Sunday, December 20, 2009

Bad Debts, Commercial Judgment and Taxation

We have discussed the controversy in Indian law surrounding the treatment of bad debts. In short, it has traditionally revolved around two questions. The first pertained to the extent to which commercial reality could influence the determination of taxable income. In particular, banks began to account interest on non-performing assets [“NPA”] or “loans” in a “Suspense account”, without, however, writing off the NPA as a bad debt. In State Bank of Travancore v. CIT, AIR 1986 SC 757, the use of the real income principle was rejected and it was held that such interest is liable to tax. While this was eventually overruled on other grounds in UCO Bank v. CIT, (1999) 4 SCC 599 and Mercantile Bank v. CIT, (2006) 5 SCC 221, one question still remained unanswered – to what extent does tax law defer to the commercial judgment of the Board of Directors in classifying a receipt as a bad debt or otherwise?

The provision governing this question is s. 36(1)(vii) of the Income Tax Act, 1961. Before its amendment in 1989, s. 36(1)(vii) allowed deduction of “any bad debt, or part thereof, which is established to have become a bad debt in the previous year”. The amendment replaced this with “any bad debt, or part thereof, which is written off as irrecoverable in the account of the assessee for the previous year”. Thus, the intent of the legislature was clearly to shift the burden of proving a bad debt from the assessee to the Revenue.

In the previous post, we noted the decision of the Bombay High Court in DCIT v. Oman International Bank SOAG, where the Court relied on this amendment to hold that writing off bad debts is essentially a matter of commercial judgment and not subject to wide-ranging review by the Assessing Officer. The Court observed “…when the assessee treats the debt as a bad debt in his books the decision which has to be a business or commercial decision and not whimsical or fanciful. The decision must be based on material that the debt is not recoverable. The decision must be bonafide. The difference between the position, pre-amendment and post amendment would be that the burden is no longer on the assessee and can be claimed in the year it is written off in the books of account as irrecoverable. The A.O. if he is to disallow the debt as a bad debt must arrive at a conclusion that the decision was not bonafide. The A.O. only in those circumstances and to that extent may interfere.” Subsequently, the ITAT followed the decision in Citigroup Global Markets India v. DCIT, [2009] 29 SOT 326 (Bom).

However, the Allahabad High Court appears to have taken a different view, in CIT v. Kohli Brothers, decided last month. A copy of the decision is available here. The assessee was engaged in the business of developing and printing photographs. He filed his returns claiming a bad debt deduction of almost Rs. 5 lakh, which was disallowed by the Assessing Officer, on the ground that the assessee had failed to furnish information as to the names and addresses of the persons with reference to whom the bad debts had been written off, copies of ledger accounts, efforts made to realise these dues etc. The Allahabad High Court framed a question of law on whether this contention was precluded by the decision of the Bombay High Court in Oman. The Court referred to the 1989 amendment, observed that it does not absolve the assessee of the burden of establishing a “semblance of genuineness” and quashed the order of the ITAT that had granted relief to the assessee on the basis of Oman.

While these decisions seem contradictory, it appears that the courts have implicitly distinguished between two factors that establish the genuineness of a bad debt: the persons who owe the debt, and whether efforts made to recover the debt can reasonably be said to be unsuccessful. Oman and Kohli Brothers can be reconciled on the basis that the first allowed the deduction since the persons with respect to whom the debt was written off were known, while Kohli Brothers did not because the assessee furnished no information whatsoever as to the identity of the persons involved. This is also consistent with the principle that commercial judgment is relevant in determining when a debt is considered “bad”, not in determining whether there exists a person who owes a debt.

Indeed, Oman had itself observed that the debt must be written off bona fide, and that the Assessing Officer may disregard it if he has “good reasons” to do so. In Dresser Valve v. ACIT, [2009] 30 SOT 495, the ITAT (Mumbai) seems to have taken this view. The Tribunal observed that a finding by the Assessing Officer that the assessee continues to have business transactions with a person whose debt he claims to have written off may constitute a “good reason” to rebut the presumption of genuineness.

The position that emerges from these judgments is that courts are unlikely to uphold disallowance if the assessee has furnished even minimal information as to the identity of the persons involved in the transactions.

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