(1) The debt or loan should be in respct of a business which is carried on by the assessee in the relevant accounting year.
(2) The debt should have been taken into account in computing the income of the assessee (C.I.T. v. Veerabhadra (155 I.T.R. 152 (SC) 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 moneylending.
(3) 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.

In the case of a banking of moneylending business, the assessee is entitled to allowanceunder this clause in respct 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 v. C.I.T. (4 I.T.R. 173, 183 (PC))). The loss of stock-in trade is always a trading loss irrespective of the method of accounting employed.

In the case of other bad debts, however, 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 should have 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 theprofessional or business debts become irrecoverable, an allowance for such bad debts would become necessary in order to arrive at the true profits and gains.

The loss of income or of capital, when arising from investments and not in connection with business assets, is not deductible as a bad debt (Thomas v. C.I.T. (48 I.T.R. 67 (SC))). However, loss of arrears of interst on unpaid sale price in respect of business assets sold by the assessee, would be deductible (Sitalpur Sugar v. C.I.T. (25 I.T.R. 548)).

A deduction should be allowed in the year in which the assessee fairly, reasonably and bona fide writes off a debt as bad; in the event of unexpected recovery of any part of the debt in a later year, the amount would be taxable as the income of that year under section 41(4).

The law has grown through the judicial process and the correct principles have now been laid down by the Bombay High Court in Jethabhai Hirji v. C.I.T. (120 I.T.R. 792) and by the :Gujarat High Court in Saranpur Cotton Mfg. 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 circumstances in determining the year in which the debt became bad.
(c) In an appropriate case a debt may be written off and allowed as a bad 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) by the Director Tax Laws (Amendment) Act, 1987, with effect from April 1, 1989, indicates legislative acceptance of the above judicial approach.

Recently, the Calcutta high court considered the question of debts taken over by a third party and heldthat such debts were fully deductible. In C.I.T. v. Howrah Flour Mills Ltrd. (236 I.T.R. 156), the assessee claimed Rs 46 lakh as bad debt in the assessment year 1984-85. Excepting for a very small portion of this sum, which was only of the order of Rs 50,000 and about which there was not much dispute, the rest was a long standing and old debt. The assessing officer accepted the assessee's claim.

The Commissioner of Income-tax, however, set aside the order under Section 263. He held that the debt had arisen some time prior to 1966-67 as a result of supplies to eleven parties; that in or about 1967, the debt was taken over by E, and hence after such takeover, the debts could not be treated as trade debts. The tribunal restored the order of the assessing officer.

On a reference, the Calcutta high court held that the Commissioner of Income-tax proceeded on the basis that the debtor having changed, the debt should also have changed into something other than a trade debt. That the debt had become bad a longtime ago, that the assessee was carrying a bad debt in its books with the dishonest and improper motive of claiming the debt as a bad debt during a year when profits arose, was not a ground for the order of the Commissioner of Income-tax. The tribunal did not enter into this question and hence it coud not be considered by the high court.

It was held that the nature and character of the debt did not change by reason of the take-over of the debt by E from the 11 original purchasers. The fact that E had become the debtor and had been accepted as the debtor instead of the 11 original purchasers was found by the Assessing Officer in the assessment order.

The commissioner did not revise the order on the ground that a takeover of liability was not permitted in the circumstances and there was nso debt at all owing to the assessee whether from E or any other party. This point was an absolutely new one and could notl therefore be considered by the high court. Hence, the amount was deductible as a bad debt.

Incoming to this decision, the court relied on the decision of the Madhya Pradesh High Court in C.I.T. v. Johilla Coalfields (P) Ltd. (146 I.T.R. 276) and the decision of the Bombay High Court in the case of Jethabhai Hirji.Section 36(1)(vii) read with Section 36(2) 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.

However, if the debt is not allowed for the year in which it is written off, the successor in business can claim it in a subsequent year without writing it off afresh (C.I.T. v. Subramania (119 I.T.R. 925).

Express provision is made for cases where the Department holds the writing off of the debt to be too early or too late.

If the assessing officer holds that the debt has been prematurely written off, it may be allowed asa deduction in a subsequent year though it would not be written off in such subsequent year (sub-section (2)(iii)).

The allowance under this clause is necessarily based upon a mere estimate (Anderton v. Birrell (16 T.C. 200,209). 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, whether the business or profession in respect of which the deduction has been allowed is in existence in that year or not (section 41(4) (Bristow v. William (27 T.C. 157)).

Similarly, the deficiency would be deductible as a business expense in order to supplement the inadequacy of the allowance (section 36(2)(ii)) (Chidambaram v. C.I.T. (39 I.T.R. 320)). However, Section 41(4) fastens liability only on the assessee to whom the deduction was allowed. If the recovery ismade by the successor in business, he would not be chargeable to tax (C.I.T. v. Kaimal (123 I.T.R. 755)).

In conclusion, it may be pointed out that if the assessee shows that in fact a certain portion of a debt has become irrecoverable, his claim to an allowance cannot be defeated by invoking the doctrine of "the substance of the matter as distinguished from the strict legal position" (Chockalingam v. C.I.T. (9 I.T.R. 278).