Supreme Court of India
MIS. SOUTHERN TECHNOLOGIES LTD.versusJOINT COMMISSIONER OF INCOME TAX, COIMBATORE
- Citation
- 2010 INSC 28
- Decided
- 11 January 2010
- Disposal
- Dismissed
- Bench
- S H KAPADIA
Holding
RBI Directions 1998 are disclosure norms that do not render the provision for NPA an income under s.2(24) nor a deductible expense under s.36(1)(vii); therefore, the provision must be added back and the appeals are dismissed.
Summary
The case concerned whether a Non‑Banking Financial Company (NBFC) could treat the "Provision for NPA" debited to its profit‑and‑loss account, as required by RBI Directions 1998, as income under s.2(24) of the Income Tax Act or claim a deduction under s.36(1)(vii). The Supreme Court held that the RBI Directions are merely prudential disclosure norms dealing with balance‑sheet presentation and do not affect the computation of taxable income; the provision is a notional expense, not an allowable deduction, and must be added back. Consequently, the provision cannot be claimed as a deduction and the appeals filed by the NBFCs were dismissed. The Court also upheld the constitutional validity of s.36(1)(viia) and s.430, finding no violation of Articles 14 or 19(1)(g).
Issues considered
- The nature of the "Provision for NPA" under RBI Directions 1998 – whether it constitutes income under s.2(24) of the Income Tax Act.
- Whether the provision is deductible under s.36(1)(vii) of the Income Tax Act.
- The applicability of s.36(1)(viia) and s.430 to NBFCs and their constitutional validity under Articles 14 and 19(1)(g).
- The relevance of Section 145 of the Income Tax Act in relation to RBI Directions.
Legislation cited
- Companies Act, 1956s. Schedule VI
- Income Tax Act, 1961s. 145, s. 2(24), s. 36(1)(vii), s. 36(1)(viia), s. 430, s. 43D, s. 450
- Reserve Bank of India Act, 1934s. 45JA
Subjects
Provision for NPARBI Directions 1998NBFCIncome Tax ActSection 36(1)(vii)Section 36(1)(viia)Section 430Article 14real income theoryadd backconstitutional validity
Judgment
(2010) 1 S.C.R. 380
A MIS. SOUTHERN TECHNOLOGIES LTD.
v.
JOINT COMMISSIONER OF INCOME TAX, COIMBATORE
(Civil Appeal No. 1337 of 2003)
JANUARY 11, 2010
B
[S.H. KAPADIA AND AFTAB ALAM, JJ.]
Income Tax Act, 1961:
c s.2(24) - Provision for NPA - Debited by NBFC to the
P&L Account - In terms of Para 9(4) of the RBI Directions
1998 - Whether the provision for NPA to be treated as income
under s.2(24) of the Act- Held: RBI directions· deal with the
presentation of the provision for NPA in the Balance Sheet
0 of NBFC - The Directions are only disclosure norms and are
not related with the computation of total taxable income under
IT Act or with the accounting treatment - Not to be treated as
"income" under s. 2(24) of the Act - RBI Directions 1998 -
Para 9(4).
E s.36(1)(vii) - Provision for NPA debited to the P&L
Account by NBFC in terms of RBI Directions 1998 - Claim
for deduction under s.36(1)(vii) - Entitlement for - Held: Not
entitled as the provision does not constitute expense.
F s.36(1)(viia) and s.43D - Different treatment for NBFC
and banks for deduction under s.36(1)(viia) and s.43D -
Constitutional validity of - Held: s. 36(1 )(viia) provides for
deduction not only in respect of "written off' bad debt but in
case of banks it extends the allowance also to any Provision
G for bad and doubtful debts made by banks which incentive is
not given to NBFCs - Banks face a huge demand from the
industry and at times 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
1-1 380
SOUTHERN TECHNOLOGIES LTD. v. JOINT COMMNR. 381
OF INCOME TAX, COIMBATORE
banks undertake, that allowances of the nature mentioned in A
s.36(1)(viia) and 43D are often restricted to banks and not to
NBFCs - Neither s.36(1)(viia) nor s.43D violates Article 14 -
The test of "intelligible differentia" stands complied with -
Constitution of India, 1950 - Article 14, 19(1)(g).
B
RBI Directions 1998:
Scope and applicability of - Discussed.
Para 9(4) - Analysis of - Held: RBI directions deal with
the presentation of provision for NPA in the Balance Sheet C
of NBFC - The Directions do not recognize the "income"
under the mercantile system - IT Act and the 1998 Directions
operate in different fields - The primary object of 1998
Directions is prudence, transparency and disclosure - The
basis of 1998 Directions is that anticipated losses must be o
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 - The nature of expenditure ·
under the IT Act cannot be conclusively determined by the E
manner in which accounts are presented in terms of 1998
Directions - RBI Directions 1998, though deviate from
accounting practice as provided in the Companies Act, do not
override the provisions of the IT Act - Income Tax Act, 1961
- Companies Act, 1956.
F
The question which arose for consideration in these
appeals filed by Non-Banking Financial Companies
(NBFC) is whether the "Provision for NPA", which in
terms of RBI Directions 1998 is debited to the P&L
Account is to be treated as "income" under Section 2(24) G
of the Income Tax Act, 1961 while computing the profits
and gains of the business under Sections 28 to 430 of
the Act.
Dismissing the appeals, the Court H
382 SUPREME COURT REPORTS [201 O] 1 S.C.R.
A HELD: 1.1. The RBI Directions 1998 deal with
Presentation of NPA provision in the Balance Sheet of an
NBFC. By Para 9 of 1998 Directions, RBI mandated that
every NBFC should disclose in its Balance Sheet, the
Provision without netting them from the Income or from
B the value of the assets and that the provision should 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
C such provision for each year should be debited to P&L
Account so that a true and correct figure of "Net Profit"
gets reflected in the financial accounts of the company.
The effect of such Disclosure is to increase the current
liabilities by showing the provision against the possible
Loss on assets classified as NPA. An NPA continues to
0
be an Asset - "Debtors/ Loans and Advances" in the
books of NBFC. 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
E accounting concepts. [Paras 6 and 7] [420-E; 421-B-F]
1.2. 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
F increase in the public making deposits in NBFCs. Hence
the object of the NBFC is disclosure and provisioning. 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
G 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
H to Section 36(1)(vii). Consequently, after 1.4.1989, a mere
SOUTHERN TECHNOLOGIES LTD. v. JOINT COMMNR. 383
OF INCOME TAX, COIMBATORE
provision for bad debt would not be entitled to deduction A
under Section 36(1 )(vii). 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 B
' 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 doubtful debt. In the latter case, assessee would not
be entitled to deduction after 1.4.1989. [Paras 7 and 8) c
[421-G-H; 422-D-H; 423-A]
Commissioner of Income Tax v. Jwala Prasad Tewari 24
ITR 537, relied on.
Vithaldas H. Dhanjibhai Bardanwala v. Commissioner of D
Income-Tax, Gujarat-V 130 ITR 95; Commissioner of
Income-Tax v. Woodward Governor India P. Ltd., 312 ITR
254; Commissioner of Income-tax, A.P. v. T. Veerabhadra
Rao K. Koteswara Rao & Co. 155 ITR 152, referred to.
E
2.1. The three deviations between RBI directions 1998
and Companies Act, are: in the matter of presentation of
financial statements under Schedule VI of the Companies
Act; in not recognising the "income" under the
mercantile system of accounting and iis insistence to
F
follow cash system with respect to assets classified as
NPA as per its Norms; and 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 G
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 H
384 SUPREME COURT REPORTS [201 OJ 1 S.C.R.
A not recognize "income from NPA" and, therefore, directs
a Provision to be made in that regard and hence an "add
back. The "add back" is there only in the case of
provisions. The Companies Act allows an NBFC to adjust
a Provision for possible diminution in the value of asset
B 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
C Sheet, i.e., under the Head "current liabilities and
provisions". The purpose of the said deviation is to
inform the user of the Balance Sheet, the particulars
concerning quantum and quality of the diminution in the
value of investment and particulars of doubtful and sub-
D 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. 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
E Directions operate in different fields. Under the mercantile
system of accounting, interest I 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
F 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. [Para 9] [424-C-H; 425-B-F]
G 2.2. RBI Directions 1998 were issued under Section
45JA of RBI Act. The primary object of the said 1998
Directions is prudence, transparency and disclosure. The
basis of the 1998 Directions is that anticipated losses
must be taken into account but expected income need
H not be taken note of. Therefore, these Directions ensure
SOUTHERN TECHNOLOGIES LTD. v. JOINT COMMNR. 385
OF INCOME TAX, COIMBATORE
cash liquidity for NBFCs which are now required to state A
true and correct profits, without projecting inflated profits.
The nature of expenditure under the IT Act cannot be
conclusively determined by the mariner in which
accounts are presented in terms of 1998 Directions. RBI
Directions 1998, though deviate from accounting practice B
as provided in the Companies Act, do not override the
provisions of the IT Act. [Para 10) [426-A-E]
2.3. Provision for NPA in terms of RBI Directions 1998
does not constitute expense on the basis of which C
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). One must keep in mind another aspect. D
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. If one keeps these E
concepts in mind, it becomes 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 oi expense to be F
decided by the AO in the assessment proceedings. [Para
10) [428-B-F]
Advance Accounts by Shukla, Gravel, Gupta, referred
to. G
2.4. "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. H
386 SUPREME COURT REPORTS [2010] 1 S.C.R.
A There is a clear distinction between the real profits and
statutory profits. The latter are statutorily fixed for a
specified purpose. 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
B 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. A provision for NPA debited to P&L
Account under the 1998 Directions is only a notional
c expense and, therefore, there would be add back to that
extent in the computation of total income under the IT Act.
Under Section 36(1 )(vii) read with the Explanation, a "write
off' is a condition for allowance. [Para 11] [429-A-B-E-G;
430-D]
D Poona Electric Supply Co. Ltd. v. Commissioner of
Income-Tax, Bombay City I, 57 ITR 521; Commissioner of
Wealth- Tax, Bombay v. Bombay Suburban Electric Supply
Ltd. 103 ITR 384, relied on.
E 2.5. 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
F 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
G 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. [Para
14] [432-C-F]
H 3. Section 430 is similar to Section 438. The reason
SOUTHERN TECHNOLOGIES LTD. v. JOINT COMMNR. 387
OF INCOME TAX, COIMBATORE
for enacting this Section is that interest from bad and A
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 B
Section 430 to provide that such interest shall be
charged to tax only in the year of receipt or the year in
which it is credited to the P&L Account, whichever is
earlier. In the context of Article 14 of the Constitution, the
test to be applied is that of "rational/ intelligible c
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, the RBI Directions/ Norms. On the other hand,
0
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. An asset is rated as NPA when over
a period of time it ceases to get converted to cash or E
generate income and becomes difficult to recover.
Therefore, Parliament realized that taxing such "income"
on accrual basis without actual recovery would create
liquidity crunch, hence, Section 430 came to be enacted.
Section 36(1)(viia) provides for a deduction not only in
respect of "written off'' bad debt but in case of banks it F
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 G
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 430 are often restricted to banks and not H
388 SUPREME COURT REPORTS (2010] 1 S.C.R.
A to NSFCs. 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. Neither Section 36(1)(viia) nor Section 430
violates Article 14. The test of "intelligible differentia"
B stands complied with. [Paras 15 and 16] (432-G-H; 433-
A-B; 434-8-H; 435-A-C]
R.K. Garg v. Union of India (1981) 4 SCC 675; Bhavesh
D Parish v. Union of India, (2000) 5 SCC 471; State of
Madras v. V.G. Row 1952 SCR 597, relied on.
c
Barclays Mercantile Business Finance Ltd. v. Mawson
(Inspector of Taxes), 2005 (1) All ER 97, referred to.
Case Law Reference:
D 130 ITR 95 referred to Para 3
312 ITR 254 referred to Para 4
155 ITR 152 referred to Para 8
E 24 ITR 537 relied on Para 8
57 ITR 521 relied on Para 11
103 ITR 384 relied on Para 11
(1981) 4 sec 675 relied on Para 11
F
(2000) 5 sec 471 relied on Para 16
1952 SCR 597 relied on Para 16
2005 (1) All ER 97 referred to Para 16
G
CIVIL APPELLATE JURISDICTION : Civil Appeal No.
1337 of 2003.
From the Judgment & Order dated 23.1.2002 of the High
Court of Judica~ure at Madras in Tax Case (Appeal No. 1 of
H 2002).
SOUTHERN TECHNOLOGIES LTD. v. JOINT COMMNR. 389
OF INCOME TAX, COIMBATORE
WITH A
Crl. Appeal No. 154 of 2010 T.C. 5 & 6 of 2005.
Vivek Tankha, ASG, Arvind Datar, Dr. Debi Prosad Pal,
Radha Rangaswamy, Pritesh Kapur, J. Balachander, K.V.
8
Mohan, Ananda Sen, Dayan Krishnan, N.L. Rajah, Gautam
Narayan, Nikhil Nayyar, Lakshmi Iyengar, Ashok K. Srivastava,
Arijit Prasad, C.V. S. Rao, B.V. Balaram Das for the appearing
parties.
The Judgment of the Court was delivered by c
S.H. KAPADIA, J. 1. Leave granted in the Special Leave
Petition.
2. Introduction
D
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 E
for NPA", which in terms of RBI Directions 1998 is debited
to the P&L Account, as "income" under Section 2(24) of
the Income Tax Act, 1961 ("IT Act" for short}, while
computing the profits and gains of the business under
Sections 28 to 43D of the IT Act?"
F
3. 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 2b03]. G
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 arfc:J .the Balance Sheet are drawn as on 30th H
390 SUPREME COURT REPORTS [2010] 1 S.C.R.
A June. ·r he 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
B 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
C Account on three counts, viz., Hire-Purchase of Rs . 57,38,980/
-, Bill Discounting of Rs. 12,79,500/- 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/-.
D
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
E 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.
F 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 Vitha/das 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.
G 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.
H
SOUTHERN TECHNOLOGIES LTD. v. JOINT COMMNR. 391
OF INCOME TAX, COIMBATORE [S.H. KAPADIA, J.]
A
4. Submissions
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 B
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)(ilii) of the IT Act. The appellant
claimed that the "Provision for NPA", however, represented c
"loss" in the value of assets and Jvas, 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 D
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. E
As per the said method of accounting, the "Provision for NPA"
actually represented depreciation in the value of the assets and,
consequently, it is deductible under Section 37(1) of the IT Act.
In this connection, appellant placed reliance on the judgment
of this Court in Commissioner of Income-Tax v. Woodward F
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 G
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
H
392 SUPREME COURT REPORTS [2010] 1 S.C.R.
A 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
B 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
C 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 a regulator wants NBFCs who accept deposits from the
public to provide for a possible loss. The RBI Directions 1998
D 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
E 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.
F 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
G 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
H can accept deposits. According to the Department, vide RBI
SOUTHERN TECHNOLOGIES LTD. v. JOINT COMMNR. 393
OF INCOME TAX, COIMBATORE [S.H. KAPADIA, J.]
Directions 1998, RBI tries to bring out the Profit in the P&L A
Account after providing for NPA which profit will be the
minimum profit that the company would make so that the real
or true and correct profit earned by an NBFC shall not be
anything lesser than what is disclosed. According to the
Department, the said "Provision for NPA" is in substance a B
"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 - C
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 D
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 E
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 deals with computation of total F
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 G
India (ICAI). It is the 1998 Directions which inter a/ia states that
NBFC shall not recognize any iq_come 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 H
394 SUPREME COURT REPORTS [2010] 1 S.C.R.
A 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
B 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,
C 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 recognise
income from NPA but it shall create a provision by debit to the
D 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
E 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
450 of the RBI Act). Therefore, according to the Department,
F inconsistency in terms of Section 450 of the RBI Act is only
with respect to the Compariies 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
G that Section 450 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
H intention of Section 450 of the IT Act. That, the said 1998
SOUTHERN TECHNOLOGIES LTD. v. JOINT COMMNR. 395
OF INCOME TAX, COIMBATORE [S.H. KAPADIA, J.]
Directions cannot be taken as an excuse by the NBFC to A
compute lower taxable income under the IT Act.
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 B
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 c
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 0
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
E
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 F
Department. According to 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. G
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. H
396 SUPREME COURT REPORTS [2010) 1 S.C.R.
A 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
B 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
c of the IT Act, entitled to deduction. According to the appellant(s),
Section 451A of the RBI Act defines "NOF". The Explanation (I)
to the said Section defines "NOF" as the aggregate of paid-
up equity capital and free reserves. According to the
appellant(s), if "Provision for NPA" is treated as reserve, it
D 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
/E created by all NBFCs under Section 451C, 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
F "provision" and "reserve":
S.No. Provision Reserve
1. Provision is a charge or Reserve is an appropriation
debit to the P& L of profits.
G Account.
2. Provision is made No reserve can be created
against gross receipts in in accounting year when
the P & L Ale irrespec- there is a loss.
tive of whether there is
H profit or loss.
SOUTHERN TECHNOLOGIES LTD. v. JOINT COMMNR. 397
OF INCOME TAX, COIMBATORE [S.H. KAPADIA, J.]
Provisions are a pretax Reserves are created out of
A
charge to P & L account post-tax profits, by way of
irrespective of whether appropriation, subject to
the NBFC makes a net there being adequate net
profit or not. profit.
B
3. If NPA is Rs. 10 lakhs, If NPA is Rs. 10 lakhs, and
then the accounting entry there is a loss, no "Reserve
is: can be created.
P&L Ale Dr. 10,00,000
To Prov. for c
NPA 10,00,000
If there is a loss, the
debit of Rs. 10,00,000/-
will increase the quantum
of loss. This aggregate
D
loss will be shown on the
assets side as debit
balance of P&L Ale.
4. Provision is based on a Reserves are based on a
one-stage entry: two stage accounting
P&L Ale Dr. process under the horizontal E
To Prov. for system. If the profits are Rs.
Excise/ PF/ Gratuity/ etc. 10 crores, the Board of
Directors may transfer Rs. 8
crores to P&L Appropriation
Ale for taxation, dividend and F
reserve. The balance will be
transferred to credit balance
of P&L Ale. The entries will
be as follows:-
G
Stage 1:
P&L Ale Dr. 10.00
To P&L
H
398 SUPREME COURT REPORTS [2010] 1 S.C.R.
A Appropriation Ale 8.00
To P& L Ale 2.00
Stage 2:
P&L Appropriation Ale 8.00
To Prov. Taxation 4.00
B
To Prov. for Dividends 2.00
To Transfer to Reserve 2.00
Thus, if there are no profits,
there can be no debit to the
c 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.
D
5. Under Clause 7(1)(a) of Under Clause 7(1 )(b) of Part
Part- Ill of Schedule VI - Ill of Schedule - VI of
of Companies Act, 1956 Companies Act, 1956 -
- provision, inter alia, reserve does not include
E is to provide for depre- any amount written off or
ciation, renewals or retained by providing for
diminution in value of depreciation, renewals, etc.
assets or to provide or providing for any known
for any taxation. liability. Under Part - I of
F Schedule .i- VI, 'reserve' can
be made in respect of
capital reserves, capital
redemption, share premium,
etc.
G 5. Provision cannot be Reserves can be utilized to
used to declare dividend pay dividends/ bonus,
etc. unless there is a statutory
bar.
H
SOUTHERN TECHNOLOGIES LTD v. JOINT COMMNR. 399
OF INCOME TAX, COIMBATORE [S.H. KAPADIA, J.]
Lastly, on the question of adding back to the taxable A
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. B
The IT Act 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 c
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 o
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, E
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 all,owable as a loss under Section
37(1) of the IT Act.
F
5. Relevant Provisions
(a) Of RBI Act, 1934
Chapter l/IB - PROVISIONS RELATING TO NON-
BANKING INSTITUTIONS RECEIVING DEPOSITS G
AND FINANCIAL INSTITUTIONS
Section 451 - Definitions
In this Chapter, unless the context otherwise requires,- H
400 SUPREME COURT REPORTS [2010) 1 S.C.R.
A (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
B 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
c 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;
D (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-
E 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
F 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
G
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 disbursing
monies in any other way, to persons from whom monies
are collected or to any other person,
H
SOUTHERN TECHNOLOGIES LTD. v. JOINT COMMNR. 401
OF INCOME TAX, COIMBATORE [S.H. KAPADIA, J.]
A
but does not include any institution, which carries on as its
principal business,-
(a) agricultural operations; or
(aa) industrial activity; or B
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);
c
(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
0
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
E
*** *** ***
Explanations.-For the purposes of this section,-
(1) "net owned fund" means-
F
(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 G
(b) further reduced by the amounts representing-
(1) investments of such company in shares of- (i) its
subsidiaries; (ii) companies in the same group; (iii) all other H
402 SUPREME COURT REPORTS [2010] 1 S.C.R.
A 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,-
B (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.
c
45-/C. Reserve fund
(1) Every non-banking financial company shall create a
reserve fund the transfer therein a sum not less than twenty
D 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
E 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
F sufficient cause being shown, extend the period of twenty-
one day~ 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
G
the Bank and having regard to the a~uacy of the paid-
up capital and reserves of a non-ba~ fiRancial
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-banking financial company for
H
SOUTHERN TECHNOLOGIES LTD. v. JOINT COMMNR. 403
OF INCOME TAX, COIMBATORE [S.H. KAPADIA, J.]
such period as may be specified in the order: A
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 B
company.
45JA. Power of Bank to determine policy and issue
directions
(1) If the Bank is satisfied that, in the public interest or to c
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 0
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 E
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 F
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 G
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 H
404 SUPREME COURT REPORTS [201 O] 1 S.C.R.
A (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
1
company ~nd other relevant considerations, may be made
B by that nor;i~banking financial company to any person or a
company bf to a group of companies.
!
45K - Poi,yer of Bank to collect information from non-
banking irlstitutions as to deposits and to give directions
c (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
D 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,
E 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
F 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
G 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-
H
SOUTHERN TECHNOLOGIES LTD. v. JOINT COMMNR. 405
OF INCOME TAX, COIMBATORE [S.H. KAPADIA, J.]
banking institution. A
[***]
(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- B
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 C
Bank.
45Q - Chapter /JIB to override other laws
The provisions of this Chapter shall have effect
notwithstanding anything inconsistent therewith contained D
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 E
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- F
Banking Financial Company the following directions. The
said directions are called as "NBFCs Prudential Norms
(Reserve Bank) Directions, 1998":
Definitions
G
2. (1) For the purpose of these directions, unless the
context otherwise requires :-
*** *** ***
(iv) "doubtful asset" means - H
406 SUPREME COURT REPORTS [201 O] 1 S.C.R.
A (a) a term loan, or
(b) a lease asset, or
(c) a hire purchase asset, or
B (d) any other asset,
which remains a substandard asset for a period exceeding
two years;
(xii) with effect from March 31, 2003, 'non-performing
c 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
D
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
E 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
F 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;
G
(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
H
SOUTHERN TECHNOLOGIES LTD. v. JOINT COMMNR. 407
OF INCOME TAX, COIMBATORE [S.H. KAPADIA, J.]
become overdue for a period of twelve months or more; A
(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
B
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; c
"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;
D
(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;
E
(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; F
(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; G
(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 H
408 SUPREME COURT REPORTS [2010] 1 S.C.R.
A 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 (incl:.iding accrued
interest) made available to the same borrower/beneficiary
B
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
c 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
D and capital reserves representing surplus arising out of
sale proceeds of asset, excluding reserves created by
revaluation of asset, as reduced by accumulated loss
balance, book value of intangible assets and deferred
revenue expenditure, if any;
E (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;
F (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
G 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
H
SOUTHERN TECHNOLOGIES LTD. v. JOINT COMMNR. 409
OF INCOME TAX, COIMBATORE [S.H. KAPADIA, J.]
3. (1) The income recognition shall be based on A
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 8
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. C
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 o.f lease assets, where lease rentals are o
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.
E
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, F
1956 (1 of 1956).
Accounting standards
5. Accounting Standards and Guidance Notes issued by
the Institute of Chartered Accountants of India (referred to G
in these directions as "ICAI") shall be followed insofar as
they are not inconsistent with any of these directions.
Provisioning requirements
H
410 SUPREME COURT REPORTS [201 O] 1 S.C.R.
A 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
B loss assets as provided hereunder :-
Loans, advances and other credit facilities including bills
purchased and discounted
(1) The provisioning requirement in respect of loans,
C 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
D permitted to remain in the
books fer any reason, 100%
of the outstandings should
be provided for;
(ii) Doubtful Assets (a) 100% provision to the
E 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
F made. The realisable value is
to be estimated on a
realistic basis;
(b) In addition to item (a) 11
above, depending upon the
G
period for which the asset
has remained doubtful,
provision to the extent of 20%
to 50% of the secured portion
(i.e. estimated realisable
H
SOUTHERN TECHNOLOGIES LTD. v. JOINT COMMNR. 411
OF INCOME TAX, COIMBATORE [S.H. KAPADIA, J.]
value of the outstandings) A
shall be made on the
following basis : -
Period for which the % of provision
asset has been B
considered as
doubtful
Upto one year · 20
One to three years 30 c
More than three years 50
iii) Sub-standard assets A general provision of 10% of
total outstandings shall be
made.
D
Lease and hire purchase assets
(2) The provisioning requirements in respect of hire
purchase and leased assets shall be as under:-
Hire purchase assets E
(i) In respect of hire purchase assets, the total dues
(overdue and future instalments taken together) as
reduced by
F
(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,
G
shall be provided for.
Explanation
For the purpose of this paragraph,
H
412 SUPREME COURT REPORTS [2010] 1 S.C.R.
A (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
B (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
c (ii) In respect of hire purchase and leased assets,
additional provision shall be made as under :
(a) Where any amounts of hire charges or lease rentals
are overdue upto 12 months
D Nil
Sub-standard assets:
(b) where any amounts of hire charges or lease rentals are
overdue for more than 12 months but upto 24 months
E 10 percent of the net book value
Doubtful assets:
(c) where any amounts of hire charges or lease rentals are
F overdue for more than 24 months but upto 36 months
40 percent of the net book value
(d) where any amounts of hire charges or lease rentals are
overdue for more than 36 months but upto 48 months
70 percent of the net book value
G
Loss assets
(e) where any amounts of hire charges or lease rentals are
overdue for more than 48 months
H
SOUTHERN TECHNOLOGIES LTD. v. JOINT COMMNR 413
OF INCOME TAX, COIMBATORE [S.H. KAPADIA, J.]
100 percent of the net book value A
(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.
B
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 c
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.
D
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 E
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 F
required to be made on NPAs on total outstanding
balances including th.e 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 G
'
{
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 H
414 SUPREME COURT REPORTS [2010] 1 S.C.R.
A 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.
B 5. The balance sheet for the year 1999-2000 to be
prepared by the NBFC may be in accordance with the
provisions contained in sub-paragraph (2) of paragraph 8.
6. All financial leases written on or after April 1, 2001
attract the provisioning requirements as applicable to hire
c purchase assets.
Disclosure in the balance sheet
9. (1) Every NBFC shall separately disclose in its balance
D 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
E separate heads of accounts as under :-
(i) provisions for bad and doubtful debts; and
(ii) provisions for depreciation in investments.
F (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,
G
held under the heads general provisions and loss reserves
may be written back without making adjustment against
them.
Schedule to the balance sheet
H
SOUTHERN TECHNOLOGIES LTD. v. JOINT COMMNR. 415
OF INCOME TAX, COIMBATORE [S.H. KAPADIA, J.]
988. Every NBFC shall append to its balance sheet A
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 8
dated July 1, 2009
2. DEFINITIONS
2.1 Non performing Assets
c
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 0
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 E
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, F
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 G
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 H.
416 SUPREME COURT REPORTS [2010] 1 S.C.R.
A 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
B 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
c
· 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
0 is actually received. Therefore, the banks should not
charge and take to income account interest on any NPA.
4. ASSET CLASS/FICA TION
4.1 Categories of NPAs
E
Banks are required to classify nonperforming assets further
into the following three categories based on the period for
which the asset has remained nonperforming and the
realisability of the dues:
F
i. Substandard Assets
ii. Doubtful Assets
.iii. Loss Assets
G
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
H than or equal to 12 months. In such cases, the current net
SOUTHERN TECHNOLOGIES LTD. v. JOINT COMMNR. 417
OF INCOME TAX, COIMBATORE [S.H. KAPADIA, J.)
worth of the borrower/ guarantor or the current market A
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 B
loss, if deficiencies are not corrected.
4.1.2. Doubtful Assets
With effect from March 31, 2005, an asset would be C
classified as doubtful if it has remained in the substandard
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
0
liquidation in full, - on the basis of currently known facts,
conditions and values - highly questionable and
improbable.
4.1.3 Loss Assets
E
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 F
is not warranted although there may be some salvage or
recovery value.
5 PROVISIONING NORMS
G
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 H
418 SUPREME COURT REPORTS [2010) 1 S.C.R.
A 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.
B
(d) Of Income Tax Act, 1961
Section 36 - Other deductions [as it stood at the material
time]
C (1) The deductions provided for in the following clauses
shall be allowed in respect of the matters dealt with
therein, in computing the income referred to in
section 28 -
D (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:
E 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
F 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
G 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 -
H
SOUTHERN TECHNOLOGIES LTD. v. JOINT COMMNR. 419
OF INCOME TAX, COIMBATORE [S.H. KAPADIA, J.)
{a) a scheduled bank not being a bank incorporated A
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 B
cent of the aggregate average advances made by
the rural branches of such bank computed in the
prescribed manner.
430 - Special provision in case of income of public c
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 D
scheduled bank or a State financial corporation or
a State industrial investment corporation, the
income by way of interest in relation to such
categories of bad or doubtful debts as may be
. prescribed.f. having regard to the guidelines issued E
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 F
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 G
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 H
420 SUPREME COURT REPORTS [2010] 1 S.C.R.
A institution or bank or corporation or company, whichever
is earlier.
6. Reasons for RBI Directions 1998
On 31.01.1998, RBI Directions 1998 introduced a new
8
regulatory framework involving prescription of Disclosure norms
for NBFCs which are deposit taking to ensure that these
NBFCs function on sound and healthy lines. Regulatory and
supervisory attention was focussed on the deposit taking
C 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
D 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.
E 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
F 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
G 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 assets. As per sub-para 2 of Para 9, "the provisions
shall be distinctly indicated under separate heads of accounts"
H on the Liability side of the balance sheet under the caption
SOUTHERN TECHNOLOGIES LTD. v. JOINT COMMNR. 421
OF INCOME TAX, COIMBATORE [S.H. KAPADIA, J.)
"current liabilities and provisions". A
It needs to be emphasized that the said 1998 Directions
are only Disclosure Norms. They have nothing to do with
computation of Total Taxable lncome\under the IT Act or with
the accounting treatment. The said 1998 Directions only lay B
down the manner of presentation of NPA provision in the
balance sheet of an NBFC.
7. Analvsis of Para 9 of RBI Directions 1998
Vide Para 9, RBI has mandated that every NBFC shall C
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 D
Sheet under "Current Liabilities and Provisions" and that such
provision for each year shall be debited to P&L Account so that
a tr:ue 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 E
against the possible Loss on assets classified as NPA. An
NPA continues to be an Asset - "Debtors/ Loans and
Advances" in the books of NBFC. For creating a provision the
only yardstick is default in terms of the loan under RBI norms,
a provision is mathematical calculation on time lines. The entire
F
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.
G
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. H
422 SUPREME COURT REPORTS [201 O] 1 S.C.R.
A 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 I
Disclosure and has nothing to do with computation of taxable
income under the IT Act.
B
8. 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
C 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 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
0
Income Tax v. Jwala Prasad Tewari 24 ITR 537 and Vithaldas
H. Dhanjibhai Bardanwa/a (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
E 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.
F 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
G 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
H liabilities and provisions" on the Liabilities side of the balance
SOUTHERN TECHNOLOGIES LTD. v. JOINT COMMNR. 423
OF INCOME TAX, COIMBATORE [S.H. KAPADIA, J.]
sheet, then it would constitute a provision for doubtful debt. In A
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, B
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. c
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 D
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-a-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 E
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. One more aspect needs F
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. G
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 H
424 SUPREME COURT REPORTS [2010) 1 S.C.R.
A 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
B 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.
9.Deviations between RBI Directions 1998 and
c Companies Act
Broadly, there are three deviations:
(i) in the matter of presentation of financial statements
under Schedule VI of the Companies Act;
D
(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;
E
(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
F 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
G Provisions created againstthem.
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
H there only in the case of provisions.
SOUTHERN TECHNOLOGIES LTD. v. JOINT COMMNR. 425
OF INCOME TAX, COIMBATORE [S.H. KAPADIA, J.]
As stated above, the Companies Act allows an NBFC to A
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 B
on the Liability Side of Balance Sheet, i.e., under the Head
"current liabilities and provisions". The purpose of the said
deviation is to inform the user of the Balance Sheet the
particulars concerning quantum and quality of the diminution in
the value of investment and particulars of doubtful and sub- C
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.
D
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 i:ibove, under.the mercantile system of accounting, E
interest I 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 F
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 G
uncertainty in collection of the income. It is for the assessing
officer to accept the claim of the assessee 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.
H
426 SUPREME COURT REPORTS (2010] 1 S.C.R.
A 10. 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
B 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 lllB which deals
with provisions relating to Financial Institutions, and to non-
e banking Institutions receiving deposits from the public. The said
1998 Directions touch various aspects such as income
recognition; asset classification; provisioning, etc. As stated
abovei, basis of the 1998 Directions is that anticipated losses
must be taken into account but expected income need not be
D 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
E do with the computation or taxability of the provisions for NPA
under the IT Act.
Prior to RBI Directions 1998, Advances were stated net
of provisions for NPAs I bad and doubtful debts. They were
F 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
G 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
H Debtors/ Advances". Therefore, RBI has taken a position as a
SOUTHERN TECHNOLOGIES LTD. v. JOINT COMMNR. 427
OF INCOME TAX, COIMBATORE [S.H. KAPADIA, J.]
matter of disclosure, with which we agree, that if an NBFC A
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 B
"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 C
from 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 D
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 E
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. F
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 G
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 H
428 SUPREME COURT REPORTS [2010) 1 S.C.R.
A expense/ loss in the financial 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
B "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
c 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
D 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
E 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.
F
11. Theory of "Real Income"
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
G 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 lncome-
H Tax, Bombay City I, 57 ITR 521 at page 530, this is what the
SOUTHERN TECHNOLOGIES LTD. v. JOINT COMMNR. 429
OF INCOME TAX, COIMBATORE [S.H. KAPADIA, J.]
Supreme Court had to say: A
"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 B
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
c
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 D
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".
The point to be noted is that the IT Act is a tax on "real E
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 F
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 G
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. H
430 SUPREME COURT REPORTS [201 OJ 1 S.C.R.
A 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
B 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 Act, unless such Losses/ Expenses are expressly or by
C 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
D 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
E to the "provision for doubtful debt".
12. Applicability of Section 145
At the outset, we may state that in essence RBI Directions
F 1998 are Prudential/ Provisioning Norms issued by RBI under
Chapter lllB 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
G 450, an overriding effect is given to the Directions 1998 vis-a-
vis "income recognition" principles in the Companies Act, 1956.
These Directions constitute a code by itself. However, these
Directions 1998 and the IT Act operate in different areas. These
Directions 1998 have nothing to do with computation of taxable
H income. These Directions cannot overrule the "permissible
SOUTHERN TECHNOLOGIES LTD. v. JOINT COMMNR. 431
OF INCOME TAX, COIMBATORE [S.H. KAPADIA, J.]
deductions" or "their exclusion" under the IT Act. The A
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 B
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 vie~ of Section 450 of the RBI Act. Hence, as far as Income
Recognition is concerned, Section 145 of the IT Act has no role C
to play in the present dispute .
•
13. Analysis of Section 36(1)(viia)
Section 36(1 )(vii) provides for a deduction in the .
0
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 E
its rural branches, of a sum not exceeding a specified
percentage of the aggregate average advances by 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
F
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 G
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) appljes, the
amount of bad and doubtful debt shall be debited to the
provision for bad and doubtful debt account and that the H
SUPREME COURT REPORTS [2010] 1 S.C.R.
A 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
8 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.
C 14. Whether provision on NPA is allowable under Section
37(1)?
•
As stated above, Section 36(1 )(vii) after 1.4.1989 draws
a distinction between write off and provision for doubtful debt.
D 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
E 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
F the IT Act even on the basis of "real income theory" as explained
above.
15._Analysis of Section 430
G It is similar to Section 438.
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
H
SOUTHERN TECHNOLOGIES LTD. v. JOINT COMMNR. 433
OF INCOME TAX, COl~BATORE [S.H. KAPADIA, J.]
basis reduces the liquidity of the bank without generation of A
income.
With a view to improve their viability, the IT Act has been
amended by inserting Section 430 to provide that such interest
shall be charged to tax only in the year of receipt or the year in B
1
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 C
arise for determination in this case did not arise in the cases
cited by the appellant(s).
16. Challenge to the constitutional validity of Sections
36(1 )(viia) and 430 of the IT Act
D
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 E
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 F
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.
G
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 H
434 SUPREME COURT REPORTS [201 OJ 1 S.C.R.
A 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
B 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.
c 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
D two concepts, namely, "risk" and "liquidity" bring out the basic
difference between NBFCs and Banks. Take the case of the
scope of impugned Section 430. 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
E to recover. Therefore, Parliament realized that taxing such
"income" on accrual basis without actual recovery would create
liquidity crunch, hence, Section 430 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
F 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,
G 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 430 are often restricted
to banks and not to NBFCs. Lastly, as stated above, even in
H the case of banks the Provision for NPA has to be added back
SOUTHERN TECHNOLOGIES LTD. v. JOINT COMMNR. 435
OF INCOME TAX, COIMBATORE [S.H. KAPADIA, J.]
and only after such add back that deduction under Section A
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 )(vii a). One more aspect needs to be
mentioned, apart from the fact that NBFCs and Banks are two B
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 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 C
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.
D
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 E
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. F
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 G
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 Direction 1998 is not applicable to Banks, there is
no question of extending the benefit of deduction to NBFCs H
436 SUPREME COURT REPORTS (2010) 1 S.C.R.
A under Sbction 36(1 )(viia) or under Section 430. 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".
B
Before concluding. we may cite the following judgments of
this Court in the context of the constitutional validity of Sections
36(1 )(vii a) and 430 of the IT Act.
C In the case of R.K. Garg v. Union of India (1981) 4 sec
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
0
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,
E etc. Moreover, there is a presumption in favour of the
constitutionality of a statute and the burden is upon him who
attacks it to show that there has been a clear transgression of
the constitutional principles. The legislature understands and
correctly appreciates the needs of its own people, its laws are
F 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
G 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.
H
SOUTHERN TECHNOLOGIES LTD. v. JOINT COMMNR 437
OF INCOME TAX, COIMBATORE [S.H. KAPADIA, J.]
In the case of Bhavesh D. Parish v. Union of India, (2000) A
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 iriterfering with its applicability. Merely because a B
statute comes up for examination and some arguable point is
raised, the legislative will should not be put under a cloud. It is
now weil 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 C
system of checks and balances has to be 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.
D
18. 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 E
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 F
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."
19. In the case of Barclays Mercantile Business Finance G
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 H
438 SUPREME COURT REPORTS [2010] 1 S.C.R.
A 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.
B 20. Conclusion
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
C costs.
D.G. Appeals dismissed.
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