Kalpesh Classes

Debt or loan ?

A debt is an outstanding amount which if recovered would have swelled the profit. It means something more than a​​ mere advance - A.V. Thomas & Co. Ltd. v. CIT [1963] 48 ITR 67 (SC). It means something which is related to business or results from it. It means a sum of money due from one person to another. ‘Debts’ denote not only the obligation of the debtor to pay but​​ also the right of the creditor to receive and enforce payment. The essential requisites of a debt are :—

1.An ascertained readily calculable amount;

2.An absolute unqualified and present liability in regard to that amount;

3.The obligation to pay​​ forthwith or in future within a time certain and the obligation must have accrued and must be subsisting - CWT v. Pierce Leslie & Co. Ltd. [1963] 48 ITR 1005 (Mad.).

If moneys are advanced by the assessees to save the other party from financial crisis, then it cannot be written off as bad debts in the account of the money - lending business and cannot be claimed as bad debts - Amarchand Sobhachand v. CIT [1965] 56 ITR 594 (Mad.) affirmed by - Amarchand Sobhachand v. CIT [1971] 82 ITR 591 (SC).

Debt is something more than an advance, which is related to and results from assessee’s business.

Before a debt can become bad or doubtful it must first be a debt. A debt is an outstanding which if recovered would have swelled the profits. It is not money handed​​ over to someone for purchasing a thing which that person has failed to return even though no purchase was made.​​ In this section a debt means something more than a mere advance. It means something which is related to business or results from it - A.V. Thomas & Co. Ltd. v. CIT [1963] 48 ITR 67 (SC).

The assessee who carried on the manufacture of sugar used to advance seedlings, fertilisers and money to sugarcane growers under an agreement by which the growers agreed to sell the next crop of the sugarcane grown by them exclusively to the assessee at current market rates and to have the advances adjusted towards the price of the sugarcane to be delivered to the company. In a certain year owing to drought the sugarcane growers could not grow sugarcane and the advances remained unrecovered. A Committee appointed by the Government recommended that the assessee should ex gratia forgo some of its dues. The assessee accordingly waived its right in respect of Rs. 2,87,422 and claimed this amount as a deduction. So far​​ as the assessee-company was concerned it was merely making a forward arrangement for the next year's crops and paying an amount in advance out of the price and ​​ there was no element of a capital investment in making the advance and the loss incurred by the​​ assessee was, therefore, a loss on the revenue side and was deductible. [1962] 046 ITR 0649- ​​ CIT vs. Mysore Sugar Co. Ltd. (Supreme Court of India) ​​ 

Amount in question must be 'debt'

In order to fall within section 36(1)(vii), the amount sought to be claimed under that section must be a 'debt'. The question as to what constitutes a debt has been the subject of much legal debate. In CIT v. Basumal Jagat Narain [1960] 38 ITR 447 , the Punjab High Court had occasion to consider the meaning of the term 'debt'. In that case, the ITO had disallowed certain advances made by the assessee earlier and written off as bad debts in the relevant previous year. The assessee, in that case, was a distributor of films and certain sums had been advanced to certain producers against distribution rights in films. The Tribunal came to a finding that the amounts in question became bad in the relevant previous year and allowed the impugned amounts as a deduction.

The department's contention before the High Court was that the amounts in question were not 'debts' due to the assessee. According to the department's contention, the assessee might have been entitled to recover money paid on an existing consideration which afterwards failed but such a debt would come into existence only on the date of the failure of the consideration and not when the assessee paid the money in accordance with the terms of the contract (with the producer).

The High Court stated as under :

". . . A debt is that which one owes to another ; any money, goods or services that one is bound to pay another ; a pecuniary due ; a liquidated demand ; a sum of money due by certain and express agreement. It includes any claim or demand upon which a judgment for a sum of money or directing the payment of money can be​​ recovered in an action. Debt denotes not only the obligation of the debtor to pay but also the right of creditors to receive and enforce payment. To constitute a valid debt, the money must have been advanced with reasonable belief at the time that it would be paid. Evidence of an obligation to repay is the first important factor to be singled out of the surrounding facts and circumstances. For the purposes of taxation, a debt is a legally enforceable obligation for payment of money. In the present case, the assessee advanced certain sums of money to the producers on the clear understanding that this money was to be repaid in accordance with the procedure set out in the body of the agreement. The debts in question continued to be valid debts although they were repayable only in a special way, that is, out of the amounts realised from the exploitation of the picture and not out of the debtor's general funds. These debts were legally recoverable. It is impossible therefore to hold that no valid debt was in existence. In the present case there was an unconditional obligation on the part of the debtor to pay a certain sum of money to the assessee. The debt had an actual existence as a debt both in law and in fact." (p. 453)

Although, such advances cannot be allowed under section 36(1)(vii ) due to the specific provision contained in section 36(2)(i)( a) nevertheless this judgment is important in so far as it deals with the question as to what constitutes a debt.

Year in which debt becomes bad

For claiming deduction under this clause, the assessee must establish that the debt in question has become bad during that year. A mere writing off the debt in the books as bad debts is not sufficient to claim the deduction under this section - CIT v. Khem Chand Bahadur Chand [1982] 134 ITR 65 (Punj.). Their Lordships has observed as under. "A debt becomes bad not because the creditor assessee is treating it as bad at a particular time but because at a particular point of time it was no longer possible to recover the same, as​​ the debtor had no means or assets to repay and the circumstances made it plain that recovery would not be possible - See also T.S. PLP Chidambaram Chettiar v. CIT [1967] 64 ITR 181, 186 (Mad.).

Claim of bad debts if cash system of accounts is followed

Except in the case of a banking company or money-lending business, there can be no allowance for bad debt where cash system of accounting is maintained. In case of money-lending or banking business, a bad debt or an irrecoverable loan is allowed irrespective​​ of the method of accounting adopted by the assessee because in case​​ of money lending, cash is assessee’s stock-in-trade or circulating capital. This view has been taken by their Lordships of the Madras High Court in the case of CIT v. Somasundaram Mills Ltd. [1964] 51 ITR 650, 656. So even though it is not allowable as bad debt, it can be allowed as loss of stock-in-trade.

Time-barred debt

A debt barred by limitation may or may not be a bad debt. It will depend on the facts of each case. In Kantilal​​ Chimanlal Shah v. CIT [1954] 26 ITR 303 (Bom.), their Lordships has observed as under :

"A statute-barred debt is not necessarily bad neither is a bad debt nor statute barred necessarily good. Therefore, the mere fact that a debt had not become time-barred is not conclusive circumstance for holding that it had become bad within the period of limitation."

Debts not incidental to the business are not deductible

Their Lordships of the Supreme Court took the view that if a debt is not incidental to the business, it is not allowable. This view has been taken by their Lordships of the Supreme Court in the case of CIT v. Abdulbhai Abdulkadar [1961] 41 ITR 545 .

Similarly same view has been taken by their Lordships of the Bombay High Court in the case of Indequip Ltd. v. CIT [1993] 202 ITR 417/[1994] 72 Taxman 380. They have observed that the loss for which the deduction is claimed must be one which springs directly from the carrying on of the business and not only loss sustained by the assessee even if it has some connection with his business.

Transferee’s case

Where a firm is reconstituted with one partner of the old firm and the business is continued by partner, then the bad debt of the old firm is allowable in the case of new firm. Their Lordships of the Kerala High Court has observed in the case of CIT v. Oppoottil Agencies [1986] 160 ITR 120 that in case of reconstitution of firm, section 2(23) will have to be considered with section 187(2). Thus, it was held in that case that reconstituted firm can claim the bad debts of old firm.

Dues from retiring partner

Dues from retiring partner are of capital nature and non-recovery thereof is not to be allowable as bad debt - Girdharilal Gianchand v. CIT [1971] 79 ITR 561 (All.). Their Lordships has observed that,​​ ‘debts due from retiring partners are capital sums and the loss of such amounts could not be written off against the profit of the year in which they were written off and claimed as bad debts’.

Advances to employees

Advances to employees are not allowable. This would not be a loan in the ordinary course of business. Even if pro-note is obtained subsequently, it would not alter the nature of transaction. InV. Ramaswami Ayyanger v. CIT [1950] 18 ITR 150 , their Lordships of the Madras High Court has observed that "In order to enable the money - lender to write-off a debt as a bad debt or irrecoverable debt, he must prove that it was a loan and not advance or overdrawing of an employee".

Overdrawings by partner

When a partner overdraws his account and does​​ not pay the overdrawn sum, then as it is a ‘loan’, the claim is not allowable - CIT v. Kanitram Hazarimal [1969] 72 ITR 853 (Cal.).

Embezzlement by employee

This is not allowable as bad debt as it is not a loan. It may be allowable under different​​ sections but cannot be allowed as bad debt - Loras Dairy Farm Ltd. v. CIT [1955] 27 ITR 700 (Bom.). Their Lordships has observed that ‘loss caused by defalcations of an employee is not a bad debt’ :

"If loss springs from his duties as employee, then it would be a trading loss and the assessee would be entitled to claim that amount as a proper deduction."

Filing of insolvency petition

Merely launching insolvency petition does not mean that the debt is bad - M.L. Dahanukar & Co. (P.) Ltd. v. CIT [1968] 68​​ ITR 533 (Bom.) : "The Court can only look at the true circumstances of the case up to the time when he wrote off the debt and cannot look at the subsequent events."

Illegal business

If illegal income can be taxed, then bad debts arising from this business is allowable - CIT v. R.B. Rungta & Co. [1963] 50 ITR 233 (Bom.). Their Lordships has observed as under : "That the legal unenforceability of the assessee’s claim did not prevent the amounts from being bad and irrecoverable debts for the purpose of the computation of taxable income of assessee and, therefore, claim is allowable."

Remission

Remission is allowable. It has been observed by the Court that if full claim is allowable, then logically part of claim should be allowed - Sitapore Sugar Works Ltd.​​ v. CIT [1954] 25 ITR 548 (Pat.) (page 2).

Bad debts of banks

Under section 36(viia ) of the Income-tax Act, special treatment for allowing bad debts to banks is given. Under this section from April 1, 2003 if certain conditions are satisfied, then 10 per​​ cent of the total income computed before making any deduction under Chapter VI-A would be allowed and an amount not exceeding 10 per cent of the aggregate average advances made by the rural branches of the such bank shall be allowed. The aggregate average​​ advances will be calculated according to rule 6ABA.

Premature claim repeatable for a subsequent year

When an assessee claims a debt having been rendered irrecoverable in a particular year and the Assessing Officer finds that the claim is premature, then​​ the decision of the Officer operates only for that year. It would be open to repeat the claim in any subsequent year, and if the Assessing Officer then finds that the debt has been rendered irrecoverable in that particular year, he has to allow the claim,​​ provided the debt has not been recovered during the interval - Rulia Mal Raunak Ram v. CIT [1934] 2 ITR 329 (Lahore) and Munnalal Biharilal v. CIT [1956] 30 ITR 809 (Nag.).

Write off essential

Under section 36(2)(vii ) the bad debt would be allowed if​​ it is ‘written off’ in the accounts of the assessee as irrecoverable. If it is not written off, then the claim would not be allowed.

No particular form or manner of writing off a bad debt has been prescribed or provided for. According to the Dictionary for Accountants by Eric L. Kohler, 5th Edition, page 497, the expression ‘write off’ means ‘to transfer the balance of an account previously regarded as an asset to an expense account or to profit and loss account’. All that the definition of Kohler shows is​​ that an account which was previously shown as an asset must be transferred to an expense account or the profit and loss account’. It is not essential that the debtor’s individual account should be squared off by an appropriate credit entry. Even if the credit is made in a ‘bad debt reserve account’ against debit to the profit and loss account indicating that the entry refers to amounts due by the particular debtor or debtors, the writing off is complete - Vithaldas H. Dhanjibhai Bardanwala’s case (supra).​​ Their Lordships of the Gujarat High Court has taken a view that when the assessee has posted entries in the profit and loss account and corresponding entries are posted in the bad debts reserve account, then that would be sufficient compliance to claim that debt as bad debt. No further requirement can be spelt out from the express language used by the Legislature. Similarly their Lordships of the Supreme Court has stated as under :

"If for some adequate reasons the taxpayer has not posted an entry and there is reasonable explanation for the default, absence of entry in writing off of an amount of debt which has become bad or doubtful which may be posted at any time at appropriate place in the books of account before the proceedings are concluded before the​​ authorities."

This provision has been explained by Circular of C.B.D.T No. 421, dated 12-6-1985/[1985] 156 ITR 141 (ST) as under :

"In order to eliminate the disputes in the matter of determining the year in which a bad debt can be allowed and also to rationalize the provisions, the Amending Act, 1987 has amended clause (vii) of sub-section (1) and clause (i) of sub-section (2) of the section to provide that the claim for the bad debt will be allowed in the year in which such a bad debt has been written off as irrecoverable in the accounts of the assessee."

Similarly if the assessee has debited a debt as irrecoverable in his profit and loss account, crediting it not to debtor’s personal ledger account but to a new doubtful debt suspense account writing off cannot be said to be defective - CIT v. EPT Jwale Prasad Tewari [1953] 24 ITR 537 (Bom.). But under the 1961 Act, the writing off has been incorporated in the section itself whether this observation is applicable or not is a doubtful proposition.

Advances made for securing raw materials

On many occasions advances are made for business and if they are not recoverable then they are allowable. Their Lordships of the Calcutta High Court has observed in the case of CIT v. Rohtas Industries Ltd. [1979] 120 ITR 110, 113 that such advances are in the nature of trade debts to be realized by the assessee from its suppliers and, therefore, the claim was allowed.

Surety debts​​ 

A businessman may have to stand surety for some one in order to get monies for his own business. There may be a custom of the business by which that may be the only method whereby he could get money for the purpose of his own business.​​ If he is to discharge a surety debt and if any such custom is established, it would be a business debt. If the assess has made a payment, not voluntarily but to discharge a legal obligation which arises from his business, he would be entitled to have the amount deducted as a bad debt - CIT V/s. Birla Bros. (P) Ltd.​​ 

The respondent, a private company, carried on​​ the business of banking and financing and also of managing agency. Starch Products Ltd., was one of the various companies managed by the respondent. Starch Products Ltd., had appointed a selling agent and the respondent stood guarantee for a loan of Rs. 6​​ lakhs which was advanced by a bank to the selling agent of the managed company. The selling agent failed to pay the loan which at the relevant time stood at Rs. 5,60,199. This amount was paid by the respondent pursuant to the guarantee and, thereafter, the​​ respondent treated the selling agent as its debtor for the amount. The selling agent went into liquidation and the respondent, not being able to recover any part of that amount, wrote off the sum of Rs. 5,60,199 in its accounts and claimed deduction thereof as a bad debt. Neither the memorandum of association of the respondent, nor the managing agency agreement contained any provision whereby it could be said that the guaranteeing of the loan to the selling agent was done in the course of the managing agency business. Nor was there even material to show that the managed-company was under any legal obligation to finance the selling agent or to guarantee any loans to the selling agent. Held on the facts, that the sum of Rs. 5,60,199 was not allowable as a bad​​ debt. The guaranteeing of the loan could not be said to have indirectly facilitated the carrying on of the respondent's business. Nor could it be said that it was in the larger interests of the respondent's business that the guarantee was given. [1970] 077 ITR 0751- ​​ CIT vs. Birla Bros. Pvt. Ltd. (Supreme Court of India)

Embezzlement losses​​ 

A debt arises out of a contract between the parties, express or implied, and when an agent misappropriates monies belonging to his employer by fraud or in breach of​​ his obligations to him it cannot be said that he owes these monies under an agreement.​​ He is no doubt liable in law to make good that amount, but that is not an obligation arising out of a contract, express or implied. Nor does it make a difference that in​​ the accounts of the business the amounts embezzled are shown as debits, the amounts realised towards them if any are shown as credits, and the balance is finally written off. They are merely journal entries adjusting the accounts and do not import a contractual liability. The amounts would therefore not be deductible as bad debt - Badridas Daga V/s. CIT [1958] 34 ITR 10 (SC).

Entitlement to successor to business​​ 

The expression ‘assessee’ in section 36(2)(i)(a) does not require as a statutory condition that the identity of the assessee both at the time when the debt comes into being and at the time when the debt becomes bad and is claimed as bad, should be the same.​​ If the business is continued right through without any break, some change merely occurring​​ in the persons carrying on the business, then the identity of the business as well as the debt to the incorporated in the accounts of the business would not get lost, and the provisions of section 36(2)(1)(a) will have to be regarded as fully complied with​​ - CIT V/s. T.Veerabhadra Rao K. Koteswara Rao & Co. [1985] 155 ITR 152 (SC).

Accounts of debtors need not be squared​​ 

Under section 36 it is clear that before any claim for allowance for a bad debt is held established by the Income-tax Officer it must​​ appear that the concerned bad debt was written off as irrecoverable in the account books of the assessee for the relevant previous years. This requirement has become a condition for the grant of claim for bad debt allowance. The requirement of section 36(2) is that the concerned bad debt must have been written off as irrecoverable in the accounts of the assessee.​​ If the debit entries posted by the assessee indicate the said fact the requisite statutory condition has got to be treated as fully complied with.​​ Once the assessee has posted entries in the profit and loss account and corresponding entries are posted in the bad debt reserve account that would be sufficient compliance with the provisions of the statutory requirement for writing off as irrecoverable​​ the concerned debt in the books of the assessee. No further requirement can be spelt out from the express language used by the Legislature. It is not necessary that the assessee must also post corresponding entries in the ledger account of the concerned parties and should close those accounts. [1981] 130 ITR 0095- ​​ Vithaldas H. Dhanjibhai Bardanwala vs. CIT (Gujarat High Court).​​ In other words It is not​​ necessary that the assessee must also post corresponding entries in the ledger account of the concerned parties and should close those accounts

Guarantee debt - allowable

[1970] 077 ITR 0751- ​​​​ CIT vs. Birla Bros. Pvt. Ltd. (Supreme Court of India) The respondent, a private company, carried on the business of banking and financing and also of managing agency. Starch Products Ltd., was one of the various companies managed by the respondent. Starch Products Ltd., had appointed a selling agent and the respondent stood guarantee for a loan of Rs. 6 lakhs which was advanced by a bank to the selling agent of the managed company.​​ The selling agent failed to pay the loan which at the relevant time stood at Rs. 5,60,199. This amount was paid by the respondent pursuant to the guarantee and, thereafter, the respondent treated the selling agent as its debtor for the amount. The selling agent went into liquidation and the respondent, not being able to recover any part of that amount, wrote off the sum of Rs. 5,60,199 in its accounts and claimed deduction thereof as a bad debt.​​ 

Neither the memorandum of association of the respondent, nor the managing agency agreement contained any provision whereby it could be said that the guaranteeing of the loan to the selling agent was done in the course of the managing agency business. Nor was there even material to show that the managed-company was under any legal obligation to finance the selling agent or to guarantee any loans to the selling agent. Held on the facts, that the sum of Rs. 5,60,199 was not allowable as a bad debt.​​ The guaranteeing of the loan could not be said to have indirectly facilitated the carrying on of the respondent's business. Nor could it be said that it was in the larger interests of the respondent's business that the guarantee was given.

Capital advances write off – Not allowed

​​ The Delhi High Court in CIT v.​​ R.G. Scientific Enterprises (P.) Ltd. [2008] 166 Taxman 161 held that​​ non recovery of sums advanced for purchase of premises would constitute a capital loss and not a business loss.​​ In a recent decision of Chennai Tribunal in Kwality Fun Foods & Restaurants (P.) Ltd. v. Dy. CIT [2007] 108 ITD 274, the assessee had paid advance for erection of plant. However, the work could not be executed due to some reasons. He, thus, recovered part amount and the balance he wrote off as business loss. The Tribunal held such loss as capital in nature. Even it did not allow such loss as bad debt. ​​ The decision of the Supreme Court in Swadeshi Cotton Mills Co. Ltd. v. CIT [1967] 63 ITR 65 goes to hold that a payment made with the object of avoiding an unnecessary investment​​ in capital assets will be in the nature of a capital expenditure. Also the Delhi High Court, in Edward Keventer(s) (P.) Ltd. v. CIT [1971] 81 ITR 126, held that the​​ payment made for the purpose of getting rid of a permanent disadvantage or onerous liability arising with regard to the lease of land which was a permanent asset of the business would a have capital character.