CAG Audit Flags Tax Irregularities in Banks: What NBFCs Must Know

The Comptroller and Auditor General of India has repeatedly flagged significant tax irregularities in the banking sector through its direct tax audit reports. CAG Report No. 11 of 2020 and subsequent performance audits documented systemic errors in how commercial banks claimed deductions for bad debts, computed reserve provisions, reported NPA interest income, and classified advances for deduction purposes under the Income Tax Act, 1961. The aggregate revenue impact runs into thousands of crores. While these findings target banks directly, the underlying tax provisions apply equally to Non-Banking Financial Companies operating under RBI regulation. NBFCs that ignore the patterns flagged by CAG risk identical assessment errors, reassessment proceedings, and penalty exposure. This article breaks down every major CAG finding, maps each to the specific Income Tax Act provision, and provides a compliance framework for NBFCs heading into FY 2026-27.

What Is a CAG Audit and Why It Matters for the Banking Sector

The Comptroller and Auditor General of India (CAG) is a constitutional authority established under Article 148 of the Indian Constitution. Among its responsibilities is the audit of receipts and expenditure of the Union and State governments, including the examination of whether tax assessments by the Income Tax Department follow the provisions of the Income Tax Act correctly. When CAG audits tax assessments of banks, it examines whether the Assessing Officers properly verified the deductions claimed, applied the correct legal provisions, and computed taxable income accurately.

CAG does not audit the banks themselves for this purpose. It audits the Income Tax Department's assessment of banks. The focus is on whether tax officers allowed deductions that were not legally admissible, failed to verify supporting documentation, or applied incorrect calculation methods. When irregularities are found, CAG quantifies the revenue impact and reports it to Parliament through its published audit reports.

Why CAG Findings Carry Institutional Weight

CAG reports are tabled in Parliament and reviewed by the Public Accounts Committee (PAC). The Income Tax Department is required to respond to each observation with corrective action. In practice, CAG findings trigger reassessment proceedings, policy circulars, and procedural changes within the tax administration. For banks and financial institutions, a CAG observation against a specific deduction pattern often leads to heightened scrutiny of similar claims across the sector. NBFCs that claim deductions under the same Income Tax Act provisions should treat CAG bank audit findings as an early warning of what their own assessments will face.

Major Tax Irregularities Flagged by CAG in Banks

Across multiple audit reports, CAG has identified five recurring categories of tax irregularities in the banking sector. Each category corresponds to a specific provision of the Income Tax Act, and each has direct relevance for NBFCs.

Section 36(1)(vii): Bad Debt Deduction Rules and CAG Findings

Section 36(1)(vii) of the Income Tax Act allows a deduction for bad debts that have been written off as irrecoverable in the accounts of the assessee. For banks and NBFCs, this is the primary mechanism for claiming tax relief on loans that have gone bad. The Supreme Court in TRF Ltd vs CIT (2010) held that it is sufficient for the assessee to write off the debt in its books; establishing that the debt has become irrecoverable is not a separate requirement.

What CAG Found Wrong

CAG audits revealed that banks were claiming bad debt deductions under Section 36(1)(vii) without physically writing off the amounts in their books of accounts. In multiple cases, banks debited the provision for bad debts account (a balance sheet item) instead of debiting the profit and loss account. Under accounting standards and Income Tax Act requirements, a valid write-off requires the specific loan account to be credited and the bad debt amount to be debited to the profit and loss account. Merely classifying an asset as NPA under RBI norms does not constitute a write-off for income tax purposes.

The CAG also found instances where banks claimed bad debt deductions for amounts that were still under active litigation or recovery proceedings before Debt Recovery Tribunals (DRTs). While the Supreme Court ruling in TRF Ltd does not require the debt to be established as irrecoverable, the write-off in books must be genuine and reflected in the financial statements. The Assessing Officers, in many cases, allowed these claims without verifying the actual accounting treatment in the bank's books.

NBFC Application: What to Watch

NBFCs face the identical compliance requirement. When an NBFC registered with RBI claims a bad debt deduction, the write-off must be reflected as a charge to the profit and loss account. The mere creation of a provision under RBI's prudential norms for NBFCs does not qualify as a write-off under the Income Tax Act. NBFCs must maintain clear separation between RBI-mandated provisioning (which is a regulatory requirement) and income tax bad debt write-offs (which require actual P&L impact). Any NBFC claiming Section 36(1)(vii) deductions should ensure that the specific loan account is individually identified, the write-off entry passes through the profit and loss account, and the board has approved the write-off through a formal resolution.

Section 36(1)(viia): Provision for Bad Debts and Who Qualifies

Section 36(1)(viia) is a special provision that allows scheduled banks, cooperative banks engaged in banking business, and specified financial institutions to claim a deduction for provision for bad and doubtful debts. Unlike Section 36(1)(vii), which requires actual write-off, Section 36(1)(viia) allows a deduction for merely creating a provision in the books, subject to prescribed limits.

How the Deduction Limit Works

The deduction under Section 36(1)(viia) is capped at the higher of two components. For a scheduled bank or cooperative bank, the deduction is limited to:

• Component 1: An amount not exceeding 8.5% of the total income before this deduction (computed before any deduction under this section)
• Component 2: An amount not exceeding 10% of the aggregate average advances made by the rural branches of the bank

The total deduction is the sum of both components. Banks with a higher proportion of rural branch advances get a larger deduction. This is where the CAG found the most systematic manipulation.

CAG Finding: Rural Advance Inflation

CAG identified that banks were misclassifying branches to inflate the rural advance component. A branch located in a semi-urban area would be classified as rural in the bank's internal records submitted to the Income Tax Department, increasing the 10% deduction base. In some cases, the branch classification used for RBI reporting (which correctly identified the branch as semi-urban) differed from the classification used in the tax return. The Assessing Officers did not cross-verify the branch classification against RBI records, allowing the excess deduction to pass through.

NBFC Eligibility: Limited but Critical

Regular NBFCs registered with RBI cannot claim deductions under Section 36(1)(viia). The section is explicitly limited to scheduled banks, cooperative banks, public financial institutions under Section 4A of the Companies Act, and state financial corporations/state industrial investment corporations. However, NBFCs that are classified as public financial institutions or that operate banking-like functions under specific RBI notifications may qualify. Any NBFC uncertain about its eligibility must obtain a written opinion from a tax professional before claiming this deduction in its income tax return.

Section 43D: NPA Interest Income and the Accrual Trap

Section 43D provides a critical exception to the accrual basis of accounting for banks, cooperative banks, financial institutions, and certain NBFCs. Under this section, interest income on non-performing assets as classified by RBI is chargeable to tax only in the year it is actually received or credited to the profit and loss account, whichever is earlier. This overrides the general rule that income must be recognized on accrual basis.

What CAG Identified

CAG found two patterns of errors in Section 43D application by banks:

1. Failure to reverse accrued interest: Banks that had already recognized interest on a loan on accrual basis failed to reverse the entry when the loan was classified as NPA. This meant the interest was included in taxable income in the year of accrual but was not reversed when the NPA classification occurred, leading to double counting in cases where the interest was later received
2. Premature exclusion: Banks excluded interest income from assets that were not yet classified as NPA under RBI norms. The Section 43D benefit applies only to assets that are NPAs as per RBI classification. A loan that is 60 days overdue but not yet classified as NPA (which requires 90 days under RBI norms) does not qualify for Section 43D treatment

NBFC-Specific Considerations

For NBFCs, Section 43D was extended through specific notifications. However, the benefit applies only to NBFCs that are classified as systematically important or those specifically notified by the government. Smaller NBFCs in the Base Layer under the RBI Scale Based Regulation framework may not automatically qualify. The distinction matters: if an NBFC claims Section 43D treatment without being an eligible entity, the Assessing Officer can add back the interest income to taxable income with interest and penalty. NBFCs must verify their eligibility under the specific notification before applying cash basis treatment to NPA interest.

The Double Deduction Problem: Section 36(1)(vii) vs Section 36(1)(viia)

One of the most significant findings across CAG audit reports is the double deduction claimed by banks under both Section 36(1)(vii) and Section 36(1)(viia) for the same non-performing loan. Understanding this interaction is critical for any financial institution, including NBFCs that may have access to both provisions.

How the Interaction Works

The proviso to Section 36(1)(vii) states that where a deduction has been allowed under Section 36(1)(viia) in respect of provision for bad debts, the bad debt written off under Section 36(1)(vii) shall be limited to the amount by which the bad debt exceeds the credit balance in the provision for bad debts account. In simple terms: if a bank has already claimed Rs. 50 crore as provision deduction under Section 36(1)(viia), and then writes off Rs. 80 crore as bad debt under Section 36(1)(vii), the Section 36(1)(vii) deduction is limited to Rs. 30 crore (Rs. 80 crore minus Rs. 50 crore).

NBFC Tax Compliance: Lessons from CAG Bank Audit Findings

NBFCs operate under a regulatory framework that shares significant overlap with the banking sector on tax provisions. While NBFC registration is governed by RBI's separate master directions, the Income Tax Act provisions governing bad debt deductions, NPA interest recognition, and reserve provisions apply to both banks and qualifying NBFCs. The CAG findings in banks serve as a direct compliance blueprint for NBFCs.

5 Critical Compliance Actions for NBFCs

1. Separate RBI provisioning from IT Act write-offs: Maintain two distinct ledgers. One tracks provisions mandated by RBI prudential norms (balance sheet treatment). The other tracks actual bad debt write-offs that qualify for Section 36(1)(vii) deductions (P&L treatment). Never conflate the two in your tax computation
2. Verify Section 43D eligibility before applying cash basis: Confirm that your NBFC falls within the notification covering Section 43D. If your NBFC is in the Base Layer under SBR with assets below Rs. 500 crore, verify the specific NPA overdue period applicable to your entity before claiming cash basis treatment for NPA interest
3. Document every bad debt write-off individually: Each write-off must have a board resolution, recovery effort documentation, account-level identification of the specific loan, and a clear P&L debit entry. The CAG found that banks maintained bulk write-off schedules without account-level detail. Do not repeat this error
4. Reconcile Section 36(1)(vii) and 36(1)(viia) claims annually: If your NBFC qualifies for both provisions, prepare a reconciliation schedule showing the provision balance, the write-off amount, the adjustment, and the net deduction claimed. This document should be part of your tax audit working papers
5. Cross-verify branch/advance classifications with RBI filings: Ensure that any classification used for Income Tax Act deduction purposes matches what you report to RBI. Discrepancies between RBI returns and income tax filings are exactly what CAG identifies during its audits

RBI Scale Based Regulation and Its Tax Compliance Impact

The RBI's Scale Based Regulation (SBR) framework, effective from October 1, 2022, fundamentally changed how NBFCs are regulated. The framework classifies NBFCs into four layers based on asset size, activity type, and systemic importance. Each layer has different regulatory expectations, and these differences directly affect tax compliance obligations.

The SBR framework means that Upper Layer NBFCs now face the same CAG-identified compliance risks as banks. Their NPA classification, bad debt write-off procedures, and interest income recognition must meet standards identical to scheduled commercial banks. Middle Layer NBFCs are transitioning toward these standards. Base Layer NBFCs have relatively lighter requirements but must still comply with the fundamental Income Tax Act provisions governing deductions and income recognition.

Income Tax Act 2025: What Changes for Banks and NBFCs

The Income Tax Act, 2025, which received Presidential assent on March 29, 2025 and takes effect from April 1, 2026, replaces the Income Tax Act, 1961 with a reorganized and renumbered statute. For banks and NBFCs, the substantive provisions governing bad debt deductions, reserve provisions, and NPA interest treatment are carried forward under new section numbers.

Section Mapping: Old Act to New Act

The provisions relevant to the CAG findings have been retained in the new Act under reorganized sections. While the specific section numbers change, the legal substance remains identical. Banks and NBFCs must update their internal compliance manuals, tax computation templates, and audit checklists to reference the new section numbers. The old section numbers will be invalid for assessment years beginning from AY 2026-27.

• Section 36(1)(vii): Bad debt write-off deduction is continued under the corresponding clause in the new Act's deductions chapter
• Section 36(1)(viia): Provision for bad debts deduction for banks and financial institutions is retained with the same eligibility criteria and computation limits
• Section 43D: Cash basis treatment for NPA interest income is carried forward for eligible banks, financial institutions, and notified NBFCs
• Section 44AB: Tax audit requirements continue with the same threshold and Form 3CD disclosure requirements

Tax Audit Requirements: Form 3CD Disclosures for Banks and NBFCs

The tax audit report in Form 3CD under Section 44AB is the primary document where bad debt deductions, NPA provisions, and interest income treatment are disclosed to the Income Tax Department. CAG findings strongly suggest that inadequate Form 3CD disclosures contributed to the assessment errors. Tax auditors who do not flag inconsistencies in their reports effectively pass the compliance risk to the Assessing Officer, who may not independently verify the claims.

Critical Form 3CD Clauses for Financial Institutions

• Clause 21(a): Details of amounts debited to the profit and loss account as bad debts, including account-level identification and the year of origination of the debt
• Clause 21(b): Details of provision for bad and doubtful debts under Section 36(1)(viia), including the computation showing total income, aggregate average advances, and the rural advance proportion
• Clause 21(d): Details of debts outstanding for more than the prescribed period, categorized by age and classification status
• Clause 26: Details of deductions claimed under various sections including Section 36(1)(vii), 36(1)(viia), and any other provisions relevant to bad debt treatment

NBFCs must ensure their tax auditor specifically verifies the reconciliation between RBI provisioning and IT Act write-offs and documents this verification in the Form 3CD working papers. A tax auditor who simply relies on the management's computation without independent verification is exposing the NBFC to CAG-pattern assessment risks.

How Assessing Officers Should Verify Bank and NBFC Deductions

CAG audit observations consistently point to a verification gap at the Assessing Officer level. The errors identified were not sophisticated tax planning strategies by banks; they were straightforward computation mistakes and documentation failures that went undetected because AOs did not perform basic cross-checks. Here is what proper verification looks like.

AO Verification Checklist (Based on CAG Recommendations)

1. Verify actual write-off in books: Check that the bad debt deduction under Section 36(1)(vii) corresponds to an actual debit in the profit and loss account, not merely a provision in the balance sheet
2. Cross-check rural branch classification: Compare the branch classification used in the Section 36(1)(viia) computation against the bank's RBI returns and actual branch location data
3. Reconcile Sections 36(1)(vii) and 36(1)(viia): Verify that the bad debt deduction is reduced by the credit balance in the provision account as required by the proviso to Section 36(1)(vii)
4. Verify NPA classification dates: Confirm that assets treated under Section 43D are classified as NPAs under RBI norms as of the relevant dates, and that interest reversal entries are correctly timed
5. Check eligibility for Section 36(1)(viia): Confirm that the entity claiming the deduction falls within the specified categories (scheduled bank, cooperative bank, public financial institution)
6. Review Form 3CD disclosures: Check that the tax audit report specifically addresses bad debt deductions, provision computations, and NPA interest treatment with account-level details

For NBFCs undergoing assessment, understanding what the AO should be checking helps prepare for the scrutiny. Proactive preparation of the verification documents listed above, bundled with your income tax return filing, reduces the risk of adverse assessment orders.

Building a CAG-Proof Tax Compliance Framework for NBFCs

NBFCs that want to avoid the assessment errors flagged by CAG in banks need a structured compliance framework that addresses each risk area systematically. Here is a practical framework that mid-sized and large NBFCs can implement for FY 2026-27.

Quarterly Compliance Review Process

• Q1 (April-June): Review NPA classification dates and ensure all loans overdue beyond 90 days are classified correctly. Verify that Section 43D treatment is applied only to eligible NPAs. Reconcile RBI provisioning entries with the IT Act treatment in the draft quarterly financials
• Q2 (July-September): Prepare an interim reconciliation of Section 36(1)(vii) write-offs against Section 36(1)(viia) provision balances. Flag any loans where the write-off entry has not yet been passed in the books despite the board approving the write-off
• Q3 (October-December): Review advance tax computations to ensure bad debt deductions and NPA interest exclusions are correctly reflected. Verify branch/advance classifications used in deduction computations against current RBI return data
• Q4 (January-March): Finalize all bad debt write-offs with board resolutions. Complete the reconciliation between RBI provisioning and IT Act deductions. Prepare the Form 3CD working papers for the tax auditor with full documentation

Documentation Standards

For each bad debt write-off claimed as a deduction, maintain a file containing: the original loan agreement, the NPA classification notice and date, all recovery effort correspondence, legal proceedings records (if applicable), the board resolution authorizing the write-off, the specific journal entry showing the P&L debit, and a computation showing how the deduction amount was arrived at after adjusting for any Section 36(1)(viia) provision. This file should be ready before the income tax return is filed, not compiled retrospectively when a notice arrives.

Penalties and Consequences for Tax Irregularities

Banks and NBFCs found to have claimed incorrect deductions face a range of financial penalties and enforcement actions under the Income Tax Act. The consequences escalate based on whether the error is classified as under-reporting or misreporting of income.

Penalty Framework Under the Income Tax Act

• Under-reporting of income (Section 270A): A penalty of 50% of the tax payable on the under-reported income. This applies when the deduction claim was incorrect but not attributable to deliberate misrepresentation. Banks that claimed excess bad debt deductions due to computational errors or incorrect provision adjustments fall into this category
• Misreporting of income (Section 270A): A penalty of 200% of the tax payable on the misreported income. This applies when the claim involves misrepresentation or suppression of facts, such as deliberately misclassifying branch locations to inflate rural advance deductions
• Interest on tax demand: Interest under Section 234A (default in filing), Section 234B (default in advance tax), and Section 234C (deferment of advance tax) applies on the additional tax demand arising from the disallowed deductions
• Prosecution provisions: In cases involving willful tax evasion exceeding the prescribed threshold, prosecution under Section 276C can be initiated, carrying imprisonment of 6 months to 7 years along with fine

For NBFCs structured as Private Limited Companies, penalties imposed on the company also reflect in its compliance record with RBI. Repeated tax assessment defaults can trigger enhanced regulatory scrutiny from RBI under the Scale Based Regulation framework, particularly for NBFCs approaching the Upper Layer threshold.

Summary

CAG audit reports on the banking sector have established a clear pattern of tax irregularities centered on five areas: excess bad debt deductions under Section 36(1)(vii), incorrect reserve provision claims under Section 36(1)(viia), NPA interest misreporting under Section 43D, rural advance misclassification, and double deductions across both provisions. These findings are not historical curiosities. They represent active assessment risk for any financial institution, including NBFCs, that claims similar deductions under identical Income Tax Act provisions. The Income Tax Act, 2025 carries forward all relevant provisions under new section numbers, ensuring that the same compliance requirements continue into AY 2026-27 and beyond. NBFCs that build a structured compliance framework with separate RBI and IT Act records, individual loan-level documentation, quarterly reconciliation processes, and proactive tax audit preparation will withstand both Assessing Officer scrutiny and CAG-level audit. Those that do not will face the same irregularity findings, reassessment demands, and penalty exposure that CAG has already documented across the banking sector.