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CASE NO.: Appeal (civil)  310 of 2001

PETITIONER: Mercantile Bank Ltd., Bombay

RESPONDENT: The Commissioner of  Income Tax Bombay City-III

DATE OF JUDGMENT: 01/05/2006

BENCH: Ruma Pal & Dalveer Bhandari

JUDGMENT: J U D G M E N T

WITH C.A. NO.311 OF 2001

RUMA PAL, J.

       The assessment year in question is 1978-79. The two  questions which are to be answered in this appeal are:  i)      Whether the appellant is liable to be taxed  under the Income Tax Act, 1961 (referred to  hereinafter as the "Act") in respect of the  interest on doubtful advances credited to the  interest suspense account?   ii)     Whether two separate limits apply for the  purposes of computing disallowance under  Section 40A (5) of the Act where an employee  retires and ceases to be in employment during  the previous year, so that one limit will apply  in respect of the amounts and benefits received  by him as an employee and another for the  amounts and benefits received by him as a  former employee.

  The High Court answered both the questions in favour  of the Revenue and against the Assessee. Being aggrieved the appellant has approached this Court.   As far as the first question is concerned, the High Court  answered it in the affirmative relying on the decision of this  Court in State Bank of Travancore vs. Commissioner of  Income Tax . In the decision of State Bank of Travancore  Vs. Commissioner of Income Tax  the minority opinion  expressed by Tulzapurkar, J, was that the stickiness  of  advances or loans objectively established to the satisfaction of  the Taxing Authorities by furnishing a proper material, is  sufficient to prevent the accrual of interest thereon as real  income and would have the affect of rendering such income  hypothetical. Therefore the interest cannot be brought to tax  irrespective of the method of accounting followed, provided the  assessee was able to establish to the satisfaction of the Taxing  Authority that the loans had in fact becomes sticky during the  concerned year or years by producing proper material and that  the assessee had invariably followed the practice of carrying  the interest of such loans to interest suspense account instead  of crediting the same to interest account or profit and loss  account with the additional safeguard of offering the same for  taxation if and when it was subsequently realized.

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The majority view, however was that carrying certain  amounts which had accrued as interest without treating it as  a bad debt or irrecoverable interest but keeping it in suspense  account would be repugnant to Section 36(1)(vii) read with  Section 36 (2) of the Act.  Where the mercantile system of  accounting  was followed and loans had not been written  off  the amounts accrued on the loans were income assessable to  tax. The question again arose for consideration before a  bench of three Judges in the case of UCO Bank Vs.  Commissioner of Income Tax (1999) 237 ITR 889,  where  the Court  affirmed the minority view of Tulzapurkar J, in   State Bank of Travancore’s case.  The assessment year in  question in that case was 1981-82. The interest on loans the  recovery of which was doubtful  had not in fact been recovered  by the assessee bank for the last three years and had been  kept in a suspense account and had not been brought to the  profit and loss account of the assessee because the amounts  were not likely to be realized.  The Court found that this  method of accounting was in accordance with  established  accounting practice.  Additionally it was held that the Central  Board of Direct Taxes had issued a circular on 6th October  1952 stating that the interest on sticky loans which were  entered in the suspense account need not be included in the  assessee’s assessable income provided the Income Tax Officer  was satisfied that there was no real probability of the loans  being repaid.   Although the 1952 circular was withdrawn in June  1978 in view of the decision of the Kerala High Court to the  contrary in State Bank of Travancore vs. Commissioner of  Income Tax (1977) 110 ITR 336,  the principle was  reintroduced  by the Central Board of Direct Taxes by  another  Circular dated 9th October, 1984.  The 1984 Circular clarified  that up to the Assessment years 1978-79 the taxability of  interest on doubtful debts credited to suspense account would  be decided in the light of the Board’s earlier Circular dated 6th  October, 1952 as the said Circular was withdrawn only in  June, 1978.  With effect from 1979-80 the new procedure  prescribed under the 1984 circular would apply.  The  procedure prescribed is not relevant for our purposes. But it is  clear that the circular issued in 1978  was effectively set aside  and rendered ineffective.  The Court in UCO Bank’s case (supra) was of the view  that these Circulars dated 6th October, 1952 and 9th October,  1984 were binding on the authorities under Section 119(1) of  the Act.  The Court was also of the view that  the judges in  State Bank of Travancore (supra) did not have the occasion  to consider the 1984 circular and proceeded on the  assumption that the 1978 circular was in force.   The Court  did not agree with the conclusion expressed by the majority in  State Bank of Travancore  and said:- "The relevant circulars of CBDT  cannot be ignored. The question is  not whether a circular can override  or detract from the provisions of the  Act: the question is whether the  circular  seeks to mitigate the rigour  of a particular section for the benefit  of the assessee in certain specified  circumstances.  So long as such a  circular is in force it would be  binding on the departmental  authorities in view of the provisions  of Section 119 to ensure a uniform  and proper administration and

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application of the Income Tax Act".  (para 18, pg.610)

Therefore the assessment year in question in this appeal  should have been dealt with by the Department in accordance  with the 1952 Circular under which the interest on doubtful  loans could not be brought to tax.  The decision of the High Court on the first question,  having been based on the decision in State Bank of  Travancore must be held to be incorrect in view of the  subsequent judgment  of this Court in the case of UCO Bank  Vs. Commissioner of Income Tax. As far as the second question is concerned, Section 40A   (5) in so far as it is relevant provided:- "40A. Expenses or payments not  deductible in certain circumstances.\027 (1) The provisions of this section shall  have effect notwithstanding anything to  the contrary contained in any other  provision of this Act relating to the  computation of income under the head  "Profits and gains of business or  profession".

(2) (a) xxx             xxx             xxx      (b) xxx            xxx             xxx (3)       xxx           xxx             xxx (4)      xxx            xxx             xxx (5) (a) Where the assessee\027 (i)     incurs any expenditure  which results directly or  indirectly in the payment of  any salary to an employee or a  former employee, or   (ii)  xxx               xxx             xxx

then, subject to the provision of  Clause (b), so much of such  expenditure or allowance as is in  excess of the limit specified in  respect thereof in Clause (c) shall  not be allowed as a deduction;

xxx             xxx             xxx

(c) The limits referred to in clause  (a) are the following, namely:-

(i) in respect of the expenditure referred  to in sub-clause (i) of Clause (a), in the  case of an employee, an amount  calculated at the rate of five thousand  rupees for each month or part thereof  comprised in the period of his  employment in India during the previous  year, and in the case of a former  employee, being an individual who ceases  or ceased to be the employee of the  assessee during the previous year or any  earlier previous year, sixty thousand  rupees:

The issue is - when an employee ceases to be in  employment during the previous year, is the employer entitled

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to deduction at the rate of Rs. 5,000/- p.m. as long as the  employee was in employment and again up to the limit of Rs.  60,000/- when the employee retires? The Calcutta High Court in the case of Hindustan  Motors Limited Vs. Commissioner of Income Tax (1985)  156 ITR 223  construed the provisions of Section 40A (5) (c)   came to the conclusion that for the period that an employee  remains in service he is to be treated  as an employee and all  payments made to him as an employee would be allowed as a  deduction within the permissible monthly limit.  After that  period, when such an employee retires, he is to be treated as a  former employee and payments made to him as former  employee again ought to be deductible within the permissible  limit.  The Court was of the view that any other construction of   such section under which such an employee is treated only as  "an employee" or as a "former employee" in the year in  question would render one part or the other of the section  nugatory. The Court rejected the submission on behalf of the  Revenue that the status of the employee as on the last date of  the previous year should be taken into consideration for the  purpose of fixing the limit of deductions. The Court said if this  contention was to be accepted then the salary paid to the  employee while he was in employment cannot be taken into  account in determining the ceiling of allowable deduction  under Section 40A (5).  The Court referred to Section 40A (5)(a)  and noted that the first proviso thereunder provided a ceiling   of Rs. 72,000/- on the permissible  deduction or of  expenditure or allowances consisting of the aggregate of four  different types of expenses and allowances mentioned  thereunder.  Similarly, under Section 40A (6) where any  expenditure was incurred by an assessee on payment of fees  as well as on payment of salary to that employee, the  deduction in respect of such expenditure was limited to Rs.  60,000/- in the aggregate. The Court noted that wherever  the  legislature had intended to limit the expenditure taking the  different contingencies into account it has made the  appropriate provision by prescribing an aggregate ceiling.  Section 40A (5) (a), (i) read with Section 40A(5) (c) (i) of the  Act  did not refer to any aggregate amount of deduction  although  two different contingencies were provided therein.  The Court  was also of the view that if the contrary interpretation were  accepted, the employer would defer the payment of the  gratuity or any other sum payable to an employee on his  employment to the subsequent accounting year to get out of  the mischief of the ceiling prescribed under Section 40A (5) (c)  (i) of the Act. This could not have been the intention of the  legislature.  Finally, it was held that if a provision of a taxing  statute was reasonably capable of more than one  interpretation, that interpretation which was favourable and  beneficial to the assessee must be accepted, even if it results  in his obtaining a double advantage.  The Bombay High Court disagreed with the reasoning.  It  relied on the definition of "salary" in Section 17 which  included pension, gratuity and other retiral benefits.  It has  also noted that under Section 45A (c) (i) the expression  "employee" comes within the definition of expression "former  employee".  It  held that the status of an "employee" on the last  date of the relevant previous year would have to be seen for  fixing the limit of deduction.  It held that there were no  separate limits prescribed by Section 40A (5). There was only  one limit in respect of the "salary" and, therefore, the object  was to limit the deduction of expenditure on account of   "salary" and that limit was the single one of Rs. 60,000/- Learned counsel appearing on behalf of the appellant has  urged that the view expressed by the Calcutta High Court in

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Hindustan Motors Vs. Commissioner of Income Tax  should  be accepted.  As far as the respondents are concerned, they  have reiterated the reasoning of the Bombay High Court and  have submitted in addition that the word "and"  in Section 40  A(5) (c) (i) should be read disjunctively as "or". Several  decisions have been cited in support of this principle of  interpretation. We are of the opinion that the opinion expressed by the  Bombay High Court is correct.  The intention of the Legislature  was to fix limits of deduction under the various clauses of sub  section (5) of Section 40A.  If the view  accepted by the  Calcutta High Court were to be accepted the fixation would be  meaningless as the limits would vary depending on the date on  which an employee may retire.  According to the Calcutta High  Court’s view if an employee serves for 12 months, and retires  on the last day of the previous year, the employer would be  entitled to claim a deduction of Rs.60,000/- on account of  salary paid to an employee while in service and another limit  of Rs.60,000/- on account of ’salary’ paid to the employee on  retirement. In other words, the employer would be entitled to a  deduction of two different amounts.   Yet Clause (c) (ii) of sub section (5) of Section 40A speaks  of "an amount". This would indicate that the employer is only  entitled to deduction of one amount.  Clause (c)(i) also speaks  of an employee as being not only one who has ceased to be in  employment, but one who ceases to be in employment.  In  respect of the latter it is assumed that the employee served for  a period but ceases to be so employed during the previous year  in question.  In such a case, the  section expressly provides for  a limit on the deduction of Rs.60,000/- Explanation (2)(a) in sub section (5) of Section 40 A  provides: "Explanation 2. \026 In this sub- section,-

(a) "Salary" has the meaning  assigned to it in clause (1) read with  clause (3) of section 17 subject to  the following modifications, namely:-

(1)     in the said clause (1), the  word "perquisites" occurring in  sub-clause (iv) and the whole of  sub-clause (vii) shall be omitted;

(2)      in the said clause (3), the  references to "assessee" shall be  construed as references to  "employee or former employee"  and the references to "his  employer or former employer"  and "an employer or a former  employer" shall be construed as  references to the assessee".

      Section 17 as it then stood defined ’salary’ as:

(i)     wages;

(ii)    any annuity or pension;

(iii)    any gratuity;

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(iv)    any fees, commission,  perquisites or profits in lieu of  or in addition to any salary or  wages;

(v)     any advance of salary;

(vi)    the annual accretion to the  balance at the credit of an  employee participating in a  recognized provident fund, to  the extent to which it is  chargeable to tax under rule 6  of Part A of the Fourth  Schedule of an employee  participating in   a recognized  provident fund, to the extent to  which it is chargeable to tax  under sub-rule (4) thereof".

              In terms of this there is only one limit for all salary  whatever it may be comprised of whether wages or terminal  benefits.              Reliance on the use of the word "aggregate" in the first  provisos to Section 40A(5)(a) and in Section 40A(6) was inapt.   Both the proviso and sub section (6) deal with different kinds  of payment or expenditure which therefore necessitated the  use of the word "aggregate".  Thus the first proviso refers to: "(a) the expenditure and  allowance referred to in sub- clauses (i) and (ii) of this  clause; and      (b) the expenditure and  allowance referred to in sub- clauses (i) and (ii) of clause (c)  of section 40".    

Similarly sub section (6) refers to

"(a) such expenditure by way of  fees, or

(b) where the assessee has  also incurred in relation to  such person any expenditure  by way of salary referred to in  sub-clause (i) of clause (a) of  sub-section (5), the aggregate  of such expenditure by way of  fees and by way of salary".  

       Sub section (5)(c) on the other hand as we have  seen  speaks of an "amount" and "salary" indicating a single  deduction where the use of the word "aggregate" was uncalled  for.         We would therefore affirm the answer given in the  impugned judgment to the second question in favour of the  revenue and hold that only one limit is prescribed for  deduction on account of salary whether paid to an employee in  service or a retired employee in any one previous year.         The appeal is accordingly partially allowed.  No order as

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to costs.  Civil Appeal No. 311 of 2001

This appeal is partially allowed without any order as to  costs in view of our judgment in Civil Appeal No.310 of 2001.