The Income-Tax Act 1961 (the Act) is sought to be replaced with a new Direct Taxes Code, 2010 (DTC). One of the key objectives of such a replacement is to simplify tax provisions and reduce tax litigation.

We have analysed the issue of allowability of bad debts and provision for bad and doubtful debts by financial institutions under the DTC. This has been a subject matter of extensive litigation under the Act.

Under the Act, foreign banks and Indian banks are allowed a deduction in respect of provision for bad and doubtful debts (PDD) to the extent of 5% and 7.5% of their adjusted total income, respectively.

Indian banks are also allowed an additional deduction in respect of provision for rural advances.

However, no such deduction is allowed to non banking financial companies (NBFCs) in respect of provisions created. Further, bad debts are also allowed as a deduction as and when they are written off, subject to netting it off with the PDD already claimed.

DTC proposes to allow amounts credited to PDD account, not exceeding 1% of the aggregate average advances, as a deduction to the financial institution or a non banking financial company as may be notified, if the amount is charged to the profit and loss account (P&L A/c) in accordance with the prudential norms of the RBI and the debt written off as irrecoverable in the books of accounts is debited to the PDD account.

Further, DTC proposes that the debit balance, if any, on the last day of the financial year, in the PDD account would be allowed as a deduction, if the said balance is transferred to the P&L A/c of the financial year.

While the intention seems to allow deduction in respect of PDD to the extent of 1% of the aggregate average advances and full deduction at the time the debt is written off in the books of accounts, the wordings of the relevant provisions raise following issues:

Allowability for bad debts: Due to the cumulative conditions provided for claim of doubtful debts, there seems to be an issue on allowability of debts written off. DTC proposes to allow claim in respect of debit balance in PDD account at the end of the financial year, as and when it is charged to P&L A/c. However, it is unclear as to how there could be a debit balance in the PDD account.

For e.g. let us say in Year 1, Co Xs aggregate average advance as computed in the prescribed manner is Rs1,000 and that the company has created provision of Rs100. In such a scenario, the company will be able to claim a deduction of Rs10 in Year 1.
Now in Year 2, the company writes off Rs50 out of the said provision. The PDD account in the books will reflect a credit balance of Rs50. As there is no debit balance in PDD account to be transferred to P&L A/c, deduction for such debt written off may not be allowed.

Prudential norms: The deduction, under the DTC, is allowable in respect of provisions made in accordance with the prudential norms of RBI.

However, the provisioning norms of RBI are minimum acceptable norms and both banks and NBFCs are free to adopt stringent provisioning norms.

It is not clear whether a deduction will be allowed in respect of PDD where such provision is credited due to stringent internal norms of a financial institution. Alternatively, one will be required to reconcile the PDD made as per their internal policies and those set by RBI in order to make appropriate claim under the
DTC, which would be an onerous task.

NBFCs to be notified?: DTC proposes to allow the above deduction to financial institutions or NBFCs as may be notified. Definition of financial institution includes NBFCs as well. Hence, it is unclear whether all NBFCs or only notified NBFCs will be eligible for the above deduction.

Routing of write offs to PDD account: The underlying presumption appears to be that that each written-off debt would have to be necessarily routed through the PDD account. This may require changes to be made to the accounting systems to ensure that all write offs are routed through the PDD account.

To summarise, it is necessary to bring clarity on above matters to avoid unnecessary litigation so that DTC may achieve one of its objective of reducing litigation.