Query .... XYZ Co-operative Bank Ltd.

1. Facts

1.1 The querist is a co-operative bank, which was so far entitled to deduction on the profits and gains attributable to its banking business u/s 80P(2)(a)(i) of I.T.Act. From A.Y. 2007-08 however this deduction is being withdrawn. For the purpose of paying advance tax and for computing its tax liability for the current year in general, the Bank is facing few problems. These were brought out in the bank‘s letter dated 30-11-2006 addressed to me and they were also orally discussed with the Accounts Officer of the Bank and with the tax consultant of the bank.

1.2 The foremost question is regarding accounting of interest on NPA advances, which the Bank is recognizing only on realization basis as per guidelines of Reserve Bank known as Prudential Norms. Whenever the interest is received on NPA advance it is accounted for in the year of realization even though it relates to earlier years.

1.3 In its accounts for year ending 31.3.06, copy of which is handed over to me shows in the balance sheet, interest of Rs. 18,43,36,704 on NPA advances s on the asset side , and same amount is shown on liability side as provision for the arrears of interest. These are accumulated figures over the years which have not been routed throught P & L A/c. As per the circular of the Reserve Bank of India containing the prudential norms of income recognition etc., income from NPA is not recognized on accrual basis but is booked as income only when it is actually received. The Banks are therefore advised not to charge and take to income account interest on all non-performing assets. The RBI has also indicated how the interest is to be shown in respect of NPA. Needless to say that the assessee has followed the direction of the RBI in that behalf.

1.4 As per the, prudential norms of R.B.I., a provision is also made in respect of loss on account of NPA. This accumulated figure of loss as on 31-3-2006 was Rs. 326.50 lakhs.

1.5 The points that have arised on the basis of above facts are as follows:

2. Queries

1. Whether the method of accounting the interest on NPA on realization basis will conflict with the amendment in the I.T. Act which does not permit mixed method of account?

2. Whether accumulated loss of Rs. 326.50 lakhs as on 31-3-2006 which is on account of NPA provision will be carried forward?

3. Whether the interest on NPA accounted for on realization thereof will be treated as income even if it pertains to the earlier years when the income from the banking activity was fully deductible?

4. Whether NPA provision which is to be made under the Prudential Guidelines of RBI and is debited to P & L account will be allowed as a deduction while computing profit liable to income tax?

5. Whether the excess provision on account of NPA on being written back in the accounts will be treated as income attracting tax liability ?

6. If the bank writes off some of its advances by debiting the same to Bad & doubtful debts Reserve, will the amount of the bad debts so written off will be deductible in computing income

3. Opinion

3.1 The problems that are raised would have been resolved if the provisions of sec. 36(1)(viia) providing deduction for provision for bad and doubtful debts subject to limits and provisions of Sec.43D were specifically made applicable to cooperative banks. It is unfortunate that when the deduction u/s 80P(2)(a)(i) was withdrawn, the provisions of sec. 36(1)(viia) and Sec. 43D should have been made applicable. The matter is of general importance, which is going to create avoidable litigation in this behalf. It is therefore suggested that the matter is required to be taken with the Finance Ministry on behalf of all cooperative banks.

3.2 The inapplicability of sec. 36(1)(viia) to the querist bank will mean that the loss on account of N.P.A. which stands to the extent of Rs. 356.50 lakhs may not be apparently allowable. The provision is towards doubtful debts on a prescribed percentage basis as per the norms laid down by the R.B.I. An assessee is entitled to bad debt if it is specifically written off in the books of account but a provision towards doubtful debts is not allowable. Since sec. 36(1)(viia) specifically excludes co-operative banks from claiming deduction, the department is most likely to disallow the claim. But it may be worthwhile to claim the said provision for loss u/s 28 as per Accounting Standard I (4)(i) notified under Notification No. 9948 dated 25 th Jan 1996 for the purpose of Sec.145.. As per this standard of prudence a provision is required to be made for all known liabilities and losses even though the amount cannot be determined with certainty and represents only a best estimate in the light of available information. It can be contended that the querist is bound to follow the prudential norms laid down by RBI and provision for loss on account of NPA is made on the principle of prudence. Such provision can be claimed to be allowable u/s 28. It is well settled that sec.28 is a charging provision for the purpose of taxing “profits and gains from business or profession”. And sec. 29 onward only list out specific items of deductions. The charge is on “profits and gains”which are required to be computed on ordinary commercial principles. The leading case on the point is that of Supreme Court in Badridas Daga vs. C.I. 34 ITR 10(SC). Reference may also be made to the decision of Supreme Court in Indore Malwa United Mills Ltd. vs. State of M.P. 55 ITR 736 (SC), Bombay High Court in case of C.I.T. vs. F.M. Chinoy & Co. Ltd. 74 ITR 780 (Bom), and Madras High Court in case of C.I.T. vs. Inden Biselers 181 ITR 69. These cases refer to irrecoverable advances made during the course of business and which were considered allowable u/s 28 of I.T. Act.

3.3 The next question is of interest on NPA which is recognised as income only on realization as per the norms laid down by RBI and which the assessee is bound to follow. On this point there was a raging dispute between banks and financial institutions on one hand and the department on the other. The banks in those years used to credit interest on doubtful advances to interest suspense account and it was being claimed that such interest was not to be considered as “real income”. This contention was however turned down by the Supreme Court in the case of State Bank of Travancore vs. C.I.T. 158 ITR 102. The question again came up before Supreme Court in UCO Bank vs. C.I.T. 237 ITR 889. In this case the earlier decision of S.C. was considered and it was held that the instructions of the Board dt. 9-10-1984 which were not brought to the notice in the earlier decisions are binding and are required to be followed. It was therefore held that where the assessee bank followed mixed method of account and was showing interest income on doubtful advances only on realization, such method was permissible and interest could not be charged on doubtful advances on accrual basis. In the meanwhile sec. 43D was introduced which permits the banks (other than co-operative banks) to show interest on doubtful advances on realization basis as per the norms laid down by RBI. It would have been permissible for the querist to follow the mixed system of account and recognize income in respect of interest on its NPS only on realization. The difficulty is created by sec. 145 which after its amendment from A.Y. 1997.98 provides that the assessee must follow either mercantile or cash method of accounts. In other words mixed method of accounting is not permissible. In view of this position of law, the department in the case of the querist may claim that the interest accrued on NPA is chargeable to tax. Since Sec.43D is not applicable, the querist will have difficulty in relying on that provision. But I feel that the assessee can contend that though the assessee is not supposed to follow the mixed method of accounting, what the assessee by accounting interest on NPA on realization basis is doing is only to follow the accounting standard. Sub.clause (4) of the standard as notified in Notification No 9949 dated 25-1-1996 requires the assessee to follow the accounting policies which should be such so as to represent a true and fair view of the state of affairs of the business. The norms laid down by RBI for the purpose of accounting is only to enable representing true and fair view of the state of affairs of the business of the bank and subject to proper disclosure therefore should be treated as part of mercantile system of accounting only. Sec.145(3) provides that if the assessee does not follow the method of accounting as per Sec.145(1) or as per accounting standard, he is empowered to compute the income as per sec. 144 ie as per “best judgment”. Assuming for sake of argument that the A,O. holds that the assessee is not following mercantile or cash method account or as per accounting standard, he is still bound to compute income to the “best judgment”. It is well settled law that the best judgment assessment cannot be arbitrary. It has to be reasonable having regard to all circumstances. In such case, if he proceeds to tax the interest on doubtful advances in spite of RBI norms to the contrary, his so-called “best judgment” can be challenged as improper. I therefore feel that the querist can contend that the method of accounting followed by the assessee is mercantile and as per accounting standards and alternately if the best judgment assessment is warranted it cannot be used to rope in the interest income in respect of NPAs.

3.4 The two principal questions regarding loss on NPA and interest on NPA are bound to lead to litigation and though I am hopeful of favourable consequences, I am not sure whether such result will follow in assessment or in further appeal forum. The loss arising on both counts so far was not of much significance in earlier years because the income from banking activity in any case was fully deductible. But now it will be of interest to claim and press both these claims in pending assessment prior to A.Y. 2007-08 so that the benefit of carry forward loss can be availed off in A.Y. 2007-08 resulting in substantial gain in tax.

3.5 The excess NPA provision written back will be income only if the said provision was allowed as deduction. Similarly if the interest on NPA is charged to P& L A/c on realization, it will be taxed if it was not charged earlier. The fact that in earlier year it was fully deductible is not relevant.

3.6 It will be advisable to claim bad debts on write off basis as per sec. 36(1)(vii)read with Sec.36(2).

3.7 I hope I have tried to answer all the doubts as expressed in querist‘s letter dated 30-11-2006. The matter was orally discussed much earlier but due to my indifferent health there was some delay in this written opinion.