Sunday, January 24, 2010

Southern Technologies and Sticky Interest - Part II

We discussed the recent decision of the Supreme Court in Southern Technologies that rejected a challenge to the constitutionality of ss. 36(1)(vii) and 43D of the Income Tax Act, 1961. The Court held that non-banking-financial institutions [“NBFC”] must account as income interest received from loans that are, for commercial purposes, bad debts. Four important issues were considered in the case: the impact of the 1998 RBI Directions on the Companies Act, 1956, and on the Income Tax Act, secondly, the distinction between the accounting concepts of a “reserve” and a “provision”, thirdly, the application of the real income principle to NBFCs and finally, the principles of interpretation of an economic legislation.

As discussed in the previous post, the 1998 RBI Directions requires NBFCs to debit a “Provision for NPAs” to the Profit & Loss account of the company. The assessee’s contention was this “provision” cannot be treated as “income”, for the purposes of s. 2(24) of the Income Tax Act. The assessee relied on s. 45Q of the RBI Act, under which directions issued by the RBI prevail over all laws to the contrary. In rejecting this contention, the Supreme Court held that the RBI Act overrides the Companies Act, but not the ITA. In particular, the Court held that the RBI Directions override the Companies Act in three respects: first, in deviating from Schedule VI on the manner of presentation of financial statements; secondly, in not recognising the mercantile system for the purposes of NPA, and requiring that it be credited to the books of the company only on actual receipt; thirdly, creating a provision for all NPAs. The RBI Directions pertain to disclosure, and not to computation of total income. Moreover, the Revenue correctly argued that if the RBI Directions on presentation of financial statements determines taxable income under the ITA, this would be true of exemptions as well, and agricultural income, dividend income etc., which are exempted under the ITA would be taxable. The conclusion of the Court that the RBI Directions operate in a different field and do not affect taxability appears, therefore, to be correct.

The second issue that the Court considered is the distinction between a “reserve” and a “provision”. Under principles of accountancy, a provision is a charge on profit, and a reserve is an appropriation of profit. The assessee argued that a reserve cannot be created in a loss-making year, and that it is created out of appropriation of post-tax profit, while a provision is charged to pre-tax profit in the Profit & Loss account of the company. The RBI Directions mandated the creation of a “provision”, not “reserve”, which the assessee argued could not constitute “income”. In view of the Court’s conclusion that the Directions operate in a different field, it did not resolve this question.

However, in what is the most controversial part of this decision, the Court seems to have assumed that the non-applicability of the RBI Directions to the ITA automatically makes the receipt “income” under the ITA. In particular, the Court’s analysis of the “real income” principle may, with respect, require reconsideration. The real income principle, as the previous post discussed, posits that the chargeability of a receipt in law depends, in significant part, on the commercial nature of the receipt. On this basis, assesses have long argued that the interest on a principal that is unlikely to be recovered is not “income”, and is not understood to be income by those engaged in that business. While the principle is subject to statutory provisions to the contrary, s. 36(1)(viii) is not such a provision, because it merely provides that banks are entitled to deduct provisions made for bad and doubtful debts under certain circumstances. It cannot be assumed that the legislature intended by this provision to treat sticky receipts as income, especially in view of the settled principle that interpretive ambiguities in tax legislation are resolved in favour of the assessee. The Supreme Court did not hold that the real income principle is not applicable, but held that a provision for bad and doubtful debts is only a “notional expense”, which would have to be “added back” to arrive at “real income”. Tulzapurkar J. had observed in his minority opinion that an entry in the accounts of a certain item is “neither accrual nor receipt of income” where income does not in fact result (State Bank of Travancore v. CIT, AIR 1986 SC 757). Whether applying the real income principle to sticky interest leads to the conclusion that it is not taxable is a matter of great disagreement, and it is unfortunate that the Court chose not to resolve this controversy.

Finally, the Court rejected a challenge to the constitutional validity of ss. 36(1)(viia) and 43D of the ITA. The assessees argued that confining the benefit of deducting provisions for bad debts to banks, thus excluding NBFCs, is contrary to Art. 14, for there is no rational nexus between this distinction and the object of the ITA. The Court rejected the challenge, holding that “liquidity” is a more important concern for banks than it is for NBFCs, and that the beneficial provisions in ss. 36(1)(viia) and 43D were enacted to avert a possible “liquidity crunch” for banks.

The Court also made general observations on the standard for challenging the validity of an economic legislation, and held that “laws relating to economic activities should be viewed with greater latitude”. Consequently, such legislations will not be invalidated unless the distinction is patently arbitrary.

In sum, while the Court has clarified the true import of the RBI Directions vis a vis the Companies Act and the ITA, the controversy over the scope of the real income principle looks set to continue.

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