Supreme Court clarifies tax treatment of broken period interest for banks: Bank of Rajasthan Ltd. vs. Commissioner of Income Tax (2024) INSC 781 (16 October 2024)

Date of the Judgment: 16 October 2024
Citation: 2024 INSC 781
Judges: Abhay S. Oka, J., Pankaj Mithal, J.
Can banks deduct the interest paid for the broken period on securities purchased as a business expense? The Supreme Court of India recently addressed this question, clarifying the tax treatment of such interest for banks. This judgment is crucial for understanding how banks can account for interest paid on securities bought between coupon dates. The bench comprised Justices Abhay S. Oka and Pankaj Mithal, with the majority opinion authored by Justice Oka.

Case Background

The case involves a series of appeals concerning the tax treatment of “broken period interest” paid by banks when purchasing government securities. Banks often buy these securities between the scheduled interest payment dates (coupon dates). In such cases, the purchasing bank pays the seller an amount equivalent to the interest accrued from the last coupon date until the purchase date. This is known as broken period interest. When the next interest payment is due, the purchasing bank receives the full interest, including the broken period interest.

The core issue revolves around whether this broken period interest can be claimed as a deduction by the banks as a business expense. The dispute arose when the Income Tax Department disallowed this deduction, arguing that it should be treated as a capital expenditure rather than a revenue expense. The banks, on the other hand, contended that these securities are part of their stock-in-trade and that the broken period interest should be treated as a deductible expense.

The primary appellant, Bank of Rajasthan Ltd., consistently followed the practice of netting off the broken period interest paid against the interest received on the sale of securities, offering the net interest income for tax. The Assessing Officer initially allowed this practice, but the Commissioner of Income Tax (CIT) intervened, disallowing the deduction.

Timeline

Course of Proceedings

The Commissioner of Income Tax (CIT) intervened under Section 263 of the Income Tax Act, challenging the assessment orders that had allowed the deduction of broken period interest. The CIT relied on the Supreme Court’s decision in Vijaya Bank Ltd. v. Additional Commissioner of Income Tax, Bangalore [ (1991) Supp (2) SCC 147], which held that broken period interest was not an allowable deduction under the head “interest on securities.”

The Income Tax Appellate Tribunal overturned the CIT’s decision, stating that the Vijaya Bank Ltd. case was based on Sections 18 to 21 of the Income Tax Act, which had been repealed. The Tribunal held that since the securities were held as stock-in-trade, the entire purchase amount, including the broken period interest, was deductible.

The High Court, however, reversed the Tribunal’s decision, again relying on the Vijaya Bank Ltd. ruling. This led to the present appeals before the Supreme Court.

Legal Framework

The core legal provisions relevant to this case are primarily within the Income Tax Act, 1961.

✓ Section 14 of the Income Tax Act categorizes income under different heads, such as “Salaries,” “Income from house property,” “Profits and gains of business or profession,” “Capital gains,” and “Income from other sources.” Clause B, “interest on securities,” was deleted effective from 1st April 1989.

✓ Section 28 of the Income Tax Act deals with profits and gains from business or profession. It states that profits and gains from any business or profession carried on by the assessee during the previous year are chargeable to income tax.

✓ Section 36(1)(iii) of the Income Tax Act allows a deduction for the amount of interest paid on capital borrowed for the purposes of business or profession.

✓ Section 37 of the Income Tax Act provides for the deduction of any expenditure not covered by Sections 30 to 36, which is not in the nature of capital expenditure and is laid out wholly and exclusively for the purposes of the business or profession.

✓ Section 56 of the Income Tax Act states that any income not excluded from total income and not chargeable under any other head is taxable under “income from other sources.”

✓ Section 57 of the Income Tax Act allows for the deduction of expenditure, not being capital expenditure, incurred exclusively for earning income under “income from other sources.”

Sections 18 to 21 of the Income Tax Act, 1961, which dealt specifically with interest on securities, were repealed by the Finance Act, 1988, effective from 1st April 1989.

Arguments

The counsels for the appellant banks argued that:

• The decision in Vijaya Bank Ltd. is not applicable because it was based on Sections 18 to 21 of the Income Tax Act, which have since been repealed. The Bombay High Court in American Express International Banking Corporation v. Commissioner of Income Tax & Anr. [(2002) 258 ITR 601 (Bombay)] correctly distinguished the Vijaya Bank Ltd. case, noting that the income in that case was taxed under Section 18, while in the present cases, it is taxed under Section 28.

• The Bombay High Court’s view in American Express International Banking Corporation has been approved by the Supreme Court in Commissioner of Income Tax, Bombay v. Citi Bank NA [Civil Appeal No. 1549 of 2006].

• Government securities held by banks are part of their stock-in-trade, as affirmed in Commissioner of Income Tax, Andhra Pradesh, Hyderabad v. The Cocanada Radhaswami Bank Ltd., Kakinada [(1965) 57 ITR 306] and United Commercial Bank Ltd.; Calcutta v. Commissioner of Income Tax, West Bengal [(1957) 32 ITR 688]. Banks purchase these securities to comply with Statutory Liquidity Ratio (SLR) requirements.

• The broken period interest is an expense, not a capital outlay, as the banks are not entitled to this interest, and the entire interest is taxed as business income.

• The consistent practice of allowing deduction of broken period interest by assessment officers for several years should not be disturbed, as per M/s. Radhasoami Satsang, Saomi Bagh, Agra v. Commissioner of Income Tax [(1992) 193 ITR 321].

• The exercise of disallowing broken period interest as a capital expenditure is revenue-neutral, as it would either reduce the income or increase the cost of acquisition, having the same effect.

• The decision in Vijaya Bank Ltd. is per incuriam, as it was rendered without considering the decisions in Cocanada Radhaswami Bank Ltd. and the Central Board of Direct Taxes (CBDT) Circular No. 665 of 1993.

• The RBI and CBDT have issued circulars that support the treatment of broken period interest as an expense, not as a capital item.

• The categorization of securities under the Banking Regulation Act does not change their nature as stock-in-trade for the purposes of the Income Tax Act.

The learned ASG argued that:

• Broken period interest on securities held to maturity (HTM) should be treated as capital expenditure because these securities are held as investments to maintain the SLR.

• The decision in Vijaya Bank Ltd. applies because the repeal of Sections 18 to 21 was accompanied by corresponding amendments in Sections 28, 56(2)(d), and 57(3) of the IT Act, making the securities taxable under “Income from other Sources.”

• The acquisition of securities increases the bank’s capital base, thus the broken period interest is a capital expenditure.

The innovativeness of the arguments lies in the assessees’ counsel successfully distinguishing the facts of the present case from the facts of the Vijaya Bank Ltd. case, and also relying on the various circulars issued by the RBI and CBDT.

Issues Framed by the Supreme Court

The Supreme Court addressed the following main issue:

1. Whether the deduction of broken period interest can be claimed by banks?
2. Whether the securities held by the banks are stock-in-trade or investment?

The court also dealt with the sub-issue as to whether the securities under the HTM category can be treated as stock-in-trade.

Treatment of the Issue by the Court

The following table demonstrates as to how the Court decided the issues:

Authorities

The Supreme Court considered the following authorities:

Judgment

The Supreme Court held that:

The Court also analyzed how the authorities were viewed:

• Vijaya Bank Ltd. [(1991) Supp (2) SCC 147]* was overruled, as it was based on the now-repealed Sections 18 to 21 of the Income Tax Act, and the facts of the case were different.
• American Express International Banking Corporation [(2002) 258 ITR 601 (Bombay)]* was followed, as it correctly distinguished Vijaya Bank Ltd. and was approved by the Supreme Court in Citi Bank NA.
• Citi Bank NA [Civil Appeal No. 1549 of 2006]* was followed, as it affirmed the view that broken period interest should be treated as a revenue expenditure.
• Cocanada Radhaswami Bank Ltd. [(1965) 57 ITR 306]* was followed, as it supported the view that securities held by banks are part of their trading assets.
• United Commercial Bank Ltd. [(1957) 32 ITR 688]* was followed, as it reinforced that banks hold securities as part of their stock-in-trade.
• Nawanshahar Central Cooperative Bank Ltd. [(2007) 289 ITR 6]* was followed, as it supported that investments are part of the banking business.
• Bihar State Co-operative Bank Ltd. [(1960) 39 ITR 114]* was followed, as it showed that securities are part of the stock-in-trade of banks.
• Radhasoami Satsang [(1992) 193 ITR 321]* was followed, as it supported the view that consistent practices accepted by the revenue should not be disturbed.
• Punjab Co-operative Bank [(1940) SCC Online PC 46]* was followed, as it showed that securities are a normal part of the banking business.
• Associated Industrial Development Company [(1972) 4 SCC 447]* was followed, as it showed that the nature of securities depends on the facts of the case.
• HDFC Bank Ltd. [(2014) 366 ITR 505]* was followed, as the Tribunal had relied on it.

What weighed in the mind of the Court?

The Supreme Court’s decision was primarily influenced by the following factors:

• Distinction from Vijaya Bank Ltd.: The court emphasized that the Vijaya Bank Ltd. case was decided under a different legal regime (Sections 18-21 of the IT Act) and that the facts of the case were different.

• Nature of Banking Business: The court reiterated that banks primarily deal in money and credit, and the securities they hold are part of their stock-in-trade, not merely investments. The court relied on the Privy Council’s decision in Punjab Co-operative Bank to emphasize this point.

• Revenue Neutrality: The court noted that disallowing the deduction of broken period interest would not lead to any additional revenue for the government, as it would merely be added to the cost of acquisition, reducing profits later.

• RBI and CBDT Circulars: The court took note of the RBI and CBDT circulars that support the treatment of broken period interest as an expense.

• Consistent Practice: The court acknowledged that banks have been consistently treating broken period interest as a deductible expense, and this practice should not be disturbed.

The court’s reasoning was influenced by both factual and legal considerations. The ratio of fact to law is as follows:

Logical Reasoning:

The court rejected the alternative interpretation that broken period interest should always be treated as a capital expenditure, emphasizing that such an interpretation would be against the nature of the banking business and the established practices.

The court’s decision was based on the following reasons:

• The decision in Vijaya Bank Ltd. was not applicable to the present case due to the repeal of Sections 18 to 21 of the IT Act.

• Banks hold securities as stock-in-trade, and therefore, the interest paid on them is a revenue expenditure.

• The disallowance of broken period interest as a capital expense is revenue-neutral.

• The RBI and CBDT have issued circulars supporting the treatment of broken period interest as an expense.

• The consistent practice of allowing the deduction should not be disturbed.

The court quoted the following from the judgment:

“Therefore, in the facts of the case, as the securities were treated as stock-in-trade, the interest on the broken period cannot be considered as capital expenditure and will have to be treated as revenue expenditure, which can be allowed as a deduction.”

“The securities of the HTM category are usually held for a long term till their maturity. Therefore, such securities usually are valued at cost price or face value. In many cases, Banks hold the same as investments. Whether the Bank has held HMT security as investment or stock-in-trade will depend on the facts of each case.”

“HTM Securities can be said to be held as an investment (i) if the securities are actually held till maturity and are not transferred before and (ii) if they are purchased at their cost price or face value.”

There were no minority opinions in this case. The bench comprised Justices Abhay S. Oka and Pankaj Mithal, and both judges agreed on the final decision.

The court’s reasoning was based on the legal interpretation of the Income Tax Act, the nature of the banking business, and the factual circumstances of each case. The court clarified that the Vijaya Bank Ltd. judgment was not applicable due to the changes in the law and the different factual context.

The potential implications for future cases are that banks can now deduct broken period interest as a revenue expenditure if the securities are held as stock-in-trade. However, the court clarified that HTM securities held till maturity at cost price will be treated as investments.

The court did not introduce any new doctrines or legal principles but clarified the existing legal position concerning the tax treatment of broken period interest.

Key Takeaways

• Banks can deduct broken period interest as a revenue expense when securities are held as stock-in-trade.

• HTM securities held till maturity at cost price are treated as investments, and broken period interest is not deductible.

• The decision in Vijaya Bank Ltd. is not applicable in cases where the income is taxed under Section 28 of the IT Act.

• Banks should maintain proper documentation to prove whether securities are held as stock-in-trade or investments.

Directions

The Supreme Court directed that the judgment of the High Court in Civil Appeal Nos. 3291-3294 of 2009 is set aside, and the decisions of the Tribunal are restored. All other appeals by the Revenue were dismissed, with a clarification regarding HTM securities.

Development of Law

The ratio decidendi of this case is that broken period interest is a deductible revenue expenditure for banks when securities are held as stock-in-trade. This clarifies the legal position and overrules the previous interpretation based on the Vijaya Bank Ltd. judgment. The court has reiterated that banks are in the business of dealing with money and credit and that securities are part of their stock-in-trade.

The judgment clarifies the definition of stock-in-trade for banks, specifically stating that securities under the HTM category can be treated as investments if they are held till maturity at cost price. The court also emphasized that consistent practices accepted by the revenue should not be disturbed.

Conclusion

The Supreme Court’s judgment in Bank of Rajasthan Ltd. vs. Commissioner of Income Tax provides significant clarity on the tax treatment of broken period interest for banks. By overruling the Vijaya Bank Ltd. decision and affirming the principles laid down in American Express International Banking Corporation and Citi Bank NA, the court has ensured that banks can correctly claim deductions for broken period interest when securities are part of their stock-in-trade. This decision also brings the tax treatment of broken period interest in line with the practical realities of banking operations and the guidelines issued by the RBI and CBDT.

The judgment has significant implications for banks, especially in the context of their tax planning and compliance. It also provides a clear and consistent framework for assessing the deductibility of broken period interest, reducing the potential for future disputes.