The Supreme Court’s judgment in CIT v. Shoorji Vallabhdas & Co., (1962) 46 ITR 144 (SC) is one of the most significant authorities in Indian tax jurisprudence on the concepts of real income, diversion of income, and accrual of income. The case has shaped how courts and tax authorities understand whether an income can be said to have “accrued,” “arisen,” or become “real” for the purpose of taxation.
This case is frequently cited in issues concerning artificial inflation of income, remission of income, transfer or diversion of income before receipt, and the distinction between real income vs. hypothetical income. For law students, it is a landmark ruling that clarifies the principle that income tax applies only to real income — not to income that “hypothetically” accrues or is waived before it accrues.
Tip: “Tax is levied on real income — not on book entries, assumptions, or hypothetical figures.”
Background and Facts of the Case
Shoorji Vallabhdas & Co. was a partnership firm engaged in managing two shipping companies. Under the original agreements, the firm was entitled to a 10% managing agency commission on the total freight earnings of the companies. This income was regularly credited to the firm’s books.
However, during the relevant previous year, the shipping companies were facing severe financial difficulties. The partners of Shoorji Vallabhdas & Co. decided to voluntarily reduce their commission entitlement from 10% to a significantly lower percentage to help the companies survive. This was not merely a waiver after receiving the income — it was a mutual revision of the original managing agency agreement.
Crucially, the waiver of commission was before the income legally accrued or became due. The reduced commission was then recorded in the books under the revised agreement.
The Income Tax Department took the position that the original 10% commission had already “accrued” to the assessee and must be taxed, regardless of the later modification.
The question before the Supreme Court was:
Whether the original commission at 10% had already accrued as income, or whether tax could be levied only on the reduced commission amount actually receivable under the revised agreement?
Also Read: CIT v. P. Mohanakala (2007)
Issues Before the Court
1. Did the original commission legally “accrue” to the assessee?
The department argued that based on the original managing agency agreement, the assessee had a vested right to receive 10% commission.
2. Can tax be imposed on income that never actually materialized?
The core issue was whether the law taxes real income or hypothetical income.
3. Did the revised agreement amount to a diversion of income before it accrued?
The assessee contended that the waiver was a pre-accrual diversion, meaning the income never became their income at all.
Tip: “Income accrues only when the right to receive it crystallizes, not when it is merely anticipated.”
Arguments Presented
Assessee’s Arguments
- The firm had mutually modified the contract before the income accrued, therefore the reduced commission was the only real income.
- An income that never came into existence cannot be taxed.
- The principle that “only real income is taxable” should apply.
- The accrual must be judged in the light of rights that exist at the moment of accrual, not based on past agreements.
Revenue’s Arguments
- The original agreement created a legal right to earn 10% commission.
- Book entries initially showed the 10% commission.
- The subsequent reduction was merely a voluntary waiver and should not affect taxability.
- Tax liability arises at the point of accrual, not at the point of receipt.
Judgment of the Supreme Court
The Supreme Court ruled in favour of the assessee, holding that income tax is levied only on real income, and income that never accrued cannot be taxed.
Key Findings of the Court
1. Income that never arose cannot be taxed
The Court famously held:
“Income must be real and cannot be based on hypothetical accrual.”
The original commission did not accrue because the contract was validly altered before the income became due.
2. The modified agreement determined the real income
The right to receive income was reduced before crystallization, meaning the assessee was never entitled to the 10% commission.
3. Book entries are not decisive
The Court clarified:
- Merely crediting an entry does not create income.
- Taxable income cannot be determined based on accounting entries alone.
4. Diversion of income at source vs. application of income
The case illustrated diversion of income at source — the assessee never acquired the higher income; hence it could not be said to have been applied after accrual.
Tip: “When income is diverted before it reaches the assessee, it is not taxable in his hands.”
Importance of the Ruling
1. Establishes the Real Income Theory
The case stands as a foundational authority on the principle that taxation must be limited to real, factual income, not theoretical earnings.
2. Clarifies Accrual vs. Receipt
Accrual requires:
- enforceable right
- corresponding obligation
- certainty of amount
If any of these is absent, no accrual exists.
3. Frequently applied in following issues:
- Remission or waiver of income
- Restructuring contracts before payment
- Disputed income
- Income suspended due to overriding title
- Entries passed only for accounting purposes
4. Limits the power of the tax department
It prevents tax authorities from taxing hypothetical income that is not supported by substantive contractual rights.
5. Basis for later decisions
The “real income” doctrine formulated in this case has been reaffirmed in several later judgments, e.g.:
- Godhra Electricity Co. v. CIT (1997)
- CIT v. Shoorji Vallabhdas & Co. is consistently cited as the controlling authority.
Tip: “Always examine whether the assessee had an enforceable legal right to receive the income.”
Conclusion
CIT v. Shoorji Vallabhdas (1962) is a landmark case that fundamentally shaped the doctrine of real income in Indian tax law. The Supreme Court drew a clear line between real income that actually accrues and hypothetical or notional income that does not truly exist.
For students of taxation law, this case reinforces the idea that the substance of a transaction prevails over mere form or book entries. If the right to receive income does not crystallize, the income cannot be taxed. The ruling protects taxpayers from unjust taxation and ensures that the Income Tax Act applies only to income that genuinely arises.