The Hindu Business Line : Claiming bad debts as a deduction

In the lending business, particularly in the case of non-banking finance companies, there have been instances of bad debts being disallowed for various reasons.

R. Anand

A debt has to be established as bad before one can claim it as a deduction. This simple statement of fact has been twisted into a complicated legal issue both by assessees and the income-tax department.

In business one has to live with the reality of losing money in the course of business. This is true for any industry — manufacturing, trading, service and lending. Why has the claim for bad debt been a contentious issue over a period of time? < /p>

This is primarily because what is at best a factual matter, to be proved and established by proper records and chain of event, are needlessly converted into a legal matter. No wonder High Courts and the Supreme Court have had the occasion to deal with allowability of bad debts in some context or the other.

There are some basic requirements to claim bad debts as a deduction: a) there must be a debt; b) debt must be incidental to business; c) debt must have been taken into account in computing assessable income; and d) debt must have been written off in the books of accounts. All the four conditions have to be satisfied together with the requisite records. In the context of lending business, particularly in the case of NBFCs (non-banking finance companies), there have been instances of bad debts being disallowed for various reasons.

RBI norms and allied issues

In the case of NBFCs, they are governed by provisioning requirements as stipulated by RBI prudential norms of 1988. These norms have clear and time-bound stipulations of the quantum and manner of provision of non-performing assets. Typically in the case of lease/hire purchase assets, loans and advances and any other form of credit, the following are the classes of assets: i) standard; (ii) sub-standard; doubtful; (iv) loss.

It is also made clear that in the case of loss assets, the entire assets shall be written off. If the assets are permitted to remain in the books for any reason, it should be provided for. The requirement of write-off is envisaged for loss assets in accordance with RBI directives. All NBFCs governed by the norms have to necessarily follow the procedure of first making a provision for non-performing assets and thereafter effecting the write off in the books of accounts.

Once the write-off is blessed by a regulator, it should normally stand the scrutiny of the income-tax authorities. But having said this, the income-tax authorities exercises an independent judgment of the conditions laid down in Section 36(1)(vii) of Income-Tax Act, 1961 before granting the write off.

In this context, Section 36(2) lays down that no deduction shall be allowed for bad debt unless such debt has been taken into account in computing the income of the previous year or represents money lent in the ordinary course of business of banking or money-lending.

Disputes have arisen primarily on satisfaction of conditions in Section 36(2) and not on the RBI requirement on write off in the books of accounts. Whether hire purchase and leasing constitute lending business in a generic sense is an ongoing debate. The fact is industry has been doing a flip-flop on this purely to duck VAT and service tax burden on what is called pure hire purchase and leasing transactions.

The recourse to loan-cum-hypothecation agreement was a phenomenon driven by the introduction of service tax effective July 16, 2001. Based on this a stand can be taken that these transactions are effectively money lending in some form and, therefore, the conditions of Section 36(1)(vii) should apply to such cases.

Court, tribunal rulings

Courts have had occasions to examine allowability of bad debts in detail. The Madras High Court, in South India Surgical Co. Ltd vs ACIT (2006 287 ITR 62), held that a unilateral act of the assessee to write off debts as bad debts is not a ground to allow the deduction. The assessee should necessarily make out a case that the debt so written off is actually irrecoverable.

In CIT vs Brilliant Tutorials (2007 292 ITR 399), the Madras High Court opined that the allowability of bad debts is essentially based on facts and honest judgment made by the assessee at the time or writing off the same.

Specific to the NBFC industry, the Madras Bench of the Tribunal, in the Shriram Transport Finance Corporation vs JCIT (IT Nos 1877 and 1878/Mds/2002) case, considered the allowability of bad debts in respect of hire purchase/lending business. The Madras Tribunal came to the conclusion that writing off bad debts in the books of accounts by itself will not be enough to claim deduction. The Tribunal reasoned that “it becomes clear that in the case before us the assessee has adopted a very reasonable and authentic system of writing off of bad debts. The same is being done on the basis of recoverability of a debt and after obtaining the report of the particular field officer, who visits the particular party and then sends the recommendations accordingly.

“Since the assessee-company is running many branches and running the business of finance, which means, the assessee has to be very careful while writing off the bad debts. The assessee-company has authorised its branch managers because it is not a case of individual businessman who will exercise his judgment and therefore no intentions for claiming the bad debt just for the purpose of taxation can be imputed to the assessee.”

Accordingly the Tribunal allowed the deduction as bad debt. However, there have been decisions in the context that it is not obligatory for the assessee to place demonstrative proof for establishing a debt as bad and if the same has been written off as recoverable it should suffice for claiming it as bad debt.

This proposition has been laid down in Newdeal Finance and Investment Ltd vs Deputy CIT (2000 60 TTJ Chennai). But viewing the matter in totality and taking a practical standpoint, the burden is cast heavily on the assessee to prove the allowablity of bad debt particularly in lending business.

Way forward

Record keeping is an essential prerequisite for successful tax proceedings. There is the old dictum — “Concentrate on the facts. The law will take care of itself.”

This message is so true for allowabilty of bad debts. In the quest for proving a legal point assessees have unduly focussed on the language in the provisions at the expense of ignoring the essentials of record-keeping. More so, if the records are not produced at the assessing officer stage, the case can become messy and complicated.

It is learnt that several NBFCs are facing a challenge in getting bad debts allowed before the lower authorities. The message is clear: They will have to establish a proper system of write off based on a tested and accepted policy. Once this is established the conditions laid down in Section 36(1)(vii) will automatically fall into place.

(The author is Partner, Global Tax and Advisory Services, Ernst & Young.)

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