1.0 Facts :
1.1 X Ltd. provides for doubtful debts of Rs.10 crores in its
accounts for the year ended 31st March, 2010. The provision is based on a list
of debtors likely to turn bad. The company has reason to form such belief. After
making the provision, the company declares a ‘book profit’ of Rs.20 crores in
its profit and loss account. It has assessed brought forward unabsorbed business
losses of Rs.30 crores. Therefore, the company in its normal computation of
income, after adding back the provision for doubtful debts, declares nil income.
1.2 The question arises in computing the ‘book profit’
u/s.115JB : whether adjustment is required in respect of Rs.10 crores being
provision for doubtful debts. Your advice is sought in this regard.
2.0 Opinion :
2.1 Adjustments u/s.115JB to the book profits can be made if
the profit and loss account is not in conformity with Schedule VI to the
Companies Act, 1956, or such adjustments are necessitated by Explanation 1 to S.
115JB of the Income-tax Act, 1961. Therefore, the issue basically requires
consideration whether the debit entry in the income statement in respect of
provision for doubtful debts is hit by any requirement of the said Schedule VI
or by any clause of Explanation 1 to S. 115JB(2).
2.2.1 As far as the requirements of Schedule VI are
concerned, the profit and loss account is in conformity with the requirements of
Schedule VI. No adjustment is required on this account.
2.2.2 Let us turn to Explanation 1 to S. 115JB. There are two
clauses which may possibly apply to the creation of a reserve in respect of
doubtful debts. Clause (c) of the said Explanation reads as, “the amount or
amounts set aside to provisions made for meeting liabilities, other than
ascertained liabilities”. Thus, what is to be decided is whether such provision
is in respect of a liability or not, and if it is in respect of a liability,
whether the liability is an ascertained liability or not.
2.2.3 The issue whether a provision for doubtful debts is for
an ascertained liability or not has been setted by the Supreme Court in its
decision in the case of CIT v. HCL Conmet Systems and Services Ltd., (2007) 292
ITR 299. The Supreme Court held that the provision for doubtful debts and
advances could not be regarded as a provision for a liability other than an
ascertained liability. Thus, it is submitted that no adjustment is required in
respect of provision for doubtful debts under clause (c) of Explanation 1 to S.
115JB(2).
2.3.1 We must now consider clause (i) of Explanation 1 S.
115JB, introduced by the Finance (No. 2) Act, 2009, with retrospective effect
from 1st April, 2001. The new clause (i) reads as, “the amount or amounts
set aside as provision for diminution in the value
of any asset”.
2.3.2.1 The crucial terms of clause (i) to be considered are
: ‘amounts set aside’ and ‘diminution in the value of any asset’.
2.3.2.2 Before we proceed further, let us understand the
nature of provision for doubtful debts. The nature of provision for doubtful
debts is that the provision is recognition of the fact that certain debts are
unlikely to be recovered. The debts have not conclusively become bad. In
accordance with the conservative principle of accountancy, a charge is soon made
to the income statement in respect of the amounts of such debts without waiting
for the debts to actually turn bad.
2.3.2.3 Clause (i) speaks of amounts being set aside as
provision. Therefore, one of the questions that we need to ask ourselves is :
Are we setting aside any amount when we create a provision for a doubtful debt ?
The answer is no. When we create a provision for a doubtful debt, we do not set
apart or set aside any amount. An amount ‘set aside’ has the characteristic of
becoming available at a later time when required to recoup loss occasioned by
the eventuality. In fact, there is no such amount set aside when a provision for
a doubtful debt is made that it may be required later or that it may be
available. Such a provision is made in accounts to ascertain how much income
should be available for distribution to the stakeholders. Strictly interpreting,
when clause (i) speaks of amounts set aside, it may apply only to cases when an
amount on the asset side of the balance sheet corresponding to the amount of the
expected loss is earmarked for meeting an eventuality. We may remember that the
theory of depreciation discusses creation of an earmarked fund as an asset
corresponding in amount to the depreciation reserve, which can be used when the
asset concerned requires replacement. A mere debit in the profit and loss
statement may not amount to setting aside any amounts for a particular purpose.
A debit creating a provision for doubtful debts is nothing more than recognition
of the fact that certain debts may not be recovered. A provision of a revenue
nature is created through a debit in the income statement, but every debit in
the income statement is not creation of a provision. Many debits are in
recognition of losses or are a charge under the matching principle. When a
provision for doubtful debts is made no amount will be required to replenish
these debts when they actually become bad and therefore no amount is set aside
when such provision is made. Thus, we can say that there is no amount set aside
when a provision for doubtful debts is made. Thus, the first limb of clause (i)
of Explanation 1 to S. 115JB(2) does not apply.
2.3.2.4 If the first limb of clause (i) fails as shown above, the whole clause (i) should fail. However, one may argue that the debit entry in the income statement creating the provision restricts the distributable profits and thereby it can be said that it sets aside an amount. Thus, according to the advocate of this argument, the first limb of clause(i) may be applicable to creation of a provision for doubtful debts. I must say that there is merit in this argument. Therefore, it will be interesting to examine whether the second limb, namely, that there is ‘diminution in the value of any asset’ applies or not. One may note the dictionary meaning of the word ‘diminution’ which is “the act, fact or process of diminishing, lessening, reduction”. The word ‘diminish’ means ‘to make or cause to seem smaller, less, less important, etc.; lessen; reduce.’ The words ‘lessen’ and ‘reduction’ have more or less the same meaning. Thus, the word basically means diminishing, reduction or lessening, as against complete annihilation or destruction. One generally will not associate the word ‘diminution’ with complete destruction or annihilation. Depreciation in respect of fixed assets is a classic example of diminution in the value of fixed assets. Provision for doubtful debts does not stand on par with provision for depreciation. Provision for depreciation is recognition of gradual fall in the value of the underlying asset, whereas the provision for doubtful debts is recognition of possible loss of an entire asset. There is no diminution, as the term is understood, of value of the debts; there is imminent complete loss of the asset. However, it may be noted that if a debt is valued (as it is valued for securitisation purpose) at a value less than the book value and a provision is made for the possible loss, such provision may be hit by clause (i) subject to consideration whether any amount can be said to have been set aside.
2.4 Conclusion:
Clause (i) of Explanation 1 to S. 115JB(2) should not apply to a bona fide provision for doubtful debts as there is neither setting aside of an amount, nor is there any recognition of diminution in the value of an asset. It is another matter that there may be a likelihood of a complete loss of value but then it is not diminution in value, it is loss of value. A question may arise : to which situation then the said clause (i) of Explanation 1 to S. 115JB(2) will apply? It will apply to a situation where the underlying asset is in existence and there is a fall in value which is recognised through the profit and loss account and a fund to recoup such loss is simultaneously created.
Note : The views are personal and expressed here to raise some arguments. The matter may be settled only through judicial intervention.
Editor’s Note: The Delhi Tribunal in the case of DCM Shriram Consolidated Ltd. vs DCIT (2010) 39 SOT 203 (Del) has taken a view contrary to the view expressed by the author in this Article.
