Concept of "Real Income Theory" under Income Tax Laws

Lord Macnaghten “Income Tax, if I may be pardoned for saying so, is a tax on ‘income’. It is not meant to be a tax on anything else” explains the concept of real income. It is in this context the argument that an income has to be real income to be taxable has been found to be an attractive one.

Income tax is levied on income which has been received or has accrued. Income is said to be accrued when it becomes due, but it must also be accompanied by the corresponding liability of the other party to pay the amount. Only then an income will be said to have accrued and is not a hypothetical income.

Central Government has the power to levy tax on income, other than agricultural income, as specified by Entry 82 of List 1 of Constitution of India. Income Tax is a charge on the income of a person, earned during the previous year, at the rate(s) specified in the relevant Finance Act. Income of an assessee has to be computed in the manner laid down under the Income-tax Act (Act). The Act has made elaborate provisions for classification of incomes under various heads and deductions permissible under each head. Under the Act, income is chargeable to tax on the basis of either receipt or deemed receipt in India in the previous year relevant to the year of which assessment is made or the income that accrues or arises or deemed to accrue or arise in India during such year. But, what is income has not been defined and the Income-tax Act, 1961 provides for an inclusive definition which has wide connotations.

It is by now well-settled that income which is susceptible to tax is the real income as is commercially understood. In determining the real income, the question is not the physical receipt of income but of the concept of receipt in law.

Real income theory

When there is no provision of exemption or deduction in the law, the concept of real income has been considered in ascertaining whether an amount is taxable or not.

Real income and accrual of income

Income becomes taxable on the footing of accrual only when the right to receive the income becomes vested in the assessee. The basic concept is that he must have acquired a right to receive the income. In other words, there must be a debt owed to him by somebody. Unless and until a debt is created in favour of the assessee by somebody, it cannot be said that the assessee has acquired a right to receive the income or the income has accrued to him.

Real income and Statutory Provisions

Principles 3, 4 and 8 basically support the provisions of the Act, which differ from concept of real income in treating certain receipts as income. There are differences between the taxable income and the real income. An assessee pays tax on his taxable income, which may or may not be his real income or some portion of the taxable income may contain income which is not real income. There are number of provisions under which income is deemed to accrue or arise by way of statutory fiction, e.g., sections 9, 12, 45, 68, 69, 69A, 69B, 69C, 69D, 93, 94 and 172(2) of the Act, and these incomes will have to be assessed, whether shown in the accounts as such or not. However, an exception is provided to the effect that upon discharging initial burden placed upon assessee to prove that assessee has not earned such income, it would be upon Revenue to prove to the contrary under most of the provisions.

Section 43D Interest on NPAs: Even though the special provision in section 43D for taxing interest income on NPAs on receipt basis does not apply to NBFCs, it does not mean that NBFCs have to offer interest on bad or doubtful debts to tax on accrual basis. Such interest is not taxable on the real income theory. Learned counsel for the Revenue submitted that the assessee had to offer the interest income to tax on accrual basis. The special provision for taxing interest income on NPAs on the basis of receipt has been made under Section 43D of the Income Tax Act, 1961 (“the Act” for short) which does not apply to NBFC. By necessary implication, therefore, the legislature desired that such benefit would be restricted only to such of the entities as are referred to in Section 43D of the Act. (Related Assessment year : 2009-10) – [PCIT v. Bajaj Finance Limited – Date of Judgement : 02.04.2019 (Bom)]

Entire law on "real income theory" and distinction between "application of income" vs. "diversion of income by overriding title" explained with reference to case laws. Law on whether if an amount is not treated as "diversion of income", it can be allowed as "business expenditure" under section  37(1) or as a "trading loss" under section 29 also explained. Issue of “Base Erosion and Profit Shifting” (BEPS) also raised in the context of "tax avoidance vs. tax evasion" and diversion of income by a MNC

Courts and the Tax Authorities can look into the real purpose of the commercial arrangements and transactions to reach the truth and the transactions having the sole purpose of tax avoidance may be held to be having no effect on the actual tax liability of the tax payer. Book entries and Method of Accounting is not determinative and conclusive for deciding the computation of ‘taxable income’ in the hands of the Assessee though they may be relevant to be considered. “Diversion of income by transfer of overriding title at source” should normally have the support of the statutory requirements or some decretal binding character of Courts of law and even though the private contractual obligations can also bring about such “diversion of income at source” but in this last sphere of private contractual obligations, the Courts and the Income Tax Authorities have to examine such aspects carefully in comparison to the above two other categories of statutory requirements and the Court decrees and then examine the real purport and object of such private arrangements and Contracts. (Related Assessment year : 2010-11) – [PCIT v. M/s. Chamundi Winery and Distillery (2018) (Karn)]

Gain arising to the assessee on account of securitization of lease receivables and credited to the Profit & Loss Account is a taxable receipt in the year of securitisation as per T. V. Sunderam Iyengar 222 ITR 344 (SC). Argument that the entry represents hypothetical income and not real income and that the amount is assessable in subsequent years on receivable basis is not correct. Question of whether income can also be deferred to subsequent years under the "Matching concept" as per Taparia Tools 260 ITR 102 (Bom)/ 372 ITR 605 (SC) left open.

Thus, if the assessee claims the expenditure in that year, the Department cannot deny it. However, in a case where the assessee himself wants to spread the expenditure over a period of ensuing years, it can be allowed only if the principle of the “matching concept” is satisfied, which up to now has been restricted only to cases of debentures. Whether the ‘matching concept’ would also apply to “income” is wholly a different matter and which would be considered in an appropriate case, as and when it so arises, provided the factual foundation is laid for the same. (Related Assessment years : 2002-03, 2003-04) – [L&T Finance Limited v. DCIT – Date of Judgement : 17.09.2018 (Bom)] 

Diversion of income by overriding title: Only income that has actually accrued to the assessee is taxable. What income has really occurred to be decided, not by reference to physical receipt of income, but by the receipt of income in reality. The fact that there is no written agreement to show that the assessee was acting as a broker is not relevant. The relationship of the assessee vis-a-vis others can be inferred from the conduct of the parties

The income that has actually accrued to the Respondent is taxable. What income has really occurred to be decided, not by reference to physical receipt of income, but by the receipt of income in reality. Given the fact that the Respondent had acted only as a broker and could not claim any ownership on the sum of Rs. 14,73,91,000/- and that the receipt of money was only for the purpose of taking demand drafts for the payment of the differential interest payable by Indian Bank and that the Respondent had actually handed over the said money to the Bank itself, we have no hesitation in holding that the Respondent held the said amount in trust to be paid to the public sector units on behalf of the Indian Bank based on prior understanding reached with the bank at the time of sale of securities and, hence, the said sum of Rs. 14,73,91,000/- cannot be termed as the income of the Respondent. - [DCIT v. T. Jayachandran – Date of Judgement : 24.04.2018 (SC)]

Only the “Revenue Income” part of the Lease Rentals could be taxed in the hands of the Assessees on the concept of taxability of “real income” only under the Act

Bifurcation of lease rentals into interest and loan recovery: An assessee can only be taxed on "real income". The bifurcation of lease rental is not an artificial calculation. Lease equalization is an essential step in the accounting process to ensure that real income from the transaction in the form of revenue receipts only is captured for the purposes of income tax. The Guidance Note issued by the ICAI carries great weight. The method of accounting prescribed in such a Guidance Note, in order to compute real income and offering the same for taxation, cannot be disregarded by the Assessing Officer unless such action falls within the scope and ambit of Section 145(3) of the Income Tax Act.

The method of accounting followed, as derived from the ICAI’s Guidance Note, is a valid method of capturing real income based on the substance of finance lease transaction. The rule of substance over form is a fundamental principle of accounting, and is in fact, incorporated in the ICAI’s Accounting Standards on Disclosure of Accounting Policies being accounting standards which is a kind of guidelines for accounting periods starting from 01.04.1991. It is a cardinal principle of law that the difference between capital recovery and interest or finance income is essential for accounting for such a transaction with reference to its substance. If the same was not carried out, the Respondent would be assessed for income tax not merely on revenue receipts but also on non-revenue items which is completely contrary to the principles of the Income Tax Act and to its Scheme and spirit. (Related Assessment year : 1999-00  - [CIT v. Virtual Soft Systems Ltd (2018) 404 ITR 409 (SC)]

Payment to NBFC for EMI default taxable on receipt basis; Propagates‘real-income’ theory

High Court rules that Additional Finance Charges (‘AFC’) collected by assessee (an NBFC) upon borrowers’ default in payment of EMIs taxable on receipt basis, not on accrual basis as sought by Revenue for Assessment years 1997-98 to 2000- 01; Accepts assessee’s contention that when uncertainty was attached to the recovery of EMIs itself, recovery of additional burden in the form of AFC was equally uncertain, therefore it cannot be taxed on accrual basis. Follows coordinate bench ruling in Annamalai Finance Ltd wherein it was held that the test of real income is the chances or probabilities of realisation and whether there was a real accrual of income to the assessee company, thus rules that the 'actual receipt' theory for AFC income stands fortified; Further, observes that collection and accrual of AFC happens simultaneously, thus no loss was caused to Revenue owing to change in method of accounting as AFC collected was offered to tax on receipt basis. (in favour of assessee) – [CIT v. Shriram Investments Ltd [TS -538-HC-2015 (Mad)]

No tax on consideration agreed under development agreement if not accrued or received; concept of ‘real income’ relevant while determining income chargeable to tax

Even if gains have accrued on execution of the development agreement as per Chaturbhuj Dwarkadas, the subsequent modification/ supercession of the agreement means that gains are not taxable as per real income theory, (ii) expenditure on buy-back of shares of warring shareholders is business expenditure. In Chaturbhuj Dwarkadas Kapadia, the issue was to determine the year in which the property was transferred for the purpose of capital gains. In this case the issue is what is the consideration received for the transfer of an asset. No income is accrued or received of the value of 18000 sq.feet of constructed area under the development agreement because the said agreement was not acted upon as it came to be uperseded/modified by the Tripartite agreement. This was the position when the return of income was filed. On the application of the real income theory, there would be neither accrual nor receipt of income to warrant bringing to tax to the constructed area of 18,000 sq.ft which has not been received by the assessee (CIT v. Shoorji Vallabhdas (1962) 46 ITR 144 (SC) followed) (Related Assessment year : 2007-08) – [CIT v. Chemosyn Ltd – Date of judgement : 11.02.2015 (Bom)]

Income accrued must be considered from a realistic & practical angle

The assessee maintains its accounts on a mercantile basis. In its return (revised on 31st March 2003) the assessee claimed a deduction of Rs. 12,57,525/- under the head advance license benefit receivable. The assessee also claimed a deduction in respect of duty entitlement pass book benefit receivable amounting to Rs. 4,46,46,976/-. These benefits related to entitlement to import duty free raw material under the relevant import and export policy by way of reduction from raw material consumption. According to the assessee, the amounts were excluded from its total income since they could not be said to have accrued until imports were made and the raw material consumed.

By his order dated 24th March 2004, the Assessing Officer did not accept the assessee’s claim on the ground that the tax ability of such benefits is covered by Section 28(iv) of the Income Tax Act, 1961 (for short ‘the Act’) which provides that the value of any benefit or perquisite, whether convertible into money or not, arising from a business or a profession is income. According to the Assessing Officer, along with an obligation of export commitment, the assessee gets the benefit of importing raw material duty free. When exports are made, the obligation of the assessee is fulfilled and the right to receive the benefit becomes vested and absolute, at the end of the year. In the year under consideration, the export obligation had been made and the accounting entries were based on such fulfilment. The Assessing Officer distinguished Jamshri on the ground that it pertained to the assessment year 1985-86 when the export promotion scheme was totally different and the taxability of such a benefit was examined only with reference to Section 28(iv) of the Act but “in the present case the taxability of such benefit is to be examined from all possible angles as it forms part of the profits and gains of business according to the ordinary principles of commercial accounting.”

Held :- Applying the three tests laid down by various decisions of this Court, namely, whether the income accrued to the assessee is real or hypothetical; whether there is a corresponding liability of the other party to pass on the benefits of duty free import to the assessee even without any imports having been made; and the probability or improbability of realisation of the benefits by the assessee considered from a realistic and practical point of view (the assessee may not have made imports), it is quite clear that in fact no real income but only hypothetical income had accrued to the assessee and Section 28(iv) of the Act would be inapplicable to the facts and circumstances of the case. Essentially, the Assessing Officer is required to be pragmatic and not pedantic. - [CIT v. M/s Excel Industries Ltd. – Date of Judgement : 08.10.2013 (SC)]

Commission, Interest, Rent etc. as also the excise duty and sales tax being indirect taxes are not part of total turnover of the Assessee for computing the benefit under Section 80HHC of the Act

In Commissioner of Income-Tax v. Lakshmi Machine Works, the Hon’ble Supreme Court dealt with the case of deduction under Section 80HHC of the Act and while holding that Commission, Interest, Rent etc. as also the excise duty and sales tax being indirect taxes are not part of total turnover of the Assessee for computing the benefit under Section 80HHC of the Act, the Court observed the following with regard to taxability of ‘real income” and the income tax not being a tax on gross receipts by the assessee.

“Section 80HHC of the Income-tax Act, 1961, is a beneficial section; it was intended to provide incentive to promote exports. The intention was to exempt profits relatable to exports. Just as commission received by the assessee is relatable to exports and yet it cannot form part of “turnover” for the purpose of section 80HHC, excise duty and sales tax also cannot form part of “turnover”.

Just as interest, commissioner, etc., do not emanate from the “turnover” so also excise duty and sales tax do not emanate from such turnover. Since excise duty and sales tax did not involve any such turnover such taxes had to be excluded. Commission, interest, rent, etc., do yield profits, but they do not partake of the character of turnover and therefore they are not includible in the “total turnover”. If so, excise duty and sales tax also cannot form part of the “total turnover” under section 80HHC(3). – [CIT v. Lakshmi Machine Works (2007) 290 ITR 667 (SC)]

In CIT v. Pepsu Road Transport Corporation, the Court considered the question as to whether the amount forfeited by the employer out of the provident fund where it was categorically mentioned that the said amount belonged to the Trust, was income of the assessee. Invoking the concept of 'real income', the High Court held the same not to be the income of the assessee. – [CIT v. Pepsu Road Transport Corporation (2002) 253 ITR 303 (P & H)]

In the case of Godhra Electricity Co. Ltd. v. CIT, it was observed that assessee would be obliged to pay tax only on such income which has been received or accrued when it is based on and backed by any legal or contractual right to receive the amount at a subsequent date. - [Godhra Electricity Co. Ltd. v. CIT (1997) 225 ITR 746 (SC)]

'Statutory levy' could not be equated as the 'real income' of the assessee

In Somaiya Organo Chemicals Ltd. v. CIT, the issue considered by Bombay High Court was – whether the cess collected and kept in a separate bank account as per the statutory order and to be utilized for a particular purpose, was 'income' in the hands of assessee? It was held that the 'statutory levy' could not be equated as the 'real income' of the assessee. – [Somaiya Organo Chemicals Ltd. v. CIT (1995) 216 ITR 291 (Bom)]

In Rajkot District Gopalak Co-op. Milk Producers' Union Ltd. v. CIT, the question which fell for consideration was-whether income of the project assigned to a Co-operative Society on lease and license basis and profits of which were to be paid to the State Government, could be treated as 'income' of the assessee? It was held that the entire income belonged to the Government and it could not be treated as the income of the assessee and was thus not taxable. – [Rajkot District Gopalak Co-op. Milk Producers' Union Ltd. v. CIT (1993) 204 ITR 590 (Guj)]

In State Bank of Travancore v. CIT (1986) 158 ITR 102 (SC) wherein the majority view was that accrual of income must be real, taking into account the actuality of the situation; whether the accrual had taken place or not must, in appropriate cases, be judged on the principles of real income theory. The majority opinion went on to say:

“What has really accrued to the assessee has to be found out and what has accrued must be considered from the point of view of real income taking the probability or improbability of realization in a realistic manner and dovetailing of these factors together but once the accrual takes place, on the conduct of the parties subsequent to the year of closing an income which has accrued cannot be made “no income”.

In the case of Parashuram Pottery Works Ltd v. ITO (1977) 106 ITR 1 (SC) on the issue of consistency held that “Revenue cannot be allowed to flip-flop on the issue, and it ought let the matter rest rather than spend the tax payer’s money in pursuing litigation for the sake of it.”

Income tax is a tax on real income

It was held that tax is exigible only on income earned in reality. In examining a transaction, the court would have more regard to the reality of the situation and lay greater emphasis on the business aspects of the matter when that can be done without disregarding the statutory language as held by Hon’ble Bombay High Court in the case of H. M. Kashiparekh & Co. Ltd. v. CIT (1960) 39 ITR 706 (Bom.). – [Poona Electric Supply Co. Ltd. v. CIT (1965) 57 ITR 521 (SC)]

Income tax cannot be levied on hypothetical income

It is now well settled that income tax cannot be levied on hypothetical income. In Commissioner of Income Tax v. Shoorji Vallabhdas and Co., it was held as follows:-

“Income-tax is a levy on income. No doubt, the Income-tax Act takes into account two points of time at which the liability to tax is attracted, viz., the accrual of the income or its receipt; but the substance of the matter is the income. If income does not result at all, there cannot be a tax, even though in book-keeping, an entry is made about a ‘hypothetical income’, which does not materialize. Where income has, in fact, been received and is subsequently given up in such circumstances that it remains the income of the recipient, even though given up, the tax may be payable. Where, however, the income can be said not to have resulted at all, there is obviously neither accrual nor receipt of income, even though an entry to that effect might, in certain circumstances, have been made in the books of account.” - [CIT v. Shoorji Vallabhdas and Co. (1962) 46 ITR 144 (SC)]

What is to be subject for taxation is only real income over which the assessee possesses a right and not any other thing

The Hon'ble Supreme Court has ruled that what is to be subject for taxation is only real income over which the assessee possesses a right and not any other thing. Sitaldas Tirathdas was an individual of Bombay (as it was then called). He had many sources of income, chief among them being property, stocks and shares, bank deposits, and a share in a partnership rm. His wife, Deviben and his children had separated from him and Deviben had led a suit in the Bombay High Court for maintenance allowance, separate residence and marriage expenses for his daughters etc. A decree by consent was passed on 11 March 1953 and maintenance allowance of Rs.1,500 per month was decreed against Sitaldas. In terms of this decree Sitaldas paid Deviben a sum of Rs.1,350 for the month of March 1953 and a sum of Rs.18,000 for the Financial Year 1953-54. He accordingly claimed a deduction of the said sum of Rs.1,350 from his income for the Assessment Year 1953-54 and Rs.18,000 for the Assessment Year 1954-55. No charge on Sitaldas' property was created for payment of this sum. Sitaldas in his assessment, claimed a deduction of these sums relying on the decision of Raja Bejoy Singh Dudhuria (supra). The Assessing Ofcer and the Appellate Assistant Commissioner disallowed this claim. On appeal, the Tribunal observed as follows: “Thisis a case, pure and simple, where an assessee is compelled to apply a portion of hisincome for the maintenance of persons whom he is under a personal and legal obligation to maintain. The IT Act does not permit of any deduction from the total income in such circumstances.” The Bombay High Court, reversed the order of the Tribunal relying on two of its earlier decisions in Seth Motilal Manekchand v. CIT (1957) 31 ITR 735 (Bom)/[TS-5-HC-1957(BOM)] and Prince Khanderao Gaekwar v. CIT (1948) 6 ITR 294]/[TS-1-HC-1948(BOM) and held that, as observed in those two cases, the test was the same, even though there was no specific charge upon property, so long as there was an obligation upon the assesse to pay, which could be enforced in a Court of law, the income to the extent of the decree should be taken to be diverted to the wife and children and never became the income of the assessee. – [CIT v. Sitaldas Tirathdas (1961) 41 ITR 367 (SC)] 

The Hon’ble Supreme Court in the case of Badridas Daga v. CIT (1958) 34 ITR 10 (SC) had allowed ‘loss on embezzlement’, though not an expenditure, as a deduction on the principle of real income theory. This theory is propounded more particularly when there is no assistance in the form of law, so that tax was levied on real income and not on hypothetical income, either on the basis of the entries in the books of account or otherwise.

It was held that if the assessee acquires a right to receive the income, the income is said to have accrued to him, though, it may be received later on. – [E. D. Sassoon & Co. Ltd. v. CIT (1954) 26 ITR 27 (SC)]

The Privy Council in CIT v. Chetnavis (SM) AIR 1932 PC 178 had allowed a bad debt as an allowable item on the basis of commercial principles, when there is no provision in law to allow such claim.