1.
Issue for consideration :
1.1 Interest on government
securities is normally payable half-yearly. When government securities are
traded, the purchaser has to pay the seller not only the purchase price of the
securities but also the interest accrued on the government securities from the
last due date of the interest till the date of purchase of the securities. This
interest from the last due date till the date of purchase/sale is referred to as
broken period interest. While the purchaser of the government securities would
pay the broken period interest, the seller would receive the broken period
interest. For a trader in government securities, including a bank, the net
position of broken period interest for the year would either be an income or an
expenditure, depending upon the quantum of government securities bought and sold
and the dates on which such transactions were effected.
1.2 In a situation where the
net broken period interest for the year is an expenditure, the issue has arisen
before the courts as to whether such broken period interest is deductible as
business expenditure. While the Bombay High Court has held that such amount of
broken period interest is an allowable deduction, the Rajasthan High Court has
taken a contrary view and held that such broken period interest cannot be
allowed as a deduction.
2.
American Express Bank’s case :
2.1 The issue first came up
before the Bombay High Court in the case of American Express International
Banking Corporation v. CIT, 258 ITR 601.
2.2 In this case, the
assessee, which was a bank, was required to maintain statutory liquidity ratio
in relation to its business in the form of government securities. It also traded
in government securities. During the year, the assessee paid Rs.7,13,627 to
sellers towards broken period interest accrued on securities till the date of
purchase by the assessee, and received Rs.4,07,288 from buyers towards broken
period interest on securities sold by it. The assessee claimed the net amount of
Rs.3,06,399 as business expenditure u/s.37.
2.3 The Assessing Officer
taxed the amount of Rs.4,07,288 received by the assessee towards broken period
interest, but denied deduction of Rs.7,13,627 broken period interest paid by the
assessee. The denial was on the ground that the expenditure was for purchase of
income-bearing assets, and was therefore a capital expenditure, which could not
be set off as expenditure against the income from such assets. The Commissioner
(Appeals) held that the amount was allowable as a deduction u/s.28. The Tribunal
upheld the order of the Commissioner (Appeals), holding that the broken period
interest of Rs.7,13,627 was allowable as a deduction.
2.4 On behalf of the
Revenue, it was argued that the government securities purchased were income
bearing assets, and that the amount spent on such purchase was capital outlay.
It was therefore argued that capital outlay on purchase of the assets could not
be set off as expenditure against income accruing from the assets purchased.
Reliance was placed on the decision of the Supreme Court in the case of
Vijaya Bank v. Additional CIT, 187 ITR 541. It was also argued that a
composite price had been paid for the purchase, consisting of interest accrued
as well as the price, and that there was no provision under the Income-tax Act
which authorised bifurcation of such a price. It was also argued that the
interest income was chargeable to tax under the head ‘Interest on Securities’,
and that therefore S. 28 could not be invoked for claiming the net interest as a
deduction.
2.5 On behalf of the
assessee, it was argued that the assessee was computing its profit from trading
in securities, which had to be computed u/s.28. To compute the correct profits,
the interest income for the period that the securities were held by the assessee
had to be recorded as its income, and it was on this basis that the net broken
period interest was claimed as a deduction. It was further argued that the
interest income in respect of such trading activity had not been taxed under the
head ‘Interest on Securities’ but under the head ‘Profits and Gains of Business
or Profession’. It was argued that the method of accounting followed by the
assessee was consistently followed by it, as well as by all other banks. It was
further argued that when the income of such broken period interest was taxed,
the payment of such broken period interest could not be disallowed.
2.6 The Bombay High Court
observed that Vijaya Bank’s case (supra) was a case where the interest on
government securities was taxable under the head ‘Interest on Securities’,
whereas the case before it was a case where the interest was taxed under the
head ‘Profits and Gains of Business or Profession’. The Bombay High Court noted
that there was no loss of revenue under the method of accounting followed by the
bank. The Bombay High Court therefore held that the broken period interest paid
by the bank was an allowable deduction in computing its business profits.
2.7 In CIT v. Citibank
NA, 264 ITR 18, the Bombay High Court has followed the view taken by it
earlier in American Express’ case.
3.
Bank of Rajasthan’s case :
3.1 The issue again recently
came up before the Rajasthan High Court in the case of CIT v. Bank of
Rajasthan Ltd., 316 ITR 391.
3.2 In this case, pertaining
to a year subsequent to deletion of the head of income ‘Interest on Securities’,
an order had been passed u/s.263 making an addition to the income returned by
the assessee-bank, representing the broken period interest paid by the bank.
This order was on the basis that such interest was not allowable as a deduction
in view of the Supreme Court decision in Vijaya Bank’s case (supra). The
Tribunal allowed the assessee’s appeal, holding that Vijaya Bank’s case did not
apply after the deletion of the head of income ‘Interest on Securities’. The
Tribunal followed the decision of the Bombay High Court in American Express
International Banking Corpo-ration’s case (supra), and quashed the order
u/s. 263.
3.3 The Rajasthan High Court considered the decision of the Supreme Court in Vijaya Bank’s case (supra), and observed that even if that decision related to deduction of interest under the head ‘Interest on Securities’, it had relied upon the English decision of the Court of Appeals in the case of CIR v. Pilcher, 31 TC 314, for the well-settled principle that outlay on the purchase of an income-bearing asset is in the nature of capital outlay and no part of the capital for laid out can be set off as expenditure against income accruing from the asset in question. It was on that reasoning that the deduction had not been allowed in that case. According to the Rajasthan High Court, the ratio of Vijaya Bank’s decision still held good even after the deletion of the head of income ‘Interest on Securities’.
3.4 The Rajasthan High Court expressed its dissent with the decision of the Bombay High Court in American Express International Banking Corporation’s case on the ground that if carried to the logical conclusion, it permitted a post-mortem of the purchase component of the asset and permitted deduction of interest element paid as business expenditure. According to the Rajasthan High Court, the Supreme Court judgment proceeded on an established legal principle deduced from previous English judgments, and could not therefore be brushed aside.
3.5 The Rajasthan High Court therefore held that the ratio of Vijaya Bank’s decision (supra) applied to the case before it, and held that the broken period interest was not deductible in computing the income of the bank.
Observations:
4.1 The whole controversy seems to revolve around the validity and continued applicability of the Supreme Court decision in Vijaya Bank’s case (supra). It would therefore be worthwhile to consider the facts and the ratio of that decision, and the circumstances in which it was rendered.
4.2 Unfortunately, the decision of the Supreme Court is a brief one-page judgment. The decision of the Karnataka High Court from which this matter came up to the Supreme Court is however reported in Tax LR (1976) 524, from which the facts can be deduced. Also, the Bombay High Court has drawn out certain facts from the deci-sion of the Karnataka High Court as well as the Supreme Court. From the decision of the Supreme Court, it is clear that though the issue before it was with reference to taxation of interest under the head of income ‘Interest on Securities’ as well as deduction u/s.28 in computation of income under the head of income ‘Profits and Gains of Business or Profession’, the Supreme Court seems to have answered the issue only from the perspective of ‘Interest on Securities’. One significant factor that needs to be understood is that under the head ‘Profits and Gains of Business or Profession’, all expenditure incurred for the purpose of the business or profession is allowable, unless specifically prohibited, as also all losses incurred during the course of carrying on of the business or profession, unlike in the case of ‘Interest on Securities’ where only expenditure incurred for purpose of realising the interest on securities is deductible as expenditure. It was therefore perhaps on account of the restricted allowability that the Supreme Court took the view that it did in Vijaya Bank’s case.
4.3 The other aspect of Vijaya Bank’s decision, as analysed by the Bombay High Court, is that Vijaya Bank had taken over the assets and liabilities of Jayalakshmi Bank Ltd., which included the government securities and interest accrued thereon. It was such interest which was claimed as a deduction by Vijaya Bank, which had accrued to Jayalakshmi Bank prior to takeover of assets and liabilities by Vijaya Bank. On the facts, it appears therefore that such government securities were investments of Vijaya Bank, and not its stock in trade. It may however be noted that the second question raised before the Supreme Court pertained to broken period interest in case of securities purchased from the open market. The Bombay High Court does not seem to have looked at this aspect of the Supreme Court’s decision.
4.4 Where the government securities form part of a trading business, it certainly cannot be said that the amount paid for the acquisition of stock in trade is a capital outlay, as such purchases and stock form part of the circulating capital of the business. The entire purchase is on revenue account, and is an allowable expenditure of the business. Therefore, even if a view is taken that the broken period interest forms part of the purchase cost of the government securities and cannot be broken up, it would still be allowable as a revenue expenditure.
4.5 Further, as anybody familiar with the government securities market in India would be aware, the purchase price of government securities quoted on the markets does not include the interest component for the broken period. Such interest component for the broken period has to be invariably computed separately and is payable over and above and in addition to the negotiated purchase price. Given this commercial reality, to say that the broken period interest is a part of the purchase price would be incorrect. In reality, what is being paid for over and above the purchase price is the right to receive the interest accrued up to the date of the transaction. Therefore, irrespective of whether the securities are held as stock in trade or as investments, such interest paid for would have to be reduced from the total interest received subsequently on the due date, since the interest received includes the interest for which payment is made.
4.6 It is also important to note that business profits have to be computed in accordance with the method of accounting followed by the assessee. In preparing its accounts, the assessee would have to follow accounting standards applicable to it. The accounting standards applicable to in-vestments (e.g., AS-13) require that when unpaid interest has accrued before the acquisition of an interest -bearing investment and is therefore included in the price paid for the investment, the subsequent receipt of interest is allocated between pre-acquisition and post-acquisition periods; the pre-acquisition portion is deducted from cost. This supports the view that the subsequent interest receipt on the due date has to be partly adjusted against the broken period interest paid, and it is only the net amount which is really the income.
4.7 Even under the Income-tax Act, all business losses and revenue expenditure are allowable as deduction in computing business income. The payment of broken period interest on purchase of government securities held as trading assets is certainly a business expenditure, if not a busi-ness loss, and is therefore clearly an allowable deduction.
4.8 Lastly, the CBDT had clarified vide its Circular No. 599, dated 24 April 1991 [189 ITR (St) 126], that securities held by banks must be regarded as stock in trade, and that interest payments and receipts for broken period on purchase of securities must be regarded as revenue payments/receipts, and only the net interest on securities should be brought to tax as business income. Though the Circular was issued subsequent to the decision of the Supreme Court in Vijaya Bank’s case, it had not considered the ratio of that decision which was rendered on 19 September 1990. This Circular was therefore withdrawn on 31 July 1991 vide CBDT Circular No. 610 [191 ITR (St) 2]. By a subsequent Circular No. 665, dated 5 October 1993 [204 ITR (St.) 39], the CBDT clarified that the Supreme Court, in Vijaya Bank’s case, was not directly concerned with the issue whether securities form part of stock in trade or capital assets. The CBDT has clarified that whether a particular item of investment in securities constitute stock in trade or capital asset is a question of fact, and that banks are generally governed by the instructions of the Reserve Bank of India from time to time with regard to the classification of assets and also the accounting standards for investments. Assessing Officers have therefore been directed to determine the facts and circumstances of each case whether a particular security constitutes stock in trade or investment after taking into account the guidelines issued by the Reserve Bank of India. In a sense, the CBDT has also therefore indirectly accepted the fact that where the government securities are held as trading assets (stock in trade), the allowability of broken period interest as a deduction should not really be an issue.
4.9 The view taken by the Rajasthan High Court therefore does not seem to be justified, given the fact that government securities are generally held as stock in trade by banks. Therefore, the view taken by the Bombay High Court is the better view of the matter, and broken period interest should be allowed as a deduction where the securities are held as stock in trade. Even if the securities are held as investments, logically the interest income actually received includes the broken period interest paid for, and to that extent the amount received on the due date does not constitute income of the recipient.
