The AO held that the expenditure as penalty levied on it for not complying with the terms of the contract, such penalty paid for violation of the contract in the course of the conduct of business could not be regarded as a deductible expenditure. The CIT(A) deleted the addition. On appeal the Tribunal held that the contract between the assessee and the buyers was clear in its terms that there was a specification as to the quality of coal that had to be supplied and should there be any variation in such quality, the price would be adjusted accordingly. In the case of supply of coal with the high moisture under low grass calorific value, the buyer would make deduction on such account. Further, the case of the assessee had been that it did not pass on the liability incurred on this count to its sellers. The Assessing Officer should have considered this aspect as to the possibility of the assessee passing on such liability to its sellers, which was not possible in the case of the penalty paid for an offence or infraction of law. The inability to meet the contractual obligation by the assessee could not be termed as an offence or infraction of law so as to deny the claim of the assessee by invoking Explanation 1 to S. 37(1). Merely because the assessee categorised the claim under “penalty levied on it for not complying with the terms of the contract”, it was not permissible to conclude that such penalty was in respect of any offence or infraction of law committed by the assessee so as to invoke the provisions under Explanation 1 to section 37(1). The expression “penalty was levied on the assessee for not complying with the terms of the contract”, clearly indicated that it was a civil consequence for not complying with certain terms of contract and had nothing to do with any offence. (AY.2012-13)