Change of method of accounting can’t be a reason to disallow claim of bad debts: HC

Case Details: L.K.P. Merchant Financing Ltd. v. DCIT - [2022] 140 taxmann.com 548 (Bombay)

Judiciary and Counsel Details

• • Dhiraj Singh Thakur & Abhay Ahuja, JJ.
  • Ms Dinkle Hariya, Ms Rashmi Vyas & Vipul B. Joshi for the Appellant.
  • Vikas T. Khanchandani for the Respondent.

Facts of the Case

Assessee was a Public Limited Company registered as a Non-Banking Finance Company. It was engaged in the business inter alia of lease finance. It entered into a lease agreement with a Company (lessee), to transfer the right to use by way of lease of certain equipment.

The first installment of the lease amount was received by the assessee. Further installments due were also accounted for as income in the respective years, as per the mercantile system of accounting although the lessee defaulted in payment of further installment.

In view of default in payments, the assessee wrote off the amount as bad debt. However, the Assessing Officer (AO) didn’t allow the said claim. It was observed that since the assessee was maintaining the mercantile system of accounting if such reversal was allowed, it would be a clear violation of the method of accounting adopted by the assessee. The dispute reached the Bombay High Court.

High Court Held

The High Court held that it was recorded in the order of the Commissioner of Appeals that the lessee company had become a sick company. The prospects of recovery of lease rentals were quite bleak and the assessee considering that the same could not be recovered in the foreseeable future decided to write off a debt as bad debt.

It is nobody’s case that the assessee had not complied with the provisions of Section 36(2). The assessee took a business decision to write off the debt as a bad debt. A wise businessman would not want to spend good money on litigating for a bad bargain. Having taken the commercial decision to write off the debt as a bad debt based on the material, cannot lead to a conclusion that the decision was not bona fide.

The lease rentals were offered as income by the Appellant on mercantile basis had become bad and the assessee decided to write it off and did write off the same in its books of accounts in terms of the amended Section 36(1) (vii).

Further, a change of the method of accounting by the assessee from mercantile to cash may even be a breach of the accounting principles. However, that is not a requirement of Section 36(1)(vii) of the Income Tax Act for allowing a debt as a bad debt.