P. JAGANMOHAN REDDY C.J. - This court had directed the Income-tax Tribunal to state a case on the following question, viz. :
'Whether, on the facts and in the circumstances of the case, the amount of Rs. 26,251 is not a permissible deduction under section 10(1) or 10(2)(xi) of the Indian Income-tax Act ?'
The answer to this question depends on whether the sum of Rs. 26,251 has been established to represent bad debts.
The assessee is a firm of three partners and the partnership was registered under section 26A of the Income-tax Act. For the assessment year 1955-56, for which the relevant accounting period was the year ended October 24, 1954, the assessee had written off certain items of debts owing from seven persons. These debts arose out of speculative transactions with the above seven persons in oil seeds, which were prohibited under law. The transactions entered into by the assessee resulted in profits, and since the method of accounting of the assessee was based on mercantile system, he had, on accrual basis, shown these amounts as income from speculative business, and, it is not denied, they were assessed and made liable to income-tax. These facts are not in dispute, and both sides as well as the statement of the case assume them to be correct. The assessee, however, claimed these amounts as bad and doubtful debts, when they were not paid and became irrecoverable. The Income-tax Officer wrote to the seven debtors enquiring whether they are intending to pay the amount; but except in the case of one person, Srikishan Narayanadas, in respect of a sum of Rs. 3,164, no reply was received from the others. Srikishan Narayanadas stated that he was unable to pay the debt. The Income-tax Officer disallowed all these debts including that of Srikishan Narayanadas, on the ground that the assessee on whom the primary responsibility of proving the claim rests, has not discharged the burden of proof. In respect of the reply received from Srikishan Narayanadas also the Income-tax Officer stated that the version given by him and the assessee were contradictory, inasmuch as while the assessee stated that Narayanadas had refused to pay, Narayanadas stated he was unable to pay. In appeal, the Appellate Assistant Commissioner frankly stated that so far as Srikishan Narayanadas is concerned, it was a clear case of bad debt; and whether he refused to pay the amount or whether he was unable to pay the amount, the fact remains that the debt of Rs. 3,164 due from him could not be recovered. He had, therefore, allowed it as a bad debt. In so far as the other debtors are concerned, as the Income-tax Officer did not receive a reply and since the assessee did not produce any letter of confirmation from them, he held that those amounts were not proved to be bad debts and were rightly disallowed by the Income-tax Officer. The Tribunal also rejected the claim of the assessee, on the grounds, firstly, that although the Income-tax Officer himself wrote to those parties, they refused to confirm or deny their liability or unwillingness to pay evidence to show that, apart from the unenforceability of the claims against the parties, either the parties were unable to pay the amounts or had even refused to pay the amounts. The Tribunal further observed that there is no proof that the debts are trading debts, which alone can be allowed as a deduction under section 10(1) or section 10(2)(xi) of the Act. In this view, the Tribunal also rejected the claim of the assessee.
It appears to us that the basic assumption made by all the three income-tax authorities is that there is no proof of the existence of the debts themselves. This appears to us to be contrary to the nature of the debts which were accrued. They are not debts due on any borrowings; they are debts due on certain transactions and that too, business transactions of a speculative nature. The Income-tax Officer, in his order, has described the business of the assessee as 'commission, trade in rice, etc., and speculation business'. It may also be pointed out that a sum of Rs. 13,239 has been claimed by the assessee as speculation trade loss. The Income-tax Officer also treated this speculation as business and dealt with the matter as such, so that the question of the speculative transactions being in the nature of business was nowhere contested. The Appellate Assistant Commissioner also has treated one of the debts as a bad debt which can only be on the basis that it was incurred as a trading debt. The Tribunal also in its order stated that the assessee had entered into certain speculative transactions in oil seeds which were prohibited under the law, with certain parties.
In a mercantile system of accounting, as is well known, the accounts are maintained on the basis of accrual. If goods are sold but the amount is not received, it is deemed to have been received on the date when the goods were sold, and the amount entered as if received, i.e., a credit will be shown of this amount in the books of the firm or individual, while a corresponding debit will be shown in the ledger of the person to whom the goods have been sold. In other words, the buyer becomes a debtor to the company in respect of that transaction as soon as the goods are sold. It is difficult to support the assumption of the income-tax authorities that there were no debts and that the entries made in respect of each of the debtors in the books of the assessee are not proof of those debts.
There is little doubt that the debts due from the 7 persons were incurred in the course of their business or trade. It is only on that assumption that the Income-tax Officer addressed letters to all the debtors. But, as the Tribunal has pointed out, since these debts are speculation debts incurred in transactions prohibited by law, which presumably contravene the Forward Contracts Regulation Act, and in some instances if they come under section 15 of that Act are even punishable under section 20(2) thereof, the non-receipt of replies from the debtors to the letters of the Income-tax Officer is understandable. the absence of replies itself shows that the debtors were not prepared to admit the debts or payment thereof. Even the Tribunal has stated that the debts due from the several debtors are 'unrealised profits'. Whether you call them unrealised profits or debts, it means no more than that what has been shown as a notional accrual and subjected to income-tax, has been treated as a debt and is liable to be deducted as a business debt if it is not paid.
The provisions under which the deductions are claimed are section 10(1) and section 10(2)(xi) which read as follows :
'10. (1) The tax shall be payable by an assessee under the head Profits and gains of business, profession or vocation in respect of the profits and gains of any business, profession or vocation carried on by him.
(2) Such profits or gains shall be computed after making the following allowances, namely :-........
(xi) when the assessees accounts in respect of any part of his business, profession or vocation are not kept on the cash basis, such sum in respect of bad and doubtful debts, due to the assessee in respect of that part of his business, profession or vocation, and in the case of an assessee carrying on a banking or money-lending business, such sum in respect of loans made in the ordinary course of such business as the Income-tax Officer may estimate to be irrecoverable but not exceeding the amounts actually written off as irrecoverable in the books of the assessee :
Provided that if the amount ultimately recovered on any such debt or loan is greater than the difference between the whole debt or loan and the amount so allowed, the excess shall be deemed to be a profit of the year in which it is recovered and if less, the deficiency shall be deemed to be a business expense of that year.'
A reading of these two provisions would show that the deductions are permissible when the assessees accounts in respect of any part of the business, vocation or profession are maintained on any basis other than cash basis. Mercantile accounting is one such basis. Section 10(2)(xi) clearly envisages debts arising out of transactions of the nature which we are considering. It is not denied that debts arising in a speculation business prohibited under law are unenforceable. No suit can be filed for the recovery thereof, though it cannot be said in all cases that they are irrecoverable. It a debtor under moral obligation or to maintain his good name, pays off the debt, it is a recoverable debt. Mr. Srinivasa Rao contends that every unenforceable debt must be treated as a bad debt, - a proposition which we cannot accept without the further qualification that there must be some proof that that debt, notwithstanding the fact that it is unenforceable, was, in fact, not realisable.
In support of his proposition, Mr. Srinivasa Rao has cited Commissioner of Income-tax v. Pranlal Kesurdas and Mr. Venkatappa, appearing for Sri Kondaiah on behalf of the department, cited several decisions in support of the proposition that there must be proof that the debts are not recoverable. We may, before examining some of these cases, observe that each of those cases was decided upon the particular facts and circumstances of that case, and cannot help in a decision on the facts and circumstances of this case. The proposition which these cases establish is that, in order that a debt may be allowed as a bad debt, two conditions are to be satisfied, viz., that there is a debt which is a business or a trade debt, and secondly, that before it is allowed to be written off, there must be proof that it has become irrecoverable. The mere fact that the assessee has written off these debts in his books is not sufficient to warrant a claim for treating them as bad debts. In Commissioner of Income-tax v. Pranlal Kesurdas the assessee carried on the business of adatia and speculation, and one of the assessees constituents incurred a loss of Rs. 14,960 in certain forward transactions in turmeric which the assessee had put through. The constituent was unable to pay the loss suffered by him, and the loss fell on the assessee. Subsequently, the constituent paid Rs. 4,000 to the assessee in full settlement of the debt and the assessee wrote off the balance of Rs. 10,960 as a bad debt. The assessee claimed this amount as a bad debt, but was disallowed. A Bench of the Bombay High Court held that the circumstances that the debt owing to the assessee from the constituent was not capable of being enforced in a court of law did not prevent the debt from being considered as irrecoverable or bad; and that on the particular facts and circumstances of the case, the inability of the assessee to recover the dues from the constituent or their becoming bad was not as a consequence of the decision of the Supreme Court but by reason of the inability of the constituent to fulfill the obligation to pay, and, therefore, the sum of Rs. 10,960 became bad and the assessee was entitled to deduct it in the computation of his business profits. Alternatively, it was held, as at the time when the forward transactions were entered into, they were entered into in the belief that the transactions were legal and the dues owing to the assessee in these transactions were considered by him as good and recoverable until it was decided by the Supreme Court that the transactions were illegal, with a consequence that the dues could not be recovered. If the constituent was either unable to pay the dues or refused to pay them because of the legal disability on the part of the assessee to recover them, the loss resulting from the transactions could be said to have fallen on the assessee at the point of time when the inability of the constituent or his refusal to pay occurred. It would be observed from this finding that the point of time at which the inability of the constituent or his refusal to pay occurred, is again a question of fact, the onus of which is upon the assessee to establish. In the result, the Bench held that the assessee was entitled to have the amount allowed as deduction. Desai J. at page 938, while considering the arguments of the departmental representative, that inasmuch as losses have arisen out of transactions which were forbidden by law and rendered illegal by providing a penalty for persons entering into such transactions in breach of the prohibition order, the losses could not get the character of debts at all, and consequently, there would be no question of their becoming bad or irrecoverable at a subsequent stage, observed :
'For one thing, if a specific head is provided under section 10(2) and an item is not allowable under that head, it could not be allowed either under the residuary head or even under section 10(1). Secondly, even if the losses in the present case were capable of being regarded as commercial losses, they obviously could not be allowed in the years of assessment because they did not pertain to those years, but to earlier years on the assessees own case, which was that the debts became bad in the years of account.'
The further argument of Mr. Joshi that a liability in order to constitute a debt has to be legally enforceable, was considered and rejected. At page 939, the learned judge said :
'Moreover, it is also well-settled that subject to the special requirements of the Act, the computation of the profits for the purposes of section 10 will have to be arrived at in a commercial manner by deducting such expenses as in a commercial sense can be regarded as expenses of the business though not specifically provided for under any of the specific heads under section 10(2). The computation of profits under section 10(2) permits the deduction of dues or debts due to the businessman in the course of the business which have become bad or irrecoverable. The circumstances that the business is illegal so that neither the profits earned nor the losses suffered would be enforceable in law is not a circumstance which detracts from the profits being taxed. Equally so it should not be a circumstance which should detract from the losses being allowed.'
This decision was followed in Commissioner of Income-tax v. R.B. Rungta & Co. by the same Bench. In that case also, in the course of its business as commission agents, the assessee put through certain transactions on behalf of its constituents in forward business, in commodities which were found to be prohibited under the Spices Forward Contract Prohibition Order, 1944. Some of the constituents did not pay their losses, and when the assessee attempted to recover the amounts they refused to pay on the ground that the transactions, being in essential commodities, were forbidden by law, and the assessee had no enforceable claim against them. The assessee had, however, to pay to the association the amount of the constituents losses, because as a condition of its business as adatias, it had given an indemnity to the association that if the losses were not paid by the constituents, they would be paid by the assessee. The amounts so paid were claimed by the assessee as amounts which had become bad and irrecoverable, but the claim was disallowed by the Income-tax Officer on the ground that since the debts were not enforceable under law they could not be considered to have become bad and were, therefore, not allowable for income-tax purpose. The Appellate Tribunal, however, took the view that the assessees claim for deduction of this amount could be allowed either under section 10(2)(xi) of the Indian Income-tax Act, 1922, or on general principles governing the computation of profits under section 10(1). The Bench held that the Tribunal was entitled to grant relief to the assessee not merely under the head under which the assessee had made its claim, but even in the alternative under another head, namely, by way of commercial losses under section 10(1) of the Act. It also observed that the legal unenforceability of the assessees claim did not prevent the amounts from being bad and irrecoverable debts for the purposes of the computation of the taxable income of the assessee, and, therefore, the amounts could also be allowed as bad and irrecoverable debts under section 10(2)(xi). These two cases are an authority for the proposition that the debts to be written off, must be trade or business debts and that there should be proof that they are bad and irrecoverable debts. None of these propositions can be doubted.
In the present case, it is clearly established, and even admitted by the department, that the debts are business debts, and in respect of one of which, at any rate, the debtor had expressed his inability to pay the debt, and it was accordingly written off. It is only in respect of the other debts the question arises whether there is any proof that those debts have become unrealisable. Two circumstances can be taken into consideration in coming to the conclusion that the debts had become irrecoverable. Firstly, the very fact that the Income-tax Officer took the statement of the assessee that the debts have become irrecoverable at its face value, and went out of his way to obtain confirmation of it by writing to the debtors, would show that the statement of the assessee was, prima facie, convincing. Secondly, the refusal of the debtors to reply to the Income-tax Officers letters would show that they did not want to commit themselves and, consequently, an inference would arise that they did not want to pay. The Tribunal itself has stated that these debts were 'unrealised profits'. Whether you described them as unrealised profits or unrealised debts, nonetheless they are unrealised. Nothing has been stated to show that subsequently at any rate, they were realised. In some of the cases, subsequent realisations have been taken as indicating that the debts were realisable. In this case, nothing has been stated as to whether these debts were realisable or realised. On the facts set out in the statement of the case, we have no hesitation in accepting the contention of the learned advocate for the assessee that the assessee could not do more than what he had done to recover these debts (short of filing a suit, which in law he cannot do) and that he had every reason to write them off as debts which are not recoverable. The attempt by the Income-tax Officer to get confirmation of the existence of the debts and their irrecoverability supports the case of the assessee. Our answer to the question, therefore, is in the affirmative and in favour of the assessee, with costs. Advocates fee Rs. 250.
Question answered in the affirmative.