Non-banking-financial institutions (“NBFCs”) face a serious setback after the judgment of the Supreme Court this Monday (11 January 2010) in Southern Technologies Ltd. v. JCIT. This blog has discussed a long-standing controversy in Indian law on the treatment of “sticky” advances. It is useful to briefly recapitulate the contours of this controversy before considering the impact of the Supreme Court’s judgment in Southern Technologies. Four circumstances are relevant in this connection – the jurisprudence of the Supreme Court on the “real income theory”, a set of circulars issued by the CBDT on the treatment of “sticky” interest, the provisions of the Income Tax Act, 1961, and directions issued by the RBI in 1998 on the treatment of NPAs.
Of the entire sum of money that is lent to various borrowers by banks and NBFCs, a significant part of the interest payable is considered “sticky”, for it represents interest on principal that is unlikely to be recovered, and which the borrower has not serviced for some length of time. Under certain circumstances, these sticky advances are considered “Non-Performing Assets” (NPA) and in other cases, are written off entirely as bad debts. The latter case presents no difficulty, since a bad debt is a deductible business expenditure, provided it is written off bona fide. However, assessees argued that sticky loans do not constitute “income” in the first place, and relied for this purpose on the “real income theory”, which posits that the classification of a receipt as an income must bear some relationship to commercial reality. In 1952, the CBDT issued a circular clarifying that interest entered in the suspense account by an assessee is not part of total income, because of the “extreme unlikelihood” in recovering the principal. This circular was withdrawn in 1978. In 1986, the Supreme Court, in State Bank of Travancore v. CIT, partly relied on this withdrawal to hold that the real income theory does not support the proposition that sticky interest is non-taxable. However, the CBDT, in 1984, had issued another circular clarifying that interest on loans that have not been repaid for three successive years is not taxable. As the Court in SBT had not noticed this circular, the case was overruled in 1999, and again in 2006. However, what is significant is that this was not an unqualified approval of the real income theory, but rather a decision that the particular circulars applied to banks to the extent specified in those circulars.
A series of retrospective amendments to the Income Tax Act added to the lack of clarity in this area. S. 36(1)(vii) of the Act originally provided that the amount of any bad debt written off in the accounts of the assessee as irrecoverable is a deductible expense. However, an Explanation was added to this provision in 2001 with retrospective effect, providing that this does not include a “provision” for bad debts. In 1997, an amendment with retrospective effect from 1989 added clause vii(a), which provided that a scheduled bank could deduct provisions for bad and doubtful debts upto a specified percentage. S. 43D was also amended in 1999 to provide that income in relation to categories of bad and doubtful debts prescribed by the Reserve Bank of India are chargeable to tax only when the income is actually received by the scheduled bank or credited to the Profit & Loss account in its books. Notably, neither s. 36(1)(viia) nor s. 43D applies to NBFCs. To complete the account of the circumstances that led to Southern Technologies, it is relevant to refer to what turned out to be the crux of the controversy – the effect of the 1998 directions of the RBI. In these Directions, the RBI defined an NPA as “any asset in respect of which interest has remained due for more than six months”, and directed NBFCs to recognise these assets as income only when income is actually received. By virtue of s. 45Q of the RBI Act, these Directions override all laws to the contrary.
In Southern Technologies, NBFCs relied on all these circumstances to challenge the taxability of NPAs and other sticky assets. In particular, assessees argued that the beneficial provisions of s. 36(1)(viia) and s. 43D must be construed to be applicable to NBFCs as well, and that confining their application to banks violates Art. 14 of the Constitution. In short, NBFCs contended that they were on exactly the same footing as banks for the purposes of the treatment of NPAs, and that the differentia between banks and NBFCs in this provision lacks any rational nexus. The assessees also relied on the real income theory to suggest that sticky interest is non-taxable. The Supreme Court rejected all these contentions and held that such income is taxable.
In a subsequent post, I will analyse the decision of the Supreme Court in greater detail, which, with respect, does not appear to be entirely correct. The following is a summary of the decision of the Court:
(a) The RBI Directions do not have any relevance to the treatment of taxable income, for the RBI Act and the IT Act operate in different fields. The RBI Act overrides the Companies Act, 1956, to the extent of presentation of accounts, but does not override the Income Tax Act.
(b) The distinction between banks and NBFCs in ss. 36(1)(viia) and 43D is not violative of Art. 14 of the Constitution.
(c) The “real income” theory requires courts to recognise that a mere provision for bad and doubtful doubts is not a “real” expense that may be deducted.
(d) Section 37 does not apply to cases that fall within s. 36 but are specifically excluded by an Explanation.This decision appears to have settled the latest chapter in a long-standing and complex controversy on the treatment of sticky interest. I will examine the reasons the court cites in greater detail in a subsequent post.