1. This Larger Bench was constituted to decide the controversy which had arisen with regard to dis- allowance of bad debts claimed by adopting mercantile system of accounts by the various banks.
2. Since it is only the above issue which is to be decided by this Larger Bench, the counsels of the taxpayers were asked to prepare a common question in order to restrict the finding by this Bench to the said extent only. The Bench therefore, shall decide the following common question framed by the taxpayers as well as the revenue while other issues shall be disposed by the respective Division Benches before whom the same shall be placed by the respective Rosters.
3. The question in issue is as follows:-- "Whether on facts and in the circumstances of the case the receivable amount could be written of by debiting it in the Profit and loss Account as expenditure, with the nomenclature `provision for bad debts' or not."
4. The taxpayers counsel Dr. Ikram-ul-Haq taking the lead at the very outset commented that this Tribunal has decided this issue in a long line of judgments among which the one which in his opinion is more comprehensive and has thken care of all the respective arguments is reported 2006 PTD 1784 (Trib.). This judgment is in the case of Soneri Bank and was recorded in a Reference Application filed by the Revenue. This Tribunal while declining to refer the question of law has dilated upon each and every aspect with regard to the issue under discussion.
5. The new controversy emerged when a judgment decided by the Hon'ble High Court of Sindh came to the knowledge of the Revenue wherein the Hon'ble Court has refused to admit a question of law proposed by a taxpayer bank. The A.R. Says that the department has not only mis-understood the ratio decidendi of the referred judgment but has also started ignoring the clear ratio of the judgments of this court as well as the other superior courts. He commented that although the said judgment is no more in field as there is again a very clear and unequivocal finding by the same Hon'ble High Court which has now been recorded as 2006 PTD 1400, the revenue is still taking an incorrect stand. The learned counsel further elaborated that the order which is now being followed by the Revenue officer in terms of I.T.A. No.565 of 2000 dated 1-3-2006 is neither a judgment in terms of Article 201 of the Constitution being a Kacha order nor it has come out with a ratio decidendi. In any case there being another judgment which has decided the issue with clarity and is required to be followed in terms of the Article referred supra there is no question of any exception.
6. The arguments advanced by the learned counsel were adopted by Mr. Naveed A. Andrabi, advocate. Besides, he further pointed out that it is only the Hon'ble Supreme Court of Pakistan whose `obiter dicta' is binding on all subordinate courts and administrative authorities and not of the other courts of the country. Still further it is a decided principle of law that in revenue Cases it is the substance of the thing which is to be looked into and not on the basis of the nomenclature. It is true that Banks as per the requirement of the Prudential Banking Regulations of the State Bank of Pakistan project it as 'provision of bad debts', but in actual form the same is a reduction from the profit. The use of nomenclature for the same as 'provision' does not restrict the actual substance of the claim. He remarked that in the prime and landmark judgment of the Hon'ble High Court Sindh in the case of National Bank of Pakistan reported as 1976 PTD 237 this matter has been dilated thoroughly and, in fact, after the said judgment as well as the other judgments in field including 2006 PTD 1784 (Trib.) referred supra the matter should have come to an end. He commented that this judgment referred by the Tribunal has attained finality in the manner that there is no issue pending with the regard thereto either before the High Court or the Supreme Court of Pakistan.
7. Since it is more comprehensive and well reasoned judgment in addition to the fact that no adverse order has been passed by the superior courts to demolish the ratio settled therein the deviation by the Revenue is un-called for, the A.R. Remarked. Needless to say that now with the latest judgment of the High Court Sindh no additional argument would be required. He further produced various judgments in support of his other arguments with regard to the principles of interpretation. His main arguments are as follows:--
(i) That accounts of the banks are maintained strictly under International Accounting Systems read with S.E.C.P. Laws as well as Prudential Banking Regulations of the State Bank of Pakistan.
(ii) That 'provision for bad debts' is only a nomenclature. However, it does not convey the substance. The entry in fact amounts to actual 'written of' as the same amount has actually been reduced from the accounts.
8. (i.e) That there is no bar in law to maintain hybrid system of accounts i.e. a part Mercantile and the other part in cash receipt basis.
(iv) That the Kacha judgment of the Hon'able Sindh High Court in terms of I.T.A. No.565 mentioned supra is not a judgment; hence does not have any binding effect.
(v) That principle of stare decisis clearly envisages that the judgment which is late in sequence has a more binding force.
(vi) That it is only the ratio decidendi of the Hon'ble High Court which is binding.
(vii) Even otherwise the referred judgment being in ignorance of the relevant provision as well as the settled ratio of the judgment of the High Court of Pakistan in terms of 1976 PTD 237 supra is a judgment per in curium.
9. Mian Ashiq Hussain, the learned counsel adopted the earlier arguments. He submitted for other cases in support of the above contentions. However, he has argued the case from another angle. In his opinion this aspect has not been discussed in the earlier judgments. The jist of his claim is that the business of the taxpayers being of Banking the money is a stock in trade. It is in strict observation of the laws of the land in terms of Prudential Banking Regulations that the debt is shown as irrecoverable. The loss of the bank in fact is much more than what it is gaining by reducing this amount from its income. This, therefore, is a trade loss and no embargo has been imposed on the claim of the assessee being a trading loss. Further explaining his case he pointed out that in the case of his bank i.e. Al-Baraka Islamic Bank the amount is reduced from the outstanding loan in the very accounts itself and has not been claimed either under section 22 of the erstwhile Income Tax Ordinance. 1979 or the corresponding provisions in the Income Tax Ordinance, 2001. He remarked that since it is not a revenue claim, hence the departmental objections with regard to lessor efforts for its collection etc. Becomes irrelevant. In support of his claim that the money is stock in trade he has placed reliance on 1982 PTD 20 re: Dawji Dada Bhai and Lo v. The Commissioner of Income Tax (West) Karachi, (1985) 55 ITR, 707 (SC of India), 2006 PTD 1400 and 2006 PTD 1784 (Trib.).
10. The other counsel advanced some arguments, however, the same being more or less on the same as above are not separately added..
11. The Revenue case, on the other hand, remains that the referred judgment of I.T.A. 565 of 2000 of the Sindh High Court supra is a clear cut direction and needs to be followed in the interest of the Revenue. Their emphasis was that the department is being deprived of its well deserved revenue through mis-use of the discretion and without making any real effort to collect the same from the defaulters. It was further commented that it amounts to providing benefit to the indolence of the assessee.
12. Having heard the concerned parties and after going through the record, going through the relevant provisions shall be of help. The comparable provision of law in various Income Tax Laws is as follows:-- "A. SECTION 10(2)(XI) OF INCOME TAX ACT, 1922 S. 10. Business.---(1) Subject to the provisions of this Act, the tax shall be payable by an assessee under the head Profits and gains of business, profession or vocation in respect of the profits or gains of any business or vocation carried on by him.
(2) Subject to the provisions of this Act such profits or gains shall be computed after making the.
13. Following allowances, namely:--
(xi) when the assessee's accounts in respect of any part of his business, profession or vocation are not kept on the cash basis, such sum, in respect of bad and doubtful debts; due to the assessee in respect of that part of his business, profession or vocation and in the case of an assessee carrying on a banking or money -lending business, such sum in respect of loans made in the ordinary course of such business as the Income-tax Officer may estimate to be irrecoverable but not exceeding the amount actually written of as irrecoverable in the books of assessee: Provided that where any such debt or loan or part thereof has already been written of as irrecoverable in the accounts of the assessee for an earlier previous year and it was not allowed to be deducted on the grounds that it had not become irrecoverable in that year, the Income-tax Officer shall, on being satisfied that it became irrecoverable in a subsequent previous year, allow It to be deducted in that previous year: Provided further that where any such debt, or loan or part thereof is written of as irrecoverable in the accounts of the assessee for a previous year and the Income Tax Officer is satisfied that such debt or loan or part thereof became ' irrecoverable in an earlier previous year not falling beyond a period of four years immediately preceding the previous year in which it was written of, the Income Tax Officer may, notwithstanding anything contained in this Act, allow such debt, loan or part thereof as a deduction for such earlier previous year if the assessee accepts such finding of the Income Tax Officer and recomputed the total income of the assessee for such earlier previous year and make the necessary amendment; and the provisions of section 35 shall, so far as may be, apply thereto, the period of four years referred to in subsection (1) of that section being reckoned from the end of the year in which the assessm ent relating to the previous year in which the debt or loan or part thereof is written of was made: Provided further that if the amount ultimately recovered on any such debt or loan is greater than the difference- between the whole debt or loan and the amount so allowed, the excess shah be deemed to be a profit of the year in which it is recovered and if less, the deficiency shall be deemed to be a business expense of that year.
(B) SECTION 23(1)(x) OF INCOME TAX ORDINANCE, 1979
(23) Deductions.---(1) In computing the income under the head "Income from business or profession", the following allowances and deductions shall be made, namely:--
(x) in respect of bad debts, such amount (not exceeding the amount actually written of by the assessee) as may be determined by the Deputy Commissioner to be irrecoverable;
(C) SECTION 29 OF INCOME TAX ORDINANCE, 2001
(29) Bad debts.---(1) A person shall be allowed a deduction for a bad debt in a tax year if the following conditions are satisfied, namely:--
(a) The amount of the debt was--
(i) previously included in the person's income from business chargeable to tax; or
(ii) in respect of money lent by a financial institution in deriving income from business chargeable to tax;
(b) the debt or part of the debt is written of in the accounts of the person in the tax year; and
(c) there are reasonable grounds for believing that the debt is irrecoverable.
(2) The amount of the deduction allowed to a person under this section for a tax year shall not exceed the amount of the debt written of in the accounts of the person in the tax year.
(3) Where a person has been allowed a deduction in a tax year for a bad debt and in a subsequent tax year the person receives in cash or kind any amount in respect of that debt, the following rules shall apply, namely:--
(a) where the amount received exceeds the difference between the whole of such bad debt and the amount previously allowed as a deduction under this section, the excess shall be included in the person's income under the head "Income from Business" for the tax year in which it was received; or
(b) where the amount received is less than the difference between the whole of such bad debt and the amount allowed as a deduction under this section, the shortfall shall be allowed as a bad debt deduction in computing the person's income under the head "Income from Business" for the tax year in which it was received.
(D) SECTION 36(2) OF INDIAN INCOME TAX ACT, 1961 36. Other deductions
(2) In making any deduction for a bad debt or part thereof, the following provisions shall apply-
(i) no such deduction shall be allowed unless such debt or part thereof has been taken into account in computing the income of the assessee of the previous year in which the amount of such debt or part thereof is written of or of an earlier previous year, or represents money lent in the ordinary course of the business of banking or money-lending which is carried on by the assessee;
(ii) if the amount ultimately recovered on any such debt or part of debt is less than the difference between the debt or part and the amount so deducted, the deficiency shall be deductible in the previous year in which the ultimate recovery is made; (i.e) any such debt or part of debt may be deducted if it has already been written of as irrecoverable in the account of an earlier previous year (being a previous year relevant to the assessm ent year commencing on the 1st day of April, 1988, or any earlier assessment year), but the Assessing Officer had not allowed it to be deducted on the ground that it had not been established to have become a bad debt in that year;
(iv) where any such debt or part of debt is written of as irrecoverable in the accounts of the previous year (being a previous year relevant to the assessment year commencing on the 1st day of April, 1988, or any earlier assessm ent year) and the Assessing Officer is satisfied that such debt or part became a bad debt in any earlier previous year not falling beyond a period of four previous years immediately preceding the previous year in which such debt or part is written of, the provisions of subsection (6) of section 155 shall applly;
(v) where such debt or part of debt relates to advances made by an assessee to which clause
(viia) of subsection (1) applies, no such deduction shall be allowed unless the assessee has debited the amount of such debt or part of debt in that previous year to the provision for bad and doubtful debts account made under that clause.
14. An analysis of above sections show that conditions laid down for allowability of bad debt as deduction in the case of banks and other money-lending institutions are the same as envisaged in section 10(2)(xi) of Income Tax Act, 1922 and section 23(1)(x) of Income Tax Ordinance, 1979." This has been observed by this Tribunal in its judgment reported as 2006 PTD (Trib.) 2784.
15. This court in the judgment reported supra has also held that "Bad Debts" and "Doubtful Debts" are synonymous. Its meanings and effects, are also similar. It has further been held in Hong Kong and Shanghai Banking Corporation v. CIT (1955) 28 ITR 199, that the two words 'bad' and 'doubtful' are always applied adjectively to the same class of debts, meaning debts of which the chance of recovery is 'nil' or slender." The C.B.R. In its Circular No.13(26)-IT/1/74 dated 2-7-1975 also has endorsed this view in the following manner:-- "It may, however. Be noted that as held in the case cited as Hong Kong and Shanghai Banking Corporation v. CIT (1955) 28 ITR 199 the expression 'bad and doubtful debts' do not contemplate two kinds of debts but refers to the same class of debts viz., debts of which the chance of recovery is nil Or slender."
16. This court in the judgment referred supra reported as 2006 PTD (Trib.) 2784 has observed as follows:-- "It is pertinent to mention that expression 'bad debt' or 'doubtful debts' were held to be contemplating the same kind of debts and hence interchangeable in Hong Kong and Shanghai Banking Corporation v. CIT (1955) 28 ITR 199. The Central Board of Revenue itself accepted this legal position in letter No.13(26) IT/I/74 dated 2-7-1975 as under:-- "It may, however, be noted that as held in the case cited as Hong Kong and Shanghai Banking Corporation v. CIT (1955) 28 ITR 199 "the expression 'bad and doubtful debts' do not contemplate two kinds of debts but refers to the same class of debts viz., debts of which the chance of recovery is nil or slender."
17. Now we shall come to the judgment in J.T.A. No.565 of 2000 which has vehemently been challenged to be as distinguishable by the tax payers. In our opinion this judgment is wrongly relied upon by the Department, and three judgments of the learned Tribunal, namely Standard Chartered Bank Ltd. (I.T.As. Nos.1302 to 1304, 1595 to 1598/KB/2003 and I.T.A. No.131/KB/2005 dated 14-1-2009), Jahangir Siddiqui Investment Bank Ltd. (I.T.As. Nos.861 and 862/KB/2009 dated 2-6-2010 and Bank Al-Falah Ltd. (I.T.As. Nos.502 to 506/KB of 2009 dated 1-7-2010), based on it, were reached per incuriam due to lack of assistance by the Department and representatives of the taxpayers.
18. Tribunal for adjudication. The Chairman Panel observed in order passed under section 62 of the repealed Income Tax Ordinance, 1979 for the assessment year 1988-1989 as under:-- "During the year under consideration, the assessee claimed provisions for bad and doubtful debts and provisions for loss on account of frauds and forgeries aggregating to Rs.8,I33,926. The amount has been deducted in the computation sheet. The provisions relate to various years starting from assessm ent years 77-78 to 87-88."
19. "Assessee claimed them in the past but the same were disallowed during the course of assessm ents for the relevant year. These disallowances of specific provisions were confirmed in appeal by the learned Income Tax Appellate Tribunal."
20. The observation of learned Commissioner (Appeals) in his order dated 13-2-1990:-- "This debt was disallowed in the assessment year 1977-1978 and has been claimed by the appellant during the year under consideration. After the expiry of 11 years the appellant could not recover the debts. This alone proves that there is no ray of hope of recovery of such debts.
21. Considering these facts the disallowances out of specific provision for bad and doubtful debts which were disallowed in the assessment years 1977-1978 to 1982-1983 and claimed afresh during the year under consideration are being allowed to the appellant."
22. Observation of learned Tribunal in order dated 21-12-1999.
23. From the above quotation it is obvious that in the said case claim of the same 'bad debt' for earlier years was pending before appellate forums while it was again claimed in the year under appeal. It was again claimed twice hence its allowance was obviously not possible.
24. The department's reliance on the above judgment of Sindh High-Court in Grindlays Bank (I.T.A.
25. No.565 of 2000 dated 2006) is without realizing that it is distinguishable not only on facts but also being not a valid authority for the reason cited in Trustees of the Port of Karachi v. Muhammad Saleem 1994 SCMR 2213 as under:-- ................ a case is only an authority for what it actually decides. I entirely deny that it can be quoted for a proposition that may seem to follow logically from it."
26. The above judgment of honourable apex Court was followed by the honourable Lahore High Court in Shahtaj Sugar Mills Ltd. Through Chief Executive v. G. A. Jahangir and 2 others 2004 PTD 1621 with the following observations:-- "In re: Trustees of the Port of Karachi v. Muhammad Saleem (1994 SCMR 2213) the Hon'ble Supreme Court of Pakistan referred to the dictum settled in (1898) AC 375 and Quinn v. Leathern (1901) AC 495 to affirm the basic principle of law of precedent, as we understand it in common law, that every judgment must be read as applicable to the peculiar facts proved, or assumed to be proved., Further that generality of the expressions which may be found in the judgement are not intended to be expositions of the whole law, that governed and qualified by the particular facts of the case in which such expression are to be found. In view of their Lordships a case was only an authority for what it actually decided and that it would not be quoted for a proposition that may seem to follow logically from it."
27. It is worth mentioning here that in the above judgment, three reported judgments, namely CIT v.
28. National Bank of Pakistan 1976 PTD 237, CIT' v. Grindlays Bank Ltd. 1991 PTD 569 and CIT v.
29. Agricultural Development Bank of Pakistan 1992 PTD 39 of honourable Sindh High Court are conspicuous by their absence. Under the established principle of stare decisis, the honourable Sindh High Court could not take adifferent view in the presence of these judgments as held by the honourable Supreme Court in PLD 1995 Supreme Court 423.
30. The fact is that honourable Sindh High decided the matter in view of circumstances bf the case where the provisions were reclaimed when the claim was still alive in the year of write of before Tribunal. In view of this particular situation the question was answered in favour of the Revenue by the Sindh High Court. This aspect escaped the attention of this learned Tribunal when deciding the cases of Standard Chartered Bank Ltd. (I.T.As. Nos.1302 to 1304, 1595 to 1598/KB/2003 and I.T.A. No.131/KB/2005 dated 14-1-2009), Jahangir Siddiqui Investment Bank Ltd. (I.T.As. Nos.861 and 862/KB/2009 dated 2- 6-2010 and Bank AlFalah Ltd. (I.T.As. Nos.502 to 506/KB of 2009 dated 1-7-2010). The correct position of law is again reiterated by the honourable Sindh High Court in I.T.R.A. No. 219 of 2008 re: CIT v.
31. Security Leasing Corporation Ltd.
(i) Whether on the facts and in the circumstances of the case, the learned ITAT was justified to hold that the amount of receivable could be written of by only creating the provision without actually crediting the accounts of debtors?
(ii) Whether on the facts and in the circumstances of the case, the provision for receivables is an admissible deduction under section 29 of the Income Tax Ordinance, 2001 without crediting the said provision to the individual debtor's account?
32. The honourable Sindh High Court has reaffirmed its earlier judgment re: CIT v. National Bank of Pakistan, Karachi 1976 PTD 237. It also quoted Manual of Instructions issued by FBR on the issue and answered both the questions in affirmative. i.e. Against the Revenue and in favour of the taxpayer.
33. Relevant part of the judgment is reproduced below:-- "A perusal of the judgment, specially para 5 of the judgment in Jwala Prasad Tinwari's case, leads to the conclusion that for the purpose of writing of, as mentioned in section 29, and the pari materia statute of the other Statutes it has been defined. This para is reproduced for the sake of convenience: "(5) "Writing of" is a technical term used by financiers and auditors. There are two methods of dealing with a debt which has been written of in the books of account, (1) by giving the corresponding credit to the debtor's account, and (2) by giving the corresponding credit to the bad and doubtful debts account. The first method is only employed where it is desired to close the account of the debtor. The second method is employed where there are some chances of recovery, howsoever remote they may be.
34. When we talk of "writing of" we are not concerned with the credit to be given to an account. "Writing of" means the raising of a debit entry. This can only be to the debit of the profit and loss account.
35. This is the only debit which can possibly be raised as a result of writing of a bad debt."
36. We also consider it relevant to reproduce the instruction given by the CBR in sub-para. (2) of Para. 23.8 of its Manual of Instructions:-- "23.8(2). So far as the requirement of writing of is concerned, the Board is of the view that there is no authority in law under which an assessee should be required to write of the debt or loan in the account of the debtor. The assessee bank would be within its right to claim the deduction under section 23(1) (x) if it so chooses by debiting the profit and loss account and crediting any other account maintained for the purpose, such as slispense account of an irrecoverable loans account.
37. This view is in conformity with the decision cited as Begg Dunlop and Company Ltd."
38. "After reading the above extract from the judgment and the judgment of his Court in the case of National Bank of Pakistan and the instruction of C.B.R. Reproduced above, we are satisfied that the bad debt had been properly written of in accordance with the provisions of section 29. We will, therefore, answer Questions Nos.1 and 2 in affirmative in favour of the respondent and against the appellant."
39. The above judgment of honourable Sindh High Court of 13-10-2010. Endorses the view taken in the detailed judgment of this learned Tribunal in 2006 PTD (Trib.) 2784. It establishes beyond any doubt that due to lack of assistance an incorrect conclusion was reached while deciding the matter in the following cases:--
(i) I.T.As. Nos.1302 to 1304, 1595 to 1598/KB/2003 and I.T.A. No.131/KB/2005 dated 14-1-2009 re.
40. Standard Chartered Bank Ltd.
(ii) I.T.As. Nos.861 and 862/KB/2009 dated 2-6-2010 re: Jahangir Siddiqui Investment Bank Ltd.
41. (i.e) I.T.As. Nos.502 to 506/KB of 2009 dated 1-7-2010 re: Bank AlFalah Ltd.
42. Obviously in view of Sindh High Court judgment in I.T.R.A. No.219 of 2008 re: CIT. v. Security Leasing Corporation Ltd., the above judgments are not enforceable. In these three judgments; the earlier judgment of this learned Tribunal 2006 PTD (Trib.)2784 escaped attention, which is now endorsed in the latest judgment of the honourable Sindh High Court. The judgment of honourable Sindh High Court in I.T.R.A. No.219 of 2008 re CIT v. Security Leasing Corporation Ltd. Is in conformity with its earlier judgment in Commissioner of Income Tax (Central Zone) Karachi v Pakistan Security Printing Press Corporation Ltd. Karachi 1985 PTD 413 wherein it was held that amounts set apart for ascertainable liabilities accrued in the relevant financial year when charged to profit and loss account are allowable deduction, The mere use of nomenclature "provision" is of no significance.
43. This court reiterates that the name of account, "provision for bad debts", does not make it provision.
44. It is in substance a charge to P&L account. It 'is a well-established principle that in revenue matters the substance and not the form of transaction decides the taxability and/or deduction or otherwise (1966) 14 Tax 304 (H.C. Kar). The title 'provision for bad debts' is due to format prescribed by the State Bank of Pakistan or Securities and Exchange Commission of Pakistan (SECP) for C presenting of accounts. In substance, this is 'loan irrecoverable account'. In the case of financial institutions engaged in money-lending business, money is their stock-in-trade and any irrecoverable loan constitutes an allowable deduction---Aranachalam Chettiar v. CIT 4 ITR 173 at 183 (PC). It is worthwhile to mention that "ir recoverability" does not mean absolute ir recoverability-1990 PTD 731.
45. Here again the reliance can be placed on three reported judgments of Sindh High Court, namely CIT v. National Bank of Pakistan 1.976 PTD 237, CIT v. Grindlays Bank Ltd. 1991 PTD 569 and CIT v.
46. Agricultural Development Bank of Pakistan 1992 PTD 39 (supra). In Grindlays Bank case, the facts were that in respect of Rs. 13,85,652 recovery proceedings were pending and for Rs.17,23,826 even no legal action was taken. The word "provision" was never used in section 23(1)(x) of the repealed 1979 Ordinance or even in the parallel provision of 1922 Act. In section 29 the Income Tax Ordinance, 2001 also this word does not appear.
47. As regards objection of the Department regarding a ray of hope of recovery in these cases, the honourable High Court, in National Bank of Pakistan (1976) 34 Tax 158 (H.C. Kar.) has made it clear that ir recoverability does not mean a loss forever and in case of any recovery or reversal, earlier entries of writing of a debt cannot be doubted. In the money-lending business, loans and advances represent stock-in-trade or circulating capital. Any irrecoverable loan/advance is thus a trading loss and allowable expenditure--Arunachalam Chetliar v. CIT 4 ITR 173, CIT v. Nanital Bank Limited 55 ITR 707 (SC) and CIT v. Veerabhadra Rao 102 ITR 604. The lender is not required to actually square up the accounts of the parties to claim this deduction (CBR's C.No.13(26)- IT/I/74 dated 2nd July 1975) In CIT v. Grindlays Bank Ltd., 1991 PTD 569 the facts were that in respect of Rs.13,85,652 recovery proceedings were pending and for Rs.17,23,826 even no legal action was taken. The honourable court even then allowed the deductions. It is pertinent to mention that in National Bank of Pakistan (1976) 34 Tax 158 (H.C. Kar.) the counsel of Tax Department during the arguments raised a number of issues, which are exactly the same as raised by the Taxation Officer e.g. The theory of ray of hope, measure taken for recovery etc. Vis-a-vis determination of ir recoverability of loans and following findings were given by the honourable High Court regarding each issue: "Now, according to Mr. S.A. Nusrat, the respondent's explanation was by itself sufficient to show that, in the opinion of the respondent, the debts had not become irrecoverable. This was also the view of the Income Tax Officer in his assessme nt orders. Therefore, the Income Tax Officer observed: "The entries pertaining to bad debts made in the accounts clearly showed that debts have been written of in the accounts as bad debts. The Income Tax Officer then further observed: "for the purpose of such final writing of of the debt, the account of the debtor is to be credited, with corresponding debt either to bad debts written of account or directly to the Income and Expenditure account or to the Profit and Loss account, as the case may be. Since the debts have been finally written of as irrecoverable and assessee has merely made a provision for bad and doubtful debts in the accounts, the claim for deduction is not admissible in terms of the Income Tax Act and is disallowed"
48. According to the respondent's explanation quoted earlier, even though the bad debts were shown in the account called "Provision for Bad Debts," recoveries made against such bad debts were debited to the Bad Debt Provision Account and credited to the income account; therefore, according to Mr. S.A. Nusrat, the books of the respondent supported the inference drawn by the Income Tax Officer that the debt written of were not really irrecoverable.
49. However, when we invited Mr. S.A. Nusrat to give an example of when a debt would be irrecoverable, he would not do so; so I would take the extreme case of a bank which has not been able to recover the loan advanced by it even though it has exhausted all its legal remedies and.
50. Obtained a bankruptcy order against the debtor. Obviously in such a case the bank would have proved, beyond any doubt, that the debt was irrecoverable. But even in such a case the debt might be repaid, if the debtor obtains an order of discharge and is able to succeed in his business, or trade. Or take the hypothetical case of a debtor receiving a Legacy, or a debtor whose relations pay of the debt for the sake of the honour of the family. Such cases do occur, but because the debt had been believed to be irrecoverable, the bank would necessarily have entered it in its Bad Debt Provision Account. Then, on the unexpected realization of the debt, the bank would have to reverse its earlier entry in the Bad Debt Provision Account and make an entry in its income account for the amount unexpectedly received by it. But, merely because of this reversal of entries, it cannot possibly be said that the earlier entry in the Bad Debt Provision Account was provisional entry.
51. However, that is what the Income Tax Officer held, and this finding was reversed by the Tribunal.
52. The learned author observes at page 365: Proviso, Final Adjustment in the year of Recovery.---The allowance under this clause is necessarily based upon a mere estimate. Ultimately, a larger or smaller portion of the debt or loan may be recovered than was estimated to be recoverable at the time of making the allowance under this clause. In such a case the excess would be taxed as profit of the year in which it is realized, to make up for the excessive allowance in a former year; The above findings of the honourable High Court squarely apply to the present_case. The criteria laid down in the above cases regarding determination of ir recoverability of bad debts can be summarised as under: The allowance of bad debt is necessarily based upon a mere estimate. Ultimately, a larger or smaller portion of the debt or loan may be recovered than was estimated to recoverable at the time of making the allowance under this clause. In such a case the excess would be taxed as profit of the year in which it is realized, to make up for the excessive allowance in an earlier year.
53. The Taxation Officer erred in holding that the respondent's entries about its bad debts "show that the debts have been written of in the accounts provisionally."
54. The argument that unless all the measures to recover the debts are exhausted the claim is not admissible was rejected.
55. The ratio of the above cases especially after latest judgment of the honourable Sindh High Court in I.T.R.A. No.219 of 2008 re: CIT v. Security Leasing Corporation Ltd. Unambiguously prove the allowability of the bank's claim in respect of provisions for doubtful and bad debts.
56. This court, therefore, has no doubt in its mind that the judgment referred as I.T.A. 565 of 2000 by the Hon'able Sindh High Court has neither given any clear finding with regard to the issue in hand nor the same has been properly represented by the assessee. Further facts of the said case which have been detailed by Mr. Naveed A. Andrabi before us are totally distinguishable. Notwithstanding the fact that there is no finding on the issue even as obiter dicta the same being in ignorance of the earlier orders which were also pending adjudication before higher courts was obviously not to be allowed in a subsequent order. In any case, all this discussion and reference become irrelevant in the presence of the other judgment of the High Court in I.T.R.A. 219 of 2008 (supra) recorded by Mr. Justice Athar Saeed. The ratio of the same being clearly applicable on the facts and circumstances of this case is re-produced for ready reference once again. The same reads as follows:- "After reading the above extract from the judgment and the judgment of this Court in the case of National Bank of Pakistan and the instruction of C.B.R. Reproduced above, we are satisfied that the bad debt had been properly written of in accordance with the provisions of section 29. We will, therefore, answer Questions Nos.] and 2 in affirmative in favour of the respondent and against the appellant. ".
57. Above finding confirms the decisions of this Tribunal recorded in a chain of the judgments.
58. As already mentioned supra the arguments of learned counsel have already been thrashed out in the judgment of Soneri Bank in continuation to 1976 PTD 237 (supra). Repetition of the same again and again will be unnecessary. This court has finally held in the said judgment that the nomenclature of provision does not. Convey the substance of the entry which, in fact, is the actual 'write of'. Further the Assessing Officer's discretion is only to the extent of determination of the value of the amount and not with regard to procedure or the factors which persuade a banker to write the same of. Since it has further been held that the Prudential Banking Regulations control this aspect and if the State Bank does not object to the said arrangement of the write of by making it a provision, the Assessing Officer is no one objects to the arrangement. Such a claim deprives the bank of much more amount than what it gains by writing it of.
59. Other factors which have also been decided in the said judgment and National Bank of Pakistan (supra) include that by calling it a provision and keeping the sticky loans in the balance sheet is for the ray of hope of its recovery. This ray of hope is supported by the taxation system in the manner that when ever that amount or a part of it is recovered in future it shall be added as income for the said year. The Revenue, therefore, does not loose anything. When earlier judgments were announced by this court, there may be some thSubts in its mind with regard to the said treatment but with the confirmation of the cases in large number earlier findings have been proved to be as correct and based upon wisdom. During the proceedings of this Full Bench the Representatives of the Banks have confirmed that a large chunk of such sticky loans written of in the past have now been recovered. The Revenue as well as the taxpayer both have gained to the extent thereof. It has also been reported that the result of said gain and the rightful decisions of this court have given boast to the banks and in the last few years they have shown a very clear improvement in their results. Almost all the banks are showing quite positive results and are now contributing to the national economy as well as to the national exchequer. Few years back certain banks which were going into liquidation are now helping the economy. All this has happened because of the policies as well as proper treatment by the courts of this country. Since all this discussion is relevant to the issue, this court does not any doubt in its mind that the issue under discussion which is of the prime importance in terms of banking business as well as for the revenue of the country has been dealt with it its actual spirit. The law of interpretation of fiscal laws is no more debatable. Famous verse of Mr. J. Rowlet in "Cape Brandy Syndicate v. Inland Revenue Commissioner" (1921 R.B. 69), which has been quoted with advantage by the courts for decades reads:- "it simply means that in a taxing Act one has to look merely of what is clearly said. There is no room for any intendment. There is no equity about a tax. There is no presumption as to a tax. Nothing is to be read in, nothing is to be implied. One can only look fairly at the language used".
60. We have been applying the said principle with full advantage and we have no doubt in our mind that there is no reason for disallowance of the claim of bad debt for the banks under discussion.
61. The only criteria is adoption of rules fixed by the State Bank. If there is no deviation of the Prudential Bank Regulations' the claim of bad debt cannot be disallowed. Since it is not the case of the department that there is deviation, the claim of bad debt of the banks are hereby allowed in full.
62. This decides the issue before full bench. For other grounds the cases may fixed before respective benches.
63. Sd/-- (KHAWAJA FAROOQ SAEED)
64. Chairperson Sd/-- (JAVED IQBAL) (Judicial Member)
65. Sd/-- (MUNIR SADIQ)
66. Judicial Member Sd/-- (Abdul Rauf)
67. Accountant Member Sd/-- (IKRAMULLAH GHAURI) Accountant Member DISSENTING NOTE The appeal before the honorable larger bench involved determination of the deletion of appellant's income proportionate to their bad or doubtful debts in terms of section 29 read with section 20 of the Income Tax Ordinance, 2001. In my opinion the issue of bad debts has far reaching and substantial tax and public policy implications. Therefore, with due deference to the valued opinion of my honorable colleagues, I would propose enlargement of the scope of the case by inclusion of a few more proposition. I consider it necessary that the issue of debt write of is determined in juxtaposition with the conditions laid down in section 29 read with section 20 of the Ordinance together with other laws applicable to remission of debts including the Prudential Banking Regulations notified by the State Bank of Pakistan and also the tax related framework of the bankruptcy law. The remission of bad debt by a bank is different from remission of bad debt by a Non-banking business firm. A large part of the bank's capital is composed of depositor's money.
68. The State Bank has a very lax requirement of capital adequacy ratios. Thus, most scheduled banks have a capital adequacy ratio as low as 8 to 10%. This means, 90% of the bank's capital is owned not by the banks but its depositors. There is a fundamental difference between the debt write of by a non-banking and a banking company. A debt written of by a non-banking company represents loss of its on money but a debt written of by a bank represents loss of depositor's money. Thus, whilst a non-banking company can rightly write of its debt comprising its on money and claim deduction of tax, a claim of tax deduction by a banking company on the ground of bad debt write of, ought to be subject to greater scrutiny because what is being generously written of is not owned by the banking company. Secondly, the debts are always secured by collateral much higher in value than the debt amount. Thirdly, banks have many options such as foreclosure of debtor's collateral, debt rescheduling, waiver of interest and assignment of debt to debt management companies, etc. Fourthly, contrary to a non-banking company, the banks have dedicated officials for due diligence before approval of debts. Fifthly, banks are subject to prudential regulations. The depositors expects their bank to protect their deposits, transact its business diligently and give them due share of the profit on the income earned out of their deposits lent to borrowers against one of the highest rate of interest around the world. When the bank reports loss of money in the form of bad debts and subsequently writes them of, the bank's income is reduced in proportion to the written of debt. The reduction of banks income and the profit eventually results in reduction of the income and profit of its depositors, too. The question is why the depositor should share loss of their income with the loss of banks income when they have no role whatsoever in lending business of the bank or debt write of. What if a debt is written of simply because of failure of the bank's management to exercise due diligence or the debt is remitted due to political or financial clout of the debtors or if the money lent to affiliates or associates is being written of. Why should the creditors be worse of for no fault of their on. Had the Bank's power to write of been absolute and unconditional, the honorable Supreme Court of Pakistan would not have taken a suo moto notice of the debt write of by banks, including the State Bank of Pakistan. Whilst the legitimacy of the Bank's power to write of is sub-judice before the honorable Supreme Court of Pakistan and the whole legal framework of debt write of by banking companies is under judicial scrutiny this Tribunal may consider due restraint in accepting the debt write Off as a vested right of banks. It is thus necessary that a holistic review of all the essential conditions laid down in section 29 read with section 20 of Income Tax Ordinance, 2001 should be undertaken before conceding an allowance on account of bad debts. In my opinion there are essentially three elements in the concept of a bad or doubtful debt which qualifies for deduction under section 29 of the Income Tax Ordinance:-- The first is that there should be a debt, properly speaking and should be one which, when good, would have come into the balance-sheet as a trading debt to swell the profits of the business. This means that the debt should be established to have become bad in the previous year.
69. The second element is that it should have been written of by the assessee in the relevant previous year in respect of which the claim for deduction is made by .The assessee.
70. The third element is that, it is fully established that there is no chance of the debt recovery e.g., a debt becomes irrecoverable and it may become irrecoverable from the debtor due to one of three causes: (i) it may be that the debtor is in bad financial position and, therefore, is unable to repay the debt, either wholly or in part, or (ii) it may be that the debtor is in sound financial position but he denies his liability to pay or it is otherwise prudent and expedient for the assessee not to seek to recover the debt. (i.e) it may be that on an examination of the position in the light of the circumstances of and objection raised by, the debtor, and after taking appropriate legal advice, the creditor comes to a conclusion that resorting to a court of law would only result in his throwing good money after bad, or that its chances of recovery are doubtful and slender.
71. Bad Debts: What does a bad debt mean.................... A debt that is not collectable and therefore worthless to the creditor. This occurs after all attempts are made to collect on the debt. Bad debt is usually a product of a debtor going into bankruptcy or where the additional cost of pursuing the debt is more than the amount the creditor could collect. This debt, once considered to be bad, will be written of by the company as an expense.
72. For example, most companies make sales on credit to increase their sales, even though some sales are to customers with less than desirable credit. Companies that do make credit sales will estimate the amount of sales they expect to lose to bad debt, which is found in the allowance for doubtful accounts. A debtor with a history of -bad debts will see their credit rating decline, which makes it difficult for the debtor to access any additional form of credit.
73. Bad debt expenses. What does a bad debt expense mean...................... An entry found on business 's income statement that represents the amount of non-collectable accounts receivable that occurs in a given period. In terms of accounting entries, every time an amount increases bad debt expense, an equivalent amount is credited to the business's allowance for bad debts.
74. For example, often times, bad debtor expenses occur as a result of a customer being unable to fulfill its obligation to pay an outstanding debt, due to bankruptcy or other financial problems.
75. However, this does not always necessarily mean that the entire amount owed will be written of.
76. Bankruptcy proceedings may be able to provide some recourse and remove some of the bad debt expense.
77. Allowances for doubtful accounts. What does allowance for doubtful accounts mean........................ An estimation made by a company and documented on its balance sheet for receivable that might go uncollected. .1 For example, it is a standard practice for a company to have funds set aside for money that cannot be collected.
78. Therefore, when money owed by customers (individuals or corporations) to another entity in exchange for goods or services that have been delivered or uses, but not yet paid for. Receivable usually come in the form of operating lines of credit and are usually due within a relatively short time period, ranging from a few days to a year. On a public balance sheet, accounts receivables is often recorded as an asset because this represents a legal obligation for the customer to remit cash for its short term debts.
79. For example, if a company has receivables, this means it has made a sale but has yet to collect the money from the purchaser. Most companies operate by allowing some portion of their sales to be on credit. These type of sales are usually made to frequent or special customers who are invoiced periodically and allows them to avoid the hassle of physically making payments as each transaction occurs. In other words, this is when a customer gives a company an assurance for receiving goods or rendering services which they have already received or rendered.
80. Thus the question whether a debt could be considered to be a bad debt or not must depend on the facts and circumstances of each case. The question must be looked at from a practical point of view. Although, the entry of bad debt made by the assessee is prima facie evidence of its candidacy for write of but that is not conclusive, unless the entry is justified and the onus is on the assessee to establish that the debt had become bad during the relevant year. Before the income tax department concedes allowance on account of debt written of, the following three requirements have to be satisfied:--
(i) that a certain assessee should have taken the debt into account in computing his on total income and should have paid tax thereon; and
(ii) that the assessee should have written of the debt as-irrecoverable by him.
81. (i.e) that the question of fact such as whether a debt has become bad during the year of account and, if so, and to what extent and why write of was the only option have to be thoroughly examined.
82. The finding on the aforementioned criteria has to be based on objective a review of all the circumstances existing in the case. A bad debt becomes bad for the purposes of deduction in the computation of total income if facts objectively considered lead one to an inference that, having regard to the circumstances of the debtor, it has become difficult or impossible to recover it.
83. Therefore, in the light of the above prepositions, before examining to the issue of bad debts 'is imperative to reproduce the issue formulated in this case, i.e., "whether, on facts and in circumstances of the case in hand the receivable amount could be written of by debiting it he the Profit and Loss Account as an ' expenditure with the nomenclature "provisions for bad debts" or not."
2. The appeals in hands relates to various banks liable to regulates their affairs under the Prudential Banking Regulations issued by the State Bank of Pakistan. All of them have made provisions for "bad debts" or "doubtful debts" placing these debts in their Profit and Loss Account under Income Tax Ordinance, 2001. It is also mandatory on the parts of the banks to follow provisions of Prudential Banking Regulations which allows deduction in computing income for the purpose of Income Tax Ordinance, 2001. Seventh Schedule deals with the computation of income of a banking company and tax payable thereon. The law of . Interpretation of statutes contemplates de-facto support of cases on the grounds of non-obstante clause which always have an overriding effect only in cases if there is an inconsistency. Therefore, the Prudential Banking Regulations operates in the field of monetary system and credit system of the country. It was never intended for computation of income for the purpose of Income Tax Act. Both the Prudential Banking Regulations and Income Tax Act, 2001 operates in different fields and they stand for different and distinct purpose without dis- obeying each other in its on field. Thus on the basis of Prudential norms, the guidelines given in respect of Non-performance of Loans is not an allowable deductions under section 20 of the Income Tax Act, 2001. As per conditions precedents to the allowable deductions on account of bad debts is subject to satisfying conditions as provided under section 29 of the Act ibid. Hence, there is no inconsistency between the two provisions and the prudential norms shall not entitle the banks or financial institutions to claim deductions in respect of provision for doubtful debts so long it does not fulfill the conditions as set forth in section 29 of the Income Tax Act, 2001 which does not allow for placing such deductions as expenditure in their Profit and Loss Account, which is an item of a balance sheet, would defeat the purpose of the Act. However, for the purpose of computation of income, the provisions of Income Tax Act are special provisions in relation to the Prudential Banking Regulations guidelines which is only confined to regulate affairs of public deposits. These guidelines are not bindings on the income tax authorities while computation of income with reference to bad debts and doubtful debts. In relative terms the Prudential Banking Regulations is in the nature of banking activities controlling banking regulations which cannot override the specific provisions of conditions as laid down in section 20 read with section 29 of the Income Tax Ordinance, 2001 and therefore, the provisions contained therein need to be complied with if deductions permissible is to be claimed as allowable. Reference is made to the decision of Hon'able Madras High Court in the case of Thammayys v. Rajah Tyada Pasupati AIR 1930 Mad 96 wherein it was held that when the legislature intended to give the benefit of allowing provisions for bad and doubtful debts to certain entities, specific provisions were made in the Act unlike sections 20 and 29 read with seventh schedule of the Income Tax Ordinance, 2001. Hence, the absence of any such specific provisions in the Prudential Regulations implies that the legislature never intended to give such benefits to banks and financial institutions which can only be remedied by the legislation. (Reliance is placed on (a) Smt. Tarulata Shyam and others v. CIT 108 ITR 345 (Supreme Court)... (b) CWT v. K.S. Vaidhyanathan, 153 ITR II (Mad)....(c) Padma Sundra Rao (Deed) and others v. State of Tamil Nadu, 255 ITR 147 (Supreme Court)....(d) ACIT v. Vellappa Textile Ltd. 263 ITR 550 (Supreme Court).... (e) Prakashnath Khanna v. CIT, 266 ITR 1 (Supreme Court).
84. What Does Loan Mean?.
3. Notwithstanding the above referred judgments, a very vital issue, whether the loans extended and being non-recoverable declared as "bad debt" would be excluded from the assets of the assessee and whether it would be taxable under the previsions as contained under wealth tax needs to be analysed along the following propositions:-- * Whether the provisions for the "bad debts" are ousted from the net wealth of the assessee for the purpose of taxation in the absence of any evidence as to the insolvency of the loanee company.
85. Whether the provisions for the "bad debts" are ousted from the net wealth of the assessee in spite of the fact that if the assessee has advanced another loan to the same loanee and the loanee company is not in a position of its repayment then why further loans are being advanced.
86. Whether the deletion of assets already claimed as "bad debt" from the net wealth of the assessee can be hold good in the event of its return in subsequent year.
87. Now the central point which will provide answer to all the three questions so formulated is as to what is the true import and meaning of a "bad debt". The dictionary meaning of a bad debt is that it is a kind of debt which is not recoverable or in other words never be paid. To hold that a debt is a bad debt, all attending circumstances are to be looked into, which include that how much efforts have been made by the creditor assessee in recovering the loan, what is the present financial status of the loanee/debtor and whether it has assets more that debt amount which can liquidate the same.If put on sale or auction.
88. The determination of the bad debt essentially requirements thorough examination of the matter which involves factual inquiry. In case the assessee claiming exemption from tax payment on such plea the burden is on him to show through evidence and cogent materials that the loan advanced by him has become a "bad debt" and despite of best efforts it cannot be recovered and it can never be recovered. Unless and until all these and other relevant conditions are fully satisfied it would be difficult to conclude that a debt claimed to be a bad one has factually been determined to be bad. Moreover, there can be no gainsaying of the fact that business of industry, trade and commerce is of fluctuating fortunes as the daily picture of the stock market by rise and fall of the share price of such business concerns tells us a lot, therefore, it is the essential obligation of the assessee to provide proof that the loanee has become absolutely insolvent and incapable of paying back the loan to the assessee but this can be achieved only by providing evidence and for which fact finding inquiry becomes more essential, in the absence of which any decision is that regard would be one in vacuum.
4. It may be worthwhile to compare how other countries treat the issues of taxation related to written-of or resolutions of bad debts and other related matters. Some jurisdictions that have been explored are the leading first world countries for common law (Australia, U.K and U.S.A) and civil law countries (France, Germany and Japan). No where in the world, loss of income due to bad debts is allowable unless certain stringent conditions are fulfilled.
89. 4.1 AUSTRALIA: Under sections 25-35(1) of the Commonwealth Income Tax. Assessment Act 1997 ("ITAA 97"), a tax deduction is allowable for a debt (or part of a debt) that is written of as a bad debt in the income year, if the following circumstances are fulfilled:--
(a) The amount owed was included as assessable income of the taxpayer in the current or a previous income year, unless the taxpayer is in the money-lending business; or
(b) The debt arises from money lent in the ordinary course of a business of lending money by the taxpayer who carries on that business.
90. To qualify under sections 25-35, it is necessary to have an existing bad debt that is written of during the income year in which the deduction is claimed.
91. A money-lending business which is almost always a bank would normally be able to justify a deduction for writing of both accrued interest under sections 25-35(1)(a) and a loss of principal under sections 25-35(1)(b). 'By contrast under this section, a lender that is not in the money- lending business as a bank would only be able to obtain a deduction for accrued interest (if it was included as assessable income in the current or previous income year), but not for any loss on the principal amount of the loan. As the repayment of principal does not constitute income2, it follows that it cannot be assessed as income of a lender in the money-lending business, who, accordingly, cannot obtain a deduction for this loss under sections 25-35(1)(a).
92. A debt is money that the taxpayer is currently entitled to receive3. Thus, if interest payments are to be paid in the future, they cannot be considered as debt under sections 25-35 for the purpose of obtaining a tax deduction. This applies equally in the case of a moneylending business like banks.
93. Deutsch et al., Australian Tax Handbook 2001 460 (Sydney: ATP, 2000)
94. 2 Id., at 39.
95. Id., at 458.
96. Whether a debt is bad is a question of fact, as demonstrated by a bona fide conclusion that the debt was bad to the extent that it was written of. It seems that the section implicitly requires that the debt be bad on an objective basis4.
97. If a business is sold, including the book debts, the purchaser cannot, in general, claim a deduction for debts that prove to be bad, because the amount would not have been returned as assessable income by the purchaser. Under sections 25-35(2), a bank who acquires a debt from another bank may claim a deduction for any amount written of as bad, but Only up to the cost paid for the debt.
98. If it were not for this specific provision, such a deduction would not be allowable under sections 25- 35(1)(b), because the bank who purchased the debt would not have been the one who lent the money.
99. There are specific limitations on the writing of of bad debts by companies to prevent a company structure being manipulated. For instance, a company structure can be exploited if shareholders obtain the benefit of a bad debt deduction when they were not shareholders at the time the income accrued to the company. Subdivision 165-C ITAA 97 requires a company to satisfy either a "same ownership and control test" or a 'same business test" in order to be eligible for a bad debt.
100. Division 245 of the ITAA 36 applies to debtors after a "commercial debt" has been forgiven by a creditor. A debt is generally defined as a legally enforceable obligation of one person to pay an amount to another persona Accrued but unpaid interest on a debt is treated as part of the debt. A commercial debt is one where the debtor is entitled to a deduction for interest paid or payable .
101. Where interest is not charged on the debt, it will still be considered to be a commercial debt if, had interest been charged, it would have been deductible for the debtor. e.
102. Under sections 245-35 ITAA 36, a debt is taken to be forgiven when : * The debtor's obligation to pay the debt is released, waived, or otherwise extinguished; * The debt becomes barred by the statute of limitatiohs; 4
5. Id., at 459.
103. This definition still applies, even if a statutory exception prevents the deduction.
104. As in n. 8, supra, the debt is still considered commercial, even if a statutory exception prevents the deduction.
105. A debt/equity swa p occurs; An "in substance forgiveness" arrangement takes place; or A "debt parking" arrangement takes place.
106. An "in substance forgiveness" arrangement is an agreement between the debtor and creditor where the debtor Is effectively released from the obligation to pay the debt, apart from liability to pay some nominal or insignificant amount in the future'. A "debt parking" arrangement involves an assignment of the debt by the creditor to a third party that is associated in some way with the debtors.' This assignment is usually performed for consideration that is lower than the amount owed. Although the debtor remains legally liable to pay the assignee in full, there is an understanding that the assignee will not seek recovery of the debt.
107. Where a commercial debt is forgiven, Division 245 allows the net forgiven amount to be applied to lower the "reducible amounts9 to which the debtor is entitled, in the following order:--
(a) Deductible revenue losses carried forward from a previous year;
(b) Deductible net capital losses carried forward from a previous year;
(c) Certain deductible expenditure carried forward from a previous year; and
(d) The relevant cost base of reducible assets other than excluded assets.
108. Where the amount forgiven exceeds the total of the reducible amounts, the excess will not be assessable. As stated in section 245-2, Division 245 ITAA 36 does not apply to the forgiveness of a debt if the forgiveness arises under an Act relating to bankruptcy.
109. An amount that the debtor is unable to pay, or a gain enjoyed by the debtor as a result of a debt forgiven by a creditor, is not treated as assessable income for a bankrupt. Rather, specific provisions exist which result in exemptions and restrictions for deductions of tax losses and for prior capital losses to reduce subsequent capital gains.
110. 7 Woellner et al., Australian Taxation Law, 773 (9th ed., CCH Australia, 1999).
8. Id.
111. "Reducible amounts" are those amounts that would otherwise have been taken into account to reduce the debtor's taxable income in the year of income in which the debt is forgiven or in a later year of income.
112. Section 36-35(1) ITAA 97 bars any deduction for tax losses incurred before bankruptcy. This is subject to sections 36-40(1), which permits a deduction for amounts paid for debts incurred before bankruptcy. Under sections 36-45(1), the total deductions under sections 36-40(1) in the income year (for the payment of debts incurred in the loss year) cannot exceed the amount of the tax loss, reduced by the sum of:--
(a) The deductions under sections 36-40(1) for amounts paid in earlier income years for debts incurred in the loss year;
(b) Any amounts of the tax less deducted in earlier income years; and
(c) Any amounts of the tax loss that, apart from sections 36-35, would have been deductible from the bankrupt's net exempt income for the income year or earlier income years.
113. Sections 102-5(3) ITAA 97 prohibits the use of prior net capital losses to determine whether a net capital gain was made in the year a taxpayer becomes bankrupt or in the year a taxpayer is released from debts under bankruptcy law or for any subsequent income year. However, this determination needs to be considered alongside sections 104-210, which provides that where a taxpayer later pays all or part of a debt that was taken into account in working out the amount of a net capital loss that could not be applied because of sections 102-5(3), some or all of the denied amount may be reinstated as a new capital loss in the year in which the payment is made.
114. 4 . 2 UNITED KINGDOM:
30. The United Kingdom refers to Great Britain (England, Scotland, Wales) and Northern Ireland. Tax provisions are enacted and interpreted with a view to producing identical effects, as far as possible for all countries of the United Kingdom. See Simon's Direct Tax Service Vol.2, para. A.1.153 (Butterworths, 2002).
115. Simon's Direct Tax Service Vol. 3, para. B.3.1461 (Butterworths, 2002).
12. Thus, in CIR v. Hagart & Burn-Murdock HL 14 TC 433 (1929), losses on advances to clients by solicitors were refused, as there was no evidence that they were money-lenders. is a question of fact and the onus of proof is on the creditor to show that the debt was bad' .
116. Further aspects relating to bad and doubtful debts for the creditor include the following:-- If the debtor is bankrupt or insolvent, the debt is deductible except to the extent that any amount may reasonably be expected to be received on it.
117. Debts or parts released wholly and exclusively for trade purposes as part of a voluntary arrangement under the Insolvency Act, 1986 or a compromise or arrangement under Companies Act, 1985 are also deductible.14 Where the market value of an asset accepted in satisfaction of a trading debt is (on the date of acceptance) less than the outstanding debt, the deficit may be allowed as a deduction.'
118. Advances to finance or recoup the losses of subsidiary or associated companies are treated as capital.
119. Although debts are specifically included as assets under section 21(1) of the Taxation of Chargeable Gains Act, 1992 ("TCGA"), the general rule is that disposal by the original creditor of a debt does not give rise to a chargeable gain or an allowable loss. However, there are several exceptions to this general rule, and they include:--
(a) The disposal of a debt on a security (section 251(1) TCGA).
120. A debt on a security is not defined by statute. Inland Revenue considers the definition of "security" in section 132 TCGA as exhaustive, but this only includes loan stock or similar security of the UK or any other government, or of any public or local authority in the UK or elsewhere, or of any company.
121. Moreover, it does not have to be secured: a debt on a security does not include mortgages or charges or other debts in which security is given. It has been distinguished from an ordinary debt in that it is a debt with "added characteristics", which enable it to be realized or dealt with at a profit.
122. Some of the added characteristics include.'6
13. Glyn Saunders et al., Tolley's Income Tax 2001-02 para. 71.44 (86th ed., London: Reed Elsevier).
14. Id. u. Id.
16. Simon's Direct Tax Service Vol.4, para. C1.1.408 (Butterworths, 2002).
123. The debt is for a fixed long term.
124. The amount required to repay the debt before the end of the term is linked to the market value of the debt at the time of repayment, calculated on the assumption that it would run its full term.
125. The debt carries interest and consequently produces income for the creditor.
126. The debt is marketable, because of the above factors.
127. If the debt is evidenced in writing, this may be a further indication that it is more than an ordinary debt, although this is not essential for it to be a debt on a security.
(b) Certain debentures (section 251(6) TCGA)
128. A debenture issued on or after 16th March 1993 is deemed to be a security where it is issued on a company reorganization or reconstruction. This means that on an exchange of shares or securities with accrued gains in return for such debentures, the gain will be rolled over and will be charged on its subsequent disposa1.17
(c) Certain loans to traders (section 253 TCGA)
129. If a loan is made and used wholly18 for the purposes of a trade by the borrower and all or part of the loan cannot be recovered, the lender may in certain circumstances claim relief for an allowable loss. "Trade" is defined to include a profession or vocation, but expressly excludes any trade involving the lending of money. Relief extends only to the principal; interest is excluded. The borrower must be a resident of the UK and no relief is available where the amount has become irrecoverable because of the terms of the loan itself.
130. Under section 94 of the Income and Corporation Taxes Act, 1988 ("ICTA"), if a trader owes a debt, which the trader deducts as a trade expense, and the debt is later released by the creditor, then the debt becomes a taxable trade receipt against the debtor in the year of its release:9 The mere failure to pay a debt does not give rise to a trading receipt; and the provision only applies if a deduction had been allowed in an earlier year. Moreover, the view of Inland Revenue is that there is a
17. CCH British Tax Guide Vol.1, para.234-750 (Oxfordshire: Croner. CCH, 2000).
18. However, in some situations, there may be an apportionment if a loan is partly used for the borrower's trade and partly used for non-trade purposes.
19. Whitehouse, supra n.23, at 128. release under section 94 ICTA whether the release is gratuitous or for value, although the extent of any value received would have to be brought into account to reduce the sum taxable .20 This provision has no application to a release forming part of a voluntary arrangement under the Insolvency Act, 1986 or a compromise or arrangement under section 425 of the Companies Act, 1985.
131. 4.3 UNITED STATES: A distinction is drawn between business debts and non-business debts in section 166 IRC. Under section 166, business bad debts can generally be deducted from gross income if a debt or part of a debt becomes worthless. By contrast, non-business bad debts are treated as short-term capital losses, subject to an annual deduction limitation of US$3000. Non-business bad debts can only be deducted when the entire debt is worthless; deduction for part of a bad debt (which is allowed for business bad debts) is not available for non-business bad debts.
132. Business debts arise from the taxpayer's trade or business. Under Treasury Regulation ("reg.") 1.166- (5b), a business debt is a debt that is either (a) created or acquired in connection with the trade or business of the taxpayer who is claiming the deduction; or (b) the loss from the worthlessness of which has been incurred in the taxpayer's trade or business.
133. To qualify for the more favorable tax treatment for business bad debts, the taxpayer must meet the "dominant motivation test", under which the taxpayer must show that the dominant motivation in making the payment was business related.
(a) A debt exists, which arises from a true debtor-creditor relationship based upon a valid and legally enforceable obligation to pay a fixed or determinable amount of money.'
20. Tiley, supra n.24, at 424.
21. G. Newton & Gilbert Bloom Bankruptchy & Insolvency Taxation 52 (New York: John Wiley & Sons, 1991).
22. This is to be contrasted with the position in Australia considered earlier.
23. CCH Editorial Staff Publication, Federal Tax Manual 2001 para.2401 (Chicago: CCH Inc.).
134. The courts will consider both substance and form in determining whether a debtor-creditor relationship or a shareholder-corporation relationship exists.
(b) The debt (or part of a debt for business debts) is "worthless". The creditor has the burden of showing to the courts that there was no reasonable or practical basis for hope of any recovery of the debt (or part of the debt) at the time the deduction was taken.24 Mere refusal of the debtor to pay is not sufficient proof of worthlessness. Moreover, bankruptcy, by itself, operates only as a general indication of the collectability of the claim and is not conclusive by itself.25 Therefore clearly USA has very strict laws of its treatments of bad debts and the debtor must prove to the court that he is unable to pay the debt where even bankruptcy is not taken as sufficient proof of inability to pay back the debt.
135. 4.4 GERMANY: A taxpayer can deduct all expenses incurred in the conduct of the taxpayer's business, irrespective of whether the expenses are necessary, customary or useful, so long as the expenses can be regarded as relating to the business activity concerned and are not associated with the taxpayer's private endeavors or personal living expenses.26 Bad debts are one example of an allowable business expense for a creditor (including a creditor corporation). Doubtful or uncollectible accounts receivable must be written down to their fair market value.
136. Under section 3 EstG, if creditors waive part or all of their claims against a corporation, no taxable income for the corporation is generated, provided:--
(a) the corporation needs "rehabilitation";
24. CCH Editorial Staff Publication, Federal Tax Manual 2001 para.2401 (Chicago: CCH Inc.).
25. Id.
26. German Tax & Business Law Guide 2001 paras. 122-350 (CCH Europe).
(b) the transaction is entered into for the express purpose of restoring the corporation to a sound financial position; and
(c) the waiver is capable of achieving this purpose.27 A corporation needs rehabilitation if, in the long run, it would not have been possible to conduct the business at a profit without the waiver. In determining .Whether this is the case, various facts are considered, such as the corporation's liquidity, its current profitability and the due dates of its liabilities.
137. The purpose of the waiver is generally assumed to be rehabilitation of the corporation if several creditors jointly waive part or all of their claims.28 If only one of several creditors waives a claim, it must be established that the purpose of the waiver was to rehabilitate of the corporation. Reasons related merely to the creditor's on business are not sufficient. According to a decision of the Federal Tax Court, a rehabilitation gain may also be recognized if the purpose of the waiver is not rehabilitation of the corporation, but the avoidance of a formal bankruptcy and making possible a "silent liquidation" of the company.
138. Therefore, Germany presents the unique case wherein deductions are allowed for bad debts but the criteria set for receiving a debt is very stringent and to qualify for a debt requires a lot of diligence on the part of the creditor. Secondly, the debt is treated as an expense but personal living expenses or private endeavors are not treated as a personal expense. Therefore any loan that may be spent on one's person or a private endeavor cannot qualify as a bad debt and cannot be waived by the bank. Any loan taken must be spent on a business and the business must show that it has complied in turn with other regulations.
139. 4.5 FRANCE: Deduction by the Creditor for Bad Debts: A tax deduction for bad debts is available in France. The calculation must be based on a debt assessm ent that takes into consideration the probability and amount of payment.30 The tax administration has generally disallowed doubtful debt provisions calculated on a percentage of turn over or on outstanding receivables.
27. German Tax & Business Law Guide 2001 paras. 122-350 (CCH Europe). Paras. 133-200.
28. Id.
29. Id.
30. Guides to European Taxation, The Taxation of Companies in Europe: France Vol.2, at 93 (Amsterdam; International Bureau of Fiscal Documentation, February, 2002).
140. However, the courts have recently been more liberal, allowing the estimation of losses by grouping similar types of debts whose risks are based on the same considerations.'
141. This risk assessm ent must however be stringent and is based on strong credit checks in place. Like Germany, to qualify for a loan in the first place is a reasonably difficult process in France.
142. 4.6 JAPAN: A corporation or bank can write of bad debts when it proves that the account receivable has become worthless only in the following cases:--32
(a) the amount written of is determined according to a reconstruction plan, special settlement contract, or composition which is admissible under legal procedures;
(b) the amount written of is determined according to a decision of a creditors' meeting or an agreement between two parties through a bank as intermediary;
(c) the creditor has given the debtor notice of exemption from liability in anticipation of no recovery;
(d) it is clear that no recovery can be expected because of the debtor's financial position; or
(e) at least one year has elapsed since the suspension of transactions with the debtor, or the cost of collection appears greater than the unsettled account receivable.
143. Although the direct write-of of accounts receivable is limited to the above categories, there are reserve procedures that, to some extent, allow deductions to be taken earlier. For this purpose, bad debt reserves are permitted.
31. Guides to European Taxation, The Taxation of Companies in Europe: France Vol.2, at 93 (Amsterdam; International Bureau of Fiscal Documentation, February, 2002).
144. 32, Yuji Gomi, Guide to Japanese Taxes 1999-2000 at 195-196 (Tokyo: Zaikei Schoho Sha).
33. Ibid, at 116. themselves on their on whims is not legal. They can declare the same but only after the mutual consent of the creditor through a third party which would then implicate the creditor and the third party into myriad legal issues and clamps on their later actions. Also it is noteworthy that the allowance for bad debts is limited to 5.5 percent of the outstanding receivables. These are examples from core capitalist countries, where the legal framework is obviously consistent with the grand norm of capitalism. We fund that the hallmark of capitalist economy is robust regulatory framework which allows every opportunity of enrichment but prevents unjust enrichment. This is why the capitalist system survives. By contrast our capitalist system seems to be the most perverse as the enable unjust enrichment at the expense of the people and the state. The regulatory mechanism is either non-existent or lacks efficiency.
5. Having briefly commented upon the international law at practice regarding tax treatment of bad, debts, I return to the case at hand and submit that in the instant case the loan extended by the company was declared as "bad debt" and non-recoverable whereas the issue of taxation of income under the wealth tax has not been dilated upon by of my learned and respectable colleagues. Whether the assessee has claimed exemption from wealth tax or not and whether they provided any information about their financial position of the debtors. This, to my mind, is an act on the part of the assessee not appealing to prudent mind as it was more risky than striking a bargain on a fish which is still in the deep sea. Therefore, while concluding the above formulated questions it is equally important to state that investments by a company with a company or companies as has been a regular phenomena is always planned and calculated one but in the instant case the assesses has not acted prudently. These circumstances would lead to a right conclusion that no financial position has been brought on record besides no conclusive findings to declare the loan as "bad debt" has been properly addressed which is not an acceptable, safe and sound yardstick for a fair decision on the subject issue.
145. From the foregoing discussions, I am of the considered opinion that the answer to the three points formulated in para 3 supra is in negative. The discussion made by my respectable colleagues did not encompass the questions as highlighted by me in the preceding paras. Therefore, I am of the considered view that the bad debts cannot be claimed as an expense by placing them in the Profit and Loss Account which is purely a subject matter of balance sheet.
6. However, since the issue is to be addressed in the light of enactment provisions of the Income Tax Ordinance, 2001, (Hereinafter referred to as "Ordinance") read with Prudential Banking Regulations of the State Bank of Pakistan, therefore, we may first refer to sections 20 and 29 of the Ordinance which deals with deductions in computing income chargeable under the head "income from business" and "bad debts" respectively. Relevant portion of sections 20 and 29 provides as under:-- Section 20: Deductions in computing income chargeable under the head "income from business".
146. (1)................. Subject to this Ordinance in computing the income of a person chargeable to tax under the head "income from business" for a tax year a deduction shall be allowed for any expenditure incurred by the person in the year wholly or exclusively for the purposes of business.
147. The bare perusal of the above provision envisaged that only those deductiOns are allowed as an expenditure which has been incurred. I, therefore, do not read in the above provision any substance that entitles any taxpayer to claim deductions as expenditure without incurring it.
148. Obviously, therefore, all such deductions cannot be granted a relief of allowable expenditure.
149. The fate of a loan proposal is determined while the proposal is processed. This means that evaluation of a lending proposition carried out diligently with professional skill and integrity would hardly let a loan go bad. There are certain basic tenets of lending which invariably apply to all lending situations, and which are relevant whether the amount requested is Rs.500 or Rs.50 million.
150. A lender needs to be sure that he has not overlooked any of the relevant facts, nor has he compromised with any of the demands of sound lending. The loans advanced by the banks are surely against certain considerations and collateral the value of which appreciates every year. The proportionate deficit of bad debts could be met through the interest income gained on the loans advance so far they are serviceable and do not convert into doubtful debts. Nonetheless to mention that while computing income chargeable to tax under the head "income from business" all such deposits acquired under the prudential nouns be charged to the gross income (profit before taxation) and debiting it to the Profit and Loss Account instead to the balance sheet would amount to reduction in the profit. Similarly, if charged to the suspense account would defeat the purpose of law for the purpose of computation of income chargeable to tax.
151. Section 29: Bad Debts........................... (1) A person shall be allowed a deduction for a bad debts in a tax year if the following conditions are satisfied namely:--
(a) the amount of the debt was:---
(i) Previously included in the person's income from business chargeable to tax or
(ii) In respect of money lent by a financial institution in deriving income from business chargeable to tax.
(b) the debt or part of the debt is written of in the accounts of the person in the tax year and
(c) there are reasonable grounds for believing that the debt is irrecoverable.
(2) The amount of deduction allowed to a person under this section for a tax year shall not exceed the amount of the debt written of in the accounts of the person in the tax year.
(3) Where a person has been allowed a deduction in a tax year for a bad debt and in a subsequent tax year the person receives in cash or kind any amount in respect of that debt, the following rules shall apply, namely:---
(a) where the amount received exceeds the difference between the whole of such debt and the amount previously allowed as a deduction under this section, the excess shall be included in the person's income under head "income from business" for the tax year in which it was received, or
(b) where the amount received is less than the difference between the whole of such bad debt and the amount allowed as a deduction under this section the shortfall shall be allowed as a bed debt deduction in computing the person's income under he head "income from business" for the tax year in which it was allowed.
7. The reading of sections 20 and 29 of the Income Tax Ordinance, suggest that the bad debts and doubtful debts cannot be written of by debiting in the Profit and Loss Account which must be Charged to the balance sheet and shown as gross income for computation purposes. The loan write of by the appellant banks is hard to be characterized as "expenditure incurred" within the meanings of section 20(1). The word "expenditure" refers to something that has been undisputably extinguished or consumed. In this case, there is no evidence that the amount of debt has been conclusively lost due to certain circumstances which lead to a reasonable belief that it is irrecoverable. Thus, the condition C of section 29 of the Income Tax Ordinance, 2001 has not been fulfilled, absent which, the deductions claimed as an "expenditure" lack legal backing at this stage.
152. The honorable Peshawar High Court in Commissioner of Income Tax Peshawar v. Haji Anwar-ur- Rehman's 2004 PTD 1940, declared the Tribunal's funding of bad debt and tax remission unsustainable , because no factual inquiry was conducted to ascertain how much effort was made to recover the debt, neither the financial status of the debtor was examined no any evidence insolvency or the debtor's inability to pay was called for. I have also relied on the judgment of the Indian Appellate Tribunal Income Tax in I.T.A. No.3958/DEL/2003 (2007 18S0T51). This judgment comes full circle with the issue as involved in these appeals before this honorable tribunal. The judgment is annexed herewith.
153. Neither, the Income Tax Ordinance, 2001 nor the international practice based on recognized principles of claiming bad debts seem to allow deductions in a void that has existed in this case.
154. The appellants easily side stepped the questions like who are the debtors, what amount of debt was written of in each individual case, what is the financial position of the debtors, what is the worth of the debt security or what efforts were made to recover the lost loans. No independent authority has looked in to these questions. The Banks on determination that a debt is bad is not enough especially when the money written of by them is not even owned by them. The comparative law discussed supra illustrates the tax treatment of debt write of in Australia, UK, USA, Germany, Japan, France and India and, its in clear that no country allows banks to whimsically claim bad debts and deprive the public exchequer of its share of taxes. In some jurisdictions the tax deduction is allowable only to the extent of non performing loan reserve. Some countries don't even recognize the banking companies right to claim tax deduction on bad debts. Other require tough conditions or the evidence of bankruptcy or court's declaration of ir recoverability of debt. In every jurisdiction, the relation between cause and effect of debt write of is considered before allowing tax deduction. For example, banks in USA are required to report the debt write of to the IRS which adds the written of debt to the income of the assessee unless there is an evidence that such amount was lost in the pursuit of business. Most often the debts become bad due to banks bad lending policy or failure of their risk management procedures. Generally, the source of repayment of loans is ignored by the banks. Evaluation of loan proposals at Pakistani banks primarily rests on the adequacy of the security, and not on the revenue-generating capacity of the projects intended to be financed. Security is always one of the last considerations in any proposition, and no lending should be made purely because good security is offered. The proposition should stand up on its on with the security providing a cushion should things go wrong. What is lost sight of is the fact that security is always the last resort to fall back upon in the event of default. It does not guarantee that the agreed repayment schedule would work unhampered. On the contrary, what makes the servicing of loan possible as per arrangement is the cash flow generated by the employment of borrowed funds. Again, valuation of collateral poses many a question. Normally, term debts are secured by the assets financed by these debts, such as, plant and machinery, land, building etc. These assets are normally overvalued to meet the prescribed debt-equity ratio without actually subscribing one's on capital. Again, plant and machinery for getting run down or turning obsolete depreciate much below their book value. Banks and other lending institutions have no effective monitoring system to watch this value depletion. At times, the deficiency in the value of collateral is made good by the personal guarantees of the sponsor-directors who are under no contractual obligation to keep their assets intact after executing the guarantee. Banks also do not have any mechanism to monitor the changes in the net worth of the guarantors subsequent to the guarantee. Instances of unauthorized releases of the pledged goods are not quite uncommon.
155. Shrewd businessm en first manage it in collusion with the bank's godown keepers, and then charge the banks for theft and pilferage on the plea that the goods were lost while they were in the custody of the bank. (He kills and gets the reward instead). Mixing of low quality goods in bulk with the small quantity of the goods of the declared quality and standard has also been a common cause of huge losses to be banks. Exhaustive checking at the time of each intake and every delivery, the only possible check against this hazard, was probably not practiced. In the sub-judice case of debt write of, the honorable Supreme Court of Pakistan has already taken notice of the debt write of arising from collusion between self indulgent plutocrats and bank officials who made their way through at the expense of national exchequer. In this case the honorable Supreme Court has made several observations about the ghost borrowers who have grabbed the country's banking sector and has ordered repayment of loans by the borrowers whose hefty loans were written of not because of business reason but as favour. The bank's power to write of at will and the role of State Bank and prudential regulations in enabling the underserved debt write of involves moral hazards and therefore, has been rightly called in to question by the honorable Supreme Court of Pakistan. .