Taxpayer wins bad debt claim under section 36(1)(vii) after fulfilling statutory requirements despite AO's sham transaction allegations

ITAT Mumbai allowed the taxpayer's appeal regarding bad debts claimed under section 36(1)(vii). The AO rejected the bad debt claim, alleging it was a sham transaction to offset long-term capital gains, citing relationships between directors and timing of assignment agreements. The ITAT held that the AO's conclusions were based on presumptions without proper inquiry. Since the taxpayer fulfilled statutory requirements under sections 36(1)(vii) and 36(2) by writing off debts in books, no further proof of actual bad debt was required. The disallowance was deleted.

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The core legal issue considered by the Tribunal is whether the bad debts written off by the assessee in the relevant assessment year can be allowed as a deduction under section 36(1)(vii) read with section 36(2) of the Income Tax Act, despite the Revenue's contention that the write-off was a colourable device to set off long-term capital gains and thus not genuine.

The Tribunal examined the following key questions:

• Whether the assessee, a Non-Banking Financial Company (NBFC), fulfilled the statutory conditions under sections 36(1)(vii) and 36(2) for claiming the bad debt deduction.
• Whether the write-off of loans given to two companies, including a subsidiary, was a genuine commercial decision or a sham transaction aimed at tax avoidance.
• The relevance and effect of assignment agreements dated prior to the year of write-off on the timing and genuineness of the bad debts.
• The validity of the Revenue's reliance on the financial performance of the borrower companies and related-party connections to disallow the deduction.
• Whether the shifting of the write-off to a later assessment year for setting off capital gains affects the allowability of the deduction.

Regarding the statutory framework, the Tribunal noted that section 36(1)(vii) allows deduction for bad debts or part thereof written off as irrecoverable in the accounts of the assessee for the previous year, subject to the conditions in section 36(2). Section 36(2)(i) requires that the debt must have been taken into account in computing income in the previous year in which it is written off or an earlier year, or represent money lent in the ordinary course of banking or money-lending business.

The Tribunal found no dispute that the assessee is an NBFC engaged in money lending and had lent substantial sums to the two companies in question. The assessee had also received and offered to tax interest income from these loans in prior years, satisfying the requirement that the debt was taken into account in computing income. The loans were written off as bad debts in the books during the relevant year, fulfilling the statutory requirement of write-off.

Precedents cited included the Supreme Court decision which clarified that after amendment to section 36(1)(vii), it is sufficient that the debt is written off in the accounts, and the assessee is not required to prove that the debt has actually become bad. The commercial wisdom of the assessee in writing off the debt is determinative, subject to the conditions in section 36(2). The Tribunal also referred to a High Court ruling emphasizing that bad debts should be allowed based on facts of each case and not on mere suspicion.

The Revenue's primary contention was that the write-off was a colourable device to create artificial loss to set off long-term capital gains earned in the same year. The AO relied on the following points:

• Common directorship links between the assessee and the borrower companies through a relative of the major shareholder.
• Existence of assignment agreements transferring the loans to other entities prior to the year of write-off, indicating the bad debts had arisen earlier.
• The borrower company's financials showed profits, suggesting no genuine reason for write-off.
• The timing of capital gains and write-off suggested manipulation to reduce tax liability.

In analyzing these contentions, the Tribunal found that the mere presence of a common director who was not a shareholder did not establish any interest or control warranting suspicion. The fact that one borrower was a subsidiary did not negate the genuineness of the loan or the bad debt claim, especially since interest was received and taxed in earlier years. The Tribunal emphasized that the AO cannot substitute his commercial judgment for that of the assessee or act as an owner to question business decisions.

Regarding the assignment agreements, the assessee explained that these were not acted upon, the assignee companies were non-performing assets, and the agreements were abandoned following professional advice. The small consideration received under these agreements was adjusted against outstanding balances. The AO's rejection of these explanations was based on presumptions without any inquiry or evidence from the assignees. The Tribunal held that such conclusions based on surmises and conjectures were not justified.

The Tribunal underscored that the statutory provisions require only that the debt be written off in the accounts and that the conditions of section 36(2) be met. The timing of the bad debt write-off vis-`a-vis capital gains is irrelevant for the purpose of allowance of deduction. The Tribunal relied on authoritative rulings which held that the commercial expediency of writing off the debt suffices for claiming deduction, and the burden to prove actual badness of debt was removed by legislative amendment.

Furthermore, the assessee, as an NBFC, was governed by RBI prudential norms which classified these loans as Non-Performing Assets (NPAs), reinforcing the commercial basis for write-off. The Tribunal observed that even if the AO's view of postponement of write-off was accepted, the deduction under section 36(1)(vii) would still be allowable in the year of write-off.

In conclusion, the Tribunal found the AO's and CIT(A)'s disallowance of bad debts to be unfounded, as it was based on unsubstantiated assumptions without proper investigation or evidence. The statutory conditions for claiming the deduction were fulfilled by the assessee, and the commercial wisdom exercised in writing off the debts was entitled to deference. The Tribunal set aside the orders of the lower authorities and directed the AO to allow the bad debts claimed.

Significant holdings include the following authoritative legal principles:

"Subsequent to the amendment to the language of section 36(1)(vii), it is sufficient if the bad debt or part thereof is written off as irrecoverable in the accounts of the assessee based on commercial expediency. The legislature has sought to exclude the burden on the assessee to prove that the debt is bad debt and leaves it to the commercial wisdom of the assessee to treat the debt as bad debt once it is written off as irrecoverable in the accounts of the assessee."

The Tribunal reaffirmed that mere suspicion or conjecture, without supporting material or inquiry, cannot justify denial of deduction. It emphasized that the Revenue cannot question the business wisdom of the assessee in writing off debts once the statutory conditions are met.

Accordingly, the final determination was that the bad debts written off by the assessee in the relevant year are allowable deductions under section 36(1)(vii) read with section 36(2) of the Income Tax Act, and the disallowance by the AO and CIT(A) was set aside.

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