NBFC Statutory Reserve Under Section 45-IC of RBI Act: Not Deductible — Madras High Court Affirms Revenue's Stand

Overview of the Case

The Madras High Court, in Shriram City Union Finance Limited Vs ACIT (T.C.A. No. 191 of 2011, decided on 04/11/2024), conclusively settled a long-standing dispute concerning the tax treatment of mandatory transfers made by Non-Banking Financial Companies (NBFCs) to the statutory reserve fund under Section 45-IC of the Reserve Bank of India Act, 1934. The Court dismissed the appeal filed by the assessee and held that such transfers represent an appropriation of profits and not a diversion of income at source by overriding title, thereby rendering them non-deductible under the Income Tax Act, 1961.

The appeal pertained to Assessment Year 2006-07 and arose from the order of the Income Tax Appellate Tribunal, Madras Bench, dated 08.12.2010 in ITA No. 502/Mds/2010.

Substantial Questions of Law Admitted

The High Court admitted the following two substantial questions of law:

  1. Whether on the facts and circumstances of the case, the Tribunal was right in holding that there has been no diversion of income by overriding charge in respect of amount transferred to Statutory Reserve Fund in compliance with the mandatory provisions of Section 45-IC read with Section 45Q of RBI Act?

  2. Whether on the facts and circumstances of the case, the Tribunal was right in noticing that the amount transferred to Reserve Fund in compliance with the provisions of Reserve Bank of India Act, 1934, by the appellant from its income, is not an allowable deduction in computing the assessable income under the provisions of Indian Income Tax Act, 1961?

Background and Statutory Framework

What Does Section 45-IC of the RBI Act Mandate?

Section 45-IC of the Reserve Bank of India Act, 1934 imposes a statutory obligation on every NBFC to create a reserve fund and transfer therein not less than 20% of its net profit every year, as disclosed in the profit and loss account, and this must be done before any dividend is declared.

Additionally, Section 45-IC(2) restricts the appropriation of any sum from this reserve — such withdrawals can only be made for purposes specified by the Reserve Bank of India from time to time, and every such appropriation must be reported to the RBI within 21 days.

Section 45Q of the RBI Act gives overriding effect to Chapter III-B of the RBI Act over all other laws, which was a central argument raised by the assessee to claim that the transfer constituted an overriding charge, thereby making it a diversion at source.

Arguments Advanced by the Assessee

The assessee's senior counsel advanced the following contentions before the Court:

  • As per Section 45-IC of the RBI Act, 20% of net profits cannot form part of the real income of the company. The company loses control over this portion from the very commencement of business, and therefore the right to the entire income is "sliced away at the threshold itself."
  • The transfer does not arise from any voluntary or gratuitous obligation created by the company but is a statutory compulsion — hence, it should qualify as an expenditure laid out wholly and exclusively for the purpose of carrying on business, deductible under Section 37 of the Income Tax Act, 1961.
  • Since Section 45Q gives overriding effect to Chapter III-B of the RBI Act over all other laws, Section 45-IC creates an overriding charge, and the deduction cannot be disallowed under the Income Tax Act.
  • NBFCs have no independent control over the reserve fund and must await RBI directives before utilising it — hence the amount is effectively outside their domain.