The judgment in ICICI Bank v. Commissioner of Income Tax (2012) is a significant decision that clarifies the taxation treatment of income arising from broken period interest in the banking sector. The case deals with a technical but extremely important question: Should broken period interest paid by banks while purchasing securities be treated as revenue expenditure or capital expenditure?
The Supreme Court resolved a long-standing controversy and aligned the tax treatment with the real income theory, ensuring that taxable income reflects the true profits of banking institutions. For law students, this case is a crucial lesson in interpreting tax statutes in line with commercial realities.
Background and Context
Banking Sector Practice: Purchase of Government Securities
Banks invest in Government securities under statutory mandates like the Statutory Liquidity Ratio (SLR). When a bank buys an interest-bearing security between two coupon payment dates, it pays the seller the accrued interest for the period from the last due date to the purchase date. This is known as broken period interest.
The issue arises when the bank later receives the full interest on the coupon date. If not adjusted properly, it could lead to taxing the same income twice, causing distortion in the computation of real income.
The Dispute Before Tax Authorities
Assessing Officers claimed that broken period interest forms part of the cost of acquiring the security, and therefore should be treated as capital expenditure. If capitalized, the bank would not be allowed to claim it as a deduction. Also, the full interest received later would be taxed as income, even though part of it had already been paid during purchase.
The bank contended that broken period interest is purely revenue in nature, and must be deducted from interest received to arrive at taxable income.
Key Issues Before the Supreme Court
Whether broken period interest paid on purchase of securities is a revenue expenditure or capital expenditure?
This was the primary legal issue. The characterization determines whether the bank can claim deduction.
Whether interest received later must be taxed in full or only to the extent of net income?
The Court had to decide if interest earned for the portion already paid to the seller should again be taxed.
How should “real income” be computed for banks under the Income Tax Act?
The Court examined whether the computation must reflect commercial reality.
Also Read: CIT v. Thalibai F. Jain (1975)
Judgment of the Supreme Court
Broken Period Interest is Revenue Expenditure
The Supreme Court held that broken period interest is a revenue expenditure allowable as a deduction. The Court reasoned that:
- Banks trade in securities as part of their business.
- The purchase of securities between interest dates is a commercial necessity.
- The interest component does not change the character of purchase.
- Charging the entire coupon interest as income, while disallowing the broken period payment as deduction, would distort taxable profit.
The Court relied on earlier judgments like CIT v. Corporation Bank (1988) and affirmed that interest should be taxed only to the extent it represents real income.
Real Income Doctrine Reinforced
The judgment reaffirmed the principle that only real income can be brought to tax.
The Court emphasized that income tax law does not tax hypothetical profits. Since the bank has already paid part of the interest to the seller, taxing it again would amount to taxing non-existent income.
Securities Held as Stock-in-Trade
One important factor in the Court’s reasoning was the finding that banks treat securities as stock-in-trade, not capital assets. Therefore:
- Broken period interest cannot form part of the cost of a capital asset.
- It is a business expenditure incurred during trading operations.
This is a crucial distinction for tax practitioners.
Legal Principles Established
Recognition of Banking Accounting Practices
The Court accepted the established accounting practice followed worldwide:
- Deduct the broken period interest paid.
- Tax only the net interest attributable to the holding period.
Taxation Must Follow Commercial Reality
The Supreme Court reiterated that tax law must be interpreted in harmony with how business is actually conducted.
Avoidance of Double Taxation
The judgment prevents de facto double taxation by ensuring that the same income is not taxed twice under different labels.
Detailed Reasoning of the Court
Nature of the Interest Component
The Court noted that interest accrues daily, even though it is paid periodically. Thus, when the seller sells the security midway, the buyer compensates the seller for the interest accrued until then. This does not convert the interest into capital cost.
Stock-in-Trade vs. Capital Asset
The banking sector typically maintains securities as stock-in-trade, which means:
- Any expenditure linked to stock-in-trade is revenue.
- Interest cannot be capitalized.
Treatment Under Section 37 of the Income Tax Act
The expenditure was held allowable under Section 37(1) because:
- It was incurred wholly and exclusively for business.
- It was neither capital nor personal expenditure.
Preventing Distortion in Profit
If broken period interest is capitalized:
- Interest income will be overstated.
- Business expenditure will be understated.
- Profit will be artificially inflated.
The Court rejected such outcomes.
Practical Impact of the Judgment
- Banks can now claim deduction for broken period interest without litigation.
- Assessment officers must compute interest income on a net basis.
- The decision harmonizes tax law with banking regulation and RBI norms.
- It reduces tax arbitrage and uncertainty in the banking industry.
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