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Bad Debt is a debt which is not collectible and is worthless to the Creditor. It is usually a product of the debtor which has gone for bankruptcy. Bad Debts can also occur when the collection cost is more than the amount of the debt. As soon as the debt is bad, the business should be allowed to write off as an expense in its income tax return.

Bad Debts

A Deduction is allowed in for the debt related to business and profession if the same has become irrecoverable in the previous financial year. If the Loans lent by banking or money lending concerns are not able to recover the debts in full or part thereof, a deduction may be allowed. The eligibility of the deduction is on the existence of debts which is irrecoverable is totally under the law or through courts.

The conditions laid down in Income Tax Act, 1961 u/s 36(2) should be fulfilled before any allowance for bad debts is allowed. The conditions are:

  1. The debt or loan should be for the business or profession of the assessee and the said debt or loan should be for the relevant accounting year. Any debt which does not relate to the assessee business or profession, the deduction is not allowed in case of such debt.
  2. In the case of “Girdhari Lal Gian-chand vs C.I.T (1917) 79 T.R 561 (Allahabad),” it is settled that if a debt due from retired partners is irrecoverable then the assessee cannot write off and claim the same as a deduction since it is a capital loss.
  3. An assessee can take the deduction in respect of those debts only which have been included in the computation of the Income Tax Return in the current period or any previous financial year. In case of the money lending business, the money lent in the ordinary course of business should be considered.
  4. The deduction claimed as the bad debts against any debt or loan or any part of it thereof should have actually been bad in the accounting year.
  5. An assessee will only be eligible to take the deduction in respect of those debts only which they have written off from the books of accounts in the previous financial year in which the deduction is also claimed.

Bad Debts of Discontinued Business

Bad Debts of a discontinued business which is already discontinued before the accounting year starts, cannot be claimed as a deduction from the profit of the continued business of the assessee. As per section 36(2)(iii) if bad debts have already been written off in the books of accounts but they are not allowed as a deduction by A.O on the ground that the debt is still having a possibility of recovery. Any such debt or part of debt should be allowed as a deduction in the year in which is becoming irrecoverable.

Bad Debts Recovered

If in any previous year, the debt has been written off as bad and the relevant deduction has also been claimed but later on the same debt is recovered in full or part, then the amount so recovered will be included as income of the financial year in which such amount has recovered.

If in any previous year, the assessee has written off a part of the debt and the said deduction was also allowed by the Assessing Officer and in future, some money is received from the debtors, then the amount so recovered will be treated as a normal realization of debts. If the amount recovered doesn’t exceed the expected, then the remaining amount will be treated as bad debts. If the amount received exceeds the recoverable amount, then the excess amount received will be treated as the income in the financial year of the receipt.

Provision for Bad and Doubtful Debts

As per section 36(1)(Viia) of the Income Tax Act, 1961 only banks and financial institutions are allowed deduction in respect of the provisions made for bad and doubtful debts. No other assessee is allowed to claim the deduction on the provision of bad debts. The limits on which the deduction is allowed to the banks and financial institutions are:

Bank Type Deduction Allowed Explanation
Indian Banks 7.5% of adjusted total income

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10% of average aggregate advances made by rural branches

Indian Bank means any bank which is not a foreign bank and is a banking company incorporated in India.
Adjusted Total Income – Gross total income before deduction under the section 36(1)(viia).
Average aggregate advances (Note below)
Foreign Banks 5% of adjusted total income Adjusted Total Income – Gross total income before deduction under the section 36(1)(viia).
Public Financial Institution, State Financial Corporation 5% of adjusted total income Adjusted Total Income – Gross total income before deduction under the section 36(1)(viia).

Note: Average aggregate advances can be computed in following steps:

  1. Calculate separately all the advances made by every rural branch
  2. Calculate average advances made by branch i.e advances made divided by no of months outstanding
  3. Total of all the average advances by every branch

Treatment as per Accounting Standard

As per Accounting Standard 29 “Provisions, Contingent Liabilities and Assets” an assessee must account for the provisions that occur in the ordinary course of business. Since the provisions are disallowed sometimes by the Income Tax Department, it creates a timing difference between the books of accounts and books as per I.T Act. Thus, an assessee will also need to create Deferred Tax Assets/Liability accordingly.

An assessee must only a deferred tax asset/liability only the timing difference of the transaction is temporary in nature and have the possibility of getting reversed in the future.

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