REPORTABLE

IN THE SUPREME COURT OF INDIA CIVIL APPELLATE/ORIGINAL JURISDICTION

CIVIL APPEAL NO. 1337/2003

M/s Southern Technologies Ltd. … Appellant(s)

              versus

Joint Commnr. of Income Tax, Coimbatore … Respondent(s)

with

C.A.No.  154 /2010  @  SLP(C) No. 22176/2009

TRANSFERRED CASE NO. 5/2005 & 6/2005

J U D G M E N T

S.H. KAPADIA, J.

Leave granted in the Special Leave Petition.

Introduction

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 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?”

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 2003].

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  and  the  Balance  Sheet  are  drawn  as  on  30th June.   The  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  

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 Account on three counts,  

viz., Hire-Purchase of Rs. 57,38,980/-, Bill Discounting of Rs. 12,79,500/-  

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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/-.

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  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.  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 Vithaldas 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.  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.  

Submissions

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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 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)(vii) of the IT Act.  The appellant claimed that the “Provision  

for  NPA”,  however,  represented  “loss”  in  the  value  of  assets  and  was,  

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 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.   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  

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Commissioner of Income-Tax v. Woodward 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 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 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  

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  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  

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a regulator wants NBFCs who accept deposits from the public to provide for  

a possible loss.  The RBI Directions 1998 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 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.   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 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  can  accept  deposits.   According to  the  Department,  vide RBI  

Directions 1998, RBI tries to bring out the Profit in the P&L Account after  

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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  “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  

–  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  

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 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  

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deals with computation of total 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 India (ICAI).  It is the 1998 Directions  

which  inter alia states that NBFC shall not recognize any income 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  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  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, 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  

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recognise income from NPA but it shall create a provision by debit to the  

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  

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 45Q of the RBI Act).  Therefore, according to  

the Department, inconsistency in terms of Section 45Q of the RBI Act is  

only with respect to the Companies 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 that Section 45Q 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 intention of Section 45Q of the IT  

Act.  That, the said 1998 Directions cannot be taken as an excuse by the  

NBFC to compute lower taxable income under the IT Act.   

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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 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 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 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  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 Department.  According to  

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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.  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.   

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  

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 of the IT Act, entitled to deduction.  According to the  

appellant(s), Section 45IA 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  

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NPA” is treated as reserve, it 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 created by all NBFCs  

under Section 45IC, 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  “provision”  and  

“reserve”:        

S.No. Provision Reserve 1. Provision is a charge or debit  

to the P& L Account.

Reserve  is  an  appropriation  of  

profits. 2. Provision  is  made  against  

gross  receipts  in  the  P  &  L  

A/c  irrespective  of  whether  

there is profit or loss.

Provisions are a pretax charge  

to P & L account irrespective  

of whether the NBFC makes  

a net profit or not.

No  reserve  can  be  created  in  

accounting  year  when  there  is  a  

loss.

Reserves are created out of post-

tax  profits,  by  way  of  

appropriation,  subject  to  there  

being adequate net profit.

3. If NPA is Rs. 10 lakhs, then  

the accounting entry is:

P&L A/c     Dr. 10,00,000

If NPA is Rs. 10 lakhs, and there  

is  a  loss,  no  “Reserve  can  be  

created.

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To Prov. for NPA 10,00,000

If there is a loss, the debit of  

Rs.  10,00,000/-  will  increase  

the  quantum  of  loss.   This  

aggregate loss will be shown  

on  the  assets  side  as  debit  

balance of P&L A/c. 4. Provision is based on a one-

stage entry:

P&L A/c     Dr.

To Prov. for

Excise/ PF/ Gratuity/ etc.

Reserves are based on a two stage  

accounting  process  under  the  

horizontal  system.   If  the  profits  

are  Rs.  10  crores,  the  Board  of  

Directors  may  transfer  Rs.  8  

crores to P&L Appropriation A/c  

for taxation, dividend and reserve.  

The balance will be transferred to  

credit balance of P&L A/c.  The  

entries will be as follows:-

Stage 1:

P&L A/c   Dr.  10.00

To P&L Appropriation A/c 8.00

To P& L A/c                        2.00

Stage 2:

P&L Appropriation A/c      8.00

To Prov. Taxation               4.00

To Prov. for Dividends       2.00

To Transfer to Reserve       2.00

Thus, if there are no profits, there  

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can  be  no  debit  to  the  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. 5. Under Clause 7(1)(a) of Part  

–  III  of  Schedule  VI  of  

Companies  Act,  1956  –  

provision,  inter  alia,  is  to  

provide  for  depreciation,  

renewals  or  diminution  in  

value of assets or to provide  

for any taxation.

Under Clause 7(1)(b) of Part – III  

of  Schedule  –  VI  of  Companies  

Act,  1956  –  reserve  does  not  

include any amount written off or  

retained  by  providing  for  

depreciation,  renewals,  etc.  or  

providing for any known liability.  

Under Part – I of Schedule – VI,  

‘reserve’ can be made in respect  

of  capital  reserves,  capital  

redemption, share premium, etc. 6. Provision  cannot  be  used  to  

declare dividend, etc.

Reserves  can  be  utilized  to  pay  

dividends/ bonus, unless there is a  

statutory bar.

Lastly, on the question of adding back to the taxable 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.   The IT Act  

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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 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  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,  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  

allowable as a loss under Section 37(1) of the IT Act.

Relevant Provisions

(a) Of RBI Act, 1934

Chapter IIIB - PROVISIONS RELATING TO NON- BANKING  INSTITUTIONS  RECEIVING  DEPOSITS AND FINANCIAL INSTITUTIONS

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Section 45I - Definitions  

In this Chapter, unless the context otherwise requires,-

(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  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 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;

(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-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  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 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  

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disbursing  monies  in  any  other  way,  to  persons  from  whom monies are collected or to any other person,

but does not include any institution, which carries on as  its principal business,-

(a) agricultural operations; or

(aa) industrial activity; or

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);

(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 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

*** *** ***

Explanations.-For the purposes of this section,-

(I) "net owned fund" means-

(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

(b) further reduced by the amounts representing-

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(1)  investments  of  such  company  in  shares  of-  (i)  its  subsidiaries;  (ii)  companies in the same group; (iii)  all  other 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,-

(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.

45-IC. Reserve fund  

(1) Every non-banking financial company shall create a  reserve  fund  the  transfer  therein  a  sum  not  less  than  twenty 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 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  sufficient  cause  being shown,  extend the period of  twenty-one days by 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 the Bank and having regard to the  adequacy of the paid-up capital  and reserves of a non- banking  financial  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-

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banking  financial  company for  such period  as  may  be  specified in the order:

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  company.

45JA. Power of Bank to determine policy and issue  directions

(1) If the Bank is satisfied that, in the public interest or to  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 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  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 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 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

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(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  company and other relevant considerations, may be made  by that non-banking financial company to any person or a  company or to a group of companies.

45K - Power of Bank to collect information from non- banking  institutions  as  to  deposits  and  to  give  directions  

(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 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, 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  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 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-banking institution.

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[***]

(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-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 Bank.

45Q - Chapter IIIB to override other laws  

The  provisions  of  this  Chapter  shall  have  effect  notwithstanding  anything  inconsistent  therewith  contained 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

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-Banking Financial  Company the following directions.  

The said directions are called as “NBFCs Prudential Norms (Reserve Bank)  

Directions, 1998”:

Definitions 2.  (1)  For  the  purpose  of  these  directions,  unless  the  context otherwise requires :-

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*** *** *** (iv) “doubtful asset” means - (a) a term loan, or (b) a lease asset, or (c) a hire purchase asset, or (d) any other asset, which remains a substandard asset for a period exceeding  two years;

(xii) with  effect  from  March  31,  2003,  ‘non- performing  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  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  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 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;  (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 become overdue for a  period of  twelve months  or  more;  (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  when  any  of  the  above  credit  facilities  becomes  non-  performing asset:  

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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;   

“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;  (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;  (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;  (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;  (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 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 (including  accrued  interest)  made  available  to  the  same  borrower/beneficiary  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;”  

(xiii)  “owned  fund” means  paid  up  equity  capital,  preference shares which are   compulsorily convertible  into  equity,  free  reserves,  balance  in  share  premium  account and capital reserves representing surplus arising  

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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;        

(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;       

(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  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    3.  (1)  The  income  recognition  shall  be  based  on  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   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. 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 of lease assets,  where lease rentals are  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.    

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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, 1956 (1 of 1956).    

Accounting standards  5. Accounting Standards and Guidance Notes issued by  the Institute of Chartered Accountants of India (referred  to in these directions as “ICAI”) shall be followed insofar  as they are not inconsistent with any of these directions.  

Provisioning requirements    

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 loss assets as provided hereunder :-    

Loans, advances and other credit facilities    including bills purchased and discounted    (1)  The  provisioning  requirement  in  respect  of  loans,  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 permitted  to remain in the books   for any  reason, 100% of the outstandings  should be provided for;

(ii) Doubtful Assets (a) 100% provision to the 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   made. The realisable value is  to  be    estimated  on  a  realistic  

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basis;    

(b)  In addition to item (a)    11  above,  depending  upon  the  period for   which the asset has  remained doubtful,   provision to  the extent of 20% to 50% of   the  secured  portion  (i.e.  estimated  realisable  value  of  the  outstandings) shall   be made on  the following basis : -    

Period  for  which  the  asset  has  been considered as  doubtful    

% of provision

Upto one year   20 One to three years   30    More  than  three  years    

50    

iii)  Sub-standard  assets    

A  general  provision  of  10% of  total outstandings shall be made.

Lease and hire purchase assets    (2)  The  provisioning  requirements  in  respect  of  hire  purchase and leased   assets shall be as under:-    Hire purchase assets    

(i)    In  respect  of  hire  purchase  assets,  the  total  dues  (overdue  and  future  instalments  taken  together)  as  reduced by    

(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,    shall be provided for.    

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Explanation    For the purpose of this paragraph,    

(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    

(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  

(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

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

10 percent of the net book  value

Doubtful assets: (c)  where  any  amounts  of  hire  charges  or  lease  rentals  are  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

Loss assets (e)  where  any  amounts  of  hire  charges  or  lease  rentals  are  overdue  for more than 48 months

100  percent  of  the  net  book value

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(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.  

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 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.  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  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  required  to  be  made  on  NPAs  on  total  outstanding  balances  including  the  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  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 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.  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.

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6. All  financial  leases  written  on  or  after  April  1,  2001 attract the provisioning requirements as applicable  to hire purchase assets.  

Disclosure in the balance sheet    9. (1) Every NBFC shall separately disclose in its balance  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  separate heads of accounts as under :-     (i) provisions for bad and doubtful debts; and    (ii) provisions for depreciation in investments.    

(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,  held under the heads general provisions and loss reserves  may   be written back without making adjustment against  them.       

Schedule to the balance sheet   9BB.  Every  NBFC  shall  append  to  its  balance  sheet  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 dated July 1, 2009

2. DEFINITIONS  

2.1 Non performing Assets

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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  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  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,  

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  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  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  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  

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3.1.1  The  policy of  income  recognition  has to  be  objective  and  based  on  the  record  of  recovery.  Internationally income from non  performing assets     (NPA)    is     not  recognised  on  accrual  basis     but  is     booked    as     income  only     when  it  is     actually  received  .  Therefore,  the banks should not charge and take to income account  interest on any NPA.  

4. ASSET CLASSIFICATION  

4.1 Categories of NPAs  

Banks are  required  to  classify nonperforming  assets further into the following three categories based on  the  period  for  which  the  asset  has remained  non- performing and the realisability of the dues:

i.Substandard Assets

ii.Doubtful Assets

iii.Loss Assets  

4.1.1    Sub  standard Assets    

With  effect  from 31  March  2005,  a  substandard  asset  would be one, which has remained NPA for a period less  than or equal to 12 months. In such cases, the current net  worth of the borrower/ guarantor or the current market  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  loss,  if  deficiencies are  not  corrected.

4.1.2. Doubtful Assets  

With  effect  from March  31,  2005,  an  asset  would  be  classified  as  doubtful  if  it  has  remained  in  the  sub-

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standard  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  liquidation  in  full,  –  on  the  basis of  currently known  facts,  conditions and  values –  highly questionable  and  improbable.

4.1.3 Loss     Assets    

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  is not  warranted  although  there  may be some salvage or recovery value.

5 PROVISIONING NORMS  

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  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.  

(d) Of Income Tax Act, 1961 Section  36  -  Other  deductions  [as  it  stood  at  the  material time]    

(1)     The deductions provided for in the following  clauses  shall  be  allowed  in  respect  of  the  

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matters dealt with therein, in computing the  income referred to in section 28 –

(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:

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 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 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 –

(a)   a  scheduled  bank  not  being  a  bank  incorporated 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  cent  of  the  aggregate average advances made by  the  rural  branches  of  such  bank  computed in the prescribed manner.

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43D -  Special  provision in case  of  income of  public  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  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 prescribed2  having regard to the guidelines issued 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 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  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 institution or bank or corporation or company,  whichever is earlier.

Reasons for RBI Directions 1998

 On 31.01.1998, RBI Directions 1998 introduced a new regulatory  

framework involving prescription of Disclosure norms for NBFCs which are  

deposit taking to ensure that these NBFCs function on sound and healthy  

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lines.   Regulatory  and supervisory attention  was focussed  on the  deposit  

taking 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 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.

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 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 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  

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assets.   As  per  sub-para  2  of  Para  9,  “the  provisions  shall  be  distinctly  

indicated  under  separate  heads  of  accounts”  on  the  Liability  side  of  the  

balance sheet under the caption “current liabilities and provisions”.   

It  needs  to  be  emphasized  that  the  said  1998  Directions  are  only  

Disclosure  Norms.   They  have  nothing  to  do  with  computation  of  Total  

Taxable Income under the IT Act or with the accounting treatment.  The said  

1998 Directions only lay down the manner of presentation of NPA provision  

in the balance sheet of an NBFC.

Analysis of Para 9 of RBI Directions 1998

Vide Para 9, RBI has mandated that every NBFC shall 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  

Sheet under “Current Liabilities and Provisions” and that such provision for  

each year shall 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  

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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  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.

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.   

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 / Disclosure and has nothing to do with  

computation of taxable income under the IT Act.  

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 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  

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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  Income Tax v. Jwala Prasad  

Tewari 24 ITR 537 and  Vithaldas H. Dhanjibhai Bardanwala (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  

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.  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 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  liabilities  and  provisions”  on  the  

Liabilities side of the balance sheet, then it would constitute a provision for  

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doubtful debt.  In 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,  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.  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 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-à-

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 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.  

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One more aspect needs 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.  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 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 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.

Deviations between RBI Directions 1998 and Companies Act

Broadly, there are three deviations:

(i) in  the  matter  of  presentation  of  financial  statements  under  

Schedule VI of the Companies Act;

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(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;

(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  

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 Provisions created against them.   

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 there only in the case of provisions.

As  stated  above,  the  Companies  Act  allows  an  NBFC to  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  on  the  Liability  Side  of  Balance  Sheet,  i.e.,  under  the  Head  

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“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-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.  

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 above, under the mercantile system of  

accounting, interest / 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  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  uncertainty  in  collection  of  the  

income.  It is for the assessing officer to accept the claim of the assessee  

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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.   

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 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 IIIB which deals with  

provisions relating to Financial Institutions, and to non-banking Institutions  

receiving deposits from the public.  The said 1998 Directions touch various  

aspects such as income recognition; asset classification; provisioning, etc.  

As stated above, basis of the 1998 Directions is that anticipated losses must  

be  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.  

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 do with  

the computation or taxability of the provisions for NPA under the IT Act.

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Prior to RBI Directions 1998, Advances were stated net of provisions  

for  NPAs  /  bad  and  doubtful  debts.   They  were  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  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  

Debtors/  Advances”.   Therefore, RBI has taken a position as a matter  of  

disclosure, with which we agree, that if an NBFC 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 “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 from  

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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 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  

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.   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 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 expense/ loss in the financial  

45

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 “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 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  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 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.

Theory of “Real Income”

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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 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 Income-Tax, Bombay City  

I, 57 ITR 521 at page 530, this is what the Supreme Court had to say:

“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.  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 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  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”.

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The point to be noted is that the IT Act is a tax on “real 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 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 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.   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 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  

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Act, unless such Losses/ Expenses are expressly or by 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  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  to  the  

“provision for doubtful debt”.

Applicability of Section 145

At the outset, we may state that in essence RBI Directions 1998 are  

Prudential/  Provisioning Norms issued by RBI under Chapter IIIB 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 45Q, an overriding effect is given to the Directions 1998  

vis-à-vis  “income  recognition”  principles  in  the  Companies  Act,  1956.  

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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 income.  These Directions cannot  

overrule the “permissible deductions” or “their exclusion” under the IT Act.  

The 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 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 view of Section 45Q  

of the RBI Act.  Hence, as far as Income Recognition is concerned, Section  

145 of the IT Act has no role to play in the present dispute.

Analysis of Section 36(1)(viia)

Section  36(1)(vii)  provides  for  a  deduction  in  the  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 its rural branches, of a sum  

not exceeding a specified percentage of the aggregate average advances by  

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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 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 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)  applies,  the  amount  of  bad  and  

doubtful debt shall  be debited to the provision for bad and doubtful debt  

account and that the 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  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.   

Whether provision on NPA is allowable under Section 37(1)?

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As stated above, 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 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 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” as explained above.  

Analysis of Section 43D

It is similar to Section 43B.

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 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 Section 43D to provide that such interest shall be charged to tax  

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only in the year of receipt or the year in 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 arise for determination in this case did  

not arise in the cases cited by the appellant(s).

Challenge to the constitutional validity of Sections 36(1)(viia) and 43D  of the IT Act      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 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 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.

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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  

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 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.   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 two concepts,  

namely, “risk” and “liquidity” bring out the basic difference between NBFCs  

and Banks.  Take the case of the scope of impugned Section 43D.  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  to  recover.  

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Therefore, Parliament realized that taxing such “income” on accrual basis  

without actual recovery would create liquidity crunch, hence, Section 43D  

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 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,  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 43D are often restricted to banks and not to NBFCs.  Lastly, as stated  

above, 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.   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)(viia).   One more  aspect  

needs to be mentioned, apart from the fact that NBFCs and Banks are two  

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  

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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  

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.   

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 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.   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 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  

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Direction 1998 is not applicable to Banks, there is no question of extending  

the  benefit  of  deduction  to  NBFCs  under  Section  36(1)(viia)  or  under  

Section 43D.  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”.  

 Before concluding, we may cite the following judgments of this Court  

in the context of the constitutional validity of Sections 36(1)(viia) and 43D  

of the IT Act.

In the case of  R.K. Garg v. Union of India (1981) 4 SCC 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 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, 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  

57

principles. The legislature understands and correctly appreciates the needs of  

its  own  people,  its  laws  are  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 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.

In the case of  Bhavesh D. Parish v. Union of India,  (2000) 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  interfering  with  its  applicability.  Merely  

because  a  statute  comes  up  for  examination  and some arguable  point  is  

raised, the legislative will should not be put under a cloud. It is now well  

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 system of checks and balances has to be  

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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.

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  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  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.”

In  the  case  of  Barclays  Mercantile  Business  Finance  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  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.

Conclusion

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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 costs.

………………………..J. (S. H. Kapadia)

………………………..J. (Aftab Alam)

New Delhi;  January 11, 2010       

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