A simple tax planning tool often overlooked by most taxpayers is of selecting an appropriate accounting method for their incomes. The Income-tax Act permits two methods of accounting—mercantile (accrual) and cash. Under the mercantile method, income and expenses are accounted as and when the right to receive or the right to pay arises. Under the cash method, income and expenses are accounted on actual receipt or payment.
For three heads of income—salaries, income from house property and capital gains—only the mercantile method of accounting is permitted. For instance, salary relating to a particular year is taxable in that year itself irrespective of whether it is actually received or not. Also, rent receivable for the year in respect of the let-out house property is taxable irrespective of when it is actually received (subject to an exception for irrecoverable rent, which is not taxed until realized). Similarly, capital gain is chargeable to tax in the year in which the asset is transferred irrespective of when the sale consideration is received and whether it is actually received or not.
Also Read Gautam Nayak’s earlier columns
You can account income under the heads “profits and gains of business or profession” and “income from other sources”, such as business profits, professional income, investment income other than capital gains, either on a cash basis or on a mercantile basis. The cash method of accounting effectively postpones (but does not permanently reduce) your tax liability to the year of actual receipt of income, whereas under the mercantile method, the tax on the income has to be paid even if the income has not been received. So, it is better to account for income that are to be received after a period of time on a cash basis. Also, if a certain income is not guaranteed, you may choose to account for it on a cash basis so that you do not end up paying tax on income that you do not eventually receive. If there is a risk of companies defaulting on their interest payment obligations in respect of fixed deposits (FD) and debentures, it is prudent to account such income on a cash basis.
What is the meaning of “receipt” under the cash system? Can you claim that you didn’t receive the interest when an FD matured and was automatically renewed by the bank? The maturity of the FD amounts to a receipt in your hands, which you have then reinvested. The interest would, therefore, be taxable as your income in the year of maturity of the FD.
Can you account for income from some investments under the cash method, while following the mercantile method for income from others? The method of accounting can differ for each source of income because the computation of income is primarily for each source. Within a particular source of income, the method has to be the same for all items. Though the Income-tax Act has not defined what exactly constitutes a source of income, courts have generally taken the view that the term “source” has to be understood in its normal context as comprising of those items which are treated as a category by the taxpayer. Therefore, each category of investments would generally constitute a separate source of income and a different method of accounting can be adopted for each category. For instance, debentures and bonds may constitute one source, company FDs another, bank FDs a third, National Savings Certificates a fourth and so on. Therefore, it is possible to account for interest on company deposits on a cash basis, while accounting for interest on bank deposits on an accrual basis.
Is it necessary to maintain books of account in order to be able to follow a particular method of accounting? There are conflicting views on this as observations of certain courts seem to indicate that a method of accounting for taxable income can be adopted without necessarily having books of account. Rather than risk litigation, the safer course of action to follow would be to maintain books of account, particularly when you have changed the method of accounting.
While a one-time change in method of accounting is normally allowed, changes in method of accounting from year to year for income from the same source, just to save taxes, is not.
If you follow the cash method of accounting, one important aspect to remember is that the tax credit for the tax deducted at source on such income will be available only in the year in which such income is offered to tax, though, the tax would generally be deducted by the payer on an accrual basis each year. Therefore, you need to ensure that the tax deduction certificates (irrespective of the year in which they were issued) are matched with the income offered to tax in the relevant year.
Gautam Nayak is a chartered accountant. Your comments are welcome at firstname.lastname@example.org