Blog # 26. Concept of Real Income under the Income Tax Act, 1961

The Concept of Income and Real Income Under the Income Tax Act

1. What is Income?

Before understanding the concept of Real Income, it shall be important to go through the terms “Income” and “Real”.

Income is defined under Section 2(24) of the Income Tax Act, 1961 (Hereinafter referred as “the Act”). The definition as provided under the Act is an inclusive definition so as to cover up all the usual as well as unusual items, however it certainly does not define it in a way that we can be said it to be precise.

The same can be understood by various Judge Made Laws. The first and the lead amongst them is a Privy Council Judgment in the case of:

Kamakshya Narain Singh CIT 11 ITR 513 (PC)

Facts: The assesse was a “Raja” gave mining lease and He received payments by way of royalty for coal mines leased out to various lessees. The case of the Assessee was that this royalty income received by the Assessee was nothing but the recoupment of the resources which shall be exhausted by the end of the lease and thus the same was not income but a capital receipt.

Held:

"Income, it is true, is a word difficult and perhaps impossible to define in any precise general formula. It is a word of the broadest Connotation".

CIT vs M/s Bhogilal Laherchand Including Batliboi and Co. 25 ITR 50

Facts: Question raised before the Supreme Court (In todays Context Section 5 read with Section 9). The Assessee claimed that there is no law to treat income as “deemed income”. The legislature cannot treat something as deemed income which was not an income at the first place.

Held:

The Supreme Court held that the Legislature has power to bring in to ambit such receipts and tax it in accordance with the law.

Navincahandra Mafatlal vs CIT in [1954] 26 ITR 758 (SC)

Facts: In the 1922 Act, capital gain was not taxable, however by way of an amendment, capital gain was included as taxable. The Question came up before the Supreme Court that whether capital gains can be considered as “Income” (With reference to interpreting the word “income” in item no. 54 in List I of the Seventh Schedule of the Government of India Act, 1935).

Held:

The Supreme Court in this judgment after relying upon English Jurisprudence held that it is always open to the legislature to treat even receipt of capital nature as income.

Sardar Baldev Singh Vs Commissioner of Income Tax [1960] 40 ITR 605 (SC)

Facts: Whether Legislature has power to include “Income of other person” in the hands of some other Person?

Held:

The Answer is Yes. The supreme court held that a law could also be passed to prevent a person from evading the tax payable on his own income. A Law can also be passed not only as authorising the imposition of a tax but also as authorising an enactment which prevents the tax imposed being evaded.

Balaji Vs ITO (1961) 43 ITR 393

Held:

The Supreme Court further held that the scope of “Income” is wide enough so as to instances wherein the income may not have been earned by the Assessee, but his spouse.

CIT vs Navnitlal Zaveri 56 ITR 198

Facts: Loan is not an income but we all are aware that S.2(22)(e) covers loans/ advances received by a share holder in conditional circumstances to be its income. The Question was raised whether transaction which has no element of income, such as transaction of loan can be brought under the purview of the word “Income” by creating a deeming fiction.

Held:

The Supreme Court held that the private companies if would have distributed the dividend, then shareholders would have paid the taxes, this is nothing else but a device to utilise the funds of the company without payment of taxes and therefore attempt of the legislature to tax even the loan as deemed income is a valid exercise.

Union of India Vs A. Sayasi Rao [1996] 85 Taxman 321 (SC)

Facts: Section 44AC which taxes income on the presumptive basis was brought in to the statute book and the Assessees challenged the piece of law on the basis that the tax is not imposed on the income and is imposed on the turnover and the union has no power to levy tax on turnover.

Held:

The Hon’ble Supreme Court held that though it is a tax on turnover, it is not a turnover tax, it is an income tax because we are now, reading down the law to require that if the assesse claims, that its taxable income is not percentage of turnover, he will be taxed on actual assessment and not on income which is presumed to be his income.

Summary: In short while construing the term income, the courts have construed it in a very wide manner so as to include, transactions, loans, and various situation which may not ordinarily be regarded as income, but has been considered as “Income”.

2. What is Real Income?

An assessee is required to pay tax on its income. The concept of income is discussed hereinabove. As per Section 145 of the Act, the income under the head “Business or profession” or “Income from other Sources” shall be determined on the basis of Accounting, followed by an assesse regularly, being mercantile system or cash system. However, there may be situation, wherein it may appear that the assesse has earned income but in reality, he may claim that he hasn’t earned such income and that is how, the concept of Real Income has evolved.

The fundamental question thus arises as to what do we mean by the term “Real”? Something which has not been earned by the Assessee, something which is being regarded as having been earned by the Assessee on a notional or Hypothetical basis but in reality is not being earned it, is being taken out from the sphere of income.

In order to better understand the concept of “Real Income”, as it stands today, it is important to go through the history of its evolution in different courts:

D. Sassoon & Co. Ltd. v. Commissioner of Income-tax [1954] 26 ITR 27 (SC)

Facts: Assessee-company were managing agents of three companies. They transferred their managing agencies to other companies during relevant accounting year and received consideration which was taken to 'capital reserve account'. As per Agreement of agency, the amount of commission becomes payable per annum, ie. only at the end of the year. The ITO taxed the commission on prorate basis ie on the basis of Services.

Held:

The Supreme Court held that as no income had accured to assessee-company on dates of respective transfers of managing agencies as the contract stipulated the accrual at the end of the year, assignment before such date to transferees defers the accrual in the hands of the Assessee.

CIT Vs. Shoorji Vallabhdas & Co.[1962] 46 ITR 144 (SC)

Facts: For the A.Y. 1948-49 Assessee-firm was managing agents of two companies. It was entitled to receive as its commission, at the rate of 10 per cent of freight charged. In 1948 on request of managed companies assessee agreed to reduce commission to 2½ per cent. In assessment proceedings, ITO took view that amount of larger commission (@10%) had already accrued.

Held:

Since reduction in share of commission was part of agreement entered into by assessee-firm agreed upon before the end of the year, larger income (@10%) neither accrued nor was received by assessee during relevant assessment year and thus only 2½ is what that can be said to have accrued.

Morvi Industries Vs CIT [1971] 82 ITR 835 (SC)

Facts: The assessee-company relinquished the managing agency commission after it became due but before it was payable in terms of clause 2(e) of the agreement, on the ground that the managed company had been suffering heavy losses. The ITO included the relevant amounts in the assessee's total income, on the ground that the commission having been forgone after it had become due, it was taxable on accrual basis.

Held:

The Supreme Court observed that in the present case, the Assesse has relinquished its rights after the income was accrued, after the completion of the year. Thus relinquishing the right to recovery does not mean that the income never accrued.

Summary: From the above cited cluster of 3 cases, it can be said that the concept of Real Income shall be checked upon at the time of Accrual and not at the time of receipt.

3. Evolution of the Law Thereafter

Godhara Electricity Co. Ltd. Vs. CIT [1997] 91 Taxman 351 (SC)/225 ITR 746

Facts: The assessee-company enhanced the charges for electricity. Suits filed by the consumers challenging enhancement were allowed by the lower courts. During pendency of these litigations the assessee-company was not able to realise the enhanced charge. The Assessing Officer included the disputed amount in the hands of the assessee-company on the ground that it was following mercantile system of accounting.

Held:

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 considered by taking the probability or improbability of realisation in a realistic manner.

Tests laid down by the Hon’ble Supreme Court to determine Real Income:

• Whether the income accrued to the assessee is real or hypothetical.

• Whether there is a corresponding liability of the other party.

• The probability or improbability of realisation of the such income by the assessee considered from a realistic and practical point of view.

CIT Vs Excel Industries Ltd. [2013] 358 ITR 295

Facts: The assessee maintained its accounts on mercantile basis and claimed deductions under the head 'advance license benefit' receivable. The Assessing Officer did not accept the claim on the ground that the taxability of such benefits was covered by section 28(iv).

Held:

There was no corresponding liability on the customs authorities to pass on the benefit of duty free imports to the assessee until the goods are actually imported and made available for clearance. The benefits represent, at best, a hypothetical income which may or may not materialise. Essentially, the Assessing Officer is required to be pragmatic and not pedantic.

4. Where did the Concept of Real Income Failed and Why?

State Bank of Travancore Vs CIT [1986] 158 ITR 102(SC)

Facts: The assessee used to charge interest on advances, including even those which it considered doubtful of recovery, termed as 'sticky advances'. It credited the same to a separate account called 'Interest suspense account' and claimed that the sums were not taxable.

Held:

It would be difficult and improper to extend the concept of real income to all cases depending upon the ipse dixit of the assessee. The concept of real income is certainly applicable in judging whether there has been income or not, but in every case it must be applied with care and within well-recognised limits, and must not be called in aid to defeat the fundamental principles of law of income-tax.

Shiv Prakash Janak Raj & Co. (P.) Ltd. 222 ITR 583 (SC)

Facts: The assessee-company had advanced a loan on which it was charging interest. However, it passed a resolution before the end of the accounting year deciding not to charge interest from the firm in view of the difficult financial position.

Held:

The concept of real income cannot be employed so as to defeat the provisions of the Act and the Rules. Where the provisions of the Act and the Rules apply, it is only those provisions which must be applied and followed.

Shri Mahila Sewa Sahakari Bank Ltd. 395 ITR 324 (Guj.)

Summary: The concept of real income can be applied at the Accrual stage and not thereafter. The same cannot be employed so as to defeat the provisions of the Act and the Rules.

5. Relevancy of Accounting Entry Vis a Vis the Concept of Real Income

Can an entry, its absence or otherwise in the books of accounts determine the taxability of Income?

Tuticorin Alkali Chemicals & Fertilizers Ltd. Vs CIT [1997] 227 ITR 172

Facts: The assessee-company invested funds borrowed for the purpose of setting up factories in short-term deposits and earned interest. It filed revised return claiming that interest and finance charges should go to reduce the pre-production expenses which would ultimately be capitalised.

Held:

It is well-settled that income attracts tax as soon as it accrues. The application or destination of the income has nothing to do with its accrual or taxability.

CIT Vs U.P. State Industrial Development Corporation [1997] 225 ITR 703 (SC)

Facts: The assessee reduced the cost of the shares held by it as stock-in-trade instead of crediting the underwriting commission and brokerage to its profit and loss account.

Held:

It is a well-accepted proposition that for the purposes of ascertaining profits and gains the ordinary principles of commercial accounting should be applied, so long as they do not conflict with any express provision of the relevant statute.

CIT Vs Virual Soft Systems Ltd. [2018] 404 ITR 409 (SC)

Facts: The assessee claimed deduction for lease equalization charges. The Assessing Officer disallowed deduction claimed.

Held:

The bifurcation of the lease rental is, by no stretch of imagination, an artificial calculation and, therefore, lease equalization is an essential step in the accounting process to ensure that real income from the transaction in the form of revenue receipts only is captured for the purposes of income tax.

6. Concept of Real Income while Valuing the Closing Stock

United Commercial Bank Vs CIT [1999] 240 ITR 355

Facts: The Assessee as per the RBIs directive valued all the securities (closing stock) on cost while preparing the financial statements. It claimed a notional loss on account of closing stock of securities at the market value.

Held:

For the purpose of income-tax whichever method is adopted by the assessee, a true picture of the profits and gains, that is to say, the real income is to be disclosed. Preparation of the balance sheet in accordance with the statutory provision would not disentitle the assessee in submitting the income-tax return on the real taxable income in accordance with the method of accounting adopted by the assessee.

Sanjeev Woolen Mills vs CIT [2005] 279 ITR 434 (SC)

Facts: The assessee valued the closing stock at the higher market-rate and claimed deduction under section 80HHC, inflating the profits.

Held:

Valuing the closing stock at the market value irrespective of the fact whether the market value of the stock at the relevant time was more than the cost value of the stock necessarily resulted in an imaginary or notional profit. It is a settled principle of the Income-tax Law that it is the real income which is taxable under the Act.

CIT vs Bannari Amman Sugars Ltd. [2012] 249 ITR 738 (SC)

Facts: Assessee valued the closing stock of incentive sugar (free sugar) at levy price. The Department valued the closing stock of incentive sugar at cost.

Held:

If the Stock is valued at cost, the difference between the cost price and levy price would be treated as a revenue receipt and tax shall be levied on such difference which cannot be permitted in the given circumstances.

7. Diversion of Income by Overriding Title

Sithaldas Tirathdas Vs CIT [1961] 41 ITR 367 (SC)

Facts: The assessee claimed deduction from his total income of the amount paid under a consent decree as maintenance to his wife and children.

Held:

Where by the obligation income is diverted before it reaches the assessee, it is deductible; but where the income is required to be applied to discharge an obligation after such income reaches the assessee, the same consequence, in law, does not follow.

Murlidhar Himatsingka vs CIT [1966] 62 ITR 323 (SC)

Facts: 'M' was carrying on business and also a partner in registered firm. A deed of partnership was executed by 'M' and his sons, creating a sub-partnership.

Held:

In the case of sub-partnership the sub-partnership creates a superior title and diverts the income before it becomes the income of the partner.

CIT Vs Sunil J. Kinariwala [2003] 259 ITR 10 (SC)

Facts: The assessee, partner of a firm, created a trust assigning 50 per cent out of his right in favour of the said trust.

Held:

When a third person becomes entitled to receive the amount under an obligation of an assessee even before he could lay a claim to receive it as his income, there would be diversion of income by overriding title; but when after receipt of the income by the assessee, the same is passed on, it will be a case of application of income.

8. Test of Real Income Applied on Any Other Head of Income

CIT vs Balbir Singh Maini [2017] 398 ITR 531

Facts: A tripartite Joint Development Agreement (JDA) fell through due to a lack of statutory permissions. The ITO attempted to tax the capital gains based on the initial handing over of possession.

Held:

In the facts of the present case, it is clear that the income from capital gain on a transaction which never materialized is, at best, a hypothetical income. No profits or gains 'arose' from the transfer of a capital asset so as to attract sections 45 and 48.

Summary Table of Key Citations