Facts of the Case

In the assessment year 1998-99, the Assessing Officer (AO) disallowed a sum of ₹87,23,257/- claimed by the assessee. This amount represented interest income from Non-Performing Assets (NPA) which had been recognized on a mercantile basis, shown as income, and offered for tax in preceding years. Following the prudential norms laid down by the Reserve Bank of India (RBI), the underlying loans advanced by the assessee turned sick, making the recovery of interest impossible. Consequently, the assessee sought to reverse the previously taxed interest income in the assessment year under consideration. The AO disallowed this reversal. The Income Tax Appellate Tribunal (ITAT) initial report also dismissed the main plea, ruling that interest charged in earlier years could not be reversed under Section 36(1)(vii) of the Income Tax Act. However, the assessee had preferred an alternative plea before the Commissioner of Income Tax (Appeals) [CIT(A)], asserting that if the actual reversal was impermissible, the unrealized interest income should be allowed as a deduction as a 'bad debt' written off under Section 36(1)(vii) read with Section 36(2) of the Act.

Issues Involved

  1. Whether an assessee following the mercantile system of accounting is entitled to a deduction under Section 36(1)(vii) read with Section 36(2) by writing off previously recognized but unrealized interest income as a bad debt when the underlying loan advances become Non-Performing Assets (NPAs) under RBI prudential norms.
  2. Whether the ITAT erred in law by restoring the matter back to the Assessing Officer to examine and consider afresh the actual write-off of interest from earlier years for the year under consideration.

Petitioner’s (Revenue/Income Tax Department) Arguments

The Appellant Revenue, represented by the learned counsel, contended that the disallowance made by the Assessing Officer was valid. It was argued that since the interest income had already accrued and been offered to tax under the mercantile system in prior assessment years, its subsequent reversal in the current year did not automatically fulfill the criteria for deduction. The Revenue opposed the alternate plea of bad debt and maintained that the provisions of Section 36(1)(vii) were not applicable to the reversal of such accrued interest, and therefore, the Tribunal should not have remanded the matter back for fresh consideration.

Respondent’s (Assessee) Arguments

The Respondent Assessee, represented by the learned Senior Counsel, argued that because the advances had become sick loans, the interest could not realistically be charged or recovered, aligning with RBI’s prudential norms. The assessee supported the alternative plea raised before the CIT(A) and the ITAT, submitting that since the interest income was unrecoverable, it was entirely permissible for the assessee to write off the said unrealized interest as a bad debt. It was maintained that the income had already been offered for taxation in earlier years, thereby perfectly fulfilling the statutory mandate of Section 36(2), making the assessee legally entitled to a deduction under Section 36(1)(vii).

Court Order / Findings

The High Court of Delhi, presided over by Hon'ble Justice A.K. Sikri and Hon'ble Justice M.L. Mehta, dismissed the appeal filed by the Revenue. The Court upheld the approach adopted by the Tribunal in restoring the matter to consider the actual write-off of interest for earlier years during the assessment year under consideration. The Court categorically observed that even when an assessee follows the mercantile system of accounting and interest is not physically received in earlier years, if it is subsequently established that the interest income is unrecoverable and the assessee chooses to write it off, the deduction thereof must be treated as a bad debt. Conclusively, the High Court held that no substantial question of law arose from the order of the Tribunal.

Important Clarification

The ruling clarifies that following the mercantile system of accounting does not permanently trap an assessee into paying taxes on unrealized income that later becomes unrecoverable. When interest income is offered to tax on an accrual basis but subsequently becomes an NPA under RBI guidelines, the asset's unrecoverable interest can legitimately be claimed as a deduction by writing it off as a bad debt under Section 36(1)(vii) read with Section 36(2), provided the statutory criteria of actual write-off in the books of accounts are duly examined and satisfied.

Section Involved

  • Section 36(1)(vii) of the Income Tax Act, 1961 (Deduction on account of bad debts written off)
  • Section 36(2) of the Income Tax Act, 1961 (Condition precedent requiring the debt to be taken into account in computing the income of the assessee)

Link to download the order -https://delhihighcourt.nic.in/app/case_number_pdf/2011:DHC:14589-DB/AKS19072011ITA832010_151010.pdf

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