TMI Blog2010 (1) TMI 5X X X X Extracts X X X X X X X X Extracts X X X X ..... nnot be made an excuse for claiming deduction under the IT Act, hence, add back . - 1337/2003, C.A.154 /2010 @ SLP(C) 22176/2009 - - - Dated:- 11-1-2010 - S.H. KAPADIA, and Aftab Alam, JJ. JUDGMENT S.H. KAPADIA, J. Leave granted in the Special Leave Petition. Introduction 2. An interesting question of law which arises for determination in these Civil Appeals filed by Non-banking Financial Companies ("NBFCs" for short) is: "Whether the Department is entitled to treat the "Provision for NPA", which in terms of RBI Directions 1998 is debited to the 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?" Facts 3. For 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]. 4. At the outset, it may be stated that categorization of assets into doubtful, sub-standard and loss is not in dispute. 5. The financial year of the Appellant is July to June and the P L Account and the Balance Sheet are drawn as on 30th June.The P L Account and Balance Shee ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... rovision 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. 9. The basic 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 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 ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... he 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 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 o ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... he 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 Act. 14. In 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 ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... tion. 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 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. 16. Coming to the accounting treatment, the appellant has given us the following chart to bring out the difference between "provision" and "reserve": S.No. Provision Reserve 1. Provision is a charge or debit to the P L Account. Reserve is an appropriation of profits. 2. Provision is made against gross receipts in the P L A/c irrespective of whether loss. there is profit or loss Provisions are a pretax cha ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ts 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 allows several such provisions under Sections 40A (7), 43B, 40 and 40A. Such 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. According 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 contemp ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... (c) of section 2 of the Industrial Development Bank of India Act, 1964 (18 of 1964); (b) the 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 persons; 45-IA. 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- (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 t ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... 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. (2) 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 (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. 45K - Power of Bank to collect information from non-banking institutions as to deposits and to give directions (1) The Bank may at any time direct that every non-banking i ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... e said directions are called as "NBFCs Prudential Norms (Reserve Bank) Directions, 1998": Definitions 2. (1) For the purpose of these directions, unless the context otherwise requires :- *** *** *** (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; (xii) with effect from March 31, 2003, `non-performing asset' (referred to in these directions as "NPA") means: (a) an asset, in respect of which, interest has remained overdue for a period of six months or more; (b) a term loan inclusive of unpaid interest, when the instalment is overdue for a period of six months or more or on which interest amount remained overdue for a period of six months or more; (c) a demand or call loan, which remained overdue for a period of six months or more from the date of demand or call or on which interest amount remained overdue for a period of six months or more; (d) a bill which remains overdue for a period of six months or more; (e) the interest in respect of a debt or the income on receivables under the head `oth ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... quity capital, preference shares which are compulsorily convertible into equity, free reserves, balance in share premium account and capital reserves representing surplus arising 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; (xv) "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; (xvi) "sub-standard assets" means - (a) an asset which has been classified as non-performing asset for a period of not exceeding two years; (b) an asset where the terms of the agreement regarding interest and/or principal have been renegotiated or rescheduled after commencement of operations, until the expiry of one year of satisfactory performance under the renegotiated or rescheduled terms; Income recognition 3. (1) The income recognition shall be based on recognised accounting principles. (2) Income including interest/discount or any other charges on NPA shall be recog ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... In 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 the asset has been considered as doubtful % of provision Upto one year 20 One to three years 30 More than three years 50 iii) Sub-standard A general provision of 10% of assets total outstandings shall be made. Lease and 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 b ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... 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. 4. An 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 is upgraded. 5. The 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. 6. All financial leases written on or after April 1, 2001 attract the provisioning requirements as applicable to hire purchase assets. Disclosure in the balance sheet 9. (1) Every NBFC shall separately disclose in its balance sheet the provisions made as per paragraph 8 above without netting them from the income or against the value of assets. (2) The provisions shall be distinctly indicated under separate h ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... not charge and take to income account interest on any NPA. 4. ASSET CLASSIFICATION 4.1 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: i. Substandard 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 corrected. 4.1.2. Doubtful Assets With effect from March 31, 2005, an asset would be classified as doubtful if it has remained in the sub-standard category for a period of 12 months. A loan classified as doubtful has all the weaknesses inher ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... 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 manner. 43D-Special provision in case of income of public financial institutions, public companies, etc. Notwithstanding 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 prescribed having regard to the guidelines issued by the Reserve Bank of India in relation to such debts; (b) in the case of a public company, the income by way of interest in relation to such categories of bad or doubtful debts as may be prescribed having regard to the guidelines issued by the National Housing Bank in relation to such debts, shall be chargeable to tax in the previous year in which it is credited by the public financial institution or the scheduled bank or the State financial corporation or the State industrial investment corporation ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... 1998 22. 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 continues to be an Asset - "Debtors/ Loans and Advances" in the books of NBFC. For creating a provision the only yardstick is default in terms of the loan under RBI norms, a provision is mathematical calculation on time lines. The entire exercise mentioned in the RBI Directions 1998 is only in the context of Presentation of NPA provisions in the balance sheet of an NBFC and it has nothing to do with computation of taxable income ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... for doubtful debt. In the latter case, assessee would not be entitled to deduction after1.4.1989. 26. We have 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 ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... y in the case of provisions. 30. As stated 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 "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. 31. Before concluding on this point, we need to emphasise that the 1998 Directions has nothing to do with the accounting treatment or taxability of "income" under the IT Act. The two, viz., IT Act and the 1998 Directions operate in different fields. As stated above, under the mercantile system of accounting, i ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... d 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 in come norm under the IT Act. At this stage, we may clarify that the entire thrust of RBI Directions 1998 is on presentation of NPA provision in the Balance Sheet of an NBFC. Presentation/ disclosure is different from computation/ taxability of the provision for NPA. ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... rudential 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. Theory of "Real Income" 35. An 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. In this connection, reliance was placed on "Real Income Theory". 36. We find no merit in the above contention. In the case of Poona Electric Supply Co. Ltd. v. Commissioner of Income-Tax, Bombay City I, 57 ITR 521 at page 530, this is what the Supreme Court had to say: "Income Tax is a tax on the "real income", i.e., the profits arrived at on commercial principles subject to the provisions of the Income Tax Act. The real profit can be ascertained only by making the permissible deductions under the provisions of the Income Tax Act. ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... me" 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" is a 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". Applicability of Section 145 40. 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. They force the NBFCs to disclose the amount of NPA in their financial accounts. They force the NBFCs to reflect "true and correct" profits. By virtue of Section 45Q, an overriding effect is given to the Directions 1998 vis-`-vis "income recognition" principles in the Companies Act, 1956.These Directions constitute a code by itself. However, these Directions 1998 and the IT Act operate in different areas. These Directions 1998 have nothing to do with computation of taxable income. These Directions cannot overrule the "permissible deductions" or "their exclusion" under the IT Act. ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... n 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. Section 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. Analysis of Section 43D 46. It is similar to Section 43B. 47. The reason for enacting this Section is that interest from bad and doubtful debts in the case of bank and financial institutions is difficult to recover; taxing such income on accrual basis reduces the liquidity of the bank without generation of income. 48. With a view to improve their viability, the IT Act has been amended by inserting ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ency 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 off take is so huge that banks face liquidity crunch. Thus, the line of business operations of NBFCs and banks are quite different. It is for this reason, apart from social commitment ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... anks 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". 54. Before 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. 55. In the 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. The Court must, therefore, adjudge the constitutionality of such legislation by the generality of its provisions. Laws relating to economic activities should be viewed with greater latitude than laws touching civil rights such as freedom of speech, religion, etc. Moreover, there is a presumption in favour of the constitutionality of a statute and the burden is upon him who attacks it to show that there has been a clear transgression of the constitutional principles. The le ..... X X X X Extracts X X X X X X X X Extracts X X X X
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