The Threat of Unconstitutionality to Explanation II to Section 37 of the Income Tax Act

[Priya Garg is a 5th year student at West Bengal National University of Juridical Sciences (WBNUJS), Kolkata]

Explanation II added to Section 37 of the Income Tax Act, 1961 (“IT Act”), which became effective from 1 April 2014, runs the risk of violating Articles 14 and 19 of the Constitution of India. This post explains the reason behind this proposition.

Explanation II states that any expenditure incurred on activities relating to corporate social responsibility (CSR) under Section 135 of the Companies Act, 2013 shall not be deemed to be an expenditure incurred by the assessee for the purposes of the business or profession. Hence, according to the literal meaning of Explanation II, under all circumstances CSR expenditure incurred pursuant to Section 135 of the Companies Act cannot be claimed as deduction under Section 37 of the IT Act.

Article 14 of the Constitution

Article 14 is a fundamental right. It guarantees to all persons (be it natural or artificial entities and be it citizens or non-citizens) equality before law and equal protection of law. Therefore, any law discriminating between two persons or class of persons will be hit by Article 14 unless the discriminatory treatment has a reasonable basis and direct nexus with the objective its classification seeks to achieve.[1] Similarly, in order to stay within the bounds of Article 14, the operation of the law should not be arbitrary because arbitrariness is antithetical to equality.[2]

I argue that Explanation II, in its present form, is discriminatory without any justification in five ways. First, Explanation II discriminates between CSR expenditure incurred under Section 135 and that incurred otherwise by a company, even when both can be justified on the ground of commercial expediency under Section 37 of the IT Act. 

This is because besides Section 135 a company can incur expenditure benefitting society under several provisions of the Companies Act. For instance, Section 166 of the Act stipulates duties of a company’s directors. It requires the director to act in the best interests of the company, its employees, shareholders, community and for the protection of environment. Hence, following the enactment of Section 166, directors can undertake any kind of social expenditure even when it falls outside the company’s objects clause as stated under its memorandum of association. This is on account of Section 6 of the Companies Act which states that the provisions of the Act prevail over the company’s memorandum of association. Similarly, social expenditure can be incurred by a company under Sections 181 to 183 of the Companies Act. In all such cases where the social expenditure is of revenue nature and can be said to have been incurred out of commercial expediency, it can be claimed as deductions under Section 37. On the other hand, under similar circumstances, CSR expenditure incurred in terms of Section 135 cannot be claimed as deduction under Section 37 due to an outright bar stated under Explanation II. This discriminatory treatment meted out to the two kinds of social expenditure is arbitrary. One can, however, counter-argue that the rationale behind incorporating Explanation II is that the government, by allowing deductions in the form of CSR expenditure, does not wish to share the monetary burden of the cost of company’s CSR activities undertaken under Section 135. However, even if that is the rationale, it cannot ‘selectively’ apply to the social expenditure incurred under Section 135 and not to that incurred outside of Section 135.

Second, Explanation II unreasonably provides for differential treatment to the companies mandatorily required to incur CSR expenditure under Section 135 and those which do not fall under the net of Section 135 but still incur ‘voluntary’ social expenditure on activities covered by Schedule VII of the Companies Act. This is because Explanation II bars the former from claiming their CSR expenditure incurred under Section 135 as deductions under Section 37 of the IT Act. However, Explanation II does not bar the latter from doing so. This inference is only an implied one. This is because in the landmark case of ACIT v. Jindal Power it was clarified that Explanation II covers only the CSR expenditure which has been incurred due to some statutory obligation. It was stated that Explanation II does not cover the CSR expenditure incurred voluntarily. This discrimination also seems to be arbitrary.

Third, since Jindal Power held that Explanation II covers only those CSR expenses which are required to be incurred under some statutory provision instead of being incurred voluntarily, it can also be stated that Explanation II, without reason, differentiates between the CSR expenditure incurred under Section 135 to the extent of 2% of a company’s average net profits and that incurred by the same company under Section 135 over and above the minimum threshold of 2%. This is because while under Section 135 the 2% expenditure (being the minimum threshold for CSR expenditure) is statutorily required, any CSR expenditure on the same activity over and above the 2% quantum is voluntary. This is more so, given that under the Companies Act any excess CSR expenditure incurred in one year cannot be carried forward to and set off against the minimum CSR expenditure required to be incurred by the same company in any of the subsequent years.[3]

Fourth, the presence of Explanation II results in meting out arbitrary differential treatment to some kind of CSR activities mentioned under Schedule VII of the Companies Act against the other. This is because while expenditure incurred on some of the Schedule VII activities such as donation towards the Prime Minister’s National Relief Fund can be claimed as deductions under Section 80G, other kind of CSR activities incurred in terms of Schedule VII cannot be claimed as deduction even they are otherwise eligible for deduction under Section 37.

Lastly, the operation of Explanation II in its present form is arbitrary. It can be understood by a careful reading of Section 135. A prima facie reading of Section 135 and the CSR Rules, 2014 give the impression that the provisions mandatorily require a company to incur the CSR expenditure of a specified quantum. This arises due to the use of the term ‘shall’ in the relevant provisions. However, this kind of ‘first impression’ is not true. This is because while for a company falling under Section 135, there is no escape to the obligation of constituting a CSR committee, the obligation to incur expenditure in terms of Section 135 can be ‘legitimately’ avoided. This is so if the company mentions in its board of directors’ report the reasons for its omission in incurring such expenditure. Further, nowhere under the Companies Act, 2013 nor through case laws has it been provided that the reason so stated in the board’s report is subject to any review by the executive or judiciary. Therefore, Section 135 is only a comply-or-explain provision. This may be the reason behind companies not incurring the required CSR expenditure despite the enactment of Section 135 in several instances. In this backdrop, incorporating a provision in the nature of Explanation II further discourages companies from undertaking the CSR expenditure.

Moreover, the existence of Explanation II creates an absurd situation. A company that is required to incur the CSR expenditure under Section 135 may decide not to incur it. Instead, it may incur the expenditure for society in relation to an activity not covered by Schedule VII. Thereafter, it can explain in its board’s report that the reason for not incurring the CSR expenditure under Section 135 is its incurring of the expenditure on some other social activity. This kind of explanation should ensure that the company’s goodwill is not affected. In such circumstances, if the social expenditure incurred by the company is of revenue nature and can be considered to have been incurred on account of commercial expediency, it may be claimed as a deduction under Section 37 of the Income Tax Act. However, this would not have been possible had the company chosen to strictly abide by Section 135 and would have incurred its CSR expenditure in terms of Schedule VII due to the existence of an absolute bar on claiming deduction on such expenditure under Explanation II. Therefore, Explanation II indirectly punishes the companies incurring the CSR expenditure in terms of Section 135 and rewards those which ignore Schedule VII activities and incur their social expenditure otherwise. This kind of discriminatory treatment is arbitrary and must be proscribed by Article 14. This was exactly how the minority judgement concluded in the Bearer Bonds case. The minority judges found the impugned law to be violative of Article 14 for it seemed to be favouring the persons possessing black money and enabling such people to evade taxation laws. The law punished honest tax payers and ‘put a premium’ on the persons indulgent in dishonest dealings. The minority opined that such a law which operated against honest people and law abiders was unreasonable.

Article 19 of the Constitution

Article 19(1)(a) guarantees to every citizen of India, the freedom of speech and expression. In order to adjudge if a law restricts rights granted under Article 19(1)(a), its direct and inevitable effect is looked at instead of checking its motive, intention or its subject matter. The freedom guaranteed by Article 19(1)(a) can be ‘reasonably’ restricted only on the grounds of safeguarding sovereignty and integrity of India, security of the state, friendly relations with foreign states, public order, decency or morality, or in relation to contempt of court, defamation or incitement to an offence. However, unlike Article 14, Article 19(1)(a) grants rights only to natural persons who should also be Indian citizens. Hence, in case of a company incorporated in India, while the company itself cannot enjoy rights under Article 19(1)(a), its owners/shareholders or other stakeholders can do so wherever any law regulates their company in a manner that their Article 19(1)(a) rights stand at the risk of being violated.

Keeping this backdrop into mind, in this part I argue that Explanation II poses a threat to the right to freedom of speech and expression of the company’s owners, managers or its board of directors. The appreciation of this argument firstly requires an overview of the scope of the freedom granted by Article 19(1)(a). Unlike the US law on this matter, Article 19(1)(a) under the Indian Constitution is broader in its scope.[4] This is because while the US law only covers freedom of speech, the Indian Constitution includes both the freedom of speech ‘and expression’ as a fundamental right. Incorporation of the term ‘expression’ takes into consideration numerous modes, besides speech, through which a person can express his thoughts, beliefs, emotions, philosophy and personality. For instance, wearing of black bands to express protest is protected under Article 19(1)(a) as it is an expression.[5] Hence, the scope of Article 19(1)(a) freedom stands much widened, so much so that voting as an activity is considered to be a mode of voter’s expressions.

The manner in and the cause for which an owner, manager or board of directors of a company incurs CSR expenditure is, in some cases, a manifestation of their personal opinion, beliefs, philosophy and personality.[6] Therefore, in such cases, CSR expenditure as a mode of expression stands protected under Article 19(1)(a).

The IT bars a company from claiming CSR expenditure incurred under Section 135 on some of the activities mentioned under Schedule VII of the Companies Act, 2013 as deduction by incorporating Explanation II. On the other hand, it allows the CSR expenditure incurred under some other heads of Schedule VII to be claimed as deduction. Hence, the direct and immediate effect of this is indirectly compelling businesses to incur CSR expenditure only on certain specific endeavours stated under Schedule VII. This is because the tax difference that comes in both the cases can be significant for a company even when it is large enough to fall under the ambit of Section 135. In such cases, the company’s owner, manager or directors may feel compelled to express their empathy towards and interest in activities and causes they may not feel for deeply. Hence, Explanation II restricts their freedom of speech and expression and that of expression if stated more precisely.

And it is prima facie evident that this restriction, indirectly imposed by the Income Tax Act, cannot be justified on any of the grounds of reasonable restrictions mentioned under Article 19(2) of the Indian Constitution. Therefore, for the limited cases where incurring of CSR expenditure is a manifestation of the spender’s expressions, Explanation II can be unconstitutional to that extent due to its violating Article 19(1)(a) of the spender.


In India, while framing the legal provisions regulating the conduct of companies, we tend to strategise and act as if companies are non-living entities, turning oblivion to the fact that they are run by businessman and managers who are humans. Hence, their psychological, cultural, emotional, instinctive and economic factors are ignored.  Hence, in such circumstances, business laws often do not reflect the emotions, instincts and thought process of the country’s businessmen. For instance, as explained in this post, while mandating CSR for companies, we forget that we are expecting certain kind of behaviour from the owners and directors of such businesses.

This may be the reason why in the UK the Corporate Governance Code is voluntary and nevertheless has a good rate of adherence by corporates. On the other hand, in India, when corporate governance standards were introduced as guidelines, they were not taken seriously unless they were introduced in the form of legislative sanctions. This write-up, though in a very different context, advances this broader proposition that expresses much graver concern regarding the nature of commercial law provisions in the country.

Priya Garg 

[1] Durga Das Basu Shorter Constitution of India, 58-62 (Justice Y.V. Chandrachud, 13th ed., 2006).

[2] E.P. Royappa v. State of Tamil Nadu, 1974 (4) SCC 3.

[3]A Ramaiyya, Guide to the Companies Act: Providing Guidance on the Companies Act, 2013, 2530 (18th ed., 2015).

[4] DD Basu Commentary on the Constitution of India, 2657 (Justice YV Chandrachud, 8th ed., 2007).

[5] DD Basu Commentary on the Constitution of India, at 2383-86.

[6] See Shivaram Rajgopal& Prasanna Tantri, Does Mandated Corporate Social Responsibility Reduce Intrinsic Motivation? Evidence from India; Mandating CSR Akin to Taxation: Ratan Tata, Business Line (6 December 2015); Vibhu Modi, Compulsory CSR Defeats its own Purpose, IIM Ahmedabad.

About the author


  • To ADD:
    The writer, a student of law by his own claim , has rightly faulted and supported his viewpoint on the not-so-obvious incongruity./ discrimination in the chosen / cherry picked enactment, made in exercise of the powers of the legislature in violation of the diktats of the Constitution,

    With the same breath, however, one is obliged to say that, – if scouted around, there could be instances galore of a similar kind, – not to speak of the “únkindest cut of all”- inflicted by amendments of the BASIC CHARTER itself, in general; and its very “basic structure”, in particular (look up the leading SC judgments delivered but on varying wavelength ) !


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