Companies Act Case Law M/s Southern Technologies Ltd Vs Joint Commnr. of Income Tax, Coimbatore

Companies Act Case Law

M/s Southern Technologies Ltd Vs Joint Commnr. of Income Tax, Coimbatore

REPORTABLE

IN THE 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. 22176/2009
TRANSFERRED CASE NO. 5/2005 & 6/2005
JUDGMENT
S.H. KAPADIA, J.
Leave granted in the Special Leave Petition.

Introduction

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
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?”

Facts

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].

At the outset, it may be stated that categorization of assets into

doubtful, sub-standard and loss is not in dispute.

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 Sheet is for shareholders, Reserve Bank of India (RBI)

and Registrar of Companies (ROC) under the Companies Act, 1956.

However, 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.

For the 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/-.

Before 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 Bardanwala v.

Commissioner 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 NBFCs.

Submissions
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.

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
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.

In reply, 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.

According 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.

Coming to 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.

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.

According 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 the Companies 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.

These 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 Act.
10
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 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.

According 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.

According 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.

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 Reserve is an appropriation of
to the P& L Account. profits.
2. 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.
there is 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.
a net 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.
13
To 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.
4. 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.
The balance will be transferred to
credit balance of P&L A/c. The
entries will be as follows:-
Stage 1:
P&L A/c Dr. 10.00
To P&L Appropriation A/c 8.00
To P& L A/c 2.00
Stage 2:
P&L 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.
Under the vertical system, “profits
available for appropriation” are
post-tax profits. Appropriation to
reserves can be made only when
there is a surplus.
5. Under 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.
for any taxation. Under Part – I of Schedule – VI,
`reserve’ can be made in respect
of capital reserves, capital
redemption, share premium, etc.
6. Provision cannot be used to Reserves can be utilized to pay
declare dividend, etc. dividends/ bonus, unless there is a
statutory bar.
Lastly, 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.

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

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.

Relevant 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”
means 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 (f);

(aa) “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;

(c) “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;

(ii) the acquisition of shares, stock, bonds, debentures or
securities issued by a Government or local authority or
other marketable securities of a like nature;

(iii) 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 1972);

(iv) the carrying on of any class of insurance business;

(v) 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;

(vi) 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);

(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-
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.

45-IC. 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 is
declared.

(2) No 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:

Provided 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.

(3) 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:

Provided 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.

45JA. 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.

(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
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.

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 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.

(2) 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.

(3) The 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.

(4) If 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.
21
[***]

(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.

45Q – 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.
(b) Of 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.

The 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 :-
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;

(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 `other current assets’ in the
nature of short term loans/advances, which facility
remained overdue for a period of six months or more;
(f) any 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;
(g) the lease rental and hire purchase instalment, which
has become overdue for a period of twelve months or
more;
(h) in 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:
23
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;

“non-performing asset” (referred to in these directions as
“NPA”) means :-
(a) an asset, in respect of which, interest has remained
past due for six months;
(b) a 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;
(ba) a 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 six
months;
(c) a bill which remains overdue for six months;
(d) the 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;
(e) any dues on account of sale of assets or services
rendered or reimbursement of expenses incurred, which
remained overdue for a period of six months;
(f) the lease rental and hire purchase instalment, which
has become overdue for a period of more than twelve
months;
(g) In 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;”

(xiii) “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;

(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 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.
(4) In 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.
25
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
5. 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 directions.

Provisioning requirements

8. Every 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 under :

(i) Loss 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 for;
(ii) 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
26
basis;

(b) 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 % 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.
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.
27

 

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…”
Additional provision for hire purchase and leased assets

(ii) In respect of hire purchase and leased assets,
additional provision shall be made as under :
(a) Where any amounts of hire Nil
charges or lease rentals are overdue
upto 12 months

Sub-standard assets:
(b) where 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:
(c) where 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.

NOTES :
1. The 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 agreement.
The value of any other security available in pursuance to
the hire purchase agreement may be deducted only
against the provisions stipulated under clause (ii) above.
2. The 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.
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.
29
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 heads of accounts as under :-

(i) provisions for bad and doubtful debts; and
(ii) provisions for depreciation in investments.

(3) Such provisions shall not be appropriated from the
general provisions and loss reserves held, if any, by the
NBFC.
(4) Such 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.
Schedule 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.
(c) Of Prudential Norms on Income Recognition, Asset Classification
and Provisioning pertaining to Advances dated July 1, 2009
2. DEFINITIONS

2.1 Non performing Assets
30
2.1.1 An asset, including a leased asset, becomes non
performing when it ceases to generate income for the
bank.

2.1.2 A non performing asset (NPA) is a loan or an
advance where;

i.interest 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.

vii. in 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.

3. INCOME RECOGNITION

3.1 Income Recognition Policy
31
3.1.1 The policy of income recognition has to be
objective and based on the record of recovery.
Internationally 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.

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-
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
improbable.

4.1.3 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.

5 PROVISIONING NORMS

5.1 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.
(d) Of 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:
Provided 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.
Explanation.- 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.
(viia) in 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 manner.
34
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 prescribed2
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 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.
Reasons 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 provisioning, etc.

The basis 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.

The RBI 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”.

It needs 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.

 

Analysis 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.

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 or accounting

concepts.

It is 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.

NBFCs 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.

Scope of 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.

However, 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.

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

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.
40
One 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.

reported 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.

Deviations between RBI Directions 1998 and Companies Act

Broadly, there are three deviations:

(i) in the matter of presentation of financial statements under

Schedule VI of the Companies Act;
41
(ii) 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;

(iii) in 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.

These 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.

Thus, the 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.

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
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.

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, 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.

Scope and 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.

The 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.

As stated above, basis of the 1998 Directions is that anticipated losses must

be taken into account but expected income need not be taken note of.

Therefore, these Directions ensure cash liquidity for NBFCs which are now

required to state true and correct profits, without projecting inflated profits.

Therefore, 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.
44
Prior 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.

Such 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.

The 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).

Provision 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.

Similarly, 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.

Theory of “Real Income”
47
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”.

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. There is a
clear distinction between the real profits and statutory
profits. The latter are statutorily fixed for a specified
purpose”.

To the 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:

“Income 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”.
48
The 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.

One of 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.

Under the 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”

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

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.
50
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.

The inconsistency between these Directions and Companies Act is only in

the matter of Income Recognition and presentation of Financial Statements.

The 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.

Analysis 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.

Section 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.

Even 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.

The point 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.

Lastly, 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.

Whether 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.

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

It is similar to Section 43B.

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.

With a 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.

Before 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).

Challenge 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.
54
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).

We find 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.
55
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.

Thus, the 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 the challenge.

As 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).

This we 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”.

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.

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
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.

In the 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.

In the case of State of Madras v. V.G. Row 1952 SCR 597, this

Court observed as follows:
“It 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 judicial verdict.”
In 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.

Conclusion
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)
New Delhi;
January 11, 2010

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