Income characterisation on sale of tax-free bonds

The
objective of introducing ICDS (previously styled as Tax Accounting
Standards) was (i) reduction of litigation; minimization of alternatives
and giving certainty to issues. The prescribed standards (in the form
they are currently) could have far reaching ramifications. It needs to
be closely examined if they have achieved the core objectives with which
they were introduced or are in the process of drifting away into a new
quagmire of controversies. A discussion is inevitable important to have a
firm ground to pitch in the newness that ICDS seeks to inject. This
write-up initiates a discussion on one such instance which interalia
finds no clarity or certainty under the ICDS regime:

An
assessee holds certain tax free bonds. These bonds are sold before the
record date for payment of interest. The question is whether the
difference between the sale price and the purchase price is to be
treated as capital gain or to be segregated into capital gain and
interest accrued till the date of sale? In other words, whether interest
accrues only on the record date or accrues throughout the year?

The
question under consideration is the ‘characterisation of receipt’ on
sale of the bonds before the record date. Whether such receipts in
excess of the purchase price is wholly chargeable to tax as ‘capital
gains’ or should it be apportioned between ‘capital gains’ and ‘tax free
interest income’? A corollary question which crops up is whether such
tax-free interest accrues only on the record date or throughout the year
on a de die in diem basis?

Section 4 of the Income-tax Act,
1961 (“the Act”) imposes a general charge. The ambit of the charge is
outlined in section 5. Section 5 encompasses not only income actually
accruing in India, but also income deemed to accrue in India. ‘Accrual’
as a legal concept refers to the right to receive. It represents a
situation where the relationship of a debtor and creditor emerges.
Section 5 focuses on ‘accrual of income’, but does not outline the
timing of such accrual. Initially, accrual of interest income chargeable
to tax under the head ‘Income from other sources’ is being examined.

Time of accrual of interest income:
Section 56 of the Act mandates that interest on securities is
chargeable to tax under the head ‘Income from other sources’ if not
chargeable as ‘Profits and gains from business or profession’. The term
‘securities’ is not defined in the section. One may possibly borrow the
meaning of ‘securities’ from The Securities Contracts (Regulation) Act,
1956 (“SCRA”). SCRA defines securities to include bonds. Accordingly,
interest on tax free bonds is enveloped within the provisions of section
56. Section 56 (although a charging section) does not provide for time
of accrual of interest income.

Section 145 of the Act requires
that income ‘chargeable’ under the head “Profits and gains from business
or profession” and “Income from other sources” be computed as per the
cash or mercantile system of accounting regularly employed by the
assessee. Section 145(2) empowers the Central Government to notify
Income Computation and Disclosure Standards (“ICDS” for brevity) to be
followed by any class of assessees or in respect of any class of income.
The Central Government has currently notified 10 ICDS(s) vide
Notification No. 32/2015 dated 31.3.2015. These standards are to be
followed in computing the income where the ‘mercantile system’ of
accounting is adopted.

On traversing through the various
ICDS(s), two standards may be relevant in the present context – namely,
ICDS I & IV. The following paragraphs discuss the impact of these
standards on the issue under consideration:

ICDS I [Accounting policies] deals
with three accounting assumptions. The third accounting assumption is
that revenues and costs accrue as they are earned or incurred and
recorded in the previous year to which they relate. Incomes are said to
accrue under the ICDS when they are ‘earned’ and ‘recorded’ in the
previous year to which they relate. The cumulation of ‘earning’ and
‘recording’ of income connote accrual under ICDS.

Accrual as
understood u/s. 5 means a “right to receive” in favour of the assessee.
It is indicative of payer’s acknowledgement of a debt in favour of the
assessee. The question is whether ‘accrual’ u/s. 5 as hitherto
understood, is now to undergo changes in the light of the definition of
the said term under ICDS.

Lack of clarity in ICDS I:
Applying the ICDS definition, interest income accrues when it is earned
and recorded in the previous year. The Standard neither clarifies the
connotation of the term ‘earn’ nor does it specify the time and place of
recording the interest. “Earn” as per the Shorter Oxford English
Dictionary means – “Receive or be entitled to in return for work done or
services rendered, obtain or deserve in return for efforts or merit”.
Earning is a phenomenon of the commercial world. It is depictive of an
event warranting a reflection in the financial statements. Accrual in a
legal sense traverses a little further. The earning of an income has to
translate/transform into a right to receive. An earning of income is the
cause of its accrual. Earning therefore precedes accrual. A lag is thus
conceivable between the two caused by time or other factors. ICDS in
attempting to equate the two is trying to blur the difference. The
attempt may not achieve its purpose as the definition (of accrual) is in
the realm of accounting and not in the sphere of section 5.

Even
otherwise, earning of income can be said to occur – (i) at the time of
investment; (ii) on a de die diem basis; or (iii) specific record dates
given in the instruments. As regards recording, a further question could
be, should the recording be done in – books of accounts or return of
income. Recording is generally referred to in relation to books of
account. If this were to be the inference, what about those assessees
who do not maintain books of account but earn interest? Throughout the
notification [notification no. 32/2015], it is clarified that ICDS does
not apply for the purposes of maintenance of books of accounts, although
the standard applies only to those who adopt the mercantile basis of
accounting. Interestingly therefore, it is arguable that ICDS would not
apply unless the mercantile basis of accounting is adopted. If no
accounting is employed, as books are not maintained, ICDS may not apply.
Although income is offered for tax on accrual basis, being one of the
parameters of section 5.

Ambiguity in ICDS I enhanced by the
language in ICDS IV: ICDS IV [on revenue recognition] provides revenue
recognition mechanism for sale of goods; provision of services and use
of resources by others yielding interest, royalty or dividends. Para 7
of the Standard deals with interest income. It reads as under:

“7.
Interest shall accrue on the time basis determined by the amount
outstanding and the rate applicable. Discount or premium on debt
securities held is treated as though it were accruing over the period to
maturity.”

The Standard specifies that interest shall accrue on
‘time basis’. Accrual of income under ICDS I refers to culmination of
earning and recording. Under ICDS IV, interest as one of the streams of
income, accrues on ‘time basis’. Time basis under ICDS IV is said to
satisfy the criteria of ‘earning’ and ‘recording’. The import of the
expression ‘time basis’ is however not clarified. Interest is inherently
a product of ‘time’. There cannot be any dispute about the involvement
of ‘time factor’ in quantification and claim to receive interest. The
Standard merely states that accrual of interest happens on time basis.
It is not clarified whether time based accrual means (i) an
‘on-going/real time’ accrual or (ii) an accrual based on the ‘specific
timing’ prescribed by the concerned instrument. Both these are offshoots
of time basis. The Standard does not pinpoint the mechanism of
determining the time of accrual. The latter portion of paragraph (7)
explicitly mentions that discount or premium on debt securities accrue
over the period of maturity. It is not a single point accrual. Such
clarity is conspicuously missing in the first portion of the para
dealing with interest income.

Role of Accounting Standards in ICDS interpretation: One
may observe that the language employed in all the notified ICDS is
largely influenced by the Accounting Standards. ICDS IV owes its genesis
to AS 9 [Revenue recognition]. Para 8.2 of the AS 9 mirrors para 7 of
ICDS IV. Para 13 of AS 9 reads as follows:
“13. Revenue arising from
the use of others of enterprise resources yielding interest, royalties
and dividends should only be recognised when no significant uncertainty
as to measurability or collectability exists. These revenues are
recognised on the following bases:
(i) Interest: on a time proportion basis taking into account the amount outstanding and the rate applicable.”

The
aforesaid AS deals with recognition on ‘time proportion basis’. The use
of the term ‘proportion’ in this expression is indicative of the
concept of recognising ‘part or share’ of income or part of a year.
Interest under the AS has thus been viewed to be a time based
phenomenon. The interest is thus mandated to be recognised on a spread
out basis. It is not on one specific date. However, ICDS IV does not
employ the term ‘proportion’. One could therefore believe that the
understanding in AS 9 cannot be imported into ICDS. The conspicuous
absence of ‘proportion’ in ICDS paves way for an interpretation which is
different from that of AS 9. The expression ‘time basis’ employed in
ICDS IV definitely appears to deviate from AS 9 theory of
proportionality. Thus, if interest is to be paid on specific dates,
‘time basis’ could mean accrued on those specific dates. Whereas ‘time
proportion basis’ would have meant accrual upto the year end at least,
if such date happens to be an intervening event between the specified
dates.

“Tax accounting” should not essentially be different from
commercial accounting. Tax accounting recognises and accepts commercial
accounting if it is consistent and statute compliant. Income recognised
as per such commercial accounting is the base from which the taxable
income is determined. Tax laws incorporate specific rules that cause a
sway from commercial accounting in determining the taxable income. This
disparity is caused by the different purposes of commercial accounting
and taxation; difficulties in precise incorporating economic concepts in
tax laws, etc. To reiterate, one of the issues where commercial
accounting may not synchronise with tax principles is “accrual of
income”.

The Guidance Note issued by ICAI on ‘Terms Used in
Financial Statements’ defines accrual and accrual basis of accounting as
under:

“1.05 Accrual
Recognition of revenues and
costs as they are earned or incurred (and not as money is received or
paid). It includes recognition of transactions relating to assets and
liabilities as they occur irrespective of the actual receipts or
payments.

1.06 Accrual Basis of Accounting
The method
of recording transactions by which revenues, costs, assets and
liabilities are reflected in the accounts in the period in which they
accrue. The ‘accrual basis of accounting’ includes considerations
relating to deferrals, allocations, depreciation and amortisation. This
basis is also referred to as mercantile basis of accounting.”

The
accounting definition of accrual and the definition provided by the
ICDS I is similar. The Guidance note on the “Terms used in financial
statements” explains that accrual basis of accounting may involve
deferral, allocation or non-cash deductions (such as depreciation/
amortisation).

For the reasons already detailed earlier, accrual
for tax purposes is different. This could be better appreciated on a
consideration of ICDS III which deals with Percentage of Completion
Method. Under this method, revenue is matched with the contract costs
incurred in reaching the stage of completion. This results in
recognising income attributable to the proportion of work completed
having satisfied the test of ‘earning’ and hence accrual from an
accounting perspective. Such accounting accrual may not satisfy the tax
concept of accrual which connotes a right to receive. Accounting accrual
is driven more by matching principles. Such a method cannot however
alter the meaning of accrual as understood in the context of section 5.
Judiciary, at various fora, has explained the meaning of the term
‘accrual’ in context of section 5. It may be relevant to quote two among
those several judgments on this matter:

(a) The Apex Court in
the case of E.D. Sassoon & Co. Ltd. vs. CIT (1954) 26 ITR 27 (SC)
discussed the concepts of ‘accrual’, ‘arisal’ and ‘receipt’. The
relevant observations are as under:

“’Accrues’, ‘arises’ and
‘is received’ are three distinct terms. So far as receiving of income is
concerned there can be no difficulty; it conveys a clear and definite
meaning, and I can think of no expression which makes its meaning
plainer than the word ‘receiving’ itself. The words ‘accrue’ and ‘arise’
also are not defined in the Act. The ordinary dictionary meanings of
these words have got to be taken as the meanings attaching to them.
‘Accruing’ is synonymous with ‘arising’ in the sense of springing as a
natural growth or result. The three expressions ‘accrues’, ‘arises’ and
‘is received’ having been used in the section, strictly speaking
accrues’ should not be taken as synonymous with ‘arises’ but in the
distinct sense of growing up by way of addition or increase or as an
accession or advantage; while the word ‘arises’ means comes into
existence or notice or presents itself. The former connotes the idea
of a growth or accumulation and the latter of the growth or accumulation
with a tangible shape so as to be receivable. It is difficult to
say that this distinction has been throughout maintained in the Act and
perhaps the two words seem to denote the same idea or ideas very
similar, and the difference only lies in this that one is more
appropriate than the other when applied to particular cases. It is
clear, however, as pointed out by Fry, L.J., in Colquhoun vs. Brooks
[1888] 21 Q.B.D. 52 at 59 [this part of the decision not having been
affected by the reversal of the decision by the Houses of Lords [1889]
14 App. Cas. 493] that both the words are used in contradistinction to
the word ‘receive’ and indicate a right to receive. They represent a
state anterior to the point of time when the income becomes receivable
and connote a character of the income which is more or less inchoate”

(b) The Apex Court in CIT vs. Excel Industries Limited (2013) 358 ITR 295 (SC) observed:

“19.
This Court further held, and in our opinion more importantly, that
income accrues when there “arises a corresponding liability of the other
party from whom the income becomes due to pay that amount.”

Thus,
judicially ‘accrual’ has been defined to mean enforcement of a right to
receive (from recipient standpoint) with a corresponding obligation to
pay (from payer’s perspective). It has the attribute of accumulation
inherent in it and a growth sufficient to assume a taxable form. It
denotes that the payer of the sums is a debtor. Interestingly, the
position in a construction contract is just the reverse, with the
contractor denoting the sums received as a liability in his books and
hence acknowledging himself to be debtor – a position contrary to what
the tax law demands for accrual.

Supremacy of section 5:
Section 5 outlines the scope of total income. It encompasses income
within its fold on the basis of accrual, arisal or receipt subject to
the residential status of the assessee and locale of income. Thus,
accrual, arisal and receipt form the basis for taxing incomes. This
canon of taxation is sacrosanct and has to be strictly adhered to. ICDS
owes its genesis from a notification which springs out of section 145.
It does not in any manner trespass the supremacy of section 5. It is
pellucid that the scope of the term ‘accrual’ in the context of section 5
remains sacrosanct and immune to ICDS. The definition of ‘accrual’ in
ICDS is the same as the definition housed in Accounting Standard I
issued u/s. 145(2).

This definition of AS 1 u/s. 145(2) has been
in existence from 1996. The presence of such definition, was not
understood to alter the understanding of section 5. The section should
not be different under the ICDS regime. The definition at best has a say
in accounting.

In such setting, ICDS should not in any manner
influence or affect the point of accrual in case of interest income. The
existing understanding of the term ‘accrual’ in the context of section 5
should hold good. The contours of our existing understanding of the
expression ‘accrual’ should be held as steadfast.

Point of accrual of interest income: The
point of accrual of interest income has been addressed by judicial
precedents. The dictum of the Courts does not appear to be unanimous.
The variety in the judgments is captured below:

(a) Interest on securities would be taxable on specified dates when it becomes due and not on accrual basis

In DIT vs. Credit Suisse First Boston (Cyprus) Ltd. 351 ITR 323 (Bombay), the Mumbai High Court observed as under:

“When
an instrument or an agreement stipulates interest to be payable at a
specified date, interest does not accrue to the holder thereof on any
date prior thereto. Interest would accrue or arise only on the date
specified in the instrument. A creditor has a vested right to receive
interest on a stated date in future does not constitute an accrual of
the interest to him on any prior date. Where an instrument provides for
the payment of interest only on a particular date, an action filed prior
to such date would be dismissed as premature and not disclosing a cause
of action. Subject to a contract to the contrary, a debtor is not bound
to pay interest on a date earlier to the one stipulated in the
agreement / instrument. In the present case, it is admitted that
interest was not payable on any date other than that mentioned in the
security.”

(b) Interest gets accrued normally on a day to
day basis, but when there is no due date fixed for payment of interest,
it accrues on the last day of the previous year.

In CIT vs.
Hindustan Motors Ltd. (1993) 202 ITR 839 (Calcutta), the
assessee-company did not charge interest for the relevant previous year
on the amount due to it by its 100% subsidiary. It was explained that
owing to difficult financial position of the subsidiary company, the
board of directors decided not to charge interest in order to enable the
subsidiary to tide over the financial crisis. The Revenue authorities
held that interest accrued on day to day basis whereas the decision not
to charge interest was taken by the assessee-company after the end of
the relevant accounting year, i.e., long after the accrual of interest.
In this context, the Calcutta High Court observed as under:

“In
our view, the income by way of interest on the facts and circumstances
of this case had already accrued from day to day and, in any event, on
31-3-1971, being the last day of the previous year relevant to the
assessment year 1971-72. Therefore, the passing of resolutions
subsequently on 10-5-1971, and/ or on 21-8-1971, in the meeting of board
of directors of the assessee- company is of no effect.”

(c) Interest accrues de die in diem [daily]

The Apex Court in the case of Rama Bai vs. CIT (1990) 181 ITR 400 (SC)

“…we
may clarify, is that the interest cannot be taken to have accrued on
the date of the order of the Court granting enhanced compensation but
has to be taken as having accrued year after year from the date of
delivery of possession of the lands till the date of such order.”

The
accrual of interest on de die in diem basis has been approved by CIT
vs. MKKR Muthukaruppan Chettiar (1984) 145 ITR 175 (Mad).

Apart
from these schools of thought, various circulars have propounded the
proposition that interest income must be offered to tax on an annual
basis. Some of such circulars are as under (although not in the context
of tax free bonds):

(a) Circular no. 243 dated 22.6.1978

Whether
interest earned on principal amount of deposits under reinvestment
deposit/recurring deposit schemes, can be said to have accrued annually
and, if so, whether depositor is entitled to claim benefit of deduction
in respect of interest which has accrued

1…..

2..

3.
The question for consideration is whether the interest at the
stipulated rate earned on the principal amount, can be said to have
accrued annually and if so whether a depositor is entitled to claim the
benefit of deduction, u/s. 80L, in respect of such interest which has
accrued.

4. Government has decided that interest for each
year calculated at the stipulated rate will be taxed as income accrued
in that year. The benefit of deduction u/s. 80L will be available on
such interest.

This was a concessional circular to help
assessees avail the benefit of section 80L over the years. The circular
does not provide any definitive timing of accrual. As evident in para 4,
the timing of taxation was a ‘decision’ of the Government and not the
enunciation of any principle.

(b) Circular no. 371 dated 21.11.1983

Interest on cumulative deposit scheme of Government undertakings – Whether should be taxed on accrual basis annually
1.
The issue regarding taxability of interest on cumulative deposit scheme
announced by Government undertakings has been considered by the Board.
The point for consideration is whether interest on cumulative deposit
scheme would be taxable on accrual basis for each year during which the
deposit is made or on receipt basis in the year of receiving the total
interest.

2. The Central Government has decided that the
interest on cumulative deposit schemes of Government undertakings should
be taxed on accrual basis annually.

3. The Government
undertakings will intimate the accrued interest to the depositors so as
to enable them to disclose it in their returns of income filed before
the income-tax authorities.

This circular also provides for
annual accretion of interest. Accrual does not await the due or maturity
date. The above convey a ‘decision’ of the Government. It does not
enunciate a principle of law.

(c) Circular no. 409 dated 12.2.1985

Interest on cumulative deposit schemes of private sector undertakings – Whether should be taxed on accrual basis annually

1.
The issue regarding taxability of interest on cumulative deposit
schemes of the private sector undertakings has been considered by the
Board. The point for consideration is whether interest on cumulative
deposit schemes would be taxable on accrual basis for each year during
which the deposit is made or on receipt basis in the year of receiving
the total interest.

2. The Central Government has decided that
interest on cumulative deposit schemes of private sector undertakings
should be taxed on accrual basis annually.

3. The private sector
undertakings will intimate the individual depositors about the accrued
interest so as to enable them to disclose it in their returns of income
filed before the income-tax authorities.

(d) Circular 3 dated 2.3.2010 [relevant extracts]

“In
case of banks using CBS software, interest payable on time deposits is
calculated generally on daily basis or monthly basis and is swept &
parked accordingly in the provisioning account for the purposes of
macro-monitoring only. However, constructive credit is given to the
depositor’s/ payee’s account either at the end of the financial year or
at periodic intervals as per practice of the bank or as per the
depositor’s/payee’s requirement or on maturity or on encashment of time
deposits; whichever is earlier.

4. In view of the above
position, it is clarified that since no constructive credit to the
depositor’s/ payee’s account takes place while calculating interest on
time deposits on daily or monthly basis in the CBS software used by
banks, tax need not be deducted at source on such provisioning of
interest by banks for the purposes of macro monitoring only. In such
cases, tax shall be deducted at source on accrual of interest at the
end of financial year or at periodic intervals as per practice of the
bank or as per the depositor’s/payee’s requirement or on maturity or on
encashment of time deposits; whichever event takes place earlier;
whenever the aggregate of amounts of interest income credited or paid or
likely to be credited or paid during the financial year by the banks
exceeds the limits specified in section 194A.

The circular
states that there could be multiple point of accrual for interest
incomes. It seeks to fasten tax withholding at the earliest point in
time.

Thus, the issue of time of accrual has received varied
interpretation on the basis of source of interest (vide a decree,
compensation, investment, etc.), terms of interest (whether payable on a
specific due date or otherwise), legal obligation and surrounding
circumstances. The alternatives discussed above can be captured in the
flowchart below:

Based on the alternatives outlined above, it is
to be examined whether interest accrues on the date of sale of bonds.
The question is whether timing of accrual (of interest) has a bearing on
the characterisation of receipts from sale of bonds. The impact can be
understood under the twin possibilities envisaged in the above diagram
as discussed below:

*
This principle may not apply in the present context since generally
interest is payable either on the stipulated dates or on withdrawal/
maturity. The case on hand contemplates a sale of instrument. The terms
of the bond may not permit interest receipt upto the date of transfer of
bonds

(a) If interest is payable on specific dates:

When
interest payable on specific due dates, the accrual of income concurs
with such dates (for the reasons already detailed earlier). If the due
date falls prior to the sale, the interest accrues in the hands of the
seller. If it is subsequent to the date of sale, the interest accrues in
the hands of buyer. The accrual of interest is distinct from sale of
bonds and the consideration involved therein.

Tax free bonds are
‘capital assets’ for the investor (assuming that the concerned assessee
is not in the business of investment in bonds). Sale of such capital
asset should culminate in capital gains or loss. There is no interest
receipt from the third party buyer as there is no debt due by the buyer
to the seller. The third party buyer of bonds is under no obligation to
pay ‘interest’. The liability to pay interest lies with the company
issuing the bonds. The diagram below explains the flow of transaction.

(b) If the interest is not payable on specific dates:

As
mentioned earlier, interest may not be received upto the date of
transfer of bonds. The receipt in such situations could be on maturity
if not on specific dates. The receipt of interest would be by the buyer
(on maturity) or specific dates. Interest accumulates, but does not
become ‘due’ and ‘payable/receiveable’ till the appointed date. The
seller thus parts away with the bonds and the legal right to receive
interest. Correspondingly, the payment made by the buyer is towards the
principal and interest element inbuilt in the bond. The question in such
an eventuality is whether the consideration receivable by the seller on
sale of bonds:

(a) Should be wholly considered as full value of consideration for sale of bonds [taxable as capital gains]; or

(b)
Should the consideration be split into consideration for sale [as
capital gains] and interest income [as other sources income].

As
mentioned earlier, tax free bonds are capital assets. Consideration on
transfer of bonds would ordinarily result in capital gains. Even if the
sale is made on ‘cum interest’ basis, one could still argue that the
amount received would constitute full value of consideration towards
transfer. Although the price paid by the third party may factor in the
interest component, the amount paid is towards ‘value’ of the bond. It
is not interest payment.

Accumulation of interest would step-up
the sale consideration. It does not alter the characterization of income
from capital gains to interest. At best, one could split the
consideration between ‘purchase price’ (of the bond) and ‘right to
receive interest’ (assuming interest component is factored in the
price). In which case, it would be sale of two separate capital assets
or an asset (tax bonds) along with congeries of rights associated
therewith.

It may be relevant to quote the observation of the
Mumbai High Court in the case of DIT vs. Credit Suisse First Boston
(Cyprus) Ltd. (referred above) wherein the Court observed:

“12.
The appellant’s submission ignores the fact that such securities or
agreements do not regulate the price at which the holder is to sell the
same to a third party. The holder is at liberty to sell the same at any
price. The interest component for the broken period i.e. the period
prior to the due date for interest is only one of the factors that may
determine the sale price of the security. There are a myriad other
factors, both personal as well as market driven, that can be and, in
fact, are bound to be taken into consideration in such transactions. For
instance, a person may well sell the securities at a reduced price in
the event of a liquidity crisis or a slow down in the market and/or if
he is in dire need of funds for any reason whatsoever. Market forces
also play a significant part.

For instance, if the rate of
interest is expected to rise, the securities may well be sold at a
discount and conversely if the interest rates are expected to fall, the
securities may well earn a premium. This, in turn, would also depend
upon the period of validity of the security and various other factors
such as the financial position and commercial reputation of the debtor.

13.
The appellant’s contention is also based on the erroneous presumption
that what is paid for is the face value of the security and the interest
to be paid for the broken period from the last date of payment of
interest till the date of purchase. What, in fact, is purchased is the
possibility of recovering interest on the date stipulated in the
security. It is not unknown for issuers of securities, debentures and
bonds, to default in payment of interest as well as the principal. The
purchaser therefore hopes that on the due date he will receive the
interest and the principal. The purchaser therefore, purchases merely
the possibility of recovery of such interest and not the interest per
se. It would be pointless to even suggest that in the case of Government
securities, the possibility of a default cannot arise. The
interpretation of law does not depend upon the solvency of the debtor or
the degree of probability of the debts being discharged. Indeed the
solvency, reputation and the degree of probability of recovering the
interest are also factors which would go into determining the price at
which such securities are bought and sold. There is nothing in the Act
or in the DTAA, to which we will shortly refer that warrants the
position in law being determined on the basis of such factors viz. the
degree of probability of the particular issuer of the security, bond or
debenture or such instruments, honouring the same.”

Based on
the above, one can conclude that excess of receipt on sale of bonds
over their costs should be categorised as ‘capital gains or loss’. The
splitting of consideration into two heads of income (with interest
falling under Income from other sources) is not a natural phenomenon. It
should be done when statutorily provided for. The law has specifically
provided for such split mechanism wherever deemed necessary. For
instance, circular 2 of 2002 explains tax treatment of deep discount
bonds. It provides that such bonds should be valued as on the 31st March
of each Financial Year (as per RBI guidelines).

The difference
between the market valuations as on two successive valuation dates will
represent the accretion to the value of the bond during the relevant
financial year and will be taxable as interest income (where the bonds
are held as investments) or business income (where the bonds are held as
trading assets). Where the bond is transferred at any time before the
maturity date, the difference between the sale price and the cost of the
bond will be taxable as capital gains in the hands of an investor or as
business income in the hands of a trader. For computing such gains, the
cost of the bond will be taken to be the aggregate of the cost for
which the bond was acquired by the transferor and the income, if any,
already offered to tax by such transferor (in earlier years) upto the
date of transfer. Thus, gains from such bonds, is specifically split
into interest and capital gains by a specific mechanism provided by the
circular.

Similarly, section 45(2A) [conversion of capital
assets into stock-in-trade] splits consideration into business income
and capital gains income. The statute may also provide for the reverse.
If the consideration includes more than one form of income, the statute
could conclude the whole of such consideration to be one form of income.
Further, section 56(2)(iii) [composite rent] concludes the whole of
consideration to be income from other sources although it contains
portion of rental incomes. Such ‘dissecting’ or ‘unified’ approach is
not prescribed for sale of bonds (whether sold cum-interest or
ex-interest).

The term ‘accrual’ connotes legal right to
receive. It is the enforcement of right to receive (from a recipient’s
standpoint) with a corresponding obligation to pay (from payer’s
perspective) [Refer CIT vs. Excel Industries Ltd (2013) 358 ITR 295
(SC)]. Thus, for an income to accrue, the right (of the income
recipient) and obligation (of the payer) must co-exist. Applying this
theorem in the present context, the question is whether the company
issuing bonds is under an obligation to pay interest when such bonds are
sold on ‘cum interest’ basis. Generally, interest on bonds would be
payable either on a periodic basis or on maturity. Bonds which are
issued without any terms on interest payouts are seldom in vogue. If
this proposition is accepted, then interest can be said to accrue only
on specific dates (being on periodic payout dates or maturity date). In
which case, interest always accrues to the buyer if the bonds are sold
on cum-interest basis. Consequently, consideration received on sale of
bonds would wholly constitute full value of consideration on transfer.
There is no interest element therein.

It may also be relevant to note that the definition of interest provided in the Act. Section 2(28A) defines interest as under:

“(28A)
“interest” means interest payable in any manner in respect of any
moneys borrowed or debt incurred (including a deposit, claim or other
similar right or obligation) and includes any service fee or other
charge in respect of the moneys borrowed or debt incurred or in respect
of any credit facility which has not been utilised”

The definition can be bisected as under –

(a)
interest payable in any manner in respect of any moneys borrowed or
debt incurred (including a deposit, claim or other similar right or
obligation); or

(b) any service fee or other charge in respect
of the moneys borrowed or debt incurred or in respect of any credit
facility which has not been utilised.

In the present context,
the payment is not towards moneys borrowed or debt or any service fee or
other charge in this regard. It is for purchase of assets. One cannot
therefore ascribe the color of interest to a consideration paid for
purchase of assets. The receipt of consideration cannot partake the
character of interest as there is no debt owed by the buyer to the
seller. There is a ‘seller-purchaser’ relationship. Thus, unless there
is a ‘lender-borrower’ relationship, the liability to pay or right to
receive interest does not arise.

The discussion would be
incomplete without a reference to the Apex Court verdict in the case of
Vijaya Bank Limited vs. CIT (1991) 187 ITR 541 (SC). In this case, the
assessee (bank) received interest on securities purchased from another
bank (as well as in the open market). The assessee claimed that
consideration paid towards acquisition of these securities was
determined with reference to their actual value and interest which
accrued to it till the date of sale. Accordingly, such outflow should be
allowed as a claim against interest income earned by the assessee
subsequent to purchase. In this context, the Apex Court observed as
under:

“In the instant case, the assessee purchased
securities. It is contended that the price paid for the securities was
determined with reference to their actual value as well as the interest
which had accrued on them till the date of purchase. But the fact is,
whatever was the consideration which prompted the assessee to purchase
the securities, the price paid for them was in the nature of a capital
outlay and no part of it can be set off as expenditure against income
accruing on those securities. Subsequently when these securities yielded
income by was of interest, such income attracted section 18.”

The
Apex Court adjudged that consideration paid for purchase of securities
is in the nature of ‘capital outlay’. It is not expenditure on revenue
account having nexus to interest income which it earned subsequently.
The entire consideration was thus concluded to be towards purchase of
bonds. When this dictum is viewed from seller’s standpoint, the entire
consideration received should constitute capital gains. There is no
interest element therein.

The possible counter to the aforesaid
discussion is that interest accrues on a de die diem basis.
Consideration received from the buyer which factors the interest element
has to be split between capital receipt and interest income. If such
split is not carried out, there may be a dual taxation. This could be
better explained through an illustration:

Mr X purchased a bond
for Rs.100. He wishes to sell this bond to Mr Y on a cum interest basis
at Rs.110. Interest accrued till the date of sale is Rs.10. In such an
eventuality, Mr X would have to bear capital gains tax on Rs.10 [being
110 (sale consideration) – 100(cost)]. Mr Y would have to discharge tax
on interest income (of Rs.10). Therefore, on an interest income of Rs.10
paid by the company, there is a taxable income of Rs.20 (being Rs.10
factored in capital gains computation of Mr X and Rs.10 as interest
income in the hands of Mr Y). One may argue that such absurd result is
unintended and cannot be an appropriate view.

However, this line
of argument can be answered by stating that there is no equity in tax.
This is an undisputed principle. The parties to the transaction being
taxed on Rs.20 (although being economically benefited by Rs.10) would
only reflect a bad bargain. Further, Mr Y would have to shoulder tax on
interest income (Rs.10) but would avail a deduction or a loss
subsequently of Rs.10 (being part of the purchase consideration of
bonds).

The learned author Sampath Iyengar in his treatise Law
of Income tax (11th edition at page 2661 – Volume II) has made a
reference on this matter (although in the context of section 18 of the
Act):

“15. Charge of interest on sale or transfer of
securities – (1) No splitting of interest as between seller and
purchaser – When an interest bearing security is sold during the
currency of an interest period, the question arises as to how far the
purchaser is liable in respect of interest accrued due before the date
of his purchase. It frequently happens that the purchaser pays to the
seller the value for interest accrued till the date of the sale, and
that the seller receives the equivalent of interest up to the date of
the sale from the purchaser. Nevertheless, for the purposes of revenue
law, the only person liable to pay tax is the person who is the owner of
the securities at the date when the interest falls to be paid. Such
owner is the person liable in respect of the entire amount of interest.
Though as between the transferor and the transferee, interest may be
computed de die in diem, it does not really accrue from day to day, as
it cannot be received until the due date. This section makes it clear
that the assessment is upon the person entitled to receive, viz, the
holder of the security on the date of maturity of interest. Further, the
machinery sections of the Act do not provide for taking separately the
vendor and the purchaser or to keep track of interest adjustments
between the transferor and transferees. Tax is exigible when the income
due is received and is on the person who receives. The principle is that
the seller does not receive interest; he receives the price of
expectancy of interest, and expectancy of interest is not a
subject-matter of taxation. The only person who receives interest is the
purchaser. Where an interest bearing security is sold and part of the
sale price represents accrued but hitherto unpaid interest that accrued
interest is not chargeable to tax, unless it can be treated as accruing
from day to day.”

To conclude, accrual is an intersection of
legal right to receive and a corresponding obligation to pay. Accrual
of interest on bonds is influenced by the contractual terms. A holder of
bond contractually holds the right to receive the interest. The
transfer of bonds results in passing on the interest (receivable from
the bond-issuing company) from the seller to the buyer. This benefit of
accumulated interest is discharged by the buyer in form of
consideration. The payment made by the buyer is for acquisition of bonds
which factors the interest element. The buyer however does not pay
‘interest’ to the seller. It is only the purchase consideration. It is
inconceivable that the purchaser would step into the shoes of the bond
issuing company and pay interest along with consideration for purchase
of bonds. Payment receivable by the seller of bonds would wholly be
included in the capital gains computation. There is no interest element
contained therein.

Financial statements form the substratum for
income-tax laws. They are two sides of the same coin, yet they operate
in their individual domains. There are inherent variations in commercial
and tax profits. Today’s accounting norms are distilled, refined and
robust. With an ‘ever evolving’ story of tax and accounting world, the
relationship remains complementary but not interchangeable. In any departure, commercial accounting norms would be subservient to tax principles.
Therefore, the attempt by ICDS to elevate the accounting principles to
match with the concept of accrual under the tax principles may not have
achieved its avowed objective.