Commissioner of Income-Tax, Madras vs A. Gajapathy Naidu

Rewritten Version Notice: This is a rewritten version of the original judgment.

Court: supreme-court

Case Number: Civil Appeal No. 617 of 1963

Decision Date: 16 April 1964

Coram: J.C. Shah, S.M. Sikri, Subba Rao

The case titled Commissioner of Income‑Tax, Madras versus A. Gajapathy Naidu was decided by the Supreme Court of India on 16 April 1964. The judgment was delivered by a bench that included Justice Subbarao, Justice K. Shah, Justice J. C. Shah and Justice S. M. Sikri. The official citation of the decision is 1964 AIR 1653 and it also appears in the Supreme Court Reporter as 1964 SCR (7) 767. The matter concerned the interpretation of section 4(1)(b)(ii) of the Indian Income‑Tax Act, 1922, particularly the meaning of the words “accrue” or “arise” and the proper year of assessment for income arising out of an earlier transaction.

According to the factual situation, the assessee received a certain sum of money as compensation for a loss that he suffered in respect of a supply made during the preceding accounting year. The Income‑Tax Officer, acting under the provisions of the Act, included that amount in the assessment year in which it was actually received. The assessee challenged this inclusion before the Appellate Assistant Commissioner and later before the Income‑Tax Tribunal, but both authorities upheld the officer’s assessment. The matter was then referred to the High Court, which held that although the legal right to receive the compensation did not arise during the accounting year of the contract, the amount should nevertheless be deemed to relate to that earlier year, i.e., the year of the contract, and should be taxed accordingly. The Commissioner appealed the High Court’s decision by way of a certificate of appeal, and the Supreme Court was asked to consider whether the High Court’s approach was correct.

The Supreme Court first observed that the High Court’s decision was misguided because it relied on English decisions that were decided in circumstances peculiar to England and on the construction of statutory provisions that were not identical to those in Indian law. The Court emphasised that provisions of the Indian Income‑Tax Act must be interpreted on their own terms, without drawing analogies from English statutes merely because some words appear similar. The Court noted that such analogies can be misleading, since the same words may have acquired different meanings in the respective legal developments of the two jurisdictions. In support of this principle the Court referred to the decision in Commissioner of Income‑Tax v. Vazir Sultan & Sons, [1959] Supp. 2 SCR 375.

Next, the Court explained the meaning of the words “accrue” or “arise” as used in section 4(1)(b)(i) of the Income‑Tax Act. It held that income is said to accrue or arise in the year in which the assessee obtains a right to receive it. This definition was adopted from the decision in S. D. Sassoon and Co. Ltd. v. Commissioner of Income‑Tax, Bombay City, [1955] 1 SCR 313, and was consistent with the earlier English case Rogers Pyatt Shellack & Co. v. Secretary of State for India (1925) I.L.R. 52 Cal 1, which the Court approved. Accordingly, when an Income‑Tax Officer decides whether a particular amount of income should be included in an assessment, he must first determine the system of accountancy adopted by the assessee and, if the mercantile system is used, ascertain the year in which the right to receive that amount accrued, subject to the deemed‑provision rules. If the officer concludes that the right accrued in a specific accounting year, then that income must be charged to the assessment of the succeeding year.

Finally, the Court held that the Income‑Tax Officer has no authority under the Act to back‑date an income that accrued in a later year to an earlier year merely because the income arose from a transaction that occurred earlier. The meaning of “accrue” or “arise” in section 4(1)(b)(i) cannot be stretched to include amounts that are actually received in a later year, even if the receipt is based on a right that originated earlier. Such amounts are, in law, deemed to be received only in the year of actual payment. The Court relied on the English authorities J. P. Hall & Co. v. Commissioner of Inland Revenue (1921) 12 T.C. 382 and Severns (H.M. Inspector of Taxes) v. Dadawall (1954) 35 T.C. 649, and also approved the decision of Commissioner of Income‑Tax, U.P. v. P. V. Kalicharan Jagannath, [1961] 41 ITR 40. Consequently, the assessment made by the Income‑Tax Officer for the year in which the compensation was received was affirmed, and the High Court’s view was set aside.

The Court observed that the Income‑tax Act does not empower an Income‑tax Officer to reverse‑track an amount that accrued or arose in a later year and attribute it to an earlier year simply because the transaction giving rise to that amount took place earlier. In other words, the statutory provision concerning the “accrual” or “arising” of income in section 4(1)(b)(i) cannot be broadened to include sums that the assessee actually receives in a subsequent year, even if the right to receive those sums was established in the earlier year. Such amounts, according to law, are deemed to be received by the assessee only in the year in which payment is made. The Court referred to the decisions of J. P. Hall & Co. v Commissioner of Inland Revenue (1921) 12 T.C. 382 and Severns (H. M. Inspector of Taxes) v Dadawall (1954) 35 T.C. 649, and approved the authority in Commissioner of Income‑tax, U.P. v P. V. Kalicharan Jagannath [1961] 41 I.T.R. 40.

The judgment under consideration arose in a civil appellate jurisdiction, specifically Civil Appeal No. 617 of 1963, which challenged the order dated 15 March 1960 of the Madras High Court in Case Referred No. 87 of 1955. The appellant was represented by counsel, and the respondent was also represented by counsel. On 16 April 1964, Justice Subba Rao delivered the opinion of the Court. The appeal was filed by way of certificate against the High Court’s ruling that a sum of Rs 12,447 received by the respondent from the Government during the accounting year 1950‑51 was not taxable for the assessment year 1951‑52.

The respondent, Gajapathy Naidu, was engaged in supplying provisions to the Government Stanley Hospital at Royapuram, Madras. During the financial year from 1 April 1948 to 31 March 1949, he entered into a contract with the Government to supply bread to the hospital at a rate of Rs 0‑4‑6 per pound. Maintaining his books on a mercantile basis, he ordinarily recorded the amount due from the Government under the contract as a credit in his accounts for that same year. Accordingly, the Income‑tax Officer assessed his income‑tax liability for the assessment year 1949‑50 on the basis of those accounts.

Subsequent to 31 March 1949, the respondent made representations to the Government seeking relief from the loss incurred in supplying bread to the hospital. By an order dated 24 November 1950, the Government directed that compensation be paid for the loss sustained during the 1948‑49 contract period. The respondent received the compensation of Rs 12,447 during the accounting year 1950‑51. In the assessment year 1951‑52, the Income‑tax Officer included this compensation amount in the respondent’s taxable income. The assessee, among other arguments, contended that the sum was received in respect of the contract entered into in the 1948‑49 accounting year and therefore should not be assessed in the 1951‑52 assessment year.

In this case the assessee argued that the sum of Rs 12,447 that he received was compensation for a contract he had entered into with the Government during the accounting year 1948‑49, and therefore the amount could not be taxed in the assessment year 1951‑52. The Income‑tax Officer rejected that argument, a decision that was upheld by the Appellate Assistant Commissioner and later confirmed by the Income‑tax Appellate Tribunal. The matter was then referred to the High Court under section 66(1) of the Indian Income‑tax Act, 1922, where two specific questions were posed: first, whether the amount of Rs 12,447 was assessable to income‑tax; and second, if it was assessable, whether it had been properly included in the assessment for the year 1951‑52. The High Court answered the first question affirmatively, holding that the amount was directly related to the assessee’s business and therefore constituted taxable trade income. No party before this Court contested that finding, so the judgment makes no further comment on it. Concerning the second question the High Court answered in the negative, concluding that the amount had not been correctly assessed in 1951‑52. The Court’s reasoning proceeded in three steps. First, it observed that at the time the bread was supplied the assessee’s only entitlement was to debit the Government at the stipulated contract rate; he was not entitled to any additional payment. The later Government order that raised rates and led to the ex gratia compensation was issued after the original transaction, so the Rs 12,447 could not have been recorded as a receivable in the books for the year 1948‑49, and those accounts had already been closed. Second, the Court stated that when a receipt is correlated with and arises out of a commercial transaction between the parties, the related right or liability should be deemed to have arisen in the earlier accounting period. This principle was not based merely on an accrual theory, because no legal right existed at that time; rather, because the receipt was tied to the original transaction, it should properly be attributed to that period, and the account should be reopened when the payment was actually received. Third, the Court concluded that because the receipt pertained to an earlier year, it could not be included in the assessment for the year 1951‑52. Accordingly, the High Court held that although the right to receive the compensation did not arise during the 1948‑49 accounting year, it should be treated as relating to the contract year for which the payment was made. The Commissioner of Income‑tax appealed this decision. Counsel for the Revenue argued that the High Court had erred by relying on English case law and that, on the basis of the High Court’s own finding that the amount accrued only in the accounting year 1949‑50, the Income‑tax Officer had correctly included it in the assessee’s income for the year 1950‑51.

The counsel for the respondent contended that the amount under discussion had been paid pursuant to a contract that the assessee had entered into with the Government. Accordingly, he argued that the amount should be treated as belonging to the accounting year 1948‑49 and therefore ought not to have been taken into account in the assessment for the year 1951‑52. To support this position, he relied upon a number of English decisions that the High Court had earlier cited. Those decisions held that, in similar circumstances, the account for the year in which the contractual liability became due could be reopened, and that an additional sum, even if it were an ex gratia payment, could be recorded in that year.

While expressing deference to the learned Judges of the High Court, the Court observed that the High Court’s reasoning was misplaced because it depended on English authorities that were decided in a context unique to that jurisdiction and on statutory constructions that were not identical to the provisions applicable in India. The Court recalled its earlier observations in Commissioner of Income‑tax v. Vazir Sultan & Sons, emphasizing that the Indian Income‑tax Act is not in pari materia with the British income‑tax statutes. The Indian statute is less detailed, contains fewer refinements, and its language and arrangement differ substantially from the English provisions that English courts have had to interpret. Consequently, the Court warned that little assistance could be obtained by interpreting the Indian Act on the basis of decisions interpreting English tax legislation, although English authorities might serve as useful guides where the provisions are analogous and the underlying concepts are the same.

The Court stressed that this caution must always be observed when construing the provisions of the Indian statute. The Indian Income‑tax Act must be interpreted on its own terms, without drawing analogies from English statutes whose terminology may appear similar on the surface but, upon closer examination, reveal differences in wording and in the meaning that particular expressions have acquired through the development of law in England. The matter before the Court could be resolved only by examining the true meaning of the express words used in section 4(1)(b)(i) of the Act. That provision states: “Subject to the provisions of this Act, the total income of any previous year of any person includes all income, profits and gains from whatever source derived which—if such person is resident in the taxable territories during such year—accrue or arise or are deemed to accrue or arise to him in the taxable territories during such year.” The Court noted that the present case did not involve the phrase “deemed to accrue or arise to him,” as that expression pertains to situations expressly provided for elsewhere in the statute.

The Court observed that the statute itself creates a legal fiction for certain classes of income. To determine when and whether an income “accrues” or “arises” within the meaning of the first part of the clause, the Court relied on its earlier decision in E. D. Sassoon and Company, Ltd. v. The Commissioner of Income‑tax, Bombay City (1). In that case the Court accepted the definition of the words “accrue” and “arise” that had been given by Justice Mukerji in Rogers Pyatt Shellack & Co. v. Secretary of State for India (2). The definition stated that both words are used in contradistinction to the word “receive” and indicate a right to receive. They represent a stage anterior to the point when the income actually becomes receivable and convey a character of the income that is still inchoate. Under the definition adopted by the Court, an income is said to accrue or arise at the moment the assessee acquires a legal right to receive it.

The Court noted that there are two principal systems of accounting for the income, profits and gains of a business: the cash basis and the mercantile (accrual) basis. The mercantile system “brings into credit what is due immediately when it becomes legally due and before it is actually received; and it brings into debit the amount of expenditure for which a legal liability has been incurred before it is actually disbursed.” Under this system, book profits are taken for the purpose of tax assessment even though the credited amount has not been realized and the debited amount has not yet been paid out. The Court explained that when an income accrues within a particular year, it becomes liable to be assessed in the succeeding year. The moment at which the right to receive an amount under a contract accrues or arises to the assessee, that is, the moment it comes into existence, depends on the specific terms of the contract. The Court found no provision in the Act that creates an exception whereby, if the assessee does not acquire a right to receive income in a given accounting year, a later receipt in connection with the same contract could, by fiction, be related back to the earlier year and taxed together with the income of that year. The Court observed that such a position is derived from reasoning favored by English courts, which holds that, based on proper commercial accounting practice, all amounts that accrue in respect of a transaction should be attributed to the year in which the transaction occurs, regardless of the year in which the actual accrual happens.

In the present matter the Court observed that the notion of reopening closed accounts in order to achieve a tax result, although it may have found support in English jurisprudence, has no foundation under the Indian Income‑Tax Act. When an Income‑Tax Officer decides to include a particular sum in a taxpayer’s assessment, he must first determine, among other considerations, (i) the accounting system that the taxpayer employs, and (ii) if the mercantile system of accounting applies, the point at which the right to receive that sum actually accrued, subject to the deemed provisions of the Act. If the officer concludes that the right to the amount accrued in a specific accounting year, then that income must be charged in the assessment of the subsequent year. The Act accords no authority to the officer to retroactively attribute an amount that accrued in a later year to an earlier year merely because the amount stemmed from an earlier transaction. Consequently, the idea of reopening accounts is irrelevant to the determination of when a taxpayer acquired a right to receive a sum. Section 34 of the Act empowers the officer to assess income that escaped assessment or was under‑assessed for the relevant assessment year; following the statutory procedure, he may incorporate the escaped income and reassess the taxpayer based on the original assessment. Likewise, under Section 35, the officers named in that provision may rectify errors either on their own motion or when such errors are brought to their attention by a party to the proceedings. In such cases the correct item may be considered for assessment, but even then there is no reopening of the taxpayer’s accounts; rather, a reassessment is made or the mistake corrected on the basis of the actual income that accrued or was received. The Court therefore found no relevance of account reopening when deciding when a taxpayer acquired a right to receive an amount.

The Court then turned to a decision cited by counsel, namely J.P. Hall & Co. v. Commissioner of Inland Revenue. That case, decided by the Court of Appeal under section 38 of the Finance (No. 2) Act, 1915 (5 & 6 Geo. V, c. 89), concerned the excess‑profits duty. The appellate court held that, for the purpose of that duty, profits arising from contracts for the purchase and sale of control‑gear were to be regarded as arising in the accounting years in which the gear was actually delivered, and not in the pre‑war period that ended on 30 June 1914, when the contracts were originally executed. In the circumstances of that case the price of the control gear was later increased, not because of any contractual obligation, but solely by a voluntary act of the purchaser. The judgment therefore emphasized that the accrual of profit was linked to the actual delivery and receipt of the gear, rather than to the earlier contractual agreement.

Although the extra amounts were only accrued to the assessee in a later year, the Court regarded those amounts as analogous to a trade debt that arose in connection with the trading operation of the earlier year. On the basis of that principle, the accounts of the assessee were reopened so that the increase could be taken into the profits of the assessee in the year in which the original transaction had occurred. That decision was subsequently accepted and extended in the case of Severns (H.M. Inspector of Taxes) v. Dadswell(2). Because the decision in Severns forms the foundation of the view expressed by the High Court, the Court set out the material facts of that case in some detail. In that case the respondent was granted a licence to mill flour in October 1941 and he continued the flour‑milling trade until September 1945. As the respondent had not been a miller at the outbreak of war, he was not entitled to the benefit of the remuneration agreement under which the Ministry of Food compensated millers for losses incurred because of wartime arrangements for the purchase of wheat and the sale of flour. However, the Ministry informed the respondent in 1943, and on two further occasions, that the remuneration of millers who had begun milling during the period of control was being considered. Acting on that information, the respondent lodged a claim in 1949 on the same terms as laid down in the remuneration agreement and he subsequently received payments as part of a settlement. The respondent argued that the sums received in 1949 were not trading receipts but ex‑gratia payments, and alternatively that the payments were made after his trade had ceased and that any debt arising to the trade at the date of cessation would have a value of zero at that date. The Court held that the payments were indeed ex‑gratia. Moreover, the Court held that if, on the discontinuance of a trade, payment for work that had already been performed in a particular year had not been finally settled, the accounts for that year could be reopened so as to include a gratuitous payment for that work that was made in a subsequent year. That judgment therefore clearly supports the respondent’s position. Although the decision could be distinguished on the ground that, in Severns, the payment for the work already done had not been finally settled, whereas in the present case there is nothing on the record indicating that it was not finally settled, the Court preferred to base its conclusion on a different ground. The Court stated that it could not extend the meaning of the words “accrue” or “arise” in section 4(1)(b)(i) of the Act so as to include amounts that were received by the assessee in a later year, even though the receipt was not based on a right that had accrued in the earlier year. Such amounts, according to law, are received by the assessee only in the year in which they are actually paid. The Court further observed that English decisions on the construction of the provisions of the Indian Act could not be applied, particularly where those provisions have already received an authoritative interpretation from this Court; consequently, it was not necessary to consider any further English decisions.

The passage was cited by counsel for the respondent in support of his contention. Earlier, before a Division Bench of the Allahabad High Court in Commissioner of Income Tax, U.P. v. Kalicharan Jagannath (1), a similar question had arisen. In that proceeding, counsel appearing for the Revenue relied upon the English decisions mentioned earlier. The High Court, however, correctly refused to rely on those decisions because they were not relevant to the interpretation of section 4 of the Indian Income‑tax Act. The Court also attempted to distinguish the English decisions on the ground that the scope of the provisions differed between the two countries. It was observed that, under the relevant English Act, the excess‑profits duty was payable on the computation of profits arising from a trade or business in different chargeable accounting periods, and therefore the emphasis there was more upon the carrying on of the trade within the chargeable period than on the income accruing during that period (1) (1961) 41 I.T.R. 40. The Court declined to express a view on this aspect of the question because the pertinent sections of the English Acts had not been placed before it. After rightly refusing to rely upon the English decisions, the learned Judges proceeded to construe the provisions of the Indian statute. During the accounting period from 1 April 1945 to 31 March 1946, the assessee entered into a contract to supply fruits and bullock carts to the military authorities at two different locations at rates fixed by the agreement. The assessee incurred a loss and, under the terms of the agreement, submitted a petition for review. On 6 November 1947 the military authorities sanctioned the payment of an additional sum, which was actually paid to the assessee on 17 February and 24 February 1948. The Income‑tax Department sought to include this additional sum in the assessment for the accounting year 1945‑46. The High Court held that, until the order of review, the only right the assessee possessed was to claim the money payable at the rates laid down in the original agreement. The additional amount became payable not by virtue of any right created by the agreement, but because of the order passed in review directing the payment, thereby creating a new right in favour of the assessee. Since the right to receive the additional sum arose after the close of the accounting year 1945‑46, the High Court concluded that the income did not accrue or arise to the assessee in that year. It may be noted that, although the original agreement permitted a right to apply for review, the Court nevertheless held that the additional payment could not be said to have accrued during the accounting year. For the reasons previously stated, the Court fully agrees with the view expressed by the Allahabad High Court and, accordingly, holds that

In this matter, the Supreme Court concluded that the High Court should have responded positively to the second question that had been referred to it for determination. Accordingly, the Court found that the decision rendered by the High Court was incorrect and therefore set aside that order. The appellate relief was granted, and the Court directed that the costs of the proceedings be awarded to the appellant. As a result, the appeal was allowed.