INCOME TAX QUESTIONS & ANSWERS SERIES PART -XV.
Sub: Whether Penalty/Penal Interest is allowed as deductible expenditure under provisions Section37(1) of the Income Tax Act, 1961.
In this article we are going to discuss a problem ,whether Penalty/Penal Interest levied on any organisation is allowed as deduction to the assessee.
PROBLEM: M/s. ABC Limited has been penalised under provisions of GST Act,2017 to the tune of Rs. 50,000/- as Penalty for late filing of returns and Penal Interest on tax submitted late. The company has claimed above amount in its books as GST Paid, the AO has disallowed above expenditure and added the same in the income of company. Whether act of AO is tenable under provisions of Income Tax Act,1961 or not.
LET’S CONSIDER PROVISIONS OF SECTION 37(1) OF THE INCOME TAX ACT,1961;
|SECTION 37 AS IT CURRENTLY STANDS READS AS UNDER: Section 37-Any expenditure (not being expenditure of the nature described in sections 30 to 36 and not being in the nature of capital expenditure or personal expenses of the assesse), laid out or expended wholly and exclusively for the purposes of the business or profession shall be allowed in computing the income chargeable under the head “Profits and gains of business or profession”. EXPLANATION 1– 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. (2) Notwithstanding anything contained in sub-section (1), no allowance shall be made in respect of expenditure incurred by an assessee on advertisement in any souvenir, brochure, tract, pamphlet or the like published by a political party. The objective of Section 37 is to claim business expenditure incurred by the assessee which is not cover under section 30 to 36 as deductions. So, this section serves as a general, catch-all section for claiming deductions. Now, to claim deduction under section 37 following ingredients should be present, • The expenditure should not be a capital expenditure. • The expenditure should not be covered under any heads in section 30 to 36 • The expenditure should be incurred for the purpose business or in the course of business. • The expenditure should not be of personal expenditure. • The expenditure should not be disallowed under sub-section 2 of section 37. • The expenditure should not be any illegal purpose or violative of any law of the land. We are going to discuss “The expenditure should not be any illegal purpose or violative of any law of the land.” Please Note That; – the Explanation 1 inserted in provisions of Section 37(1) to remove lacuna in the Section and to clarify ambiguity in decisions of various Courts and Forums. The provisions of Section 37(1) has been explained differently by various Courts and Tribunals. Tribunal, in case of Pranav Constructions Vs. CIT controversially, held that payments made by a builder for the purpose of providing security to the partners or for getting the tapories vacated was deductible, there being circumstantial evidence supporting such payments. Intention behind insertion of Explanation 1 Prior to Explanation 1 of S.37 there were a catena of decisions dealing with the allowability of expenditure u/s 37, whether illegal or not, treated on a case by case basis. One principle of note which seems to be present right from pre-amendment days is that if the amounts paid were compensatory in nature they were allowable, if they were penal in nature it wasn’t to be allowed as enshrined by the; SC in Mahalakshmi Sugar Mills Co. Ltd. vs CIT (123 ITR 429) and CIT vs Hyderabad Allwyn Metal Works Ltd (172 ITR 113 SC) wherein it was held that when an amount paid by assessee could be regarded as compensatory (reparatory) in character then it would be allowable u/S 37(1) and if it were penal in nature it was not allowable. In another landmark case the SC in Haji Aziz and Abdul Shakoor Bros. v CIT Bombay City II 1 held that: “in our opinion, no expense which is paid by way of penalty for a breach of the law can be said to be an amount wholly and exclusively laid for the purpose of the business. The distinction sought to be drawn between a personal liability and a liability of the kind now before us is not sustainable because anything done which is an infraction of the law and is visited with a penalty cannot on grounds of public policy be said to be a commercial expense for the purpose of a business or a disbursement made for the purposes of earning the profits of such business”. Pravan Constructions Vs. CIT this insertion of Explanation 1 seems to have been brought out by the controversial decision, among others, of Pranav Constructions v CIT2 by the Mumbai Tribunal wherein payment of hafta, extortion charges by builders in Mumbai was upheld. The facts of the case were that a partner of the company has paid money to various persons in form of cash for the purpose of providing security to partners and for getting the “tapories” vacated earlier. Paper reports also supported the assesse’s claim that builders engaged in construction activities are vulnerable to such danger as extortion, haftas, etc. and unless they oblige it would be impossible to conduct the business The Tribunal, controversially, held that payments made by a builder for the purpose of providing security to the partners or for getting the tapories vacated was deductible, there being circumstantial evidence supporting such payments. CBDT INITIATIVE AND NOTIFICATIONS The Department wanting to enshrine in law that illegal expenditure cannot be a deduction under the ambit of Income Tax. Thus Explanation 1 was inserted by the amendment by Finance Act, 1998 and was given retrospective effect from April 1 1962. The legislative intent behind the insertion of this explanation as given in memorandum of Finance Bill 1998 being as follows: “It is proposed to insert an explanation after sub section (i) of section 37 to clarify that no allowance shall be made in respect of expenditure incurred by an assessee for any purpose which is an offence or which is prohibited by law. This proposed amendment will result in disallowance of the claim made by certain tax payers of payment on account of protection money, extortion, hafta, bribes, etc. as business expenditure.” Further, the CBDT clarified this position vide Circular 722 dated 23/12/1998 whose operative part reads as follows: Section 37 of the Income-tax Act is amended to provide 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 purposes of business or profession and no deduction or allowance shall be made in respect of such expenditure. This amendment will result in disallowance of the claims made by certain assessees in respect of payments on account of protection money, extortion, hafta, bribes etc. as business expenditure. It is well decided that unlawful expenditure is not an allowable deduction in computation of income. This amendment will take effect retrospectively from 1st April, 1962 and will, accordingly, apply in relation to the assessment year 1962-63 and subsequent years.|
ANSWER: General Rule Provides that- if an assessee is penalised under one Act, he cannot claim that the amount is deductible against his income under another Act, because that will be frustrating the entire object of imposition of penalty . If the assessee resorts to unlawfull means to augment his profits or deuce his loss, then the expenditure incurred for these unlawful activities cannot be allowed to be deducted whether the business is lawful or otherwise. Even if whole business of an assessee is illegal or unlawful then also his income will be taxable under the Act, 1961 but expenditure in the illegal or unlawful business is not allowed to be deducted.
The Explanation 1 has been inserted by the Finance Act(No.2),1988. Even if assessee has to pay fine or penalty because of inadvertent infraction of law ,which does not involved any moral obliquity, the result will be the same. Even in such cases ,deduction will not be permitted of the amount paid as penalty or fine or of the value the goods confiscated by the statutory authority as expenditure incurred wholly and exclusively for the purpose of carrying on the trade. It was held that fines or penalty paid for violation of any law cannot be allowed as deduction under provisions of the Income Tax Act,1961.
We have to keep following points in mind ;
- Penalty which is compensatory in nature and paid for breach of a contract or statute ( not being one which is treated as an offence or prohibited by any law)is deductible;
- Penalty or interest or fine under direct taxes is not deductible. For example interest is levied on the assessee for delay in filing return will not be allowable as a business expenditure;
- One of the important tests to determine whether levy is compensatory or penal in nature is whether for non-compliance of the provisions any criminal liability or prosecution is provided. If any criminal liability or prosecution is provided then the levy is certainly in penal nature.[CIT Vs. catholic Syrian Bank Ltd.(2003)130 Taxmann.com 447(Kerala)].
WHAT IS MEANING OF “COMPENSATORY”
- Compensatory damages represent the money awarded to a plaintiff in a lawsuit.
- This type of compensation is awarded in civil court cases.
- There are two types of compensatory damages—general and actual.
- Actual damages are intended to provide funds to only replace what was lost.
- General compensatory damages awarded are more complex, as these compensatory damages do not represent a monetary expenditure.
In the case of M/s. ABC Limited the pantry imposed for non filing of returns is penal in nature and hence not deductible but late payment of taxes is compensatory in nature and hence allowed as a deductible expenditure under provisions of Section 37(1) of the Income tax Act,1961.
LET’S DISCUSS SOME MORE DECISIONS;
- Suppose a penalty under the GST Act,2017 has been levied on an assessee for purchasing goods for specified purpose on concessional tax rate than @1% ( normal rate @4%) and not utilise the same for the purpose for which it was bought. This penalty or fine has been levied for breach of contract to utilise goods for specified purpose and same will be allowed as deduction.
- A penalty for breach of contract is deductible and a penalty for breach of legal provisions of any Act, is no deductible.
- The interest paid on arrears of GST and outstanding balance of GST is compensatory and hence allowed as deduction.
- The penalty paid for non-payment of GST within the prescribed time ,is not deductible as expenditure.
- Where an assessee has paid penalty to Electricity Board for late supply of required materials as mentioned in the contract , is allowed as deductible expenditure . The penalty is paid for breach of terms of a contract and not violation of any provisions of Act and is on compensatory nature.
- The damages paid for failure to comply with terms o agreement ,due to change in government policies is allowable as deductible expenditure.
- Penalty paid by the assessee contractor for non-completion of contract within a stipulated time is allowable as deduction.
- The liquidation damages paid in consequence of contractual liability would be allowable as business expenditure.
- An amount paid under Section 14B of the EPF as damages for default in making payment of PF contributions ie penal in character and hence not allowed as an expenditure.
- Where there is allotment of quota for import of foreign cotton by federation and the assessee did not import the allotted quantity, the payment of guarantee amount for bales not imported is not in nature of penalty and hence allowed as an expenditure.
- The amount paid due to shortfall in export performance is allowable as decduction
CONCLUSION: the penalty or fine levied on the assessee is allowed as expenditure under provisions of Section 37(1) only on the basis of their nature, whether such fine or penalty is of compensatory nature or penal nature. If fine or penalty is of compensatory nature then it will be allowed as expenditure or in case it is penal , not allowed as deductible expenditure. A fine or penalty consisting of monetary as well as prosecution will be always considered as penal action and not allowed as deduction.
Therefore ,the expenditure which can be deducted in connection with the business carried by the assessee is the expenditure which can properly be regarded as such. The penalties paid for violating the law in the course of the conduct of business cannot be regarded as deductible expenditure , as the assessee is expected to carry on business in accordance with the laws of land and not in violation of law. The penalty incurred by the assessee for the violation of applicable statute ,unless the true nature of penalty is compensatory, is not to be regarded as deductible item of expenditure.
DISCLAIMER; above write up is an attempt to share information and knowledge with our readers. The view expressed here are the personal views of the author and same should not be considered as a professional advice. It is advisable to consult with your tax consultant before acting on any part of this article.