Mercantile system

Income tax does not fix one date for taxing interest. It follows the books the taxpayer keeps.

Section 145 of the Income-tax Act allows two methods. The mercantile system is one. The cash system is the other. Whichever method the taxpayer uses regularly is the one the tax office applies.

Under the mercantile system, interest is taxed when it becomes due. It does not matter whether the money has arrived yet.

So interest that builds up in March is taxed in that year. Even if the bank pays it out in June, it belongs to the earlier year.

The cash system does the opposite. It waits for the money.

The rule. Section 145 says income chargeable under the head income from other sources, or as business income, is computed in accordance with the method of accounting regularly employed by the assessee. Two methods are allowed: the mercantile system and the cash system.

What each one does to interest on securities. Under the mercantile system, interest on securities is taxable on an accrual basis. Under the cash system, it is taxable on a receipt basis.

And to business profits. The workbook applies the same split in Chapter 7: if the assessee follows the cash system, profits are computed on a receipts basis, while in the mercantile system they are computed on an accrual basis.

The word regularly is doing work. The method is not chosen fact by fact or bond by bond. It is the method the assessee regularly employs, and the computation follows it.

Where it changes the answer most. For a bond held through its whole life, a full year in the middle taxes one year of coupon either way. The two systems part company at the edges — the first year, the last year, and any year in which an interest date falls after the year end.

One knock-on. Where a bond is sold between two interest dates, the interest accrued and unpaid at the date of sale is taxed as interest income and then stripped out of the sale price before computing capital gains. Whether that accrued slice is taxable in the year of sale at all turns on which of the two systems the seller follows. The mechanics of that adjustment are on the accrued interest in sale consideration page.

The workbook's own Example 1 from Chapter 10. Mr A, resident in India, buys 1,000 bonds of an Indian company at Rs 100 each on 1 January 2024. Face value Rs 100, coupon 7.50% per annum, maturity 31 December 2029. Interest is paid half-yearly on 30 June and 31 December.

So a full year of interest is 1,000 x Rs 100 x 7.50% = Rs 7,500. A half-yearly payment is Rs 3,750 and a quarter is Rs 1,875.

The workbook's table, period by period:

Total for financial year 2024-25:

The two totals match, because 2024-25 is a full middle year and one year of coupon is Rs 7,500 either way. What differs is which slice sits in which year. The Rs 1,875 for January to March 2024 is taxed in 2023-24 under the mercantile system, because it accrued then. A cash-system assessee has nothing for that quarter until the 30 June 2024 payment arrives.

Chapter 10 (Taxation of Debt Products), section 10.1.1, states Section 145 and the two methods, and section 10.2.1 works Example 1's period-by-period table. Chapter 9 repeats the rule for interest on securities under income from other sources, and Chapter 7 applies it to business profits. Expect exactly the Example 1 shape: a bond with half-yearly interest dates straddling a financial year, and a question asking how much interest is chargeable in a named year under one of the two systems.

• Mercantile means accrual; cash means receipt. The workbook uses mercantile, not accrual, as the label, and a question may use either word.
• The taxpayer does not pick the method for each transaction. It is the method regularly employed, and the whole computation follows it.
• In a full middle year the two systems give the same total. Candidates who expect a difference every year misread the table. The gap shows up in the first year, the last year, and wherever an interest date falls after the year end.
• The Jan to Mar 2024 slice is the giveaway row. Rs 1,875 in 2023-24 under mercantile, nothing until 30 June 2024 under cash.
• It governs interest and business profits, not capital gains. Capital gains have their own timing rules; Section 145 is about income from other sources and business income.
• Do not confuse a method of accounting with a head of income. Interest on securities is taxed under income from other sources unless it is business income; the method only decides the year.