Are all contraventions at par through the lens of Income Tax deductibility?

The trade industry of today face a multitude of laws and regulations, and contraventions and fines become inevitable, even if unintended. Indiscriminate disallowance will drive such expenses underground. Going by different judicial decisions rendered in different circumstances and at different point of time (before and after the amendment to the section), one may feel deluded as to which act is seen as an offence or violation of law, and which is seen as a cure of mere irregularity in compliance. What happens to an act tainted with illegality or subversive of public policy, and what to a mere disobedience of procedural requirement? Whether the payment is a penalty under a law, or an option given by a statute to pay and get away? Tax laws in this regard are divided, resulting in ultra-technical interpretations that sometimes favour an illegal business expenditure in preference to legal ones with innocent lapses. While stuck at loggerheads, one needs to apply the fundamental touchstone that the nomenclature of an impost under the respective statute does not matter, and the Scheme of the concerned statute may need intensive examination to determine the real nature of such levy.

Section 37 of the Income-tax Act, 1961 deals with prerequisites around the allowability of expenses, being not capital or personal in nature and incurred wholly and exclusively for the purposes of the business or profession.

Sometimes, the assessee incurs a statutory impost in consequence of an unlawful or prohibited action undertaken in the course of doing business. In such a situation, the business test is whether such expenses are to be seen as commercial losses incurred by the assessee in carrying on business.

In this regard, it may be pertinent to draw attention to the ratio laid down in a judgement of the Apex Court in Haji Aziz & Abdul Shakoor Bros.1 dealing with a penalty on account of confiscation of imported dates in violation of the import law, as follows:

“If a sum is paid by an assessee conducting his business, because in conducting it he has acted in a manner which has rendered him liable to penalty, it cannot be claimed as a deductible expense. It must be a commercial loss and in its nature, must be contemplable as such. Such penalties which are incurred by an assessee in proceedings launched against him for an infraction of the law cannot be called commercial losses incurred by an assessee in carrying on his business. Infraction of the law is not a normal incident of business and, therefore, only such disbursements can be deducted as are really incidental to the business itself. They cannot be deducted if they fall on the assessee in some character other than that of a trader. Therefore, where a penalty is incurred for the contravention of any specific statutory provisions, it cannot be said to be a commercial loss failing on the assessee as a trader…… 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.”

Emphasis supplied

Such a strict decision is strongly contrasted by a liberal view of the Apex Court in CIT v/s. Piara Singh2 dealing with loss or expenditure in gold-smuggling or illegal business. It was held therein that if the activity of smuggling can be regarded as a taxable business, those who are carrying on that business must be deemed to be aware that a necessary incident involved in the business is detection by the Customs authorities and the consequent confiscation of the currency notes. It is an incident as predictable while carrying on the activity as any other feature of it, and to such extent, admissible.

Legislative Amendment

Explanation 1 (originally inserted as Explanation) to Section 37(1) of the Act was inserted by the Finance (No. 2) Act, 1998, with retrospective effect since the inception of the Act, i.e., 1st April 1962. It provides 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.

Since the law disallowed expenses related to violation of law even prior to insertion of the explanation, the Explanation was intended to target payments which by themselves constitute an offence like ‘protection money, extortion, hafta, bribes, etc.’ as elucidated by the Memorandum to the Finance Bill, 1998.

Explanation 3 to sub-section (1) of section 37 of the Act was amended vide Finance (no. 2) Act, 2024 to clarify that the term “expenditure incurred by an assessee for any purpose which is an offence or which is prohibited by law” will also include any expenditure incurred by an assessee to settle proceedings initiated in relation to a contravention under any law for the time being in force, as may be notified by the Central Government in the Official Gazette in this behalf. In this context, contraventions under the following laws has been notified vide recent CBDT Notification3a dated 23rd April 2025–

  • (i) the Securities and Exchange Board of India Act, 1992 (15 of 1992)
  • (ii) the Securities Contracts (Regulation) Act, 1956 [42 of 1956]
  • (iii) the Depositories Act, 1996 [22 of 1996]
  • (iv) the Competition Act, 2002 [12 of 2003].

So, what is an offence to attract Explanation 1?

While Explanation 3 clarifies to some extent, the law does not provide a water-tight definition or scope for covered offences. Section 2(38) of the General Clauses Act, 1897 defines ‘offence’ as “any act or omission made punishable by any law for the time being in force”. Under the Indian Penal Code, section 40 defines it as “a thing punishable by this Code”, read with section 43, which defines ‘illegal’ as being applicable to “everything which is an offence or which is prohibited by law, or which furnishes ground for a civil action”. It is therefore clear that Explanation 1 contains within its ambit all such activities which are illegal/ prohibited by law and/ or punishable.

– Apex Laboratories (P.) Ltd. v. DCIT (SC)3

Does the gravity of the offence not matter at all?

There is a lot of jurisprudence holding some payments in lieu of contraventions as disallowable, while some as not; hence, it is adequately clear that not all violations are caught within the mischief of Explanation 1 to section 37(1) of the Act, and thus, not all would be disallowed. Moral turpitude or deliberate defiance of law should be inferred in law when the word used in the Explanation is “offence” signifying criminality or mens rea as understood in law. That should be distinguished from minor unintended infractions faced by assesses amidst the mass of regulations in modern business situations.

Legal Position – Pre-introduction of Explanation

Prior to the introduction of Explanation 1 to Section 37(1) of the Act, the Courts have laid down certain principles to test an expense, regardless of the name by which they are debited to the Statement of Profit and Loss of the assessee. Some of them are as follows:

  • Mere nomenclature of the relevant levy as given by the statute is not determinative of its nature;
  • Examination of the scheme of the provisions of the relevant statute is critical to determine the nature of such levy;
  • Essential to distinguish the nature of the levy as ‘compensatory’ or ‘penal’ in nature;
  • Essential to bifurcate a composite levy.
  • Deduction of the amount of levy, which is compensatory in nature.

Reference to some such significant jurisprudence is as follows:

Particulars of contraventionCase lawJudicial ratio
Delayed payment of Sales Tax and contribution under the ESI ActPrakash Cotton Mills (P.) Ltd v. CIT4Examine the scheme of the statute to determine the nature of the impost and bifurcate between compensatory or penal.
Penalty under section 17(3) of the Madhya Pradesh General Sales Tax Act for failure to furnish a return, and under section 8 of such Act if raw materials bought at a concessional rate were used for other than the designated purposeMalwa Vanaspati Chemical Co. v. CIT5Penalty, which partook of the character of compensation alone, could be allowed as a deduction; however, penalty paid under section 17(3) of the MP Sales Tax Act for failure to furnish a return, being not compensatory in nature and not allowable expenditure.
Composition fee for the construction of a multistoried building for sale, more than the floor area permitted by the concerned Municipal CommitteeLoke Nath & Co. v. CIT6The statutory provision in section 195 of the Punjab Municipal Act, 1911, envisages the disobedience of a statutory restriction, an offer by the assessee, and the acceptance by the Committee of a sum by way of compensation. The mandate of the Legislature is that, on the acceptance of the compensation, there is condonation of the disobedience of a procedural requirement. This compensation was not a penalty payment to save the assessee from criminal liability or to compound any offence.
Payment to Andhra Pradesh Welfare Fund for obtaining a license for exporting boiled rice to Kerala under a scheme evolved between Rice Millers Association and the District CollectorSri Venkata Satyanarayan Rice Mill Contactors Co vs CIT7Reversing the High Court’s judgement of this payment being “subversive of public interest,” the Apex Court held that contributions made to a public welfare fund solely for promotion of the assessee’s business, whether at the instance of the authorities or otherwise, cannot be treated at par with illegal gratification.
Compensation paid to the Government for the shortfall of export obligationCIT v. Ahmedabad Cotton Mfg. Co. Ltd.8Amount paid is not a penalty or akin to a penalty if the amount paid by the assessee was in exercise of the option conferred upon him under the very law or scheme concerned.
Payment to Andhra Pradesh Welfare Fund for obtaining a license for exporting boiled rice to Kerala under a scheme evolved between Rice Millers Association and the District CollectorSri Venkata Satyanarayan Rice Mill Contactors Co vs CIT9Reversing High Court’s judgement of this payment being “subversive of public interest,” the Apex Court held that contributions made to a public welfare fund solely for promotion of the assessee’s business, whether at the instance of the authorities or otherwise cannot be treated at par with illegal gratification.
Pre-Explanation jurisprudence

Legal Position – Post-introduction of Retrospective Explanation by Finance Act, 1998

Judicial Precedents hold that old is gold:

While the above judgements were rendered prior to the insertion of Explanation 1 to section 37(1) of the Act by Finance Act, 1998 w.e.f. 1 April 1962, it may be noted that even post insertion of the said Explanation, the Courts / Tribunal have continued on some occasions to test the expense based on the above-referred judicially enshrined parameters. The said judgements are discussed as under:

Particulars of contraventionCase lawJudicial ratio
The manufacturer of ENA (Extra Neutral Alcohol) and Rectified Spirit had to make a contractual bond to compensate the State Excise Authority on account of failure to comply with a condition laid by the excise department.PCIT, Jaipur-II v. Agribiotech Industries Ltd10
Relied on: CIT v. Hyderabad Allwyn Metal Works Limited11, Prakash Cotton Mills4		The duty paid is the same as per the rates notified by the government, therefore, the said payment in discharging the contractual obligation to indemnify the excise department for the payment of the excise duty to the government exchequer, cannot be held in penal nature.
A drug manufacturer paid the Department of Chemical and Petrochemicals (DCP) an amount overcharged on the sale of certain controlled drugs and interest for violation of norms notified by the Government of India vide (Drugs (Prices Control) Order) (DPCO).Dr. Reddy’s Laboratories Ltd v. ACIT12Excess collection was contractual and not penal in nature. Interest took colour from the principal recovery, hence allowable.
Penalty charges which were charged by the National Stock Exchange to the assessee on account of auction short delivery charges, delivery margin pay-in-shortage, bad delivery charges, interest on aforesaid charges, and violation fines (margin).Classic Shares & Stock Broking Services Ltd. v. DCIT13Payments are compensatory in nature, charged for certain default and to compensate the NSE for the loss involved in the process as the transaction involved financial dealing. The payment being for the purpose of the violation of contractual obligation is part and parcel of transactions which are arising out of ordinary course of business.
Penal interests and penalty for contravention of statutory obligations under several laws (Provident Fund Act, Sales Tax Act, ESI Act, etc.)

Penalty levied under section 45A of the KGST Act, 1963		ACIT v. Khoday India Ltd.14
PTL Enterprises v. DCIT15		It is the duty of the assessee to show that the amounts claimed are compensatory in nature in case these are to be allowed.
Redemption fine paid by the assessee as differential duties to the Customs authorities on re-exporting imported softwareUsha Micro Process Controls Ltd. v. CIT16On a proper application of the ruling in Prakash Cotton Mills Pvt. Ltd.’s case (supra), the amount of redemption fine in the present case was compensatory and therefore, fell outside the mischief of explanation of Section 37(1).
Interest paid by an exporter to DGFT for default in fulfillment under the EPCG SchemeEnchante Jewellery v. CIT17Revenue authorities failed to establish that the assessee’s conduct was an offence or that it did anything that was prohibited by law any provision of law that was violated by the assessee, hence allowable.
Payment to a consultant for providing expertise in the application and follow-up of a tender floated by a PSUStandipack Pvt Ltd v CIT18This was considered to be illegal and disallowed. This decision may be considered for review, considering the Supreme Court has decided in quite a few cases, including those referred above, that too rigid a view on the part of the Revenue may not be justified.
Post-Explanation — compensatory penalty upheld as allowable

Judicial Precedents holding old may not always be gold:

In contrast to the above decisions where the appellate forums have upheld the principle of compensatory penalty being allowable, it has been held in certain judgements that the principle of compensatory penalty being allowable does not hold good anymore after insertion of the Explanation. The said judgements are discussed as under –

Particulars of contraventionCase lawJudicial ratio
Compounding fine paid by the assessee to regularize the construction of the building made in violation of the Building RegulationsCIT v. Mamta Enterprises19
Nahar Spinning Mills Ltd20
Distinguished judgement in Loke Nath & Co6
Relied on Haji Aziz & Abdul Shakoor Bros.1		When the section is clear and unambiguous, it is not permissible for the Courts to stretch the meaning attached to the provision of law to extend the benefit to a person who violates the law, or the Regulations/ Rules made by the Corporation or the Municipal Authorities with impunity. Under these circumstances, the expenditure incurred to pay the penalty cannot be treated as loss in business to get the benefit. The same is now even confirmed with insertion of Explanation 3 to section 37(1).
Payment of freebies by a pharmaceutical company to medical practitionersApex Laboratories (P.) Ltd. v. DCIT3Though the memorandum to the Finance Bill, 1998 elucidated the ambit of Explanation 1 to section 37(1) to include ‘protection money, extortion, hafta, bribes, etc.’, yet, ipso facto, by no means is the embargo envisaged restricted to those examples. It is but logical that when acceptance of freebies is punishable by the MCI (the range of penalties and sanctions extending to a ban imposed on the medical practitioner), pharmaceutical companies cannot be granted the tax benefit for providing such freebies, and thereby (actively and with full knowledge) enabling the commission of the act which attracts such opprobrium. The same is now even confirmed with insertion of Explanation 3 to section 37(1).
Post-Explanation — compensatory penalty held not allowable

Conclusion

In view of the divided jurisprudence in the matter, one may contend in support of suitable claims of the assessee that despite retrospective insertion of Explanation 1 of section 37, the age-old tests of compensatory v/s. penal and that not all violations are offences for the purpose of this section, hold good. Since the Act is not concerned with legality of transactions as far as taxing profits from an illegal business is concerned; infractions of law mainly of administrative regulations, should at least not be construed in all cases as defeating the right of the assessee to claim a deduction for costs incurred as a result of the infraction. One needs to still do a factual threadbare analysis as to whether the assessee exercises the option conferred under a statute to make good a contravention by paying a sum (even if upheld as a statutory default) or for a purpose which is an offence under the law or which is prohibited by law. Courts have time to time, cast the onus to demonstrate this on the assessee, and professionals can play a pivotal role in helping the latter to collate and enumerate relevant facts for such purpose through the lens of available judicial wisdom.

Author may be reached at dagashreya1992@gmail.com and eboard@icai.in

References

  1. (1961) 41 ITR 350 (SC)
  2. (1980) 124 ITR 40 (SC)
  3. [2022] 135 taxmann.com 286
  4. F. No. 38/2025/F. No 370142/11/2025-TPL (Notification 3a)
  5. [1993] 67 Taxman 546 (SC)
  6. [1997] 225 ITR 383 (SC)
  7. [1984] 147 ITR 624 (Del HC)
  8. [1997] 223 ITR 101 (SC)
  9. [1994] 205 ITR 163 (SC)
  10. [1997] 223 ITR 101 (SC)
  11. [2018] 2 taxmann.com 371 (Raj HC)
  12. (1988) 172 ITR 113 (AP)
  13. [2014] 51 taxmann.com 136 (Hyd ITAT)
  14. [2007] 11 SOT 377 (Mum ITAT)
  15. [2009] 32 SOT 373 (Bang ITAT)
  16. [2021] 133 taxmann.com 452 (Ker HC)
  17. [2013] 37 taxmann.com 324 (Del HC)
  18. [2013] 40 taxmann.com 216 (Del HC)
  19. (2013) 350 ITR 251 (Cal)
  20. [2004] 266 ITR 356 (Kar HC-Full Bench)
  21. [2014] 49 taxmann.com 565 (P&H HC)

Note: Footnote markers 1–3, 4–9, 10–16 and 17–20 follow the original article’s per-page numbering; the reference list above collates them in their order of first appearance.

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