The facts of the case were as under :
The assesee invested a sum of Rs 9 lakhs in IDBI capital bonds. The scheme under which the bonds were issued provided for two options for receipt of interest.
Under the half-yearly option, interest was to be paid half yearly upto the date of maturity of the bonds. Under the discounted value option, interest for the entire three year period was to be discounted to the acceptance date at 9 per cent per annum and paid soon after the realisation of cheque/demand draft.
The assessee opted for the discounted value option. The assessee received the discounted interest for three years during the year. However, the assessee offered for tax only interest attributable to the previous year on the ground that the discounted value of interest included interest which would accrue over the period of three years.
The assessing officer held that the entire interest was liable to be assessed as income during the year. In appeal both the appellate assistant commissioner and the tribunal, held that the assessee was entitled to have interest income spread over for three years. Being aggrieved the revenue appealed to the high court.
The high court observed that by the exercise of the second option, the entire interest accrued to the assessee during the year. It was also received by the assessee during the same year.
The assessee contended that, the discounted interest that was received during the year, was in fact interest that was receivable in future and hence the interest must be spread over the three years and assessed on that basis.
The assessee relied on the decision of the Madhya Pradesh High Court in MP Financial Corporation v CIT (1987 165 ITR 765 MP), which was affirmed by the Supreme Court in Madras Industrial Investment Corporation Ltd v CIT (1997 225 ITR 802).
In the case of MP Financial Corporation, the assessee had issued bonds at a discount and claimed that the entire amount of discount was liable to be deducted during the year. There the court held that the assessee was not entitled to discount the entire amount during the year since the amount of discount in effect represented deferred interest and therefore, the proportionate amount of discount may be written off out of revenue every year during the period the bonds would remain outstanding.
The high court took the view that in the above case the assessee was claiming a deduction of the whole of the discounted amount as business expenditure during the year of issue and the ratio of that decision cannot have application in the case on hand.
Here the assessee was receiving interest income and he had to exercise his option to receive the same, either spread over three years or at a discounted rate in the year itself. The assessee chose to exercise his option to receive the income during the year. By exercise of that option, the entire discounted interest income accrued to the assessee.
The high court observed that under section 145 of the Income Tax Act, 1961 income has to be computed in accordance with either the cash or mercantile system of accounting, regularly employed by the assessee. Here going by either system, it must be held that the entire interest income received by the assessee has become chargeable under the head "Income from other sources".
The high court observed that once the whole of the interest has accrued to the assessee by the virtue of his exercise of an option in that behalf, it is not possible to postulate accrual of portions of that income for the future years. There can be only one accrual and that accrual in respect of the entire discounted interest took place in this case on exercise of option by the assessee.
In respect of deep discount bonds, the CBDT vide its letter F No 225/45/96-97 ITAII dated 12th August, 1996 has clarified that the surplus will be treated as interest in the year of redemption on maturity and would be assessable as capital gains, if sold in the market prior to redemption. This decision is in accordance with the said view of the CBDT. However such a view is rather difficult to reconcile with the existing principles of accounting and taxation.
Interest is compensation for use of funds paid by the borrower to the lender and is determined in accordance with the duration of the use of the funds. Interest therefore accrues on day to day basis. In the context of bank deposits the CBDT has taken a view vide circular no 243, dated June 22, 1978 that interest, at the stipulated rate, earned on principal amount will accrue annually and will be taxed as income accrued in that year.
In the case of Madras Industrial Investment Corporation, supra, the Supreme Court has held that allowing the entire discount on issue of debentures in the year of issue, might give a distorted picture of the profits of a particular year and therefore the expenditure should be allowed to be spread over the period of the debentures. The same principle should apply in case of income also. However the assessee’s may keep in mind the ratio of the above decision and the views of the CBDT while planning their tax affairs.