S. 145: Even if assessee is following mercantile system, income cannot be assessed, on “real income” vs. “hypothetical income” theory, if its collection/ receipt is not certain

The assessee advanced funds to various parties on which it was entitled to receive interest. However, owing to the financial difficulties of the borrower, the assessee did not receive any interest. It accordingly did not offer any interest income to tax. However, the AO & CIT(A) held that as the assessee was following the mercantile system of accounting, the said interest had accrued to it and was chargeable to tax notwithstanding the inability of the borrower to pay the same. On appeal by the assessee to the Tribunal HELD allowing the appeal:

(i) To arrive at the real income, accrual basis cannot be a justifying factor and the commercial and business realities of the assessee, should be considered. The interest income has been recognized in the books of accounts only to the extent of actual collection, which is the recommended/ recognized method as per Accounting Standard 9 of ICAI which lays down that when uncertainties exist regarding the determination of the amount or its collectability, the revenue shall not be treated as accrued and hence shall not be recognized until collection. The recognition of revenue on accrual basis presupposes the satisfaction of two conditions (a) The revenue is measurable (b) The revenue is collectable with certainty. The interest income has been admittedly recognized only on receipt basis. The contention of the revenue that the loan agreements have interest clause permitting the assessee to charge interest at the rate of 14% is not tenable. The terms of the agreements, which enabled the assessee company to demand interest were only enabling provisions and those enabling provisions did not guarantee the collection of overdue interest. They only gave a cause of action to the applicant;

(ii) The method of accounting, as followed by the assessee, does not create any income. The method of accounting only recognizes income. Income cannot be taxed on hypothetical basis, and it is only the real income that is to be brought to tax. When the principal itself is overdue and not collected, there is no basis for making out a case that interest income would be collectable with certainty. Even where an assessee is following the mercantile system of accounting, it is only accrual of real income which is chargeable to tax, that accrual is a matter to be decided on commercial belief having regard to the nature of business of the assessee and character of the transaction. Accordingly, for the purpose of determining whether there has been accrual of real income or not, recourse is to be made to ascertain the nature of business and character of the transaction and the realities and peculiarities of the situations (Godhra Electricity 225 ITR 746 (SC), Excel Industries Ltd 358 ITR 295 (SC) & UCO Bank 237 ITR 889 (SC) followed)