2010 (1) TMI 5 - SC - Income Tax

Provisions for NPAs must be added back before deduction; Section 36(1)(viia) and Section 43D upheld

M/s Southern Technologies Ltd. Versus Joint Commnr. of Income Tax, Coimbatore

SC held that provisions for non-performing assets debited to the profit & loss account are not deductible as business income unless added back first; ... Income under Section 2(24) - Provision for NPA - difference between 'provision' and 'reserve' - Whether the Department is entitled to treat the 'Provision for NPA', which in terms of RBI Directions 1998 is debited to the P&L Account, as 'income' under Section 2(24), while computing the profits and gains of the business under Sections 28 to 43D of the IT Act? - Held that:- Section 36(1)(viia) provides for a deduction not only in respect of 'written off' bad debt but in case of banks it extends the allowance also to any Provision for bad and doubtful debts made by banks which incentive is not given to NBFCs - even in the case of banks the Provision for NPA has to be added back and only after such add back that deduction under Section 36(1) (viia) can be claimed by the banks - that neither Section 36(1)(viia) nor Section 43D violates Article 14. We further hold that the test of 'intelligible differentia' stands complied with and hence we reject the challenge - Provision for possible loss are only notional for purposes of disclosure, hence, they cannot be made an excuse for claiming deduction under the IT Act, hence, 'add back'. Issues Involved:1. Whether the 'Provision for NPA' can be treated as 'income' under Section 2(24) of the Income Tax Act, 1961.2. Whether the 'Provision for NPA' is allowable as a deduction under Section 36(1)(vii) or Section 37(1) of the Income Tax Act.3. Applicability of Section 145 of the Income Tax Act concerning the method of accounting prescribed by RBI.4. Constitutional validity of Sections 36(1)(viia) and 43D of the Income Tax Act in relation to NBFCs.Detailed Analysis:1. Treatment of 'Provision for NPA' as 'Income' under Section 2(24) of the Income Tax Act:The court examined whether the 'Provision for NPA' debited to the P&L Account, as per RBI Directions 1998, should be treated as 'income' under Section 2(24) of the Income Tax Act. The Department argued that the provision for NPA is not an actual expenditure or loss but a provision against a possible loss, and thus should not be deductible under Section 36(1)(vii). The court concurred, stating that the 'Provision for NPA' is a notional expense for presentation purposes under RBI Directions and does not constitute real income for tax purposes. Consequently, the provision must be added back to the taxable income under the IT Act.2. Deductibility of 'Provision for NPA' under Section 36(1)(vii) or Section 37(1) of the Income Tax Act:The court analyzed whether the 'Provision for NPA' could be claimed as a deduction under Section 36(1)(vii) or Section 37(1). It was noted that prior to 1.4.1989, a provision for bad debt could be treated as a write-off. However, post-1.4.1989, the Explanation to Section 36(1)(vii) clarified that a provision for bad and doubtful debts does not qualify as a write-off. Therefore, the provision for NPA cannot be deducted under Section 36(1)(vii). Additionally, Section 37(1) applies only to expenses not covered under Sections 30 to 36. Since the provision for doubtful debts is explicitly excluded by Section 36(1)(vii), it cannot be claimed under Section 37(1).3. Applicability of Section 145 of the Income Tax Act:The court discussed the applicability of Section 145, which deals with the method of accounting. It was argued that NBFCs must follow the accounting method prescribed by RBI. However, the court clarified that while RBI Directions 1998 mandate a specific method of accounting for income recognition, these directions do not override the provisions of the IT Act concerning taxable income computation. The court emphasized that the RBI Directions are primarily for presentation and disclosure purposes and do not affect the taxability of income under the IT Act.4. Constitutional Validity of Sections 36(1)(viia) and 43D of the Income Tax Act:NBFCs challenged the constitutional validity of Sections 36(1)(viia) and 43D, arguing that denying them the same deductions available to banks and other financial institutions violated Article 14 (equality before the law) and Article 19(1)(g) (right to carry on business) of the Constitution. The court rejected this contention, stating that the differentiation between NBFCs and banks is based on rational criteria related to risk and liquidity management. The court held that the provisions in question are not discriminatory and do not impose unreasonable restrictions on the business operations of NBFCs. The court also emphasized the importance of maintaining transparency and protecting depositors, which justified the differential treatment.Conclusion:The court dismissed the appeals filed by the NBFCs, upholding the Department's stance that the 'Provision for NPA' should be added back to the taxable income and cannot be claimed as a deduction under Sections 36(1)(vii) or 37(1). The court also upheld the constitutional validity of Sections 36(1)(viia) and 43D of the Income Tax Act, confirming that the differential treatment between NBFCs and banks is justified and does not violate constitutional principles.