doctrine of real income that has been recognised and
invoked by Courts while imposing tax liability under the Act?
Secondly, can the mercantile system of accounting, though
regularly employed, 'determine' accrual of real income?
Since the answer to the second question has been already
indicated in the earlier part of our judgment we shall dispose B
of second question first. As regards the mercantile.system of
accounting regularly employed by the assessee there are two
-. aspects which we like to stress. First, the High Court, in my
view, was in error in observing that the assessee' s income
"will have to be determined pursuant, to the provisions con-
tained in the Income Tax Act 1961, in accordance with the
accounts regularly maintained by it." I have already indicated c
above that the illethod of accounting regularly employed by an
assessee is. relevant only for the purpose of computation of
income, profits and gains under s. 28 of the Act and that it
cannot enlarge or restrict the content of the taxable income
under the Act and that under s. 145 the assessee's regular
method of accounting determines the mode of computing taxable D
income but it does not determine or even effect the range of
taxable income or ambit of taxation. ln other words simply
because the assessee has been regularly employing the mercan•
tile system of accounting it would not mean that any hypothe-
tical income which may 'have theoretically accrued but has not
truly resulted to him in the concerned accounting year can be E
brought to charge and, therefore, the question whether the
three sums representing interest on sticky loans had really
accrued to the assessee or not would·be a matter. of substance
and cannot be determined by merely having regard to the method
of accounting (here mercantile system) adopted by the
assessee. Secondly it will have to be.borne in mind that this F
is not a case where the assessee had ignored or failed to make
any entries at all in regard to such. interest on advances or.
loans which had become sticky in its books maintained on
mercantile system but it had charged such interest by debiting
the accounts of concer.ned debtors and had designedly cr.e4ited
it to 'Interest Suspense Account' instead of carrying it to G
'Profit and Loss A:!count' with a view to avoid showing unreal
or inflated profits. A 'suspense account' in book-keeping
means "an account in which items are temporarily carried pend-
ing their final disposition; it does _not appear in financial
statements" (vide Kohler's Dictionary for Accountants, l'hird
F.dition). Since the final disposition of the sums in question H
was uncertain and hung in balance these items were properly
50 SUPREME COURT REPORTS (1986] 1 s.c.R.

A
carried to 'Int~rest Suspense Account' and could not and did
not find a place in_ the financial statement like the Profit
and Loss Account. -From the mere fact that such interest was
charged to the concerned debtors by making debit entries in
their respective accounts no inference could be drawn that the
assessee had regarded it as accrued income because simul-
B taneously such interest was credited to Interest Suspense
Account and not to Profit and Loss Account. The tSJ<ing
authorities, the Tribunal and the High Court clearly erred in
drawing such inference against the assessee. In fact by making
the aforesaid entries and treating the three sums in the
manner done the assessee must be regarded as having demonstr-
c ably shown an intention to treat such interest as its hypothe-
tical and not real income.
Counsel for the assessee pointed out that after all the
primary purpose of book-keeping, whatever be the method of
accounting, wa~ to make a systematic record of business
transactions in,a manner which must show the correct financial
D position of a lmsiness house at a given point of time and
reflect the real and true profits of the business done by it
during the year i of account and contended that in treating the
three sums in guestion
I
in the manner done the assessee had
merely followed: a universally recognised practice invariably
adopted by bank$ and financial institutions who maintain their
E accounts on mercantile system and what was more this practice
accorded with the principle that no item should be treated as
income unless it has been actually received or has accrued in
the sense that there is reasonable certainty that it will be
realised. I find considerable force in this contention of
counsel for the assessee. That the practice of carrying
F interest on such sticky loans to 'Interest Suspense Account'
instead of crediting the same to 'Iaterest Account' or to
'Profit and Loss Account' is a universally recognised practice
and is wholly consistent with the mercantile system of
accounting will be clear. fr.om the standard text books on
accountancy. For instance, in the treatise 'Advanced Accounts'
G by Shukla and Grewal (Ninth Revised and Enlarged Edition 1981)
a clear reference to such practice finds a place in the
following paragraph occurring at page 1089 under the heading
'Interest on doubtful debts' : '
"Interest on doubtful debts should be debited to
the loan account concerned but should not be
H credited to Interest Account. Instead it should be I
STATE BANK v. C. I. T. [TULZAPURKAR, J. ] 51
A

credited to Interest Suspense Account. To the
extent the interest is received in cash, the
Interest Suspense Accounts should be transferred to
Interest Account; the remaining a11XJUnt should be
closed by transfer to the Loan Account. This treat- B
ment accords with the principle that no item should
be treated as income unless it has been received or
there is a reasonable certainty that it will be
realised. 11
Similarly in Spicer and Pegler's 'Practical Auditing' by W.W.
Bigg (Fourth Indian Edition by s. v. Ghatalia) the learned
author has suggested that instead of leaving irrecoverable c
interest on· doubtful loans out of account altogether the
practice of charging such interest to the parties concerned
but crediting it to the Interest Suspense Account is more
appropriate for reflecting the correct state of affairs and
t.he true profits. The relevant passai:te occurring at pages
186-187 runs thus: D
"Where interest has not_ been paid, it is sometimes
left out of account altogether. This prevents the
possibility of irrecoverable interest being credit-
ed to revenue, and distributed as profit. On the
other hand, this treatment does not record. the
actual state of the loan account, and in the case E
of banks and other concerns whose business it is to
advance money, it is usual to find that interest is
regularly charged up, but when its recovery is
doubtful, the a11XJunt thereof is either fully
provided against or taken to the credit of an
Interest Suspense Account and carried forward, and F
not treated as profit until actually received.''
Reference may also be made to the Approved Text of the 'Inter-
national Accounting Standard 18'. (Supplement to 'The Manage-
ment Accountant', December 1982) a publication of the Inter-
national Accounting Standards Committee. The concept of
revenue recognition is explained thus in para 5:" G
"Revenue recognition is mainly concerned with when
revenue is recognised in the income statement of an
enterprise. The amount of revenue arising on a
transaction 'is usually determined by agreement
between the parties involved in the transaction.
H
52 SUPREME COURT REPORTS [1986] l S.C.R.
A

Whe!]. uncertainties exist regarding the detennina-
tion of the amount, or its associated costs these
uncertainties may influence the timing of revenue
recognition."
The effect of uncertainties on revenue recognition has been
B set out in paragraphs 16 to 27 and para 25 is material which
runs thus:
"Revenues arising from the use by others of enter-
prise rescftlrces yielding interest, royalties and
dividends should only be recognised when no signi-
ficant uncertainty as to measurability or
c collectability exists."
In other words 'according to International Accounting Standard
18 if significant uncertainty as to collectability of interest
exists· such revenue should not be recognised. In view of what
has been stated in the standard books on accountancy as also
in the International Accounting Standard 18 I am clearly of
D the view that in the case of interest on sticky loans the
practice of debiting the accounts of the concerned debtors
with such interest and carrying the same to 'Interest Suspense
Account' instead of to· 'Interest Account' or 'Profit and Loss
Account' is a well recognised and accepted practice of commer-
cial accountancy, that it is wholly consistent with mercantile
E method of accounting and 'that it prevents the wrong crediting
and improper and illegal distribution or remittance of infla-
ted and unreai profits and by making the appropriate entries
following such practice the assessee had clearly indicated
that the three sums in question being interest on sticky loans
constituted it.a hypothetical income and not real income.
F
Turning ~o the first question it is true that under s. 5
taxabillity i$ attracted not merely when income is actually
,
received but ~lso when it has 'accrued' and it is also true,
as has been <µ<plained by this Court in Thiagaraja <lletty' s
case (supra) :and Morvi Industries' case (supra) that income
G accrues when it 'falls due', that is to say when it becomes
legally recoverable irrespective of whether it is actually
received or. not and 'accru~d income' is that income which 'the
assessee has a legal right to receive'. Incidentally it may be
stated that in both of these cases, where the legal aspect of
accrual has been explained, no question of applying the
H
,
doctrine of real income could arise; for., in the former case '-:"
STATE BANK v. c.r.T. [TULZAPURKAR, J,] 53
A
after the commission payable to the managing agents had
accrued at the end of the accounting year the managed company
had, instead of paying it, kept it in a suspense account pend-
ing settlement of a dispute in regard to another debt owed to
it by the managing agents (which proposed settlement was ulti-
B
mately rejected) and the Court held that such keeping it .in
the suspense account pending settlement of another in,debte.d-
ness would not pr.ev~nt its accrual to the managing agents,
while in the other case a unilateral relinquishment of the
commission by the managing agents was after its accrual and
hence the Court ruled that it could not escape liability to
tax, While the legal aspect of accrual thus holds good this
Court in C.I.T. v. Shoorji Vallabhdas & Co. 46 I.T.R. 144 has
c
enuciated the doctrine of real income in these terms:
"Income-tax is a levy on· income. No doubt, the
Income-tax Act takes into account two points of
time at which the liability to tax is attracted,
via., the accrual of the income or its receipt; but
D
the substance of the matter is the income. If
income does not result at all, there CSDllOt be a
tax, even though in book-keeping, an entry is made
about a hypothetical income, which does not materi-
alise. Where income has, in fact, been received and
is subsequently given up in such circumstances that
E
it remains the income of the recipient, even though
given up, the tax may be payable. Where, 00...,ver,
the income CBI\ be said not to have resulted at
all, there is obviously neither accrual nor receipt
of income, even though sn entry to that ·effect
might, in certain circumstances, have been made in
F
the books of account."
(Emphasis supplied)

The above observations were made in the context of these
facts. The asseasee-firm was the managing agent of two shipp-
ing companies; between April 1, 1947 and December. 31, 1947 an
G
amount of Rs, 1, 71,885 from one company and Rs. 2,56,815 from
the other company became due to the assessee as commission @
10 per cent under. the managing agency agreement and in its
books the assessee had er.edited these amounts to itself and
debited them to the managed companies. In November., 1947 the
assessee desired to have the managing agency transfered to two
H
private limited companies and in this connection agreed in
-~
54 SUPREME COURT .REPORTS [1986] 1 s.c.R.
A

December .1948 to accept 2-1/2 per cent as commission and gave
up 75 per · cent of its earnings. The department sought to
assess the amounts of Rs. 1,36,903 and Rs. 2,00,625 being the
75 per cent which the assessee have given up, on the ground
that commission at JO per cent had already accrued to the
B assessee in the year of account which ended on March 31, 1948
and the agreerltent in December 1948, after the close of the
pt'evious year, to give up a portion of income could not save
!

that portion from liability to income-tax. Negativing the
contention this Court, in agreement with the High Court's
view, held that the subsequent agreement has altered the rate
c of commission in such a way as to make the income which really
accrued to the assessee different from what had been entered
in the. books of account and that this was not a case of a gift
by the assessee to the managed companies of a portion of
income which had. already accrued, but an agreement to receive
a lesser remuneration than what had been agreed upon. The
D Court relied upon the fact that the assessee had in fact
received only 'he lesser amount in spite of the entries in the
accounts books'I and held that such lesser amount alone was
taxable. ,
A large !lumber of decisions rendered by this Court as
well as by the High Courts were cited at the bar by Counsel on
E the either side in which this aforesaid theory of real income
has been invoked and applied and in some of them emphasis has
been laid on the aspect that accrual is the matter of
substance to b¢ decided on commercial principles having regard
to the business character of the transactions and the reali-
ties of the situation. After having gone through these
F decisions I am in agreement with the submission of the learned
counsel for the revenue that these decisions involving the
application of the concept fall into two groups: (a) cases
where there has been a surrender or relinquishment of income
that may have ~heoretically accrued and (b) cases where these
haa been diversion of income at source either under a statute
G or by over riding title; but in both types of cases the
Court's endeavour was to determine whether there was accrual
of real income having regard to the realities or specialities
of the situation. It is not necessary to deal with each and
every decision· falling under either one or the other group but
confining atttlntion to the decision of this Court it will
H suffice to indicate that in the former group fall the follow-
ing decisions, namely C.I.T. v. Bari Vallabhadas Kal.idas &
Co., 39 I.T.R. I, C.I.T. v. Qumian!al Mangaldas & Co. and
STATE BANK v. C.I.T. [TULZAPURKAR, J.] 55

C.I.T. v. Mangaldas Girdhardas. Parekh Ltd., 39 I.T.R. 8, A
• C.I.T. v. Messrs Shoorji Vallabhadas and Co. (supra), C.I.T.
Madhya Pradesh v. Kalooram Govindram, 57 I.T.R. 630 and C.I.T.
v. Birla Gwalior (P) Ltd., 89 I.T.R. 266, while the decision
in Poona Electric Supply Co. Ltd. v. C.I.T. Bombay, 57 I.T.R.
521, falls in the latter group. Since the instant case is not
one of diversion of income at source either under a statute or B
by over-riding title I need dilate only on the decisions in
the former group.
As regards the decisions falling in group (a) I would
·-.< like to point out that the ratio of all these decisions
'
clearly is that where income or part thereof has theoretically
accrued but has been, either unUaterally or as a result of.
bilateral arrangement, voluntary relinquished or surrendered c
by the assessee before its accrual the same cannot be regarded
as real income of the assessee and cannot be brought to tax,
and such conclusion has been reached having regard to the
business character of the transactions and the realities of
the situation notwithstanding that some entries have been made
in the assessee' s books maintained in the mercantile system • D
...,. The decision of the Bombay High Court in H.M. Kashiparekh
Co.'s case 39 I.T.R. 706 is a typical instance in point. The
assessee, which maintained its accounts i.n the mercantile
system, was the managing ~gent of a paper mill company; under
the managing agency ·agreement it was under a duty to forego up
to one-third of its commission where the profits of the E
managed company were not sufficient to pay a divident of 6 per
cent; for the accounting year ending March 31, 1950 the
assessee earned a commission of Rs. 1, 17, 644 but as a result
of resolutions passed by the managed company and the assessee
company the assessee gave up a sum of Rs. 97,000 (Rs.57785
over and above Rs. 39215 which it was bound to forego) in F
' December 1950. Though the Appellate Tribunal found that the
excess amount of Rs. 57785 had also been given up for reasons
of commercial expediency it held that the maximum amount which
could be foregone by the assessee was only Rs. 39215 and
therefore included the excess amount of Rs. 57785 in. the tax-
able income, On a Reference, the High Court held that it was G
the real income of the assessee company for the accounting
year that was liable to tax, that the real income could not be
arrived at without taking into account the amount-foregone by
the assessee and that in ascertaining the real income of the
'r- fact that the asses see followed mercantile system of account
' dld not have any bearing. The Court further held that the H
56 SUPREME COURT REPORTS (19861 i s.c.R.
A

accrual of commission, the making of the accounts, the legal
obligation to give up part of the commission and the foregoing
of the commission at that time of the making of the accounts
were not disjointed facts; there was a dovetailing about them
which could not be ignored and therefore the real income of
B
the assessee was Rs.27644 and the amount of Rs.97000 foregone
by the assessee could not be included in the real income of
the assessee for the accounting year.
It will be significant to mention that during the hear-
ing of the Reference counsel for the re.venue raised a conten-
tion that even if the amount of Rs. 57785 had been foregone by
c the assessee company on grounds of commercial expediency that
was riot done in the accounting year which ended on March 31,
1950 but it was done in December 1950 as a result of two
resolutions, one passed by the managed company and the other
passed by the assessee company and that since admittedly the
assessee was following.the mercantile system of accounting it
lJ could not avail of the benefit of the doctrine of real income
where the income by way of the managing agency commission had
y
been credited in the books in the year of account and had been
surrendered by it in the next year; in other words it was
specifically urged that if the surr.ender was not ma.de and
entered in the books in the same year no question of real
E income could arise and in this behalf counsel relied upon the
well-settled rule that for purposes of income-tax each year
(J was required ·to be regarded as a distinct and self-contained
unit. Apropos this contention the Court observed thus:
"The two rules that income-tax is annual in its
structure meaning thereby that for computation each
F year is a distinct self-contained unit and the
other that the income to be taxed is the real
7
income of the assessee do not seem to us to be
incompatible or irreconcilable. Mr. Joshi (counsel
for the revenue) also is not prepared to go so far
as that and has fairly stated that there is no
G antithesis between the two rules. The facts of a
case may present some difficulty in applying the
rules by the conflict would, in our opinion, be
rather apparent than real. The facts of a given
case may create the impression of a discrepant
situation but the apparent discrepancy can be
H solved in a manner not inconsistent with the basic 7'
concepts underlying the two rules. In.our judgment,
STATE BANK v. C. I. T. [TULZAPURKAR, J.] 57
A

they permit of harmonious application, though the
application is to a degree rust de?end on the
circumstances of each case. Some propositions could
be forrulated but whether a general forrula appli- B
cable to all circumstances could be hit on we
rather doubt.

1bough it may not be possible to prescribe a
general forrula which successfully compose every
conflicting situatlon, the position in law seems
clear to us that in applying the two rules to c
particular transactions regard rust be had to the
true legal rights and the true situation. A fair
interpretation of the transaction and the situation
would lead to a preferable and, if we may say so, a
correct solution than she'er adherence to one rule
and discounting of the other." 0

At page 720 of the Report the Court went on to
observe thus:

"In the course of his argument, learned counsel for the
Revenue stated that there rust have been entries in the books E
of the managed company and the· managing company in consonance
with clause 5 of the managing agency agreement ••••••••••• •••
we shall proceed on the footing that, the assessee company
having followed the mercantile, system of account, there must
have been entries made in its books in the accounting year in
respect of the amount of the commission. In our judgment, we F
'<.would not be justified in attaching any particular importance·
in this case to the fact that the company followed the
mercantile system of account. 1bat would not have any
particular bearing in applying the principle of real income to
the facts of this case. Incidentally, we may observe that we
ourselves pointed out in the case of Comnissioner of G
Income-tax v. Shoorji Vallabhadas & Co. that the question
whether the income accrued or not is not a mere matter of
cogency of the entries made in the account books of the
assessee but is essentially one of substance and of th~ real
nature of what happened; a mere book entry is not conclusive
~ of the question whether the assessee had become entitled to the H
58 SUPREME COURT REPORTS [1986] 1 s.c.R.
A

sums or not• It may also be mentioned that in that ~
case we were dealing with an assessee who followed
the mercantile system of account. The crucial
question before us, therefor-e, is whether the two
facts, one the amount of Rs. 1,17,644.4 annas which
B
would have become payable to the managing company
but for the surrender and the factus of surrender, ,
are to be isolated or treated as of cogency in
determining the actual accrual of income, by which ~
we mean the real income of the assessee company. If
the fact of foregoing or surrendering the amount of
c Rs. 57,000 odd is to be regarded as of cogency in
the context of the present point of real income and
if it be remembered that the surrender was made at
the time of ascertaining the quantum of the
commission payable to the assessee company and
further if it be remembered, as now found by the
D
Tribunal, that the surrender was made bona fide and
on grounds solely of commercial expediency, it 'I'
seems very difficult to us to see how the Revenue
is justified in contending that the real income of
the assessee was something different than the
amount of Rs. 20,000. (Sic R.27644) which was shown
by it at the time of assessment as its income from
managing agency commission."
The Court further expressed the view that the principle of
real income was not to be so subordinated as to amount
virtually to a negation of it when a surrender or concession
or rebate in respect of managing agency commission is made,
F
agreed to or given up on grounds of commercial expediency,
simply because it takes place some time after the close of the7
accounting year and that in examining any transaction and
situation of this nature the Court would have more regard to
the reality and speciality of the situation rather than the
purely theoretical or doctrinaire aspect of it and it will lay
gr.eater emphasis on the business aspect of the matter. viewed
as a whole when that can be done without disregarding the
decision of the Bombay High Court has been fully approved by
this Court in Birla Gwalior (P) Ltd.'s case (supra).
It will thus be clear that even under the mercantile
system of accounting whenever adopted i t is only the accrual -....
H
of real income which is chargeable to tax, that accrual is a '
matter of substance and that it is to be decided on commercial
STATE BANK v. C.I.T, [TULZAPURKAR, J,] 59

A
principles having regard to the business character of the
transactions and the realities and specialities of the situa-
tion and cannot be determined by adopting purely theoretical
or doctrinaire or legalistic approach. If, therefore; for the
purpose of determining whether there has been accrual of real
income or not regard is to be had to the business character of B
the transactions and the realities and specialities of the
situation in preference to theoretical, doctrinaire or legal-
istic approach I fail to appreciate why interest on sticky
loans, which has theoretically accrued but has not factually
resulted or materialised at all to an assessee hypothetical
income and not real inc6me? Tii.ere is no reason why the factum
of stickiness of loans operating throughout the accounting c
period or periods, not on the basis of mere lpse dixit of the
assessee but on being objectively established to the satis-
faction of the taxing authorities by ref,erence to the facts
showing the deteriorating financial position of the conc~rned
debtors and the history of their accounts should not have the
effect of preventing the accrual of interest thereon as real D
income to the assessee? If voluntary relinquishment or
surrender of income done unilaterally or as a result of
bilateral arrangement can prevent its real accrual there is no
reason why the factum of sti.ckiness of loans objectively
established should not prevent accrual of interest thereon as
real incorre. In fact in the former case considerations of E
cormnercial expediency could be a motivating force ·behind such
voluntary relinquishment or surrender of the income resulting
in its non-accrual but in the latter case the non-accrual
would be due to circumstances beyond the assessee's control. I
am, therefore, clearly of the view that the stickiness. of
'""( advances or loans objectively established to the satisfaction F
of the taxing authorities by producing proper material, is
sufficient to prevent the accrual of lnterest thereon as real
income and would have the effect of rendering such lncome
hypothetical and the same cannot be brought to tax. In
my view under the Income Tax Act in order that income should
accrue it should not merely fall due or become legally G
recoverable but should also ·be factually and practically
reallsable during the accounting year or years. In other words
merP. non-receipt of income, when it is reasonably realisable,
., will not affect accrual but factual or practical unrealis-
ability thereof may prevent its accrual depending upon the
facts and circumstances attending upon the transaction. H
60 SUPREME COURT REPORTS [ 1986] 1 S, C.R.
A

Counsel for the revenue raised two objections to extend !
the theory of real income so as to E!Xclude from chargeability
the interest on sticky loans merely because it suffers from
high improbability of recovery, j:n the first place he urged
that the Act contains no provision excluding or deducting such
B
interest from computation of income and the only provision for
deduction of debts is to be found in s. 36 (1) (vii) where-
under debts which are established to have become irrecoverable
and bad in the previous year are permitted to be deducted on >-
fulfilment of certain conditions specified in sub-section (2)
and as such the extension of the theory of real income
c as sought would entrench upon s. 36 (1) (vi), Secondly, it was
urged that such extension will be ill-advised inasmuct, as, if
done, it will apply to cases of interest accruing to all
money-lenders and not merely to cases of interest accruing to
banks and financial institutions. As regards the first
objection the argument amounts to saying that the exclusion or
D
deduction in respect of irrecoverable and bad debts under s.
36 (1) (vii) read with the conditions mentioned in sub-sec. 1'
(2) proceeds on the basis that in substance such debts do not
constitute real income of the assessee and therefore exclusion
of interest on sticky loans from computation of income for
which there is no provision in the Act and that too without
E
any conditions would impinge upon the specific provision
contained in s. 36 (1) (vii) read with sub-section (2). The
answer to this objection is that it is not as if that in the
absence of some specific provision exclusion of hypothetical
income cannot be done; in fact such exclusion rests not upon
any slippery or slushy ground but upon the principle that
F
under the Act chargeability is ·attracted only to real income
and in this behalf it will be pertinent to mention that the ,
provision for exclusion or deduction of bad debts was intro-
duced in the income tax law (the 1922 Act) fot the first time
in 1939 but even prior to the insertion of such provision in
the 1922 Act the Privy Council in C.I,T. v. Sir S.K. QU.tna-
G
vis, 6 I.I. Cases 453 had, on the basis of ss. 10 and 13 of
the 1922 Act, ruled that such bad debts were necessarily
allowable as deduction on grounds of first pdnciples of
accountancy. At page 457 of the Report the Privy Council have
observed: "Although the Act nowhere in terms authorises the
deduction of bad debts of a business, such a dtduction is .,,.
H
necessarily allowable. What are chargeable to income-tax in
respect of a business are the profits and gains of a year; and
in assessing the amount of the profits and gains .of a year
STATE llANK v. C.I.T. [TULZAPURKAR, J,] 61
A
account must necessarily be t.aken of all losses incurred,
otherwise you would not ·arrive at the true porfits and gains."
Moreover, there is a clear distinction between an irrecover-
able loan and a Sticky lo.an; the former would be a bad debt in
respect whereof the chances of recovery are almost nil having
been written off the same can form the subject matter of a B
deduction under s. 36 (1) (vii) while the latter is a loan to
whl.ch a high degree of improbability of recovery attaches in a
particular year or years due to which inter.est thereon becomes
hypothetical income and not real income during the said year
or years and therefore, it cannot be brought to tax, though if
realised subsequently the same could be and ought to be
brought to tax, if this distinction is borne in mind no c
question of impinging upon the provision contained in s. 36
. (1) (vii) read with sub-Section (2) can arise by extending the·
theory of real income to the interest on sticky loans.
As regards the second objection, if on principle interest
on sticky loans is merely hypothetical income and is not real
income and is on that account to be excluded from computation D
of income we fail to see why the benefit of this principle
under the theory of·. real income should not be available to
private money-lenders. The theory of real income must apply to
all cases irrespective of who the assessee is. All that is
required to be ensured is that like the banks and financial
institutions the money-lenders must also establish to the E.
satisfaction of the taxing authority that the loans in
question had in fact become sticky during the concerned year
or years by producing proper material and that they have
invariably followed the practice of carrying the interest of
such loans to Interest Suspense Account in stead of crediting
the same to Interest Account or Profit & Loss Account with F
the additional safeguard of offering the same for taxation if
', and when it is subsequently realised. It will be pertinent to
mention in this connection that the earlier Circulars issued
by the Central Board of Revenue and 'Reserve Bank of India
(vide C.B.R. Circular No. 37/54 dated 25.8.1924, No. 41 (V-6)
D of 1952 dated 6.10.1952, CBDT's Letter F.No. 207/10/73 ITA G
II dated 16.4.1973 and RBI Circular IFD No. 0,P,R. 1076/1 (5)
to SFCs dated 21.11.1973) which conferred the benefit of
excluding such interest on sticky loans albeit by way of
concession were applicable to private money lenders also. In
the circumstances both the objections are liable to be
Y rejected. H
I may now deal with the decisions of the High Courts,
Directly on the point at issue there are five decisions which
62 SUPREME COURT REPORTS [1986] 1 s.c.R.
A

we need consider. Out of these counsel for. the assessee relied
upon three decisions , two of the Madras High Court in lk>tor
Credit Co. case, and Devi Films case.and one of the Punjab &
Haryana High Court in Ferozepur Finance case (supra) where a
view has been taken that interest on sticky loans being hypo-
B thetical and not real income should be excluded from the
computation of the assessee 's· income while counsel for. the
r.evenue relied upon two decisions one of the Bombay High Court
in C.I.T. v. Confinance Ltd. 89 l,T,R, 292 and the other of
the Calcutta High Court in James Finlay & Co. v. C.l.T. 137
I. T. R. 698 as both these apparently seem to take a contrary
c view.
I shall first deal with two decisl.ons on which counsel
for the revenue placed rell.ance. In C.l.T. v. Confinance Ltd.
the assessee was carrying on money lending business and bank-
ing business and followed mercantile system of accounting. For
the accounting year ending March 31, 1959 the assessee stated
D that no credit was taken in it,s balance-sheet in respect of
inter.est on several loans advanced by it as inter.est had
remained unpaid from March 31, 1956, For the assessment years
1959-60 and 1960-61 interest in respect of amounts due by
debtors amounting to Rs. 9,275 and Rs. 13,033 respectively was
brought to tax by the I.T.O. and A.A.C. The Tribunal reversed
E the orders on the ground that the records showed that there
had hardly been any receipts of interest for a number of years
past. On a reference, the High Court reversed the Tribunal's
view and held that the facts that there were hardly any
receipts in respect of items of interest or that the bona
fides of the assessee in not charging inter.est was not disput-
F ed were circumstances which by themselves were in sufficient
to support the conclusion that there was no real income in
7
respect of items of interest inasmuch as none of the debts due
by the several·debtors was written off by the assessee and no
evidence was produced to show that. interest in respect of the
debts was given up and therefore the two sums were properly
G includible in the total income of the assessee for the two
assessment years respectively. From the judgment we find that
counsel for the assessee sought to apply the doctrine of real
income as e~pounded in·Kashiparekh's case to the facts of the
case but the High Court declined to do so by adopting a legal-
isti~ approach that the assessee had been following mercantile
H system of accounting that the interest had accrued and further
laid considerable emphasis on two aspects, namely, that none
of the debts due by the several debtors was written off by the
STATE BANK v. C.I.T, [TULZAPURKAR, J,] 63

assessee and no evidence was produced to show that interest in A
respect of the debts was given up. In my view the High Court
• failed to appreciate that the method of accounting employed by
an assessee merely determined the mode of computing the income
and not the range of taxable income and furl:her failed to
notice that there could be and was a clear distinction between
an irrecoverable or a bad debt on the one hand the sticky loa~ B
on the other to which we have adverted earlier.
In James Finlay's case decided by the Calcutta High Court
the items of interest receivable from two parties qn advances
-<: made to them were sought to be excluded from computation of
income of the assessee for 1970-71 on the ground that since
1.1.1968 the assessee had decided to change its method of
accounting in respect of interest, which was doubtful of C
recovery, by crediting the same to the Suspense Account and
also on the ground that ·before the closing of the books of
account of the relevant accounting year the assessee had
adbandoned its claim for such interest. The High Court held
that theie was no change in the mercantile system .of account-
ing that had all along been empolyed by the assessee, that the D
..,. .transfer of items of interest to Suspense Ac.count could not be
termed as a change in the method of accounting and therefore
the amounts were assessable on accrual basis; as regards the
other ground the High Court held that though there was diffi-
culty in realising the interest in the year of account there
was no material to show that there was any agreement 'with the E
debtors to waive the interest or to keep it in the Suspense
Account and hence the claim for interest had not been given
up. In our view the decision mainly turned upon whether the
assessee had changed its method of accounting or not and the
finding was it has not and as far as the theory of real income
is concerned the Court did not reject the same but on facts F
~ came to -the conclusion that it was not applicable inasmuch as
the claim for interest had not been reUnquished or given up.
On the other hand in the three decisions on which counsel
for the assessee relied two High Courts have invoked and
applied the theory of real income to cases of interest on
sticky loans and taken the view that such interest being hypo- G
thetical and not real is' not includible in the assessable
income of the assessee. Only one decision may be referred to
in detail. In the Motor Credit Co's case the assessee in the
course of its business as financiers for purchase of motor
vehicles advanced, under a hire purchase agreement, moneys to
two firms which were plying buses. The routes of these two H
64 SUPREME COURT REPORTS [1986] l s.c.R.
A

firms having been taken over by the State transpor.t Corpora- ,.
tion,· the firms defaulted in making payments of hir.e purchase
instalments, and consequently the buses were seized. As the
assessee company was advised that there was no prospect of
r.ecover.ing even the principal amount it did not er.edit the
B interest on the outstandings fr.om the two firms even though it
was adopting the mercantile system of accounting. The ITO,
however, included a sum of Rs. 56,163 by way of accrued
intetest on the amounts outstanding fr.om these two fir.ms, The
AAC deleted the addition. The Tribunal held that the assessee >-
could not have expected to get any interest income on the
c outstandings found due from two firms and it would be wholly
unrealistic on the part of the assessee to take credit fr.om
the 'interest income and consequently confirmed the AAC 's·
order. On a reference at the instance of the Collllllissioner the
Madras High court held that the Tr.ibunal was right in its
conc1;,..ion that though the assessee had adopted the mer.cantile
D system of accounting no interest income could be assessed in
its hands on accrual basis and it would be ver.y unrealistic on
the part of the assessee to take credit for the highly >'
illusory interest. Following the decision of this Court in
Sboorji Vallabhdas Co's case and of the Bombay High Court in
Kasbiparekh's case the High Court took the view that the
E regular. mode ·of accounting merely detennl.ned the mode of
computing the taxable income and the point of time at which
the tax liability was attracted and it could not determine or
affect the range of taxable income or the ambit of taxation.
lt further observed that it was not the hypothetical accrual
of income based on the mer.cantile system of accounting follow-
F ed l>y the sssessee that had to be taken into account but what
should be considered was whether the income had really
materialised or. r.esulted to the assessee and that question had '
to be considered with reference to commercial and business
realities of the situation in which the assessee had been
placed and not with r.ef~rence to his system of accounting and
G held that since there was not even the r.emotest possibility of
any inter.est income materialising in favour of the assessee in
respect of the outstandings for. the accounting year. relevant
to the assessment year. in question no liability to tax could
be imposed on the assessee. To the same effect ar.e the other
two decisions in Devi Films case and Ferozepur Finance case. I
H approve these three decisions. v
In view of my collclusiOil that th1s theory of real income
could be and should be extended to interest on sticky loans and
STATE BANK v. C.I.T. [TULZAPURKAR, J,] 65

that on principle such interest being hypothetical cannot be A
brought to tax it ts unnecessary to deal with the earlier
Circulars of the Central Board of Revenue and the Reserve Bank
of India all of which were in the nature of concession granted
to an assessee according to counsel fo_r the revenue.
1 Having regard to the above discussion i.t is clear that
the three sums representing interest on sticky advances in the B
instant case being hypothetical and not real income of the
assessee could not be brought to tax for the three concerned
assessment years and we answer the first question in the
negative in favour of the assessee and against the. revenue. Of
course it goest without saying that if and when these SUlllS or
any part thereof- are realised subsequently the same could be
brought to tax in the year of realisation. c
The second question raised for our determination in these
appeals relates to the taxability of Rs •. 1,66,128 which
represents the exchange difference arising:' on devaluation of
the Indian Rupee on August 6, 1966 and the question relates to
the assessement year 1967-68 only. The facts giving rise to
the question are these. Admittedly the . business of the D
assessee-bank included buying and selling of foreign exchange
and therefore any foreign currency held. by it would be its ·
stock-in-trade and if foreign currencies bought ·at the pre-
devaluation rate of exchange were sold at post: ·:devaluation
rate of exchange resulting in a surplus the same would 'be its
business receipt or revenue receipt and therefore liable to E
tax as part of business profits. Indisputably, just before the
devaluation of the Indian Rupee on August 6, 1966 the
assessee-bank held foreign exchange by way of cash balances
available with their foreign correspondents, forward
contracts, items in transit etc., amounting to L-33,780,76 in
US Dollars and L-9552.0.2 in Sterling which when converted F
back to Rupees at the post devaluation rates gave rise to a
profit of 57.5% or Rs. 1,66,128 in the transaction; the
assessee-bank·credited thiS surplus to an account designated
"Provision for Contingencies". It was contended on behalf of
the assessee before the lower taxing authorities that this
profit should not be taxed as it was of a casual and non- G
recurring nature. 'nle contention was negatived by the authori-
ties on the ground that even assuming, without conceding, that
it was a windfall and, therefore, of a casual nature the same
had arisen from the business activities of the assessee-bank
and, therefore, was not exempt but was liable to tax. Before
the Appellate Tribunal an attempt was made by counsel for the H
assessee-bank to contend that the cash balance in terlllS of
66 SUPREME COURT REPORTS (1986] 1 s.c.R.
A

dollars and sterlings at the end of the accounting period,
i.e., on December 31, 1966 was higher than that as existed on
the crucial date, namely, August 6, 1960 and, therefore, this
precluded any inference that the stock of dollars and ster-
lings that existed on the devaluation date had been converted
B into Indian currency thua resulting in profits. The Tribunal
rejected the contention as being without force inasmuch as the
assessee-bank had revalued the cost of foreign exchaiige in
terms of rupees as on the date of devaluation to bring it on
par with the post-devaluation rate by giving a corresponding
credit to the "Provision for Contingencies" thus treating the
c surplus resulting from the fluctuation of exchange rate as its
income and the mere fact that the same had been carried to the
account style·"Provision for Contingencies" did not alter the
true character of the transaction. The High Court confirmed
the ultimate conclusion of the Tribunal by answering the
relevant question referred to it in favour of the Revenue.
D Counsel for the assessee fairly conceded two positions
arising in the case. In the first place he conceded that
foreign exchange was held by the assessee-bank as its stock-
in-trade and he further conceded that any sale of such stock-
in-trade must result in business income but he urged that if
the stock-in-trade remains unused and unsold its notional
E appreciation or book appreciation in value does not result in
taxable profit (vide C.I.T. v. ll!ghal Line Lt:d. 46 I.T.R. 590,
arid according to him thl.s is what had happened in the instant
case. According to counsel the fact that the stock-in-t·rade in
terms of foreign currency that was held by the assessee just
prior to the date of devaluation was shown not to have been
F depleted between the date of devaluation and December 31, 1966
(the end of accounting period) clearly suggested that the
stock-in-trade initially held had remained unused and unsold
during this entire period, especially when the sotck-in-tr.ade
held on December 31, 1966 was shown to be higher. than the one
held just prior to the devaluation date; and therefore it was
G a case of a mer.e nominal appreciation or. book appreciation in
the value of the stock and as such the same could not be
brought to tax. There can be no dispute with regard to the
principle that if the stock-in-trade remains unused or unsold
the mere book appreciation in the value thereof cannot be
brought to tax but on the facts requisite to sustain the pro-
H position the assessee-bank does not seem to stand on any firm
footing. In the first place by carrying the surplus resulting
STATE BANK·v. C.I,T. [SABYASACHI MllKHARJI, J, J 67
A
from the devaluation of the Indian rupee to an account desig-
-1, nated "Provision for Contingencies" the assessee bank itself
could be said to have clearly treated such surplus as its
business income. Secondly, the AAC in his appellate order has
recorded a categorical finding that the stock in trade in
terms of foreign currency was sold and used by the assessee in
B
its normal banking business. This is what the AAC has
observed:

''What is important is that the profit on account of
the difference in exchange rate should have arisen
in the course of trading operationa of the bank.
There is no dobut that it did so arise in ·the
instant case. The bank acquired and sold the
c
foreign exchange assets in course of its normal
banking business and therefore, the profit arising
out of the fluctuation in exchange rates, however,
large and however unexpected any particular fluctu-
ation may be, arose in the course of and incidental
D
to such business of the bank."
Having regard to the aforesaid factual position I confirm the
High Court's view that the second question has to be answered
in the affirmative in favour of the Revenue and against the
assessee.
In the result I would allow the appeals in so far as the
E
first question is concerned and dismiss the same as regards
the second question. In the circumstances there will be no
order as to costs.
SABYASACHI MllKHARJI,J. These appeals by certificate arise
from the decision of the High Court of Kerala in respect of
the assessment years 1965-66, 1966-67 and 1967-68 relating to
F
the previous ·calendar year 1964, 1965 and 1966 respectively.
" The following two questions are involved in these appeals:

(1) Whether, on the facts and in the circumstances
of the case, the addition of the sums of Rs.67,170.
Rs, 47,777. and Rs. 57,889 representing interest on
G
'sticky' advances as income for the assessment
years 1965-66, 1966-67 and 1967-68 respectively was
justified in law?

(2) Whether on the facts and in the circumstances
of the case, the exchange difference of Rs.
H
68 SUPREME COURT REPORl'S [19861 i s.c.R•
.A
1,66,128 arising on revaluation of the Indian rupee
on 6. 6.1966 was rightly treated as income of the
assessment year 1967-<>8?
In view of i:he categorical findings of fact recorded by
the Tax au.thorities and the Tribunal and mentioned in the
jildgment of tulzapurkar, J., I am in respectful agreement with
B
the opinion of tulzapurkar, J. that the High Court was right
4nd the ·second question lllU8t be answered in the· affirmative
and .in favour of the revenue, and the appeals on this aspect
must be'd1Bliitssed.
With. regard· to the first question, with respect, it is
not paaiible to agree with 'the reasoning and the conclusions
c arrived at by tulzapurkar, J., in the judgment. It is necesary
for tlite reason to re.iterate in brief the facts relating to
the first que~tion. The assessee is a subsidiary bank of the
State ·ililik of India. It used to maintain in the relevant
accounting years its accounts in mercantile system; therefore,
entries ifare made and· income and loss were calculated on
D
acerual bBsis. The assessee in the course of its banking
buaine~s \Hied to charge interest on advances, including even
those '1!Uch it con1idered cioubtful of recovery and which the
allaesa..e tenied as i1ticky advances' by debiting the concerned
pat~i·~· Ii~~ 'in atead of carrying. the sama to its 'Profit &
toa& Account' , credited the same i:-o. a aeparate acccount called
E
'lnt.erest S11Spense Acc!luii:t '. Accord~ng ·co the aStlessee the
principal amounts of theae . adVlli:tceli label.led as 1 sticky
advances' had become not :bed or irre.:.averable, but extremely
doubtful of recovery. In its ret•1rns the assessee had disclos-
e! silch inter~ata separately and claimed that the SUlllS were
not taxable as income of the concerned years. In view of the
F · relev~t y!Jar.• ~nvolyed, tba 'iue&tion must be considered in ,.
thfi lisht iif the provisiona of tlte Income ?ax Act, 1961 (here-
inafter called the : 'Act');> .
Blifor~ the taxing Officera, the Tribunal and the High
Gourt .~ .the aaaeHee 'e, contention waa that having regard to bad
alld deterl.oratina financial conditions of the parties
conaernad •• llell .as history of their accounts. the recovery
of even the prilleipal debts ha~ become improbable and doubt-
ful, the~eby makinil these loans or advances as the assessee
called 'sticky' and, as such interest on these though debited
t.o the respective debtors was taken to 'Interest Suspense
H
Account'. 'lh.is 1 according to the assessee, became necessary
•
STATE BANK v. C.I.T. [SABYASACHI MUKHARJI, J.] 69

A
to avoid showing inflated profits by including hypothetical
and unreal income and, such income, according to the assessee,
was not his real income. It was· contended by the assessee that
the said sums namely the interest on the so called 'sticky'
loans was not taxable in its hands. This. contention was, how-
ever, rejected by the Income-tax authorities as well as the B
High Court.
The following were the grounds for such rejection:
(a) The assessee was following the mercantile
system of accounting; such interest, therefore, had
accrued to the assessee at the end of the account-
ing year.
c
(b) The assessee itself had treated such income as
accrual of interest by charging the same to the
parties concerned by making debit entries in their
tespective accounts•

---<: · It was pointed out that if any part of these debits had D
later on ·become irrecoverable in any year, the assessee could
have, in that year, treated the . same as such and claimed
deduction under section 36(l)(vil.) of the Act. Reliance was
placed by the High Court on an earlier decision of the same
High Court in the case of CatbOllc Bank of India (In liqui-
dation) vs. Cocimissioner of 1--'?ex, lerala, Emalml . . ., E
[1964] K.L.T. 653 ~ [1965] 1 I.T. Journal 355. In that case
in spite of the directions issued by the Reserve Bank of India
to the assessee bank not to carry interest of such sticky
advances to 'Profit and Loss Account' and also in.spite of the
fact, that the assessee bank in pui:susnce of these directions
'\ omitted their interest from its 'Profit and Loss Account', the F
court took the view that such interest was taxable as income
in the hands of the assessee l>ank because the mercantile
system of accounting had been.regularly followed by the bank
and that had not been changed even after receiving directions
from the Reserve Bank of India, The Kerala High Court had
relied upon certain observations in the commentary on the G
Income Tax Act, 1961, by Kanga, 5_th Edn. Vol. I, page 665
wherein the learned author has stated:

"The a_asessee cannot escape liabl.lity to. tax by
omit~ing to make an entry or making a wrong entry
in tlie acccounts•; The date of. taxability of income H
70 SUPREME COURT REPORTS [1986] I S.C.R.
A

is the date when the appropriate entries are made #
or should be made in the accounts in accordance
with the method of accounting regularly employed by
the assessee. The substantive part of the section
makes it clear that the income is to be computed'
B in according with the method of accounting regular-
ly employed.' The Income-tax Officer may include in
the computation of income an amount which does not
figure in the accounts but the inclusion of which
is required by the assessee's method of ac~ounting;
that is to say., the Income-tax officer may without
c deviating from the assessee's method, make such
adjustments in the profit and loss account as are
necessary for giving full and true effect. to that
method itself. Having adopted a regular method of
accounting, the assessee cannot be allowed to
change it or depart from it for a particular year
or for part of the year or in respect of particular
transactions."
The High Court. of Kerala was of the view that the facts
of the instant case out of which these appeals arise being the
same as those in Catholic Bank's case except that there was a
direction from the Reserve Bank of India to Catholic Bank,
E which is absent in the instant case before us, the same con-
clusion must follow. In the opinion of the High Court, the
presence or absence of such direction from the Reserve Bank
was not determinative of the question. There was accrual of
income to the assessee considering the fact that the assessee
had been following the mercantile method of accounting which
F had been regularly adopted by the assessee and accepted by the
taxing authorities. The High Court l.n that view of the matter 7·
answered the question in favour of the revenue. For subsequent
years 1968-69 in respect of the same asses see, an identical
view was reiterated by the said High Court in the ~ssessment
year 1968-69 as reported in 110 I.T,R. 336. The correctness of
G this view is under challenge in these appeals before us.
The assessee indubitably maintained its accounts on mer-
cantile basis and had regularly adopted it. The assessee
claimed that the three sums represented interests on what it
called 'sticky' loans in its books of account but having
regard to the deteriorating financial position of the concern- ..,,
H ed debtors and the history of these accounts, the assessee was
of the view that in the relevant years the advances had become
STATE BANK v. C.I.T. [SABYASACHI MUKHARJI, J.] 71

A
so 'sticky' that even the recovery of the principal amounts
had become highly improbable and extremely doubtful. There-
fore, though the assessee charged such interests by debiting
the concerned parties (emphasis supplied) yet it credited the
said amounts to a separate account styled as 'Interest
Suspense Account' • This the assessee claimed on the theory B
that it was to avoid showing unreal or inflated profits. The
assessee claimed that it was not taxable as real income had
not accrued to it. It was, however·, disallowed on the ground
that the advances had not been treated as irrecoverable or bad
debts in terms of section 36(l)(vii) of the Act. In coming to
the conclusion that these sums were taxable, the taxing
authorities, the Tribunal and the High Court proceeded on c
well- settled principles pertaining to the mercantile system
and took the view that such interest had fallen due and became
legally recoverable in accordance with the system of account-
ing during each of the relevant accounting years.
In support of the assessee' s contention learned counsel
contended before us that what are chargeable to·income--tax in D
respect 6£ a business, are profits and gains of that business
actually resulting from the transactions of the previous year.
It was submitted that even under the mercantile system of
accounting accrual or "real income" in the commercial sense
only was chargeable to tax and this mst acc·rue in substance
according to the realities of the situation. It was submitted E
that if regard is had to realities of the situation as well as
the actual commercial principles, it would be evident that in
'' cases of banks, financial institutions and money-lenders bulk
of the income is usually earned by way of interest and as
such there cannot be any accrual of real income from interest
on doubtful advances or sticky advances and, therefore, the F
entries made in respect of such accounts in case of all such
traders following the mercantile system of accounting only
reflected hypothetical income which does not materialise in
income. It was submitted that, therefore, it was proper to
carry such interest to 'Interest Suspense Account' as carrying
the same to 'Profit and Loss Account' would amount to showing G
an unreal and inflated prof.it and thereby lead to imp~oper and
illegal distribution or remittances thereof.
Therefqre, the question, ls, whether on the theory of
real income, interests which had accrued legally to an
assesse~ - in this case banking institution following the
mercantile system of accountancy can be kept out of the net of H
72 SUPREME COURT REPORTS [1986] 1 s.c.R.

A
taxation. How far does the concept of real ·income defeat
accrual of income in any particular case according to the
well-recognised theory of accounting principles which are
accepted by the legal standards so far followed?
In this country, by and large, two systems of account
keeping are followed - one is the cash and the other, mercan-
B tile. .Plainly speaking, the cash system postulates actual
receipt of money; and for exigibili ty of income tax, such
receipt from buainess, profession or vocation or from other
sources has to be actual in the relevant year of account. The
mercantile system, on the other hand, is one where accounts
are maintained on the basis of entitlement of credit and/or
c debit. A sum of nx>ney, as soon as it becomes payable, is taken
into account without reference to actual recceipt and a debit
becomes admissible when liability to pay is created even
though the sum of nx>ney l.s yet to be paid.
Several circulars issued by the Central Board of Taxes
were placed before ua in course of the hearl.ng. One such was
D C.B.R, Circular No. 37/54 dated 25th August, 1924. There the
Central Board had aaid that it accepted the conclusion reached
at the Conference of Income-tax Commissioners held l.n August,
1924 that if a money-lender who kept hl.s accounts on the
~ommercial system maintained a suspense account in which he
entered loans which in his opinion were extremely unlikely to
E be recoverable though he did not yet wish actually to write
them off, interest accruiiig on such loans need not be included
in the assessee' s taxable income, if the Income-tax officer
was satisfied that there was little provabl.lity of recovery of
the loan. This was obviously on the footing .that the last ray
of hope of recovery had not been extinguished and the stage
F for write off had not come. The second circular is one dated
6th October, 1952, which is Circular No. 41(V-ii)D of 1952
dealing with · the subject of bad and doubtful debts - irre-
coverable loans or bank interest on such debts. It was indica-
ted therein that when there was unll.kelihood of loans being
revcovered, inter.eats from such loans need not be included in
·G the taxable income if the Income-tax Officer was satisfied
that there was really little possl.bility of the loans being
repaid. But an account was to be maintained for future
allowances for taxation of recoveries in subsequent assessment
years. There is also a letter dsted 16th April, 1973, from the
Under Secretary, Central Board of Direct Taxes referring to
H D.O. letter dated 15th March, 1973 reiterating that the
STATE BANK v. C.I.T. [SABYASACHI MUKllARJI, J.] 73

A
.C. amounts kept ip suspense account under those circumstances
would not be taxable. The assessee was, however, required to
maintain a systematic method of accounting i.n respect of
dobutful debts subject to checks and counter-checks. By the
letter dated 21st November, 1973, the Reserve Bani< of India
wrote that there was no unif orml.ty in the practice followed by B
State Fi.nancl.al Corporati.ons on sticky loans wehre the same
position was reiterated. A letter was written ·on 20th June,
1978, by the Ce.ntral Board of Direct Taxes to the Coonnissi.oner
of Income-tax soon after the decision rendered in the
assessee's case i.n 110 I.T.R. 336 referred to hereinbefore. In
that letter. reference was made to the previous circulars and
it was pointed out that the stand taken in these cl.rculars was c
not acceptable to the Revenue Audit Department and i.t had
objected to the exclusion of such amounts of interest from the
total income. The Board advised that where accounts were kept
on mercantile basis, interest was taxable irrespective of
whether the same was credited to suspense· account or to
interest account .. Reference was· made to the decision of the D
·-< Kerala High Court in 110 I.T.R. 336 which has been followed in
the instant case. The Central Board, therefore, di.rected that
such interests should be i.ncludible in the taxable income, and
all pending cases should be disposed of keeping the present
instructions in view. It was. further directed that immediate
review should be undertaken under sectl.on 147(b) or sectin 263 E
of the Act in respect of assessments which had been completed
in accor.dance with the Board's earli.et directions. In the last
letter., the same position was reiterated but :1.t was further
clarified as to future course of action. In these appeals we
are not concerned with the actual effect of these Circulars
and these need not be set out .and examined. F
Several financl.al institutions sought to Intervene as the
question involved herein i.s of some importance to them. We
have allowed them to make their submissions and taken them
into consideration. It was urged that the Instructions
contained in these circulars noted before were in consonance
with the accepted prl.nciples of accountancy and these Instruc- G
tions have held the field for over 53 years. It was also
submitted that as such claims have been allowed to be exempted
for more than half a century, and the pract:l.ce had tr.ans formed
itself into law, this posi.tion should not have been deviated
from. This submi.ssion, of course, cannot be accepted. The
question of how far the concept or real income enters J.nto the H
question of taxability in the facts and cir.clllDStances of thi.s
74 SUPREME COURT REPORTS [1986] l s.c.R.
A
case and how far and to what extent the concept of real >
income should inter-ntl.ngle with the accrual of Income will
have to be judged J.n the light of the provisions of the Act,
the principles of accountancy recognised and followed and the
feasibl.lity, The earlier circulars being executive in
character cannot alter the provisl.ons of the Act. These were
B in the nature of concessions ~nd could always be prospectively
withdrawn.. However, on what lines the r:f.ghts of the parti.es
should be adjusted in consonance with justice J.nview of these
cJ.rculars is not a subject matter to be adjudJ.cated by us and -
as rightly contended by counsel for the revenue, the cl.rculars
cannot detract from the Act.
c The profits and gains chargeable to tax under the Act are
those which have been either received by the assessee or have
accrued to the assessee durl.ng the period between the fl.rat
and the last day of the year of account and are receivable.
Income received or income accrued are both chargeable to tax
under. section 28 of .the Act, The computation of this Income is
D provl.ded for J.n sectJ.on 29 of the Act. WhHe we are on the
sections, it may be appropriate to refer to section 36 also. >-
Section 36(a) provides for certain deductions from the compu- >
tation of income and sub-section (vii) thereof deals with bad
debts in these terms:

E "(vii.) subject to the provl.sions of sub-section
(2), the amount of any debt, or part thereof, which
is establi.shed to have become a bad debt J.n the
previous year."

Section 36(2) prescribes the conditions to be satisfied for
F earning deduction for a bad debt. There J.s no dispute in these
appeals ·that such conditi.ons ar.e not satisfied. )'
Section 56 of the Act deals with 1.ncome from other
sources and sectl.on 57 deals with deductions in computation of
income from other sources. Section 145 deals with the method
of accountl.ng, Sub-sectl.on (1) of the sal.d sectl.on provides
G that income chargeable under the head "ProfJ.ts and gaJ.ns of
business or profession" or "Income from other sources" shall
be computed l.n accordance wl.th the method of accounting
regularly employed by the assessee. The provl.so Jn certain
eventuali.tl.es perml.ts the Income-tax Offl.cer to adopt the mode
for computatlm; of income. SJ.mliar too J.s the positi.on of >'
H sub-section (2).
STATE BANK v. C.l.T. [SABYASACHI MUKHAR.JI, J.] 75

A
It is settled that the income of the assessee will have,
to be determined according to the provisions of the Act in
consonance with the method of accountancy regularly employed
by the assessee. The method of accounting regularly employed
by the assessee helps computation of income, prof its and gains
under section 28 of the Act and the taxability of that income
B
under the Act will then have to be determined. The question,
is, whether the income which has been computed according to
the method of accounting followed regularly by an assessee can
be diminuted or diminished by any notion of real income. This
has to be judged in the light of the well-settled principles.
In Conlmissioner of Income-tax, Madrast v. K.R.M~T.T.
Thiagaraja Chetty & Company, 24 l.T.R. 525,. this Court as
early as 1953 reiterated that once the Slllll of Rs. 2,26,850 in
c
that case was arrived at as income that had accrued to the
assessee, it did not cease to be the income by reason of the
fact that it was carried to the suspense account by a resolu-
tion of the directors and that it was, therefore, ·assessable
---\ to tax. The assessee firm therein was a managing agent of a
D
limited company. Under the managing agency agreement the
assessee was entitlted to a certairi mOnthly remuneration - a
commission of ten per cent on the net profits of the company
and a ~mall percentage on sales and purchases. The agreement
further provided that the assessee was at liberty to retain,
reimburse and pay themselves out of the funds of the Company
E
all moneys expended on its behalf and all sums due to them for
commission or otherwise. During the year of account ending
31st March, 1942, the assessee had become entitled to a
commission of Rs. 2,26,850. On 30th March, 1942, the assessee
wrote to the company requesting that a certain debt, which the
'( assessee owed to the company for along time past, should be
F
written off, The directors.by their resolution, passed on the
same debt, refused to write off the amount without consulting
the general body of shareholders and pending the settlement of
the dispute resolved to keep the sum of Rs. 2,26,850 was
debited as a revenue expenditure of the company and was
allowed as deduction in computing the profits of the company
G
for the purpose of income-tax. The question was whether in the
assessment year 1942-43, the assessee was liable to pay tax on
the sum of Rs. 2,26,850. The Tribunal held that the assessee
was being assessed on cash basis in previous years, that the
income had not accrued to the assessee and that the sum of
Rs. 2,26,850· should be excluded from taxation as not having
H
.been received in the accounting year. The High Court came to
A
76 SUPREME COURT REPORTS [19861 i s.c.R.

the conclusion that there was no mated.al for the 'rrl.bunal' s
finding that the assessee was being assessed on cash basl.s in
the previous years but held (Satyanarayana Rao, J,, confl.rming
the decisi.on of the Appellate Trl.bunal; VJ.swanatha Sastrl., J.,
l! contra) that the sum of Rs. 2,26,850 was not liable to tax,
inasmuch as it was not Income of the assessee whi.ch had
accrued or arl.sen in the accountl.ng year. Thl.s Court J.n appeal
held that the llJ.gh Court was d.ght J.n its conclusl.on that
there was no mated.al for the Trl.bunal' s fl.nding that the
assessee was beJ,ng assessed on cash basi.s on the sums
c mentl.oned whl.ch had accrued to the assessee and J.t did not
cease to be Income. In thl.s connectl.on, this Court at page 531
of the Report referred to the observati.ons of VJ.swanatha
Sastrl., J, wherei.n the learned judge had stated: "The sum had
Irrevocably entered the debl.t sl.de of the company's account as
a disbursement of managl.ng agency commJ.ssi.on to the fl.rm and
D had been approprfated to the fl.rm' s dues and same could not
agai.ri be entered i.n a suspence account at a later date. The
sum, therefore, belonged to the fl.rm and had to be Included i.n
the computatl.on of the prof! ts and gal.us that had accrued to
J.t unless the flrm had regularly kept j ts accounts on a cash
basi.s, wh:J.ch i.s not the case here."
E
Thl.s problem may be better looked into J.f the questl.on of
dl.fference between the mercantl.le system and cash system J.s
examined J.n a Uttle detal.l.
Si.r Courtney Terrel, C,J, dell.verl.ng the judgment of the
Patna High Court l.n lllakeshwar Prasad Narain Singh v.
Commissioner of Income Tax, llihar & OrJ.ssa, 4 I. T.R. 71 at
F 74., noted the difference between the two methods of account-
ing for Income, prof!. ts and gal.ns of busi.ness. The learned
Chl.ef Justice observed at page 74 of the report:
"Now, there are two methods of accounti.ng for the
income, profl.ts and gal.ns of a busl.ness whl.ch are
generally referred to as the cash basJ.s and the
G mercantl.tle basl.s. Accordl.ng to the former a record
J.s, as J.n thl.s case, kept of actual recel.pts and
actual payments, entri.es bei.ng made only when money
J.s actually collected or dl.sbursed and J.f the
pr.ofi.ts of the business are accounted for i.n thi.~
way the tax J.s . payable on the dl.fference between
II the recel.pts and the dl.sbursements for the perl.od
J.n questl.on. There J.s, secondly, the mercantl.le
STATE BANK v. C.I.T. [SABYASACHI MUKHARJI, J.] 77
A

system under whl.ch a profi.t and loss account is
maintai.ned. At the end of the fi.nancjal year the
assets and li.abiliti.es are valued and enter.ed in
the account and the dl.fference between the i:wo is
the proHt upon which the tax is paid." B
The Coamissioner of Income Tax, Bombay v. Sarangpur
Cotton Manufacturi.ng Co. Lt:d., 6 I. T.R. 36. Lord Thankerton,
speaking for the Judi.cial Commi.ttee after referring. to secti.on
·~ .\ 13 of 1922 Act whi.ch was more or less similar to secti.on 145
of the present Act observed at page 40 as follows:
"Thei.r Lordshi.ps are clearly of opini.on that the
secti.on relates to a method of accounti.ng reglllarly c
employed by the assessee for his own purposes - in
thl.s case for the purposes of the Company's
business - and does not relate to a method of
making up the statutory return of assessment to
income-tax. Secondly, the secti.on clearly makes
sucha method of accounting a compulsory basis of D
·" computation. unless i.n the opini.on of the Income-tax
Offi.cer, the income, proHts and gains cannot
properly be deduced therefrom. It may well be that,
though the profi.t brought out in the accounts i.s
not the true fi.gure for income-tax purposes the
true Hgure can be accurately deduced therefrom. E
The simplest case would be where it appears on the
face of the accounts that a stated deductl.on has
been made for the pur.pose of a reserve. But there
may will be more complicated cases in whl.ch never-
theless, it is possible to deduce the true profi.ts
from the accounts, and the judgment of the Income- F
·~. tax OfHcer under the proviso must be properly
exerci.sed. It is misleading to describe the duty of
the Income-tax Officer as a discretionary power."
Iqbal Ahmad, C.J. has aptly descri.bed in Coolllissioner of
Income ·rax v. Shrimat:i Sini!arl Bai, 13 I.T.R. 224, the mercan-
ti.le system of accountancy and has _observed at page 227 of the G
report as follows:

"The distingui.shi.ng feature of this method of
accountancy is that i.t bri.ngs into credi.t what is
due immediately i.t becomes legally due and before
it is actually received; and it bri.ngs into debit H
78 SUPREME COURT REPORTS [1986] 1 s.c.R.

A
expenditure the amount for which a legal liability
has been incurred before it is actually disbursed.
The 'mercantile accountancy system' _is the opposite
of the 'cash system' of book-keeping' under which a
recordis kept of actual .cash receipts and actual
cash payments, entries being made only when money
B is actually collected or disbursed."
In Commissioner of Income.-Tax 9 Madras v. A. ICrl.slmaswaml
Mudaliar and Others, 53 I.T.R. 122, this Court had to refer to
the distinction between mercantile system and cash system. r
Referring, however, to the relevant section appropriate to ,•'

section 145 of the present Act, this Court observed that the
c section did not compel the Income-tax Officer to accept a
balance-sheet of cash receipts and outgoings prepared from the
books of account: it was for him to compute the income in
accordance with the method of accounting regularly employed by
the assessee. Referring to the prevalent system of book-keep-
ing in India, Shah, J. speaking for this Court observed at
D pages 129-130 of the report as follows:
"Among Indian businessmen, as elsewhere, there are
current two principal systems of book-keeping.
There is, firstly, the cash system in which a
record is maintained of actual receipt and actual
disbursements, entries being posted when money or
E 100ney's worth is actually received, collected to
disbursed. There is, secondly, the mercantile
system, in which entries are posted in the books of
account on the date of transaction, i.e., on the
date on which rights accrue or liabilities are
incurred, irrespective of the date of payment. For
F example, when goods are sold on credit, a receipt ,
entry is posted as of the date of sale, although no
cash is received immediately in payment of such
goods; and a debit entry is similarly posted when a
liability is incurred although payment on account
of such liability is not made at the time. There
G may have to be appropriate var.iations when this
system is adopted by an assessee who carries on a
profession. Whereas under the cash system no
account of what are called the outstandings of the
business either at the colllllencement or at the close
of the year is taken, according to the mercantile
H method actual cash receipts during the year and the
STATE BANK v. C.I.T. [SABYASACHI MUKHARJI, J.] 79

, A
actual cash outlays during the year are treated in
the same way as under the cash system, but t0 the
balance thus arising, there is added the amount of
outstandinge not collected at the end of the year
and from this is deducted the liabilities incurred
or accrued but not discharged at the end of the B
year. Both the methods are somewhat rough. In some
cases these methods may not give a clear picture of
the true profits earned and certainly not of tax-
able profits. The quantum of allowances permitted
to be deducted under diverse heads under section
10(2) from the income, profits and gains of a
business would differ according to the system c
adopted. This is made clear by defining in sub-
section (5) the word "paid" which is used in
several clauses of sub-section (2) as meaning
actually pai<! or incurred according to the method
of accounting upon the basis of which the prof its
or gains are computed under section 10. Again where D
the cash system is adopted, there is no question of
bad debts or outstanding at all, in the case of
mercantile system against the book profits some of
the bad debts may have to be set of when they are
found to be irrecoverable. Besides the cash system
and the mercantile system, there are innumerable E
other systems of accounting which may be called
hybrid or heterogeneous - in which certain elements
and incidents of the cash and mercantile systems
are combined. 11
For the content of the taxable income, one has to refer
v to the substantive provisions of the Act, mainly section 5 of F
1
the Act read with other relevant sections.
In Commissioner of Income-Tax, Bombay City I v. lless:rs.
Sboorji Vallabhdas and Co., 46 I. T.R. 144, this Court
discussed the concept of real income. There the relevant fact
was that before the close of the relevant accounting year
which was from 1st April, 1947 to 31st December, 1947, in G
November, 1947 the 'assessee had desired to hRve the managing
agency transferred· to two private companies _and this was
transferred by a subsequent agreement after the c.lose of the
year. The assessee in that case in fact received only the
lesser amount in spite of the entries in the account books,
and it was held that this lesser amount alone was taxable. It H
80 SUPREME COURT REPORTS [1986] 1 s.c.R.
A
was reiterated by Hidayatullah J, as the learned Chief Justice ,~
then was, that income-tax is a levy on income and the Income-
tax Act took into account two points of time at which the
liability to tax was attracted viz., the accrual of the income
or its receipt; yet the substance of the matter was income. If
income did not result at all, there could not be any tax, even
B though in book-keeping, an entry was made about a "hypotheti-
cal income" which did not materialise. Where income has, in
fact, been received and is subsequently given up, in such r
circumstances that it remains the income of the recipient,
even though given up, the tax might be payable. Where, how-
ever, the income can be said not to have resulted at all,
c there was obviously neither accural nor receipt of income,
even though an entry to that effect might, in certain circum-
stances, have been made in the books of account. This decision
and the use of the expression that entry of the ;hypothetical
income' is often misunderstood in the sense that after the
accrual if the income did not materialise thefi on the basis of
D
the actuality or reality of the situation it should not be >-
considered to be income at all. But the significant fact which
is often lost sight of is that within the relevant accounting
year viz. 1st April, 1947 and 31st December, 1947, in Novem-
ber, 1947 the assessee had desired to have the managing agency
transferred to two private companies and the subsequent agree-
E ment in the following year viz. December, 1948 was merely
fructif ication or carrying into effect of that desire and as a
result of the same, the income did not accrue. That this was
the basis for the ratio of the decision of this Court would be
clear because this Court referred to and relied on the
decision of the Bombay High Court in Conmissioner of Income-
F tax,' Bombay North, Kutch and Saurashtra, Ahmedabad v. Chaman- >
lal Mangaldas & Co., 29 I.T.R. 987,in this respect. That was
also a case of managing agency company's entitlement to re-
ceive commission at a certain rate. By another agreement, in
the case of commission earned by the managing agent for the
calender year 1950 was reduced to Rs. 1 lakh. That agreement
G i.e. the subsequent agreement took place during the previous
year, and the resolution of the board of the director of the
managed company was also in the previous year but it was,
however, made final on 8th April, 1951, at a meeting of the
board of directors but at a time beyond the previous year. The -~
High Court had taken the view that by reason of the resolution
H
during the currency of the previous year, the right of the
assessee ·to commission ceased to be under the original agree-
ment and dependent upon and arose only after the decision of
STATE BANK v. C.I.T. [SABYASACHI MUKHARJI, J,] 81

A
4 the board of directors to reduce the commission. The assessee
was, therefore, held not ·liable on the larger sum as it was
only a hypothetical income which it might have earned if the
old agreement had subsisted. This Court. found that the facts
of that case were almost identical with the facts in Shoorji
Vallabdas's case. Therefore Shoorji Vallabhdas's case must be B
understood on the footing that because of the desire in
November, 1947, the commission did not accrue at the end of
the accounting year. In that sense there was no accrtlal of the
income. It may be reiterated that in some limited fields where
something which is the reality of the situation prevents the
accrual of the income, then the notion of real income i.e.
making the income accrue in the real sense of the term can be C
brought into play but the notion of real income as it shall
presently be indicated cannot be brought into play, where
income ·has accrued ~ccording to the accounts of the assessee
and there is no ind~cation by the assessee to treat the amount
as not having accrued. Suspended animation following inc.lusion
-~ of the amount in the suspense account does not negate accrual D
and after the event of accrual, corroborated by appropriate
entry in the books of acco4nt, on the mere ipse dixit of the
assessee, no reversal of the situation can be brought about.
Morvi Industries Ltd. v. Commissioner of Income-Tax
(Central), Calcutta, 82 I.T.R., 835., was also a case of
giving up the commission which had accrued though in that case E
the payment had been deferred till after the accounts had been
passed in the meetings of the managed company •.This Court held
that such a situation did not affect the accrual of the
income. This Court found that the amounts of ·income for the
relevant years were given up unilaterally by the assessee
·~ after these had accrued and it could not escape liability to F
tax on those amounts. This Court reiterated that income
accrued when it became due. The postponement of the date of
payment did not affect the accr~al of income. The fact that
the amount of the income was not subsequently received by the
asse~see would not also detract from or affect the accrual of
the income although non-receipt may in appropriate cases be a G
valid ground for claiming deduction. This Court 'reiterated
that the mercantile system of accounting differed substantial-
ly from the cash system of book-keeping. Under the cash
system, it was only actual cas~ receipts and actual cash pay-
ments that were recorded as credits and debits; whereas,
under the mercantile system, credit entries were made in H
respect of amounts due immediately they became legally payable
82 SUPHEME COUKT HEPORTS [1986] l s.c.R.
A
and before they were actually received. Similarly, the expen-
diture items for which legal liability had been incurred were
immediately debited even before the amounts in question were
actually disbursed. This position was reiterated by this Court
in 1971 after taking into consideration various decisions of
this Court. In our view, ·therefore, the concept of real income
B
cannot be so used as to make accrued income non-income simply
because after the event of accrual, the assessee neither
decides to treat it as bad debt nor claims deductions under
section 36(2) of the Act, but still enters the same with a
diminished hope of recovery in the suspense account. Extension
of the concept of real income to this field to negate accrual
c after the amount had become payable is contrary to the postu-
lates of the Act.
It may be mentioned that before the decision of the
Bombay High Court in H.M. Kashiparekh & Co. Ltd.'s case, 39
I.T.R. 706., rendered on 1st and 2nd April, 1960, a decision
having relevance on the concept of real income and about whose
D
important facts we shall advert later, this Court in February,
1960 in Coumrl.ssioner of -Income-Tax Bombay North v. Chamanlal
llaogaldas & Co. (supra) had to consider some of these aspects.
In that case there was provision for reduction of collllllission
where profits were insufficient in case of the managing agent.
There was modificatior. of the commission before the end of the
E year. The amount was given up by the managing agent. The
question that arose was whether the income had accrued and
what was the effect of the entries made in the books of
account. It was held by this Court that the agreement was an
integrated and indivisible one and the managing agent's
commission was only determinable and accrued when the year was
F
over. It was further held that the fact that the amounts of
commission were credited in the books of the managed
company every six months only meant that as an interim
arrangenlent the accounts of all sales were made up at the end
of six months also. But this did not affect the construction
of the clause containing the terms for payment of commission
G
nor the deduction made therein as a result of the modified
arrangement. The amount which arose or accrued and which the
managing agent had the right to receive was not affected by
the manner in which the entry was made. The managing agent was
entitled to receive as commission only a sum of Rs. 4,11,875
and that amount alone accrued to the managing agent. This
H
Court reiterated the principle that the amount which would
STATE BANK v. C.I.T. [SABYASACHI MUKHARJI, J.] 83
A
arise or accrue to the managing agent and the managing agent
'°" would have a right to receive would not be affected by the
manner in which entry was made. The existence of the right to
receive i.e. accrual, is important and that is a matter of the
reality of the situation keeping the terms and conditions and
the conduct of the parties. In Kashiparekh·'s case (supra), the
B
Division Bench of the Bombay High Court dealt with an assessee
firm which had maintained its account in the mercantile
system. The assessee was the managing agent of a paper mill
company. Under the managing agency agreement, it was under a
duty to forgo upto one-third of its commission when the
prof its of the managed company were not sufficient to pay the
dividend of 6 per cent. For the accounting year ending on 31st
December, 1950, the assessee had earned a comnission of Rs.
c
l, 17, 644 but as a result of the resolutions passed by the
managed company and the assessee company the assessee gaVe up
a sum of Rs. 97,000 in December, 1950. The Appellate Tribunal
held that the maximum amount the assessee was bound to forgo
was only Rs. 39,215 and included the balance of amount forgone
D
-{ viz. Rs. 57,785 in the taxable income. The Tribunal, however,
found that tha sum of Rs.57,785 was also given up for reasons
of commercial expediency. The Division Bench of the Bombay
High Court held that it. was the real income of the assessee
company for the accounting year that was liable to tax and
that the real income could not be arrived at without taxing
E
into the account the amount forgone by the assessee. In ascer-
taining the real income the fact that the assessee followed
the mercantile system of accounting did not have any bearing.
The accrual of the commission, the making of the accounts, the
legal obligation to give up part of the COlllllission and the
forgoing of the commission at the time of the making of the
F
x accounts were not disjointed facts: there was a dovetailing
' about them which could not be ignored (emphasis supplied). The
real, income of the assessee, it was further held, was Rs.
2 7, 644 and the amount of Rs. 97, 000 forgone by the assessee
could not be included as the real income of the assessee for
the accounting year. The two rules that income-tax is annual
G
in its structure, and, therefore, the computation for each
year is a distinct self-contained unit and the other that the
income to ~ taxed is the real income of the assessee are not
incompatible or irreconcilable; they admit of harmonious
application. The principle of real income is not to be so
subordinated to virtually amount to a negation of it when a
H
surrender or concession or rebate in respect of managing
agency commission is made, agreed to or given on grounds of
84 SUPREME COURT REPORTS [1986] l s.c.R.
A
commercial expediency, simply because it takes place some time ,>--
afte'r the close of an accounting year. In examining any
transaction and situation of this nature, the court would have
more regard to the reality and speciality of the situation
rather than the purely theoretical and doctrinaire aspect of
it. It laid great emphasis on the business aspect of the
B matter viewed as a whole when that could be done without
disregarding the language of the statute. It may be pointed
out that the decision in Kashiparekh 's case (supra) has r
received approval of this Court in Commissioner of Income-Tax,
West Bengal II v. Birla Gwalior (P) Ltd., 89 I.T.R. 266., but
in our opinion it is necessary to reiterate the real facts and
c the basic principles of Kashiparekh's case. It is true that
the concept of real income will have its effect also in
mercantile system of accounting. There the accounting year was
ending 31st March, 1950. For the account year 31st March, 1950
the assessee had earned connnission but as a result of resolu-
tions passed, ·the assessee company gave up Rs. 97 ,000 in
D December, 1950. >--
The question involved, was, whether the accrued interest
in the accounting year could be given up subsequently or not.
Now looked at from the proper perspective, the Court was of
the view, as we read it, that the right to the commission
arose under the managing agency agreement. Under the agreement
E there was a duty to forgo upto one-third of the commission
where profit of the managed company was not sufficient to pay
a di vident of 6 per cent. It is in the peculiar situation
arising out of the managing agency agreement that subsequently
a suin of Rs. 97 ,000 was given up in December, 1950, In this
context the fact of surrender and the concept of real income
F DllSt be viewed. It was really to implement the obligation ,
under the managing agency agreement that the giving up took
place. Therefore, the accrual of commission, the making of.the
accounts, the legal obligation to give up part of ·the
commission and the forgoing of the commission at the time of
the making of the accounts were considered not to be disjoin-
G ted facts. There was dovetailing about these which in reality
of the situation could not be ignored. This is not a case
where there being no previous obligation after interest having
been earned in the sense of having accrued according to the
mercantile system of accounting, the assessee after the close
of the accounting year without giving up the interest which ~
H the assessee could have as a bad debt, did not offer it for
taxation but carried it to 'interest suspense account'.
STATE BANK v. C.I.T. [SABYASACHI MUKHARJI, J,] 85

A
Carrying certain amount which had accrued as interest without
treating it as bad debt or irrecoverable interest but keeping
in suspense account would be repugnant to section 36(l)(vii)
read with section 36(2) of the Act. The concept of real income
must not be so read as to defeat the object and the provision
of the statutory enactment. In that "view of the matter B
Kashiparekh' s case would not be of any assistance to the
assessee for the contentions it sought to urge before this
Court in the instant case.
As mentioned hereinbefore this Court in Birla Gwalior

- (P) Ltd. 's case (supra) had. dealt with Kashiparekh's case.
That decision before the court was an appeal from the decision
of the Calcutta High Court (78 I.T.R. 788) in which I c
delivered the judgment. It was felt by the High Court that
reading the order of the Tribunal as a whole though various
contentions were raised before the Tribunal, the Tribunal had
mainly decided the question applying the theory of real income
and held that these amounts did not form the real income of
the · assessee, inasmuch as, according to the Tribunal, the D
remunerations were forgone on grounds of commercial expe-
diency. The High Court held that once it was decided that
these amounts did not form part of the real income of the
assessee which was liable to tax, the question of deduction
under section 10(2)(xv) of the 1922 Act became· irrelevant.
There the question really was ·when did the income really E
accrue - whether at the end of the accounting year or upon the
making up of the accounts, in case of the entitlement of
commission of. the assessee in the managing agency commission
and office allowance. This .Court (at page 270 of 89 I. T.R.)
noted that the date for payment of the commission was s tipu-
~ lated in the managing agency agreement. The accounting year of F
the assessee as well as the managed companies was the
financial year, The respondent gave up the managing agency
commission from both the managed companies, for the assess-
ment years 1954-55 to 1956-57, after the end of the relevant
financial years but before the accounts were made up by the
managed companies. This Court emphasised that as the managing G
agency commission receivable could have been ascertained only
after the managed company had made up it.s accounts and the
assessee had given up the commission even before the managed
company made up its accounts, and no date had been fixed in
the agreement for the payment of the commission, the mere fact
that the respondent was maintaining its accounts on the H
mercantile system did not lead to the conclusion that the
86 SUPREME COURT REPORTS (19861 1 s.c.R.

A
commission had accrued to it by the end of the relevant ~
accounting year. The commission given up by the respondent
could not be considered to be its real income. It is clear
that the fact of the case was that the managing agency
commission receivable by the assessee could have been ascer-
tained only after the managed company had made up its accounts
B and as it had not made up its accounts, the commission did not
accrue to the assessee company and therefore the giving up
which was for valid reasons was not given up after the accrual )--
of income.
Dealing with Kashiparekh's case this Court observed that
an argument was advanced before this Court that as the
c assessee was maintaining its accounts ori mercantile basis, the
commission had accrued. This contention did not find favour
with this Court, because this Court noted that no due date was
fixed for payment of the.commission under the managing agency
agreement. Therefore, whether in a particular case managing
agency commission had accrued or not would depend upon various
factors and there is a dovetailing of these factors. It is in ~
D
this light that this Court understood Kashiparekh' s case and
approved that decision at page 270 of the report. In my
opinion, this approval by this Court on this basis. does not
help the assessee in the present appeals before us. It has to
be pointed out that the facts in Kashiparekh's case were
E peculiar and the court wanted to relieve the assessee from the
undue hardship of tax liability. The ratio of a case with
such special features may not be available for general
application.
The Bombay High Court in Collllilissioner of Income-tax,
Bombay Iv. Confinance Ltd., 89 I.T.R. 292, held that under
F the income-tax law receipt of income, either actual or deemed, y
is not a condition precedent to taxability. 'Ihese were assess-
able if these had arisen or accrued or deemed to have accrued
or arisen under the Act. This principle would be attracted
even in cases where an assessee followed the mercantile system
of accounting. However, in examining any transaction or situa-
G
tion, the Court would have more regard to the reality of the
situation rather than purely theoretical or doctrinaire
aspect. It was held in that case after discussing the facts
that there were hardly any receipts in respect of items of
interest or that the bona f ides of the assessee in not charg-
ing interest were not disputed, Were circumstances which were -f
H by themselves insufficient to support the conclusion that
STATE BANK v. C.I.T. [SABYASACHI MUKHARJI, J,] 87

there was no real income in respect of the items of interest A
""- as none of the debts due by the several debtors was written
.off by the assessee and no evidence was produced to show that
interest in respect of the debts was given up. The High Court,
therefore, held that there. was no giving up and these incomes
were assessable. I am in respectful agreement with the con-
clusion of the Bombay High Court. In the instant case before B
us the facts are still worse. The assessee has not only nOt.
written off, but it is still treating loans as alive by_
keeping them in suspense account. Kantawala, J., as the Chief
Justice then was, followed the correct principle therein after
consid~.ring Kashiparekh 's case (supra). The principles enun-
ciated therein are in consonance with the decision of the
Calcutta High Court in James Finlay & Co. v. Commissioner of c
Income Tax., 137 I.T.R. 698, where all these relevant autho-
rities including Kashiparekh's case as well as Birla Gwalior
(P) Ltd.'s case have been discussed and analysed. In that case
the accounts of the assessee company for the year 1970-71
included an amount of 8,264 from B & G and Rs. 55,920 from
S.P. Ltd. receivable as interest. The interest due from B & G D
were on advances made in 1966 and that from S.P. Ltd. were on
advances made in 1965, The assessee was following the mercan-
tile system of accounting and the Income-tax Officer treated
both the items of interest as the assessee's income for
1970-71. The assessee used to credit the interest to its
profit and loss account. It urged that it had decided to E
change w.e.f. 1st January, 1968, its method of accounting in
respect of inter.est which was doubtful of recovery, and that
such interest was thence forward credited to the suspense
account. The Tribunal held that there was no change in the
method of .accounting and that before the closing of the books
-;,- of account of the relevant accounting year, the assessee had F
" not abandoned its claim of interest and as such .the amounts
were assessable on accrual basis. On a referene ,_ the High
Court held that the alteration ·of practice in ·book-keeping and
transfer of amounts to the suspense account could not be
termed as a change in the method of accounting. In the instant
appeals before us, the position is still worse for the G
assessee. There is no claim that there was any change in the
method of accounting. The High Court further held in James
Finlay's case that though there was difficulty in realising
the interests in the year of account, there was· no inaterial to
show that there was any agreement with the debtors to waive
the interest or to keep these in suspense account. HenCe, the H
claim for interest had not been given up. The amounts accrued
88 SUPREME COURT REPORTS (19861 l s.c.R.
A

and continued to remain accrued and were therefore income )i
assessable to tax.
Our attention was drawn to certain passages in some
•
recognised tex~ books on accountancy. Reference was made to
"Advanced Accounts" by Shukla and Grewal (Ninth Revised and
B Enlarged Edition 1981) as well as to Spicer and Pegler's
"Practical Auditing" by W.W. Bigg (Fourth Indian Edition by
S.V. Ghatalia) where it has been suggested that doubtful debts
might be carried to interest suspense account. Reference was
also made to the Approved Text of the "International Account-
ing Standard 18". Relevant passages from these books have been
c set out in the judgment of our learned brother Tulzapurkar, J.
No useful purpose will be served by repeating these. Even if
in a given circumstance, the amounts may be treated as
int~re.st suspense account for accountancy purpose th~t would
not affect the question of taxability as such. This must he
determined by well-settled legal principles and principles of
D
accountancy which have been ref erred to hereinbef ore.
, The concept of reality of the income and the actuality
of the situation are relevant factors which go to the making
.up at the accrual of income but once accrual takes place and
income accrues, the same carmot be defeated by any theory of
real income. Reference may be made to Calcutta Co. Ltd. v.
E
Commissioner of Income-Tax, West Bengal, 37 I.T.R. 1.

Three decisions, two of the Madras High Court and one of
the Punjab and Haryana High Court, which shall presently be
noticed, were pressed into service on behalf of the assessee
to suggest that the concept of real income can be so applied
as to make, where the chances of realisation of accrued income
F
are less it non est.
----
In Commissioner of Income-tax, Tamil Nadu-V v. Motor
Credit Co. Pvt. Ltd., 127 I.T.R. 572, the assessee, a private
company, was carrying on business as financier for purchase of
motor vehicles on hire purchase. It advanced under hire
G
purchase agreements monies to two firms which were plying
buses. The routes of these two firms having been taken over by
a State Transport Corporation following nationalisation, the
firms defaulted in making payment of the hire purchase instal-
ments, and consequently the buses were seized. As the
assessee-company was advised that there was no prospect of ·--,I
H
recoVeriilg even the principal pmount, the assessee-company did
STATE BANK v. C.I.T. [SABYASACHI MUKHARJI, J,] 89
A
'- ' -I. not credit the interest on the outstandings from the two
companies even though it was adopting the mercantile system of
accounting. The Income-tax Officer, however, included a sum of
Rs. 56,163 by way of accrued interest on the amounts outstand-
ing against these two firms. There in fact no interest accrued
in view of the facts because there was hire purchase and the B
State transport corporation had taken over the firms. There-
fore, there was no question of paying any hiring charges or
~.
interest. In that view it was considered to be unrealistic
that income accrued. If the actuality _of situation or the
reality of a particular situation makes an income not to
accrue, then very different considerations would apply. But
where interest has accrued and the assessee has debited the c
account of the debtor the difficulty of the recovery would_ not
make the accrual non-accrual of interest.

In Colllllissioner of Income-Tax, Madras Central· v. ·Devi
Films (P) Ltd., 143 I. T. R. 386, the Madras High Court held
~
that the regular mode of accounting only determined the mode D
of computing the taxable income and the point of time at which
the tax liability was attracted. It would not determine or
affect the range of taxable income or the ambit of taxation.
It was further held that where no income had resulted,. it
could not be said that income had accrued merely on the ground
that the assessee had been following the mercantile system of E
accounting. Even if the assessee made a credit entry to that
effect still no income could be said to have "accrued to the
assessee according to the Madras High Court. If no income had
materialised, it was pointed out, there could be no liability
to tax on any hypothetical accrual of income based on _the
, mercantile system of accounting followed by the asessee that F
· had to be taken into account, but what should be considered
was whether the income had really materialised or resulted to
the assessee. The question whether real income had materialis-
ed to the assessee had to be considered with reference to
commercial and business realities of the situation. In that
case the assessee company had entered into an agreement with M G
who was producing a Kannada film. The film was in the process
of production and the producer wanted finance to complete the
picture and approached the assessee and offered the exclusive
distribution rights of the picture in certain areas in
Karnataka State. The assessee agreed to advance a sum of Rs.
2,80,000. Under the agreement the assessee as distributor H
could deduct the commission and appro~riate the balance
90 SUPREME COURT REPORTS [1986] I S.C.R.
A

towards the discharge of the amount advanced to the producer r
and after the advance was completely adjusted, the distributor
had to remit to the producer the realisactions after deducting
the colllllission. The distribution colllllission was to be calcula-
ted at 35% of the net realisation on the picture. The producer
B undertook to complete and deliver the prints for the release
of the picture.failing which the producer under took to pay
damages together with interest for the amount received at 12%
per annum from the date of default to the date of deli very of ,_
the prints and also providi!d certain sum for certain contin-
gency. It is not necessary to set out in detail the further
c facts, It was held that the assessee was in a position to
realise only Rs. 3,47,000 approximately during the three years
in question as against a total sum or Rs. 4,37,828 incurred as
the cost of production. The Tribunal was justified in the High
Court's view that having regard to the terms of the agreement
entered into between the parties and in the light of the
D entries contained in the accounts, the commission could not be
said to have accrued in favour of the assessee, as commission ~
could be earnt only after the entire advance had been
realised. The decision, as is apparent from its tenor rested
upon· the peculiar facts. As the advances could not be realised
because of the contingencies that happened in that case, the
E commissions did not accrue or could not be said to have
actually accrued. As mentioned before, the concept of real
income may have to be given precedence in computation of
income in a particular case but accrued income cannot be
waived as not having accrued to the assessee. Sethuraman, J,
who delivered the judgment of the bench noted the distinction
F between the James Finlay's case and the case before him in the
Madras High Court. Dealing with the Calcutta case, Sethuraman, •
J, observed at page 395 that the waiver of interest would be
inconsistent with the entries in the books, since the interest
had been credited to the suspense account. As in the instant
case before us in these appeals the learned judges of the
G Madras High Court also ref erred to llorvi Iru!uatriea Ltd.
(supra) where affirming the Calcutta High Court decision, it
was found that the relinquishment by the assessee of its remu-
neration after it had become due was of no effect and that the
an.>unt was liable to be taxed. The Madras High Court felt that
this Court had considered only in the light of the system of
H accounting followed by the assessee and further observed thst './
this Court in the aforesaid decision had not been referred to
the notion of real income. It is unfortunate that the High
STATE BANK v. C.I.T. [SABYASAC.'H,l MUKHARJI, J. J 91

A
Court chose to side-track a binding decision of this Court on
a wholly untenable ground.
In Commissioner of Income-Tax, Amritsar-II v. Ferozepur
Finance (P) Ltd. 124 I.T.R. 619., the facts were different
and the Punjab and Haryana High Court hald that that even in
the mercantile system of accountancy an assessee could forgo B
the whole or part of a .debt, whi_ch was irrecoverable. There
the court came to the. conclusion that there was no income in
view of the·particular facts and circumgtances of the case.
An acceptable formula of co-relating the notion of real
income in conjunction with the method of accounting· for the
purpose of computation of income for the purpose of taxation
is difficult to evolve. Besides any straight jacket formula is c
bound to create pi"oblems in its application to every situa-
tion. It must depend upon the facts and circumstances of each
case. When and how does an income accrue and what are the
consequences that follow from accrual of income are well-
settled. The accrual must be real taking into account the
actuality of the situtation. Whether an accrual has taken D
place or not must in appropriate cases be judged on the
principles of real income theory. After accrual non-charging
of tax on the same because of certain conduct based on the
ipse dixit of a particular assessee cannot be accepted. In
determining the question whether it is hypothetical income or
whether real income has materialised or not, various factors E
will have to be taken into account. It would be difficult and
improper to extend the concept of real income to all cases
depending upon the ipse dixit of the assessee _which would then
become a value judgment only. \/hat has really accrued to the
assessee has to be found out and what has accrued must be
considered from the point .of view of real income taking the F
probability or improbability of realisation in a realistic
manner and dovetailing of these factors .together but once the
accrual takes place, on the conduct of the par.'ties subsequent
to the year of closing an income which baS accrued cannot be
made "no income'.'.
The extension of such a value judgment to .such a field G
is a pregnant with the possibility of mis'Use and should be
treated with caution; otherwise one would be on sticky
grounds. One should proceed cautiously and not fall a prey to
the shifting sands of time. ·-
As a result of the aforesaid discussion, the following
propositions emerge; H
92 SUPREME COURT REPORTS [1986'1 .1 s.c.R;

A
(l) It is the income which has really accrued or .arisen
to the assessee that is taxable. Whether .the income has really
accrued or arisen to the assessee lllllSt be judged· in the light
of the reality of the situation. (2) ,The concept of real
income would apply where there has been ~ surrender of income
which in theory may' have accrued but in the reality of the
B situation no income had resulted because the income did not
really accrue. (3) where a' debt has bedome bad c!edtiction in
compliance with the provisions of the Act should be. claimed
and allowed. ( 4) Where the Act applies the concep~. of real
income should not be so read as to defeat the provisions of
the Act. (5) If there is any diversion of income at source
c under any statute or by over-riding title then there is no
income to the assessee. (6) The conduc.t of the parties tn
treating the income in a particular manner is material
evidence of the fact whether income has accrued or not. (7)
Mere improbability of recovery, where. the conduct of the
assessee is unequivocal, cannot be treate;d as eivdence _of the
D fact that income has not resulted or accrued to the ·.assessee.
After debiting the debtor's account and not reversing that
entry - but taking the interest merely in suspense account
cannot be such evidence to show that no real income has
accrued to the assessee or treated as such by the assessee.
(8) The concept of real income is certainly applicable in
E judging whether there has been income or not but in every case
·it lllllst be applied with care and within well-recognised
limits.
We were invited to abandon legal fundamentalism. With a
problem like the present one, it· is better to adhere to the
basic fundamentals of the law with clarity and consistency
F than to be carried away by common cliches, The concept of real
income certainly is a well~accepted one and lllllSt be applied in
appropriate cases but with circumspection and lllllst not be
called in aid to defeat the fundamental principles of .law of
income-tax as developed.
- For the reasons aforesaid, with respect, it is not
G possible for me to agree with the answer proposed by my learn.-
ed brother, Tulzapurkar, J, on the first questiol), In th,e
premises question number (1) should be answered in the affir~
mative and in favour of the revenue and question number · (2)
must also, in respectful agreement with my learned brother, be
answered in the affirmative and in favour of the revenue. The
H appeals therefore must fail and are dismissed. But in view of
STATE BANK v. C,l.T. [RANGANATH MISRA, J.] 93

the facts and circumstances of these cases, parties will bear A
their own costs throughout.
RANGANATH MISRA, J, ·I have had the advantage of reading
the two separate judgments by my learned brothren • Tulzapurkar
and Mukharji, JJ,
I am in agreement with both of them that the second .B
question had been correctly answered in favour of the Revenue
by the High Court and the appeals are to be dismissed on
affirmation of that. conclusion so far as that aspect is
concerned.
In regard to the answer proposed for the first question,
I have bestowed my careful consideration and I am in agreement c
with the reasonings and conclusions reached by my lear.ned
Brother Mukharji, J, I am of the view that section 36(2) of
the Income Tax Act covers the entire field regarding deduction
for bad debt. Though the concept of 'real income' is well
recognised.one, it cannot be introduced aB an outlet of income
'from taxman's net for assessment on the plea that though shown
in the account book as having accrued, the same became a bad D
debt and was not earned at all. It is well settled that the
citizen is entitled to the benefit of every ambiguity in a
taxing statute but where the law is clear considerations of
hardship, injustice or anomaly do not afford justification for
exempting income from taxation (see Mapp v. Oram., [1969]
~ (vol.Ill) All Eng. Reports 219 (H.L.) E
The appeals shall stand dismissed with the direction
that- the parties shall bear their own re&pective costs
throughout.

ORDER
F
In view of the majority judgments appeals are dismissed.

A.P.J.