Background:

The Banking Regulation Act,1949 read with the guidelines of the Reserve Bank of India (RBI) mandates Banks to purchase Government Securities to maintain the Statutory Liquidity Ratio (SLR) requirements.

These securities are categorised into the following three categories:

(a) Held to Maturity (HTM); (b) Available for Sale (AFS); and (c) Held for Trading (HFT).

The interest on such securities is paid on specific fixed dates called ‘coupon dates’. When a Bank purchases a security on a date which falls between the dates on which interest is payable, the purchaser Bank, in addition to the price of the security, pays an amount equivalent to the interest accrued for the period, from the last interest payment till the date of purchase. This interest is termed as the ‘interest for the broken period’. When the interest becomes due after the purchase of securities, the interest including the broken period interest is paid to the purchaser Bank by the Government.

The Supreme Court, in its recent ruling, held that deduction for such broken period interest to Banks shall be allowed as a deductible expense if such security is held as ‘stock-in-trade’. Thereby, deduction under section 37 of the Income-tax Act, 1961 (IT Act) was allowed to the taxpayer.

We, at BDO in India, have summarised the above ruling and provided our comments on the impact of this decision hereunder.

Facts of the Case:

• The taxpayer is a scheduled bank, governed by the Banking Regulation Act, 1949 read with guidelines of the RBI.

• The taxpayer was engaged in trading Government Securities for maintenance of the SLR ratio and, accordingly, treated such securities as ‘stock-in-trade’. Further, the taxpayer followed the method of setting off the broken period interest and interest recovered on the sale of securities, thereby offering net income to tax.

• The Commissioner of Income Tax (CIT), relying upon a decision of the Court in the case of Vijaya Bank Ltd. v. Additional Commissioner of Income Tax¹, Bangalore contended that under the head ‘interest on securities’, the interest for a broken period was not an allowable deduction.

• Aggrieved by the order of the CIT, the taxpayer preferred an appeal before the Tax Tribunal.

• The Tax Tribunal held that as the taxpayer was holding the securities as stock-in-trade, the entire amount paid by the taxpayer for the purchase of such securities, which included interest for the broken period, was deductible. The Tax Tribunal held that the decision relied upon by the CIT (Vijaya Bank Ltd. v. Additional Commissioner of Income Tax²), was based on sections 18 to 21 of the IT Act which were repealed with effect from 1 April 1989 and hence, not applicable

• Aggrieved by the order of the Tax Tribunal, the tax authorities preferred an appeal before the Rajasthan High Court.

• The High Court, relying on the decision in the case of Vijaya Bank Ltd. v. Additional Commissioner of Income Tax³  disallowed the broken period interest.

• Aggrieved by the order of the High Court, the Taxpayer has preferred an appeal before the Supreme Court.

Supreme Court Ruling:

• The Hon’ble Supreme Court observed that in a banking business, apart from dealing with money and credit, it is essential to keep sufficient cash or easily realisable securities to meet the demand of depositors. In relevance to this, it was observed that taxpayers realised some of the securities to meet withdrawals by depositors. Hence, the Hon’ble Supreme Court held that the securities that were acquired by the taxpayer were a part of the banking business and shall be held as stock-in-trade and not as an investment.

• Further, the Hon’ble Supreme Court observed that 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 shall be allowed as a deduction.

• Reliance is also placed on the ruling in the case of HDFC Bank Ltd. v. CIT⁴ where it was held that the securities in the category of HTM were also held as stock-in-trade, and such income arising out of such securities, including HTM securities, has been treated as business income. The Tax Tribunal held that the interest for the broken period would be admissible as a deduction, and the Bombay High Court confirmed the same.

• Further, before the Karnataka High Court in the case of CIT vs. State Bank of India⁵, the tax authority argued that the increase in capital results in the expansion of the Bank's capital base, which helps in profit making. Therefore, the expenditure in the nature of broken period interest was capital expenditure. However, the Karnataka High Court rightly rejected the contention of the department that the outlay on the purchase of securities was capital outlay.

• The Supreme Court confirmed the above position and also clarified that if a broken period interest is not deducted, it will be added to the acquisition cost of securities. This means it will be deducted from the sale proceeds later, reducing the profit from the sale. Thus, the Department's actions are deemed largely academic.

• In view of the above, it was concluded that broken period interest will be allowed as a deduction under section 37 of the IT Act provided securities were held as stock-in-trade. Accordingly, the Hon’ble Supreme Court dismissed the Tax Authorities appeal and upheld the decision of the Tax Tribunal.

BDO in India Comments:

The Supreme Court ruling is a significant judgement and has put to rest the ground of litigation surrounding the claim of broken period interest.
This decision reaffirms the practice largely followed by the Banks and provides much-needed clarity on the tax treatment of interest income from government securities in the context of the banking sector. The Supreme Court has also examined the importance of distinction in the nature of securities held by the banks for meeting SLR requirements, i.e. stock-in-trade vs investment, for treatment of broken period interest.
Further, CBDT Circular⁶ and Tax Tribunal ruling in the case of CIT vs. State Bank of Hyderabad⁷ had also taken a position that the broken period interest should be allowed as a deduction where the securities are held as stock in trade.

Taxpayers who are required by regulations to invest in government securities may evaluate how interest income is treated in cases where the securities are held as investments and interest income received includes the broken period interest.