V.K. Singhal, J. - (1.) IN respect of the assessment years 1978-79 and 1979-80 at the request of the Revenue, the Tribunal has formulated the following two questions of law arising out of its order dated May 20, 1984, and referred under Section 25.6(1) of the INcome-tax Act, 1961 : "1. Whether, on the facts and in the circumstances of the case, the Tribunal was justified in holding that the allowance under Section 36(1)(viii) is to be computed before making any deduction under Chapter VI-A as well as any deduction under Section 36(1)(viii) of the INcome-tax Act, 1961 ?
(2.) WHETHER, on the facts and in the circumstances of the case, the Tribunal was justified in holding that interest amounting to Rs. 17,65,281 (assessment year 1978-79) and Rs. 17,70,210 (assessment year 1979-80) on cases in litigation could not be treated as income of the assessee ?" 2. The questions relate to the interpretation of the provisions of Clause (viii) of Sub-section (1) of Section 36 of the Income-tax Act for computing the income under the head "Profits and gains of business and profession". The said clause during the year under assessment read as under ; "In respect of any special reserve created by a financial corporation which is engaged in providing long-term finance for industrial or agricultural development in India, an amount not exceeding -- (a) in the case of a financial corporation or a joint financial corporation established under the State Financial Corporations Act, 1951 (63 of 1951), or an institution deemed under Section 46 of that Act to be a financial corporation established by the State Government for the State within the meaning of that Act, 40 per cent.; (b) in the case of any other financial corporation, -- (i) where the paid-up share capital of the corporation does not exceed three crores of rupees, 25 per cent; (ii) Where the paid-up share capital of the corporation exceeds three crores of rupees, 10 per cent.; of the total income (computed before making any deduction under Chapter VI-A) carried to such reserve account." In accordance with the above clause deductions at the rate of 40 per cent, of the total income (computed before making any deduction under Chapter VI-A) is allowable. The dispute in the present matter relates to the computation of deduction for the purpose of Clause (viii) of Sub-section (1) of Section 36 whether it could be interpreted to mean a figure before making any deduction under Chapter VI-A, i.e., the deduction is to be computed with reference to the gross total income. Chapter VI-A provides for certain deductions out of the gross total income to arrive at the total income. The case of the assessee was that for the purpose of Clause (viii) such deductions are not to be taken into consideration, and the gross total income will be the total income for the purpose of this clause. Under Section 2(45) of the Income-tax Act, the total income has been defined to mean the total amount of income referred to in Section 5, computed in the manner laid down in the said Act. The total income will be after allowing the deductions under Clause (viii) and not before that. In the case of the assessee for the assessment year 1978-79 a similar point was involved and following that, the Tribunal came to the conclusion that the total income will be before allowing the deductions under Clause (viii) aforesaid and not after allowing the deductions under this clause. Accordingly, the Income-tax Officer was directed to recompute the deductions with reference to the total income computed before making any deductions under Chapter VI-A as well as any deductions under Section 56(1)(viii) of the Income-tax Act. In respect of the second point on the interest amount of Rs. 9,85,821 included in the income, the Commissioner was of the view that the order of assessment is prejudicial to the interests of the Revenue and he, therefore, exercised the powers under Section 263 in respect of the assessment year 1977-78. The claim of the assessee was that the interest is not charged from the parties from whom-even the principal amount was doubtful of recovery. The assessee is maintaining the hybrid system of accounting. The interest on such doubtful parties aggregated to Rs. 17,65,281 and Rs. 17,70,210 for the assessment years 1978-79 and 1979-80, respectively. The Income-tax Officer was directed in 1977-78 by the Commissioner of Income-tax to include the said figure in the income of the assessee. The Tribunal found that there was no error and the order was not prejudicial to the interests of the Revenue. This dispute has arisen because in the annual report of the assessee, there was a note accompanying the balance-sheet that interest had accrued on the amount decreed or under litigation. According to the Income-tax Officer, the assessee was following the mercantile system of accounting and, therefore, he should have included the interest which has accrued in its income in the profit and loss account. It appears that on that basis the Income-tax Officer included the interest in the income of the assessee, in the assessment years 1978-79 and 1979-80. Before the Tribunal, it was found that the observations of the Commissioner of Income-tax that it is not open to the assessee to follow a hybrid system of accounting was hot proper. The assessee was found to have been following the hybrid system of accounting right from the beginning which was accepted by the Revenue in the past. No particular reason for the departure in the assessment year 1977-78 has been given except that the decision in the case of the Kerala High Court was against the assessee. The case of CIT v. Motor Credit Co. P. Ltd. [1981] 127 ITR 572 (Mad) was also taken into consideration and it was found that the assessee was following the hybrid system of accounting. The assessee advanced money to two firms whose business was taken over by the State and there was no prospect of recovery of even the principal amount. The company did not credit the interest on the outstanding amount from the two companies although it was following the mercantile system of accounting. The accrued interest was added by the Income-tax officer but the addition was deleted by the Appellate Assistant Commissioner. The High Court agreed with the Tribunal holding that no interest income could be assessed in the hands of the company on accrual basis as it would be very unrealistic on the part of the assessee to take credit for a highly illusory interest. From the said decision, it was inferred that an assessee who is following the mercantile system of accounting, under certain circumstances, need not account for interest on advances considered doubtful. The Tribunal was of the view that this decision affirms the principle of hybrid system of accounting. It was found that once right from the beginning the hybrid system was being followed, the assessee has chosen not to debit interest to parties from the date of initiation of legal proceedings for recovery of the principal amount and the interest accrued earlier, it is to be concluded that the assessee is taking a realistic approach in the matter of interest which it is likely to realise thus bringing the case within the ratio of the decision of the Madras High Court. So far as question No. 2 is concerned, the matter was considered In the case of CIT v. Rajasthan Financial Corporation (No. 1) [1998) 229 FIT 246 (Raj). D.B.I.T.R. No. 81 of 1982, decided on May 8, 1996, and it was. held that since the assessee was maintaining hybrid system of accounting and in respect of interest where the litigation is going on cash system has been followed. We are of the view that the Tribunal was justified in holding that the interest amounting to Rs. 17,65,281 (assessment year 1978-79) and Rs. 17,70,210 (assessment year 1979-30) on cases in litigation could not be treated as income of the assessee.
(3.) IN respect of question No. 1, it may be observed that the provisions of Section 36(1)(viii) contemplate that in respect of any special reserve created by a financial corporation, which is engaged in providing long-term finance for industrial or agricultural development in INdia or by a public company formed and registered in INdia with the main object of carrying on the business of providing long-term finance for construction or purchase of houses in INdia for residential purposes, an amount not exceeding forty per cent, of the total income computed before making any deduction under this clause is to be carried to such reserve account. The Income-tax Officer was of the view that the amount of 40 per cent, should be worked out on the net income and not on the gross total income. Circular No. 204/72/75/ITA/1, dated August 13, 1979, was issued in which it was stated that the relief under Section 36(1)(viii) is to be worked out on the net income and on that basis the assessment was framed. The Commissioner of Income-tax (Appeals) has followed the decision of the Tribunal in respect of the earlier year wherein it was observed : "Section 56(1)(viii) provides deduction of 40 per cent, of the total income (computed before making any deduction under Chapter VI-A). The dispute now is as to what is total income for the purpose of Clause (viii). The view of the Income-tax Officer as well as the Commissioner of Income-tax (Appeals) is that this clause specifically mentions that the total income will be before making any deduction admissible under Chapter VI-A. In other words, it will be the gross total income and 40 per cent, deduction is to be computed with reference to the gross total income. Chapter VI-A provides for certain deductions out of the gross total income to arrive at the total income. For the purpose of Clause (viii) such deductions are not taken into consideration. In other words, the gross total income will be the total income for the purpose of this clause. Under Section 2(45) of the Income-tax Act, total income means the total amount of income referred to in Section 5 computed in the manner laid down in this Act. The total income has, therefore, to be computed as per Section 2(45) in the manner laid down in the Income-tax Act, 1961. Clause (viii) of Sub-section (1) of Section 36 contains one of the deductions to be given before computing the total income or the gross total income. In other words, the total income will be after allowing the deductions under Clause (viii) aforesaid and not before allowing deductions under Clause (viii) aforesaid. In this view of the matter, we are of the opinion that the total income for this purpose will be after allowing deduction under Clause (viii) and, therefore, the deduction under this clause will have to be worked out on this basis. We, therefore, direct the Income-tax Officer to recompute the deductions with reference to the total income computed before making any deductions under Chapter VI-A as well as any deduction under Section 36(1)(viii) of the Income-tax Act, 1961." ;