Tuesday, March 1, 2011

Interest on Non Performing Assets which is doubtful of recovery, taxable on receipt basis

In a recent decision, in the case of CIT v. Vasisth Chay Vyapar Ltd. (Delhi High Court) [ITA 552/2005] dated 29 November, 2010 , the Delhi High Court in the context of loans given by a Non-Banking Financial Company ("NBFC") held that in a scenario where interest on Non Performing Assets ("NPA") was doubtful of recovery due to adverse financial circumstances of the borrower, it was legitimate move to infer that interest income had not accrued and was therefore not exigible to tax, irrespective of the fact that assessee followed mercantile system of accounting.

Facts

•           The assessee a NBFC had advanced Inter Corporate Deposits ("ICD") to M/s Shaw Wallace Company. The interest on such ICD was outstanding since assessment year 1996-97 and the position remained the same until assessment year 2006-07.

•           The assessee being an NBFC had classified the ICD as NPA in accordance with the provisions of the Reserve Bank of India Act, 1934 ("RBI Act") read with NBFCs Prudential Norms (Reserve Bank) Directions, 1998 ("Prudential Norms"). Accordingly, the interest accrued on such NPA was not recognised as income in the books of accounts of the assessee.

•           The Assessing Officer ("AO") made additions on account of the interest on such NPA holding that interest had accrued to the assesse even if it was not realised, since the assessee was following mercantile system of accounting.

•           The Commissioner of Income-tax (Appeals) (CIT(A)) affirmed the order of the AO.

•           The Income-tax Appellate Tribunal ("Tribunal") held that the provisions of section 45Q of the RBI Act override the provisions of the Income-tax Act, 1961 ("the Act"). The treatment of the interest income from the NPA was in accordance with the provisions of the RBI Act and the Prudential Norms issued thereunder and hence in accordance with law. Thus, no additions could be made under the provisions of section 145 of the Act, in the hands of the assessee in respect of the unrealised interest on the ICD

Assessee's contentions

•           The provisions of section 45Q of the RBI Act override the provisions of the Act. This is in view of the decision of the Supreme Court ("SC") in case of TRO v. Custodian, Special Court Act, 1934 [2007] 293 ITR 369 (SC), wherein it was held that, where a provision under any enactment begins with a non-obstante clause, it would override the provisions of all other enactments.

•           The assessee being an NBFC was bound to follow the provisions of the RBI Act and the Prudential Norms issued thereunder and hence the non-credit of interest income on NPA was in accordance with law.

•           The Madras High Court in the case of CIT v. Elgi Finance Ltd. [2007] 293 ITR 357 (Mad) in almost identical controversy held that no interest could be said to have accrued on loans which are doubtful of recovery and classified as NPA.

•           The SC, in the case of CIT v. KICM Investment Ltd. (Supreme Court order dated January 12, 2009 in CC No.29 of 2009) dismissed a Special Leave Petition filed by the tax department against the decision of the Calcutta High Court. In this case, the Calcutta High Court held that interest on NPA cannot be taxed on accrual basis even though mercantile system of accounting was followed.

•           The undisputed facts of the case clearly indicated the uncertainty of ultimate collection of interest, due to tight and precarious financial position of the borrower.

•           The Courts (See Note 1) have recognised the theory of 'real income' and irrespective of the method of accounting followed, the tax payer could only be taxed on real income and not any hypothetical income.

•           The assessee was required to comply with the provisions of section 145(1) of the Act and sections 209 and 211 of the Companies Act, 1956 which mandate observance of the accounting standards as prescribed in a consistent manner. In view of the uncertainty of the ultimate collection of interest due the accounting treatment followed by the assessee in respect of interest on ICD due from M/s Shaw Wallace Company was in conformity with the accounting standards. This was on the ground that M/s Shaw Wallace Company was passing through a financial crisis and winding-up petitions filed by many creditors were pending in courts against the company.

•           The Courts (Note-2) have held that even under the mercantile system of accounting it is

illusory to take credit for interest where recovery of the principal itself was doubtful.

Revenue's contentions

•           The revenue contended that under the provisions of section 5 of the Act, interest income had accrued to the assessee.

•           Provisions of the RBI Act and the Prudential Norms issued thereunder cannot override the provisions of the Act.

•           The SC in the case of Southern Technologies Ltd. v. JCIT [2010] 320 ITR 577 (SC) in the context of deductibility of provision for NPAs upheld the aforesaid principle and held that the RBI Act and the Act operate in different fields, and hence, the Prudential Norms are mere guidelines for accounting purposes and have nothing to do with the computation, or taxability, under the Act.

High Court ruling

The High Court observed and held that,

•           The assessee, being an NBFC, was bound by the provisions of the RBI Act and the Prudential Norms issued thereunder. The treatment to ICDs advanced to M/s Shaw Wallace Company as NPA was in accordance with the Prudential Norms issued by the RBI.

•           Accordingly, interest income could not be said to have accrued to the assessee since the ICD had become an NPA and interest on the NPA was not received by the assessee as the possibility of recovery was almost nil. This accounting practice was in line with the Accounting Standard issued by the Institute of Chartered Accountants of India (AS-9 on Revenue Recognition) which provides that in case of uncertainty, recognition of revenue is to be postponed.

•           Given the financial position of M/s Shaw Wallace Company, where the recovery of the principal amount itself was doubtful, the interest income thereupon could not be said to have accrued to the assessee.

•           The decision of the SC in the case of Southern Technologies Ltd. (above) heavily relied upon by the revenue was distinguishable on facts. The dispute before the SC in that case was with respect to deductibility of provision for NPA. Further, the SC in the context of income (interest) recognition had approved the 'real income' theory.

•           Further, the decision of the SC in the case of Southern Technologies Ltd. (above) relied upon by the revenue had to be read with the decision of the SC in the case of Custodian, Special Court Act, 1934 (above) dealing with situations where there is a provision in other enactment which contains a non-obstante clause, that would override the provisions of the Act.

• In view of the above, the High Court upheld the order of the Tribunal in favour of the assessee and against the revenue.

Conclusion

The decision of the High Court would bring some relief to NBFCs. However, given the fact that this is a debatable issue and unless affirmed by the SC, the tax authorities may continue to dispute the issue. This debate arises primarily due to the fact that under the Act, there is a specific provisions under Section 43D of the Income tax Act, 1961 dealing with interest on NPA with respect to specified financial institutions (including banks) which does not include NBFCs.

However, under the Direct Taxes Code Bill, 2010 proposed to be effective from April 2012, this should not be an issue as it has been proposed that interest on bad and doubtful debts, in cases of all financial institutions (including NBFCs), will be chargeable to tax in the financial year in which the interest is credited to the profit and loss account, or is actually received, whichever is earlier.

Note:-

   1. UCO Bank v. CIT [1999] 237 ITR 889 (SC), CIT v. Shoorji Vallabhdas and Co. [1962] 46 ITR 144 (SC), Godhra Electricity Co. Ltd. v. CIT [1997] 225 ITR 746 (SC)
   2. CIT v. Goya! M.G.Gases (P) Ltd. [2008] 303 ITR 159 (Del), CIT v. Eicher Ltd. (ITA No.431/2009 dt.15.7.2009), CIT v. Ferozepur Finance (P) Ltd. [1980] 124 ITR 619 (P&H), CIT v. Motor Credit Co. (P) Ltd. [1981] 127 ITR 572 (Mad)



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