Mercantile system of accounting should be applied on real income – SC

Accrual system of Accounting is also known as the mercantile system of accounting wherein the transactions are recognized and recorded as and when they take place. Under the accrual accounting method, the revenue is recorded when it is actually earned, and the expenses are reported when they are incurred. The accrual method of accounting is used by most of the entities as it records the past transactions regarding the revenue and expense, but it also predicts the cash receipts and payments expected to arise in the future. Let us refer to the case of B.R. Sridhar (AAR Karnataka), where the issue under consideration was whether mercantile system of accounting can be applied on notional income or not.

Facts of the Case:

• On 1922 the Government of Bombay granted a licence under the Indian Electricity Act, 1910 to Lady Sulochana Chinubhai & Company authorising it to generate and supply electricity to the consumers in Godhra area.
• The assessee company was the successor of the said licensee.
• Up to AY 1963 -64 the assessee-company was assessed on the basis of the accounts maintained according to the mercantile system.
• For the subsequent assessment years, the assessee-company deducted Rs. 10,87,828 from the total earnings in respect of sale of electrical energy on the ground that the said amount was not actually recovered by it from the consumers since the consumers had filed a suit against the assessee-company and had obtained interim relief in that behalf.
• The disputed amounts were shown by the assessee-company on the liability side in the balance sheet under the head “Disputed increase in rates charged to customers (consumer) carried forward pending settlement of disputes in the District court”
• In AY 1968 -69 there was an adjustment of the claim amounting to Rs. 3,54,152 while making the assessment for the AY 1969-70
• The income Tax officer included the said amount of Rs. 7,33,676 on the ground that the suit filed against the assessee-company by the consumers was decided in favour of the assessee-company by this court during 1968-69 and the assessee-company had the legal right to recover the said amount and on the basis of the accountancy followed by the assessee-company.
• The amount will have to be taxed as the income that has accrued to the asseeeee-company on account of the decision of this court in the assessment year 1969-70.

Proceedings of the Appellate Authorities

• The said addition made by the income tax officer was however deleted by the appellate assistant commissioner (appeals) on the view that no legally enforceable claim had accrued to the assessee-company during the previous year by which it could recover the arrears of motive power and electricity for lights and fans from the consumers.
• The income tax appellate tribunal (ITAT) on further appeal held that the question of fixing a reasonable return was still an open issue since it was a subject matter of further litigation wherein as a result of the decision of civil judge junior division Godhra the assessee-company was restrained from recovering the charges for motive power from the customers and that the right to receive the increased rated had not crystallized accounting to the Tribunal.
• The claim at the increased rates as made by the assessee-company and on the basis of which necessary entries were made in the books, represented only hypothetical income and the impugned amount as brought to tax by the income Tax officer did not represent the income which had accrued to the assessee- company during the relevant previous year.

Observations of the High Court

• The HC held that the assessee-company was following the mercantile system of accounting and that even under this system in order to visit the assessee-company with the obligation to pay tax the profit must become actually due no matter when it is received and that income cannot be said to have accrued to an assessee-company if it is based on a mere claim not backed by any legal or contractual right to receive the amount at a subsequent date.
• The HC held that in the mercantile system of accounting it was the real income as distinguishes from a hypothetical income which can be brought to tax.

Observations of the Supreme Court (SC)

• Under the Act income charged to tax is the income that is received or is deemed to be received in India in the previous year relevant to the year for which assessment is made or on the income that accrues or arises or is deemed to accrue or arise in India during such year.
• The computation of such income is to be made in accordance with the method of accounting regularly employed by the assessee.
• It may be either the cash system where entries are made on the basis of actual receipts and actual outgoings or disbursements or it may be the mercantile system where entries are made on accrual basis i.e. accrual of the right to receive payment and the accrual of the liability to disburse or pay.
• In commissioner of Income tax Bombay city-I v. Messrs. Shoorji Vallabhdas and co.(supra) it was laid down that income tax is a levy on income no doubt the Income Tax act takes into account two points of time all which the liability to tax is attracted viz the accrual of the income or its receipt; but the substance of the matter is the income. if income does not result at all there cannot be a tax even though in book keeping an entry is made about a hypothetical income which does not materialise.

• This principle is applicable whether the accounts are maintained on case system or under the mercantile system. If the accounts are maintained under the mercantile system what has to be seen is whether income can be said to have really accrued to the assessee-company
• The question whether there was real accrual of income to the assessee-company in respect of the enhanced charges for supply of electricity had to be considers by taking the probability or improbability of realisation in a realistic manner.
• If the matter was considered in this light it was not possible to hold that there was real accrual of income to the assessee-company in respect of the enhanced charges for supply of electricity which were added by the income tax officer while passing the assessment orders in respect of the assessment years under consideration.

• The Appellate Assistant commissioner was right in deleting the said addition made by the income tax officer and the tribunal had rightly held that the claim at the increased rates as made by the assessee-company on the basis of which necessary entries were made represented only hypothetical income and the impugned amounts as brought to tax by the income tax officer did represent the income which had really accrued to the assessee-company during the relevant previous years.
• The High court in SC’s option was in error in upsetting the said view of the ITAT

In conclusion, even though assessee was following mercantile system of accounting, if no real income had accrued to the assessee, then the same could not be charged to tax.

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