The Law On Deductibility Of Expenditure Incurred For An “Unlawful Purpose”

Section 37 of the Income Tax Act, 1961 (the “Act”) has been a source of numerous disputes between the department and the taxpayer.  For the sake of convenience, the sub-section with explanation thereto is quoted below:

37 (1) Any expenditure (not being expenditure of the nature described in sections 30 to 36 and not being in the nature of capital expenditure or personal expenses of the assessee), laid out or expended wholly and exclusively for the purposes of the business or profession shall be allowed in computing the income chargeable under the head “Profits and gains of business or profession”.

Explanation—For the removal of doubts, it is hereby declared that any expenditure incurred by an assessee for any purpose which is an offence or which is prohibited by law shall not be deemed to have been incurred for the purpose of business or profession and no deduction or allowance shall be made in respect of such expenditure.

The Explanation was introduced in 1998 and the amendment was made retrospective from 01st April, 1962.  The Memorandum Explaining the Provisions of the Finance Bill 1998  stated as follows:

It is proposed to insert an explanation after sub-section (i) of section 37 to clarify that no allowance shall be made in respect of expenditure incurred by an assessee for any purpose which is an offence or which is prohibited by law. This proposed amendment will result in disallowance of the claim made by certain tax payers of payments on account of protection money, extortion, hafta, bribes, etc. as business expenditure.

This amendment will take effect from 1st April, 1962 and will accordingly apply in relation to the assessment year 1962-1963 and subsequent years.

The disallowance under this Explanation, therefore, rests on the following conditions precedent:

(1) It should be an expenditure; and

(2) It should have been incurred for any purpose which is an offence or which is prohibited by law.

In a judgment delivered on 05th May, 1959 in the matter of Indian Molasses Company Pvt. Ltd. v Commissioner of Income Tax, West Bengal [1959] 37 ITR 66 (SC), their Lordships of the Supreme Court interpreted the meaning of the word “expenditure” in the context of Section 10(2)(xv) the Income Tax Act of 1922.  Their Lordships’ observed as follows:

‘Expenditure’ is equal to ‘expense’ and ‘expense’ is money laid out by calculation and intention though in many uses of the word this element may not be present, as when we speak of a joke at another’s expense. But the idea of spending in the sense of paying out or away is the primary meaning and it is with that meaning that we are concerned. ‘Expenditure’ is thus what is ‘paid out or away’ and is something which is gone irretrievably. In a later paragraph, their Lordships’ observed as follows: To be a payment which is made irrevocably there should be no possibility of the money forming, once again, a part of the funds of the assessee company.

In another judgment delivered on 04th April, 1997 in the matter of Madras Industrial Investment Corporation Ltd. v The Commissioner of Income Tax, Tamil Nadu [1997] 225 ITR 802 (SC), their Lordships’ of the Supreme Court, relying on the judgment in India Molasses Company Pvt. Ltd. (supra) held as follows: Therefore, although expenditure primarily denotes the idea of spending or paying out, it may, in given circumstances, also cover an amount of loss which has not gone out of the assessee’s pocket but which is all the same, an amount which the assessee has had to give up. It also covers a liability which the assessee has incurred in praesenti although it is payable in the future. A contingent liability that may arise in the future is, however, not ‘expenditure’. It would also cover not just a one time payment but a liability spread out over a number of years.

From the above two judgments, the following may be culled out: for something to qualify as an ‘expenditure’, it must be paid out in a manner that makes it irrecoverable (or, gone for good) and the amount should be an ascertained one, even if payable in the future.

Once it is established that the amount is ‘expenditure’, the second condition precedent for attracting disallowance under Explanation to Section 37(1) is whether it has been incurred by the assessee for any purpose which is an offence or which is prohibited by law.

The word “offence” is not defined in the Income Tax Act. However, it is defined in Section 3(38) of the General Clauses Act, 1887 as follows:  “offence” shall mean any act or omission made punishable by any law for the time being in force;”.  The expression “prohibited by law” , too, is not defined in the Income Tax Act. It may be viewed either as an act arising from a contract which is expressly or impliedly prohibited by statute, or contracts entered into with the object of committing an illegal act.

Prior to the retrospective amendment by way of insertion of Explanation to Section 37(1), there were some landmark rulings in relation to expenses that were deductible from income in order to ascertain profits. A large number of such rulings were in the context of Section 10(2)(xv) of the Act of 1922.

In their judgment delivered on 05th October, 1971 in the case of CIT v S.C.Kothari (1971) 82 ITR 794 (SC), their Lordships’ of the Supreme Court held as under: If the business is illegal neither the profits earned nor the losses incurred would be enforceable in law. But that does not take the profits out of the taxing statute. Similarly, the taint of illegality of the business cannot detract from the losses being taken into account for computation of the amount which can be subjected to tax as “profits’… This decision was referred to by the Apex Court in the case of CIT Patiala v Piara Singh (1980) 124 ITR 40. In that case, Piara Singh was a smuggler who was apprehended in September, 1958 while attempting to cross the Indo-Pakistan border into Pakistan. A sum of INR 65,500/- was recovered from his person. On interrogation, Piara Singh stated that he was carrying the currency into Pakistan for the purpose of buying gold which he would then intended to smuggle into India. In proceedings initiated by the ITO, the amount was treated as undisclosed income of Piara Singh. Appellate Assistant Commissioner dismissed the appeal and Piara Singh preferred a second appeal before the ITAT in which he took the plea that if he was to be regarded as carrying on the business of smuggling, then he was entitled to a deduction u/s 10(1) of the Income Tax Act, 1922 of the entire sum that was confiscated on the ground that it was a loss incurred in business. The ITAT upheld the claim. The Revenue appealed before the High Court but the appeal failed. On further reference to the Supreme Court it was held that  the assessee was carrying on the business of smuggling and, therefore, was liable to income tax on income from that business. The currency notes carried by the assessee across the border were an essential part of the smuggling operation. If the activity of smuggling can be regarded as a business, those who are carrying on that business must be deemed to be aware that a necessary incident involved in the business is detection by the Customs authorities and the consequent confiscation of the currency notes. It is an incident as predictable in the course of carrying on the activity as any other feature of it. Having regard to the nature of the activity possible detection by the Customs authorities constitutes a normal feature integrated into all that is implied and involved in it. The confiscation of the currency notes is a loss occasioned in pursuing the business; it is a loss in much the same way as if the currency notes had been stolen or dropped on the way while carrying on the business. It is a loss which springs directly from the carrying on of the business and is incidental to it. Applying the principle laid down by the Court in Badridas Daga v. Commissioner of Income Tax the deduction must be allowed.

In another judgment delivered by their Lordships’ of the Supreme Court on 24th November, 1960 in the matter of Haji Aziz and Abdul Shakoor Bros. v CIT Bombay City II (1961) 41 ITR 350, it was held that In our opinion, no expense which is paid by way of penalty for a breach of the law can be said to be an amount wholly and exclusively laid for the purpose of the business. The distinction sought to be drawn between a personal liability and a liability of the kind now before us is not sustainable because anything done which is an infraction of the law and is visited with a penalty cannot on grounds of public policy be said to be a commercial expense for the purpose of a business or a disbursement made for the purposes of earning the profits of such business.

The facts in Piara Singh’s case as well as that of S.C.Kothari may be distinguished from the facts in Haji Aziz and Abdul Shakoor Bros’ case. In the last-named case, the assessee was carrying on the lawful business of importing dates from abroad and selling them in India. The import of dates by steamer was prohibited under law but the assessee nonetheless did so. The consignment was confiscated by the customs authorities but was released on payment of a fine. The assessee claimed deduction of fine u/s 10(2)(xv) of the 1922 Act but the claim was rejected on the ground that the amount paid was for infraction of law. An infraction of law was not a normal incident of business carried on by a trader.

As a result of the decisions referred to above, a situation arose where a person conducting illegal business was at an advantage as compared to someone conducting a legal business but merely violates some law for one reason or another. In his erudite commentary on the Law of Income Tax, A.C.Sampath Iyengar states that this is difficult to justify.

The question that arises for consideration is whether all penalties/fine that are paid for lead to a disallowance?

In CIT v KAP Scan and Diagnostic Centre P. Ltd. [2012] 344 ITR 476, the Punjab & Haryana High Court dealt with the admissibility of commission paid to doctors for referring patients for diagnosis. Expenses claimed by the assessee towards such commission had been disallowed. The assessee sought to rely on the decision of the Apex Court in the case of Dr. T.A.Quereshi [2006] ITR 547 and of the Allahabad High Court in CIT v Pt. Vishwanath Sharma [2009] 316 ITR 419. In the case of Dr. Quereshi, the assessee was found manufacturing heroin and other contraband substances and claimed the value of heroin seized as a business loss. The Apex Court held that the value of heroin seized, being a part of stock-in-trade of the assessee, represented a business loss and not a business expenditure and was, therefore, not covered by section 37 in the first place. In the case of Pt. Vishwanath Sharma, the High Court had held that payment of commission to Government doctors for prescribing assessee’s medicines was in contravention of public policy and not admissible as expenditure. The Punjab & Haryana High Court distinguished the cases of Dr. Quereshi and Pt. Vishwanath Sharma on the grounds that the former did not deal with Section 37 and the latter did not distinguish between Government doctors and private doctors and was, therefore, of no use to the assessee in KAP Scan’s case. The High Court further considered The Indian Medical Council (Professional Conduct, Etiquette and Ethics) Regulations, 2002 and concluded therefrom that such payment of commission was opposed to public policy. It consequently disallowed the expenditure.

In J.K.Panthaki and Co. v ITO (Investigation) [2012] 344 ITR 329, the Karnataka High Court dealt with a case where the assessee was a registered firm of construction engineers and designers. During the assessment years 1983-84 and 1984-85, its main income was from the contract receipts for civil construction from one KBBCL. There were some changes in structural designs of the building which resulted in a cost reduction of around INR 48 Lakhs as compared to original estimates. The Directors’ of KBBCL entered into an agreement with the assessee whereby the managing partner of assessee agreed to pay such cost reduction of INR 48 Lakhs as commission to them in consideration of their awarding the contract of construction to the assessee. The assessee claimed deduction of the amount as an expenditure but this claim was rejected by the Assessing Officer. This was upheld by the Tribunal. The High Court dismissed assessee’s appeal on the ground that what was being paid was a kick back or bribe couched in respectability by naming it “commission”. It could not be allowed as expenditure u/s 37.

However, there are also instances of fines /penalties that have been allowed as admissible expenditure.

In CIT v Prasad and Co. [2012] 341 ITR 480, the Delhi High Court dealt with the case of assessee, a share broker,  paying penalty to the Delhi Stock Exchange and National Stock Exchange for late deposit of margin monies and other violations of timely delivery. Following an ITAT decision in Master Capital, the High Court held that these payments were in the normal course of business of the assessee and there was no infraction of law.

In Mahalakshmi Sugar Mills Co. v. Commissioner of Income Tax, Delhi, [1980] 123 ITR 429, the Supreme Court had to decide the question whether the interest paid by the appellant-assessee therein under Section 3(3) of the U.P. Sugarcane Cess Act, 1956 for delayed payment of cess payable thereunder was an allowable expenditure under Section 10(2)(XV) of the I.T. Act of 1922. For deciding that question, the Court examined the provisions of Sugarcane Cess Act, 1956 which provided for taking of several kinds of action against a person who defaulted in payment of the cess imposed under that Act. Section 4 was found to make the defaulter liable to imprisonment or fine or both. Section 3(5) was found to make the defaulter liable for payment of penalty, an amount which far exceeded the amount of cess. Then, Section 3(3) was found to make the defaulter liable for payment of interest at 6 per cent per annum from the date of default till the date of payment. On an analytical examination of the said provisions, the Court took the view that interest paid under Section 3(3) by the defaulter for delayed payment of the cess could not be described as a penalty imposed upon him for infringement of the law but ought to be regarded as an amount of compensation paid by him to the Government for delayed payment of the cess levied against him under the Act. In that view of the matter, the Court held that the interest paid by the appellant assessee on delayed payment of cess was an allowable expenditure under Section 10(2)(XV) of the I.T. Act of 1922.

Referring to its decision in Mahalakshmi Sugar Mills’ case as well as a passage from a judgment of the Division Bench of the Andhra Pradesh High Court in CIT v Hyderabad Allwyn Metal Works Limited [1988] 172 ITR 113, the Supreme Court , in Prakash Cotton Mills Pvt. Ltd. v CIT (Central) Bombay held that  whenever any statutory impost paid by an assessee by way of damages or penalty or interest, is claimed as an allowable expenditure under section 37(1) of the I.T. Act, the assessing authority is required to examine the Scheme of the provisions of the relevant statute providing for payment of such impost notwithstanding the nomenclature of the impost as given by the statute, to find whether it is compensatory or penal, in nature. The authority has to allow deduction under Section 37(1) of the I.T. Act, where ever such examination reveals the concerned impost to be purely compensatory in nature. Where ever such impost is found to be of a composite nature, that is, partly of compensatory nature and partly of penal nature, the authorities are obligated to bifurcate the two components of the impost and give deduction to that component which is compensatory in nature and refuse to give deduction to that component which is penal in nature.

Conclusion

The law relating to disallowances under Explanation to Section 37(1) remains contentious even after the insertion of the explanation. Disallowances under this Explanation are not as easy as they seem and require rigorous analysis to establish whether the ingredients of the Explanation are, indeed, satisfied. The law as it stands on date is not entirely free from controversy and each case has to be considered on its own merits.