Writing of Bad Debts: Commercial judgment given primacy

One of the recent controversies in income tax is related to the treatment of bad debts. Does an assessee have to prove, as a matter of fact, that a debt has become irrecoverable before it can be written off as a bad debt; or is it enough if the debt is written off as bad in the books of account? The Supreme Court has settled the question of law in favour of the assessee, by preferring the latter interpretation.

Prior to 1989, the relevant provision in the Income Tax Act, Section 36(1)(vii), allowed deductions of “any bad debt, or part thereof, which is established to have become a bad debt in the previous year…” The 1989 amendment replaced this with “any bad debt, or part thereof, which is written off as irrecoverable in the account of the assessee for the previous year…” The intent of the legislature – it appears clear from the amendment – was to respect the commercial judgment of the assessee in treating a debt as ‘bad’ in the books of account; without the assessee having to establish that the debt was in fact irrecoverable.

This reading of the amendment was preferred by the Special Bench of the Income Tax Appellate Tribunal in DCIT v. Oman International Bank. This was then approved by the Bombay High Court in DIT v. Oman International Bank, with the caveat that the entry in the books of account must be bona fide. The issue was then considered in CIT v. Kohli Brothers by the Allahabad High Court. As ITAT online reports in a summary of that case, the High Court held that “The effect of the amendment to s. 36 (1) (vii) is that it is not necessary for the assessee to establish that the debt had become bad in the previous year and mere writing of the debt as irrecoverable is sufficient. However, the said entry of write off of the bad debt in the books of accounts is not conclusive and the AO is not precluded from making inquiries as to whether the entries are genuine and not imaginary or fanciful. The AO has the power u/s 143(2) to see that the entries are not mere paper work or fake…” Thus, while the entries in the books of account are enough to suggest that prima facie there is a bad debt; the AO can go behind those entries to see if the debts are actually bad. One reading of the Allahabad High Court would be to suggest that the High Court held that the 1989 amendment only shifted the burden of proof; and did not change the position substantively. The Bombay High Court’s judgment in Oman seems to support this reading, as the Court has stated that after the 1989 amendment, the burden is not on the assessee to show the debt is “bad”. In order to disallow the deduction, the AO must show that the decision of the assessee was not bona fide. Again, this can be treated as going to the issue of burden of proof.

In TRF Ltd. v. CIT, the Supreme Court seems to have rejected this reading. The Court has clarified, “After 1^st April, 1989, it is not necessary for the assessee to establish that the debt, in fact, has become irrecoverable. It is enough if the bad debt is written off as irrecoverable in the accounts of the assessee.” Arguably, even an enquiry into the reasons behind the entry is not to be undertaken after the Supreme Court decision. This is because the decision to treat a debt as bad or not is a purely subjective commercial decision for the assessee in question to take. The fact that no further enquiries are to be made gets further support as the matter was remanded by the Supreme Court to the AO to consider solely whether the requisite entry appeared in the books of account. The Court has not left open the possibility to the AO to go behind the entry to ascertain the genuineness thereof. In the words of the Court, “… in the present case, the Assessing Officer has not examined whether the debt has, in fact, been written off in accounts of the assessee. When bad debt occurs, the bad debt account is debited and the customer's account is credited, thus, closing the account of the customer. In the case of Companies, the provision is deducted from Sundry Debtors. As stated above, the Assessing Officer has not examined whether, in fact, the bad debt or part thereof is written off in the accounts of the assessee. This exercise has not been undertaken by the Assessing Officer. Hence, the matter is remitted to the Assessing Officer for de novo consideration of the above-mentioned aspect only and that too only to the extent of the write off.”

For another reading of Kohli Brothers, reconciling it with Oman, see this post on Indian Corporate Law. Following the Supreme Court judgment, Kohli Brothers must be restricted to this reading or must be considered as being impliedly overruled. If Kohli Brothers is given a restricted scope, the position then would be, as noted in the above post, “Oman and Kohli Brothers can be reconciled on the basis that the first allowed the deduction since the persons with respect to whom the debt was written off were known, while Kohli Brothers did not because the assessee furnished no information whatsoever as to the identity of the persons involved. This is also consistent with the principle that commercial judgment is relevant in determining when a debt is considered “bad”, not in determining whether there exists a person who owes a debt.” This harmonious reading would not be affected by the Supreme Court decision in TRF; as the Court is quite clear that the identity of the debtor should be evident in the books (this is clear from references to “the customer’s account”). In other words, the entry can be treated as not being bona fide only if even the identity of the alleged debtor is not shown in the books of account. If the identity is shown, the entry would be bona fide and the decision to treat the debt as bad would be a matter left for commercial judgment.

In sum, the judgment of the Supreme Court in TRF clarifies that the decision to treat a debt as bad is a commercial decision to be taken by the assessee; and the scope for interference with the judgment is almost non-existent.