Section 36(1) (vii) of the Income-Tax Act, 1961, grants an allowance in respect of bad debts of a business, profession or vocation, and in respect of irrecoverable loans in the case of banking or money-lending business. A bad debt presupposes the existence of a debt, and in cases in which there never was any debt owing to the assessee, no question can arise of invoking this clause (National Petroleum vs CIT (13 ITR 336)). A debt which arises from an illegal transaction or which is otherwise unenforceable in law is nevertheless covered by this clause(CIT v Pranlal (49 ITR 931).

Four conditions govern the grant of an allowance under this clause (Sarangpur vs CIT (143 ITR 166,171)):-

1. The debt or loan should be in respect of a business which is carried on by the assessee in the relevant accounting year.

II. The debt should have been taken into account in computing the income of the assessee of the accounting year or of an earlier accounting year or should represent money lent in the ordinary course of his business of banking or money-lending.

III. The amount of the debt or loan, or part thereof, which is claimed as a deduction, should have become bad.

IV. The amount should be written off as irrecoverable in the accounts of the assessee for that accounting year in which the claim for a deduction is made for the first time.

The above conditions are dealt with below seriatim.

In order to entitle an assessee to allowance for bad debts, the debts should be in respect of a business which is carried on by the assessee in the accounting year. Noallowance can be claimed in respect of the bad debts of a business which has been discontinued before the commencement of the accounting year, nor can the bad debts of a discontinued business be deducted from the profits of a separate existing business (Kameshwar v. CIT (15 ITR 246)).

In the case of a banking or money-lending business, the assessee is entitled to allowance in respect of irrecoverable loans advanced in the ordinary course of business, regardless of the method of accounting employed. The reason is that money is the stock-in-trade or the circulating capital of a banker or moneylender (Arunachalam vs CIT (4 ITR 173, 183 (PC))). The loss of stock-in-trade is always a trading loss irrespective of the method of accounting employed.

However, in the case of other bad debts, an allowance can be made only if two conditions are fulfilled -

(a) the debt should have been taken into account in computing the income of the accounting year or of an earlier accounting year, and(b) such computation shouldhave been of the income of the assessee himself or, in cases of succession, of his predecessor in business.

The first condition would be satisfied only if the mercantile or other non-cash system of accounting is followed. Where accounts are kept on the mercantile basis, the tax is charged on profits which may not have been realised; and if the professional or business debts become irrecoverable, an allowance for such bad debts would become necessary in order to arrive at the true profits and gains. However, if the accounts are maintained on cash basis, no question can arise of any allowance for bad debts, for unless a debt is actually realised it would not come in to swell the profits.

``Bad debts'' is a commercial term for trade debts (Thomas v. C.I.T. (48 ITR 67 (SC) and cannot include loans made to one's own employee or moneys overdrawn by an employee on commission account, which are entirely private matters independent of the business (Re Chhitarmal (3 ITC 54)). Moneys embezzled (Badridas vs CIT (34ITR 10, 14 (S.C.) or overdrawn (Ramaswamy v. C.I.T. (18 I.T.R. 150)) by an employee do not constitute a debt incidental to a business or a loan in the ordinary course of a money lending business, and cannot be allowed, though they may be deductible, apart from the provisions of sections 30 to 37, on ordinary principles of commercial accounting.

The law has grown through the judicial process and the correct principles have been laid down by the Bombay high court in Jethabhai Hirji vs CIT (120 ITR 792) and by the Gujarat high court in Sarangpur Cotton Mfg. Co. Ltd. v. C.I.T. (143 I.T.R. 166):

(a) The requirement that the debt should have become bad or irrecoverable in the accounting year does not mean that the Department can insist upon demonstrative and infallible proof that the debt has become bad.

(b) When a businessman bona fide writes off a debt it is a material circumstance in determining the year in which the debt became bad.

(c) In an appropriate case a debt may be written off and allowed as abad debt, even if the assessee has not taken legal proceedings against the debtor or even if the legal proceedings taken are pending in the year for which the claim for bad debt is made and they subsequently end in a decree in favour of the assessee (C.I.T. v. Darabji (143 I.T.R. 778)).

The amendment of clause (vii) of section 36(1) by the Direct Tax Laws (Amendment) Act, 1987 with effect from 1st April, 1989 indicates legislative acceptance of the above judicial approach.

This section makes it clear that the assessee's writing off the debt as irrecoverable in his accounts is a condition precedent to allowance. The principle that emerges from the section is that the debt should in all cases be written off by the assessee in the year in which he claims a deduction for the first time in respect of that debt.

In C.I.T. v. Santosh Rice Mills (230 I.T.R. 813), the assessee, who was supplying goods to a party in Cuttack, noticed that the financial position of the said party had become weak and considered itinadvisable to have further transactions with the said party.

On September 27, 1976, the assessee entered into an agreement with the debtor firm whereby the assessee agreed to receive a sum of Rs.12,000 in full and final settlement of the sums due from the firm. This agreement was acted upon and the assessee wrote off the balance of Rs.45,370 as a bad debt in the assessment year 1977-78.

The assessee claimed deduction of the amount of Rs.45,370. The Income-tax Officer rejected the claim for deduction on the ground that the same had been written off with an ulterior motive, because the assessee had not taken any legal steps for the recovery of the dues and that the transaction with the firm was not genuine.

On appeal, the Commissioner of Income-tax (Appeals) also rejected the claim for deduction. On further appeal, the Tribunal found that the transaction between the assessee and the firm took place in the ordinary course of business, that the Income-tax Officer failed to examine the firm and had nomaterial before him to show that the firm was in a sound financial position in September, 1976, and that, therefore, there was nothing suspicious about the transactions between the assessee and the firm. Hence, the assessee was entitled to deduction of the bad debt.

On a reference to the Madhya Pradesh High Court, it was held affirming the decision of the Tribunal, that the sum of Rs.45,370 was deductible as a bad debt.

In conclusion, the amended law prevents the Department from raising questions it formerly used to do regarding the quality of the debt and the year of allowance, - provided the assessee has acted bona fide. Thus, the degree of interference by the Assessing Officer with the assessee's judgment is justly and substantially reduced but it is not altogether eliminated; the field of dispute between the assessee and the Department is substantially narrowed but it is not altogether obviated.