A Re-Examination of the First Principles of Sections 28 and 37 of the Income Tax Act: Part I

[Rucha A Vaidya is an Advocate, Bombay High Court. The author would like to thank Mr. Mihir Naniwadekar, Advocate Bombay High Court, for his comments on the earlier draft of this post]

This is a two-part post on a judgment of the Supreme Court of India (SC) in PCIT v. Prakash Chand Lunia (24 April 2023), which provides an opportunity for closely examining some of the fundamental principles underlying the taxation of business profits under the Income Tax Act, 1961 (“Act”). Part I of the post discusses the factual background and the judgments of M.R Shah and M.M Sundresh JJ. Part II dives into the analysis of the underlying fundamentals governing the operation of sections 28 and 37 of the Act pertaining to the claims for expenses or losses arising in the course of ‘illegal’ activities.

The case involved a claim of trading loss on account of goods confiscated by Customs Authorities due to an infraction of the law. It raised issues on the scope of the Explanation to section 37 of the Act and the application of that Explanation to claims of loss made under section 28.

The brief facts of the case were that the assessee was engaged in the business of purchase and sale of silver. A search was conducted at the business premises of the assessee, and slabs of silver and silver ingots were recovered by the Department of Revenue Intelligence (“DRI”). The Collector Customs ordered absolute confiscation of unaccounted slabs of silver on the ground that the silver confiscated was smuggled as no details for same were found in the assessee’s books of accounts. The assessee claimed that the loss on account of confiscation should be allowed as a trading loss incidental to the business. During the assessment, the Assessing Officer observed that the assessee could not explain the nature and source of acquisition of the said silver. Consequently, he passed an assessment order and made additions under section 69A. The Appellate Authorities upheld the additions made by the assessing officer. On appeal, the Rajasthan High Court held that when the value of silver was added to the assessee’s income, the loss by confiscation of the silver was required to be allowed as a business loss to the assessee. On an appeal by the revenue to the Supreme Court, the judges (Shah and Sundresh JJ.) hearing the appeal delivered two separate but concurring judgments, albeit with different reasonings.

It would be convenient to first set out the contents of these sections. Section 28 of the Act deals with the mechanism to compute profits from business or profession. While computing such profits, a loss incurred during an assessee’s business is allowed to be reduced from the profits of the business. As per accounting principles, business loss is allowable in order to derive the true profits of the business or profession. On the other hand, sections 30 – 37 of the Act provide various deductions for expenditures to be deducted from the profits of the business. Sections 30-36 provide specific expenditures that are allowable as deductions. Section 37 is a residuary and general provision. Explanation 1 to section 37, inserted by the Finance Act 1998 with retrospective effect from 1 April 1962, states as under:

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 facts in the case of Lunia provided an opportunity for the Supreme Court to consider the application and scope of this Explanation.

Judgment delivered by Shah J.

Shah J. held that the loss claimed by the assessee in the present case is not allowable as a business loss. Though he recognised that the assessee had claimed a business loss as opposed to a business expenditure, it was held that Explanation 1 to section 37 of the Act had a bearing on the business loss claimed due to the confiscation of the silver bars. Shah J. referred to the decisions of CIT v. Piara Singh relied upon by the assessee and Haji Aziz & Abdul Shakoor Bros v. CIT, Soni Hinduji Kushalji & Co. v. CIT  and J.S Parkar v. V.B Palekar relied upon by the revenue. He held that the fundamental difference in the facts of Piara Singh, on the one hand, and Haji Aziz, Soni Hinduji Kushalji, and J .S Parkar, on the other hand, was that in Piara Singh, the assessee was engaged in a smuggling business which was an illegal business while in the other three cases, the assesses were otherwise engaged in legitimate businesses. Therefore, in the case of Piara Singh, the confiscation was of smuggled goods which was a penal action for the illegal business carried on by the assessee, and since the assessee was anyways engaged in an illegal business, such loss on account of confiscated goods had a nexus with the business of the assessee. It could therefore be allowed as a business loss in the facts of that assessee. However, in the present case, the assessee was otherwise engaged in the legal business of dealing in silver, and the loss on account of confiscated silver bars had no nexus with the general conduct of the assessee’s business and is hence not allowable as a business loss. Therefore, the decision of the Supreme Court in Piara Singh was (according to Shah J.) inapplicable to the facts of the present case, while Haji Aziz, Soni Hinduji Kushalji, and J .S Parkar were applicable.

Judgment delivered by Sundresh J.

The Judgment of Sundresh J. can be segregated into two segments:

Obliteration of the Distinction Between Business Expenditure and Business Loss

Relying on the decision of the Supreme Court in Badridas Daga v. CIT, Sundresh J. held that there was a similarity in the test qua a ‘loss’ as laid down by the Supreme Court in Badridas Daga and ‘expenditure’ under section 37 of the Act. There was a distinction only in the accounting treatment of the two concepts. Thus, the phrase ‘any expenditure’ mentioned in section 37 of the Act took in its sweep ‘loss’ occasioned in the course of business, as well. Hence, the logic of disallowing expenditure under Explanation 1 to section 37 could also be extended to disallowing losses under s 28.

Treatment of Precedents

In support of the extension of Explanation 1 to section 37 to cover even business losses under section 28, the following decisions were relied on by Sundresh J.:

– Badridas Daga, wherein it was held that a loss can be claimed if it arises out of and is incidental to the assessee’s business. A claim for deduction of a loss is allowable so long as it emanated directly from the carrying on of the business, being incidental to it. In other words, it did not include loss of any nature, even if it had some connection with the business if the same cannot be said to be incidental to the business.

– Haji Aziz, wherein the Supreme Court held that penalty for an infraction of the law can never be said to arise out of the business. The role in which an assessee conducts an activity for which a penalty is laid is different from the role that an assessee assumes while conducting his business. Therefore such a loss caused due to the penalty can never be regarded as a commercial loss.

– Soni Hinduji Kushalji & Co.’s case where the Andhra Pradesh High Court considered the law laid down on deduction of loss incurred by way of confiscation and penalty. It was held that a loss must be one arising directly from the business or trade, being incidental to it, as laid down by this Court in Badridas Daga’s case. The Court, while noting the decision of this Court in Maqbool Hussain v. State of Bombay, and Haji Aziz & Abdul Shakoor Bros, held that confiscation of contraband being an action in rem is not available for deduction, as the same, by no process of reasoning can be said to be trading or commercial loss connected with or incidental to the assessee’s business.

– J. S. Parkar, where the Bombay High Court followed the ratio laid down in Haji Aziz and Soni Hinduji Kushalji

While dealing with the decision of the Supreme Court in Piara Singh, Sundresh J. held that the Supreme Court in that case drew a distinction between an infraction of law committed in carrying out a lawful business as against one committed in an inherently unlawful business. However, according to Sundresh J., the decisions of Haji Aziz andBadridas Daga were not considered in Piara Singh. Therefore Sundresh J. held:

We would only clarify the position that, in any case, the law as laid down in Piara Singh case may not have any application to a case of deduction of expenditure/loss incurred on account of penalty/confiscation coming under section 37(1) of the Act, particularly in light of Explanation 1.

While dealing with Dr. T A Quereshi v. CIT  relied upon by the assessee, Sundresh J. held that TA Qureshi merely followed Piara Singh without taking note of the binding principles laid down in Haji Aziz, Badridas Daga. Sundresh J. therefore observed:

Therefore, there cannot be a situation where an assessee carrying on an illegal business can claim deduction of expenses or losses incurred in the course of that business, while another assessee carrying on a legitimate one cannot seek deduction for loss incurred on account of either a confiscation or penalty. The interpretation of section 37 of the Act given by the Court in Dr. T.A. Quereshi case, leads to a situation where the expenditure incurred in manufacturing something illegal may not be allowable as a deduction in view of the Explanation 1, however, if upon seizure, the manufactured goods are confiscated, in that case deduction will be allowable on commercial principles. This classification being artificial not borne out by statute, which mischief is sought to be clarified by the Explanation, has no legal basis.

The second part of this post will consider the reasoning and analysis in further detail.

– Rucha A Vaidya

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