1985 PLP 715 (PTD)

SETHURAMAN, J.‑At the instance of the Commissioner of Income‑tax ad in pursuance of the direction of this Court,. two questions have been referred under section 256 (1) (256 (2)3) of the Income‑tax Act, 1961. The first of them is :‑ "Whether, on the facts and in the circumstances of the case and having regard to the terms of the agreement entered into between the parties and in the light of the entries contained in the accounts of the assessee, the Appellate Tribunal was right in deleting the commission added to the assessee's income for the respective assessment years?"

2. The assessee is private limited company. It derives income inter alia from film distribution and financing. We are concerned with the assess ment years 1964‑65, 1965‑66 and 1966‑

67. The relevant accounting years re the Tamil years. The assessee had entered into an agreement with Matha 'ictures on 19th September, 1962. Matha Pictures was producing a Kannada film called "Sathi Sakhti". While the film was in the process of production, he producer who wanted finances for completing the picture, approached he assessee and offered to entrust it with the exclusive rights of distribution n certain areas in Karnataka State. The assessee agreed to advance a sum if Rs. 2,80,000 to be spent only towards the production of the said picture. a sum of Rs. 85,000 was to be paid in full settlement of the amounts due to mother distributor. The balance was to be paid on different occasions. nor instance, a sum of Rs. 40,000 was to be paid on signing the agreement, mother sum of Rs. 25,000 after fifteen call‑sheets were shot, another sum of Rs. 25,000 after completing thirty call‑sheets which would complete the picture and the balance of Rs. 80,000 was to be retained towards the cost of prints in publicities. There were certain other provisions which are usually to be found in such agreements and which are not of any significance to me. It is enough for our purpose to refer to those clauses which are material. Clause 5 provided for a distribution commission calculated at 35 per cent. on the net realisation of the picture. Under clause 6 the expression `net realisation' was defined as meaning the distributor's share, after deducting the taxes, 9erived from the screening of the picture. Clause 7 authorised the distributor to deduct the distribution commission as mentioned in clause 5 and appropriate the balance towards the discharge of the amounts advanced to the producers. After the advance was completely adjusted, .he distributor had to remit to the producer the realisations after deducting the distribution commission. Clause 14 provided that in the event of the advance not being fully adjusted and wiped off during the period of twelve months from the date of release of the picture, the producer was to refund to the distributor immediately such unrecouped portion of the amount stipulated. The distributor was also entitled under clause 15 to demand and receive the overflow collections from certain, other distributors. The producer undertook to complete and deliver the prints for the release of the picture on 27‑1 I‑1962, that is, the Deepavali day in that year, failing which it (the producer) undertook to pay damages together with interest for the amount received at 12 per cent per annum from the date of default upto the date of delivery of the prints. If the producer was unable to complete the picture and deliver the prints by the Deepavali day mentioned above, the distributor was at liberty to take possession of the negatives of the picture so far produc ed and to proceed with the completion of the picture at the cost of the producer, in which event the producer was to render all assistance to the assessee for the production and completion of the picture. The expenditure incurred by the distributor was to be entirely borne by the producer which had to be treated as further distribution advance under the contract.

3. In the accounts for the year ended 12‑4‑1964, the assessee had passed entries in its books debiting the account of "Sathi Sakthi", in which the amounts advanced had also been debited with a sum of Rs. 91,887.84 p. The narration in the journal read as follows :‑ "Being the distribution commission at 35 per cent on the realisation of Rs. 2,62,536.68 p. made upto 12‑4‑1964, adjusted to producer's account." The picture was released only in September, 1963 and the collections upto 12‑4‑1964 came to Rs. 2,62,536 68 p. The assessee had actually advanced Rs. 4,37,828.43 p. for the completion of the picture. The net realisation upto 12‑4‑1964 included the realisations for the earlier years. viz. Rs. 2,99,366.68 p.

4. The I.‑T. O., included in the assessment for the assessment year 1964‑65, the said amount of Rs. 91,888 being the commission calculated at 35 per cent of the net realisations during the year ended 12‑4‑1964. Similarly, he included the amount of commission at 35 per cent out of the realisations for the assessment years i 965‑66 and 1966‑67 and brought the amounts to tax. The amounts so brought to tax for those two years came to Rs. 22,152 and Rs. 7,

770. In making these assessments the I. T. O. rejected the assessee's claim that it could expect to earn the commission only after the capital was realised and that so long as the amount realised fell short of the said capital, the assessee could not be taxed on the commission.

5. The assessee appealed against the assessments for all these years to the Appellate Assistant Commissioner who confirmed the assessments. The matter was further taken to the Tribunal and the Tribunal for the reasons stated in its order, dated 7th May, 1974, held that the amount was not liable to be taxed in these years. In the view of the Tribunal, the assessee was justified in coming to the conclusion that till the last day of each of these accounting years there was no scope for realising this income as the collections would barely cover the investments alone. The Tribunal looked into the accounts and found that the assessee had not appropriated any amount to the commission account though, in respect of other pictures for which there were similar distribution agreements, the amounts had been appropriated to the commission account. The Tribunal directed the exclusion of the three amounts mentioned already from the respective assessments. 1t is to challenge this order that the Commissioner of Income‑tax has obtained reference of the questions in this case.

6. Learned counsel for the commissioner contended that the assessee was maintaining accounts on mercantile basis and that on the mercantile system of accounting, the assessee has to show as income the amounts that had accrued as income, whether the accrued amounts were subsequently actually realised or not. It is in this context that he brought to our notice the several decisions to be adverted to presently. For the respondent‑assessee the learned counsel relied on the clauses in the agreement as showing that no income could be said to have accrued to the assessee in the relevant years. He cited certain other decisions, which will also be considered now.

7. We have already summarised the agreement and referred to the relevant clauses, which are material here. The agreement contemplated release of the picture on 27‑11‑1962. It is not in dispute that the picture could not be completed and that the assessee had to take over the production from the original producer. The production was completed only by September, 1963 when the picture was released. Thus, there was a breach of the agreement by the producer as he did not complete the picture within the stipulated period. The further fact that emerges from the accounts as shown in the annexures is that the assessee had actually advanced a sum of Rs. 3,37,828.43 p. He had also to incur further expenditure by 'way of additional prints, excise duty, advertisement charges etc. The total amount incurred by the assessee before distribution of the picture came to Rs 4,63,574.11 p. The realisation upto 12‑4‑1964 was only Rs. 2,62,536.68 p. The further realisations upto 12‑4‑1965 and 13‑4‑1966 came to Rs. 66,298.47 p. and Rs. 22,187.48 p. From these figures it would be clear that the picture had no successful run, Apparently because of the difficulties the producer is stated to have become a sanyasin. But, the assessee had to take over the production of the picture only because he bad made ‑substantial advances and had to look to the realisations for the purpose of recovering the amounts so advanced. The way in which the public received the picture could, in the circumst ances, have shown to the assessee that even the amounts advanced could not have been realised. The question of realisation of the commission or the interest that is contemplated by the agreement would thus be a very doubtful one. It is in the background of these facts that we have to examine the relevant authorities.

8. The Bombay High Court in Kashiparekh & Co. Ltd. v. Commissioner of Income‑tax (1960) 39I T R 706: A I R 1961 Bom. 84) enunciated the principle of "real income" applying to the taxation of income. In that case the assessee maintained its accounts in the mercantile system of accounting. It was managing agent of a paper mill. Under the managing agency agreement it was under a duty to forgo one- third of its commission if the profits of the managed company were not sufficient to pay a dividend of 6 per cent. But, as a result of the resolutions passed by the managed company, the assessee gave up some further amounts. The maximum amount that could have been forgone by the assessee was Rs. 39,215 under the agreement. The balance forgone came to Rs. 57,

785. The question was whether the Income‑tax Authorities were justified in taxing the said sum of Rs. 57,

785. It was held that the assessee could be taxed only on the real income and not on any hyphothetical income. The following passage at page 722 (of I T R) : (at p. 88 of A I R) brings out the principle to be applied in such situations: "We do not think it to be in accord either with the authorities cited that the principle of real income is to be so subordinated as to amount virtually to a negation of it when a surrender or concession of rebate in respect of the managing agency commission is made, agreed to or given on commercial expediency simply because it takes place some time after the close of an accounting year. In examining any transac tion and situation of this nature, the Court would have more regard to the reality and speciality of the situation rather than the purely theoretical or doctrinaire aspect of it. It will lay greater emphasis on the business aspect of the matter viewed as a whole when that can be done without disregarding the statutory language." This decision was referred to with approval by the Supreme Court in Poona Electric Supply Co. Ltd. v. Commissioner of Income‑tax (1965) 571TR521 1 AIR1966SC30). It is not necessary for our present purpose to go into the facts of the decision of the Supreme Court. It is enough to set out certain principle, which has been summarised at page 530 (of I T R) : (at p. 35 of A I R) "Income‑tax is a tax on the real income, i. e. the profits arrived at on commercial principles subject to the provisions of the Income‑tax Act. The real profit can be ascertained only by making the permissible deduction. There is a clear‑cut distinction between deductions made for ascertaining the profits and distributions made out of profits. In a given case whether the outgoings fall in one or the other of the heads is a question of fact to be found on the relevant circumstances having regard to the business principles. Another distinction that shall be borne in mind is that between the real and the statutory profits, i. e. between the commercial profits and statutory profits. The latter are statutorily fixed for a specified purpose." The passage from the decision of the Bombay High Court extracted above was reproduced in Commissioner of Income‑tax v. Arumugham Pillai (1969) 73 I T R 382) and was followed in a later decision of this Court reported in C. I. T. v. Motor Credit Co. Private Ltd (1981) 127 I T R 572). This was a case of a limited company carrying on business as financiers for purchase of motor vehicles under hire purchase scheme. Money had been advanced to two firms carrying on bus transport business. The routes of these two firms were taken over by the State Transport Corporation. The firms defaulted in making the payments of the hire purchase instalments and consequently, the buses were seized. The assessee was advised that there was no prospect of recovering even the principal amount. It did not, therefore, credit interest on the out-standings from the two firms even though it followed mercantile systems of accounting. The Income‑tax Officer, however, included the accrued interest on the out-stan dings due from those firms. The Appellate Assistant Commissioner and the Tribunal deleted the amount from the assessment, and on reference, this Court held that the Tribunal was correct in its conclusion that though the assessee had adopted the mercantile system of accounting no interest could be assessed in its hands on accrual basis as it would be very unrealistic on the part of the assessee to take credit for a highly illusory interest. The principle to be applied in such a situation has been set out at page 576 : "Regular mode of accounting only determines the mode of computing the taxable income and the point of time at which the tax liability is attracted. It cannot determine or affect the range of taxable income or the `ambit of taxation. Where no income has resulted, it cannot be said that income has accrued merely on the ground that the assessee has been following mercantile system of accounts. Even if the assessee makes a debit entry to that effect, still no income can be said to have accrued to the assessee. If no income has materialised, there can be no liability to tax a hypothetical income. It is not hypothetical accrual of income based on the mercantile system of accounts followed by the assessee that has to be taken into account, but what should be considered is whether the income has really materialised or resulted to the assessee. The question whether real income has materialised to the assessee has to be considered with reference to commercial and business realities of the situation in which the assessee has been placed, and not with reference to his system of accounting." We are in agreement with this view.

9. This case broke new ground. The theory of real income had so far come in for application only in two types of cases; namely (1980) 124 I T R 619 :1981 Tax L R 505) where there was a surrender of the income which may in theory have accrued and (198.1) 22 Cur Tax Rep 289 : 1981 Tax L R N O C 212) where there is diversion of income by overriding title. In the case of the Motor Credit Company Private Limited, the facts did not fit in with either of these two categories. But still, this Court considered it proper to apply the principle of real income to such a case, the case being one where interest, though it could be taken to have theoretically accrued, was only illusory or hypothetical.

10. The theory of real income being liable to taxation, is not based on any accounting principle or accounting entries. If accounting entry is the only criterion, then it would furnish easy means of escape for unscrupulous asses sees who, by declining to make an entry, may get out of the net of taxation. Accounting entry does not also create any estoppel as against the assessee and in favour of the department. The liability to taxation is based on the statute and an assessee is not liable to be taxed because of his mistake. In the present case if strictly the principle of mercantile system of accounting is to be stressed, then the assessee could have made an entry crediting the amount of commis sion as its income, and simultaneously or at the close of the year debiting it as a loss of the said income, because the assessee had no hope of recovering the said amount. . The result would be that the entries would have cancelled themselves out and there would be no scope for taxation. It is true as contended by the learned counsel for the Commissioner that there have been receipts as and by way of realisation on the exhibition of the film. But, in the context in which the assessee was placed, where he had not only advanced a huge sum of Rs. 2,80,000 but also further sums totalling in all Rs. 4,37,828, be had to take into account even the principal amount advanced not being realisable. The slow process by which the realisation came in does establish the bona fides of the assessee. Thus, as against a sum of Rs. 4,37,828 incurred as cost of production the assessee was in a position to realise only Rs. 3,47,000 approximately during the years with which we are now concerned. The Tribunal has taken these facts into consideration in holding that the commis sion could not be said to have accrued in favour of the assessee.

11. The High Court of Punjab and Haryana had occasion to consider a related question in Commissioner of Income‑tax v. Ferozepur Finance (P) Ltd. (1971) 82 I T R 835 : 1971 Tax I. R 1558). In that case, the assessee was a financing company as its name itself disclosed. It bad made certain advances to a debtor whose financial position was bad. There was no hope of recovering even the principal amount. The assessee did not, therefore, consider it necessary to charge an interest to the said account. The I. T. O., however, on the basis of the system of accounting being mercantile, brought the amount of interest liable to be charged by the assessee, but not actually entered, as income of the assessee The Appellate Tribunal deleted the addition made by the I. T. O. and in the reference, the High Court held that even in the mercantile system of accounting, an assessee could forgo the whole or part of the amount of debt am the same cannot be added to the income of the assessee. This case support the view that we have indicated above.

12. Learned counsel for the Commissioner placed strong reliance or two decisions, one of the Supreme Court and the other of the Calcutta High Court, The Supreme Court decision is reported in Morvi Industries Ltd. v Commissioner of Income‑tax (1971) 82 I T R 835 : 1971 Tax I. R 1558). In that case, the assessee was the managing agent and as such, entitled to commission and office allowance. By resolutions passed after the commission had become due, the assessee relinquished its commission on sales and office allowance, because the managed company had suffered heavy losses in the past years. The Calcutta High Court held agreeing with the Tribunal, that the relinquishment by the assessee of itl remuneration after it had become due was of no effect and that the amount was liable to be taxed. The Supreme Court confirmed this decision. The Supreme Court has considered the question only in the light of the system of accounting followed by the assessee. The decision of the case turned on the fact that the relevant resolution was passed after the accounting year when the commission had accrued. The aspects which we have referred earlier had not been put forward in the said case and we do not find the principle of that decision to be applicable here.

13. The decision of the Calcutta High Court is reported in James Finlay & Co. v. Commissioner of Income‑tax (198.1) 22 Cur Tax Rep 289 : 1981 Tax L R N O C 212). The assessee in that case had advanced monies to two parties and the amount receivable as interest was credited to the suspense account. The assessee was following the mercantile system of accounting. According to the assessee, there was an extreme unlikelihood of the loan being recovered. The High Court held that having regard to the system of accounting followed by the assessee, the amount was liable to be taxed. It is in this context that the principle of real income was considered and it was pointed out that in examining any transaction the Court would have more regard to the reality and speciality of "the situation rather than the theoretical or doctrinaire aspect. It would lay greater emphasis on the business aspect of the matter viewed as a whole when that can be done without disregarding the statutory language. However, while considering the facts, it was pointed out that the agreement did not provide for giving up the interest and that there was no claim of waiver of interest at all. The waiver of interest would be inconsistent with the account-entries, since the interest had been credited to the suspense account. Thus, the decision turned on the particular facts. However, in so far as the learned Judges have referred to the reality of the situation rather than the theoretical or doctrinaire aspects of it, we are in agreement with them.

14. The only other decision to which reference was made by the counsel for the Commissioner was that State Bank of Travancore v. Commissioner of Income‑tax (1977) 110 I T R 336 : 1975 Tax E, R 886 (Ker.). In that case, the assessee, a Bank did not credit in its account interest accrued on what were called "sticky advances" because the assessee felt that the interest may not be paid. It credited the interest to a separate account known as interest suspense account. On a reference it was held by the Kerala High Court that there was accrual of income liable to tax and that the assessee was not justified in not crediting the interest accrued on such advances in its interest account. The Court has not gone into the principle of real income which we have discussed above. The case turned on the manner of maintenance of accounts and the accrual of income therefrom. In these circumstances, we do not think it possible to apply the said decision to the facts here. .

15. The result is that the first question is answered in the affirmative and in favour of the assessee.

16. The second question referred to us runs as follows :‑ "Whether, on the facts and in the circumstances of the case, the Appellate Tribunal was right in cancelling the penalties levied under section 271 (1) (c) in the assessee's case?" For the three years, penalties, under section 271(1) (c) of the Acct were levied by the Inspecting Assistant Commissioner, in relation to the aforesaid amounts, as if, they were concealed income. The amounts so levied as penalty came to Rs. 20,071.71 p. and Rs. 2,183 respectively. The Tribunal cancelled those penalties in the light of its decision that the relevant amounts brought to tax in the assessment as income, which has resulted in the levy of, penalties, were not taxable as income. As the amounts did not represent income, there was no question of the assessee disclosing the same in its return and therefore, the penalties levied were cancelled. As we have agreed with the conclusions of the Tribunal, we consider that there is no question of levy of penalty on the facts here. When the amounts were not liable to be taxed, there could be no levy of penalty for their omission from the return. The question relating to penalty is also answered in the affirmative and in favour of the assessee. The assessed will be entitled to its costs. Counsel's fee, Rs. 500 (Rupees five hundred only), one set. M. B. A. Reference answered in the affirmative.