Writing off Bad Debts and Tax Liability

The treatment of bad debts has been a constant source of disagreement between financial institutions and the Tax Department. Banks typically argued that some advances were so unlikely to be recovered that they may justifiably be regarded as “sticky” advances, and that interest on these advances should not be treated as income for the purposes of taxation. The Department’s response was that the bank wanted to have its cake and eat it too, since it was unwilling to write off the sticky loans as bad debts, and relied on that very characteristic to claim tax deduction.

Mr. Palkhivala used what has come to be known as the “real income principle” to support the bank’s claim. In State Bank of Travancore v. CIT, AIR 1986 SC 757, the Supreme Court rejected the argument, and held that interest on sticky loans is part of taxable income unless the loans are written off as bad. After relevant amendments to s. 36(1)(viii) of the Income Tax Act, 1961, and a CBDT Circular dt. 9-10-1984, the position began to change, and the Supreme Court overruled its decision in State Bank of Travancore in 1999 and again in 2006 (UCO Bank v. CIT, (1999) 4 SCC 599; Mercantile Bank v. CIT, (2006) 5 SCC 221).

Thus, the position of law today is that banks are entitled to treat a loan as commercially “bad” even without so accounting it in its books of accounts, and exclude interest on it from its taxable income. In this context, a recent decision of the Bombay High Court on a related but different question assumes some importance – DCIT v. Oman International Bank SOAG (ITA 114/2009, decided on 9 April 2009). A copy of the decision is available here. Accepting that banks are entitled to write off sticky interest as described above, and write off actual bad debts, the question arises as to when debt may be considered bad, and more importantly, who is to make that assessment. A Special Bench of the Mumbai ITAT had disagreed on this question – the majority holding that it was upto the lender’s commercial assessment, while the minority required the lender to prove that the debt had become bad.

In what will come as a relief to banks, the Bombay High Court has upheld the view of the majority. The following observations are particularly significant:

“Subsequent to the amendment from the language of the Section it is sufficient if the bad debt or part thereof is written off as irrecoverable in the accounts of the assessee based on commercial expediency. If we apply the Rule of interpretation as spelt out in Hyden’s case, it would lead to an irresistible conclusion, that the Legislature by the amendment has sought to exclude the burden on the assessee to prove that the debt is bad debt and leaves it to the commercial wisdom of the assessee to treat the debt as bad, once it is written off as irrecoverable in the accounts of the assessee.”

The only requirement that the Court has imposed is that the decision of the bank to write off the debt in its books must be bona fide. In sum, the law on bad debts and sticky loans has radically changed in the last few years – from a scenario where banks had to both prove bad debts and include sticky interest, the law today allows them a presumption that a debt written off as bad is in fact bad, and that sticky interest is not part of taxable income. It is even conceivable that these benefits are extended to NBFCs, as the Kerala High Court is currently seized of a writ petition that has challenged the decision of the Government to confine these benefits to banks.

Other analyses of these developments are available here and here.