ARTICLE
Taxability of Sticky Loans under the Income Tax Act, 1961
1. Introduction
The issue of taxability of ‘sticky loans’ has remained one of the most debated questions in Indian income-tax jurisprudence. The term ‘sticky loans’ generally refers to advances or debts where recovery is doubtful, and the creditor—often a bank, non-banking financial company (NBFC), or financial institution—is unable to realise even the principal, let alone the interest. The central question is whether interest on such sticky loans, which remains unrealised, can still be deemed to accrue as income under the mercantile system of accounting, thereby attracting taxation under the Income-tax Act, 1961 (the Act).
Judicial pronouncements have consistently grappled with the balance between the doctrine of real income and the strict accrual principles under section 5 of the Act. Courts have had to reconcile statutory provisions with commercial and accounting realities, particularly when Reserve Bank of India (RBI) Prudential Norms govern recognition of non-performing assets (NPAs). This article critically analyses the development of law on sticky loans, with detailed reference to leading precedents such as CIT v. Shoorji Vallabhdas & Co., CIT v. Vasisth Chay Vyapar Ltd, , Barkha Investment & Trading Co. v. CIT, CIT v. Elgi Finance Ltd., CIT v. Motor Credit Co. (P.) Ltd., and others.
2. Concept of Real Income and Accrual
2.1 Section 5 of the Act and Accrual
Section 5 of the Income-tax Act provides that income is chargeable to tax when it is received or accrues or arises. Under the mercantile system of accounting, income is taxed on accrual rather than receipt. However, the Supreme Court in CIT v. Shoorji Vallabhdas & Co. [1962] 46 ITR 144 (SC) clarified that hypothetical or illusory income is not taxable. This principle forms the foundation of the doctrine of ‘real income’.
2.2 Sticky Loans and Non-Performing Assets
Sticky loans, or Non-Performing Assets (NPAs), are debts where recovery of principal or interest is improbable. Under RBI guidelines, loans are classified as NPAs if overdue beyond a specified period, and recognition of interest on NPAs is prohibited. This creates conflict: while Section 5 suggests accrual, RBI directions and commercial realities suggest no real income has arisen.
3. Jurisprudential Development
Judicial precedents have clarified the taxability of sticky loans through the application of the real income doctrine:
I. CIT v. Shoorji Vallabhdas & Co. [1962] 46 ITR 144 (SC): Hypothetical income not taxable.
In this landmark case, the Supreme Court laid down the foundation of the “real income” theory. The Court ruled that income tax is levied only on real income, not hypothetical accruals. In the case, commission income that had been contractually waived could not be taxed, since the assessee never had a right to receive it. Applied to sticky loans, the principle is that where recovery of interest is highly improbable, mere book entries under mercantile accounting do not create taxable income. Tax cannot be levied on amounts that have not truly accrued or materialized in the hands of the assessee. The judgment emphasizes substance over form and ensures that taxation does not extend to illusory or unrealizable income. It remains a cornerstone for later rulings where interest on non-performing or doubtful assets is excluded from taxable income until actual realization.
II. CIT v. Motor Credit Co. (P.) Ltd. [1981] 6 Taxman 63 (Mad.): No accrual where recovery of principal doubtful.
The assessee, engaged in vehicle hire-purchase financing, had advanced funds to two transport firms. These firms defaulted after their bus routes were taken over by the State, leaving no prospect of recovery of even the principal. The assessee, though following mercantile accounting, did not record any interest on these sticky loans. The AO, however, added notional accrued interest. Both the AAC and Tribunal deleted the addition, and the High Court upheld their view. It held that while mercantile accounting determines the timing of taxation, it cannot override the doctrine of real income. Tax cannot be levied on hypothetical accruals when commercial realities show no chance of recovery. The Court stressed that where no income has materialised, interest cannot be said to accrue merely due to accounting method. Thus, notional interest on irrecoverable sticky loans is not taxable, as taxation applies only to real, not illusory, income
III. CIT v. Ferozepur Finance (P.) Ltd. [1980] 4 Taxman 439 (P&H): Sticky loans yield no real income.
The assessee, engaged in finance and hire purchase, had a debtor with a poor financial position. No interest was charged on his large outstanding balance. The AO, applying mercantile accounting, added notional interest as accrued income. The Tribunal deleted this addition, noting the debtor’s huge tax arrears, pending penalty appeals, and inability to pay even the principal except through distress sales. The High Court upheld the deletion, emphasizing that income tax is levied on real income, not hypothetical entries. Even in mercantile accounting, if recovery is impossible, interest cannot be said to accrue. Citing Shoorji Vallabhdas & Co. and Chamanlal Mangaldas & Co., the Court reiterated that there must be real accrual or receipt, not mere book entries. Since the assessee’s consistent practice was to forgo interest in cases of financial stringency, and the debtor’s insolvency was clear, the interest foregone could not be taxed
IV. CIT v. Elgi Finance Ltd. [2007] 293 ITR 357 (Mad.): Notional entries on sticky loans not taxable.
The assessee, a finance company, advanced hire purchase loans where several parties defaulted. Though the assessee maintained mercantile accounts, it stopped recognizing interest on such defaulting accounts, citing uncertainty of recovery. The AO added notional interest, arguing accrual arises under mercantile accounting regardless of receipt. The Tribunal deleted the addition, and the Madras High Court upheld this view. It emphasized that only real income is taxable, not hypothetical figures. In finance business, if the principal itself becomes doubtful, there is no real accrual of interest. The Court cited Shoorji Vallabhdas & Co. and Godhra Electricity Co. to reaffirm that book entries cannot create taxable income in absence of commercial reality. Since recovery of principal was in jeopardy, treating interest as accrued was unrealistic. The decision firmly established that sticky loans cannot generate taxable income merely because mercantile accounting is followed, safeguarding assessees against taxation of illusory accruals.
V. CIT v. Vasisth Chay Vyapar Ltd. [2011] 196 Taxman 169 (Delhi): RBI norms prohibit recognition of interest on NPAs.
The assessee, an NBFC, had advanced loans to a company later declared sick under BIFR. Even the principal became doubtful. Following RBI directions, no interest was credited on these sticky advances. The AO still taxed notional interest on accrual basis. The Delhi High Court rejected this, holding that real income theory and RBI prudential norms prevail. It ruled that once a debtor is declared sick and recovery is improbable, no accrual of interest arises, despite mercantile accounting. Section 45Q of the RBI Act gives overriding force to RBI directions, requiring banks/NBFCs to recognize income only on actual receipt. The Court emphasised that tax cannot be levied on illusory income which is commercially unreal. This case provided strong authority for NBFCs that interest on sticky loans, governed by RBI guidelines, is not taxable until realised, thereby aligning income recognition with prudential banking practices and commercial reality.
VI. Barkha Investment & Trading Co. v. CIT [2006] 150 Taxman 523 (Guj.): Reinforced real income doctrine.
The assessee, engaged in money-lending, had advanced large sums to borrowers who defaulted. With recovery of even principal amounts doubtful, no interest was credited to income. The AO nevertheless taxed notional interest, citing mercantile accounting. The Tribunal sided with the assessee, and the Gujarat High Court upheld it. The Court stressed that the doctrine of real income overrides notional accrual. Income cannot be taxed merely on book entries; there must be real enforceable accrual and a practical chance of recovery. When financial circumstances of the debtor clearly indicate that neither principal nor interest can be recovered, treating interest as income is unjust. The Court held that in such situations, notional interest lacks the character of real income. Relying on Shoorji Vallabhdas & Co. and similar precedents, the Court confirmed that interest on sticky loans is not taxable until it materialises, protecting assessees from taxation on illusory accruals.
VII. CIT v. Eicher Ltd. [2009] 185 Taxman 243 (Delhi): Accrual requires enforceable right.
The assessee advanced money to group companies facing severe financial distress. No interest was charged, and the AO sought to tax notional interest under mercantile accounting. The Tribunal held, and the Delhi High Court affirmed, that interest income accrues only when there exists a reasonable certainty of recovery. The Court explained that accrual is not a mechanical outcome of mercantile accounting but depends on enforceable rights and commercial reality. When even the principal is in doubt, charging interest is commercially unrealistic. Tax cannot be levied on hypothetical income which never accrued in fact. Following Shoorji Vallabhdas & Co. and Godhra Electricity Co., the Court reiterated the real income doctrine. Since the debtor companies were financially sick and unable to pay, no real accrual of interest had arisen. Therefore, no addition could be made. The judgment strengthened the principle that uncertain, illusory accruals on sticky loans are outside the tax net.
VIII. CIT v. Nainital Bank Ltd. [2009] 309 ITR 335 (Uttarakhand): RBI guidelines prevail.
The assessee bank followed RBI prudential norms, under which no interest could be recognized on NPAs until actual receipt. The AO added notional interest on sticky loans, arguing that under mercantile accounting, accrual occurs irrespective of receipt. The Tribunal deleted the addition, and the High Court upheld this. It ruled that RBI guidelines have overriding effect under section 45Q of the RBI Act, and interest on NPAs does not accrue for tax purposes until realised. The Court reinforced the doctrine of real income, holding that statutory recognition of NPAs by RBI norms leaves no scope for taxing unrealised interest. Since the assessee had correctly followed RBI directions, no fault could be found in excluding such notional income. The judgment harmonised tax law with banking regulations, establishing that interest on sticky loans classified as NPAs cannot be brought to tax unless actually received.
IX. CIT v. Goyal M.G. Gases (P.) Ltd. [2007] 163 Taxman 541 (Delhi): Income recognition must be realistic.
The assessee had advanced funds to parties who defaulted; cheques bounced, and winding-up petitions were filed. The borrowers were declared sick by BIFR. The AO added notional interest, arguing that under mercantile accounting, accrual arose automatically. The Tribunal deleted the addition, holding that no real income had accrued, since even the principal was irrecoverable and later written off as bad debts under section 36(1)(vii). The Delhi High Court upheld this, relying on Shoorji Vallabhdas & Co. and Godhra Electricity Co.. It stressed that real accrual, not hypothetical accrual, governs taxability. If a debtor is financially incapable and legal remedies are exhausted, no prudent lender would expect interest. Therefore, interest that never materialized cannot be taxed, even under mercantile accounting. The Court also noted that the assessee’s subsequent write-off of principal as bad debt was accepted by the Revenue, reinforcing the finding that no genuine accrual of interest ever arose
X. Godhra Electricity Co. Ltd. v. CIT [1997] 91 Taxman 351 (SC)
The Supreme Court in Godhra Electricity extended the principle of “real income” to cases involving revenue recognition. The assessee had enhanced electricity charges, but recovery was stayed by litigation and uncertainty persisted. The Court held that where the very right to receive income is in dispute, or recovery is improbable, no real income accrues for taxation. This reasoning applies to sticky loans, where interest may be computed notionally but cannot be considered taxable until realization. The Court clarified that accrual under mercantile accounting presumes enforceability and reasonable certainty of receipt. Where such certainty is absent, taxing unrealizable amounts would violate the principle that only real income is taxable. Hence, like stayed tariff charges, interest on sticky loans kept in suspense and not credited to P&L cannot be taxed. The decision fortifies the jurisprudence that taxation is concerned with substance and realizability, not hypothetical claims.
XI. Southern Technologies Ltd. v. JCIT [2010] 187 Taxman 346 (SC)
This case dealt with NBFCs and RBI Prudential Norms on non-performing assets (NPAs). The assessee argued that provisions for NPAs should reduce taxable income. The Supreme Court clarified that RBI norms govern presentation /disclosure, not computation of taxable income under the Income-tax Act. However, the Court acknowledged the principle that anticipated losses must be recognized but unrealized income need not. Applying the “real income” doctrine, the Court held that while provisions for doubtful debts are not deductible, interest on sticky loans that has not accrued in real terms may be excluded from taxable income. Collectibility is distinct from accrual: if interest is not realistically collectible, it cannot be treated as income. Thus, for sticky loans, unless recovery is probable, notional accrual cannot be taxed. This reinforced earlier jurisprudence while distinguishing between provisioning (disallowed) and non-recognition of unrealizable interest (permissible).
XII. UCO Bank v. CIT [1999] 104 Taxman 547 (SC)
In UCO Bank, the Supreme Court directly addressed sticky loan interest. The assessee-bank credited interest on doubtful loans to a suspense account without transferring it to the P&L, consistent with CBDT Circulars. The Court upheld that such interest is not taxable until realization, as recovery was improbable. It endorsed the Board’s circular of 1984 that interest on loans unpaid for three years should not be taxed until received. The Court emphasized that tax must follow the real income concept: only enforceable and realizable income can be taxed. Mercantile accounting does not compel taxation of hypothetical accruals, especially when recognized banking practice and CBDT directions validate suspense accounting. This ruling provided strong judicial backing to exclude sticky loan interest from taxation until actual recovery, balancing statutory provisions with commercial reality. It remains a binding precedent ensuring that banks are not taxed on illusory interest income.
4. Doctrinal Underpinnings
1. Real Income Doctrine: Only real income is taxable, not hypothetical accrual.
2. Prudential Norms: Section 45Q of the RBI Act overrides other laws, prohibiting recognition of interest on NPAs.
3. Accrual vs. Receipt: Accrual requires enforceable right and commercial realisability.
5. Section 145 and Method of Accounting
Section 145 mandates computation of income according to the accounting method followed. However, the real income doctrine overrides this. For NBFCs and banks, RBI norms form part of mandatory accounting, ensuring interest on NPAs is excluded until realised.
Comparative Judicial Analysis
Case Court Ratio Decidendi
Shoorji Vallabhdas & Co. SC Hypothetical income not taxable.
Motor Credit Co. (P.) Ltd. Madras HC Sticky loans with doubtful recovery not taxable.
Ferozepur Finance (P.) Ltd. P&H HC No accrual where principal recovery doubtful.
Elgi Finance Ltd. Madras HC Notional entries on sticky loans not taxable.
Vasisth Chay Vyapar Ltd. Delhi HC BI norms bar recognition of interest on NPAs.
Barkha Investment & Trading Co. Guj HC Real income doctrine excludes sticky loans.
Eicher Ltd. Delhi HC Accrual requires enforceable right.
Nainital Bank Ltd. Uttarakhand HC RBI guidelines on NPAs prevail.
Goyal M.G. Gases (P.) Ltd. Delhi HC Income recognition must be realistic.
6. Practical Implications
I. For Banks/NBFCs: Interest on NPAs not taxable until recovery, aligning with RBI norms.
II. For Non-Financial Companies: Real income doctrine protects from taxation of sticky loan interest
III. For Tax Authorities: Must consider commercial reality and precedent
IV. For Taxpayers: Proper disclosure and evidence of doubtful recovery essential.
7. Critical Evaluation
The jurisprudence on sticky loans reflects judicial pragmatism. Courts prioritise substance over form, ensuring taxation is based on real income. However, challenges remain, such as applicability to non-NBFCs, partial recoveries, and divergence between tax and accounting principles.
8. Conclusion
The law on sticky loans establishes that taxation is on real income, not hypothetical accruals. Key principles include:
1. Income accrues only when realisation is reasonably certain.
2. Interest on sticky loans with doubtful recovery does not accrue.
3. RBI norms override other provisions for NBFCs and banks.
4. Section 145 does not compel taxation of illusory income.