Section 43B – Preposterous Amendment

Under section 145 of the Income-tax Act, 1961, the assessee is allowed to maintain his accounts on either cash system or mercantile system. In case of mercantile system of accounting, the income and expenditure are accounted for on accrual basis – whether or not actually received or paid; whereas in cash system of accounting, the income and expenditure are accounted for on the basis of actual payment. Hybrid system of accounting, which was permitted up to the A.Y. 1996-97 has been prohibited by the Finance Act, 1995 by amending section 145 w.e.f. A.Y. 1997-98. Contrary to this, section 43B that was introduced by the Finance Act, 1983 w.e.f. A.Y. 1984-85 provided for a hybrid system in favour of the revenue and the same has been continued even today with amendments having severe consequences.

Contrary to the provisions of section 145, in case of assessee following the mercantile system of accounting, section 43B provided that certain statutory liabilities and Government dues, the expenditure would be allowed only on actual payment and not on accrual basis. Assessees were claiming deduction for statutory dues such as taxes, duties, PF, ESIC, etc., by making provisions in the books of account but not actually paying them to the Government and in a number of such cases, there used to be inordinate delays in such payments. So as to ensure early payment of such dues, section 43B was introduced providing therein that the deduction would be allowable only on actual payment. In case of PF, ESIC and other welfare payments, the intention was to ensure timely payment of the said amounts.

The scope of this provision was extended to interest by the Finance Act, 1988 w.e.f. A.Y. 1989-90. Clause (d) to section 43B was inserted by the Finance Act, 1988 with effect from 1-4-1989 to cover the expenditure by way of interest on any loans or borrowings from any public financial institution, etc. Further, clause (e) was inserted by the Finance (No. 2) Act, 1996 w.e.f. 1-4-1997, i.e. A.Y. 1997-98 to cover the expenditure by way of interest on loans and advances from scheduled banks.

In fact, with the prohibition of the hybrid system by the Finance Act, 1995 w.e.f. A.Y. 1997-98, the provisions of section 43B should have also been deleted by the same logic. This has not happened. On the other hand, the provisions of section 43B as regards PF, ESIC, etc. were too harsh since there was a total denial of deduction in the event of non-payment within the due date in view of the second proviso in section 43B. The Finance Act, 2003 finally removed this harshness w.e.f. 1-4-2004, i.e. A.Y. 2004-05 and accordingly the case of PF and ESIC are brought on par with the other items.

Finance Act, 2006

Instead of deleting section 43B or further rationalizing it, the Finance Act, 2006 has brought a most illogical and preposterous amendment by introducing Explanations 3C and 3D to section 43B.

Explanation 3C to section 43B provides that deduction for interest payable to financial institutions as mentioned in clause (d) shall be allowed only on actual payment and any conversion of such interest into loan shall not be deemed to have been actually paid. This amendment has been made to take retrospective effect from 1-4-1989, i.e. A.Y. 1989-90. Explanation 3D makes similar provisions in respect of interest payable to banks as mentioned in clause (e) of section 43B. Explanation 3D has been introduced with retrospective effect from 1-4-1997, i.e. A.Y. 1997-98.

These amendments are patently illogical and irrational. Under the provisions of section 43B, the interest amount is deductible on its ‘actual payment’. What constitutes ‘actual payment’ needs a patient ponder. Actual payment need not be restricted to physical handling of money. Squaring of accounts by passing book entries to extinguish the liability also amounts to ‘actual payment’. Squaring of accounts to extinguish the liabilities is a well accepted practice in the financial world and this practice is the result of convenience. Instead of making a fresh borrowing to pay off the interest, the interest is converted into the loan. This conversion amounts to ‘actual payment’ of interest. This aspect has also been accepted by the Department in case of conversion of sales tax liability into loan under the sales tax incentive schemes of the State Government. CBDT has also issued circulars bearing Nos. 494 of 1983 and 673 of 1997. When the conversion of sales tax liability into loan is accepted as ‘actual payment’, by the same logic, conversion of interest into loan should also be treated as ‘actual payment’. The amendments by way of insertion of Explanations 3C and 3D to section 43B are contrary to these well established principles and hence illogical and irrational.

These amendments totally ignore the following aspects:

1. Funding of interest during the initial moratorium period allowed to the borrower by the lending institutions.

2. Funding of interest in terms of financial restructuring arrived at either in terms of scheme approved by BIFR and/or between the Financial Institutions/Banks and the borrower.

3. isallowance of compound interest – as the working of compound interest automatically makes it a part of the loan amount.

4. Deductibility of payment of funded interest – When the interest is converted into loan, it loses the character of revenue and becomes capital. Repayment of such interest afterwards amounts to repayment of capital, making the assessee lose the benefit of deduction of such payment.

What Department of Banking, Ministry of Finance proposes, the Department of Revenue, Ministry of Finance disposes. Two hands of the same Ministry doing exactly the opposite of each other. The amendment is not only illogical but preposterous – touching the abyss in absurdity.

Explanatory statement to the Finance Bill, 2006 describes these amendments under the head – "widening and rationalizing the tax base". In the zest and zeal of "widening" the tax base, the Government seems to have sacrificed the "rationalization" at the altar preposterity.

One is left wondering whether any sick unit or any person who negotiates financial restructuring of his loan amount will ever get the deduction of payment of such funded interest! There is absolutely no mention anywhere providing for the deduction of payment of such funded interest in terms of financial restructuring. The only way out of this disallowance is to take a fresh loan first and then pay off the interest instead of converting the interest into loan. But how is it possible in financial restructuring?

Special Story : The Finance Act, 2006

It has been our practice in the past to come out with a Special Story on Finance Bill in the month of March. This time it was thought that a Special Story on Finance Act will be of greater utility and accordingly we have chosen the special story on "The Finance Act, 2006" for this month. I thank Shri Paras Savla for designing the Special Story for this month. I also thank all the authors for sparing their valuable time and giving their articles in time.