This Tax Alert summaries a recent ruling of the Honorable Supreme Court (SC) [2010-TIOL-31-SC-IT] in the case of Vijaya Bank (Taxpayer) on the issue of whether a credit entry in individual debtor’s account is a prerequisite for allowing the amount as a deduction for write off as bad debts in terms of Section 36(1)(vii) (Section) of the Indian Tax Law (ITL).
The Taxpayer had reduced the amount debited to the Profit and Loss Account (P&L) from the Loans and Advances/ Debtors Account (Debtors A/c) on the assets side of the Balance Sheet. Considering this, the SC held that such a treatment constituted actual write off for the purposes of the Section and it was not necessary to credit individual debtor’s account to claim the deduction for write off.
Background and facts of the case
In computing profits and gains of business chargeable to tax, the Section provides for a deduction for the amount of bad debts, or part thereof, which is written off as irrecoverable in the books of account (accounts) of a taxpayer. The deduction is subject to fulfillment of certain conditions. For taxpayers engaged in the business of banking or money lending, such a deduction is also allowed for money lent in the ordinary course of banking or money lending business.
Under a different provision of the ITL, any subsequent recovery of bad debts written off and allowed as a deduction is taxed as business income in the year of such recovery.
The Finance Act, 2001 inserted an Explanation in the Section, with retrospective effect from 1 April 1989 (Explanation), to provide that any bad debts, or part thereof, written off as irrecoverable in the accounts of a taxpayer shall not include any provision for bad and doubtful debts made in the accounts.
For the tax year 1993-94, the Taxpayer, a banking company, debited its P&L by an amount of INR 71.04m and credited the amount to Provision for Doubtful Debts Account’. In the Balance Sheet, it reduced the same amount from the Debtors A/c and reflected the Debtors A/c at net figure. The Taxpayer claimed the amount of INR 71.04m as a deduction under the Section.
The Tax Authority disallowed the deduction on the ground that the entry made by the Taxpayer was a mere provision and could not be equated with actual write off of bad debts in terms of the Section.
The Taxpayer appealed to the first appellate authority which held that it was not necessary for the purpose of write off to pass credit entries in the individual account of each and every debtor. It was also held that it would be sufficient if the debit entries are made in the P&L and corresponding credit entries are made in ‘Bad Debt Reserve Account’.
Aggrieved by the first appellate authority’s decision, the Tax Authority appealed further to the Tribunal which held that since the Debtors A/c was shown at net figure in the year-end Balance Sheet, the requirements of the Section stood fulfilled and the Taxpayer was entitled to the deduction.
The Tax Authority appealed further to the High Court (HC). Upholding the dis allowance made by the Tax Authority, the HC held that, in view of the Explanation, mere creation of provision did not amount to actual write off of bad debts.
The Taxpayer appealed to the SC against the HC’s decision.
Contentions of the Taxpayer
Once the amount debited to the P&L is carried to the Balance Sheet and reduced from the Debtors A/c depicted on the assets side of the Balance Sheet, it constitutes actual write off of bad debts since, at the year end, the Debtors A/c are reflected at net amounts.
It is not necessary that each and every individual debtor’s account is credited in the accounts to constitute actual write off for the purposes of the Section.
Contentions of the Tax Authority
Mere debit entry in the P&L and reduction from the Debtors A/c in the Balance Sheet is not sufficient for allowance of deduction under the Section. Credit entry in each and every individual debtor’s account is a prerequisite to constitute actual write off of bad debts.
Prior to the insertion of the Explanation, taxpayers used to take benefit of the deduction by merely debiting the P&L and, hence, the Parliament stepped in to clarify that mere reduction of profits by debit to the P&L would not constitute write off.
The Explanation makes it clear that there is a distinction between a provision and an actual write off. A mere debit to the P&L without a credit entry in individual debtor’s account constitutes a provision. The deduction for such a provision is specifically prohibited by the Explanation.
If credit entry is not made in individual debtor’s account, it is possible that taxpayers may claim double deduction viz. once by reflecting as a reduction from the assets side in the Balance Sheet and subsequently by crediting the account of the debtor with a corresponding debit, on both occasions to the P&L.
There is also a likelihood that, on subsequent recovery of the bad debts written off, the taxpayer may merely reflect the recovery in the Debtors A/c in the Balance Sheet without crediting the P&L, thus, resulting in escapement of income.
Ruling of the SC
The SC ruled in favor of the Taxpayer and held that a credit entry in each and every individual debtor’s account is not necessary to constitute actual write off of bad debts for the following reasons:
Referring to its earlier ruling in the case of Southern Technologies Ltd. v. JCIT [320 ITR 577] , the SC explained the impact of the Explanation and the concept of write off as follows:
To understand the above dichotomy, one must understand ‘how to write off’. If an assessee debits an amount of doubtful debt to the P&L Account and credits the asset account like sundry debtor’s Account, it would constitute a write off of an actual debt. However, if an assessee debits ‘provision for doubtful debt’ to the P&L Account and makes a corresponding credit to the ‘current liabilities and provisions’ on the Liabilities side of the balance sheet, then it would constitute a provision for doubtful debt. In the latter case, assessee would not be entitled to deduction after April 1, 1989.’
In the present case, the Taxpayer had not only debited the P&L but also correspondingly reduced the amount from Debtors A/c on the assets side of the Balance Sheet and, consequently, at the end of the year, the figure shown on the assets side was net of the alleged provision. This treatment amounts to actual write off for the purpose of availing benefit of deduction under the Section.
Mere apprehension on the part of the Tax Authority that a taxpayer may claim double deduction if credit entry is not made to individual debtor’s account, would not alter the legal position. It is always open to the Tax Authority to call for the relevant details of individual debtor’s account if it reasonably believes that the taxpayer has claimed deduction twice over. In the present case, there is no finding by the Tax Authority that the Taxpayer had unauthorizedly claimed double deduction under the Section. On the other hand, credit entry in individual debtor’s account may impair the taxpayer’s chances of success in recovery suits filed against the debtor since the debtor, in such an event, would contend that no amount is due and payable by him as per the taxpayer’s accounts.
The Tax Authority’s apprehension of possible escapement of income on subsequent recovery of bad debts is also not well-founded. For the Taxpayer, being a bank, what is of relevance is the Head Office (HO) accounts. In the present case, these HO accounts reflect that the recovery by the branches in subsequent years is duly offered to tax by a credit to the P&L. If the recovery is not credited to the P&L, there would be a mismatch between the HO accounts and the branch accounts. In any case, the ITL contains specific provisions to tax such subsequent recovery which sufficiently empowers the Tax Authority to prevent the escapement of income.
The deduction in respect of bad debts constitutes one of the significant items impacting computation of taxable income, particularly for the banking sector in the context of non-performing assets. The issue of what constitutes write off, admissible for tax purposes, has been a subject matter of litigation. Taxpayers usually argued that provision in respect of specific debts constitutes effective write off. However, the statutory amendment introducing the Explanation, which provides that bad and doubtful debts do not constitute write off, tilted the issue against the taxpayers. The present ruling now settles the issue in favor of the taxpayers and provides guidance that credit entry in individual debtor’s account is not necessary to constitute actual write off for the purposes of the Section. It is sufficient if the amount debited to the P&L is reduced from the Debtors A/c, reflected on the assets side of the Balance Sheet. In terms of this ruling, the taxpayers would now be better placed to claim deduction in respect of write off of bad debts.