TaxTMI 
TaxTMI 
2010 (1) TMI 5
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....ssets into doubtful, sub-standard and loss is not in dispute. 5. The financial year of the Appellant is July to June and the P&L Account and the Balance Sheet are drawn as on 30th June.The P&L Account and Balance Sheet is for shareholders, Reserve Bank of India (RBI) and Registrar of Companies (ROC) under the Companies Act, 1956. However, for IT Act, a separate P&L Account is made out for the year ending 31st March and the Balance Sheet as on that date is prepared and submitted to the Assessing Officer (AO) for computing the Total Income under the IT Act, which is not for use of RBI or ROC. 6. For the accounting year ending 31.03.1998, Assessee debited Rs. 81,68,516/- as Provision against NPA in the P&L Account on three counts, viz., Hire-Purchase of Rs. 57,38,980/-, Bill Discounting of Rs. 12,79,500/- and Loans and Advances of Rs. 31,84,701/-, in all, totalling Rs. 1,02,03,121/- from which AO allowed deduction of Rs. 20,34,605/- on account of Hire Purchase Finance Charges leaving a balance provision for NPA of Rs. 81,68,516/-. 7. Before the AO, Assessee claimed deduction in respect of Rs. 81,68,516/- under Section 36(1)(vii) being Provision for NPA in terms of RBI Directi....
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.... Ltd., 312 ITR 254. According to the appellant, applying "real income theory", the "Provision for NPA" which is debited to P&L Account in terms of the RBI Directions 1998 and shown accordingly in the Balance Sheet can never be treated as income under Section 2(24) of the IT Act and added back while computing profits and gains of business under Sections 28 to 43D of the IT Act. 10. In reply, the Department contended before us that the IT Act is a separate code by itself; that the taxable total income has to be computed strictly in terms of the provisions of the IT Act; that the Reserve Bank of India Act, 1934 ("RBI Act" for short) operates in the field of monetary and credit system and that the said RBI Act never intended to compute taxable income of NBFC for income tax purposes; and, hence, there was no inconsistency between the two Acts. 11. According to the Department, RBI has classified all assets on which there is either a default in payment of interest or in repayment of the principal sum for more than the specified period as NPA. According to the Department, NPA does not mean that the asset has gone bad. It still continues to be an asset in the books of the lender, i.e.....
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.... is shown in the balance sheet. However, RBI, in the case of NBFC, has deviated from the above accounting concept by insisting that the provision for NPA shall not be netted against the assets and should be shown separately on the liability side of the balance sheet so as to inform its user about the quantum and quality of NPA, in a more transparent manner. To this extent, there is a deviation from Part I of Schedule VI to the Companies Act, 1956. 12. Coming to the scope of Section 145 of the IT Act, it was submitted by the Department that Section 145 occurs in Chapter IV of the IT Act which deals with computation of total income. It indicates how the taxable income should be arrived at vide Sections 14 to 59. It is not an assessment Section. Section 145 helps to arrive at taxable total income. It nowhere indicates that the net profit arrived at shall be by adopting the accounting standards of Institute of Chartered Accountants of India (ICAI). It is the 1998 Directions which inter alia states that NBFC shall not recognize any income from an asset classified as NPA on mercantile system of accounting and that such Income shall be recognized only on cash basis. In the case under a....
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....en if "Provision for NPA" is treated to be in the nature of a reserve still it will not convert a statutory debit in the P&L Account or a statutory charge in the said Account as "real income". It is contended that under Section 145 of the IT Act, NBFCs are bound to follow the method of accounting prescribed by RBI. Hence, a statutory debit or a statutory charge under RBI Directions 1998 issued under Section 45JA of the RBI Act cannot form part of the "real income" and, consequently, it cannot be subjected to tax under the IT Act.According to the appellant(s), the "real income theory" is concerned with determining whether a particular amount can be treated as taxable income based on commercial principles. According to the appellant(s), the statutory provision for NPA represents an amount forming part of the value of the asset that the assessee is entitled to, but not likely to receive. According to the appellant(s), they are in the business of lending of money, financing by way of hire purchase, leasing or bill discounting. According to the appellant(s), on default, interest as well as the principal remains unrealized and, thus, the "provision for NPA" provides for a diminution in t....
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.... Account. Reserve is an appropriation of profits. 2. Provision is made against gross receipts in the P & L A/c irrespective of whether loss. there is profit or loss Provisions are a pretax charge tax to P & L account irrespective of whether the NBFC makes being a net profit or not. No reserve can be created in accounting year when there is a. Reserves are created out of post- profits, by way of appropriation, subject to there adequate net profit. 3. If NPA is Rs.10 lakhs, then the accounting entry is: P&L A/c Dr. 10,00,000 To Prov. for NPA 10,00,000 If there is a loss, the debit of Rs. 10,00,000/- will increase the quantum of loss. This aggregate loss will be shown on the assets side as debit balance of P&L A/c. If NPA is Rs.10 lakhs, and there is a loss, no "Reserve can be created. 4. Provision is based on a one- stage entry: P&L A/c Dr To Prov. For Excise/PF/Gratuity/etc Reserves are based on a two stage accounting process under the horizontal system. If the profits are Rs.10 crores, the Board of Directors may transfer Rs. 8 crores to P&L Appropriation A/c for taxation, di....
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.... a method of accounting has been prescribed by RBI. This accounting method cannot be used by the Department to assume existence of an income when such income does not really exist and, consequently, add back to the taxable income is not contemplated by the IT Act, nor is it contemplated under the "real income theory", however, if at all it has to be taken into account, it should be made allowable as a loss under Section 37(1) of the IT Act. Relevant Provisions (a) Of RBI Act, 1934 Chapter IIIB - PROVISIONS RELATING TO NON-BANKING INSTITUTIONS RECEIVING DEPOSITS AND FINANCIAL INSTITUTIONS Section 45I - Definitions In this Chapter, unless the context otherwise requires,- (a) "business of a non-banking financial institution" means carrying on the business of a financial institution referred to in clause (c) and includes business of a non-banking financial company referred to in clause (f); (aa) "company" means a company as defined in section 3 of the Companies Act, 1956 (1 of 1956), and includes a foreign company within the meaning of section 591 of that Act; (c) "financial institution" means any non-banking institution which carries on as its business or part ....
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....balance of loss; (ii) deferred revenue expenditure; and (iii) other intangible assets; and (b) further reduced by the amounts representing- (1) investments of such company in shares of- (i) its subsidiaries; (ii) companies in the same group; (iii) all other non-banking financial companies; and (2) the book value of debentures, bonds, outstanding loans and advances (including hire-purchase and lease finance) made to, and deposits with,- (i) subsidiaries of such company; and (ii) companies in the same group, to the extent such book value exceeds ten per cent, of (a) above. 45-IC. Reserve fund (1) Every non-banking financial company shall create a reserve fund the transfer therein a sum not less than twenty per cent of its net profit every year as disclosed in the profit and loss account and before any dividend is declared. (2) No appropriation of any sum from the reserve fund shall be made by the non-banking financial company except for the purpose as may be specified by the Bank from time to time and every such appropriation shall be reported to the Bank within twenty-one days from the date of such withdrawal: Provided that the Bank may, in any particul....
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....d other securities which, having regard to the paid-up capital, reserves and deposits of the non-banking financial company and other relevant considerations, may be made by that non-banking financial company to any person or a company or to a group of companies. 45K - Power of Bank to collect information from non-banking institutions as to deposits and to give directions (1) The Bank may at any time direct that every non-banking institution shall furnish to the Bank, in such form, at such intervals and within such time, such statements information or particulars relating to or connected with deposits received by the non-banking institution, as may be specified by the Bank by general or special order. (2) Without prejudice to the generality of the power vested in the Bank under sub-section (1), the statements, information or particulars to be furnished under sub-section (1), may relate to all or any of the following matters, namely, the amount of the deposits, the purposes and periods for which, and the rates of interest and other terms and conditions on which, they are received. (3) The Bank may, if it considers necessary in the public interest so to do, give directions....
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....b) a term loan inclusive of unpaid interest, when the instalment is overdue for a period of six months or more or on which interest amount remained overdue for a period of six months or more; (c) a demand or call loan, which remained overdue for a period of six months or more from the date of demand or call or on which interest amount remained overdue for a period of six months or more; (d) a bill which remains overdue for a period of six months or more; (e) the interest in respect of a debt or the income on receivables under the head `other current assets' in the nature of short term loans/advances, which facility remained overdue for a period of six months or more; (f) any dues on account of sale of assets or services rendered or reimbursement of expenses incurred, which remained overdue for a period of six months or more; (g) the lease rental and hire purchase instalment, which has become overdue for a period of twelve months or more; (h) in respect of loans, advances and other credit facilities (including bills purchased and discounted), the balance outstanding under the credit facilities (including accrued interest) made available to the same borrower/benefic....
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....ndard assets" means - (a) an asset which has been classified as non-performing asset for a period of not exceeding two years; (b) an asset where the terms of the agreement regarding interest and/or principal have been renegotiated or rescheduled after commencement of operations, until the expiry of one year of satisfactory performance under the renegotiated or rescheduled terms; Income recognition 3. (1) The income recognition shall be based on recognised accounting principles. (2) Income including interest/discount or any other charges on NPA shall be recognised only when it is actually realised. Any such income recognised before the asset became non-performing and remaining unrealized shall be reversed. (Effective from May 12, 1998) (3) In respect of hire purchase assets, where instalments are overdue for more than 12 months, income shall be recognised only when hire charges are actually received. Any such income taken to the credit of profit and loss account before the asset became non-performing and remaining unrealised, shall be reversed. (4) In respect of lease assets, where lease rentals are overdue for more than 12 months, the income shall be recognised....
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.... provisioning requirements in respect of hire purchase and leased assets shall be as under:- Hire purchase assets (i) In respect of hire purchase assets, the total dues (overdue and future instalments taken together) as reduced by (a) the finance charges not credited to the profit and loss account and carried forward as unmatured finance charges; and (b) the depreciated value of the underlying asset, shall be provided for. Explanation For the purpose of this paragraph, (1) the depreciated value of the asset shall be notionally computed as the original cost of the asset to be reduced by depreciation at the rate of twenty per cent per annum on a straight line method; and (2) in the case of second hand asset, the original cost shall be the actual cost incurred for acquisition of such second hand asset..." Additional provision for hire purchase and leased assets (ii) In respect of hire purchase and leased assets, additional provision shall be made as under : (a) Where any amounts of hire charges or lease rentals are overdue upto 12 months Nil Sub-standard assets: (b) where any amounts of hire charges or lease rentals are overdue for more than 1....
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.... 1999-2000 to be prepared by the NBFC may be in accordance with the provisions contained in sub-paragraph (2) of paragraph 8. 6. All financial leases written on or after April 1, 2001 attract the provisioning requirements as applicable to hire purchase assets. Disclosure in the balance sheet 9. (1) Every NBFC shall separately disclose in its balance sheet the provisions made as per paragraph 8 above without netting them from the income or against the value of assets. (2) The provisions shall be distinctly indicated under separate heads of accounts as under :- (i) provisions for bad and doubtful debts; and (ii) provisions for depreciation in investments. (3) Such provisions shall not be appropriated from the general provisions and loss reserves held, if any, by the NBFC. (4) Such provisions for each year shall be debited to the profit and loss account. The excess of provisions, if any, held under the heads general provisions and loss reserves may be written back without making adjustment against them. Schedule to the balance sheet 9BB. Every NBFC shall append to its balance sheet prescribed under the Companies Act, 1956, the particulars in the format as....
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.... value of the security charged is not enough to ensure recovery of the dues to the banks in full. In other words, such an asset will have well defined credit weaknesses that jeopardise the liquidation of the debt and are characterised by the distinct possibility that the banks will sustain some loss, if deficiencies are not corrected. 4.1.2. Doubtful Assets With effect from March 31, 2005, an asset would be classified as doubtful if it has remained in the sub-standard category for a period of 12 months. A loan classified as doubtful has all the weaknesses inherent in assets that were classified as substandard, with the added characteristic that the weaknesses make collection or liquidation in full, - on the basis of currently known facts, conditions and values - highly questionable and improbable. 4.1.3 Loss Assets A loss asset is one where loss has been identified by the bank or internal or external auditors or the RBI inspection but the amount has not been written off wholly. In other words, such an asset is considered uncollectible and of such little value that its continuance as a bankable asset is not warranted although there may be some salvage or recovery value. ....
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....r doubtful debts as may be prescribed having regard to the guidelines issued by the Reserve Bank of India in relation to such debts; (b) in the case of a public company, the income by way of interest in relation to such categories of bad or doubtful debts as may be prescribed having regard to the guidelines issued by the National Housing Bank in relation to such debts, shall be chargeable to tax in the previous year in which it is credited by the public financial institution or the scheduled bank or the State financial corporation or the State industrial investment corporation or the public company to its profit and loss account for that year or, as the case may be, in which it is actually received by that institution or bank or corporation or company, whichever is earlier. Reasons for RBI Directions 1998 18. On 31.01.1998, RBI Directions 1998 introduced a new regulatory framework involving prescription of Disclosure norms for NBFCs which are deposit taking to ensure that these NBFCs function on sound and healthy lines. Regulatory and supervisory attention was focussed on the deposit taking NBFCs so as to enable the RBI to discharge its responsibilities to protect the inte....
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....effect of such Disclosure is to increase the current liabilities by showing the provision against the possible Loss on assets classified as NPA. An NPA continues to be an Asset - "Debtors/ Loans and Advances" in the books of NBFC. For creating a provision the only yardstick is default in terms of the loan under RBI norms, a provision is mathematical calculation on time lines. The entire exercise mentioned in the RBI Directions 1998 is only in the context of Presentation of NPA provisions in the balance sheet of an NBFC and it has nothing to do with computation of taxable income or accounting concepts. 23. It is important to note that the net profit shown in the P&L Account is the basis for NBFC to accept deposits and declare dividends. Higher the profits higher is the NOF and higher is the increase in the public making deposits in NBFCs. Hence the object of the NBFC is disclosure and provisioning. 24. NBFCs have to accept the concept of "income" as evolved by RBI after deducting the Provision against NPA, however, as stated above, such treatment is confined to Presentation / Disclosure and has nothing to do with computation of taxable income under the IT Act. Scope of the ....
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....according to the IT Act .In the present case, we are not concerned with taxability under the IT Act or the accounting treatment .We are essentially concerned with presentation of financial statements by NBFCs under the 1998 Directions. The point to be noted is that even according to the assessee "Bad debts/ Advances Written Off" is a distinct head of expenditure vis -vis "Provision for Bad Debt" .One more aspect needs to be highlighted. It is true that under Part I of Schedule VI to the Companies Act,1956 an amount could be first included in the list of sundry debtors/ loans and then deducted from the list as "provision for doubtful debts" .However, these are matters of Presentation of Provisions for doubtful debts even under the Companies Act and have nothing to do with taxability under the IT Act. One more aspect needs to be mentioned. Section 36(1) (vii) is subject to sub-section (2) of Section 36. The condition incorporated in Section 36 of the IT Act, which was not there in Section 10(2)(xi) of the 1922 Act, is that the amount of debt should have been taken into account in computing the income of the assessee in the previou year. Under the IT Act, the emphasis is not on the....
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....antum and quality of the diminution in the value of investment and particulars of doubtful and sub-standard assets. Similarly, the 1998 Directions does not recognize the "income" under the mercantile system and it insists that NBFCs should follow cash system in regard to such incomes. 31. Before concluding on this point, we need to emphasise that the 1998 Directions has nothing to do with the accounting treatment or taxability of "income" under the IT Act. The two, viz., IT Act and the 1998 Directions operate in different fields. As stated above, under the mercantile system of accounting, interest / hire charges income accrues with time. In such cases, interest is charged and debited to the account of the borrower as "income" is recognized under accrual system. However, it is not so recognized under the 1998 Directions and, therefore, in the matter of its Presentation under the said Directions, there would be an add back but not under the IT Act necessarily. It is important to note that collectibility is different from accrual. Hence, in each case, the assessee has to prove, as has happened in this case with regard to the sum of Rs.20,34,605/-, that interest is not recognized or....
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.... advances", it would amount to netting from the value of assets which would constitute breach of Para 9 of RBI Directions 1998. Consequently, NPA provisions should be presented on the "Liabilities side" of the Balance Sheet under the head "Current Liabilities and Provisions" as a Disclosure Norm and not as accounting or computation Of in come norm under the IT Act. At this stage, we may clarify that the entire thrust of RBI Directions 1998 is on presentation of NPA provision in the Balance Sheet of an NBFC. Presentation/ disclosure is different from computation/ taxability of the provision for NPA. The nature of expenditure under the IT Act cannot be conclusively determined by the manner in which accounts are presented in terms of 1998 Directions. There are cases where on facts courts have taken the view that the so-called provision is in effect a write off. Therefore, in our view, RBI Directions 1998, though deviate from accounting practice as provided in the Companies Act, do not override the provisions of the IT Act. Some companies, for example, treat write offs or expenses or liabilities as contingent liabilities. For example, there are companies which do not recognize mark-to-....
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....e cannot be added back as is sought to be done by the Department. In this connection, reliance was placed on "Real Income Theory". 36. We find no merit in the above contention. In the case of Poona Electric Supply Co. Ltd. v. Commissioner of Income-Tax, Bombay City I, 57 ITR 521 at page 530, this is what the Supreme Court had to say: "Income Tax is a tax on the "real income", i.e., the profits arrived at on commercial principles subject to the provisions of the Income Tax Act. The real profit can be ascertained only by making the permissible deductions under the provisions of the Income Tax Act. There is a clear distinction between the real profits and statutory profits. The latter are statutorily fixed for a specified purpose". 37. To the same effect is the judgment of the Bombay High Court in the case of Commissioner of Wealth-Tax, Bombay v. Bombay Suburban Electric Supply Ltd. 103 ITR 384 at page 391, where it was observed as under: "Income Tax is a tax on the real income, i.e., profits arrived at on commercial principles subject to the provisions of the Income Tax Act, 1961. The real profits can be ascertained only by making the permissible deductions". 38. The p....
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....y with Income Recognition. They force the NBFCs to disclose the amount of NPA in their financial accounts. They force the NBFCs to reflect "true and correct" profits. By virtue of Section 45Q, an overriding effect is given to the Directions 1998 vis-`-vis "income recognition" principles in the Companies Act, 1956.These Directions constitute a code by itself. However, these Directions 1998 and the IT Act operate in different areas. These Directions 1998 have nothing to do with computation of taxable income. These Directions cannot overrule the "permissible deductions" or "their exclusion" under the IT Act. The inconsistency between these Directions and Companies Act is only in the matter of Income Recognition and presentation of Financial Statements. The Accounting Policies adopted by an NBFC cannot determine the taxable income. It is well settled that the Accounting Policies followed by a company can be changed unless the AO comes to the conclusion that such change would result in understatement of profits. However, here is the case where the AO has to follow the RBI Directions 1998 in view of Section 45Q of the RBI Act. Hence, as far as Income Recognition is concerned, Section 145....
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....sion for doubtful debt is expressly excluded from Section 36(1) (vii) then such a provision cannot claim deduction under Section 37 of the IT Act even on the basis of "real income theory" as explained above. Analysis of Section 43D 46. It is similar to Section 43B. 47. The reason for enacting this Section is that interest from bad and doubtful debts in the case of bank and financial institutions is difficult to recover; taxing such income on accrual basis reduces the liquidity of the bank without generation of income. 48. With a view to improve their viability, the IT Act has been amended by inserting Section 43D to provide that such interest shall be charged to tax only in the year of receipt or the year in which it is credited to the P&L Account, whichever is earlier. 49. Before concluding, we may state that none of the judgments cited on behalf of the appellant(s) are relevant as they do not touch upon the concept of NPA. In our view, the issues which arise for determination in this case did not arise in the cases cited by the appellant(s). Challenge to the constitutional validity of Sections 36(1) (viia) and 43D of the IT Act. 50. According to NBFCs, there ....
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....ld create liquidity crunch, hence, Section 43D came to be enacted. So also, as stated above, 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. Banks face a huge demand from the industry particularly in an emerging market economy and at times the credit off take is so huge that banks face liquidity crunch. Thus, the line of business operations of NBFCs and banks are quite different. It is for this reason, apart from social commitments which banks undertake, that allowances of the nature mentioned in Sections 36(1) (viia) and 43D are often restricted to banks and not to NBFCs. Lastly, as stated above, 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. Therefore, even in the case of banks, there is an element of add back, however, by way of special provision banks are allowed to claim deduction under Section 6(1)(viia). One more aspect needs to be mentioned, apart from the fact that....
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.... possibilities of abuse but on that account alone it cannot be struck down as invalid. These can be set right by the legislature by passing amendments. The Court must, therefore, adjudge the constitutionality of such legislation by the generality of its provisions. Laws relating to economic activities should be viewed with greater latitude than laws touching civil rights such as freedom of speech, religion, etc. Moreover, there is a presumption in favour of the constitutionality of a statute and the burden is upon him who attacks it to show that there has been a clear transgression of the constitutional principles. The legislature understands and correctly appreciates the needs of its own people, its laws are directed to problems made manifest by experience and its discrimination is based on adequate grounds. There may be cases where the legislation can be condemned as arbitrary or irrational, hence, violative of Article 14. But the test in every case would be whether the provisions of the Act are arbitrary and irrational having regard to all the facts and circumstances of the case. Immorality, by itself, cannot be a constitutional challenge as morality is essentially a subjective ....