Supreme Court disallows bad debt deduction on advance given by real estate developer and financier to purchase commercial property

This Alert summarizes a recent decision[1] of three-judge bench of Supreme Court (SC) in the case of PCIT v. Khyati Realtors Pvt. Ltd[2] (Taxpayer) on bad debt deduction for advance given by a real estate developer and financier to purchase commercial property.

The Taxpayer claimed write off of advance as bad debt deduction under section (s.) 36(1)(vii) of the Income tax Act, 1961 (ITA) and alternatively, as revenue business expenditure or trading loss under s. 37(1). The tax authority and the first appellate authority (FAA) denied deduction under both provisions on the grounds that (a) the conditions for claiming bad debt deduction were not fulfilled and (b) since the claim fell under bad debt deduction provision but could not be allowed due to non-fulfilment of conditions thereof, it cannot be allowed under s.37(1) as well.

On further appeal by the Taxpayer, the Mumbai Tribunal confirmed non-admissibility of claim as bad debt deduction due to non-fulfillment of conditions thereof but allowed the deduction under s.37(1) on the ground that the advance was given in the ordinary course of real estate development business. The Tribunal also noted that the Taxpayer had offered subsequent recovery of part of advance in subsequent tax year as business income. On further appeal by the tax authority, the Bombay High Court (HC) upheld the Tribunal ruling on allowance of deduction under s.37(1). The tax authority appealed further to the SC.

Reversing the decisions of the Tribunal and the HC, the SC ruled in favor of the tax authority and held that the deduction was not allowable for the following reasons:

(a)The Taxpayer could neither establish from its accounts that the advance was given in the ordinary course of Taxpayer’s business nor could it establish that the amount was given as loan in the ordinary course of moneylending business.

(b)Furthermore, the Taxpayer could not establish from its record that the bad debt was written off as irrecoverable in the books of account.

(c)Also, since the advance was given to acquire immovable property, it was in the nature of capital expenditure and, hence, not allowable as revenue business expenditure.

(d)It is true that a revenue expenditure incurred wholly and exclusively for business purposes, if not allowable under any of the specific provisions, is allowable as deduction under residual provision of s.37(1). However, in the present case, as held by the SC in an earlier ruling, provision for doubtful debt not allowable under s.36(1)(vii) is also not allowable under s.37(1), since s.37(1) applies only to items which do not fall under earlier provisions.

[1] dated 25 August 2022
[2] TS-671-SC-2022