The amount which is not recoverable will be considered as bad debt. When there is any person who is selling the goods or services or both to the customers on credit but of total sale if some amount is not receivable or irrecoverable then it will be considered as bad debt. This situation arises when the debtor becomes insolvent or bankrupt. The situation of the bad debts will be occurred when the amount of the expense is more than the amount of debts.
Now we will discuss the concept of the bad debts by the way of example- Mr. Ram, he sales goods to the customers at credit and he sold some goods to Mr. Sohan of Rs. 50000. Due to the reason of insolvency, Mr. Sohan is not in the situation to pay such amount (50000) to Mr. Ram so such amount will be considered as a bad debts expense and Mr. Ram will book such expenses/ loss in his books of accounts as the amount of expense and when we will calculate the amount of business income as per the income tax act 1961, such amount of bad debts will be allowed as an expense.
There are certain conditions that are laid down in taxation Act, 1961 u/s 36(2) if all the conditions are fulfilled then any allowance for bad debts are going to be allowed. The conditions are:
(i) The deduction which is claimed by the assessee because the bad debts against any debt or loan or any a part of it thereof should have actually been bad within the accounting year .
(ii) The debt or loan should be related to the business or profession of the assessee and the said debt or loan should be for the relevant accounting year. If there is any debt that is not related to the business or profession of the assessee, the deduction shall not be allowed in the respect of such debt.
(iii) As per the case law of “Girdhari Lal Gian-Chand vs C.I.T (1917) 79 T.R 561 (Allahabad),” it was settled that if a debt is due from retired partners and it’s irrecoverable then the assessee cannot write off and claim the identical as a deduction since it’s a capital loss.
(iv) An assessee shall be eligible to take the deduction of the debts which are included in the computation of the Income Tax Return in the current period or any previous financial year. If there’s any assessee who is involved within the money lending business, the cash lent within the ordinary course of business should be considered.
(v) An assessee shall be eligible to take the deduction of those debts which are written off from the books of accounts in the previous financial year in which the deduction is claimed by the assessee.
Bad Debts Recovery
In any of the previous year, any amount of the debt has been written off by the person as bad debts and deduction has also been claimed by the person but in any year such amount debt is recovered in full or part, then the amount which is recovered will be considered as an income of the person in the financial year in which such amount is recovered.
In any previous year, the assessee has written off any part of the debt and he has taken the deduction in the respect of such bad debts but in future, such amount of bad debts is recovered from the debtors, then the amount so recovered will be treated as a normal realization of debts. If the amount which is recovered is less than the total amount of bad debts, then the remaining amount will be treated as bad debts. If the amount which is recovered is more than the recoverable amount, then the excess amount received will be considered as the income in the financial year of the receipt.
Provision for bad debts in the case of Banks and Financial Institutions
As per section 36(1) (vii-a) of the Income Tax Act, 1961 the banks and the financial institutions are allowed a deduction to take the deduction of the provisions made for bad and doubtful debts. No other assessee is eligible to claim the deduction on the provision of bad debts.
The amount of deduction which is eligible for the deduction for the banks and the financial institutions-
1- Indian Banks- 7.5% of adjusted total income + 10% of average aggregate advances made by rural branches.
2- Foreign Banks- 5% of adjusted total income
3- Public Financial Institution, State Financial Corporation- 5% of adjusted total income
Adjusted Total Income – Gross total income before deduction under section 36(1)(vii-a).