Interest on Bad and Doubtful Debts: Section 56 for Banks and Financial Institutions (Income Tax Act 2025)

Section 56 of the Income-tax Act, 2025 is a special rule for banks and similar lenders. Interest on a bad or doubtful debt earned by a "specified financial institution" is taxed as business income in the tax year in which it is credited to the profit and loss account or actually received, whichever is earlier. Rule 42 of the Income-tax Rules, 2026 lists the debts that count, mostly using a 180-day overdue test.

This guide explains who is covered, which debts qualify, and how the "earlier of" test works with worked examples. Every condition below comes from section 56 and rule 42 (as amended by the Finance Act, 2026). It is information, not advice, and it does not map the section to any provision of the 1961 Act.

What does section 56 of the Income-tax Act, 2025 say?

Section 56(1) starts with "irrespective of anything to the contrary contained in this Act". So it overrides the general rules on when income is taxed. For a specified financial institution, the interest income in relation to bad or doubtful debts:

• is chargeable under the head "Profits and gains of business or profession"; and
• is taxed in the tax year in which it is credited to the profit and loss account or actually received, whichever is earlier.

The practical effect: if a lender does not book the interest in its profit and loss account (for example because it is held back as unrecognised), tax does not arise until the cash is actually received. If it is booked first, tax arises on booking.

Who is a "specified financial institution"?

Section 56(2)(a) defines it as any of the following:

Clause	Institution
(i)	A public financial institution
(ii)	A scheduled bank
(iii)	A co-operative bank, other than a primary agricultural credit society or a primary co-operative agricultural and rural development bank
(iv)	A State Financial Corporation
(v)	A State Industrial Investment Corporation
(vi)	Any class of non-banking financial companies the Central Government notifies

An NBFC is covered only if it falls in a class that the Central Government has notified under clause (vi). Being an NBFC alone is not enough.

Which debts count as "bad or doubtful" for section 56?

Section 56(2)(b) leaves the categories to the rules, "having regard to" Reserve Bank of India guidelines. Rule 42 prescribes them. It has two parts, depending on the type of lender.

Rule 42(1): public financial institutions, scheduled banks, State Financial Corporations and State Industrial Investment Corporations

Section 56 applies to their interest income if it relates to these debts:

Rule 42(1)	Test
(a)(i)	Loan or advance: interest or instalment of principal overdue for more than 180 days
(a)(ii)	Overdraft or cash credit account is "out of order"
(a)(iii)	Bills purchased and discounted: bill overdue for more than 180 days
(a)(iv)	Short-duration crop loan: instalment or interest overdue for two crop seasons
(a)(v)	Long-duration crop loan: overdue for one crop season
(a)(vi)	Securitisation liquidity facility outstanding for more than 180 days
(a)(vii)	Derivatives: overdue positive mark-to-market receivable unpaid for 180 days from the specified due date
(b)(i)	Working capital account with irregular drawings for a continuous 180 days (outstanding based on drawing power from stock statements older than six months is treated as irregular)
(b)(ii)	Credit limits not reviewed or renewed within 180 days of the due date or ad hoc sanction
(b)(iii)	Security eroded: realisable value is less than 50% of the value assessed at the last inspection
(b)(iv)	Realisable value of security is less than 10% of the outstanding in the borrowal account

An overdraft or cash credit account is "out of order" under rule 42(3)(a) if the balance stays above the sanctioned limit or drawing power for 180 days continuously. It is also out of order if the balance is within the limit but there are no credits for 180 days continuously, or credits do not cover the interest debited in the previous 180 days.

For crop loans, "long duration crop" means a crop season longer than one year, and "short duration crop" is any other crop. The crop season is the period up to harvest, as determined by the State Level Bankers' Committee of each State (rule 42(3)(b), (d), (e)).

Rule 42(2): the "public company" (housing finance)

Rule 42(2) applies section 56 to a "public company" whose interest income relates to a doubtful asset or a loss asset.

• Doubtful asset: a debt that has stayed a non-performing asset for more than two years. The non-performing asset categories in rule 42(2)(a)(ii) are mostly built on the 180-day overdue test (interest overdue, term loan instalment overdue, demand or call loan overdue, bills, lease rentals and hire purchase instalments, and so on). Agricultural term loans use the two-crop-season and one-crop-season test.
• Loss asset: an asset identified as a loss asset and considered uncollectible, but not yet written off by the assessee.

Here "public company" has a narrow meaning in rule 42(3)(c). It must be a public company under section 2(71) of the Companies Act, 2013, its main object must be long-term finance for construction or purchase of houses in India for residential purposes, and it must be registered under the National Housing Bank Act, 1987 route or the housing finance company directions named in the rule.

Rule 42(1) names four kinds of lenders and rule 42(2) names housing finance public companies. Co-operative banks and notified NBFC classes appear in the section 56 definition, but the rule's text does not list them separately, so check the rule wording against your client's facts before relying on it.

How does the "earlier of credit or receipt" test work?

Worked example 1: bank with a non-performing term loan

Assumptions (tax year 2026-27): Ravi Traders has a term loan of Rs 20,00,000 from a scheduled bank at 12% a year. The instalments have been overdue for more than 180 days, so the loan falls under rule 42(1)(a)(i). Interest accrues at Rs 20,00,000 x 12% = Rs 2,40,000 a year, or Rs 20,000 a month. The bank does not credit the overdue interest to its profit and loss account. It receives Rs 60,000 in cash during the year.

Step	Working	Amount (Rs)
1. Interest accrued in the year	20,00,000 x 12%	2,40,000
2. Credited to P&L	Not credited	0
3. Actually received	Cash received in 2026-27	60,000
4. Taxable under section 56 in 2026-27	Earlier of credit or receipt, so the receipt counts	60,000
5. Not yet taxable	2,40,000 - 60,000	1,80,000

The Rs 1,80,000 becomes taxable in a later tax year, when it is credited to the profit and loss account or received, whichever happens first. The Rs 60,000 is business income of the bank for 2026-27.

Worked example 2: credit versus receipt in the same year

Assumptions (tax year 2026-27): A scheduled bank has a working-capital account of Rs 50,00,000 at 11%. The security was assessed at Rs 1,00,000,000 (Rs 1 crore) at the last inspection and is now realisable for only Rs 45,00,000. First, test the account against rule 42(1)(b):

Test	Working	Result
(b)(iii): realisable value below 50% of assessed value	50% of 1,00,00,000 = 50,00,000; realisable value is 45,00,000	Met, since 45,00,000 < 50,00,000
(b)(iv): realisable value below 10% of outstanding	10% of 50,00,000 = 5,00,000; realisable value is 45,00,000	Not met

One test is enough, so the account is a rule 42(1) bad or doubtful debt. Annual interest is Rs 50,00,000 x 11% = Rs 5,50,000, or Rs 1,37,500 a quarter. During 2026-27:

Quarter	What happens	Taxable in 2026-27 (Rs)
Q1 and Q2	Not credited, not received	0
Q3	Rs 1,37,500 received in cash	1,37,500
Q4	Rs 1,37,500 credited to P&L on 31 March, not yet received	1,37,500
Total taxable under section 56		2,75,000

The Q1 and Q2 interest (Rs 2,75,000 in all) stays outside the 2026-27 income until one of the two events occurs.

Real-life scenarios

Scenario 1: the recovery after a long wait. Meena is the finance head of a State Financial Corporation. A borrower stopped paying two years ago and the interest was never booked. This year the borrower settles and pays Rs 8,00,000, of which Rs 3,00,000 is interest. Under section 56(1)(b), the interest received is taxed as business income of this tax year, because it was received and had not been credited to the profit and loss account earlier.

Scenario 2: the housing finance company. Sunil is the CA for a housing finance public company that fits the rule 42(3)(c) definition. A loan has been a non-performing asset for 26 months. It is over the two-year mark, so it is a "doubtful asset" under rule 42(2)(a). Interest on it is governed by section 56. If the asset is instead identified as uncollectible and not yet written off, it is a "loss asset", which also falls under rule 42(2)(b).

Scenario 3: a lender outside the list. Kiran runs a small non-banking finance company that has not been notified under section 56(2)(a)(vi). Its overdue interest is not covered by section 56, so the general rules on when income is taxed decide the year.

Common mistakes

• Assuming every NBFC is covered. Only classes notified by the Central Government qualify under section 56(2)(a)(vi).
• Treating section 56 as covering all interest. It applies to interest relating to bad or doubtful debts in the rule 42 categories, not to performing loans.
• Waiting for cash only. The test is the earlier of P&L credit and receipt. Once the interest is credited to the profit and loss account, it is taxed even if nothing has been received.
• Ignoring the head of income. The interest is business income, not "income from other sources".
• Mixing up the two parts of rule 42. Rule 42(1) uses the 180-day and security tests; rule 42(2) applies only to the housing finance "public company" and uses the doubtful asset and loss asset tests.
• Counting days loosely. The tests say "more than 180 days", so check the exact overdue date from the loan record.

Quick reference

Point	Rule	Where
Head of income	Profits and gains of business or profession	Section 56(1)
Year of taxation	Earlier of P&L credit or actual receipt	Section 56(1)(a), (b)
Who is covered	Public financial institution, scheduled bank, co-operative bank (with two exclusions), State Financial Corporation, State Industrial Investment Corporation, notified NBFC class	Section 56(2)(a)
Overdue threshold	More than 180 days (most categories)	Rule 42(1)(a), (b); rule 42(2)(a)(ii)
Doubtful asset age	NPA for more than two years	Rule 42(2)(a)(i)
Security erosion	Realisable value below 50% of assessed value, or below 10% of outstanding	Rule 42(1)(b)(iii), (iv)

Where this is in the Act

• Section 56(1): charge to tax and timing of interest on bad or doubtful debts
• Section 56(2)(a): specified financial institution
• Section 56(2)(b): bad or doubtful debts, as prescribed
• Rule 42(1): categories for banks and public financial institutions, State Financial Corporations and State Industrial Investment Corporations
• Rule 42(2): doubtful asset and loss asset for the housing finance public company
• Rule 42(3): definitions of out of order, crop duration and public company

For the borrower's side and the related deduction for bad debts, see our guide to bad debt and provision for doubtful debts under the Income Tax Act 2025.

For a CA firm with bank, NBFC or housing finance clients, the work is tracking which accounts crossed the 180-day mark, which interest was credited or received in the year, and what year-end evidence is still missing. Finexo's practice management software keeps per-client checklists and document requests so those items are chased before filing. It does not compute the income for you.