BALASUBRAHMANYAN J. - (1.) THIS is a case stated by the Income-tax Appellate Tribunal under s. 256(1) of the I.T. Act, 1961. The first question, which falls for our decision in this case is :"Whether, on the facts and in the circumstances of the case, the Tribunal was right in holding that the assessee's claim for deduction of bad debts aggregating to Rs. 5, 276 was not admissible as the requirements of section 36(2)(i)(a) of the Income-tax Act, 1961, were not satisfied ?" *The assessee, who claimed the allowance of bad debts in this case, is a registered firm called "E.A.V. Krishnamurthy and Son, Madurai" carrying on business in cloth. The firm consisted of two equal partners. E.A.V. Krishnamurthy and E.K.Kasiviswanathan.
(2.) THE business of this partnership firm was originally carried on by a Mitakshara joint family in which these individuals were members. In April, 1972, this business was subjected to a partial partition between these two individuals, who immdediately thereafter constituted themselves into the present partnership firm and continued the business. Amongst the assets of the business, as might be expected, were trade debts and other outstandings. A few of them, however, became bad and doubtful debts after the business became that of the partnership. With some of the debtors, the partnership firm entered into a settlement. Under this scheme, the firm was above to realise all but a settlement. Under this scheme, the firm was above to realise all but a portion from the debtors. THE balance of the book debts amounting to Rs. 5, 276 however, was written off in the Firm's books as bad and irrecoverable. The settlement between the debtors and the write-off in the accounts happened in the accounting year ended on April 12, 1973. In the relevant assessment of the firm for 1973-74, the question arose whether the sum of Rs. 5, 276 written off the accounts was allowable as bad debts in the computation of the firm's business income. The ITO held that as the debts in question were incurred when the joint family had been carrying on the business and as that business became partitioned and the business was subsequently continued by the assessee-firm, the loss in the hands of the assessee was a capital loss. Much the same view was taken by the AAC in appeal. But he thought that to the extent the writ-off consisted of interest and debt charges which had accrued after the partnership took over the business, the assessee-firm was entitled to an allowance, which he computed in the sum of Rs. 717. On further appeal, the Tribunal confirmed the AAC's order.Before the Tribunal, the question of allowance of bad debts provoked a wide range of discussion. One of the points considered by the Tribunal was whether the claim for allowance could be sustained under s. 36(1)(vii) of the I.T. Act, 1961. the tribunal pointed out that the allowance under this provision was subject to the fulfillment of the conditions set out in s. 36(2) of the Act. clause (i)(a) of s. 36(2) laid down the condition that the debt in question, in order to be allowed as a bad debt of a previous year, must have been taken into account in the income computation of the joint family and not in that of the assessee-firm, the Tribunal held that the statutory condition was not fulfilled. The Tribunal expressed the view that cl. (i)(a) of s. 36(2) imported a condition precedent for allowance of bad debts which was not laid down as a requirement in the corresponding provisions of s. 10(2)(xi) of the Indian I.T. Act, 1922. In this view, the Tribunal declined to follow the earlier court decisions bearing on the interpretation and the application of s. 10(2)(xi) of the 1922 Act.In this reference, this view of the Tribunal is canvassed as incorrect. Mr. Janakiraman, learned counsel for the assessee-firm, submitted that the Tribunal ought to have followed the authority of the decisions bearing on s. 10(2)(xi) of the 1922 Act for the present case as well. the learned counsel said that it was a well-settled principle of income-tax law that a trade debt which had arisen in a business before it was taken over by an assessee is eligible to allowance in the assessee's hands whenever it becomes bad. The learned counsel submitted that s. 36(2)(i)(b) of the present I.T. Act does not prohibit such an allowance either expressly or by necessary implication. he cited, in support, the decisions of the Andhra Pradesh, allahabad and Punjab and Haryana High Courts as well as a decision of this court-all of which were rulings bearing on s. 36(2)(i)(b) of the I.T. Act, 1961.Mr. Jayaraman, learned counsel for the Department, however, maintained that what s. 36(2)(i)(b) of the present Act has laid down was a clear departure from the pre-existing position of the law relating to allowance of bad debts. He distinguished this court's decision In Addl. CIT v. S. RM.PL, Subramania chettiar as bearing on a different provision, namely, s. 36(2)(iii) of the Act. He relied, however, on a later Bench decision of this court in CIT v. P. K. Kaimal although it only had a bearing on s. 41(4) of the I.T. Act. According to the learned counsel, this later decision enunciated a principle which was appropriate to the understanding of s. 36(2)(i)(b) as well.Before addressing ourselves to a consideration of the submissions on either side and the case law bearing on the subject, it would, we think, assist the discussion to find out the reasonable behind the allowance of bad debts as an item of admissible deduction in the computation of taxable income from business. any assessee carrying on business is liable to pay income-tax on his annual profits and gains derived from his business. the annual profits, broadly speaking, are ascertainable by setting against receipts from the business, the expenses which had gone into that business in order to earn those receipts and also other debit items which are to be charged against profits. Where the impact and result of the business transactions are reckoned by the assessee, according to the mercantile system of accounting, as opposed to the cash system, the assessee would quite naturally account for, or take into account, sums which are receivable from parties with whom he trades, by giving credit to such transactions and by debiting the parties. Where, for instance, the assessee sells his trading stock, he will forthwith credit the sales account for the price, although actual payment might be postponed. The unpaid purchase price thus becomes a book debt, because the amount would stand to the debit of the customer's at the same time, the amount representing the sale price would already go into the assessee's trading and profit and loss account, because of the treatment accorded to it under the mercantile accounting system. If, in those circumstances, the customer subsequently pays the price, well and good that would only make a difference in the assessee's cash position, and not in the assessee's profit position which, exhypothesi, has already taken note of the amount covered by the sale of the trading stock. But what if the customer fails, and the amount not only is not paid, but become doubtful or impossible of recovery ? In that situation, the trade debt which figures as an outstanding in the assessee's books, would become bad and irrecoverable. It is, therfore, quite proper and even necessary that if the accounts are to reflect the net financial effect to the assessee of the whole course of transactions of this kind, then the credit earlier given to the sales account must be properly offest by a credit reflecting the subsequent impracticability or impossibility of realising that money.
(3.) THIS is done by writing off the debt as bad and irrecoverable - the debt which, in its genesis had swollen the assessee's profits in an earlier year and which had continued to remain in the books thereafter as an outstanding. The writ-off of the debt is done by crediting the doubter's account in which the amount already stands as a debt and as an amount still owing by him. By this entry, the assessee washes of his hands, as it were, of this outstanding. Correspondingly, the profit and loss account is debited with the amount of the bad debt. THIS is because the amount already had been taken into account when it was goods, that is to say, in the sales account and, necessarily, in the trading and profit and loss account.It is a fundamental principle of income-tax accounting that taxable profits in business will have to be ascertained on the basis of ordinary acceptable principles of commercial accounting. Where, therefore, the assessee makes up his accounts under the mercantile system, his business profits for income-tax purposes would have to be computed in accordance with those principles. there is a distinct provision in the Act to that effect. The only cautionary rider is that the following of the commercial method of accounting adopted by the assessee must truly reflect the real profits of the given business he happens to carry on.In this background, therefore, there is really no need as at all for any specific profession in the income-tax statute for allowance of bad debts. For, as we have shown earlier, if sales under the mercantile system are given credit to, then and there, without waiting for their realisation, then it stands to reason that where the sale price is not subsequently realized, and the purchaser fails for some reason for other and is not in a position to pay the amount, the amount has necessarily to be written off as bad and irrecoverable in such a way that it will be a proper debut item in the ascertainment of profits. however, it has been a characteristic of income-tax law in this country that right form the very start, the Legislature had always enacted a specific provision under which bad debts may be claimed by the assessee and allowed by the Department, in the computation of assessable business profits. In England, there is no such provision, but nevertheless a like allowance is given to taxpayers for deduction of bad debts, in the computation of annual profits of trade, on the principle which has been succinctly set out by Rowlatt J., in the following passage in Courts v. J. & G. Oldfield Limited 1925 9 TC 319, 330 : "When the rule speaks of a bad debt, it means a debt which is a debt that would have come into the balance-sheet as a trading debt in the trade that is in question and that it is bad. It does not really mean any bad debt which, when it was a good debt, would not have come in to swell the profits." *In the Indian I.T. Act, 1922, s. 10 has laid down the manner in which the profits and gains of a business, as a separate head of income, have to be computed. sub-s. (2) of s. 10 provided for the computation of the various allowances which have top be made in arriving at the taxable profits form the business. One of such allowances specified in s. 10(2) of the Act related to bad debts. The relevant clause, clause (xi), was in the following terms :"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, .......... as the Income-tax Officer may estimate to be irrecoverable but not exceeding the amount actually written off as irrecoverable in the books of the assessee." *It might be noticed that the language of this clause specifically refers to bad and doubtful debuts as being due to the assessee in respect of his business, profession or vocation where his accounts are not kept on the cash basis. notwithstanding the reference to the assessee's accounts and the debt being but to the assessee in respect of his business, profession or vocation, the allowance claimed under this provision has been held by court courts to be available even in cases where a debt had been incurred in a business carried on by some one and subsequently the business changes hands either by voluntary transfer or by the operation of law and subsequently the debt becomes bad and allowance is claimed by the transferee who subsequently happens to carry on the business. In a decision by a Bench of this court in Mettur Sandalwood Oil Co. v. CIT this point was discussed in some detail. In that case, the business was originally carried on by a HUF. ;