Deductibility of bad debts is a soft target

Written by Pawan Kumar | Sunil M Lala | Updated: Jan 31 2008, 07:21am hrs
The Income Tax law allows a taxpayer in business a choice to follow either the cash system or the mercantile system of accounting. In case the taxpayer chooses to maintain the accounts on mercantile basis, he has to account for credit sales as revenue receipts. He is then faced with incidental losses of business in the form of non-realisation of such credit sales, which he needs to write off as bad debts to the profit and loss account.

The amount of bad debts written off, which may range from a few thousands to crores of rupees, is generally a soft target for disallowance at the time of assessment with the tax authorities insisting upon the taxpayer to prove that the debt had actually become bad during the year in which the deduction is claimed.

Specific provisions dealing with the deductibility of bad debts in computing the income for tax purposes have been enacted in the Indian Income-Tax Act by way of Section 36(1) (vii) and Section 36(2) of the Act.

Section 36(1) (vii), as amended by the Direct Tax Laws (Amendment) Act 1987 with effect from Assessment Year 1989-90, provides that the amount of any bad debt or part thereof which is written off as irrecoverable in the accounts of the taxpayer for the previous year would be allowed as a deduction in computing the business income. As per the pre-amended law, it was obligatory for the taxpayer to prove that the debt had actually become bad in the year under consideration.

This is subject to the provisions of Section 36(2), which requires that the debt, which is claimed as bad, should have been taken into account in computing the income of the taxpayer in that year or in an earlier year.

The CBDT Circular No 551 dated 23-01-1990 explained the scope of the amendment. As per the circular, the old provisions which required that the debt must be established to have become bad in the year under consideration led to enormous litigation. Therefore, in order to eliminate the disputes in the matter of determining the year in which a bad debt can be allowed, the Section had been amended to provide that the claim for bad debt will be allowed in the year in which such a bad debt has been written off as irrecoverable in the accounts of the taxpayer.

However, it is often experienced that in spite of the above-referred crystal clear position in law, revenue authorities still mandate the taxpayer to establish that the debt had actually become bad in the year of claim.

The special bench decision of the tribunal in the case of Oman International Bank (2006) (100 ITD 285) (Mum) specifically analysed in detail the position of law after the amendment and observed that it is clear from the substitution that the intention of the legislature was to leave it to the prudence of the business man to judge himself as to whether a particular debt has become irrecoverable or not. If he writes it off as irrecoverable in his accounts of the previous year, it is sufficient compliance for claiming debt as bad debt under Section 36 (1) (vii) of the Act.

This position of law is also supported by the decisions of the Delhi High Court in the cases of Morgan Securities and Credits P Ltd (2006) (292 ITR 339) and Global Capital Ltd. (2007) (201 Taxation 210). In these cases, the Delhi High Court has held that a conjoint reading of Section 36(2) and Section 36 (1) (vii) makes it clear that the taxpayer would be entitled to a deduction of any bad debt which has been written off as irrecoverable in its accounts for the previous year.

With the rendering of these decisions, the tax authorities will hopefully stop impressing upon the taxpayer to prove that the debt had actually become bad and allow the taxpayer the necessary deduction as long as he can prove that it has been written off as irrecoverable in its books and had been offered to tax in an earlier year. In case not, the issue can be strongly challenged with the appellate authorities.

Lala is executive director and Kumar is associate director of PricewaterhouseCoopers Tax Litigation Cell