Assessing Incidental Transactions In Financial Companies: A Taxation Conundrum

The two most central tenets of claiming the deduction provided under Section 36(1)(vii) of the Act are that:

(a) the debt must be taken into account for computing the income of the assessee in the previous year in which the amount is written of or prior previous years; or

(b) represents money lent in the ordinary course of business of banking or money lending^[1].

The ambivalence, however, creeps in categorisation of transactions which are incidental or ancillary to the main business activities of the assessee and may/ may not be integral to them. In cases where such incidental transactions are integral to the main business activity, the deduction under Section 36(1)(vii) may still be permissible, if there is a direct nexus between the incidental transaction and the core business offerings. However, the deduction shall not be permitted when such incidental transactions are not integral to the main business activity.

Whether an incidental transaction is integral to a business enterprise or not often becomes hard to discern especially in the cases of financial services companies. Financial services companies often engage in a wide array of activities beyond their primary offerings, such as advisory services, investment activities, and ancillary operations. They offer a bunch of products, often bundled together. It may be possible that in certain cases, one has to offer services, in order to retain clientele, beyond the mandate of its Article of Association but nevertheless a financial offering. Determining whether losses from these incidental activities would qualify as a bad debt or not becomes a black box, as the integrality of such incidental transactions can be highly subjective.

Such a unique proposition was recently dealt with by the Delhi High Court in WGF Financial Services Pvt Ltd (supra). In the said case, the assessee, a financial company engaged in the business of, inter alia, bill discounting, claimed a deduction for bad debt under Section 36(1)(vii) of the Income Tax Act, asserting that the debt arose from a financial transaction in lieu of standing as a corporate guarantor for another firm. However, the Revenue disputed the nature of this debt, arguing that it did not directly arise from the core activities of the company and the entire transaction was engineered in a way to reduce the assessee's tax.

Findings of AO and CIT, and ITAT

The Assessing Officer (AO) disallowed the bad debt claim, reasoning, inter alia that standing as a guarantor was not one of the main objects of the assessee company. The Commissioner of Income Tax (CIT) (Appeals) upheld this view. The Income Tax Appellate Tribunal (ITAT), however, ruled in favour of the assessee, holding that since the assessee was engaged in the business of lending and advancing money, furnishing a guarantee to a lender also fell within its ordinary course of business.

High Court's Holding and Reasoning

The High Court overturned the ITAT's ruling and upheld the disallowance made by the AO and CIT. It held that while the objectives of incorporation of the assessee company was codified in a comprehensive manner and permitted the assessee company to offer various financial products in the nature of bill discounting services, investment or acquisition of securities, underwriting services, leasing services etc; it did not include standing as a guarantor to secure the lenders against the defaults in repayment obligation by borrowers. The Court also noted that the assessee company had not entered into a similar transaction whereby it had stood as a surety/ guarantor for any other entity for consideration, save and except the transaction under dispute. The Court observed that the learned ITAT's finding that the assessee company was engaged in business of financing which would include services in the nature of standing as a guarantor was not backed by the material on record. Accordingly, the impugned judgement was set aside.

The aforementioned judgement is an inspiring example where court applied an independent mind and assessed the nature of the transaction under dispute, its relevancy to the assessee's main business operations and whether the said transaction was integral to assessee's core business offerings.

While it may not be permissible to codify an exhaustive list of factors to be considered by the AO whilst determining whether an incidental or ancillary service was integral or central to a financial service firm's core operations and hence bad debts arising out of such transaction be permitted deduction under Section 36(1)(vii) of the Act, consideration of following factors may lead to uniformity in application of mind by different adjudicatory bodies:

(i) Nature of the Transaction:

o Determining whether a transaction is a regular part of the company's business or merely incidental.​

o Assessing if the transaction aligns with the company's main objectives as stated in its memorandum of association.​

(ii) Frequency and Regularity:

o Evaluating how often such transactions occur. Regular engagement may indicate integration into the main business.​

(iii) Purpose and Profit Motive:

o Understanding the intent behind the transaction—whether it's aimed at profit generation or serves another purpose.​

The above list is in no shape or form exhaustive but would lead to consistency in thought and approach. Uniformity and consistency in taxation code and its interpretation at various levels of appeal is of utmost importance for ease of doing business. Uniformity and consistency in the taxation code and its interpretation at various levels of appeal are of utmost importance for ease of doing business. Inconsistent rulings create uncertainty, leading to prolonged litigation and increased compliance costs for businesses. When different appellate authorities adopt divergent views on similar issues, it not only erodes taxpayer confidence but also disrupts financial planning and decision-making. A predictable and coherent tax framework ensures that businesses can operate with clarity, fostering investment and economic growth. Therefore, it is imperative that judicial and quasi-judicial bodies adhere to established principles of statutory interpretation, ensuring that taxation laws are applied in a fair, transparent, and consistent manner.

The author is an Advocate at Supreme Court of India. Views are personal.

[1] Principal Commissioner of Income Tax-7 v. WGF Financial Services Pvt Ltd in ITA 184/2022 decided on 25.02,2025