1. The question referred to us by the Commissioner of Income-tax, Madras, is 'whether the sum of 13,301 dollars is allowable in this case as a deduction under Section 10(2)(iii) of the Income-tax Act as interest paid in the year Krodhana.' under Section 10 profits and gains of a business carried on by an assessee are to be computed after making certain allowances and Sub-clause (iii) allows the deductions of interest paid in respect of capital borrowed for the purposes of the business. The assessee is a Nattukkottai Chetty residing in the Ramnad District and has rubber gardens and a money-lending business at Taiping in the Federated Malay States. In the year Krodhana (1925-1926) he received a sum of Rs. 55,423 in British India from his business at Taiping and in the course of the assessment proceedings of 1926-1927 the question arose whether this sum, or any part of it, represented profit of the Taiping business liable to tax under Section 4(2) of the Indian Income-tax Act. The Income-tax Officer examined the accounts of the Taiping business and computed the profits for the year of account, Krodhana (13th April, 1925 to 12th April, 1926) to be 22,820 dollars and taxed this sum as profit remitted to British India. The assessee claimed an allowance of 22,573 dollars as expenditure in the business for that year and under the following circumstances. The assessee had borrowed money from certain Nattukkottai Chetty firms and the accounts showed that these loans had been taken on 'three months tavanai' and this is conceded by the assessee. In the course of the year of account, four of these tavanai periods terminated and the total amount of interest that fell due on those four occasions was 9,272 dollars. This sum the Income-tax Officer allowed as a deduction, but the assessee claimed in addition the sum of 13,301 dollars which represented the interest which had fallen due on the expiry of previous tavanai periods. It is admitted that those tavdnai periods expired in previous years or at any rate in the year previous to the year of account. The Income-tax Officer held that this interest, in view of the fact that these were tavdnai loans, must be regarded as having been paid in previous years and could not be treated as expenditure of the year of account. He accordingly disallowed the assessee's claim with regard to 13,301 dollars. In the accounts maintained by the assessee the whole of the sum of 22,573 dollars which represents the interest due on the expiry of all tavanai periods including those of the previous years is adjusted as having been paid to the, lenders in the year of account. Corresponding entries showing the receipt of interest were made in the accounts of some of the lenders. It is admitted that these entries are not a record of cash payments but they are used by the assessee to prove an agreement between him and his lenders to pay and receive the whole of the accumulated interest of the previous years in the year of account and that there was in consequence a constructive payment of the whole sum in that year. We think it is perfectly clear that in order to claim an allowance in respect of interest paid on borrowed capital it must be interest paid during the year of account. It may be interest actually paid in cash which is the cash basis of accounting or it may be by adjustment which is the mercantile basis of accounting. No regular basis of accounting seems to have been adopted by the assessee but in any case, in our view, it does not matter what method was adopted because the whole question depends upon what the arrangement was between the assessee and the persons who advanced the money at the time of its advance. It is conceded that the money upon which the interest was due to be paid was advanced to the assessee on what is known as the tavanai system; and the learned Commissioner in his reference to us states as follows:
Tavanai means a period of rest, and the distinguishing feature of such loans is that at the close of each period (in this case a period of three months) the interest due, if payment in cash has not been demanded by the creditor, is added on to the principal sum lent, and becomes merged in it, and begins to bear interest as part of such principal.
2. In Narayanan Chetty v. Suppiah Chetty : (1920)38MLJ437 it was held that such an arrangement as this is a deposit and when the interest is not demanded, the interest is to be added to the deposit as an increase to the deposit. That means that the interest though not demanded is to be treated as paid and received and is to be added to the deposit itself to carry interest. The Income-tax Officer, has therefore treated the interest due to the end of these tavanai periods as interest paid and he has adopted the same principle for both the years previous to the year of account and the year of account itself and has given the assessee the deduction allowable in respect of the tavanai periods ending in the year of account. But since the tavanai periods in respect of which the assessee claims the allowance of 13,301 dollars ended not in the year of account but in the year previous to it, it must be taken similarly that the interest was paid by the assessee in that previous year and added to the principal and therefore not having been paid in the year of account the Income-tax Officer was quite correct in disallowing the assessee's claim.
3. For these reasons we answer the question referred to us in the negative.
4. The Commissioner on this reference will get his costs, viz., Rs. 250.