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

[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.

Part I is available here]

Having considered the facts and the judgments of Shah and Sundresh JJ in PCIT v. Prakash Chand Lunia in the earlier part, this post will analyse the underlying issue concerning sections 28 and 37 of the Act.

The fundamental difference between section 28 and section 37 is that section 28 provides a mechanism to first arrive at the profits from the business/profession. Therefore, it becomes crucial to account for goods lost that do not form part of the business’s stock in trade and hence naturally are not a part of the stock in trade used in order to earn the profit. Therefore, these losses should be rightfully claimed under section 28. In other words, losses of a business are inherently within the scope of section 28: those losses simply fall on the business and therefore reduce the business profits.

On the other hand, section 37 allows the expenditures which are expended wholly and exclusively for the purposes of the business that are incurred for earning the profits to be reduced therefrom. It is in this context that the question of whether an expenditure is incidental or has a nexus with the profits of the business becomes relevant.

Losses of stock/funds that form part of trade may or may not be connected as such with the running of the business. For example, theft is not in any manner connected with the natural course of conducting a business. However, not allowing the loss caused due to theft would be unreasonable since the goods lost due to theft ought to be reduced while calculating the profits that are earned from the goods sold in the business. In other words, when determining whether goods/funds lost can be allowed as a business loss, it must be seen whether such loss ‘belongs to the business’. It was in this context that in Badridas Daga v. CIT, the Supreme Court, dealing with whether bad debts caused due to misappropriation of an assessee’s funds engaged in a banking business fell under a business expense under section 10(2)(xv) or under a business loss under section 10(1)  of the Income Tax Act, 1922 (corresponding to sections 37 and  28 of the Act respectively), held that such bad debts are deemed to be incidental to the business since they occurred due to an act of the assessee’s employees and was as such connected to the assessee’s business.

The words ‘incidental’ were used to tie a thread between the loss caused to the assessee in his business with the running of the business itself. Thus, the words ‘incidental’ / ‘connected to the business’ must be interpreted in a manner meaning ‘of / belonging to the business’. As a general principle, any loss that arises out of factors not strictly connected with the business cannot be denied to be reduced from the profits by applying a literal interpretation of the words ‘incidental to the business’ since such losses, by their very nature, do not arise in the normal course of the business. What is important is to see is whether the loss is a loss ‘of the business’. It is important to bear in mind that a loss is distinct from an expense – a loss simply falls where it does, and there is no ‘purpose’ for a loss. If a loss falls on the business, then the effect of that loss is to strip away the receipts of that business and thus automatically reduce the profits of that business. On the other hand, an ‘expenditure’ is incurred for certain purposes; hence, in dealing with expenditure, it becomes important to look at the purpose of that expenditure to see whether the expenditure was ‘wholly and exclusively for business purposes’.

In Haji Aziz & Abdul Shakoor Bros v. CIT, the Supreme Court was dealing with the issue of whether the penalty paid for confiscation of dates would be deductible under section 10(2)(xv) of the Income Tax Act, 1922 (corresponding to section 37 of the Act). A penalty of such nature, by its very nature, is an expenditure that is incurred on account of an infraction of the law; in that sense, the penalty is not wholly and exclusively for the purposes of business. It was therefore held to not be allowed u/s 10(2)(xv) of the 1922 Act. On the other hand, PCIT v. Prakash Chand Lunia was concerned with the loss of confiscated silver bars and not with any penalty paid in order to redeem the confiscated goods. Confiscation of the goods itself cannot be equated with a penalty/fine paid for redeeming such goods. A confiscation is simply an event that causes a loss that falls on the assessee. The question of whether a loss is “wholly or exclusively” for the purposes of business does not arise. The only question is whether the loss is ‘of’ the business, in the sense that it is the loss that is suffered by the business. Therefore, the question remains whether the principles of section 37 can be extended to section 28 as the two sections operate on different functions. The conceptual distinction between a loss and an expense cannot be wished away. Therefore, the judgment of Haji Aziz seems to be of little relevance when dealing with a ‘loss’ case.

Similarly, the judgment of the Bombay High Court in J.S Parkar v. V.B Palekar does not help much since the assessee was engaged in the business of transporting iced fishes, mangoes, and other goods by sea while the Central Excise authorities confiscated gold. Therefore, the confiscated goods, anyways, did not form part of the assessee’s business and were hence disallowed as a business loss. This can be explained on the basis that the loss did not fall on the business at all, as the gold was not a part of the stock of the business. Therefore, the decision in J S Parkar, when seen in the proper perspective of the facts in that case, is also factually distinct and does not throw any light on the controversy which really arose in Lunia.

All in all, the decisions of the Andhra Pradesh High Court in Soni Hinduji Kushalji & Co. v. CIT and that of the Supreme Court in Dr. T A Quereshi v. CIT are the ones more directly relevant to answer the controversy which arose in Lunia.

The reasoning given by the Andhra Pradesh High Court in Soni Hinduji undoubtedly merits detailed consideration. The Court stated:

what are chargeable to tax in respect of a business carried on by the assessee are the profits or gains of a particular assessment year. While assessing the profits, necessarily loss incurred in the business during the year should be taken into account, as otherwise it is not possible to arrive at the true profits earned by the assessee. It is well-settled that the taint of illegality associated with profits or income is immaterial for the purpose of taxation. Income-tax Acts are not necessarily restricted in their application to lawful business only. One who contravenes a statute and trades in business prohibited by law while being liable for prosecution for the offence committed by him will, at the same time, be liable to pay tax out of the income or profits earned from the illegal trade or business.”.

However, it also states that the loss incurred by an assessee due to the confiscation of goods is not as a trader/ in the role of a trader, and therefore such loss could not be held to be a business/ commercial loss.

At first glance, this seems to be a logical view to take. However, this raises the question of why one is to think of this loss as not being suffered by the business. The ratio laid down by the Supreme Court in Dr. T A Quereshi provides an answer to this question. The Andhra Pradesh decision was prior in point of time to TA Qureshi, so the Andhra Pradesh High Court did not have the benefit of the exposition of law by the Supreme Court on this point. In TA Qureshi, the Supreme Court does not merely follow its decision in Piara Singh but gives its own reasoning by observing-

“15. In our opinion, the High Court has adopted an emotional and moral approach rather than a legal approach. We fully agree with the High Court that the assessee was committing a highly immoral act in illegally manufacturing and selling heroin. However, cases are to be decided by Court on legal principles and not on one’s own moral views. Law is different from morality, as the positivist jurists Bentham and Austin pointed out.

16. As already observed above, the facts of the case are squarely covered by the decision of this Court in Piara Singh’s case (supra).

17. The Explanation to section 37 has really nothing to do with the present case as it is not a case of a business expenditure, but of business loss. Business losses are allowable on ordinary commercial principles in computing profits. Once it is found that the heroin seized formed part of the stock-in-trade of the assessee, it follows that the seizure and confiscation of such stock-in-trade has to be allowed as a business loss. Loss of stock-in-trade has to be considered as a trading loss vide CIT v. S.N.A.S.A. Annamalai Chettiar AIR 1973 SC 1032.”


Thus, following the above observation by the Supreme Court, it can be said the purpose of the Income Tax Act 1961 is to enable an assessment and collection of tax. The allowance/disallowance of losses cannot be motivated by whether the same arises from an infraction of law or not. The Income Tax Act 1961 is not a penal statute. Action for violation of the law can be very well taken under penal statutes. Therefore, as long as a tax on the confiscated goods is collected, there should be no bar to allowing the confiscated goods as a business loss. There is no valid conceptual basis as to why the Explanation to section 37 (in the context of expenditures) ought to be applied to section 28 (in the different context of losses). In any event, the decision in Qureshi was binding on the coordinate Bench in Lunia; and the decision in Haji Aziz was on the issue of expenditures and not on losses.

Considering all the cases referred to in Lunia, some of which are factually different and some of which discussed eligibility of expenditures u/s 37, it would seem that there are strong grounds for the decision in Lunia to be reconsidered (both as a matter of principle and on account of how it dealt with the precedent on the point, particularly TA Qureshi) and for the issue involved being referred to a larger bench of the Supreme Court.


– Rucha A Vaidya

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