1. At this instance of the Commissioner of Income-tax and in pursuance of the directions of this court, two questions have been referred under s. 256(1) of the I.T. Act, 1961. The first of them is :
'Whether, on the facts and in the circumstances of the case and having regard to the terms of the agreement entered into between the parties and in the light of the entries contained in the accounts of the assessee, the Appellate Tribunal was right in deleting the commission added to the assessee's income for the respective assessment years ?'
2. The assessee is a private limited company. It derives income, inter, alia, from film distribution and financing. We are concerned with the assessment years 1964-65, 1965-66 and 1966-67. The relevant accounting years are the Tamil Years. The assessee had entered into an agreement with the Matha Pictures on September 31, 1962. Matha Pictures was producing a Kannada film called 'Sakthi Sakthi'. While the film was in the process of production, the producer, who wanted finances for completing the picture, approached the assessee and offered to entrust it with the exclusive rights of distribution in certain areas in Karnataka State. The assessee agreed to advance a sum of Rs. 2,80,000 to spent only towards the production of the said picture. A sum of Rs. 85,000 was to paid in full statement of the amounts due to another distributor. The balance was to be paid on different occasions. For instance, a sum of Rs. 40,000 was to paid on signing the agreement, another sum of Rs. 25,000 after fifteen call sheets were shot, another sum of Rs. 25,000 after completing thirty call sheets, which would completed the picture, and the balance of Rs. 80,000 was to be retained towards the cost of prints and publicities. There were certain other provision which are usually to be found in such agreement and which are not of any significance to us. it is enough for our purpose to refer to those clauses which are material. Clause 5 provided for a distribution commission calculated at 35 per cent. on the net realisation of the picture. Under clause 6, the expression 'net realisation' was defined as meaning the distributor's share, after deducting the taxes, derived from the screening of the picture. Clause 7 authorised the distributor to deduct the distribution commission as mentioned in clause 5 and appropriate the balance towards the discharge of the amounts advanced to the producer. After the advance was completely adjusted, the distributor had to remit to the producer the realisation after deducting the distribution commission. Clause 14 provided that in the event of the advance not being fully adjusted and wiped off during the period of twelve months from the date of realise of the picture, the producer was to refund to the distributor immediately such unrecouped portion of the amount stipulated. The distributor was also entitled under clause 15 to demand and receive the overflow collections from certain other distributors. The producer undertook to complete and deliver the prints for the realise of the picture on November 27,1962, that is, the Deepavali day in that year, failing which the producer undertook to pay damages together with interest for amount received at the 12 per cent. per annum from the date of default up to the date of delivery of the prints. If the producer was unable to complete the picture and deliver the prints by the Deepavali of the negatives of the picture so far produced and to proceed with the completion of the render all assistance to the assessee for the production and completion of the picture. The expenditure incurred by the distribution was to be entirely borne by the producer which had to be treated as further distribution advances under the contract.
3. In the accounts for the year ended April 12,1964, the assessee has passed entries in its books debiting the account of 'Sakthi Sakthi', in which the amounts advanced had also been debited with a sum of Rs. 91,887.84. The narration in the journal read as follows : 'Being the distribution commission at 35 per cent on the realisation of Rs. 2,62,536.68 made up to April 12, 1964, adjusted to producer's account. The picture was released only in September, 1963, and the collections up to April 12, 1964, came to Rs. 2,62,536.68. The assessee had actually advanced Rs. 4,37,828.43 for the completion of the picture. The net realisation up to April 12, 1964, included the realisation for the earlier year, viz., Rs. 2,99,366.68.
4. The ITO included in the assessment for the assessment years 1964-65 the said amount of Rs. 91,888, being the commission calculated at 35 per cent, of the net realisation during the year ended April 12, 1964. Similarly, he included the amount of commission at 35 per cent. out of the realisation for the assessment years 1965-66 and 1966-67 and brought the amounts to tax. The amounts so brought to tax for those two years came to Rs. 22,152 and Rs. 7,770. In making these assessments the ITO rejected the assessee's claim that it could expect to earn the commission only after the capital was realised and that so long as the amount of realisation fell short of the said capital, assessee could not be taxed on the commission.
5. The assessee appeal against the assessment for all these years to the AAC who confirmed the assessments. The matter was further taken to the Tribunal, and the Tribunal for the reasons stated in its order dated May 7, 1974, held that the amount was not liable to be taxed in these years. In the view of the Tribunal, the assessee was justified in coming to the conclusion that till the last day of each of these accounting years there was no scope for realising this income as the collections could barely cover the investment along. The Tribunal looked into the accounts and found that the assessee had not appropriated any amount to the commission account though, in respect of other pictures for which there were similar distribution agreements, the amounts had been appropriated to the commission account. The Tribunal directed the exclusive of the three amounts mentioned already from the respectively assessments, it is to challenge this order that the Commissioner has obtained reference of the question in the case.
6. Learned counsel for the Commissioner contended that the assessee was maintaining account on the mercantile basis and that under the mercantile system of accounting, the assessee has to show as income the amounts that had accrued as income, whether the accrued amounts were subsequently actually realised or not. It is in this context that he brought to our notice the several decision, to be adverted to presently. For the respondent-assessee, the learned counsel relied on the clauses in the agreement as showing that no income could be said to have accrued to the assessee in the relevant years. He cited certain other decision which will also be considered now.
7. We have already summarised the agreement and referred to the relevant clauses which are material here. The agreement contemplated release of the picture on November 27,1962. It is not in dispute that the picture could not be complete and that the assessee had to take over the production from the original producer. The production was completed only by September, 1963, when the picture was released. Thus, there was a breach of the agreement by the producer as he did not complete the picture within the stipulated period. The further fact that emerges from the accounts as shown in the annexures is that the assessee had actually advanced a sum of Rs. 4,37,828.43. He had also to incur further expenditure by way of additional prints, excise duty, advertisement charges, etc. The total amount incurred by the assessee before distribution of the picture came to Rs. 4,63,574.11. The realisation up to April 12, 1964, was only Rs. 2,62,536.68. The further realisation up to April 12, 1965, and April 13, 1966, came to Rs. 66,298.48 and Rs. 22,187.48. From these figures it would be clear that the picture had no successful run. Apparently, because of the difficulties, the producer is stated to have become a sanyasi. But the assessee had to take over the production of the picture only because he had substantial advances and had to look to the realisation for the purpose of recovering the amounts so advanced. The way in which the picture was receiving by the public could, in the circumstances, have shown to the assessee that even the amounts advanced could not have been realised. The question of realisation of the commission or the interest that is contemplated by the agreement would thus be a very doubtful one. It is in the background of these facts that we have to examine the relevant authorities.
8. The Bombay High Court in H. M. Kashiparekh & Co. v. CIT : 39ITR706(Bom) , enunciated the principle of 'real income' applicable to the taxation of income. In that case, the assessee maintained its account on the mercantile system of accounting. It was the managing agent of a paper mill. Under the managing agency agreement it was under a duty to forgo one-third of its commission if its profits of the managed company were not sufficient to pay a dividend of 6 per cent. But, as a result of the resolution passed by the managed company, the assessee gave up some further amounts. The maximum amount that could have been for gone by the assessee was Rs. 39,215 under the agreement. The balance forgone come to Rs. 57,785. The question was whether the I.T. Authorities were justified in taxing the said sum of Rs. 57,785. It was held that the assessee could be taxed only on the real income and not on any hypothetical income. The following passage, at p. 722, brings out the principle to be applied in such situations :
'We do not think it to be accord either with the authorities cited that the principle of real income is to be subordinated as to amount virtually to a negation of it when a surrender or concession or rebate in respect of managing agency commission is made agreed t or given on grounds of commercial expediency simply because it takes place some grounds of commercial experience simply because it takes place some time after the close of an accounting year. In examining any transaction and situation of this nature, the court would have more regard to the reality and speciality of the situation rather than the purely theoretical or doctrinaire aspect of it. It will lay grated emphasis on the business aspect of the matter viewed as a whole when that can be done without disregarding the statutory language.'
9. This decision was referred to with the approval by the Supreme Court in Poona Electric Supply Co. Ltd. v. CIT : 57ITR521(SC) . It is not necessary for our present purpose to go into the facts of the decision of the supreme Court. It is enough to set out certain principles which have been summarised at p. 530 :
'Income-tax is a tax on the real income, i.e., the profits arrived at on commercial principles subject to the provisions of the Income-tax Act. The real profit can be ascertained only by making the permissible deductions. There is a clear-cut distinction between deductions made for ascertaining the profits and distributions made out of profits. In a given case whether the outgoings fall in one or the other of the heads is question of fact to be found on the relevant circumstances, having regard to business principles. Another distinction that shall be borne in mind is that between the real and the statutory profits, i.e., between the commercial profits and statutory profits. The latter are statutorily fixed for a specified purpose.'
10. The passage from the decision of the Bombay High Court, extracted above, was reproduced in CIT v. Arumugham Pillai : 73ITR382(Mad) , and was followed in a later decision of this court in CIT v. Motor Credit Co. Ltd. : 127ITR572(Mad) . This was a case of limited company carrying on business as financiers for purchase of motor vehicles under a hire purchase scheme. Money had been advanced to two firms carrying on bus transport business. The routs of these two firms were taken over by the State Transport Corporation. The firms defaulted in making the payments of the hire purchase instalments and, consequently, the buses were seized. The assessee was advised that there was no prospect of recovering even the principal amount. It did not, therefore, credit interest on the outstanding from the two firms even though what it followed was the mercantile system of accounting. The ITO, however, included the accrual interest on the outstanding due from those firms. The AAC and the Tribunal deleted the amount from the assessment and, on a reference, this court held that the Tribunal was correct in its conclusion that though the assessee had adopted the mercantile system of accounting, no interest could be assessed in its hands on accrual basis as it would be very unrealistic on the part of the assessee to take credit for a highly illusory interest. The principle to be applied in such a situation has been set out at p. 576 :
'The regular mode of accounting determines only the mode of computing the taxable income and the point of time at which the tax liability is attracted. It cannot determine or affect the range of taxable income or the ambit of taxation. Where no income has resulted, it cannot be said that income has accrued merely on the ground that the assessee has been following the mercantile system of accounting. Even if the assessee makes a debit entry to that effect, still no income can be said to have accrued to the assessee. If no income has materialised, there can be no liability to tax on a hypothetical income. It is not the hypothetical accrual of income based on the mercantile system of accounting followed by the assessee that has to be taken into account, but what should be considered is whether the income has really materialised to the assessee has to be considered with reference to commercial and business realities of the situation in which the assessee has been placed, and not with reference to his system of accounting.'
11. We are agreement with this view.
12. This case broke new ground. The theory of real income had so far come in for application only in two types of cases, namely, (1) where there was a surrender of income which may in theory have accrued, and (2) where there is a diversion of income by overriding title. In the case of Motor Credit Co. P. Ltd. : 127ITR572(Mad) , the facts did not fit in with either of these two categories. But still, this court considered it proper to apply the principle of real income to such a case, the case being one where interest, though it could be taken to have theoretically accrued, was only illusory or hypothetical.
13. The theory of real income being liable to taxation, is not based on any accruing principle or accounting entries. If accounting entry is the only criterion, then it would furnish each means of escape for unscrupulous assessee who, by declining to make an entry, may get out of the net of taxation. Accounting entry does not also create any estoppel as against the assessee and in favour of the Department. The liability of taxation is based on the statute and an assessee is not liable to be taxed because of his mistake. In the present case, if strictly the principle of mercantile system of accountings is to be stressed, then the assessee could have made an entry crediting the amount of commission as its income, and simultaneously or at the close of the year debiting it as a loss of the said income, because the assessee had no hope of recovering the said amount. The result would be that the entries would have cancelled themselves out and there would be no scope for taxation. It is true as contended by the learned counsel for the commissioner that there have been receipts as and by way of realisation on the exhibition of the film. But, in the context in which the assessee was placed, where he had not only advanced a huge sum of Rs. 2,80,000, but also further sums totalling in all Rs. 4,37,828 he had to take into account even the principle amount advanced not being realisable. The slow process by which the realisation came in does establish the bona fides of the assessee. Thus, as against a sum of Rs. 4,37,828 incurred as cost of production the assessee was in a position to realise only Rs. 3,47,000 approximately during the years with which we are now concerned. The Tribunal has taken these facts into consideration in holding that the commission could not be said to have accrued in favour of the assessee.
14. The High Court of Punjab and Haryana had occasion to consider a related question in CIT v. Ferozepur Finance (P.) Ltd. . In that case, the assessee was a financing company as its name itself disclosed. It had made certain advances to a debtor whose financial position was bad. There was no hope of recovering even the principle amount. The assessee did not, therefore, considered it necessary to charge any interest to the said account. The ITO, however, on the basis of the system of accounting being mercantile, brought to tax the amount of interest, liable to be charged by the assessee but not actually entered, as income of the assessee. The Appellate Tribunal deleted the addition made by the ITO and in the reference, the High Court held that even in the mercantile system of accounting, an assessee could forgo the whole or part of the amount of debt and the same cannot be added to the income of the assessee. This case supports the view that we have indicated above.
15. Learned counsel for the Commissioner placed string reliance on two decisions, one of the Supreme Court and the other of the Calcutta High Court. The Supreme Court decision is Morvi Industries Ltd. v. CIT : 82ITR835(SC) . In that case, the assessee was the managing agent and as such, entitled to commission and office allowance. By resolution passed after the commissioner had become due, the assessee relinquished its commission on sales and office allowance, as the managed company had suffered heavy losses in the part years. The Calcutta High Court held, agreeing with the Tribunal that the relinquishment by the assessee of its remuneration after it had become due was of no effect and that the amount was liable to be taxed. The Supreme Court confirmed this decision. The Supreme Court has considered the question only in the light of the system of accounting followed by the assessee. The decision of the case turned on the fact that the relevant resolution was passed after the accounting year when the commission had accrued. The aspect to which we have referred earlier had not been put forward in the said case and we do not find the principle of that decision to be applicable here.
16. The decision of the Calcutta High Court is James Finaly & Co. v. CIT : 137ITR698(Cal) . The assessee in that case had advance money to two parties and the amount receivable as the interest was credited to the suspense account, since the assessee followed the mercantile system of accounting. Accorting to the assessee, there was an extreme unlikehood of the loan being recovered. The High Court held that having regard to the system of accounting followed by the assessee, the amount liable to be taxed. It is in this context that the principle of real income was considered and it was pointed out that in examining any transaction the court would have more regard to the reality and speciality of the situation rather than the theoretical or doctrinaire aspect. It would lay greater emphasis on the business aspect of the matter view as a whole when that can be dome without disregarding the statutory language. However, while considering the facts, it was pointed out that the agreement did not provide for at all. The waiver of interest would be inconsistent with the account. Thus, the decision turned on the particular facts. However, in so far as the learned judges have referred to the reality of the situation rather than the theoretical or doctrinaire aspect of it, we are in agreement with them.
17. The only other decision to which reference was made by the counsel for the Commissioner was State Bank of Travancore v. CIT : 110ITR336(Ker) . In that case, the assessee, a bank did not credit in its account interest accrued on what were called 'stictly advances' because the assessee felt that the interest may not be paid. It credited the interest to a separate account known as interest suspense account. On a reference, it was held by the Kerala High Court that there was accrual of income liable to tax and that the assessee was not justified in not crediting the interest accrued on such advances in its interest account. The court has not gone into the principle of real income, which we have discussed above. The case turned on the manner of maintenance of accounts and the accrual of income therefrom. In these circumstances, we do not think it possible to apply the said decision to the facts here.
18. The result is that the first question is answered in the affirmative and in favour of the assessee.
19. The second question referred to us runs as follows :
'Whether, on the facts and in the circumstances of the case, the Appellate Tribunal was right in cancelling the penalties levied under section 271(1)(c) in the assessee's case ?'
20. For the years, penalties, under s. 271(1)(c) of the Act, were levied by the IAC, in relation to the aforesaid amounts, as if they were concealed income. The amount so levied as penalty came to Rs. 20,071.71 and Rs. 2,183 respectively. The Tribunal cancelled those penalties in the light of its decision that the relevant amounts brought to tax in the assessment as income, which has resulted in the levy of penalties, were not taxable as income. As the amounts did not represent income, there was no question of the assessee disclosing the same in its return and, therefore, the penalties levied were cancelled. As we have agreed with t he conclusions of the Tribunal, we consider that there is no question of levy penalty on the facts here. When the amounts were not liable to be taxed, there could be no levy penalty for their omission from the return. The question relating to penalty is also answered in the affirmative and in favour of the assessee. The assessee will be entitled to its costs. Counsel's fee Rs. 500 (rupees five hundred only). One set.