Whether accrued interest will be nullified by subsequent modification in terms ?

1.3 Recently, the issue referred to in Para 1.2 above, came
up for consideration before the Apex Court in the case of Sarabhai Holding P.
Ltd. This judgment throws considerable light on the issue and the same would be
a good guide for dealing with such issues. Therefore, it is thought fit to
consider the same in this column, as such issue very often arises in the
day-to-day practice.

Sarabhai Chemicals Pvt. Ltd. v. CIT,

257 ITR 355 (Guj.) :

2.1 The name of the above Company had subsequently undergone
change and the Company was then known as Sarabhai Holdings P. Ltd. In the above
case, various issues with regard to liability to pay interest u/s.215, penalty
u/s.272(2) for under-estimate of income for payment of advance tax, concealment
penalty u/s.271(1)(c), etc. had come up before the Court, with which we are not
concerned in this write-up. The main issue was with regard to accrual of
interest income and taxability thereof, which is similar to the issue referred
to in Para 1.2 above and accordingly, only relevant facts in that context are
considered here. The accounting year of the assessee was July-June. The issue
related to A.Ys. 1979-80 and 1980-81. As such, the relevant previous years were
the periods from 1-7-1977 to 30-6-1978 and 1-7-1978 to 30-6-1979 as per the
provisions of the Act at the relevant time. The assessee was following the
Mercantile System of Accounting. The relevant facts were : Under an agreement
dated 28-2-1977, the assessee had transferred (effective from that date) its
industrial undertaking of Sara-bhai Chemicals & Business Activity of Sarabhai
Company Services Division as a going concern (hereinafter referred to as the
said Unit) to its wholly-owned subsidiary, namely, Elscope (P.) Ltd.
(hereinafter referred to as the said Elscope) for an agreed consideration and,
in turn, after four months, the said Elscope had transferred the said Unit to
its subsidiary, namely, Ambalal Sarabhai Enterprises Ltd. The said agreement
dated 28-2-1977 was amended by supplementary agreement dated 4-3-1977 and the
Deed of Assignment was executed on 28-6-1977. Under the terms of the agreement,
the said Elscope was liable to pay part of the consideration when demanded by
the assessee and payment of part consideration was deferred, which was to be
paid in eight equal annual instalments on 1st October of every year beginning
from 1-10-1979 and the same was to carry simple interest @ 11% per annum on the
amount outstanding from time to time.

2.1.1 On 15th June, 1978, the said Elscope wrote to the
assessee proposing modification in terms of payment and requested, inter alia,
that the interest be charged on the deferred sale consideration from 1-7-1979
instead of from 1-3-1977. It was also proposed that certain amount will be
payable (Rs.1.84 crores) as and when the assessee demands without any interest
and part of the amount (Rs.4.70 crores) will be paid in five annual instalments
beginning from 1-3-1987, which will carry simple interest @ 11% per annum with
effect from 1-7-1979. The said Elscope also offered to secure the said amount of
Rs.4.70 crores to the satisfaction of the assessee [eventually, it seems that
Secured Debentures of the said Ambalal Sarabhai Ltd. were given as security]. On
30th June, 1978, the proposal sent by the said Elscope vide letter dated
15-6-1978 was decided to be accepted by the assessee and a resolution to that
effect was passed (hereinafter referred to as the said Resolution) in the
Meeting of the Board of Directors. The relevant portion of the said Resolution
reads as under :

2.1.2 The assessee company furnished Returns of Income for the A.Y. 1979-80, declaring business income of Rs.772 and for the A.Y. 1980-81, declaring loss of Rs.17,345. In these returns, the assessee had not considered the interest income from the said Elscope, on the ground that as per the revised arrangement such interest was payable by the party only from 1-7-1979. The Income-tax Officer (ITA) took a view that by the date the said Resolution [dated 30-6-1978] was passed, the interest for the whole year had already accrued to the assessee. It was further held that the assessee has relinquished the interest without any commercial consideration as the two companies were closely related and it was the case of collusion to evade tax liability. Accordingly, the ITa added the interest income of Rs.66,29,236 for the A.Y. 1979-80. Almost for similar reasons, the ITa also made an addition of Rs.55,67,750 for the A.Y. 1980-81 on account of such interest. The first Appellate Authority [CIT(A)] confirmed the action of the ITa. The CIT(A) also commented on the nature of security given by the said Elscope while revising the terms of payment of interest and pointed out that the security of bonds of Ambalal Sarabhai Enterprises Ltd. were redeemable during the year 1991 or subject to some conditions in the year 1987. Accordingly, considering its quoted market price, the same are worth about %rd of the face value. Thus, in the process, the assessee company has accepted assets worth %rd of the market price as such security.
 
2.1.3 When the matter came up in the second appeal, the Tribunal took the view that it is pertinent to note that there is no indication in the said Resolution to suggest that the revised mode of payment was effective from any date prior to 30-6-1978. Therefore, it is not a case where the income though given up during the year could not be said to accrue, the accrual of interest commenced from the beginning of the accounting year as interest accrues from day to day. Accordingly, the Tribunal rejected the contention of the assessee that no interest accrued for the accounting year relevant to the A.Y. 1979-80 and confirmed the action of the ITA as well as CIT(A) for that year. However, for the A.Y. 1980-81, the Tribunal pointed out that there was a material distinction between the facts for that year and the earlier year. This difference was caused by the said Resolution (dated 30-6-1978), under which the original agreement stood modified. Accordingly, it was held that as a result of the said Resolution, no income could be said to have accrued to the assessee for this year, as the interest was to start accruing from 1-7-1979. The Tribunal also stated that as there was no accrual of income at all, no question of relinquishment of any right to receive arises. Accordingly, the Tribunal deleted the addition made in respect of interest income for the A.Y. 1980-81.

2.2 When the matter came up before the High Court, on behalf of the assessee, it was, inter alia, contended that in view of the said Resolution, there was no accrual of interest to the assessee till 30-6-1979. It was further contended that it was open for the assessee to agree to modification of the terms of payment and substitute the original stipulation re-garding the payment of interest by fixing time, from which the interest would accrue and that was done before the end of the relevant accounting year. Alternatively, it was contended that if the interest is treated as accrued for the A.Y. 1979-80, it should be held that the income accrued was given up by the assessee for valid commercial expediency and for that purpose, reliance was placed on concept of real income. It was pointed out that the assessee had agreed to modify the terms with a view to get his dues secured. Reliance was placed on the judgments of various High Courts and the Apex Court in support of such propositions.

2.3 On behalf of the Revenue, it was, inter alia, contended that there was no commercial expediency for which interest that had already accrued could have been given up. The transaction between the parties was not a genuine transaction as the said Elscope was only made a conduit pipe as the said Elscope had transferred the said Unit to its subsidiary within a short period of four months. It was also contended that the said Resolution did not effectively change the mode of payment even for the A.Y. 1980-81 and the interest continued to accrue to the assessee under the existing mode of payment stipulated in the agreement and the deed of assignment. It was also pointed out that the said Resolution could not be given retrospective effect, because on the last day of the accounting year, the interest had already accrued and the same could not have been affected by such resolution. It was also contended that there was no reason for the said Elscope to make the proposal for modification as its subsidiary (Ambalal Sarabhai Enterprises Ltd.) had also stepped in its shoes by that time. Reliance was also placed on the judgments of various High Courts and the Apex Court in support of such propositions.

2.4 After considering the contentions raised on behalf of both the parties and various judgments on which reliance was placed, the Court proceeded to decide the issue for the A.Y. 1979-80. For this purpose, the Court noted various terms and conditions stipulated in the original agreement, the supplementary agreement and the deed of assignment. Having referred to the same, the Court observed as under (pages 391/392) :

“It would be a trite thing to say that the terms of payment of interest which were binding on the parties were those which finally came to be incorporated in the deed of assignment. Payment of interest was treated as essence of the contract and as noted above. If the instalments were not duly paid, the rate of interest was to be higher than 11% per annum and the vendee was in the event of default of payment of instalment bound to pay interest at the rate payable by the vendor to its bankers in the ordinary course of business. These terms regarding mode of payment were never disturbed until the last date of the accounting year ending on June 30, 1978 on which date the assessee passed the resolution dated June 30, 1978, ‘by which it accepted the proposal of its subsidiary Elscope sent on June IS, 1978 and substituted the mode of payment by purporting to shift the date of charging of interest by July I, 1979.”

2.5 The Court, then, noted that from the terms of various agreements, it is seen that the transaction took place with effect from 1-3-1977 and the obligation to pay interest was incorporated in such agreement in the context of such transaction. The obligation to pay interest was not a separate debt, but the debt incurred under the contract included the obligation to pay interest. Therefore, to say that no date of accrual of interest was fixed in the contract is to misconstrue the provision thereto, despite the express stipulation about the obligation to pay interest which was to be treated as the essence of the contract. When no date is specified in the transaction which incorporated an obligation of party thereto to pay interest, it obviously would mean that the date from which the interest is to be paid would be the point of time from when the obligation to pay the outstanding amount starts and that will be the date from which the creditor’s entitlement to recover interest starts.

2.6 Having made the above-referred observations, the Court finally, while deciding the issue against the assessee with regard to accrual of interest, held as under (page 393) :

“Interest accrues in most circumstances on the time basis to be determined by the amount out-standing and the rate applicable. Recognition of the revenue requires that the revenue is measurable, and that at the time of sale, it would not be unreasonable to accept ultimate collection. In the present case, in view of the categorical stipulation that interest will be payable on the deferred consideration amount in respect of the sale which became effective from March 1, 1977, the interest started accruing on that time basis from March I, 1977 determined by the amount outstanding from time to time and the rate applicable which were stipulated in clearest possible terms in the deed of assignment dated June 28,1977, and the agreements which preceded it. That what already accrued during the accounting year from July I, 1977 to June 30,1978 could not be nullified by the resolution of June 30, 1978, said to have been passed at 2.00 p.m. on that day. As held by the Supreme Court in CIT v. Shiv Prasad Janak Raj and Co. (P.) Ltd. (1996) 222 ITR 583, the concept of real income cannot be employed so as to defeat the provisions of the Act and the Rules. In that case, it was held that waiver of interest after the expiry of the relevant accounting year only meant that the assessee was giving up the money which had accrued to it. It cannot be said that the interest amount had not accrued to the assessee.”

2.7 The Court, then, stated that now the only question remains to be examined is whether the interest that had accrued and which the assessee did not in fact receive was given up for any commercial expediency after its accrual as contended on behalf of the assessee on an alternative basis. For this, the assessee relies on the fact that the debt which was earlier unsecured became secured on such re-arrangement. After referring to the factual position in this regard, the Court stated that admittedly no security passed. The CIT(A) has admirably discussed this aspect in his order and exposed the hollowness of the assessee’s stand that it secured debt with the bonds of Ambalal Sarabhai Enterprises Ltd. According to the Court, the last-minute arrangement was made to ward off the payment of tax on interest income that had accrued to assessee during the accounting year ending 30-6-1978 (till the moment the resolution dated 30-6-1978 was passed at 2 p.m.). For this, the ground of commercial expediency was created of getting debt secured. In fact and reality, neither was there in particular security offered in the proposal, nor was there any acceptance of security. A ghost was created to hide the real object of modification of the mode of payment, which was to ward off payment of tax on interest income that already had accrued to the assessee. Accordingly, the Court confirmed the decision of the Tribunal for the A.Y. 1979-80 and upheld the addition on account of interest income made by the ITO.

2.8 The Court then noted that there was no challenge levelled against the genuineness of the said Resolution. The law permits the contracting parties to change their stipulations by mutual agreement and, therefore, there was no impediments in changing the terms of the contract. The resolution dated 30-6-1978 accepted the proposal of the said Elscope. In view of this, under the changed mode of payment adopted in it, no interest was to accrue during the accounting period from 1-7-1978 to 30-6-1979. Therefore, no interest accrued to the assessee during that period and hence, the reasoning of Tribunal for deleting the addition of such interest income for the A.Y. 1980-81 is correct. Since no interest accrued during this period, no question of relinquishment of interest for any commercial expediency arises, as you cannot relinquish the income that has not accrued at all. Accordingly, the Court decided the issue in favour of the assessee for the A.Y. 1980-81.

CIT v. Sarabhai  Holdings  P. Ltd., 307 ITR 89 (SC) :
3.1 The above-referred   judgment  of the Gujarat High Court came up before the Apex Court at the instance of the Revenue as well as the assessee. On behalf of both the parties various contentions were raised to support their case, which were similar to the contentions raised before the High Court.

3.2 After considering the factual position with regard to both the assessment years and the contentions raised by the parties, the Court, first dealt with the contention of the Revenue that the assessee was trying to avoid payment of tax on the interest by making such arrangements and in that context observed as under (page 98) :

“We cannot understand the criticism of learned senior counsel appearing on behalf of the Revenue that by resolution dated June 30, 1978, the assessee was avoiding the payment of tax on the interest which had accrued. The genuine nature of the resolution was not and could not be disputed. When we see the letter dated [une 15, 1978, and also note that the letter was complied with by Elscope in providing adequate security of the payable amount, there is nothing to dispute or suspect the genuineness of the transaction. The whole transaction would have to be viewed on that backdrop. In the commercial world, the parties are always free to vary the terms of contract. Merely because by resolution dated June 30, 1978, the assessee agreed to defer the payment of interest, that would not mean that it tried to evade the tax. What is material in tax jurisprudence is evasion of the tax, not the beneficial lawful adjustment therefor. Considering the genuine nature of the transaction based on the letter dated June 15, 1978, and the resolution dated June 30, 1978, it cannot be said that the whole transaction was in order to evade the tax.”

3.3 Having accepted the genuineness of the said Resolution and the object of the assessee, the Court confirmed the decision of the High Court for both the assessment years and held as under (page 99) :

“We agree with the High Court’s finding that the law permits the contracting parties to lawfully change their stipulations by mutual agreement and, therefore, the assessee and the vendee had no legal impediment in modifying the terms of their contract. We also agree with the further finding of the High Court that the resolution could not be given any retrospective effect so as to facilitate evasion of tax liability that had already arisen for the A.Y. 1979-80.We further agree with the High Court’s finding that it being a valid stipulation, it changed the mode of payment from the date of the resolution and, therefore, under the changed mode of payment adopted under the resolution dated June 30,1978, no interest was to accrue during the accounting period from July 1, 1978, up to June 30, 1979, and, therefore, the reasoning of the Tribunal on that count appeared to be correct as regards  the assessment  year 1980-81 is concerned. We further confirm the finding that since no interest had accrued in the accounting year July 1, 1978 to June 30,1979, there could arise no question of relinquishment of interest for any commercial expediency.”

Conclusion:

4.1 The above judgment of the Apex Court confirms the principle that generally interest accrues on day-to-day basis. The Court has also accepted the view of the High Court that the interest so accrued cannot be nullified by the resolution subsequently passed.

4.2 It seems to us that the effect of the resolution in the above case has been decided on the basis of the facts of that case. It also seems that the above principle cannot have universal application in every case dealing with the time of accrual of interest irrespective of the facts of the case. In a given case, based on the terms of agreement and/or facts and circumstances of the case, a different view may also emerge.

4.3 Though the concept of real income still holds good, the same has to be applied cautiously and in case of non-receipt of accrued interest, it may be difficult to apply when the assessee follows the Mer-cantile System of Accounting.