Question And Answer
Subject: Real Income Theory Of Taxation
Category:  Income Tax
Asked by: Prashant Joshi
Answered by:
Date: September 26, 2018
Query asked by Prashant Joshi

What is the “real income theory” according to which only “real income” and not “notional income” can be assessed to tax?

The concept of “real income” under the provisions of the Income Tax Act, 1961 has been explained in a number of judgements of the Supreme Court.

Some of the leading judgements on the concept of real income theory are the following:


CIT Vs. Shoorji Vallabhdas & Co. 46 ITR 144 (SC)

Godhra Electricity Co. Ltd Vs. CIT 225 ITR 746 (SC)

CIT Vs. Chemosyn Ltd 371 ITR 427 (Bom)

Poorna Electric Supply Co. Ltd Vs. CIT [1965] 56 ITR 521 (SC)

CIT Vs. Chamanlal Mangaldas & Co. 39 ITR 8 (SC)

CIT Vs. Chamanlal Mangaldas & Co. 29 ITR 987 (Bom)

CIT Vs. Harivallabhadas Kalidas & Co. 39 ITR 1 (SC)

CIT Vs. Virtual Soft Systems Ltd 404 ITR 409 (SC)

CIT Vs. Lakshmi Machine Works 290 ITR 667 (SC)

Miss Dhun Dadbhoy Kapadia Vs. CIT 63 ITR 651 (SC)

CIT Vs. Bokaro Steel Ltd 236 ITR 315 (SC)

In Commissioner of Income-Tax Vs. Virtual Soft Systems Ltd. [2018] 404 ITR 409(SC), a Two Judges’ Bench of the Hon’ble Supreme Court dealt with a case of taxability of Lease Rentals recovered by the Assessee, where a portion of it was recovery of the capital cost and part of it was in the nature of a ‘Revenue Income” and the Assessee made such bifurcation relying upon the Guidance Note on ‘Accounting for Leases’ prepared by the Institute of Chartered Accountants of India, the Hon’ble Supreme Court upheld that method of Accounting and held that 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. 

The relevant extract from the said judgment is quoted below for ready reference:-

“The Guidance Note on Accounting for Leases, revised in 1995, adjusts the inflated cost of interest of the assets in the balance-sheet. Secondly, it captures “real income” by separating the element of capital recovery (essentially representing repayment of principal by the lessee, the principal amount being the net investment in the lease), and the finance income, which is the revenue receipt of the lessor as remuneration for the lessor’s investment. 

According to the Guidance Note, the annual lease charge represents recovery of the net investment/fair value of the asset lease term. The finance income reflects a constant periodic rate of return of the net investment of the lessor outstanding in respect of the finance lease. 

While the finance income represent a revenue receipt to be included in income for the purpose of taxation, the capital recovery element (annual lease charge) is not classifiable as income, as it is not, in essence, a revenue receipt chargeable to income-tax.

The method of accounting as derived from the Institute’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 Institute’s Accounting Standards on Disclosure of Accounting Policies being accounting standards which are a kind of guidelines for accounting periods starting from April 1, 1991. 

It is a cardinal principle of law that the difference between capital recovery and interest of finance income is essential for accounting for such a transaction with reference to its substance. If this was not carried out, the assessee would be assessed for income-tax not merely on revenue receipts but also on non-revenue items which is completely contrary to the principle of the Income-tax Act, 1961 and to its scheme and spirit.

Held accordingly, that the assessee could be charged only on real income which could be calculated only on a real income which could be calculated only after applying the prescribed method. The Act is silent on such deduction. For such calculation, the assessee had to have recourse to the Guidance Note prescribed by the Institute of Chartered Accountants of India. Only after applying such method which was prescribed in the Guidance Note, could the assessee show fair and real income liable to tax under the Act. 

Therefore, it could not be said that the assessee claimed deduction by virtue of the Guidance Note: it only applied the method of bifurcation as prescribed by the expert team of the Institute of Chartered Accountants of India. The assessee was entitled to bifurcate the lease rental in accordance with the accounting standards prescribed by the Institute. There was no express bar in the Act regarding the application of such accounting standards.”

In Commissioner of Income-Tax Vs. Lakshmi Machine Works [2007[ 290 ITR 667 (SC), 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).

We do not find any merit in the above contentions advanced on behalf of the Department. It is important to note that tax under the Act is upon income, profits and gains. It is not a tax on gross receipts. Under section 2(24) of the Act the word “income” includes profits and gains. 

The charge is not on gross receipts but on profits and gains properly so called. Gross receipts or sale proceeds, however, include profits. According to The Law and Practice of Income Tax by Kanga and Palkhivala, the word “profits” in section 28 should be understood in normal and proper sense. However, subject to special requirements of the income-tax, profits have got to be assessed provided they are real profits. 

Such profits have got to be ascertained on ordinary principles of commercial trading and accounting. However, the Income-tax Act has laid down certain rules to be applied in deciding how the tax should be assessed and even if the result is to tax as profits what cannot be construed as profits, still the requirements of the Income-tax Act must be complied with.

Where a deduction is necessary in order to ascertain the profits and gains, such deductions should be allowed. Profits should be computed after deducting the expenses incurred for business though such expenses may not be admissible expressly under the Act, unless such expenses are expressly disallowed by the Act.”

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