Expenses Incurred by the Assessee: Penal or Compensatory in Nature?

[Amrit Singh is a fourth-year B.A., LL.B. (Hons.) student at Institute of Law, Nirma University]

Section 37 of the Income Tax Act, 1961 states that any expenditure laid out or expended wholly and exclusively for the purposes of the business or profession shall be allowed for deduction. However, this provision excludes the nature of expenditure mentioned in sections 30 to 36, capital expenditures and personal expenses of the assessee.

The explanation added to the said provision is quite interesting inasmuch as it prohibits deduction in cases where the assessee has incurred expenditure for any purpose which is an offence or is prohibited by law. It is important to note that the said exception to the provision has been interpreted by different courts and tribunals in varying ways.

In DCIT v. M/s Rungta Mines Ltd, the Income Tax Appellate Tribunal (ITAT) Kolkata Bench had to decide whether certain expenses incurred by the assessee were compensatory charges or in the nature of penalty. In the said case, it was found that the assessee loaded goods beyond the permissible capacity as provided under section 72 of the Railways Act. The mandate of section 73 stipulates that the railway administration has the power to recover punitive charges for overloading from the assessee.

The entire debate related to whether the payment made in compliance with section 73 was in the nature of penalty for infringement of law or was merely a compensatory charge. The Assessing Officer (AO) had disallowed the expenditure while computing the income from business in accordance with the explanation to section 37(1) of the Income Tax Act. However, in appeal the Commissioner of Income Tax (CIT) granted allowance to the assessee and set aside the order of the AO. The matter was finally placed before the ITAT.

The assessee argued that the term “punitive charge” was not related to any offence or infringement of law, but rather was the additional charge recovered by the administration for overloading. The assessee also relied on the notification dated 23 December 2005 issued by the Ministry of Railways wherein the said term had been defined to state that the charges were compensatory in nature.

On the other hand, the Revenue argued that the marginal note to section 73 of the Railways Act refers to a “punitive charge for overloading a wagon” and that the term “penalty” has been used in the said provision. The main contention of the Revenue was that the expenditure made by the assessee was for an offence and, therefore, no deduction should be allowed for such an expenditure.

The ITAT placed reliance on the decision laid down in M/s Taurian Iron & Steel Co. v. ACIT, where the ITAT Mumbai Bench held:

Though the words used are punitive charges, they are payment which are neither an offence nor is prohibited by the law rather the payment is in accordance with the law as provided in the notification of Ministry of Railways dated 23.12.2005.

Hence, the ITAT upheld the claim of the CIT(A) and allowed the claim of the assessee for deduction.

Moreover, in Ocean Agro (India) Ltd. v. DCIT, the ITAT Ahmedabad Bench had to decide whether the legal expenses incurred by the assessee should be allowed deduction according to section 37 of the Income Tax Act. The Revenue contended that the payment made by the assessee to the Legal Metrology Department was penal in nature as opposed to compensatory as was claimed by the assessee.

After analysing the facts and circumstances of the case, the ITAT noticed that the assessee incurred expenditure of Rs. 20,000/- in order to settle disputes and avoid any future litigation. According the explanation to section 37 of the Income Tax Act, only if the expenses incurred by the assessee are for any purpose that is any offence or prohibited by law, can allowance or deduction be rejected. However, the ITAT in the present case observed that the expenditure is compensatory in nature as it was made for promoting the interest of the business and that it does not satisfy the requirements of the explanation added to section 37.

Another interesting case on this point is Velankani Information Systems Ltd. v. Deputy Commissioner of Income Tax. In this case, the ITAT Bangalore Bench had to decide whether the interest paid on delayed service tax was penal in nature. The assessee in the said case relied on the judgment rendered by the ITAT Kolkata Bench in Dy. CIT v. Narayani Ispat Pvt. Ltd. It is pertinent to highlight that in the above-mentioned case, the ITAT Kolkata Bench had placed reliance on the judgment of the Supreme Court in the case of Lachmandas Mathura v. CIT and the relevant paragraph of the said Supreme Court judgment reads as follows:

The learned counsel appearing for the appellant-assessee states that the said judgment of the Full Bench has been reversed by the larger Bench of the High Court in Triveni Engg. Works Ltd. v. CIT, wherein it has been held that interest on arrears of tax is compensatory in nature and not penal.

The assessee also relied on another case CIT v. Kaypee Mechanical India (P) Ltd. wherein the Gujarat High Court explicitly stated that the assessee paid interest on delayed payment of service tax and that this expenditure was incurred by the assessee during the course of business and exclusively for the purpose of business. Therefore, it was held that the payment made by the assessee cannot be construed to be a payment made for violation of any law.

Further, the ITAT Bangalore Bench also referred to the decisions of the Supreme Court in CIT v. Luxmi Devi Sugar Mills P. Limited and Mahalakshmi Sugar Mills Company v. CIT, which clearly provided that payment of interest is compensatory in nature and cannot be equated with the character of penalty.

Hence, the ITAT Bangalore Bench, after relying on various decisions, arrived at a conclusion that the interest paid on delayed deposit of service tax is compensatory in nature and that explanation 1 to section 37 cannot be attracted in the present case. Hence, the ITAT allowed the deduction of interest amounting to Rs. 56,11,697.

Moreover, recently in J.P. Morgan (P) Ltd. v. Deputy Commissioner of Income Tax, the ITAT Mumbai Bench was faced with a similar issue. It had to decide whether the fine paid by the assessee in the said case, which was J.P. Morgan (P) Ltd., was penal in nature in terms of section 37(1) of the Act. In this case, the assessee had paid a certain amount of fine to National Securities Clearing Corporation Limited (NSCCL) for non-confirmation of clearing house trades and client code modifications. The important thing to note is that NSCCL is an independent body and its bylaws had no statutory force of law. The CIT(A) construed these bye laws as private contracts and it held that any violation of such bylaws could not be termed as an offence or an act that is prohibited by law.

Thus, the CIT(A) held that the assessee incurred expenses in the regular course of business and that those expenses were compensatory in nature. Therefore, it allowed deduction in terms of explanation 1 to section 37 of the Act. The same issue was then again contended before the ITAT. The ITAT did not deviate from the view of the CIT(A) as it held that the payment of fine was not on account of any violation of law. Therefore, the ITAT did not interfere with the recordings and findings of the CIT(A) and allowed the deduction under section 37 of the Act.

 Hence, it can be safely concluded that the applicability of explanation 1 to section 37 of the Act varies on a case to case basis. As it can be observed, there is no strict demarcation which can assist a tribunal or court in identifying as to the nature of expenses incurred by an assessee. Therefore, in order to see whether an expense is compensatory or penal in nature, the adjudicatory body would have to closely analyse the provisions of the relevant act on the basis of which the applicability of explanation 1 is being contended.

Amrit Singh

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