Notional interest cannot be charged on sticky loans where principal recovery is doubtful despite mercantile accounting.

The appellant-assessee was originally assessed under Section 143(3) of the Income Tax Act for A.Y. 2000-01, where the Assessing Officer (AO) made additions by disallowing interest and charging notional interest on outstanding dues from two entities: M/s. Vani Industries and M/s. Super Investment & Finance Ltd

On an initial appeal, the ITAT remanded the matter back to the CIT(A) to evaluate the assessability of this income in light of the financial position of these two entities

During remand, the assessee contended that M/s. Vani Industries’ sales tax registration was cancelled in 1997 and the debt was written off in F.Y. 2004-05; meanwhile, M/s. Super Investment & Finance Ltd was wound up due to poor financial health

Despite this, the CIT(A) sustained an addition of 12% notional interest, a decision upheld by the ITAT on the grounds that the assessee failed to produce the balance sheets of the debtor concerns

1. Whether, on the facts and in the circumstances of the case, the Income Tax Appellate Tribunal was justified in upholding the direction to the Assessing Officer to charge interest @ 12% on the amount outstanding from M/s Vani Industries & M/s. Super Investments & Finance Ltd?

The court examined the principles of the mercantile system of accounting under the Income Tax Act, 1961, which generally taxes income on an accrual basis

principle that the "real income" theory overrides notional accrual if the recovery of the principal itself is doubtful due to the debtor's insolvency or cessation of business

documentary evidence of business closure (such as cancellation of Sales Tax and Excise registrations) constitutes sufficient proof of a debtor's inability to pay interest

The High Court found the ITAT’s findings to be "perverse" as they ignored material evidence provided by the assessee

While the ITAT claimed the assessee failed to provide financial documents, the High Court noted that the paper-book contained evidence that M/s. Vani Industries had its Sales Tax registration cancelled in 1997 and had applied for Excise registration cancellation, proving it had no business activity

Regarding M/s. Super Investment & Finance Ltd, the court noted it had been wound up and no interest had been received for the previous two years

The Court reasoned that since the principal amount was doubtful of recovery and no interest had actually accrued or been paid for years, the Revenue could not charge tax on "notional interest" solely because the parties were related

The court held that the close relationship between the partners/directors cannot be the sole factor for assuming interest accrual when business realities prove otherwise

The Court held that the ITAT was not justified in upholding the 12% notional interest charge. Consequently, the High Court set aside the ITAT’s order and ordered the deletion of the additions made on account of notional interest for both M/s. Vani Industries and M/s. Super Investment & Finance Ltd

The appeal was allowed with no order as to costs