Section 37(1): Allowance of Expenditure of Penalty/Penal Charges

Section 37(1): Allowance of Expenditure made by any entity and booked under the Head “Penalty/Penal Charges”

Brief Analysis of the Section

Section 37(1) :  Conditions laid down under this section for allowance of expenditure –

a)   It should not be in the nature of expenditure described in section 30 to 36.

b)   It should not be in the nature of capital or personal expenditure.

c)    It must be expended wholly and exclusively for the purpose of the business.

Explanation to Section 37(1) :

Expenditure incurred for any purpose which is an offence or prohibited by law shall not be allowed.

Brief Facts related to the discussion :

There are instances where the assessee incurs and pays certain amount for not fulfilling certain terms of any agreement. In these cases, some of the assessees book the expenditure under ‘Penalty’ or ‘Penal Charges’ in the Profit and Loss Account. Now, they claim it to be an allowable deduction under section 37(1) of the Act. However, if the case is selected for regular assessment u/s 143(3) and the A.O. notices this particular heading in the P/L account then it is more likely than not that the same would be disallowed on the ground that is in the nature of penalty [i.e., Explanation to Sec 37(1)].

 Points to be Considered in this particular case :

The fact that the expenditure has been booked under Penalty, the same gives a perception that it is in the nature mentioned in Explanation to Section 37 (1) and therefore should be disallowed. However, the fact is that if any expenditure is made as a consequence of an agreement, then the same is not in the nature of violation of law and does not partake the character as highlighted in the Explanation and hence is an allowable expenditure.

The Proposition as discussed above is laid down by various Courts in judicial pronouncements.

Judicial Pronouncements in support of the Assessee  

The most recent decision on this issue is that of the Hon’ble Bombay High Court in the case of CIT –vs.- M/s. Regalia Apparels Pvt. Ltd. (ITXAL No. 88 of 2013) (Bom.)

Summary of the Case : The assessee company was granted an export entitlement by Apparel Export Promotion Council (APEC) for export of garments and knit wares. The assessee furnished bank guarantee in support of its commitment to abide by the terms and conditions in respect of export entitlements. One of the terms decided upon in this agreement was that the bank guarantee would be forfeited if the export obligation was not fulfilled. The assessee company in view of incurring heavy losses, decided not to utilize the entitlement. Consequentially, APEC encashed the bank guarantee (as forfeiture) and the same was booked under ‘Penalty’ by the assessee in its books of accounts. The Assessing Officer (A.O.) disallowed the same concluding that the forfeiture was in the nature of penalty.

The CIT (Appeals) deleted the addition made by the A.O. On further appeal by the Revenue, the Tribunal confirmed the order of the A.O.

Decision of the Hon’ble Bombay High Court

The Hon’ble Bombay High Court held that the assessee took a business decision not to honour its commitment of fulfilling the export entitlement in view of loss being suffered by it. The genuineness of the claim of expenditure being for business purpose is not disputed by the A.O. The Court confirmed the finding of the Tribunal that the assessee has not contravened any provision of law and the forfeiture of the bank guarantee is compensatory in nature and does not attract the Explanation to s. 37(1) and thus, dismissed the appeal of the Revenue.

Note: The decision lays down the fact that payments which are compensatory in nature should not be disallowed in Income Tax solely on the basis of nomenclature. If the substance of the payment makes it evident that it is not incurred towards violation of any law, rather it is an expenditure incurred in the course of business then it should be allowed while computing Taxable Income.

Other judicial pronouncements on the same line –

a)   Prakash Cotton Mills Private Limited –vs.- CIT (1993) 201 ITR 684 (SC)

b)   ACIT –vs.- Taurian Iron and Steel Co. Pvt. Ltd. (ITA No. 1613/Mum/2010)

c)    ITO –vs.- VRM Share Broking (P) Ltd. (2009) 27 SOT 469 (Mum)

Thus, Explanation to section 37(1) is to be invoked only in those circumstances when there is really a breach of any law like penalty imposed under State VAT Act for non filing of return, etc.

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