[Priya Garg is a 5th year student at West Bengal National University of Juridical Sciences (WBNUJS), Kolkata]
The Income Tax Act, 1961 (“IT Act”) allows various business expenses to be claimed as ‘deductions’ while computing taxable income under the head ‘profit and gains of business or profession’.[1] Section 37 of the IT Act is a residuary provision on deductions. It permits any business expenditure to be availed as deduction, provided the expense (a) cannot be claimed as deduction under sections 30 to 36, (b) is of revenue nature and (c) has been expended wholly and exclusively for the purposes of business or profession, i.e. is not of personal nature.[2]
The last of the three prongs requires that the expenditure can be justified on the ground of commercial expediency.[3] This implies that it need not have any direct and immediate relation with business operations; instead it is sufficient if the expenditure indirectly ensures the smooth conduct of business operations. Further, the term commercial expediency does not necessitate that the expenditure be incurred to earn profits so long as the expenditure has relation with business operations. Expenditure incurred as a matter of commercial expediency becomes a charge on profits instead of being an application or appropriation of profits which is another pre-condition for expenditure to be claimed as deduction under section 37.[4] It is worth noting that each of the above-mentioned pre-conditions for an expenditure to be claimed as deduction under section 37 are inter-related.
If the above-mentioned three pre-conditions are satisfied, expenditure can be claimed as deduction under section 37 even when it has been incurred voluntarily by a business instead of being required to be incurred under some statute or contract. Such expenditure can be claimed as deduction even when benefits arising positively affect not only the concerned business but also the general members of community. This is why in various cases social expenditure incurred by businesses, for instance for installing traffic light in a public lane, has been categorised as the expenditure incurred ‘wholly and exclusively’ for the purposes of business and has been allowed as a deduction under section 37.[5]
Section 135 of the Companies Act, 2013 requires a company having net worth, turnover or net profits above a certain threshold over a certain period of time to constitute a corporate social responsibility (CSR) committee. The CSR committee has the mandate to draft the company’s CSR policy whereby at least 2% of the company’s average net profits are expended on any activity specified under Schedule VII of the Companies Act.
Since, prior to the enactment of section 135, certain kinds of CSR expenditure were permitted to be claimed as deduction under section 37, ambiguity arose whether all the CSR expenses incurred under section 135 could also be claimed as deductions under section 37 once they meet all the above-mentioned three pre-conditions. Foreseeing the prospective loss in its revenues if section 135 expenditure is claimed as deduction under section 37, the Government hastily addedExplanation II to Section 37 through its Finance Act, 2014 which was to become effective from April, 2015. Under the Explanation, an expenditure incurred by an assessee’s business on CSR activities in accordance with section 135 cannot be claimed as deduction under section 37 because such expenditure is not deemed to be an expenditure incurred by the assessee for the purposes of the business or profession. Interestingly, it has been claimed that the Explanation is merely clarificatory in its nature. This post analyses if it is indeed so.
The memorandum to the Explanation states that it is merely clarificatory because CSR expenditure incurred under section 135 is an application of and not charge against profits. This argument arises due to the existence of provisions such as rule 4(1) under the Companies (Corporate Social Responsibility) Rules, 2014 (“CSR Rules”). Rule 4(1) clarifies that for the purposes of section 135, CSR expenditure shall not include an expenditure incurred on activities undertaken in the normal course of company’s business. Further, as stated earlier, an item of expenditure which is not incurred for the purpose of business operations and thereby cannot be justified on the grounds of ‘commercial expediency’ cannot be considered as a charge on profits and cannot thereby be allowed as deduction under section 37 of the IT Act. Therefore, on a conjoint reading of section 37 and rule 4(1) of the CSR Rules, it has been reasoned that Explanation II is only clarificatory in its nature. This is because expenditure which is not hit by rule 4(1) will be a CSR expenditure and it could anyway not have been claimed as deduction under section 37 as it would not have been an expenditure on account of commercial expediency.
I, however, disagree with this line of reasoning. This is because, according to logic and under law, a business activity can fall within company’s objects clause of its Memorandum of Association (“MoA”), yet it can be outside its ‘normal’ course of business in the sense the term as has been used under rule 4(1) of the CSR Rules, 2014. This is because objects clause is given very wide interpretation under company law jurisprudence. Any activity, including charitable activity, may fall within company’s objects provided it somehow contributes to the company’s main business. Nevertheless, such activity may still be outside the preview of the ‘normal’ or routine course of company’s business. This is because a transaction falls under the ‘normal’ course of business only if it pertains to the usual operations of the business and is carried out as a matter of ordinary business custom or practice.
For example, expenditure incurred by a company towards renovation of primary schools in its neighbourhood to muster the support of the local community there can qualify as an expense on that activity of the company which falls within its object clause. This is because such an activity ultimately helps the company in fulfilling the main objects stated in its MoA. Therefore, such type of expenditure can be justified on the ground of commercial expediency according to section 37 and can be claimed as deduction. On the other hand, this expenditure on renovation of a school may not still be expenditure incurred in the business’s ‘normal’ course of operations according to rule 4(1) and is thereby not disqualified from being CSR expenditure in terms of section 135. Therefore, it would be an incorrect proposition that due to rule 4(1), as a matter of universality, the CSR expenditure incurred in terms of section 135 would always be expenditure that cannot be justified on the ground of commercial expediency under section 37.
Therefore, for such instances of CSR expenses which are not hit by rule 4(1) and could otherwise have been claimed as deduction under section 37 because they could be justified on the ground of commercial expediency, Explanation II is not merely clarificatory in nature. Hence, an outright exclusion of all kind of CSR expenditure incurred under section 135 from the ambit of section 37 deductions involves the creation of a completely new exception in itself.
– Priya Garg
[1] For example, sections 30 to 37 of the IT Act.
[2] A.C. Sampath Iyengar, The Law of Income Tax, 256-57 (10thed, 2005); Nitisha Malpani, Deduction of CSR Expenses under Income Tax Act, 1961; Kanga & Palkhiwala’s The Law and Practice of Income Tax, 940 (Arvind P Datar, 10thed., 2014) (meaning of the term expenditure has been explained).
[3] A.C. Sampath Iyengar, above, at 3261, 3270; CIT v. Infosys Technologies Ltd, (2014) (360 ITR 714); CIT v. Wipro Ltd, (360 ITR 658) (Kar);Commissioner Of Income-Tax v. Madras Refineries Ltd, 2004 266 ITR 170 Mad; Commissioner of Income Tax v. Madura Coats, (2009) 24 DTR (Mad) 24; Infosys Technologies Ltd v. Joint Commissioner of Income Tax, (2007) 109 TTJ Bang 631; B.K. Khanna & Co. (P) Ltd v. CIT, (2000) 164 CTR (Del) 259; C.I.T., Punjab, Haryana, J & K v. Panipat Woollen & General Mills, AIR 1976 SC 640.
[4] Rajasthan State Industrial Development & Investment Corp. Ltd v. DCIT, Circle-6, ITA No. 311/JP/2014.
[5] Madras Refineries Ltd., above;Commissioner of Income Tax v. Madura Coats, (2009) 24 DTR (Mad) 24; B.K. Khanna & Co. (P) Ltd v. CIT, (2000) 164 CTR (Del) 259; Mysore Kirloskar Ltd. v. CIT, Appeal (civil) 5374 of 1994; Delhi Cloth & General Mills Co. Ltd, AIR 1976 SC 640; Commissioner of Income-Tax v. T.S. Hajee Moosa & Company, 1985 153 ITR 422 Mad.