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Accrual When income accrues and is chargeable to tax

Subject : Income Tax LawMonth-Year : Oct 2005Author/s : Chetan A. KariaChartered Accountant

Facts :

1. The querist is company carrying on business of construction contractor. Itundertakes work of civil construction for its clients for buildings and other civilwork. During the previous year relevant to A.Y. 2003-04, the querist hadundertaken a contract for civil construction. The work was executed for an Indianoffice of an MNC on urgent basis. As the work was of emergency nature andcertain specific requirements of the client were to be adhered to, the quotation ofrates was higher than normal rates and the local office had indicated that it does

not have power to accept the same, though it agreed with quotation given asreasonable. In view of past relationship, the querist started work though a formalcontract was not entered into as the rates for work to be done were yet to beapproved by head office of the client. The client had issued a letter indicating thatif the head office does not accept the rates as quoted, then the querist would bepaid as per earlier fixed rates, which were much lower than the rates quoted forthe job and the querist would have incurred a loss. However, the querist wasassured by the local office that the rates quoted would be approved by the headoffice.

2. Work had commenced in January, 2003 and completed by March, 2003. Thequerist had also received an amount as per normal rates as advance and it was sotreated by the client as well as the querist. The querist had finalised its accountsby June, 2003 by which time the client had not received approval from the headoffice and, therefore, neither a formal contract was entered into, nor a bill raisedfor such work. Therefore, both the cost incurred and the advance received werenot reflected in profit and loss account and both the amounts were carried forwardto the next year.

3. After the approval was received, a formal contract was entered into and thequerist raised a bill and payment was also received for the same. The queristdeclared whole of the income in the previous year relevant to A.Y. 2004-05.

4. During the course of assessment proceedings, the Assessing Officer called fordetails of the transaction and he is of the view that income from the said project isassessable as income in A.Y. 2003-04, as work was done in the said year andamount has also been received as per the quotation of the querist. The AO hasstated that approval received in the next year cannot be a reason forpostponement of taxation, more so when the amount as quoted has beenreceived.

Query :

5. On the above facts, the querist seeks opinion as to whether income from thesaid project has accrued and is taxable in A.Y. 2003-04 or in A.Y. 2004-05.

Opinion :

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6. To summarise the facts stated by the querist, during A.Y. 2003-04, the work hadcommenced and was also completed. The querist had received amounts as perearlier rate contracts as advance and as per such rate contract, it has incurred aloss in the said contract. However, the querist had quoted a higher amount andthe local office of the client did not have the necessary authority to agree to suchan amount. No contract had been entered into. Though the local office of the clienthad assured that the head office would agree to the quotation, it had clarified thatin absence of such approval, the querist would be paid only as per pre-approvedrate contract. As such, during relevant previous year, though advance amount hadbeen received but considering the same as receipt, the querist had incurred a loss.

The querist makes a profit only if higher rates are agreed to, which had not beenagreed to till the end of the financial year, rather even up to the date offinalisation of accounts, such approval had not come. In the background of theabove, let us examine whether income from the said project is taxable in A.Y.2003-04.

7. S. 5 of Income-tax Act, 1961 charges to tax income received by or accruing orarising to any person. Therefore, before any amount is charged to tax, it musteither be income received or accrued or arisen. In the facts of the case of thequerist, the term received is not relevant because even if advance received istreated as income, though it is not so, the querist has incurred a loss and it wouldinstead be entitled to claim loss.

8. Meaning of the words income accrued or arisen were considered by theSupreme Court in E. D. Sassoons case, 26 ITR 27 (SC) where it was held at page51 :

"But in order that the income can be said to have accrued to or earned by the

assessee, it is not only necessary that the assessee must have contributed to itsaccruing or arising by rendering services or otherwise, but it must have created adebt in his favor. A debt must have come into existence and it must have acquireda right to receive the payment. Unless and until his contribution or parenthood iseffective in bringing into existence a debit or a right to receive the payment or inother words, a debitum in praesenti, solvendum in futuro, it cannot be said thatany income has accrued to him. The mere expression earned in the sense ofrendering the services, etc., by itself is of no avail."

It was further held at page 63 :

"But the true test u/s.4(1)(a) of the Income-tax Act is not whether the transferorsand the transferees had worked for any particular periods of the year, but whetherany income had accrued to the transferors and the transferees within thechargeable accounting period. It is not the work done or the services rendered bythe person, but the income received or the income which has accrued to theperson within the chargeable accounting period that is the subject-matter oftaxation. That is the proper method of approach while considering the taxability orotherwise of income and no considerations of the work done for broken periods orcontribution made towards the ultimate income derived from the source ofincome, nor any equitable considerations can make any difference to the positionwhich rests entirely on a strict interpretation of the provisions of S. 4(1)(a) of theIncome-tax Act."

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9. In CIT v. Ashokbhai Chimanbhai, 46 ITR 42 (SC), the issue was when the incomeaccrued and it was held at page 49 :

"In our judgement, income becomes taxable on the footing of accrual only afterthe right of the taxpayer to the income accrues or arises, and in the case of anagreement which makes profits receivable at or on the happening of acontingency, the fact, that the profits are the result of transactions spread over aperiod which covers a period preceding the happening of the contingency, wouldnot make the receipt liable to be paid to persons other than those who are entitledto receive it on the date which it is actually received or became receivable."

10. In Godhra Electricity Co. Ltd., 225 ITR 746 (SC), enhanced charges werecredited in books of accounts. The enhancement was disputed and it was held thatthe same is not income accrued. At page 760 it was observed :

"The question whether there was real accrual of income to the assessee companyin respect of the enhanced charges for supply of electricity has to be considered

by taking the probability or improbability of realisation in a realistic manner."

11. In Hope (India) Ltd., 238 ITR 740 (Cal.), the Calcutta High Court was dealingwith a case where the landlord had claimed enhanced rent which was agreed to bytenants with retrospective effect. Holding that such enhanced rent is not incomeaccrued in the years prior to the year in which agreement actually took place, itwas observed at page 753 that :

"but even in a mercantile system of accounting income would be assessed inrespect of such amount which the assessee had a right to receive and/or becameaccrued. A mere claim or a mere demand without anything else is not incomewithin the meaning of S. 5 of the Income-tax Act."

12. Applying the above principles to the facts of the case of the querist, it is onlywhen the head office had agreed to quotation that a debt arose in favour of thequerist to receive the amount in question. Till such time, no right had accrued infavour of the querist, rather local office of the client had clearly informed that ifapproval is not received, the querist would be entitled to only pre-approved rates.

The fact that work is already done in the previous year is not relevant, but the realissue is whether any right to receive had accrued in favour of the querist, which isnot so. Further, subsequent approval of the quotation does not create a right as on31-3-2003. What is chargeable to tax in A.Y. 2003-04 is income accrued or arisingin the relevant previous year and in the present case, no income had accrued or

arisen during the relevant previous year.

13. In view of the above, the querist has a strong case to contend that incomefrom the said project is not taxable in A.Y. 2003-04, but in A.Y. 2004-05 whenterms were agreed to.