Bad debts, a payment to a relative and undervalued closing stock: admissible or not

Under the head Profits and gains of business or profession (PGBP), income is the net profit of the profit and loss account adjusted for items the Act allows or disallows. The three items are treated as follows.

(i) Actual bad debts and a provision for bad debts

Actual bad debts: admissible. A debt (or part of it) written off as irrecoverable in the books in the tax year is deductible (section 31(2); formerly section 36(1)(vii)) if:

1. it was taken into account in computing the assessee's income of the tax year in which it is written off or of an earlier tax year (for example, a sale on credit included in sales), or it is money lent in the ordinary course of a banking or money-lending business carried on by the assessee (section 31(2)(a)); and
2. it is actually written off in the accounts of the year.

Where only part of a debt was allowed and what is finally recovered falls short of the rest of the debt (the debt less the amount already allowed), that shortfall is deductible in the tax year in which the final recovery is made (section 31(2)(b)). A bad debt written off does not include a provision for bad and doubtful debts (section 31(3)(a)). A bad debt that was taken into account as income of that or an earlier tax year under the notified income computation and disclosure standards, without being recorded in the accounts, is allowed in the tax year in which it becomes irrecoverable and is deemed to have been written off in the accounts for section 31(2) (section 31(3)(b)).

The assessee need not prove that the debt has become bad; writing it off is enough for an ordinary business. (A bank or other lender allowed a deduction for a provision under section 31(1) must also meet section 31(2)(c): the bad debt is first set against that provision account, and only the excess is allowed; the bad debt must be debited to that provision account in the tax year, and there may be only one such account, covering all types of advances, including those made by rural branches (section 31(2)(c)(i)-(iii)).) Outside a banking or money-lending business, a loan to a friend or an advance for a capital asset is not a trade debt and is not allowed. If a debt allowed earlier is recovered later, the recovery is taxed as business income of the year of recovery.

Provision for bad and doubtful debts: inadmissible for an ordinary business. A provision is only an estimate of a possible loss; no debt has been written off. It is added back to the net profit. Only the lenders listed in section 31(1) may deduct a provision, within its limits: banks (scheduled, non-scheduled or incorporated outside India), co-operative banks (except primary agricultural credit societies and primary co-operative agricultural and rural development banks), public financial institutions, State Financial Corporations, State Industrial Investment Corporations and non-banking financial companies. The limits are set by the Table in section 31(1): for scheduled banks (other than foreign banks), non-scheduled banks and those co-operative banks, not more than 8.5% of the total income computed before this deduction and Chapter VIII, plus up to 10% of the aggregate average advances made by rural branches (computed as prescribed), and, for scheduled and non-scheduled banks at their option, a further amount up to the income from redemption of securities under a scheme framed by the Central Government, where that income has been disclosed in the return of income under the head PGBP; for foreign banks, public financial institutions, State Financial Corporations, State Industrial Investment Corporations and non-banking financial companies, not more than 5% of that total income.

(ii) Payment to a relative

Admissible to the extent reasonable; the excess is inadmissible. A payment to a relative for goods, services or facilities is allowed as a business expense, but where the Assessing Officer considers it excessive or unreasonable, having regard to (a) the fair market value of the goods, services or facilities, or (b) the legitimate needs of the business, or (c) the benefit derived by or accruing to the assessee from it, the excess is disallowed (section 36(2); formerly section 40A(2)). For an individual, a specified person includes any relative: the spouse, brother or sister, and any lineal ascendant or descendant (section 36(3) and section 2(94)). For other assessees the specified persons are a director of a company, a partner of a firm, or a member of an association of persons or a Hindu undivided family, or a relative of any of them (section 36(3)(a)(i), Table: Sl. Nos. 2-5). The term also covers:

• a person (an individual, company, firm, association of persons or Hindu undivided family) with a substantial interest in the assessee's business or profession; any director, partner or member of that person; any relative of that individual, director, partner or member; and any other company in which that first company itself has a substantial interest (section 36(3)(a)(ii));
• a company, firm, association of persons or Hindu undivided family one of whose directors, partners or members has a substantial interest in the assessee's business or profession, together with its directors, partners or members and their relatives (section 36(3)(a)(iii)); and
• a person carrying on a business or profession in which the assessee has a substantial interest, or in which the relatives of an individual assessee, or the directors, partners or members of a company, firm, association or family that is the assessee (or their relatives) have such an interest (section 36(3)(a)(iv)).

A person has a substantial interest (section 36(3)(b)) where, at any time during the tax year: if the business is carried on by a company, he is the beneficial owner of shares carrying not less than 20% of the voting power, shares carrying a fixed-rate dividend (whether or not they also share in profits) not being counted; and in any other case, he is beneficially entitled to not less than 20% of the profits of the business or profession.

Example: a trader pays his son ₹60,000 a month as accountant, though the work is worth ₹35,000 a month in the market. ₹3,00,000 a year (₹25,000 × 12) is disallowed; the rest is allowed. A payment that is not for the business at all (for example, a gift or pocket money to the son) is wholly inadmissible as a personal expense.

(iii) Undervaluation of closing stock

Not admissible: the undervaluation is added back. Closing stock is credited to the trading account, so valuing it too low lowers the profit of the year. For PGBP, inventory must be valued at the lower of actual cost and net realisable value, as the income computation and disclosure standards require, and the value is adjusted to include any tax, duty, cess or fee actually paid or incurred to bring the goods to their present location and condition (section 277(1)(i)-(ii); formerly section 145A); such a tax, duty, cess or fee includes every such payment, whatever right arises from the payment (section 277(4)). Securities held as inventory follow their own rule: securities not listed on a recognised stock exchange, or listed but not quoted on one with regularity, are valued at the actual cost initially recognised, and other securities at the lower of actual cost and net realisable value, compared category-wise; a scheduled bank or public financial institution values its securities under the income computation and disclosure standards, taking into account the Reserve Bank of India's guidelines (section 277(1)(iii)-(iv), (2) and (3)). Income under this head is computed on the cash or mercantile system of accounting regularly employed by the assessee (section 276(1)), following the income computation and disclosure standards that the Central Government notifies under section 276(2).

So where closing stock worth ₹5,00,000 (at cost, below its net realisable value) is shown at ₹4,20,000, the ₹80,000 undervaluation is added to the net profit. The opening stock of the next year is taken at the same corrected value, so the profit of the next year falls by the same amount. If the Assessing Officer is not satisfied about the correctness or completeness of the accounts, or the method of accounting in section 276(1) has not been regularly followed, or income has not been computed as per the notified standards, he may make a best judgment assessment in the manner of section 271 (section 276(3)).

Summary