Holding

Interest earned on government securities placed with the State Bank of India/Reserve Bank of India does not constitute income from banking activity and is not exempt under Section 81 of the Income Tax Act.

Summary

The Madhya Pradesh Co-operative Bank Ltd., an apex co-operative bank, claimed that all its income, including interest earned on government securities placed with the State Bank of India/Reserve Bank of India and interest on Provident Fund deposits, arose from its banking business and was therefore exempt under Section 81 of the Income Tax Act, 1961. The Income Tax Officer rejected the exemption for these items, and the matter was upheld by the Tribunal and the High Court. The Supreme Court examined whether such interest constitutes income from the bank's circulating capital or stock‑in‑trade, which is required for exemption under Section 81. It held that the securities earmarked for the Reserve Fund are not part of the bank's circulating capital and cannot be treated as essential banking activity; consequently, the interest earned thereon is taxable. The Court also clarified that the proviso to Section 81 makes any income not attributable to banking activity taxable even if the society engages only in banking. The appeals were dismissed with costs.

Issues considered

Whether interest earned on government securities placed with the State Bank of India/Reserve Bank of India, earmarked for the Reserve Fund, qualifies as income from the business of banking under Section 81 of the Income Tax Act.
Whether interest on Provident Fund deposits can be exempt under Section 81.
Interpretation of the proviso to Section 81 concerning activities not attributable to banking.

Legislation cited

Income Tax Act, 1961s. 81

Subjects

Income TaxSection 81Co-operative bankTax exemptionGovernment securitiesReserve fundCirculating capitalBanking activityProvisoInterest income

Judgment

...
~ THE MADHYA PRADESH CO-OPERATIVE·
BANK LTD. JABALPllR ETC.
A

v.
THE ADDITIONAL COMMISSIONER OF INCOME TAX. ETC.

JANUARY 19, 1996
B
, <
[A.M. AHMADI, CJ! AND B.L. HANSARIA, J.]

Income Tax Act, 1961

S.Sl(New s.SOP)-Income of Co-operative society-Exemption from c
tax-Co-operative society engaged in banking business-Govenunent
secwities placed with State Bank of lndia/Rese1Ve Bank of India-Held, not
an essential pa1t of assessees banking activity as the same does not fom1 part
of its stock-in-trade or working/circulating capital--lncome de1ived therefrom
cannot qualify for exemption from tax.
D
The appellant-assessee, a co-operative society controlling all the
District Co-operative Banks in the State of Madhya Pradesh, filed retnrns
for the relevant assessment years claiming that the entire income was from
banking business and, therefore, exempt from tax under s.81 of the Income
Tax Act, 1961. The Income Tax Officer rejected the claim in respect of the . E
interest earned on securities earmarked against resenres and the interest
earned on Provident Fund deposits. The assessee having unsuccessfully
challenged the order before the higher authorities under the Act as also
before the High Court, filed the appeals before this Court.

It was contended for the assessee that Government securities placed F
with the State Bank or the Reserve Bank form part of the bank's stock-in·
trade and interest earned thereon would be the income earned by the Bank
from its circulating capital and cannot, therefore, be brought to tax.

Dismissing the appeals, this Court
G
-~

HELD : 1. The income derived by the assessee from the investment
in Government securities placed with the State Bank of India/Reserve
Bank of India cannot be regarded as an essential part of assessee's
banking activity inasmuch as the same does not form part of its stock-in·
trade or working/circulating capital and, therefore, it cannot qualify for H
773
(
774 SUPREME COURT REPORTS [1996] 1 S.C.R.

A exemption under s.8l(new s.80 P) of the Income Tax Act. (780-D]
Commissioner of Income Tax, Lucknow v. U.P. Cooperative Federation
Ltd., (1989) 176 ITR 435 (SC) and Assam Co-operative Apex Ma1keting
Society Ltd. v. CIT (Addi.), (1995) 201 ITR 338 (SC), relied on.

B 2. The object of s.81 was to encourage the co-operative movement in
the country by providing tax exemption to those co-operatives engaged in '
activities set out in clauses (a) to (I) thereof. One such activity is the
carrying on of the business of banking or providing credit facilities to its
members by a co-operative society. The section, therefore, provides that
C income- tax shall not be payable by a co-operative society in respect of the
profits and gains of business carried on by it, if it arises from the business
of banking or providing credit facilities for its members. However, in view
of the proviso to s.81 even if a co-operative society is engaged only in the
business of banking, but part of its activity is not attributable to engage-
ment in such activity, income derived from that part of activity would
D become taxable. (778-F-H] -'

3.1 There is no dispute, that the assessee is engaged in carrying on
the business of banking which, inter alia, includes the activity of providing
credit facilities to its members. A co- operative Bank is Iecally obliged to
place certain government securities with the State Bank/Reserve Bank.
E Under Section 44 of the Co-operative Societies Act, the assessee is required
to invest or deposit its funds to maintain a cover to the extent necessary
and it further provides that the Reserve Fund of the Society shall be ,
invested and lfiilised as may be laid down by the Registrar, which it does
by investing in government securities purchased with the bank's funds. As
F per the M.P. Government's instructions No. C.R.25/26 dated 7.10.1960 no
part of the Reserve Fund can be utilised as working capital nor can any
part of the Reserve Fund deposits be withdrawn except with the permission
of the Registrar to meet losses or at the time of winding up and not
otherwise. (776-H, 777-A-B, G]
G 3.2. It is clearly understood in banking parlance that circulating
capital is that which is put into circulation or turned over to earn profits.
Government securities coming out of Reserve Fund which cannot be easily
encashed and which can be utilised only when the contingencies mentioned
therein arise cannot be considered to be circulating capital or stock-in-
H trade, more so when the co-operative bank does not have an absolute and
.)
~

'j M.P. CO-OP. BANK LIB. v. ADLL.COMMR. OF!'. TAJI: [AHMADI, CJ] 775
t
"' unfettered right to withdraw the same whenever it liked. It is different from A
income derived ·fiy way' of interest on short-term deposits as reserves
maintained by the bank to meet the emergencies e.g. a f"Urt in withdrawals
by depositors for diverse reasons. [780-H, El
....
Bihar State Co-operative Bank Ltd. v. Commissioner of Income Tax,
B
, (1960) 39 !TR 114 (SC); Commissioner of Income Tax v. Bombay State Co-
operative Bank. Ltd., (1968) 70 !TR 86(SC); Malabar Co- operative Central
Bank Ltd. v. Commissioner of Income Tax, Kera/a, (1975) 101 !TR 87
1
(Kerala); Commissioner of Income Tax, Orissa v. 01issa State Co-operative
Housing Corpn. Ltd., (1976) 104 !TR 157 (Orissa) and Punjab Co-operative
Bank Ltd. v. Commissioner of Income Tax, (1940) 8 !TR 635, distinguished. c
CIVIL APPELLATE JURISDICTION : Civil Appeal No. 1116
(NT) of 1979 Etc.
,
From the Judgment and Order dated 9.10.78 of the Madhya Pradesh
) D
High Court in M.C.C. No. 228 of 1972.

Harish N. Salve, A.K. Chitle and D.M. Mishra for J.B.D. & Co., for
the Appellants.

K.N. Shukla, Manoj Arora and S.N. Terdol for the Respondents.
E
The Judgment of the Court was delivered by :

AHMADI, CJ Special leave granted in SLP (C) Nos. 5813-14 of 1982.

The assessee in all these cases is a Co-operative Society registered F
under the Madhya Pradesh Co-operative Societies (Amalgamation) Act,
1957, hereinafter called 'the Act'. While framing assessment for the
relevant assessment years in question, the income Tax Officer, included in
the taxable income of the assessee interest earned on securities earmarked
against reserves and interest earned on Provident Fund deposits. The
~ assessee contended that it was entitled to the benefit of Section 81 of the G
Income Tax Act as in force at all material time. The Income Tax Officer
rejected this claim of exemption form tax put forward by the assessee. Since
the assessee's contention did not find favour at the higher levels also,
including the reference to the High Court, the assessee has approached
this Court. H
(
776 SUPREME COURT REPORTS (1996) 1 S.C.R.

A Section 81 of the Income-Tax Act on which the assessee's case is :. .#
based thus at all material time :

"Income of co-operative societies - Income Tax shall not be payable
by a co-operative society. --

B (i) in respect of the profits and gains of business carried on by
it, if it is. -

(a) a society engaged in carrying on the business of banking or
providing credit facilities to its members;

c xxx xxx

Provided that, in the case of a co-operative society which is also
engaged in activities other than those mentioned in this clause,
nothing contained herein shall apply to that part of its profits and
'
gains as is attributable to such activities and as exceeds fifteen
D thousand rupees."

On a plain reading of this provision it becomes clear that every income of
a society carrying on banking business is not exempt from the payment of
tax. Only the income from banking business is exempt from tax. The
E question which we are required to answer is whether the income from
interest accruing on government securities ear-marked for Reserve.
Fund/Provident Fund can be said to be income derived by the assessee
from the business of banking within the meaning of Section 81 to qualify
for exemption. This question arises in the backdrop of the following facts.

F
The assessee is an Apex Body controlling all District Co-operative
Banks. It is registered under the provisions of the Co-operative Societies
Act, 1912 read with Section 6 of the Act. The assessee filed returns for the
relevant Years claiming that the entire income was from banking business
and, therefore, exempt from tax under Section 81 of the Income Tax Act.
G The Income Tax Officer rejected the claim in regard to interest being "·
exempt under the said provision. There is no dispute, and indeed there can
be none, that the assessee is engaged in carrying on the business of banking
which, inter alia, includes the activity of providing credit facilities to its
members. In the course of its business it receives deposits and makes
H advances to borrowers at a rate of interest higher than what it. pays on
\
M.P. CO-OP. BANK LTD. v. ADLL. COMMR. OF!. TAX [AHMADI, CJ] 777

deposits. A part of these deposits are, however, invested in the form of A
government securities with the State Bank of India or the Reserve Bank.
" ' Under Section 44 of the Co-operative Societies Act, the assessee is re-
quired to invest or deposit its funds to maintain a cover to the extent
necessary and further provides that the Reserve Fund of the Society shall

--
be invested and utilised as may be laid down by the Registrar, which it does
B
by investing in government securities purchased with the bank's funds. The
question is whether the interest earned by the assessee from government

-- securities placed with the State Bank or the Reserve Bank can qualify for
exemption under Section 81 of the Income Tax Act?

Before we proceed to answer this question we may refer to the M.P. c
Government's instructions No. CR 25/26 dated October 7, 1960 which,
insofar as it concerns Apex Banks, reads as under:

"(C) APEX BANK

The Reserve Fund of the Apex Bank shall be fully invested outside D
its business in Government securities. No part of its reserve fund
should be utilised as its working capital.

3. All investments of Reserve fund shall be specially marked as
"Reserve Fund Investment" and shall be shown separately in the
annual balance sheets. The Reserve Fund deposit at every level
E
shall carry the maximum rate of interest which a Central Bank or
Apex Bank pays on fixed deposits for longest period or 3%
whichever is higher. No part of the Reserve Fund deposits shall
;.
be drawn without the previous sanction of the Registrar, in the
case of Apex Bank, Central Banks and Large Sized Societies and F
in the case of other primary societies without the permission of
the Deputy Registrars. Such Approval can be given when the
Amount is either required to meet losses, or, when the society is
to be wound up. These eventualities will, however, be very rare. 11

Obviously as per the above instructions no part of the Reserve Fund
G
can be utilised as working capital nor can any part of the Reserve Fund
deposits be withdrawn except with the permission of the Registrar to meet
losses or at the time of winding up and not otherwise. In the circumstances
the Revenue contends that the securities relating to the Reserve Fund can
never be considered to be the circulating or working capital of the bank or H
(

(
778 SUPREME COURT REPORTS [1996] 1 S.C.R.

A its stock-in-trade to qualify for exemption under Section 81 of the Income
Tax Act.

Insofar as interest on Provident Fund deposits are concerned, admit-
tedly the same was included in the Profit and Loss Account of the Bank.
It appears from the observations in paragraph 11 of the appellate order of
B the Tribunal that even the assessee's counsel found it difficult to justify the
claim and said that it ought not to have been included in the Profit and
Loss Account of the Bank since it belonged to the Provident Fund as the
...
Bank was merely holding those deposits as Trustees. The Tribunal did not
examine this contention, and in our opinion rightly, since the same was not
C agitated before the authorities below and no foundation was laid for the
same. The Tribunal held that since the interest earned therefrom was
included in the Profit and Loss Account of the assessee and was shown as
earnings, it was liable to tax since it did not form part of the assessee's
stock-in- trade or circulating capital and could not, therefore, be described
D as income from the business of banking to qualify for exemption. The
Tribunal, therefore, held that this income was liable to tax. Mr. Salve, the
learned Senior Counsel for the assessee with his usual fairness stated that
in the absence of the foundational facts, the Tribunal was justified in
refusing to examine the contention of the assessee's counsel and he was
not in a position to assail the Tribunal's approach. He, therefore, did not
E press the contention under this head. We are, therefore, left with the first
contention only, namely, \Vhether interest .on government securities earned
by the assessee is exempt from tax under Section 81 of the Income Tax
Act. •

F There can be no doubt that the object of section 81 was to encourage
the co-operative movement in the country by providing tax exemption to
those co-operatives engaged in activities set out in clauses (a) to (t) thereof.
One such activity is the carrying on of the business of banking or providing
credit facilities to its members by a co-operative society. The section,
therefore, provides that income-tax shall not be payable by a co-operative
G society in respect of the profits and gains of business carried on by it, if it
arises from the business of banking or providing credit facilities for its
members. However, if such a co-operative society also engages itself in
activities other than the business of banking or providing credit facilities
the profits derived from such business shall not be exempt from tax if it
H exceeds rupees fifteen thousand. It is, therefore, obvious that the entire
•
M.P. CO-OP. BANK LTD. v. ADLL. COMMR. OF I TAX [AHMADI, CJ] 779

income derived by a co-operative society from the business of banking or A
providing credit facilities to ils member.s is exempt from income tax, but if
that society also engages itself in any other activity and earns profit there-
from, the income so derived becomes liable to assessment and payment of
income tax if it exceeds the ceiling amount. The normal banking activity is
to receive deposits and utilise such deposits by advancing loans, etc., to
.... B

-
borrowers. Since the rate at which interest is paid to depositors is lower
than the rate charged from borrowers, the difference in the rates generates
income for the banks. The banks may have to maintain certain reserves to
meet with emergencies, e.g. a spurt in withdrawals by depositors for diverse
reasons. Investments which permit withdrawals at short notice would,
therefore, be a part of the requirement of banking business and interest c
accruing on such investments would be outside the tax-net. That is why this
Court in Bihar State Co-operative Bank Ltd. v. Commissioner of Income
Tax, (1960) 39 !TR 114 (SC), while dealing with income derived by way of
interest on short-term deposits by the bank, held that it was income from
normal banking business and was, therefore, exempt from the liability to D
pay income-tax. This Court held that since the society was engaged in
banking activity, its normal business was to deal in money and credit and,
therefore, the money laid out in the form of short-term deposit did not
cease to be a circulating capital and interest earned thereon cannot be
other than income generated from the business of banking and was, there-
fore, exempt from tax. The same view was reiterated in Co1nniissioner of E
Income Tax v. Bombay State Co-operative Bank Ltd., (1968) 70 !TR 86
(SC), Malabar Co-operative Central Bank ltd. v. Commissioner of Income
Tax, Kera/a, (1975) 101 !TR 87 (Kerala) and Commissioner of Income Tax,
Orissa v. Orissa State Co-operative Housing Co1pn. Ltd., (1976) 104 ITR 157
(Orissa). The Privy Council in Punjab Co-operative Bank Ltd. v. Commis- F
sioner of Income Tax, (1940) 8 !TR 635 also held that bankers have always
to keep sufficient cash or readily realisable securities to meet with any
probable demand of depositors in the normal course of banking business
and such founds, counsel argued, would really form part of the bank's
circulating capital and, therefore, interest earned thereon would be exempt
from tax. G

' . Placing strong reliance on the aforesaid line of reasoning, counsel for
the asSessee argued, that interest earned oil government securities placed
with the State Bank or Reserve Bank would be income earned by the bank
form its circulating capital and in any case in the normal course of banking H
(
780 SUPREME COURT REPORTS [1996] 1 S.C.R

A business and cannot therefore be brought to tax. It was said that the
government securities form part of the bank's stock-in-trade and any
income earned thereon would be outside the tax-net. Counsel for the
revenue, however, distinguished the decisions relied on by the assessee
mainly on the ground that the bank's funds were utilised in short-term
deposits or in government securities which could be easily encashed to
B

-
meet with a probable sudden rush of depositors and, therefore, the fund
employed for the purpose never went out of circulation but was kept apart
to meet a probable eventuality and, therefore, a business obligation. He
pointed out that in the case of Reserve Fund Investments no part of the
deposits was permitted to be withdrawn unless the money was required to
c meet losses or the society had to be wound up and that too with the
Registrar's permission only. Therefore, he submitted, these securities could
not be utilised as a working capital nor did they form part of the circulating
capital or stock-in-trade of the bank and hence the interest earned thereon
and shown as forming part of the income of the society cannot qualify for
D exemption.

Counsel for the revenue did not join issue on the proposition that if
circulating capital or stock-in-trade of a co-operative bank is invested in
securities, interest earned thereon would be income from banking business
and would, therefore, qualify for exemption. However, can the investment
E in securities of the Reserve Fund be said to be investment of circulating
capital or stock-in-trade, more so when it is noticed that the co-operative
bank does not have an absolute and unfettered right to withdraw the same
whenever it liked? We have noticed that the co-operative bank is legally
obliged to place certain government securities with the State Bank/Reserve
F Bank and these securities cannot be withdrawn by the said bank at its sweet
will and can only be withdrawn in certain situations referred to earlier. That
is because the investment of the Reserve Fund in securities is not to meet
with the probable eventuality to pay off the depositors should they demand
the same. It is, therefore, difficult to comprehend how such government
securities relating to Reserve Fund can be considered the bank's stock-in-
G trade or circulating capital. It is clearly understood in banking parlance
that circulating capital is that which is put into circulation or turned over
to earn profits. Government securities coming out of Reserve Fund which
cannot be easily encashed and which can be utilised only when the contin-
gencies mentioned therein arise cannot, be considered to be circulating
H capital or stock-in-trade. It is more or less in the nature of a fixed asset of
\

M.P. CO-OP. BANK LID. v. ADLL. COMMR. OF I. TAX [AHMADI, CJ] 781

the society, being out of circulation for an indefinite period. It is, so to say, A
at arm's length from the normal banking business, to be utilised on the
' ' happening of certain events, e' ents which may virtually bring a cessation
of the business. If that be the purpose and object of setting apart the funds
in the form of government securities and the like, it cannot be reasonably
contended that the funds placed in cold storage continue to constitute the
B
bank's stock-in-trade or circulating capital. The learned counsel for the
revenue was, therefore, right in contending that the case law cited at the
Bar by the learned counsel for the assessee cannot come to the rescue of
the assessee.

We may make a brief reference to two more cases to which our . C
attention was drawn by the learned counsel for the revenue. The first case
is of Commissioner of Income Tax, Lucknow v. U.P. Cooperative Federatzon
Ltd., (1989) 176 ITR 435 (SC). In that case, the Apex Co-operative Society,
which was expected to regulate the supply of sugar, coal, cloth, etc., to its
members, had received two sums, namely (i) Rs. 9,000 as interest on cash D
security deposit with a co-operative sugar factory for carrying on sugar
agency business; and (ii) Rs. 51,295 as interest on amounts which it had
advanced to its members since they were not able to arrange for the entire
finance needed to lift the stocks. This Court held that the first amount did
not qualify for exemption because it represented only interest on security
deposit and could not be mixed up with other sum received in the course E
of business. Even the learned counsel for the assessee did not. press for
exemption so far as that claim is concerned. The second claim was allowed
on the ground that the money had to be provided to run the business and
generate profit and the funding was, therefore, in the nature of 'investment'
within the meaning of the relevant provision, in that, the money was F
ultimately to be utilised by the member society for the purchase of stocks.
The distinction is obvious, namely, where the money is ultimately to be used
for business purpose, either directly or through the member-bank, the
interest thereon would qualify for exemption and not otherwise. The
second case to which our attention was drawn is of Assam Co-operative G
Apex Marketing Society, Ltd. v. CIT (Addi.), (1993) 201 !TR 338 (SC). In
that case the appellant was appointed as the procuring agent for paddy
by the Assam Government. The members of the appellant were primary
marketing societies and societies at the village level, with membership of
agriculturists, being the members of the former. Thus no agriculturist was
the direct member of the appellant. So, the produce w~s received by the H
(
782 SUPREME COURT REPORTS [1996] 1 S.C.R.

A village level societies from its agriculturist-members and was then passed
on to the primary societies which in turn made it over to the appellant. A Jo ,
Commission was charged for the procuring activity which was divided
between the three, the appellant and the village society each taking 19 paise
in a rupee and the remaining 62 paise went to the primary society. The
question was whether the appellant's share in the wmmission could be
B
brought to tax. The Tribunal as well as the High Court on reference held
that the assessee was not entitled to exemption and this Court affirmed the
finding on the following line of reasoning.

"A reading of clause (i) of section 81 shows that the idea and
c intention behind the said clause was to encourage basic level
societies engaged in cottage industries, marketing agricultural
produce of its members and those engaged in purchasing and
supplying agricultural implements, seeds, etc., to their members
and so on. The words 'agricultural produce of its members' must
D be understood consistent with this object and if so understood, the
words mean the agricultural produce produced by the members.
If it is not so understood, even a co-operative society comprising
traders dealing in agricultural produce would also become entitled
to exemption which could never have been the intention of Parlia-
E ment. The agricultural produce produced by the agriculturist can
legitimately be called agricultural produce in his hands but in the
hands of traders, it would be appropriate to call· it agricultural
commodities; it would not be his agricultural produce. According-
ly, it must be held in this case that since the agricultural produce
marketed by the assessee was not the agricultural produce
F
produced by its members, namely, primary co-operative society,
the assessee cannot claim the benefit of the said exemption."

The learned counsel for the assessee tried to distinguish both these
cases but in our opinion the purport of the decisions is obvious. However,
G even if we were to agree with learned counsel for the assessee that both
cases had no application to the facts of these appeals, it would make no
rifference because we have on first principles come to the conclusion, for
reasons set out hereinbefore, that the interest on government securities
placed with the State Bank of India/Reserve Bank of India, cannot qualify
H for exemption under Section 81 (now Section 80 p) of the Income Tax Act.
,
I
M.P. CO-OP. BANK LTD. v. ADLL. COMMR. OF!. TAX [AHMADI, CJ] 783

Before we part, we must take note of Shri Salve's contention that the A
proviso to section 81 would apply in the case of that co-operative society
alone which is engaged in an activity other then those mentioned in clauses
(a) to (f) which not being so as regards the appellants, the proviso has no
application; and so, no part of its profit or gain can attract income tax. We
do not think this to be the correct reading of the proviso, notwithstanding B
the use of the word "also". According to us, what the proviso seeks to
convey is that even if a co-operative society is engaged only in the business
of banking, but part of its activity is not attributable to engagement in such
activity, income derived from that part of activity would become taxable.
And as held above, the income derived from the investment in Government
securities placed with the State Bank of India/Reserve Bank of India C
cannot be regarded as an essential part of its banking activity inasmuch as
the same does not form part of its stock-in-trade or working/circulating
capital. Therefore, we see no force in Mr. Salve's premises.

For the above reasons we see no merit in these appeals and dismiss
the same with costs. D

R.P. Appeals dismissed.

'