JUDGMENT Jagannatha Shetty, J.
1. The following question has been referred to this court under s. 256(1) of the I.T. Act, 1961 :
"Whether the Tribunal is correct in holding that the amount of depreciation debited to accounts of a charitable institution is to be deducted to arrive at the income available for application to charitable and religious purposes ?"
2. The assessee is a society known as "The Society of the Sisters of St. Anne, Bangalore". It is a charitable institution running a school. It was assessed as an association of persons for the assessment year 1977-78. The assessee filed a return of income on August 6, 1977, declaring "nil" income. The gross receipt as per income and expenditure statement was shown as Rs. 1,93,185. Expense claimed as allowance under s. 11(1) was shown as Rs. 1,37,389. While arriving at this figure, depreciation of Rs. 5,781 was claimed in the statement of accounts as a debit in respect of the school building. The ITO disallowed that claim stating that depreciation is required to be allowed only when the incnome is computed under the head "Business" falling under s. 28 of the I.T. Act, 1961. He also observed that what is contemplated u/s. 11(1) is actual application of the institution's income towards charitable objects and not an expenditure which has not been actually incurred to meet the expenses. The depreciation being a notional expenditure could not be said to have been incurred or applied for charitable purposes.
3. The assessee appealed to the AAC against the said disallowance. The AAC held that the assessee was entitled to the benefit of Rs. 5,781 in the computation of its income.
4. The ITO preferred an appeal to the Tribunal against allowing depreciation by the AAC. The Tribunal, while dismissing the appeal, upheld the order of the AAC, observing as follows :
"The income within the meaning of sec. 11(1) should be the income in the real sense which can be applied to charitable purposes and from which surplus can arise if a part thereof is not applied to the objects of the trust. Viewed from this angle, the Bombay Bench held that it was its considered opinion that the provisions of depreciation at 2 1/2 per cent. was not only prudent but was essential for the purpose of arriving at income available for distribution for application to charity. Following that order, I hold that the amount of depreciation was not the income available for application with the assessee. In that view of the matter, the departmental appeal is dismissed."
5. Being aggrieved by the said order, the Department has, in this reference, sought for the opinion of this court on the aforesaid question.
6. Mr. Srinivasan, learned counsel for the Revenue, while challenging the correctness of the order of the Tribunal, submitted that the word "income" in s. 11(1)(a) must represent the money that is available for being applied to charitable or religious purposes and that income should be construed as the actual receipts minus the actual expenses. The notional expenses like depreciation is not an expense that is relevant for arriving at the real income referred to in s. 11(1)(a).
7. Mr. Prasad, for the assessee, and Mr. Sarangan, as intervener, on the other hand, urged that the word "income" in s. 11(1)(a) cannot be understood to exclude the depreciation merely because the subsequent word "income" is succeeded by the word "applied". The income that is left in the hands of the society is the residue that is available for application after allowing all the expenditure, and depreciation is one such expenditure recognised under law and therefore, the benefit of that allowance cannot be denied to the assessee. They also urged that even the Board has approved the method of accounting in the commercial principle for determining the income derived from the trust and under that principle of accounting, the depreciation allowance is a necessary outgoing.
8. We may turn now to the relevant provisions of s. 11 of the Act. Section 11(1) provides that subject to the provisions of ss. 60 to 63, the "total income" of the previous year of the person in receipt of that income shall not include the income derived from property held under trust. Under s. 11(1)(a) a trust for charitable or religious purposes is allowed to accumulate or set apart without any additional conditions up to 25 per cent. of its income. Out of the balance, amount actually spent in India to charitable or religious purposes will be exempt. But the accumulation must be with the object of application of the accumulated amount to charitable or religious purpose in India at a later date.
9. This rule also applies to property held under trust in part only for religious and charitable purposes. In other cases too the amount actually spent in India to such purposes will be exempt, and, in addition, any income finally set apart for application to such purposes in India, to the extent of 25 per cent. of the income will be exempt.
10. Apart from these provisions for free accumulation the trust has also got right of additional accumulation. The relevant provisions are contained in sub-s. (2) of s. 11 of the Act.
11. The Explanation to s. 11(1) makes it clear that in computing the 25 per cent. of the income which may be accumulated or set apart, all voluntary contributions referred to in s. 12 are to be deemed to be a part of the income. Under the provisions effective up to the assessment year 1975-76, a charitable or religious trust was entitled to claim that the application of the trust's income in the three months' period immediately following the end of the relevant previous year should be treated as an application within the year itself. But those provisions were not sufficient to meet many cases where the trustees were, due to circumstances beyond their control, unable to make the application even within the extended three months' period.
12. The provisions of the Explanation to s. 11(1), effective from the assessment year 1976-77, envisage two circumstances : (i) where the trustees are unable to spend the required 75 per cent. of the income during the relevant previous year itself for the reason that the whole or any part of the income has not been received during that year, and (ii) where such inability arises from any other reason. In the first class of cases the extended period of application will consist of the previous year in which the income is received plus the previous year immediately following. But the amount which may be so claimed to have been applied during the subsequent previous year cannot, of course, exceed the amount of the income which had not been received earlier but is received during the subsequent previous year.
13. It is clear from the above provisions that the income derived from property held under trust cannot be the total income because s. 11(1) says that the former shall not be included in the latter, of the perosn in receipt of the income. The expression "total income" has been defined under s. 2(45) of the Act to mean "the total amount of income referred to in s. 5 computed in the manner laid down in this Act". The word "income" is defined under s. 2(24) of the Act to include profits and gains, dividends, voluntary payment received by trust, etc. It may be noted that profits and gains are generally used in terms of business or profession as provided u/s. 28. The word "income", therefore, is a much wider term than the expression "profits and gains of business or profession". Net receipt after deducting all the necessary expenditure of the trust (sic).
14. There is a broad agreement on this proposition. But still the contention for the Revenue is that the depreciation allowance being a notional income (expenditure ?) cannot be allowed to be debited to the expenditure account of the trust. This contention appears to proceed on the assumption that the expenditure should necessarily involve actual delivery of or parting with the money. It seems to us that it need not necessarily be so. The expenditure should be understood as necessary outgoings. The depreciation is nothing but decrease in value of property through wear, deterioration or obsolescence and allowance is made for this purpose in book keeping, accountancy, etc. In Spicer & Pegler's Book-keeping and Accounts, 17th Edn., pp. 44, 45 & 46, it has been noted as follows :
"Depreciation is the exhaustion of the effective life of a fixed asset owing to 'use' or obsolescence. It may be computed as that part of the cost of the asset which will not be recovered when the asset is finally put out of use. The object of providing for depreciation is to spread the expenditure, incurred in acquiring the asset, over its effective lifetime; the amount of the provision, made in respect of an accounting period, is intended to represent the proportion of such expenditure, which has expired during that period."
"At the end of its effective life, the assets ceases to earn revenue, i.e., the capital value has expired and the asset will have to be replaced or a substitute found. Provision for depreciation is the setting aside, out of the revenue of an accounting period, the estimated amount by which the capital invested in the asset has expired during that period. It is the provision made for the loss or expense incurred through using the asset for earning profits, and should, therefore, be charged against those profits as they are earned."
"If depreciation is not provided for, the books will not contain a true record of revenue or capital. If the asset were hired instead of purchased, the hiring fee would be charged against the profits; having been purchased, the asset is, in effect, then hired by capital to revenue, and the true profit cannot be ascertained until a suitable charge for the use of the asset has been made. Moreover, unless provisin is made for depreciation, the balance sheet will not present a true and fair view of the state of affairs; assets should be shown at a figure which represents that part of their value on acquisition, which has not yet expired."
15. In CIT v. Indian Jute Mills Association [1982] 134 ITR 68, the Calcutta High Court, while construing the expression "expenditure incurred" in s. 44A of the Act, observed :
"depreciation claimed shall include the expenditure incurred."
16. There are only two recognised methods of accounting : (i) cash basis, and (ii) merecantile basis. Under the cash basis only cash transactions are recorded. It is only cash receipts and cash payments which find entries in the books of account. Mercantile system of accounting was explained by the Supreme Court in Keshav Mills Ltd. v. CIT [1953] 23 ITR 230 at 230 in the following words :
"The mercantile system of accounting or what is otherwise known as the double entry system is opposed to the cash system of book keeping under which a record is kept of actual cash receipts and actual cash payments, entries being made only when money is actually collected or disbursed. That system brings into credit what is due, immediately it becomes legally due and before it is actually received and it brings into debit expenditure the amount for which a legal liability has been incurred before it is actually disbursed."
17. It is not in dispute that if the mercantile system is followed, the depreciation allowance in respect of the trust property should be allowed.
18. Mr. Srinivasan, however, urged that there are enough indications in s. 11 to exclude the mercantile system of accounting. The learned counsel relied upon s. 11(1)(a) and s. 11(4) in support of his contention. We do not think that there is anything in these sub-sections to support the contention of Mr. Srinivasan. Explanation to s. 11(1)(a), on the contrary, takes note of the income not received in a particular year. It lends support to the contention of the assessee that accounting need not be on cash basis only. Section 11(4) is not intended to explain how the accounts of the business undertaking should be maintained. It is intended only to bring to tax the excess income computed under the provisions of the I.T. Act in respect of business undertaking.
19. The depreciation if it is not allowed as a necessary deduction for computing the income from the charitable insitutions, then there is no way to preserve the corpus of the trust for deriving the income. The Board also appears to have understood the "income" u/s. 11(1) in its commercial sense. The relevant portion of the Circular No. 5-P (LXX-6) of 1968, dated July 19, 1968, reads :
"Where the trust derives income from house property, interest on securities, capital gains, or other sources, the word 'income' should be understood in its commercial sense, i.e., book income, after adding back any appropriations or applications thereof towards the purpose of the trust or otherwise, and also after adding back any debits made for capital expenditure incurred for the purposes of the trust or otherwise. It should be noted, in this connection, that the amounts so added back will become chargeable to tax u/s. 11(3) to the extent that they represent outgoings for purposes other than those of the trust. The amounts spent or applied for the purposes of the trust from out of the income computed in the aforesaid manner, should be not less than 75 per cent. of the latter, if the trust is to get the full benefit of the exemption u/s. 11(1)."
20. In CIT v. Trustee of H. E. H. The Nizam's Supplemental Religious Endowment Trust [1981] 127 ITR 378, the Andhra Pradesh High Court has accepted the accounts maintained in respect of the trust in conformity with the principles of accountancy for the purpose of determining the income derived from the property held in trust.
21. In CIT v. Rao Bahadur Calavala Cunnan Chetty Charities [1982] 135 ITR 485 at 495, the Madras High Court observed :
"The income from the properties held under trust would have to be arrived at in the normal commercial manner without reference to the provisions which are attracted by s. 14."
22. In the result, we answer the question in the affirmative and against the Revenue.
23. The parties will pay and bear their own costs.