Southern Technologies Ltd. Vs. Joint Commnr. of Income Tax, Coimbatore 
INSC 30 (11 January 2010)
SUPREME COURT OF INDIA CIVIL APPELLATE/ORIGINAL JURISDICTION CIVIL APPEAL NO.
1337/2003 M/s Southern Technologies Ltd. ... Appellant(s) versus Joint Commnr.
of Income Tax, Coimbatore ... Respondent(s) with C.A.No. 154 /2010 @ SLP(C) No.
granted in the Special Leave Petition.
An interesting question of law which arises for determination in these Civil
Appeals filed by Non-banking Financial Companies ("NBFCs" for short)
the Department is entitled to treat the "Provision for NPA", which in
terms of RBI Directions 1998 is debited to the 2 P&L Account, as
"income" under Section 2(24) of the Income Tax Act, 1961 ("IT
Act" for short), while computing the profits and gains of the business
under Sections 28 to 43D of the IT Act?"
the sake of convenience, we may refer to the facts in the case of M/s. Southern
Technologies Ltd. [Civil Appeal No. 1337 of 2003].
outset, it may be stated that categorization of assets into doubtful, sub-standard
and loss is not in dispute.
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
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.
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/- 3 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/-.
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 Directions 1998 on the
ground that Assessee had to debit the said amount to P&L Account [in terms
of Para 9(4) of the RBI Directions] reducing its Profits, contending it to be
write off. In the alternative, Assessee submitted that consequent upon RBI
Directions 1998 there has been diminution in the value of its assets for which
Assessee was entitled to deduction under Section 37 as a trading loss. This led
to matters going in appeal (s). To conclude, it may be stated that following
the judgment of the Gujarat High Court in the case of Vithaldas H. Dhanjibhai
of Income-Tax, Gujarat-V 130 ITR 95, the ITAT held that since Assessee had
debited the said sum of Rs. 81,68,516/- to the P&L Account it was entitled
to claim deduction as a write off under Section 36(1)(vii) which view was not
accepted by the High Court, hence, this batch of Civil Appeal (s) are filed by
4 Appellant made "Provision for NPA" amounting to Rs. 81,68,516/- for
the financial year ending 31st March, 1998. This was calculated as per Para 8
of the Prudential Norms 1998. Accordingly, the P & L Account was debited
and corresponding amount was shown in the Balance Sheet. The Department sought
to add back Rs. 81,68,516/- to the taxable income on the ground that the
provision for bad and doubtful debt was not allowable under Section 36(1)(vii)
of the IT Act. The appellant claimed that the "Provision for NPA",
however, represented "loss" in the value of assets and was,
therefore, allowable under Section 37(1) of the IT Act. This claim of the
appellant was dismissed on the ground that the provisions of Section 36(1)(vii)
of the IT Act could not be by-passed.
submission of the appellant in the lead case before us was that an amount
written off was allowable on the basis of "real income theory" as well
as on the basis of Section 145 of the IT Act. In this connection, the appellant
submitted that it was bound to follow the method of accounting prescribed by
RBI in terms of Paras 8 and 9 of the Prudential Norms 1998. As per the said
method of accounting, the "Provision for NPA" actually represented
depreciation in the value of the assets and, consequently, it is deductible
under Section 37(1) of the IT Act. In this connection, appellant placed
reliance on the judgment of this Court in 5 Commissioner of Income-Tax v.
Woodward Governor India P. 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.
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.
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., NBFC under the head "Debtors/Loans and Advances".
According to the Department, RBI as 6 a regulator wants NBFCs who accept
deposits from the public to provide for a possible loss. The RBI Directions
1998 insists that non-payment on Due Date alone is sufficient for creation of a
"Provision for NPA" (hereinafter referred to as
"provision"). In this connection, it was submitted that even if a
borrower repays his entire loan liability subsequent to the closing of the
Books on 31st March, say on 10th April, even then as per the RBI Directions
1998, a provision has to be created to cover a possible loss. According to the
Department, even applying "real income theory" as propounded on
behalf of the assessee(s), the said theory presupposes that not only income but
even expenditure or loss incurred should be real. According to the Department,
"Provision for NPA" is definitely not an expenditure nor a loss, it
is only a provision against possible loss and, therefore, it is not open to the
appellant(s) to claim deduction for such provision under Section 36(1)(vii) of
the IT Act, as it stood at the material time. The only object behind RBI
insisting on an NBFC to make "Provision for NPA" compulsorily is to
enable NBFC to state its profits only after compulsorily creating a
"Provision for NPA" because it is the net profit of NBFC which is the
base to determine its capacity to accept deposits from the public. More the
profit more they can accept deposits. According to the Department, vide RBI
Directions 1998, RBI tries to bring out the Profit in the P&L Account after
7 providing for NPA which profit will be the minimum profit that the company
would make so that the real or true and correct profit earned by an NBFC shall
not be anything lesser than what is disclosed. According to the Department, the
said "Provision for NPA" is in substance a "Reserve", which
has been named as a "Provision" in the RBI Directions 1998 to protect
the depositors of NBFC. According to the Department, even under accounting
concepts, a provision for possible diminution in value of an asset is a reserve.
In this connection, the Department has given three illustrations - Depreciation
Reserve, Reserve against Long Term Investments, and Reserve against bad and
doubtful debts. According to the Department, as per accounting principles,
reserves are normally adjusted against the assets and only a net figure 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.
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 8 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.
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 appeal, the Assessing Officer,
in his wisdom, has not considered Rs.20,34,605/- as "income" (being
income accrued on mercantile system of accounting) and did not include the same
in computing the total income.
to the Department, under the accounting concepts, a provision is a charge
against a profit, whereas, a reserve is an appropriation of profit. According
to the Department, the RBI Directions 1998 are not in conflict with the
provisions of the IT Act, however, they constitute deviations to the
presentation of the financial statements indicated in Part I of Schedule VI to
Act, 1956. For example, under the 1998 Directions,
Income from NPA under mercantile system of accounting is not recognized and to
that extent it insists on NBFCs following the cash system of accounting. Thus,
the P&L Account prepared by NBFC shall not 9 recognise income from NPA but
it shall create a provision by debit to the P&L Account on all NPAs.
Similarly, under the said 1998 Directions, there is insistence on creation of a
provision in respect of all NPAs summarily as against creation of a provision
only when the debt is doubtful of recovery.
deviations are made mandatory with the paramount object of protecting the
interest of the depositors, even though they are against accounting concepts.
To the extent of these above mentioned specific deviations, the RBI Directions
1998 shall prevail over the provisions of the Companies Act (See Section 45Q of
the RBI Act). Therefore, according to the Department, inconsistency in terms of
Section 45Q of the RBI Act is only with respect to the Companies Act, 1956 so far as it relates to Income recognition and
Presentation of assets and Presentation of Provision/ Reserve created against
NPAs and not with the IT Act. According to the Department, if the argument that
Section 45Q prevails over the IT Act is accepted, then various incomes like
dividend income, agricultural income, profit on sale of depreciable assets,
capital gains, etc. which items are all credited to P&L Account, but, which
are exempted under the IT Act would become taxable income which is not the
intention of Section 45Q of the IT Act. That, the said 1998 Directions cannot
be taken as an excuse by the NBFC to compute lower taxable income under the IT
rejoinder, it has been submitted on behalf of the appellant(s) /assessee(s)
that even 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.
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 the amounts realizable (assets) and, consequently, "provision for
NPA" cannot be treated as "real income" and added back to the
taxable income of NBFCs, as is sought to be done by the Department. According
to 11 the appellant(s), they have never asked for deduction under Section
36(1)(vii) of the IT Act. It is the case of the appellant(s) that if one
applies "real income theory", "Provision for NPA" cannot be
added back to the income of NBFCs, as is sought to be done by the Department.
It is this "add back" which is impugned in the present case.
According to the appellant(s), when RBI Act has specifically used the words
"provision", "reserves", "assets", etc., it is
not permissible to treat a "provision for NPA" mentioned in the 1998
Directions as a "reserve" for income tax proceedings.
to the appellant(s), the RBI Directions 1998 provides for a mandatory method of
accounting. It inter alia mandates Income recognition of NPA on cash basis and
not on mercantile basis as required by Section 209(3) of the Companies Act. It lays down, vide para 8, the "provisioning
requirements" which have got to be followed and the aggregate amount
whereof has got to be debited to the P&L Account. According to
appellant(s), para 8 of the 1998 Directions shows that the "Provision for
NPA" takes into account diminution in value of the security charge, hence,
it was, under Section 37 of the IT Act, entitled to deduction. According to the
appellant(s), Section 45IA of the RBI Act defines "NOF". The
Explanation (I) to the said Section defines "NOF" as the aggregate of
paid-up equity capital and free reserves. According to the appellant(s), if
"Provision for 12 NPA" is treated as reserve, it would increase the
NOF of the company and, consequently, the higher the provision for NPAs, higher
will be the net worth of the company which could never have been the intention
or objective of the RBI Directions 1998. Further, according to the
appellant(s), in view of a statutory reserve fund which has to be created by
all NBFCs under Section 45IC, the "Provision for NPA" can never be
treated as one more another type of reserve.
the accounting treatment, the appellant has given us the following chart to bring
out the difference between "provision" and "reserve":
Provision is a charge or debit Reserve is an appropriation of to the P& L
Provision is made against No reserve can be created in gross receipts in the P
& L accounting year when there is a A/c irrespective of whether loss.
profit or loss. Reserves are created out of post- Provisions are a pretax
charge tax profits, by way of to P & L account irrespective appropriation,
subject to there of whether the NBFC makes being adequate net profit.
profit or not.
3. If NPA
is Rs. 10 lakhs, then If NPA is Rs. 10 lakhs, and there the accounting entry
is: is a loss, no "Reserve can be P&L A/c Dr. 10,00,000 created.
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.
Provision is based on a one- Reserves are based on a two stage stage entry:
accounting process under the P&L A/c Dr. horizontal system. If the profits
To Prov. for are Rs. 10 crores, the Board of Excise/ PF/ Gratuity/ etc.
Directors may transfer Rs. 8 crores to P&L Appropriation A/c for taxation,
dividend and reserve.
balance will be transferred to credit balance of P&L A/c. The entries will
be as follows:- Stage 1:
A/c Dr. 10.00 To P&L Appropriation A/c 8.00 To P& L A/c 2.00 Stage 2:
Appropriation A/c 8.00 To Prov. Taxation 4.00 To Prov. for Dividends 2.00 To
Transfer to Reserve 2.00 Thus, if there are no profits, there 14 can be no
debit to the reserve.
vertical system, "profits available for appropriation" are post-tax
profits. Appropriation to reserves can be made only when there is a surplus.
Clause 7(1)(a) of Part Under Clause 7(1)(b) of Part - III - III of Schedule VI
of of Schedule - VI of Companies Companies Act, 1956
- Act, 1956 - reserve does not provision, inter alia, is to include any amount
written off or provide for depreciation, retained by providing for renewals or
diminution in depreciation, renewals, etc. or value of assets or to provide
providing for any known liability.
taxation. Under Part - I of Schedule - VI, `reserve' can be made in respect of
capital reserves, capital redemption, share premium, etc.
Provision cannot be used to Reserves can be utilized to pay declare dividend,
etc. dividends/ bonus, unless there is a statutory bar.
on the question of adding back to the taxable income, it has been submitted on
behalf of the appellant(s) that the profits arrived as per the P&L Account
under the Companies
Act are after debiting several provisions under
various accounting heads. There are several statutory liabilities like
provision for excise duty, gratuity, provident fund, ESI, etc. The IT Act 15
disallows several such provisions under Sections 40A(7), 43B, 40 and 40A.
disallowances alone could be added back to the taxable income. The IT Act does
not disallow a provision for NPA; that, unless the "provision for
NPA" is specifically disallowed under the IT Act, the same cannot be added
back and, hence, such a provision for NPA cannot be added back in computing the
taxable income. According to the appellant, the purpose behind prescribing RBI
Directions 1998 is to ensure that members of the public and shareholders of the
company obtain a true picture of the financial health of the company. Its
purpose is not to create a notional income.
to the appellant, in the present case, only 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.
Provisions (a) Of RBI Act, 1934 Chapter IIIB - PROVISIONS RELATING TO NON-
BANKING INSTITUTIONS RECEIVING DEPOSITS AND FINANCIAL INSTITUTIONS 16 Section
45I - Definitions In this Chapter, unless the context otherwise requires,- (a)
"business of a non-banking financial institution"
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
"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;
"financial institution" means any non-banking institution which
carries on as its business or part of its business any of the following
activities, namely:- (i) the financing, whether by way of making loans or
advances or othervise, of any activity other than its own;
acquisition of shares, stock, bonds, debentures or securities issued by a
Government or local authority or other marketable securities of a like nature;
letting or delivering of any goods to a hirer under a hire-purchase agreement
as defined in clause (c) of section 2 of the Hire-Purchase Act, 1972 (26 of
carrying on of any class of insurance business;
managing, conducting or supervising, as foreman, agent or in any other
capacity, of chits or kuries as defined in any law which is for the time being
in force in any State, or any business, which is similar thereto;
collecting, for any purpose or under any scheme or arrangement by whatever name
called, monies in lump sum or otherwise, by way of subscriptions or by sale of
units, or other instruments or in any other manner and awarding prizes or
gifts, whether in cash or king, or 17 disbursing monies in any other way, to
persons from whom monies are collected or to any other person, but does not
include any institution, which carries on as its principal business,- (a)
agricultural operations; or (aa) industrial activity; or Explanation.-For the
purposes of this clause, "industrial activity" means any activity
specified in sub-clauses (i) to (xviii) of clause (c) of section 2 of the
Industrial Development Bank of India Act, 1964 (18 of 1964);
purchase, or sale of any goods (other than securities) or the providing of any
services; or (c) the purchase, construction or sale of immovable property, so,
however, that no portion of the income of the institution is derived from the
financing of purchases, constructions or sales of immovable property by other
Requirement of registration and net owned fund *** *** *** Explanations.-For
the purposes of this section,- (I) "net owned fund" means- (a) the
aggregate of the paid-up equity capital and free reserves as disclosed in the
latest balance-sheet of the company after deducting there from- (i) accumulated
balance of loss; (ii) deferred revenue expenditure; and (iii) other intangible
assets; and (b) further reduced by the amounts representing- 18 (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.
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
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:
that the Bank may, in any particular case and for sufficient cause being shown,
extend the period of twenty-one days by such further period as it thinks fit or
condone any delay in making such report.
Notwithstanding anything contained in sub-section (1), the Central Government
may, on the recommendation of the Bank and having regard to the adequacy of the
paid-up capital and reserves of a non- banking financial company in relation to
its deposit liabilities, declare by order in writing that the provisions of
sub-section (1) shall not be applicable to the non- 19 banking financial
company for such period as may be specified in the order:
that no such order shall be made unless the amount in the reserve fund under
sub-section (1) together with the amount in the share premium account is not
less than the paid-up capital of the non-banking financial company.
Power of Bank to determine policy and issue directions (1) If the Bank is
satisfied that, in the public interest or to regulate the financial system of
the country to its advantage or to prevent the affairs of any non-banking
financial company being conducted in manner detrimental to the interest of the
depositors or in a manner prejudicial to the interest of the non-banking
financial company, it is necessary or expedient so to do, it may determine the policy
and give directions to all or any of the non-banking financial companies
relating to income recognition, accounting standards, making of proper
provision for bad and doubtful debts, capital adequacy based on risk weights
for assets and credit conversion factors for off balance-sheet items and also
relating to deployment of funds by a non-banking financial company or a class
of non-banking financial companies or non-banking financial companies
generally, as the case may be, and such non-banking financial companies shall
be bound to follow the policy so determined and the direction so issued.
Without prejudice to the generality of the powers vested under subsection (1),
the Bank may give directions to non-banking financial companies generally or to
a class of non banking financial companies or to any non-banking financial
company in particular as to- (a) the purpose for which advances or other fund
based or non-fund based accommodation may not be made; and 20 (b) the maximum
amount of advances of other financial accommodation or investment in shares and
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.
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.
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.
Bank may, if it considers necessary in the public interest so to do, give
directions to non-banking institutions either generally or to any non-banking
institution or group of non-banking institutions in particular, in respect of
any matters relating to or connected with the receipt of deposits, including
the rates of interest payable on such deposits, and the periods for which
deposits may be received.
any non-banking institution fails to comply with any direction given by the
Bank under sub-section (3), the Bank may prohibit the acceptance of deposits by
that non-banking institution.
(6) Every non-banking institution receiving deposits shall, if so required by
the Bank and within such time as the Bank may specify, cause to be sent at the
cost of the non-banking institution a copy of its annual balance-sheet arid
profit and loss account or other annual accounts to every person from whom the
non-banking institution holds, as on the last day of the year to which the
accounts relate, deposits higher than such sum as may be specified by the Bank.
Chapter IIIB to override other laws The provisions of this Chapter shall have
effect notwithstanding anything inconsistent therewith contained in any other
law for the time being in force or any instrument having effect by virtue of
any such law.
Notification No. DFC.119/DG(SPT)-98 dated 31st January, 1998 issued by RBI
under Section 45JA RBI, having considered it necessary in public interest and
being satisfied that for the purpose of enabling the Bank to regulate the
credit system, it was necessary to issue directions relating to Prudential
Norms, gives to every Non-Banking Financial Company the following directions.
directions are called as "NBFCs Prudential Norms (Reserve Bank)
For the purpose of these directions, unless the context otherwise requires :-
22 *** *** *** (iv) "doubtful asset" means - (a) a term loan, or (b)
a lease asset, or (c) a hire purchase asset, or (d) any other asset, which
remains a substandard asset for a period exceeding two years;
with effect from March 31, 2003, `non- performing asset' (referred to in these
directions as "NPA") means:
asset, in respect of which, interest has remained overdue for a period of six
months or more;
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;
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;
bill which remains overdue for a period of six months or more;
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;
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;
lease rental and hire purchase instalment, which has become overdue for a
period of twelve months or more;
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/beneficiary
when any of the above credit facilities becomes non- performing asset:
Provided that in the case of lease and hire purchase transactions, an NBFC may
classify each such account on the basis of its record of recovery;
asset" (referred to in these directions as "NPA") means :- (a)
an asset, in respect of which, interest has remained past due for six months;
term loan inclusive of unpaid interest, when the instalment is overdue for more
than six months or on which interest amount remained past due for six months;
demand or call loan, which remained overdue for six months from the date of
demand or call or on which interest amount remained past due for a period of
bill which remains overdue for six months;
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 over due for a period of six months;
dues on account of sale of assets or services rendered or reimbursement of
expenses incurred, which remained overdue for a period of six months;
lease rental and hire purchase instalment, which has become overdue for a
period of more than twelve months;
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/beneficiary
when any of the above credit facilities becomes non- performing asset :
that in the case of lease and hire purchase transactions, an NBFC may classify
each such account on the basis of its record of recovery;"
"owned fund" means paid up equity capital, preference shares which
are compulsorily convertible into equity, free reserves, balance in share
premium account and capital reserves representing surplus arising 24 out of
sale proceeds of asset, excluding reserves created by revaluation of asset, as
reduced by accumulated loss balance, book value of intangible assets and
deferred revenue expenditure, if any;
"standard asset" means the asset in respect of which, no default in
repayment of principal or payment of interest is perceived and which does not
disclose any problem nor carry more than normal risk attached to the business;
"sub-standard assets" means - (a) an asset which has been classified
as non-performing asset for a period of not exceeding two years;
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
The income recognition shall be based on recognised accounting principles.
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 unrealised 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.
respect of lease assets, where lease rentals are overdue for more than 12
months, the income shall be recognised only when lease rentals are actually
received. The net lease rentals taken to the credit of profit and loss account
before the asset became non- performing and remaining unrealised shall be reversed.
Explanation For the purpose of this paragraph, `net lease rentals' mean gross
lease rentals as adjusted by the lease adjustment account debited/credited to
the profit and loss account and as reduced by depreciation at the rate
applicable under Schedule XIV of the Companies Act, 1956 (1 of 1956).
Accounting Standards and Guidance Notes issued by the Institute of Chartered
Accountants of India (referred to in these directions as "ICAI")
shall be followed insofar as they are not inconsistent with any of these
NBFC shall, after taking into account the time lag between an account becoming
non-performing, its recognition as such, the realisation of the security and
the erosion over time in the value of security charged, make provision against
sub-standard assets, doubtful assets and loss assets as provided hereunder :-
Loans, advances and other credit facilities including bills purchased and
discounted (1) The provisioning requirement in respect of loans, advances and
other credit facilities including bills purchased and discounted shall be as
Assets The entire asset shall be written off. If the assets are permitted to
remain in the books for any reason, 100% of the outstandings should be provided
Doubtful Assets (a) 100% provision to the extent to which the advance is not
covered by the realisable value of the security to which the NBFC has a valid
recourse shall be made. The realisable value is to be estimated on a realistic
addition to item (a) 11 above, depending upon the period for which the asset
has remained doubtful, provision to the extent of 20% to 50% of the secured
portion (i.e. estimated realisable value of the outstandings) shall be made on
the following basis : - Period for which % of provision the asset has been
considered as doubtful Upto one year 20 One to three years 30 More than three
50 years iii) Sub-standard A general provision of 10% of assets total
outstandings shall be made.
hire purchase assets (2) The 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..."
provision for hire purchase and leased assets (ii) In respect of hire purchase
and leased assets, additional provision shall be made as under :
any amounts of hire Nil charges or lease rentals are overdue upto 12 months
any amounts of hire 10 percent of the net book charges or lease rentals are
overdue value for more than 12 months but upto 24 months Doubtful assets:
any amounts of hire 40 percent of the net book charges or lease rentals are
overdue value for more than 24 months but upto 36 months (d) where any amounts
of hire 70 percent of the net book charges or lease rentals are overdue value
for more than 36 months but upto 48 months Loss assets (e) where any amounts of
hire 100 percent of the net charges or lease rentals are overdue book value for
more than 48 months 28 (iii) On expiry of a period of 12 months after the due
date of the last instalment of hire purchase/leased asset, the entire net book
value shall be fully provided for.
amount of caution money/margin money or security deposits kept by the borrower
with the NBFC in pursuance of the hire purchase agreement may be deducted
against the provisions stipulated under clause (i) above, if not already taken
into account while arriving at the equated monthly instalments under the
of any other security available in pursuance to the hire purchase agreement may
be deducted only against the provisions stipulated under clause (ii) above.
amount of security deposits kept by the borrower with the NBFC in pursuance to
the lease agreement together with the value of any other security available in
pursuance to the lease agreement may be deducted only against the provisions
stipulated under clause (ii) above.
3. It is
clarified that income recognition on and provisioning against NPAs are two
different aspects of prudential norms and provisions as per the norms are
required to be made on NPAs on total outstanding balances including the
depreciated book value of the leased asset under reference after adjusting the
balance, if any, in the lease adjustment account. The fact that income on an
NPA has not been recognised cannot be taken as reason for not making provision.
asset which has been renegotiated or rescheduled as referred to in paragraph
(2) (xvi) (b) of these directions shall be a sub-standard asset or continue to
remain in the same category in which it was prior to its renegotiation or
reschedulement as a doubtful asset or a loss asset as the case may be.
Necessary provision is required to be made as applicable to such asset till it
balance sheet for the year 1999-2000 to be prepared by the NBFC may be in accordance
with the provisions contained in sub-paragraph (2) of paragraph 8.
financial leases written on or after April 1, 2001 attract the provisioning
requirements as applicable to hire purchase assets.
in the balance sheet
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.
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.
provisions shall not be appropriated from the general provisions and loss
reserves held, if any, by the NBFC.
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.
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 set out in the schedule annexed hereto.
Prudential Norms on Income Recognition, Asset Classification and Provisioning
pertaining to Advances dated July 1, 2009
performing Assets 30 2.1.1 An asset, including a leased asset, becomes non
performing when it ceases to generate income for the bank.
non performing asset (NPA) is a loan or an advance where;
and/ or instalment of principal remain overdue for a period of more than 90
days in respect of a term loan, ii.the account remains `out of order' as
indicated at paragraph 2.2 below, in respect of an Overdraft/Cash Credit
(OD/CC), iii.the bill remains overdue for a period of more than 90 days in the
case of bills purchased and discounted, iv. the instalment of principal or
interest thereon remains overdue for two crop seasons for short duration crops,
v. the instalment of principal or interest thereon remains overdue for one crop
season for long duration crops, vi. the amount of liquidity facility remains
outstanding for more than 90 days, in respect of a securitisation transaction
undertaken in terms of guidelines on securitisation dated February 1, 2006.
respect of derivative transactions, the overdue receivables representing
positive mark-to-market value of a derivative contract, if these remain unpaid
for a period of 90 days from the specified due date for payment.
Income Recognition Policy 31 3.1.1 The policy of income recognition has to be
objective and based on the record of recovery.
income from nonperforming assets (NPA) is not recognised on accrual basis but
is booked as income only when it is actually received. Therefore, the banks
should not charge and take to income account interest on any NPA.
Categories of NPAs Banks are required to classify nonperforming assets further
into the following three categories based on the period for which the asset has
remained non- performing and the realisability of the dues:
Assets ii.Doubtful Assets iii.Loss Assets 4.1.1 Substandard Assets With effect
from 31 March 2005, a substandard asset would be one, which has remained NPA
for a period less than or equal to 12 months. In such cases, the current net
worth of the borrower/ guarantor or the current market 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
Doubtful Assets With effect from March 31, 2005, an asset would be classified
as doubtful if it has remained in the sub- 32 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
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.
General 5.1.1 The primary responsibility for making adequate provisions for any
diminution in the value of loan assets, investment or other assets is that of
the bank managements and the statutory auditors. The assessment made by the
inspecting officer of the RBI is furnished to the bank to assist the bank
management and the statutory auditors in taking a decision in regard to making
adequate and necessary provisions in terms of prudential guidelines.
Income Tax Act, 1961 Section 36 - Other deductions [as it stood at the material
time] (1) The deductions provided for in the following clauses shall be allowed
in respect of the 33 matters dealt with therein, in computing the income
referred to in section 28 - (vii) subject to the provisions of sub-section (2),
the amount of any bad debt or part thereof which is written off as
irrecoverable in the accounts of the assessee for the previous year:
that in the case of an assessee to which clause (viia) applies, the amount of
the deduction relating to any such debt or part thereof shall be limited to the
amount by which such debt or part thereof exceeds the credit balance in the
provision for bad and doubtful debts account made under that clause.
For the purposes of this clause, any bad debt or part thereof written off as irrecoverable
in the accounts of the assessee shall not include any provision for bad and
doubtful debts made in the accounts of the assessee.
respect of any provision for bad and doubtful debts made by - (a) a scheduled
bank not being a bank incorporated by or under the laws of a country outside
India or a non- scheduled bank, an amount not exceeding five per cent of the
total income (computed before making any deduction under this clause and
Chapter VIA) and an amount not exceeding ten per cent of the aggregate average
advances made by the rural branches of such bank computed in the prescribed
34 43D -
Special provision in case of income of public financial institutions, public
anything to the contrary contained in any other provision of this Act, - (a) in
the case of a public financial institution or a scheduled bank or a State
financial corporation or a State industrial investment corporation, the income
by way of interest in relation to such categories of bad or doubtful debts as
may be prescribed2 having regard to the guidelines issued by the Reserve Bank
of India in relation to such debts;
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.
for RBI Directions 1998 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 35
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
interest of the depositors. These NBFCs are subjected to prudential regulations
on various aspects such as income recognition; asset classification and
of every business is that anticipated losses must be taken into account but
expected income need not be taken note of. This is the basis of the RBI
Directive of 1998 as it is closer to reality of cash liquidity that prevents
NBFC from collapse.
Directions 1998 deal with Presentation of NPA provision in the Balance Sheet of
an NBFC. Before 1998, the Balance Sheet and P&L Account of an NBFC were
required to be prepared in accordance with Parts I and II of Schedule VI as
provided under Section 211 of the Companies Act, 1956 like any other company.
Schedule VI Part I of the Companies Act, 1956 specifically provides that
Provision for doubtful debts should be reduced from the gross amount of debtors
and advances. NBFCs were following the same practice of disclosure in their
audited financial statements as done by the Company. Therefore, vide Para 9(1)
of 1998 Directions, NBFCs are now obliged to disclose in the Balance Sheet the
Provision for NPAs without netting them from the income or value of the 36
assets. As per sub-para 2 of Para 9, "the provisions shall be distinctly
indicated under separate heads of accounts" on the Liability side of the
balance sheet under the caption "current liabilities and provisions".
to be emphasized that the said 1998 Directions are only Disclosure Norms. They
have nothing to do with computation of Total Taxable Income under the IT Act or
with the accounting treatment. The said 1998 Directions only lay down the
manner of presentation of NPA provision in the balance sheet of an NBFC.
of Para 9 of RBI Directions 1998 Vide Para 9, RBI has mandated that every NBFC
shall disclose in its Balance Sheet the Provision without netting them from the
Income or from the value of the assets and that the provision shall be
distinctly indicated under the separate heads of accounts as: - (i) provisions
for bad and doubtful debts, and (ii) provisions for depreciation in investments
in the Balance Sheet under "Current Liabilities and Provisions" and
that such provision for each year shall be debited to P&L Account so that a
true and correct figure of "Net Profit" gets reflected in the
financial accounts of the company. The 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 37 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.
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.
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.
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.
the Finance Act No. 2 of 2001 w.e.f. 1.4.1989 insofar as Section 36(1)(vii) is
concerned Prior to 1.4.1989, the law, as it then stood, took the view that even
in cases in which the assessee (s) makes only a provision in its accounts for
bad debts and interest thereon and even though the amount is not actually
written 38 off by debiting the P&L Account of the assessee and crediting
the amount to the account of the debtor, assessee was still entitled to
deduction under Section 36(1)(vii). [See Commissioner of Income Tax v. Jwala
Prasad Tewari 24 ITR 537 and Vithaldas H. Dhanjibhai Bardanwala (supra)] Such state
of law prevailed upto and including assessment year 1988-89.
by insertion (w.e.f. 1.4.1989) of a new Explanation in Section 36(1)(vii), it
has been clarified that any bad debt written off as irrecoverable in the
account of the assessee will not include any provision for bad and doubtful
debt made in the accounts of the assessee. The said amendment indicates that
before 1.4.1989, even a provision could be treated as a write off. However,
after 1.4.1989, a distinct dichotomy is brought in by way of the said
Explanation to Section 36(1)(vii). Consequently, after 1.4.1989, a mere
provision for bad debt would not be entitled to deduction under Section
36(1)(vii). To understand the above dichotomy, one must understand "how to
write off". If an assessee debits an amount of doubtful debt to the
P&L Account and credits the asset account like sundry debtor's Account, it
would constitute a write off of an actual debt. However, if an assessee debits
"provision for doubtful debt" to the P&L Account and makes a
corresponding credit to the "current liabilities and provisions" on
the Liabilities side of the balance sheet, then it would constitute a provision
for 39 doubtful debt. In the latter case, assessee would not be entitled to
deduction after 1.4.1989.
examined the P&L Account of First Leasing Company of India Limited for the
year ending 31st March, 2003. On examination of Schedule J to the P&L
Account which refers to operating expenses, we find two distinct heads of
expenditure, namely, "Provision for Non-performing Assets" and
"Bad Debts/ Advances Written Off". It is for the appellant (s) to
explain the difference between the two to the assessing officer. Which of the
two items will constitute expenditure under the IT Act has to be decided
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.
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 previous year. Under the IT Act, the emphasis is not on the
assessee being the creditor but taking into account of the debt in computing
the business income. [See Section 36(2)] In Commissioner of Income-tax, A.P. v.
T. Veerabhadra Rao K. Koteswara Rao & Co.
in 155 ITR 152 at 157, it was found that the debt was taken into account in the
income of the assessee for the assessment year 1963-64 when the interest
accruing thereon was taxed in the hands of the assessee. The said interest was
taxed as income as it represented accretion accruing during the earlier year on
the moneys owed to the assessee by the debtor. It was held that transaction
constituted the debt which was taken into account in computing the income of
the assesee of the previous years.
between RBI Directions 1998 and Companies Act Broadly,
there are three deviations:
the matter of presentation of financial statements under Schedule VI of the Companies Act;
in not recognising the "income" under the mercantile system of
accounting and its insistence to follow cash system with respect to assets
classified as NPA as per its Norms;
creating a provision for all NPAs summarily as against creating a provision
only when the debt is doubtful of recovery under the norms of the Accounting
Standards issued by the Institute of Chartered Accountants of India.
deviations prevail over certain provisions of the Companies Act, 1956 to
protect the Depositors in the context of Income Recognition and Presentation of
the Assets and Provisions created against them.
P&L Account prepared by NBFC in terms of RBI Directions 1998 does not
recognize "income from NPA" and, therefore, directs a Provision to be
made in that regard and hence an "add back". It is important to note
that "add back" is there only in the case of provisions.
above, the Companies Act allows
an NBFC to adjust a Provision for possible diminution in the value of asset or
provision for doubtful debts against the assets and only the Net Figure is
allowed to be shown in the Balance Sheet, as a matter of disclosure. However,
the said RBI Directions 1998 mandates all NBFCs to show the said provisions
separately on the Liability Side of Balance Sheet, i.e., under the Head 42
"current liabilities and provisions". The purpose of the said
deviation is to inform the user of the Balance Sheet the particulars concerning
quantum 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.
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 taken into account due to uncertainty in collection of the
income. It is for the assessing officer to accept the claim of the assessee 43
under the IT Act or not to accept it in which case there will be add back even
under real income theory as explained hereinbelow.
applicability of RBI Directions 1998 RBI Directions 1998 have been issued under
Section 45JA of RBI Act. Under that Section, power is given to RBI to enact a
regulatory framework involving prescription of prudential norms for NBFCs which
are deposit taking to ensure that NBFCs function on sound and healthy lines.
primary object of the said 1998 Directions is prudence, transparency and
disclosure. Section 45JA comes under Chapter IIIB which deals with provisions
relating to Financial Institutions, and to non-banking Institutions receiving
deposits from the public. The said 1998 Directions touch various aspects such
as income recognition; asset classification; provisioning, etc.
above, basis of the 1998 Directions is that anticipated losses must be taken
into account but expected income need not be taken note of.
these Directions ensure cash liquidity for NBFCs which are now required to
state true and correct profits, without projecting inflated profits.
in our view, RBI Directions 1998 deal only with presentation of NPA provisions
in the Balance Sheet of an NBFC. It has nothing to do with the computation or
taxability of the provisions for NPA under the IT Act.
to RBI Directions 1998, Advances were stated net of provisions for NPAs / bad
and doubtful debts. They were shown at net figure (Advances less Provisions for
NPAs) and the amount of provision for NPA was shown in the notes to the
accounts only. Such presentation of NPA Provision warranted disclosure.
Therefore, Para 9(1) of RBI Directions 1998 stipulates that every NBFC shall
separately disclose in its Balance Sheet the provision for NPAs without netting
them from the income or against the value of assets. That, the provision for
NPA should be shown separately on the "Liabilities side" of the
Balance Sheet under the head "Current Liabilities and Provisions" and
not as a deduction from "Sundry Debtors/ Advances". Therefore, RBI
has taken a position as a matter of disclosure, with which we agree, that if an
NBFC deducts a provision for NPA from "sundry debtors/ loans and
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 income 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 45 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-market loss on its derivative
contracts either by creating reserve as suggested by ICAI or by charging the
same to the P&L Account in terms of Accounting Standards. Consequently,
their profits and reserves and surplus of the year are projected on the higher
side. Consequently, such losses are not accounted in the books, at the highest,
they are merely disclosed as contingent liability in the Notes to Accounts. The
point which we would like to make is whether such losses are contingent or
actual cannot be decided only on the basis of presentation.
presentation will not bind the authority under the IT Act. Ultimately, the
nature of transaction has to be examined. In each case, the authority has to
examine the nature of expense/ loss. Such examination and finding thereon will
not depend upon presentation of expense/ loss in the financial 46 statements of
the NBFC in terms of the 1998 Directions. Therefore, in our view, the RBI
Directions 1998 and the IT Act operate in different fields.
question still remains as to what is the nature of "Provision for
NPA" in terms of RBI Directions 1998. In our view, provision for NPA in
terms of RBI Directions 1998 does not constitute expense on the basis of which
deduction could be claimed by NBFC under Section 36(1)(vii).
for NPAs is an expense for Presentation under 1998 Directions and in that sense
it is notional. For claiming deduction under the IT Act, one has to go by the
facts of the case (including the nature of transaction), as stated above. One
must keep in mind another aspect. Reduction in NPA takes place in two ways,
namely, by recoveries and by write off. However, by making a provision for NPA,
there will be no reduction in NPA.
a write off is also of two types, namely, a regular write off and a prudential
write off. [See Advances Accounts by Shukla, Grewal, Gupta, Chapter 26, Page
26.50] If one keeps these concepts in mind, it is very clear that RBI
Directions 1998 are merely prudential norms. They can also be called as
disclosure norms or norms regarding presentation of NPA Provisions in the
Balance Sheet. They do not touch upon the nature of expense to be decided by
the AO in the assessment proceedings.
interesting argument was advanced before us to say that a provision for NPA,
under commercial accounting, is not an "income" hence the same cannot
be added back as is sought to be done by the Department.
connection, reliance was placed on "Real Income Theory".
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:
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
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:
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".
point to be noted is that the IT Act is a tax on "real income", i.e.,
the profits arrived at on commercial principles subject to the provisions of
the IT Act. Therefore, if by Explanation to Section 36(1)(vii) a provision for
doubtful debt is kept out of the ambit of the bad debt which is written off
then, one has to take into account the said Explanation in computation of total
income under the IT Act failing which one cannot ascertain the real profits.
This is where the concept of "add back" comes in. In our view, a
provision for NPA debited to P&L Account under the 1998 Directions is only
a notional expense and, therefore, there would be add back to that extent in
the computation of total income under the IT Act.
the contentions raised on behalf of NBFC before us was that in this case there
is no scope for "add back" of the Provision against NPA to the
taxable income of the assessee. We find no merit in this contention.
IT Act, the charge is on Profits and Gains, not on gross receipts (which,
however, has Profits embedded in it). Therefore, subject to the requirements of
the IT Act, profits to be assessed under the IT Act have got to be Real Profits
which have to be computed on ordinary principles of commercial accounting. In
other words, profits have got to be computed after deducting Losses/ Expenses
incurred for business, even though such losses/ expenses may not be admissible
under Sections 30 to 43D of the IT 49 Act, unless such Losses/ Expenses are
expressly or by necessary implication disallowed by the Act. Therefore, even
applying the theory of Real Income, a debit which is expressly disallowed by
Explanation to Section 36(1)(vii), if claimed, has got to be added back to the
total income of the assessee because the said Act seeks to tax the "real
income" which is income computed according to ordinary commercial
principles but subject to the provisions of the IT Act. Under Section
36(1)(vii) read with the Explanation, a "write off"
condition for allowance. If "real profit" is to be computed one needs
to take into account the concept of "write off" in contradistinction
to the "provision for doubtful debt".
of Section 145 At the outset, we may state that in essence RBI Directions 1998
are Prudential/ Provisioning Norms issued by RBI under Chapter IIIB of the RBI
Act, 1934. These Norms deal essentially with Income Recognition.
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.
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
inconsistency between these Directions and Companies Act is only
in the matter of Income Recognition and presentation of Financial Statements.
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 of the IT Act has no role to play
in the present dispute.
of Section 36(1)(viia) Section 36(1)(vii) provides for a deduction in the
computation of taxable profits for the debt established to be a bad debt.
36(1)(viia) provides for a deduction in respect of any provision for bad and
doubtful debt made by a Scheduled Bank or Non- Scheduled Bank in relation to
advances made by its rural branches, of a sum not exceeding a specified
percentage of the aggregate average advances by 51 such branches. Having regard
to the increasing social commitment, Section 36(1)(viia) has been amended to
provide that in respect of provision for bad and doubtful debt made by a
scheduled bank or a non-scheduled bank, an amount not exceeding a specified per
cent of the total income or a specified per cent of the aggregate average advances
made by rural branches, whichever is higher, shall be allowed as deduction in
computing the taxable profits.
Section 36(1)(vii) has been amended to provide that in the case of a bank to
which Section 36(1)(viia) applies, the amount of bad and doubtful debt shall be
debited to the provision for bad and doubtful debt account and that the
deduction shall be limited to the amount by which such debt exceeds the credit
balance in the provision for bad and doubtful debt account.
to be highlighted is that in case of banks, by way of incentive, a provision
for bad and doubtful debt is given the benefit of deduction, however, subject
to the ceiling prescribed as stated above.
the provision for NPA created by a scheduled bank is added back and only
thereafter deduction is made permissible under Section 36(1)(viia) as claimed.
provision on NPA is allowable under Section 37(1)? 52 As stated above, Section
36(1)(vii) after 1.4.1989 draws a distinction between write off and provision
for doubtful debt. The IT Act deals only with doubtful debt. It is for the
assessee to establish that the provision is made as the loan is irrecoverable.
However, in view of Explanation which keeps such a provision outside the scope
of "written off" bad debt, Section 37 cannot come in. If an item
falls under Sections 30 to 36, but is excluded by an Explanation to Section
36(1)(vii) then Section 37 cannot come in.
37 applies only to items which do not fall in Sections 30 to 36. If a provision
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.
of Section 43D It is similar to Section 43B.
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.
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 53 only in
the year of receipt or the year in which it is credited to the P&L Account,
whichever is earlier.
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).
to the constitutional validity of Sections 36(1)(viia) and 43D of the IT Act
According to NBFCs, there is no reason why a Provision for NPA of an NBFC be
treated differently from a provision for NPAs of banks, SFCs, HFCs, etc.
According to NBFCs, the Disclosure Norms for NBFCs are designed to bring NBFCs
in line with banks, SFCs, HFCs, etc. That, if NPAs are similar to Doubtful
Debts, then permitting deductions only in the case of Provisions for doubtful
debts of banks, cooperative financial corporations, etc. will violate Article
14 of the Constitution. In this connection, it was submitted that when banks,
financial institutions and NBFCs are all subject to RBI norms in the matter of
Income Recognition, denial of deduction only to NBFCs in respect of Provisions
which they make against their NPAs and not including NBFCs in Sections 43D and
36(1)(viia) would be wholly discriminatory and violative of Article 14.
According to NBFCs, levying a tax on the Provision for NPA would amount to an
unreasonable restriction on the right of the NBFCs to carry on business under
Article 19(1)(g) of the Constitution. For example, in the case of First Leasing
Company, who made the Provision for NPA of Rs. 15.77 crores, the taxable income
stands increased by the said sum even when it does not represent real or
notional income. Accordingly, the taxable income of the Company stands raised
by a fictitious amount. This, according to the Company, would constitute an
unreasonable restriction on the fundamental rights of the Company to carry on
business under Article 19(1)(g).
no merit in the above contentions. In the context of Article 14, the test to be
applied is that of "rational/ intelligible differentia" having nexus
with the object sought to be achieved. Risk is one of the main concerns which
RBI has to address when it comes to NBFCs. NBFCs accept deposits from the
Public for which transparency is the key, hence, we have the RBI Directions/
Norms. On the other hand, as far as banking goes, the weightage, one must place
on, is on "liquidity". These two concepts, namely, "risk"
and "liquidity" bring out the basic difference between NBFCs and
Banks. Take the case of the scope of impugned Section 43D. As stated above, an
asset is rated as NPA when over a period of time it ceases to get converted to
cash or generate income and becomes difficult to recover.
Therefore, Parliament realized that taxing such "income" on accrual
basis without actual recovery would 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 offtake is so huge that banks face liquidity crunch.
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
36(1)(viia). One more aspect needs to be mentioned, apart from the fact that
NBFCs and Banks are two different entities, under Section 36(1)(viia) the banks
are allowed deductions subject to a ceiling or a limit and if the contentions
of NBFCs are to be 56 accepted that NBFCs should also be included in Section
36(1)(viia), then, we will be undertaking judicial legislation which is not
allowed, hence, in our view, we hold that neither Section 36(1)(viia) nor
Section 43D violates Article 14. We further hold that the test of
"intelligible differentia" stands complied with and hence we reject
regards challenge to the validity of Sections 43D and 36(1)(viia) as violative
of Article 19, we find that RBI Directions 1998 govern the business of NBFCs.
To protect the investors, RBI has prescribed norms for provisioning and
disclosure. These norms have nothing to do with computation of taxable income
under the IT Act. These Directions 1998 do not apply to banks. Ultimately, the
challenge is to the validity of a taxing enactment. In such cases, we must give
some latitude to the law makers in enacting laws which impose reasonable
restrictions under Article 19(6).
say so for two reasons. Firstly, the impugned allowance under Section
36(1)(viia) cannot be extended to NBFCs which are vulnerable to economic and
financial uncertainties. Secondly, the RBI Directions 1998 are only Disclosure
Norms. They require NBFCs to make a Provision for possible loss to be made and
disclosed to the public. Such debits are only notional for purposes of
disclosure, hence, they cannot be made an excuse for claiming deduction under
the IT Act, hence, "add back". Since RBI 57 Direction 1998 is not applicable
to Banks, there is no question of extending the benefit of deduction to NBFCs
under Section 36(1)(viia) or under Section 43D. Keeping in mind an important
role assigned to banks in our market economy, we are of the view that the
restriction, if any placed on NBFC by not giving them the benefit of deduction,
satisfies the principle of "reasonable justification".
concluding, we may cite the following judgments of this Court in the context of
the constitutional validity of Sections 36(1)(viia) and 43D of the IT Act.
case of R.K. Garg v. Union of India (1981) 4 SCC 675 this Court held that every
legislation, particularly in economic matters, is essentially empiric and it is
based on experimentation. There may be 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.
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 58
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 value. The terms
"reasonable, just and fair" derive their significance from the
existing social conditions.
case of Bhavesh D. Parish v. Union of India, (2000) 5 SCC 471, this Court laid
down that while considering the scope of economic legislation as well as tax
legislation, the courts must bear in mind that unless the provision is
manifestly unjust or glaringly unconstitutional, the courts must show judicial
restraint in interfering with its applicability. Merely because a statute comes
up for examination and some arguable point is raised, the legislative will
should not be put under a cloud. It is now well settled that there is always a
presumption in favour of the constitutional validity of any legislation unless
the same is set aside for breach of the provisions of the Constitution. The
system of checks and balances has to be 59 utilised in a balanced manner with
the primary objective of accelerating economic growth rather than suspending
its growth by doubting its constitutional efficacy at the threshold itself.
case of State of Madras v. V.G. Row 1952 SCR 597, this Court observed as
is important in this context to bear in mind that the test of reasonableness,
wherever prescribed, should be applied to each individual statute impugned, and
no abstract standard, or general pattern of reasonableness can be laid down as
applicable to all cases. The nature of the right alleged to have been
infringed, the underlying purpose of the restrictions imposed, the extent and
urgency of the evil sought to be remedied thereby, the disproportion of the
imposition, the prevailing conditions at the time, should all enter into the
case of Barclays Mercantile Business Finance Ltd. v. Mawson (Inspector of
Taxes), 2005 (1) All ER 97, the House of Lords observed that "a tax is
generally imposed by reference to economic activities or transactions which
exist in the real world". When an economic activity is to be valued, it is
open to the law makers to take into account various factors like public
investments, disclosure and transparency in the matter of maintenance of
accounts, reflection of true and correct profits, etc. This is precisely what
is done by RBI Directions 1998.
60 For the afore-stated reasons, we find no merit in the Civil Appeals filed by
the NBFCs, so also in the Transferred Cases, and, accordingly, the same are
dismissed with no order as to costs.
.............................J. (S. H. Kapadia)
.............................J. (Aftab Alam)