Ahmedabad ITAT Allows ₹602 Crore Pfizer Settlement as Business Expenditure, Holds Foreign Patent Settlement Not Hit by Explanation 1 to Section 37(1)

Sun Pharmaceutical Industries Limited Vs DCIT (ITAT Ahmedabad)

The Ahmedabad ITAT partly allowed the appeal of Sun Pharmaceutical Industries Ltd. and dismissed the Revenue’s appeal, holding that the ₹602.40 crore paid towards an out-of-court settlement with Pfizer Inc. in a US patent dispute was an allowable business expenditure under section 37(1). The Tribunal held that the settlement was entered into out of commercial expediency to protect the assessee’s business interests, reputation and market presence, and did not amount to expenditure incurred for an offence or a purpose prohibited by law. It further observed that Explanation 1 to section 37(1) could not be invoked in the absence of any finding of guilt and that alleged infringement of foreign patent laws did not automatically attract the disallowance contemplated under Indian tax law.

The Tribunal also allowed the consequential deduction of interest of ₹15.81 crore incurred on borrowings used to finance the settlement, while holding the corresponding MAT issues under section 115JB to be infructuous. On the issue of section 14A, it restricted the disallowance to the amount of actual exempt dividend earned and reiterated that such disallowance could not be added while computing book profits under section 115JB. However, it declined to interfere with the treatment of software expenditure as capital in nature since depreciation had already been allowed thereon.

The Tribunal followed its own earlier decisions in the assessee’s case on several recurring issues, including transfer pricing adjustments, R&D expenditure, wealth tax provision under section 115JB, Cephalon patent settlement, and gift expenses. Consequently, the assessee’s appeal was partly allowed, while the Revenue’s appeal was dismissed.

Cases Discussed

• Ranbaxy Laboratories Limited (merged with Sun Pharmaceutical Industries Limited), ITAT, ITA No. 360/Ahd/2017 vide order dated 03.09.2021
• Mylan Laboratories Ltd. Vs. DCIT, 113 taxmann.com 6
• DCIT v. Anil Dhirajlal Ambani, 93 taxmann.com 492
• CIT v. Desiccant Rotors International (P.) Ltd., 347 ITR 32 (Delhi HC)
• S.A. Builders Ltd. v. CIT (SC), 288 ITR 1
• CIT v. Delhi Safe Deposit Co. Ltd., 133 ITR 756
• Sri Venkata Satyanarayana Rice Mill Contractors Co. v. CIT (SC), 223 ITR 101
• DCIT v. VLS Finance Ltd.
• CIT v. Parthasarathy (Madras HC), [1995] 78 Taxman 470
• Abdul Hameed v. Mohd. Ishaq, AIR 1975 All. 166
• Prakash Cotton Mills P. Ltd. v. CIT (SC), (1993) 201 ITR 684
• Standard Batteries Ltd. v. CIT (SC), (1995) 211 ITR 444
• Swadeshi Cotton Mills Co. Ltd. v. CIT (SC), (1998) 233 ITR 199
• CIT v. Bharat Television Pvt. Ltd. (AP HC), (1996) 218 ITR 173
• CIT v. Hyderabad Allwyn Metal Works Ltd. (AP HC), (1988) 172 ITR 113
• Kedarnath Jute Mfg. Co. Ltd. v. CIT (SC), [1971] 82 ITR 363

FULL TEXT OF THE ORDER OF ITAT AHMEDABAD

These cross appeals, one by the assessee and the other by the Revenue, arise out of the order dated 25.03.2019 passed by the Ld. Commissioner of Income-tax (Appeals)-2, Vadodara [“Ld. CIT(A)”] under section 250 of the Income-tax Act, 1961 [“the Act”] for Assessment Year 2014-15.

2. Since both the appeals emanate from the same appellate order, involve common facts and interconnected issues, they were heard together and are being disposed of by this consolidated order for the sake of convenience and brevity.

3. The assessee has raised following grounds of appeal:-

“1. On the facts and in the circumstances of the case and in law, the order passed by the Learned Commissioner of Income-tax (Appeals) [the ‘Ld. CIT(A)’] erroneously affirming the findings of the learned Assessing Officer [the ‘Ld. AO’] is unsustainable and ought to be quashed.

1. Ground No. 1: Transfer pricing adjustment on transfer of electricity by Captive Power Plant (“CPP”) – Rs. 13,43,19,516/-:

1.1 The CIT(A) has grossly erred in upholding the order of the AO/TPO who erred in am rejecting the transfer pricing benchmarking carried out the Appellant and determined the Arm’s Length Price by taking average of two rates i.e. rate fixed by GERC and the market clearing price (as per IEX).

1.2. Without prejudice to the above, the Ld. AO/TPO grossly erred in adopting the rate at which distribution entity purchases power from CPP unit without appreciating that. the power was generated by the Appellant for captive consumption and not for sale to any distribution entity.

1.3. Without prejudice to the above, the Ld. AO/TPO grossly erred in ignoring the fact that there is only one prime seller in Appellant’s region i.e. GEB, therefore, the open market rate for such power at which all these buyers are paying to GEB/Distribution Companies should be considered as a comparable uncontrolled price.

2. Ground No. 2: Disallowance under section 14A read with Rule 8D – Rs. 9,20,833/-

2.1. On the facts and in the circumstances of the case and in law, the Ld. CIT(A) grossly erred in sustaining the disallowance of Rs. 9,20,833/- made by the Ld. AO under section 14A read with rule 8D without appreciating that invocation of rule 8D is not automatic and recording of satisfaction and establishing a direct nexus between the expenditure incurred and the exempt income is a sina qua non.

2.2. On the facts and in the circumstances of the case and in law, the Ld. CIT(A) ought to have appreciated that once it is undisputed that the Appellant had sufficient interest free funds to make the investments and that the Appellant had not incurred any expense to earn exempt income, disallowance under section 14A read with rule 8D cannot be invoked.

3. Ground No. 3: Disallowance of compensation paid in pursuance of out-of-court settlement with Pfizer Inc – Rs. 602,39,80,000/-:

3.1. On the facts and in the circumstances of the case and in law, the Ld. CIT(A) has grossly erred in confirming the disallowance made by the Ld. AO of Rs. 602,39,80,000/- paid in pursuance of out-of-court settlement.

3.2. On the facts and in the circumstances of the case and in law, the Ld. CIT(A) has grossly erred in holding that the expenditure is not for the purposes of the Appellant’s business without appreciating that with effect from the appointed date of demerger, the Specified Undertaking belonged to the Appellant and any expenditure incurred in relation to the Specified Undertaking is wholly and exclusively for the purposes of business of the Appellant.

3.3. The Ld. CIT(A) grossly erred in holding that expenditure was not business expenditure by observing that filing of Para IV application was not part of business operation of the Appellant without appreciating that the Appellant is a pharmaceutical company and its objects cannot be interpreted restrictively to carry only generic business. The CIT(A) ought to have appreciated that Para IV filing is also part of generic business carried on by the Appellant.

3.4. The Ld. CIT(A) grossly erred in alleging the demerger of the Specified Undertaking to be a colourable device without appreciating that there was valid business and commercial rationale for the same.

3.5. The Ld. CIT(A) has grossly erred in confirming the disallowance without appreciating that:

3.5.1. Amount paid pursuant to out-of- court settlement is civil and compensatory in nature and not for ‘any purpose’ which is an offence or prohibited by law; 3.5.2. The Appellant has not been convicted by any Competent Court of Law and mere accusations/allegations do not prove one guilty:

3.5.3. In absence of such conviction, the Income-tax Officer has no authority to determine whether provisions of other statutes have been contravened;

3.5.4. The ambit of Explanation 1 is restricted to laws prevailing in India and infringement, if any, of foreign alien laws cannot be covered;

3.5.5. Entering of out-of-court settlement is a commercial decision and does not per se imply any infraction of law;

3.5.6. Commercial Expediency is a prerogative of the Assessee and has to be looked at from the perspective of a prudent businessman;

3.6. On the facts and in the circumstances of the case, the Ld. CIT(A) has grossly erred in drawing reference to the order of the Hon’ble Tribunal in Appellant’s own case for the assessment year 2008-09 without appreciating that the same was pronounced in the context of completely dissimilar facts and different issues.

3.7. On the facts and in the circumstances of the case and in law, the Ld. CIT(A) has grossly erred in treating the impugned amount as a capital expenditure without appreciating that neither has there been any accrual of advantage of enduring nature to the Appellant in the capital field nor has it formed a part of the profit-making apparatus of the Appellant’s business.

3.8. On the facts and in the circumstances of the case and in law, the Ld. AO has grossly erred in treating the entire expenditure as a prior period item without appreciating that the expenditure has crystallized during the year under consideration.

4. Ground No. 4: Addition of compensation paid in pursuance of out-of-court settlement with Pfizer Inc under section 115JB-Rs. 602,39,80,000/-:

4.1. On the facts and in the circumstances of the case and in law, the Ld. CIT(A) grossly erred in confirming the action of the Ld. AO of adding back Rs. 602,39,80,000/- while computing book profits under section 115JB holding.

4.2. The Ld. CIT(A) failed to appreciate that the accounting treatment meted out by the Appellant was in accordance with generally accepted accounting framework in India and the requirements of the Schedule VI of the Companies Act, 1956 and duly accepted by the statutory auditor and the shareholders.

4.3. On the facts and in the circumstances of the case and in law, the Ld. CIT(A) ought to have appreciated that in absence of any adjustment prescribed under Explanation 1 to section 115JB(2) mandating addition of the impugned amounts, it is not open to the tax authorities to vitiate from the net profit except as provided in Explanation 1 to section 115JB(2) as deeming provisions are to be construed strictly.

4.4. On the facts and in the circumstances of the case and in law, the Ld. CIT(A) grossly erred in treating the said liability as unascertained without appreciating that the same has duly crystallized during the year under consideration.

5. Ground No. 5: Disallowance of interest payment relating to the settlement – Rs. 15,81,50,414/-:

5.1. On the facts and in the circumstances of the case and in law, the Ld. CIT(A) grossly erred in not allowing interest deduction of Rs. 15,81,50,414/- incurred by the Appellant.

5.2. The Ld. CIT(A) failed to appreciate that the interest was incurred as part of Appellant’s business and that having satisfied all the conditions of section 36(1)(iii) it was allowable as deduction under the Act.

5.3. The Ld. CIT(A) ought to have appreciated that, with effect from the appointed date of demerger, the business activities were undertaken by Sun Pharma Global FZE for and on behalf of the Appellant and accordingly, all liabilities and expenditures arising thereafter are incumbent on the Appellant.

5.4. The Ld. CIT(A) grossly erred in confirming the action of the Ld. AO of regarding the borrowed funds as being utilized for the purpose of infraction of law. Without prejudice, the Ld. CIT(A) ought to have appreciated that allowability of interest deduction is independent of the nature of expenditure for which the borrowed funds have been utilized.

5.5. Without prejudice to the above, impugned interest payment should have been allowed as a deduction under section 37(1) of the Act.

6. Ground No. 6: Addition of interest payment relating to the settlement under section 115JB-Rs. 15,81,50,414/-:

6.1. On the facts and in the circumstances of the case and in law, the Ld. CIT(A) grossly erred in treating the interest payment as being unascertained in nature without appreciating that the same has duly accrued and recognized as an expense during the year under reference in accordance with the requirements of the Schedule VI of the Companies Act, 1956 and duly accepted by the statutory auditor and the shareholders.

6.2. On the facts and in the circumstances of the case and in law, the Ld. CIT(A) ought to have appreciated that in absence of any adjustment prescribed under Explanation 1 to section 115JB(2) mandating addition of the impugned amounts, it is not open to the tax authorities to vitiate from the net profit except as provided in Explanation 1 to section 115JB(2) as deeming provisions are to be construed strictly.

7. Ground No. 7: Disallowance of software expenses – Rs. 12,81,93,468/-:

7.1. On the facts and in the circumstances of the case and in law, the Ld. CIT(A) has grossly erred in not treating the expenditure incurred towards computer software amounting to Rs. 12,81,93,468/- as revenue expenditure without appreciating that the treatment in the books of accounts is not conclusive for income-tax purposes as has been judicially settled in the case of Kedarnath Jute Mfg. Co. Ltd. v. CIT [1971] 82 ITR 363 (SC) thereby committing breach of judicial discipline.

7.2. Further, the Ld. CIT(A) ought to have appreciated that:

7.2.1. the software did not add to the profit earning apparatus of the Appellant.

7.2.2. they were routine and recurring expenses incurred in the ordinary course of business

7.2.3. they did not result into any benefit of enduring nature in the capital field thereby eligible for deduction under section 37(1) of the Act.

8. Ground No. 8: Disallowance of business promotion expenses – Rs. 26,08,155/-:

8.1. On the facts and in the circumstances of the case and in law, the Ld. CIT(A)/Ld. AO grossly erred in not allowing business promotion expenditure of Rs. 26,08,155/-without appreciating that such expenditure has been incurred wholly and exclusively for the purpose of business and hence, deductible under section 37(1).

9. Ground No. 9: Non-taxability of Export incentives being capital receipt – Rs. 29,88,53,239/-

9.1. On the facts and in the circumstances of the case and in law, the Ld. CIT(A) grossly erred in not treating export incentives granted under various schemes of Central Government as capital receipt not subject to tax both under normal as well as MAT provisions.

10. Ground No. 10: Deduction of foreign tax credit under section 37(1) – Rs. 7,10,520/-

10.1. On the facts and in the circumstances of the case and in law, the Ld. CIT(A) grossly erred in not allowing deduction under section 37(1) in respect of taxes paid in foreign countries of which no credit is available as per section 90/91 of the Act without appreciating that the same has been incurred wholly and exclusively for the purposes of business and is not covered by section 40(a)(ii) of the Act.

11. Ground No. 11: Deduction of education and secondary & higher education cess under section 37(1) – Rs.. 25,17,48,231/-:

11.1. On the facts and in the circumstances of the case and in law, the Ld. CIT(A) grossly erred in not granting deduction under section 37(1) for education cess payable by the Appellant.”

4. The Revenue has raised the following grounds of appeal:-

“1. On the facts and in the circumstances of the case, learned CIT(A) erred in law and on facts in deleting the additions made on TP issues on account of interest on loans given to Associated Enterprises and in holding that no adjustment is called for on account of interest on share application money pending for allotment by relying upon the decision of ITAT, Ahmedabad in the case of the assessee for A.Y. 2008-09, ignoring the facts that the department’s appeal on the same has been admitted by Gujarat High Court for A.Y. 2008-09 vide tax appeal No. 318 of 2018 and is still pending.

2. On the facts and in the circumstances of the case, learned CIT(A) erred in law and facts in deleting the addition on account of price difference on sales made to AEs and in holding that no upward adjustment is called for in the case of the assessee by relying upon the decision of CIT(A) in the case of the assessee for A.Y. 2008-09 & 2009-10, ignoring the facts that the department’s appeal on the same has been admitted by Gujarat High Court for A.Y. 2008-09 vide tax appeal No. 318 of 2018 and is still pending.

3. On the facts and in the circumstances of the case, learned CIT(A) erred in law and facts in deleting the addition made by the TPO on the issue of adjustment in respect of benchmarking of Bad Debts written off by the assessee company. Since, the assessee company could not offer any plausible or satisfactory explanation in this regard during TP proceedings as well as appellate proceedings.

4. On the facts and in the circumstances of the case, the learned CIT(A) erred in the law and facts in deleting the addition made on account of disallowance of weighted deduction on Trade Mark Registration & Overseas Product Registration expenses u/35 (2AB) by relying upon the decision of ITAT in assessee’s case for A.Y. 2008-09, ignoring the fact that the department’s appeal on the same has been admitted by Gujarat High Court for A.Y. 2008-09 vide tax appeal No. 318 of 2018 and is still pending.

5. On the facts and in the circumstances of the case, the learned CIT(A) erred in the law and facts in deleting the addition made on account of disallowance of weighted deduction on repair of building and payment of Municipal taxes u/s. 35 (2AB) by relying upon the decision of ITAT in assessee’s case for A.Y. 2008-09 & 2009-10 even when the expenses on repairs to building and payment for municipal taxes do not lead to any R & D activity.

6. On the facts and in the circumstances of the case, the learned CIT(A) erred in the law and facts in deleting the addition made on account of Lunch & refreshment and brokerage on property when these expenses does not relate to any R & D activity.

7. On the facts and in the circumstances of the case, the learned CIT(A) erred in the law and facts in deleting the addition made on account of provision of wealth tax of Rs.22,70,000/- for computation of book profit u/s. 115JB without considering the fact that provisions for wealth tax forms part of Income Tax Act, 1961, and therefore, provision for Wealth tax is to be added for the purpose of determination of book profit u/s. 115JB.

8. On the facts and in the circumstances of the case, the learned CIT(A) erred in the law and facts in partly deleting the addition made by invoking the provisions of section 14A r.w. Rule 8D of the IT Act by ignoring that Rule 8D is applied in full and not in part.

9. On the facts and in the circumstances of the case, the learned CIT(A) erred in the law and facts in partly deleting the addition made by invoking the provisions of section 14A r.w. Rule 8D of the IT Act and in holding that the disallowance made u/s. 14A out of expenses cannot be added to Book profit u/s. 115JB of the Act.

10. On the facts and in the circumstances of the case, the learned CIT(A) erred in the law and facts in deleting the disallowance made by the AO on account reallocation of revenue R & D expenses of Rs.286,06,77,112/- in ratio of turnover of formulation manufactured in SPIL & SPLL without appreciating that the AO had applied the same pro-rata method of allocating the R & D expenditure which the assessee itself was applying for allocation of the R & D expenditure within its units in the ratio of their turnover.

11. On the facts and in the circumstances of the case, the learned CIT(A) erred in the law and facts in deleting the disallowance made by the AO on account reallocation of capital R & D expenses of Rs.43,98,86,376/- without appreciating that the capital R & D expenditure was correctly allocated in the ratio of turnover of formulations manufactured in SPIL and SPLL, since entire R & D activity of SPLL was taking place in the R & D centre of the assessee company.

12. That on the facts and circumstances of the case and in law the decision of CIT(A) on the issue of excess claim weighted deduction u/s. 35(2AB) of the Act is contrary in as much on the one hand the CIT(A) directed the AO to delete the disallowance made on and on the other hand held that “In fact, the assessing officer has to examine the expenses and find out if any part of expenses is not incurred on in-house R&D activity and then make the disallowance to that extent only”.

13. On the facts and in the circumstances of the case, the learned CIT(A) erred in the law and on facts in deleting the addition made on account of disallowance of assessee’s claim of payment of Rs.43,38,60,000/- made to Cephalon in respect of breach of their patents without appreciating the fact that the amount was paid by the assessee company for out of court settlement of patent infringement suit filed by Cephalon and this payment of Penal nature and this type of penal expenses are not allowable as business expenditure.

14. On the facts and in the circumstances of the case, the learned CIT(A) erred in the law and on facts in partly deleting the addition made on account of disallowance of gift expenses of Rs.52,16,310/- without appreciating the fact that the assessee could not justify the business expediency of the gift expenses at the time of assessment proceedings and gift expenses are not allowable as business expenditure.”

5. The brief facts of the case are that the assessee-company is the flagship company of Sun Pharma Group. The assessee is a pharma company listed in BSE/NSE. The assessee-company is engaged in manufacturing, trading and export of pharmaceutical products in India as well as outside India and also leasing of assets, financing/financial services. The manufacturing unit of the assessee situated at its various factories located at Silvasa, Dadra, Ankleshwar, Panoli, Halol, Ahmednagar, Kanchipuram and Karkhadi.

5.1 For the year under consideration, the assessee filed its original return of income on 30.11.2014 declaring a loss of Rs.5,13,31,53,516/-under the normal provisions of the Act and a book loss of Rs.95,47,10,196/-under section 115JB of the Act. Subsequently, the assessee filed a revised return of income on 31.03.2016 declaring a total loss of Rs.5,13,31,38,242/-under the normal provisions and a book loss of Rs.98,45,05,240/- under section 115JB of the Act.

5.2 The return of income was selected for scrutiny under the Computer Assisted Scrutiny Selection (CASS) and statutory notices u/s 143(2) and 142(1) of the Act, along with detailed questionnaires, were issued and duly complied with by the assessee. Since the assessee had entered into international transactions with its Associated Enterprises, a reference under section 92CA(1) of the Act was made to the Transfer Pricing Officer (TPO) for determination of the arm’s length price of such transactions. The TPO passed an order under section 92CA(3) proposing various transfer pricing adjustments. Thereafter, the Assessing Officer incorporated the transfer pricing adjustments along with several other additions and disallowances while completing the assessment under section 143(3) read with sections 92CA and 144C(3) of the Act vide order dated 06.02.2018. In the assessment so framed, the Assessing Officer determined the total income under the normal provisions at Rs.25,41,89,18,130/- as against the returned loss and computed the book profit under section 115JB at Rs.5,20,11,09,287/-, after making various additions and disallowances under the normal provisions as well as under the MAT provisions.

5.3. Aggrieved by the assessment order, the assessee carried the matter in appeal before the Ld. CIT(A). The Ld. CIT(A), vide order dated 25.03.2019, granted substantial relief to the assessee by deleting certain additions and disallowances while sustaining others.

5.4. Being aggrieved by the additions and disallowances sustained by the Ld. CIT(A), the assessee is in appeal before us. The Revenue has also preferred a cross appeal challenging the relief granted by the Ld. CIT(A).

Ground No.1 of Assessee’s appeal:-

– TP adjustment on transfer of electricity generated by Captive Power Plant (CPP)-Rs.13,43,19,516/-

6. By way of Ground No.1, the assessee has challenged the transfer pricing adjustment made in respect of transfer of electricity generated by its Captive Power Plant to its manufacturing units by rejecting the benchmarking adopted by the assessee and by determining the Arm’s Length Price on the basis of the average of the tariff determined by the Gujarat Electricity Regulatory Commission (GERC) and the Market Clearing Price (MCP) prevailing on the Indian Energy Exchange (IEX). The Assessing Officer, on the basis of the order passed by the Transfer Pricing Officer under section 92CA(3) of the Act, held that the rate adopted by the assessee for transfer of electricity to its eligible units was not at arm’s length and accordingly made the impugned transfer pricing adjustment.

6.1 In appeal, the Ld. CIT(A), after considering the submissions of the assessee and the facts on record, upheld the action of the Assessing Officer/TPO.

6.2 Before us, the Ld. AR reiterated the submissions advanced before the lower authorities and contended that the benchmarking adopted by the assessee was in accordance with the CUP Method. The Ld. AR submitted that the appropriate comparable is the tariff at which the distribution company supplies electricity to industrial consumers and not the rate at which electricity is procured by the distribution company. It was further submitted that the TPO erred in adopting the average of the GERC tariff and the IEX Market Clearing Price, which does not represent an uncontrolled comparable transaction.

6.3 The Ld. DR, on the other hand, supported the orders of the Assessing Officer and the Transfer Pricing Officer.

6.4 We have heard the rival contentions and perused the material available on record. We find that this issue stands covered by the order of the Tribunal in assessee’s own case for the AY 2013-14 in ITA No. 1519 & 1520/Ahd/2018. In the absence of any change in factual matrix and legal proposition, respectfully following the order of the Co-ordinate Bench in assessee’s own case, the addition made by the Assessing Officer is ordered to be deleted.

Ground No. 2 of Assessee’s appeal
Ground Nos. 8 & 9 of Revenue’s appeal

– Disallowance u/s 14A r.w. Rule 8D

7. Ground No. 2 raised by the assessee relates to the disallowance made u/s 14A read with Rule 8D. The corresponding Ground Nos. 8 and 9 raised by the Revenue challenge the partial relief granted by the Ld. CIT(A) in respect of such disallowance and the consequential deletion of the addition while computing book profit under section 115JB. Since these grounds arise out of the same issue, they are taken up together for adjudication.

7.1. During the course of assessment proceedings, the Assessing Officer observed that the assessee had earned exempt income during the year. Being of the view that expenditure had been incurred in relation to such exempt income, the Assessing Officer invoked the provisions of section 14A read with Rule 8D and computed the disallowance under Rule 8D(2). The Assessing Officer also added the said disallowance while computing the book profit under section 115JB of the Act.

7.2. In appeal, the Ld. CIT(A), after considering the submissions of the assessee and the material available on record, partly accepted the contentions of the assessee. The Ld. CIT(A) restricted the disallowance u/s 14A in accordance with law and further held that the disallowance computed u/s 14A r.w.r. 8D could not be imported into clause (f) of Explanation 1 to section 115JB(2) for the purpose of computing book profit. Accordingly, partial relief was granted to the assessee.

7.3 On this issue, we find that the dividend earned by the assessee was Rs.159,975/- and hence, we restrict the addition to the amount of the dividend earned. By now, it is settled law that provision of Section 115JB are not attracted on this issue.

Thus, the ground of appeal raised by the assessee is partly allowed, while the grounds raised by the Revenue are dismissed.

Ground Nos. 3 – Pfizer settlement (Normal provisions & MAT)

8. The facts, in brief, are that the assessee company is engaged in the business of manufacturing and trading of pharmaceutical products. During the year under consideration, pursuant to a Scheme of Demerger sanctioned by the Hon’ble Gujarat High Court vide order passed in August 2014 the Specified Undertaking of Sun Pharma Global FZE (“SPG FZE”), a step-down wholly owned subsidiary of the assessee incorporated in the United Arab Emirates, stood vested in the assessee. The appointed date for the said demerger was 01.05.2013. The Specified Undertaking of SPG FZE was engaged in the business of manufacturing and trading Ulcer therapeutics and also carried out certain investing and financing activities. The principal market of the said undertaking was the United States of America. Prior to the aforesaid demerger, the Specified Undertaking of SPG FZE had filed a Paragraph IV certification before the US Food and Drug Administration (“US FDA”) in connection with the launch of its generic product Pantoprazole in the United States market. Consequent thereto, Wyeth LLC, a wholly owned subsidiary of Pfizer Inc., along with Nycomed GmbH (formerly known as Altana Pharma AG), instituted patent infringement proceedings against SPG FZE before the competent court in the United States. The litigation continued for several years. Subsequently, in June 2013, the parties entered into a settlement agreement with a view to resolve the dispute and avoid further litigation. Under the terms of the settlement agreement, SPG FZE agreed to pay an aggregate sum of USD 550 million to the concerned patent holders. As per the marketing and distribution arrangement entered into between SPG FZE and Caraco Pharmaceutical Laboratories Limited, USA (“Caraco”), a portion wholly and exclusively for the purposes of business and was allowable under section 37(1) of the Act.

8.1 The Assessing Officer, not being convinced with the explanation furnished by the assessee, held that the payment was towards infringement of law and, therefore, represented expenditure incurred in consequence of infraction of law. The AO further held that the expenditure was capital in nature and, in any event, did not pertain to the year under consideration. He also observed that no corresponding income had been credited to the Profit & Loss Account against which the said expenditure could be allowed. Accordingly, the claim of deduction amounting to Rs. 602,39,80,000/- was disallowed by AO.

8.2 Aggrieved by the aforesaid disallowance, the assessee carried the matter in appeal before learned CIT(A) who also rejected the claim of the assessee by observing as under:

2.1. The demerger was effectively a colourable device designed to shift and absorb the substantial liability of the offshore entity to claim a tax set-off in India. Further, the impugned expenditure did not pertain to, nor was it attributable to, the business of the appellant during the relevant period, thereby failing the fundamental test of commercial expediency. It was also observed that the out-of-court settlement was an attempt to mitigate the consequences of an established patent law violation. Consequently, the CIT(A) deemed the payment hit by explanation 1 to Section 37(1) of the Act, classifying it as an expense incurred for a purpose prohibited by law.

2.2. The Id. CIT(A) alternatively backed the AO’s stance by characterising the payment as a capital expenditure. It was reasoned that the liability arose directly from the restructuring and amalgamation of the capital structure of the merging entity with the appellant. Additionally, learned CIT(A) considering that judicial decree pursuant to which the amount is determined dated back to 2010, held the amount constituted a prior-period expense. Thus, the learned CIT(A) confirmed the disallowance.

8.3 Being aggrieved by the order of the Ld. CIT(A), the assessee is in appeal before us.

8.4 The Ld. AR submitted that the issue under consideration is similar to the issue adjudicated in favour of the assessee by the co-ordinate bench in case of Ranbaxy Laboratories Limited (now merged into assessee) for AY 2012-13 in ITA No. 360/Ahd/2017 vide order dated 03.09.2021. The co­ordinate bench had opined that in absence of any offence proved against the assessee, the explanation 1 to section 37(1) of the Act cannot be invoked.

8.5 In addition to the above, the Ld. AR submitted that the impugned expenditure arose pursuant to a settlement agreement entered into during the year under consideration whereby the pending patent litigation in the United States was amicably resolved. It was contended that although the underlying dispute had originated in earlier years, the liability became quantified and crystallized only upon execution of the settlement agreement during the year and, therefore, the expenditure was allowable in the year under consideration and could not be regarded as a prior period item. The Id. AR further submitted that the continuing litigation in US had exposed the assessee to loss of business in the US, substantial legal costs, diversion of senior management resources, business uncertainty and potential reputational risks. It was argued that the decision to settle the dispute was taken as a matter of commercial prudence with a view to protect the assessee’s business interests, preserve its reputation in a key market and ensure smooth conduct of business. Accordingly, the expenditure was incurred wholly and exclusively for the purposes of business and was allowable under section 37(1) of the Act. The Id. AR contended that the Revenue authorities were not justified in questioning the commercial wisdom of the assessee. According to him, the question whether an expenditure is commercially expedient has to be examined from the perspective of a prudent businessman and not from the viewpoint of the Assessing Officer. Reliance was placed on various judicial precedents including the decision of the Hon’ble Supreme Court in S.A. Builders Ltd. v. CIT (288 ITR 1) and other authorities laying down that expenditure voluntarily incurred on grounds of commercial expediency for facilitating business operations is deductible under section 37(1) of the Act. The Id. AR further submitted that expenditure incurred for protection of business reputation and preservation of profit-earning apparatus has consistently been held to be allowable as revenue expenditure. According to him, the settlement was entered into primarily to avoid prolonged litigation and adverse publicity which could have affected the assessee’s goodwill, reputation and business prospects in its principal market. Therefore, the expenditure was incurred for preservation and protection of business and not for acquisition of any capital asset.

8.6 In the alternative, the Id. AR submitted that the impugned payment could not be regarded as expenditure incurred for any offence or for any purpose prohibited by law. It was contended that the settlement agreement was entered into without any admission of guilt and there was no adjudication by any court or competent authority holding the assessee guilty of patent infringement. Mere allegations made by the plaintiff could not be equated with an established violation of law. The Id. AR submitted that a distinction must be drawn between allegations and proven guilt. According to him, the patent proceedings had not culminated in any finding adverse to the assessee and the dispute stood resolved through settlement before adjudication. Therefore, no inference could be drawn that the assessee had committed any infringement merely because it chose to settle the dispute. It was argued that every person is presumed innocent unless proven guilty and hence the expenditure could not be disallowed on the basis of unproven allegations. The Id. AR also contended that a compromise decree or consent order merely records the agreement arrived at between the parties and does not constitute a judicial determination of rights or liabilities. Accordingly, AR submitted that the settlement could not be construed as any violation of law by the assessee. The Id. AR further submitted that the impugned payment was compensatory and not penal in character. According to him, the payment was made to resolve civil proceedings and compensate the counterparty for settlement of claims. It did not partake the character of a fine, penalty or punishment imposed for infraction of law. Reliance was placed on the decision of the Hon’ble Delhi High Court in CIT v. Desiccant Rotors International (P.) Ltd. wherein compensation paid pursuant to settlement of patent litigation was held to be allowable under section 37(1) of the Act.

8.7 The Id. AR contended that explanation 1 to section 37(1) requires examination of the purpose for which the expenditure was incurred. According to him, the purpose of the payment was not commission of any offence or violation of law but settlement of litigation, protection of business interests and avoidance of prolonged disputes. Therefore, the expenditure fell outside the scope of explanation 1 to section 37(1) of the Act. In any case, the Id. AR submitted that the expression “offence” or “prohibited by law” occurring in Explanation 1 to section 37(1) should be construed with reference to Indian law and could not automatically extend to alleged violations of foreign laws. Since the dispute arose under foreign patent laws and had no nexus with any violation of Indian law, the provisions of Explanation 1 were stated to be inapplicable. The Id. AR also submitted that the AO was not the competent authority to determine whether the assessee had infringed any foreign patent law. In the absence of any finding by a competent court or regulatory authority, the AO could not assume jurisdiction to conclude that the assessee had committed any infringement and thereafter invoke explanation 1 to section 37(1).

8.8 As regards the nature of expenditure, the Id. AR submitted that the payment neither resulted in acquisition of any tangible or intangible asset nor conferred any proprietary or enduring right upon the assessee. Therefore, the expenditure was incurred in the revenue field and could not be treated as capital expenditure merely because the benefit of avoiding litigation may endure for a future period. The Ld. AR submitted that the demerger, having been undertaken pursuant to a scheme duly sanctioned by the Hon’ble High Court, could not be disregarded as a colourable device in the absence of any material establishing that it was a sham or lacked commercial substance. It was contended that the demerger was driven by genuine business and commercial considerations relating to corporate restructuring and reorganisation, and merely because it resulted in a tax benefit would not render it devoid of commercial rationale. Accordingly, the authorities below erred in characterising a court-approved transaction as a colourable device without any cogent evidence to support such a conclusion.

8.9 In support of the above propositions, the Id. AR relied upon various judicial precedents including S. A. Builders Ltd. v. CIT (288 ITR 1), CIT v. Delhi Safe Deposit Co. Ltd. (133 ITR 756), Sri Venkata Satyanarayana Rice Mill Contractors Co. v. CIT (223 ITR 101), CIT v. Desiccant Rotors International (P.) Ltd. (347 ITR 32), DCIT v. Anil Dhirajlal Ambani (93 taxmann.com 492), DCIT v. VLS Finance Ltd. and other decisions dealing with commercial expediency, protection of business reputation, compensatory payments and settlements entered into without admission of guilt.

8.10 By way of an alternative plea, the Id. AR submitted that even if the expenditure were to be regarded as capital in nature, the assessee would be entitled to depreciation thereon under section 32 of the Act, since the Revenue itself had proceeded on the basis that the expenditure resulted in acquisition of an intangible benefit.

8.11 On the other hand, the Id. DR supported the orders of the Assessing Officer and the Id. CIT(A). He submitted that the impugned payment arose out of a patent infringement litigation initiated against SPG BVI, a foreign entity, in relation to a Paragraph IV filing in the United States. According to the Id. DR, the liability did not originate from the business operations of the appellant but from the actions of a separate offshore entity and therefore failed the test of expenditure incurred wholly and exclusively for the purposes of the appellant’s business. The Id. DR further submitted that the US District Court had already rendered findings adverse to the concerned foreign entity in relation to patent infringement and the subsequent settlement was merely an attempt to mitigate the consequences flowing from such violation. According to him, the expenditure represented a payment arising out of infringement of law and therefore the same was clearly hit by Explanation 1 to section 37(1) of the Act. The Id. DR contended that merely because the matter was ultimately settled out of court would not alter the true character of the payment. The Id. DR further relied upon the findings recorded by the Id. CIT(A) that the merger of SPG BVI into the assessee pursuant to the demerger scheme effectively resulted in transfer of the liability to the assessee and enabled the claim of deduction in India. According to him, the surrounding circumstances demonstrated that the impugned liability was not a normal business expenditure of the assessee but was intrinsically linked to the restructuring of the foreign entity and therefore could not be allowed as a revenue deduction.

8.12 In the alternative, the Id. DR submitted that the expenditure was capital in nature inasmuch as the liability had arisen as a consequence of the amalgamation and restructuring of the capital framework of the entities concerned. He further contended that the underlying cause of action as well as the adverse judicial findings had arisen in earlier years and therefore the impugned amount could not be regarded as an allowable expenditure of the year under consideration.

8.13 The Id. DR accordingly submitted that the AO was justified in disallowing the claim and that the Id. CIT(A) had correctly confirmed the addition on multiple independent grounds, namely lack of business nexus, applicability of explanation 1 to section 37(1), capital nature of expenditure and its characterization as a prior-period liability.

8.14 We have heard the rival contentions of the Ld. Representatives of the parties and gone through the record.

We find that the issue stands covered by the decision of the coordinate bench in the case of the assessee’s predecessor entity, Ranbaxy Laboratories Limited (merged with Sun Pharmaceutical Industries Limited), for AY 2012-13 in ITA No. 360/Ahd/2017 vide order dated 03.09.2021. It is necessary to notice precisely what the payment in that case was for. The assessee group there had paid an aggregate sum of Rs. 25,95,95,57,864/-, comprising a settlement agreement of Rs. 1827,65,57,864/-and a plea agreement of Rs. 768,30,00,000/-, to the Department of Justice of the United States and to the participating States, consequent upon a Consent Decree of Permanent Injunction entered into with the US Food and Drug Administration and approved by the US District Court for the District of Maryland, in relation to alleged non-compliance with current Good Manufacturing Practice at its Paonta Sahib and Dewas facilities. The settlement in that case was thus arrived at with a sovereign regulator and a prosecuting agency, was preceded by a consent decree of injunction, and was accompanied by a plea agreement executed under the Federal Rules of Criminal Procedure. Even in that far more adverse setting, the coordinate bench held that Explanation 1 to section 37(1) of the Act was not attracted, for the reason that no offence stood proved against the assessee. If the deduction was allowable there, it must follow a fortiori in the case before us, where the settlement is with private commercial litigants, there is no regulator, no consent decree of injunction and no plea agreement, and no admission of guilt of any description.

8.15 The relevant findings of the coordinate bench read as under:-

“69. We have heard the rival contentions and perused the materials available on records. From the preceding discussion, we note that the assessee has paid a sum of Rs. 25089.58 Millions in-pursuant to the settlements/plea agreements for the alleged non-compliance of cGMP as prescribed by the US FDA which resulted various suit against assessee group in the USA. The same was disallowed by the AO on various reasons which have already been discussed in the preceding paragraphs. Subsequently the Id. DRP confirmed the order of the Assessing Officer

69.1 CGMP refers to the Current Good Manufacturing Practice regulations enforced by the FDA, CGMPs provide for systems that assure proper design, monitoring, and control of manufacturing processes and facilities. However, there are serious consequences of Non-Compliance of cGMP. Medicine can be dangerous enough when it is not prepared according to the prescribed guidelines. In situations where current good manufacturing practices weren’t followed, the Department of Justice and Health and Human Services have the authority to take actions against any manufacturing company that violates good manufacturing practices.

69.2 Now coming to the facts of the case on hand. The proceedings were initiated against the assessee in the court of US when it was found during the inspection that the assessee was not complying with the standards of CGMP. However, the assessee before the verdict of the court has entered into the consent decree and further in pursuance to such consent decree entered into the settlements with the government of USA through DOJ. The consent decree was entered by the assessee in the month of December 2011 which was approved by the US District Court of Maryland in the month of January 2012.

69.3 A consent decree is a legal agreement that is reached between a company and the government (in this case, DOJ). It is a negotiated agreement detailing the voluntary actions pledged by the affected company to remedy non-conformances, including systems improvements, and to avoid FDA litigation. FDA uses consent decrees to change the overall corporate culture in compliance matters by pulling the company out of a pattern of long-standing CGMP problems and raising it to current standards. A consent decree commits the company to perform corrective actions in a timely manner, as verified by a third party.

69.4 Based on the consent decree which was approved by competent court, the assessee started negotiation with DOJ and entered into the settlement agreements in the year May 2013. Now the question arises whether the consent decree should be viewed as an offence provided under explanation 1 to section 37(1) of the Act. The word consent decree itself suggests that the offence has not been framed under the provisions of law by the order of the court. But the party has resolved the same by entering into this consent decree for various reasons which was also accepted by the other party i.e. FDA in the present case. These reasons may include to avoid the litigation cost, damage of the reputation/goodwill, litigation time etc. On perusal of the consent decree we note that the assessee has out rightly denied to accept any allegation. The relevant portion of the consent decree reads as under:

The United States of America, plaintiff, by its undersigned attorneys, having filed its complaint for injunctive relief against defendants, Ranbaxy Laboratories Ltd. and Ranbaxy, Inc. corporation (“Corporate Defendants”) and Dale Adkisson (who was hired by Ranbaxy Laboratories Ltd., and assumed the position of Senior Vice President, Head Global Quality in January 2010, after all of the activities alleged in the complaint had occurred), Arun Sawhney (who assumed the position of Managing Director of Ranbaxy Laboratories, Ltd. on August 20, 2010 after all the activities alleged in the complaint had occurred), and Venkatachalam Krishnan, Regional Director Americas (collectively, “Defendants”), and Defendants having appeared and having consented to the entry of this Consent Decree of Permanent Injunction (the “Decree”), without contest and before any testimony had been taken and without admitting or denying any allegation of the complaint and disclaiming any liability in connection therewith, and the United States of America, having consented to this Decree.

69.5 Based on the consent decree, settlement agreements were made as detailed under.

1. Settlement Agreement between assessee group and DOJ on behalf various departments of United States and participating States, placed at pages 668 to 696 of paper book.

2. Plea Agreement between M/s Ranbaxy USA Inc and DOJ, placed at pages 697 to 718 of paper book.

3. Settlement Agreement between assessee group and State of Connecticut, placed at pages 724 to 741 of paper book

4. Settlement Agreement between assessee group and State of Oregon, placed at pages 742 to 753

69.6 On perusal of all the settlement agreement as mentioned above it is found the assessee has not admitted or found guilty of any misconduct or violation of law. For ready reference the relevant portion of settlement agreement between assessee and DOJ is reproduced hereunder:

This Agreement is neither an admission of liability by Ranbaxy, except to the extent admitted by Ranbaxy USA, Inc. under the terms of the Plea Agreement. nor a concession by the United States that its claims are not well founded. Ranbaxy expressly denies the contentions and allegations of the United States and Relator as described in the Covered Conduct and set fourth herein and in the Civil Action, and denies that in engaged in any wrongful conduct, except as to such admissions that Ranbaxy USA, Inc. is required to make under the terms of the Plea Agreement.

69.7 The copy of the Plea Agreement is placed on pages 697 to 718 of the paper book. On perusal of the same we note that, plea agreement was part of overall settlement offer made by the DOJ to resolve the issue. As such the plea agreement was dependent upon the civil settlement meaning thereby that if assessee chooses to enter a settlement for civil liability then it has to enter into plea agreement also. The relevant portion of the plea agreement is reproduced as under:

This letter, together with the sealed Supplement, confirm the plea agreement that has been offered to the Defendant by the United States Attorney’s Office for the District of Maryland and the Consumer Protection Branch of the U.S Department of Justice (collectively “this officer” The agreement will be presented to the Court pursuant to Federal Rule of Criminal Procedure 11(c)(1)(c). This agreement is contingent upon execution of a Civil Settlement Agreement between Ranbaxy USA, Inc, and the United States. If the Defendant accepts this offer, please have a responsible corporate officer execute it in the spaces provided below. The terms of the argument are as follows:

69.8 On conjoint reading of the above agreements, there remains no doubt that the assessee has not admitted or found guilty of misconduct or breach of law. 69.9 In view of the above, we are of the considered opinion that the provisions of explanation 1 to section 37(1) of the Act cannot be invoked in the given facts and circumstances for the reasons that there was no offence proved against the assessee.

69.10 In holding so we draw support and guidance from the order of Mumbai tribunal in the case of Deputy Commissioner of Income tax, Circle 3(3)(1) Mumbai v. Anil Dhirajlal Ambani reported in 93 taxmann.com 492 wherein it was held as under.

Now coming to the argument of learned DR, that the reason for filing the consent application and paying the settlement fee/consent charges is the alleged fact that the assessee was apprehensive of the serious consequences of the offence committed by it is without any basis. There is nothing whatsoever to support this contention except the ipsi dixit of the Revenue. The assessee has always submitted that there was no offence. Even the consent application was filed without admitting guilt. There is no finding or order by any authority. It is logical to hold that the assessee was apprehensive of the toll that a long winded litigation both, in terms of time, cost and hassle as also in terms of reputation – would take. The fact that the consent application proposed by the Respondent was accepted by SEBI also on the footing that the Respondent has paid the settlement “without admitting or denying the charges” indicates that the SEBI was not unaware of the outcome of its case against the Respondent. There is no reason to believe or infer that consent application without admitting guilt amounts to evidence of an offence having been committed.

48. In view of the above discussion, we can safely observe that the detailed findings recorded by CIT(A) are as per material on record an require no interference on our part. Accordingly, there is no infirmity in the order of the CIT(A) for deleting disallowance made by invoking explanation to 37(1) of the IT Act.

69.11 We also draw support and guidance from the judgment of Hon’ble Delhi High court in case of Dessicant Rotors International (P.) Ltd (Supra) wherein it was held as under At the outset, the submission of the assessee that the paramount and governing consideration behind such a settlement/agreement could be to avoid the expenses and uncertainty of further litigation was to be accepted. It is a matter of common knowledge that litigation can turn out to be quite expensive and it cannot be even possible, what to talk of feasible, for a small time/middle level company in India like the assessee to litigate in US Court. Furthermore, the settlement agreement contained a specific recital to this effect inasmuch as it records “whereas, in order to avoid the expenses or uncertainty or further litigation, the parties desired to settle and adjust all differences and controversies among themselves subject to the terms of this Agreement.” No doubt in the agreement, the assessee accepted the patent of SEMCO. That by itself would not mean that the assessee also accepted that it was infringing the said patent. Secondly, payment was made by the assessee to SEMCO for “loss of goodwill and damages to its capital and for terminating of case in US Courts” as was clearly mentioned in the agreement. No finding was given by any Court that the assessee had violated the patent right of SEMCO. [Para 18]

69.12 Without prejudice to the above, with respect to the plea agreement, we note that there was the agreement between the US FDA and Ranbaxy USA INC. The copy of the plea agreement is placed on pages 697 to 718 of the paper book. In other words, the assessee was not the party to it. Accordingly, it can be inferred that there was no crime committed by the assessee. The question also arises why the assessee is claiming the expenses in its books of accounts when it is not the party to the agreement. Undoubtedly, the proceedings initiated on account of non-compliance of CGMP by the assessee in its factories located in India. RPI was procuring the goods from India which was supplied by the assessee from its factories. Therefore, the consequences faced by the RPI was the non­compliance of CGMP in India by the assessee. Therefore, the assessee was under the obligation to compensate the losses incurred by the RPI on account of its mistake.

69.13 Now let us proceed to examine the fact from a different angle whether the non-compliance of CGMP requires the invocation of the explanation 1 to section 37 (1) of the Act. The provisions of section 37(1) of the Act provides the deduction of the business expenditure not covered by earlier sections 30 to 36 in computing the taxable income subject to certain conditions. The provisions reads as under.

“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 assessee), 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”

69.14 The following are the ingredients of section 37 of the Act:

(i) Expenditure should not be covered under the specific sections, i.e., 30 to 36 of the Act; (ii) Expenditure should not be of capital nature; (iii) Expenditure. should have been incurred during the previous year, (iv) Expenditure should not be of a personal nature; (v) Expenditure should have been incurred wholly or exclusively for the purpose of the business or profession.

69.15 All of the five conditions mentioned above are to be satisfied before claiming any expense as a deduction under this section.

69.16 An Explanation was added to this sub-section by the Finance (No. 2) Act, 1998 with effect from April 1, 1962 which reads 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”.

69.17 The Explanation was brought in the statute in the year in 1998 which made applicable retrospectively from 1st April, 1962. The Memorandum Explaining the Provisions of the Finance Bill 1998 expounds the purpose for which this explanation was brought under the statute which reads as under 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 payments on account of protection money, extortion, hafta, bribes, etc, as business expenditure.

69.18 The Explanation is couched as a ‘declaration’ so as to create a fiction whereby any expenditure incurred by any assessee for any purpose (i) which is an offence, or (ii) which is prohibited by law, shall not be treated as incurred for the purpose of business or profession. This declaration itself makes such an expenditure an ineligible item for deduction in the computation of income from business or profession. However, to make it more clear, the Explanation further provides that no deduction or allowance shall be made in respect of such expenditure.

69.19 The word “offence” has not been defined under the Income Tax Act. However, it is defined under section 3(38) of the General Clauses Act, 1887 which is reproduced as under.

“offence” shall mean any act or omission made punishable by any law for the time being in force;”

69.20 The word/expression “prohibited by law” has also not been defined under the Income Tax Act. However it may be regarded to any act of the party which is explicitly or impliedly barred by statute. It refers the act of prohibiting by authority.

69.21 Admittedly, the alleged default which compelled the assessee group to pay the amount of USD 500 Million was alleged to be committed in a country outside India. Thus the controversy arises whether the default committed by the assessee in a country outside India, the provisions of explanation 1 to section 37(1) of the Act can be attracted. In this regard we find that the expression “prohibited by law” can only mean prohibited by law in force in India. The expression “prohibited by law” as used in the Explanation to section 37(1) has the same contextual import as the expression “forbidden by law” as used in section 23 of the Indian Contract Act, 1872. This came up for the consideration of the Full Bench in the case of Abdul Hameed v. Mohd. Ishaq AIR 1975 All.

166 wherein the Allahabad High Court observed as under:

“12. The expression ‘law’ has not been defined in the Contract Act, nor in the U. P. General Clauses Act, 1904, but in the Central General Clauses Act, 1897, ‘Indian Law’ is defined in section 3(29) as below:- “”Indian law’ shall mean any Act, Ordinance, Regulation, rule, order, bye law or other instrument which before the commencement of the Constitution had the force of law in any Province of India or part thereof, or thereafter has the force of law in any Part A State or Part C State or part thereof, but does not include any Act of Parliament of the United Kingdom or any Order in Council, rule or other instrument made such Act.”

69.22 At this juncture, it is also important to refer the order of the Hyderabad tribunal in the case of Mylan Laboratories Ltd. Vs. DCIT reported in 113 taxmann.com 6 where it has been held that the provisions of explanation 1 to section 37(1) of the Act can be invoked where there is an office committed under the law applicable for the time being in force in India. Thus the office committed by the assessee under the provisions of foreign law cannot be subject to the provisions of explanation 1 to section 37(1) of the Act. The relevant extract of the order is reproduced as under:

“8.9 Thus, from the above decisions, it is clear that what has to be disallowed under Explanation 1 to Sec. 37(1) of the Act is a payment made, for contravention of laws in force in India and not of any foreign country. The laws are specific to each of the countries according to their rules and regulations and an offence in one country may not be so in another country. Therefore, we agree with the contentions of Ld. Counsel for the assessee that it is only payment made for contravention of laws in force in India that disallowance under Explanation 1 to Sec. 37(1) of the Act is to be made.”

69.23 It becomes necessary, in view of the above, to see whether contravention of the law committed by the assessee pertains to Indian law or foreign law. In the given case, the proceedings were initiated for the alleged default committed in a country outside India. Therefore, there cannot any disallowance for the impugned penalty under explanation 1 to section 37(1) of the Act.

69.24 Moving ahead we note that before invoking the explanation 1 to section 37(1) of the Act, it is necessary to understand the provisions of the scheme of the relevant statute in respect of which the offence has been committed by the assessee. In holding so we draw support and guidance from the judgment of The Hon’ble Madras High Court in the case of CIT v. Parthasarathy [1995] 78 Taxman 470 wherein it was held as under.

“The latest rulings of the Supreme Court in the cases of Prakash Cotton Mills (P.) Ltd. v. CIT [1993] 201 ITR 684and CIT v. Ahmedabad Cotton Mfg. Co. Ltd. [1994] 205 ITR 163, give a wider scope to consider the question in spectrum analysis, in examining the scheme of the provisions of the relevant broad statute, providing for payment of such imports, notwithstanding the nomenclature of the impost as given by the statute, to find out whether it is compensatory or penal in nature. The authority has to allow deduction under section 37(1) whenever such examination of the scheme of the provisions of the relevant statute reveals the concerned impost to be purely compensatory in nature. Whenever such impost is found to be of composite nature, that is, partly of compensatory nature and partly of penal nature, the authorities are obliged to bifurcate the two components of the impost and give deduction to that component part which is compensatory in nature and refuse to give deduction to that component which is penal in nature.”

69.25 Such understanding is required to find out whether such penalty in the compensatory nature or panel in nature. The courts have held that the penalty which is in the nature of compensation are allowable deduction and therefore these penalties are outside the purview of the provisions of explanation 1 to section 37(1) of the Act. In holding so we draw support and guidance from the judgment of Hon’ble Supreme court in case of Prakash Cotton Mills P. Ltd. v. CIT (1993) 201 ITR 684, 690-91(SC), Standard Batteries Ltd. v. err (1995) 211 ITR 444, 446(SC), Swadeshi Cotton Mills Co. Ltd. v. err. (1998) 233 ITR 199, 202(SC) and Hon’ble high court of Andhra Pradesh CIT v. Bharat Television Pvt. Ltd (1996) 218 ITR 173(AP), CIT v. Hyderabad Allwyn Metal Works Ltd., (1988) 172 ITR 113. 121 (AP) 70.26 We note that there can be instances that a penalty levied in the foreign law is compensatory in nature and vice versa. Accordingly it is necessary to understand the scheme the provisions of the relevant statute. But the Revenue has failed to bring anything on record whether the penalty is in the nature compensation or penal in nature. It is because there was no charge framed against the assessee. As such the dispute was amicably resolved by entering into consent decree as discussed above.

69.26 Another noteworthy point is that the Explanation to section 37(1) is a deeming provision. It only creates a legal fiction. Next, the Explanation comes into play when expenditure, though incurred for business purpose, is coupled with purpose which is offence or prohibited by law. It may be that a particular payment made by the assessee under a statutory provision, though called a penalty, is a composite one comprising both a penalty and a compensation for delayed payment. Under section 37(1), only that portion of such payment having composite nature which is attributable to its compensatory character can only be allowed as a deduction. The other portion which is attributable to its penalty nature cannot be allowed as a deduction under section 37(1) because such payment is for infraction of law

69.27 The next controversy arises whether the impugned amount relates to the year under consideration or it represents the contingent liability. On perusal of the consent decree entered in the year December 2011 which was approved in January 2012, the amount of the payment was not quantified. As such the amount was quantified at the time of settlement agreement which was entered in the month of May 2013. Accordingly it was contended by the learned DR that the impugned amount represents the contingent liability. It is because the amount was quantified in May 2013. In this connection, we note that admittedly, the amount was not quantified at the time of consent decree. But the liability has certainly accrued on the assessee once the consent decree was entered and approved by the US District Court of Maryland in January 2012. We further note that the learned AR had drawn our attention on email conversation between its attorney and authority of DOJ wherein an amount of USD 500 million was informed to the assessee as lump-sum figure for overall settlement of civil as well as criminal liability. The relevant correspondence of the emails are enclosed as annexure-1.

69.28 On perusal of the above emails, there remains no ambiguity that the liability was very much quantified in the year under consideration. The amount mentioned in the emails was subsequently confirmed in the settlement agreement which was entered in the year May 2013. Thus in such a situation, the liability in the year under question cannot be treated as contingent liability 69.29 It was also submitted that the observation letter was received by the assessee in the year 2008 thus the impugned amount representes the prior period expenses and therefore the same cannot be allowed as deduction. In this connection we note that the observation letter was received in the year 2008 but that does not make the assessee accountable to make the provisions in the books of accounts. It is because at that point of time there was no whisper so as to hold that the assessee was thinking to enter into the consent decree. Therefore, we find no force in the argument of the learned DR.

69.30 A question was also raised that the impugned amount of penalty was allowing the assessee to continue business and therefore the assessee by way of this settlement agreement was able to get the benefit of enduring nature. Accordingly such amount of liability should be treated as capital in nature. There is no dispute to the fact that the assessee has been doing the business in the US market since many years. However, the business of the assessee came to halt once there was an Alert notice issued by the US FDA with regard to import of drugs/product manufactured at assessee certain facilities in India. In fact the assessee by making the impugned payment was able to resume its business.

Therefore it cannot be said that the assessee has got any benefit of enduring nature. Therefore the impugned payment cannot be treated as capital in nature. 69.31 We also agree with the contention of the leamed AR that the TPO and the AO has taken different stand with respect to the amount paid in dispute as discussed above. The TPO while working out the profit level indicator of the assessee has treated the said amount y as operating expenses whereas the AO has disallowed the same is not eligible for deduction under section 37 of the Act. In our considered view the TPO and the AO are part of the income tax Department and therefore there has to be consistency in the approaches of both the authorities. As such the authorities should not take different stand while determining the taxable income of the assessee otherwise it would lead to the double addition which is not desirable under the provisions of the Act.

69.32 In view of the above and after considering the facts in totality, we are of the view that the assessee is entitled for the deduction for the payment made by it as a result of settlement agreements as discussed above under the provisions of section 37 1 of the Act. The impugned payment not be treated as penalty in the nature of provided under explanation 1 to section 37 1 of the Act. Hence the ground of appeal of the assessee is allowed.”

8.16 We have analysed the judicial precedents cited by both sides and have given our careful consideration to the rival submissions as well as the material placed on record. The central controversy before us is whether the payment of USD 106 million (equivalent to Rs. 602,39,80,000/-) made pursuant to a voluntary, out-of-court settlement agreement to resolve the patent infringement suit instituted by Wyeth LLC, a wholly owned subsidiary of Pfizer Inc., along with Nycomed GmbH, can be allowed as a business expenditure under Section 37(1) of the Act. The Revenue has denied this deduction primarily on five grounds: that it represents a penalty for the infraction of a foreign law and is therefore hit by Explanation 1 to Section 37(1); that it constitutes capital expenditure; that it is prior period item; and that the expenditure does not pertain to the business of the assessee inasmuch as the liability originated in the hands of the Specified Undertaking of SPG FZE; and that no corresponding income stood credited to the Profit and Loss Account against which the expenditure could be allowed. At the very threshold, however, we may observe that the genuineness of the payment itself is not in doubt. The settlement was arrived at with unrelated multinational pharmaceutical majors who were adversarial litigants before the US District Court, the settlement agreement was placed before and taken on record by that Court, and the quantum of payment and its actual discharge have not been disputed by the AO. The controversy is thus confined to the legal character of the payment and not to its factum or genuineness.

8.17 We first turn to the Revenue’s contention that the settlement payment is hit by Explanation 1 to Section 37(1) of the Act. Explanation 1 declares, for the removal of doubts, 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 thereof. The provision creates a legal fiction and it is trite law that a deeming fiction which operates to the prejudice of the assessee must be construed strictly and cannot be extended beyond the purpose for which it was enacted. What the Explanation mandates to be examined is the purpose for which the expenditure was incurred, namely, whether the expenditure was laid out for the commission of an offence or for a purpose prohibited by law. The purpose of the impugned payment, on the admitted facts, was the resolution of a pending civil dispute, the avoidance of protracted litigation and the protection of the business of the assessee in its principal market. The burden lay squarely upon the Revenue to demonstrate on the basis of cogent material that the purpose of the expenditure was an offence or one prohibited by law, and, as discussed hereinafter, that burden has not been discharged.

8.18 On a careful perusal of the settlement agreement filed before the US District Court, we find that the dispute was amicably settled between the parties without any admission of liability or guilt. The compromise decree merely sets the judicial seal on a voluntary agreement inter se between private commercial entities; it records the consensus arrived at between the parties and does not embody any judicial determination of infringement against the assessee or its predecessor. There is a fundamental distinction between an allegation levelled in a plaint and guilt established upon adjudication. Mere accusations or allegations in a patent infringement suit do not equal proven guilt, and it is elementary that every person is presumed innocent unless proven guilty. The proceedings stood terminated by settlement before any final and conclusive adjudication of infringement, and the Revenue has not placed before us any finding of a competent court or authority proving any violation of law by, or recording any admission of guilt on the part of, the assessee or the Specified Undertaking. It is observed that the settlement arrived at without admitting guilt cannot be treated as evidence that an offence was committed, this proposition is supported by the Decision of ITAT Mumbai in the case of DCIT, Circle 3(3) (1), Mumbai v. Anil Dhirajlal Ambani, 93 taxmann.com 492. It was held there that an apprehension of protracted litigation, in terms of time, cost and reputation, is by itself a sufficient and logical explanation for entering into a settlement, and that a compromise arrived at without admitting guilt furnishes no basis whatsoever to infer the commission of an offence.

8.19 The reliance placed by the Revenue on the verdict of the United States District Court of New Jersey of the year 2010 does not carry its case any further. The record shows that the litigation did not attain finality with the said verdict; the proceedings remained alive and contested, and it was only in June 2013 that the parties mutually resolved to settle the entire dispute out of court. The quantum itself bears out that the payment was the product of a negotiated compromise and not the enforcement of any adjudicated liability: as against a claim which, according to the Revenue itself, exceeded a billion US dollars, the parties settled the entire matter for USD 550 million, of which the amount ultimately borne by the Specified Undertaking from its own funds was USD 106 million. The payment thus flowed from, and only from, the settlement agreement voluntarily executed between the parties, and not from any decree or judicial determination. Once the parties compromised the dispute, whatever had transpired earlier in the litigation stood subsumed in the settlement, which was entered into without any admission of liability.

8.20 We are further constrained to observe that the stand taken by the Ld. CIT(A) on this issue is irreconcilable with his own findings recorded elsewhere in the very same impugned order. By ground No. 22 before him, the assessee had claimed deduction of Rs. 43,38,60,000/- (USD 7 million) paid to Cephalon Inc. under a materially identical out-of-court settlement of a patent infringement suit instituted in the same United States District Court of New Jersey following an ANDA filing with a Paragraph IV certification. Dealing with that ground, the Ld.CIT(A) recorded in para 25.2.2 of the impugned order that “Settling such matters pertaining to ANDAs which form the core ingredient of the Appellant’s profitability is wholly and exclusively related to the Appellant’s business operations”, and thereafter held in para 25.2.3 as under:

“25.2.3. However, under the above undisputed facts; that though the plaintiffs had accused the Appellant of infringing its patents, nowhere in the agreement filed with the Court has it been mentioned that the payment made by the Appellant is in the nature of damages pursuant to violation of any statute. No competent authority had adjudged the matter, it could not be concluded that the amount paid by the Appellant was for contravention of any law. The Appellant had never been proven guilty on this count, it was unfair and wrong on the part of the Assessing Officer to allege that Appellant Company had breached any law, the compensation paid pursuant to the settlement between the parties is more to compensate the plaintiffs in exchange for avoiding protracted litigation. Therefore, there is no way that such payment, made pursuant to settlement of disputes inter se between the parties, be termed as payment in violation of law to attract Explanation (1) to section 37(1). Anyway, the Assessing Officer is no statutory authority empowered to decide whether any law has been contravened or not. This matter has to be decided by the relevant court or relevant statute. In the instant case, under the US law, the Appellant has never been held guilty as explained above. As no federal Court has proved that these expenses violate any law, I am of the considered view that the same is merely civil and compensatory but not penal in nature.”

8.21 Applying the aforesaid reasoning, the Ld. CIT(A) deleted the said disallowance vide para 25.2.7 of the impugned order. No distinction of substance exists between the two settlements save the assertion that the 2010 verdict preceded the Pfizer settlement, an assertion which, as held above, ignores the fact that the said verdict never attained finality and stood superseded by the compromise voluntarily arrived at between the parties. There cannot be two contradictory approaches to the self-same legal issue in the same order for the same assessment year. On the parity of the reasoning adopted by the Ld. CIT(A) himself while deleting the Cephalon disallowance, the impugned disallowance also deserves to be deleted.

8.22 Furthermore, the remedy for the infringement of a patent involves a purely civil action aimed at compensating the patent holder for the loss of profit or royalty attributable to the alleged infringement. Such a payment is restitutionary and compensatory in character; it recompenses the claimant for a private commercial injury and does not partake of the character of a fine or penalty imposed. As held by the Hon’ble Supreme Court in Prakash Cotton Mills (P.) Ltd. v. CIT (1993) 201 ITR 684 (SC), whenever an impost is claimed as a deduction, the authority must examine the scheme of the relevant statute under which the amount is paid to discern whether the impost is compensatory or penal in nature, and the nomenclature attached to the payment is not conclusive; the component which is compensatory in character is allowable as a deduction. The same approach was adopted by the Hon’ble Madras High Court in CIT v. Parthasarathy [1995] 78 Taxman 470 (Mad), which applied Prakash Cotton Mills (supra) read with CIT v. Ahmedabad Cotton Mfg. Co. Ltd. [1994] 205 ITR 163 (SC) to hold that the scheme of the relevant statute must be examined in a broad spectrum analysis, irrespective of the nomenclature given to the impost by the statute, and that the component which is compensatory must be allowed. Applying that test, a payment made under a negotiated settlement to compromise a civil claim for damages in patent litigation clearly falls on the compensatory side of the line. The Hon’ble Delhi High Court in CIT v. Desiccant Rotors International (P.) Ltd. (2012) 347 ITR 32 (Del) dealt with a closely comparable situation, where an amount paid by the assessee to settle proceedings instituted in the United States alleging misappropriation of intellectual property was held allowable under section 37(1) of the Act, it being found that the payment was made to protect the business interests and reputation of the assessee and not for any purpose which was an offence or prohibited by law. The ratio of the said decision applies on all fours to the facts before us.

8.23 It is to be noted that the conclusion that Explanation 1 to section 37(1) does not extend to alleged infractions of foreign law is placed beyond doubt once the legislative history of the provision is traced. Explanation 1 was inserted in section 37(1) by the Finance (No. 2) Act, 1998 with retrospective effect from 01.04.1962, and the object of its insertion, as explained by the CBDT, was to deny deduction in respect of payments in the nature of protection money, extortion, hafta, bribes and the like, each of which constitutes an offence under the laws in force in India. Neither the text of Explanation 1 as it stood during the year under consideration nor the object of its insertion took within its sweep an amount paid under a commercial settlement of a civil dispute arising under the laws of a foreign country. The precise question came up for consideration before the coordinate bench of the Tribunal in Mylan Laboratories Ltd. v. Deputy Commissioner of Income-tax [2020] 113 taxmann.com 6/ [2020] 180 ITD 558 (Hyderabad -Trib.), a decision rendered for the very same assessment year as is before us. namely AY 2014-15. In that case, the assessee had paid an amount pursuant to a fine levied by the European Commission for alleged violation of European Union competition law, and the Revenue sought to disallow the payment by invoking Explanation 1 to section 37(1) of the Act. The coordinate bench examined the issue, including the CBDT Circular explaining the insertion of Explanation 1, the decision of the Hon’ble Delhi High Court in Desiccant Rotors International (P.) Ltd. (supra), and noticed the object of the provision in para 8.2 of its order as under:

“8.2 The CBDT Circular, explained the amendments made to the Finance Act, 1998 for the introduction of the Explanation 1 to Sec.37(1) of the Act as under:

“20.1 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. 20.2 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.

8.24 The operative conclusion of the coordinate bench is recorded in para 8.9 of the said order, which reads as under:

“8.9 Thus, from the above decisions, it is clear that what has to be disallowed under Explanation 1 to Sec.37(1) of the Act is a payment made, for contravention of laws in force in India and not of any foreign country. The laws are specific to each of the countries according to their rules and regulations and an offence in one country may not be so in another country. Therefore, we agree with the contentions of Ld. Counsel for the assessee that it is only payment made for contravention of laws in force in India that disallowance under Explanation 1 to Sec. 37(1) of the Act is to be made.”

8.25 In the present case, the out-of-court settlement, the compensation payment made thereunder and the debit of the said amount to the Profit and Loss Account all pertain to the previous year relevant to AY 2014-15, prior to the amendment made by the Finance Act, 2022. Consequently, no disallowance can be made in respect of the impugned payment by reference to the amended provision, and the only the Explanation 1 as it stood at the relevant time should be considered, which, as held above, did not extend to alleged infractions of foreign law. Thus, the Explanation 3 operates only prospectively and has no application whatsoever to the year under consideration. The entire controversy before us stands covered by the Decision of the coordinate bench of this Tribunal in DCIT v. AIA Engineering Ltd., ITA Nos. 565/Ahd/2025 and 351/Ahd/2025, vide order dated 01.10.2025. In that case also concerned a payment made in settlement of a suit for infringement of patent instituted in the United States, which the authorities below had disallowed by invoking Explanation 1 to section 37(1) of the Act. The coordinate bench held that the expression “prohibited by law”, in the context of section 37(1), takes in only an act or omission which is an offence or which is declared illegal as being against public policy, societal welfare, ethical standards or the common good, and that private or individual disputes between parties do not fall within its scope and ambit. An out-of-court settlement arrived at to close, finally and amicably, a litigated claim or counter-claim over private or civil rights relating to ownership, title or licence is accordingly outside the expression, notwithstanding that in such litigation the act or omission of the party which does not succeed may be found to be in violation of the rights of the party which does. The relevant findings of Decision of coordinate bench in DCIT vs. AIA Engineering Ltd (supra) is as under:

22. We have carefully considered the rival submissions and perused the materials on record. The central issue revolves around the disallowance of Rs. 31,11,00,000/- paid by the assessee to M/s. Magneco/Metrel, Inc. (MI) towards the settlement of a patent infringement dispute in the USA. The lower authorities disallowed the expenditure, treating it as a payment for a purpose prohibited by law, falling within the mischief of Explanation 1 to Section 37(1) of the Act. The issue is otherwise squarely covered by the decision of the Hon’ble Delhi High court in the case of CIT v. Desiccant Rotors International P Ltd. 347 ITR 32 (Delhi), wherein it has been held that where a payment is made under a settlement to avoid the expenses and uncertainty of exorbitant litigation, the payment is to be treated as compensatory and not penal in nature. Moreover, the Hon’ble Delhi High Court has also emphasized that the remedy for patent infringement, under both US and Indian law, is a civil action for damages, not a penalty. The Hon’ble High Court held that an expenditure motivated purely by commercial purpose is allowable under section 37(1) of the Act.

22.2. We also find force in the alternate contention of the Ld. AR regarding the applicability of Explanation 3 to Section 37(1) of the Act for the Assessment year under consideration, which was inserted by the Finance Act, 2022, with effect from April 1, 2022. As pointed out in Para 19 above, prior to this amendment, the expression “prohibited by law” under Explanation 1 was confined to the laws in force in India. Its scope has been extended to offshore countries by inserting explanation 3 w.e.f. 1.4.2022 but stating into to be clarificatory. It is a cardinal principle of tax law, affirmed by the Hon’ble Supreme Court in a catena of judgments including CIT v. Vatika Township (P.) Ltd. 367 ITR 466 (SC) and M.M. Aqua Technologies Ltd. v. CIT (2021) 436 ITR 582 (SC), that any amendment which widens the scope of a provision to the detriment of the assessee cannot be applied retrospectively unless the statute expressly provides for it. Explanation 3 widened the scope of disallowance to include violations of laws outside India. The Memorandum to the Finance Act, 2022, also clearly states that the amendment will take effect from April 1, 2022. Therefore, the CIT(A) was in error in applying this provision retrospectively to the assessment year 2014-15. The assessee succeeds in respect of its this alternate contention also.

23.3. In view of the detailed discussion above, we conclude that the payment of Rs. 31,11,00,000/- was a compensatory payment made out of commercial expediency to settle a civil dispute and protect the assessee’s business interests. It was not a penalty for an offense or for a purpose prohibited by law under Explanation 1 to Section 37(1). Even the Explanation 3 to Section 37(1) is not applicable to the year under consideration. Even the issue is also not covered under newly inserted clause (iv) to Explanation 3 to section 37(1) of the Act. We, therefore, find the disallowance to be unsustainable and the same is ordered to be deleted. Grounds No. 1 and 2 of the assessee’s appeal are allowed.

24. Since we have allowed the claim of the assessee under section 37 of the Act, the alternative plea of the assessee vide Ground No. 2 to treat the same as a business loss under section 28 of the Act becomes academic and is not adjudicated upon separately.

8.26 The coordinate bench held that Explanation 3, having widened the scope of the disallowance to the detriment of the assessee, cannot be applied retrospectively, and relied for that purpose upon CIT v. Vatika Township (P.) Ltd., 367 ITR 466 (SC) and M.M. Aqua Technologies Ltd. v. CIT, (2021) 436 ITR 582 (SC), as also upon the Memorandum to the Finance Act, 2022 which states in terms that the amendment takes effect from 01.04.2022. It is also relevant to refer to the Decision of ITAT Bangalore in the case of Infosys Limited vs The Joint Commissioner of Income Tax vide ITA Nos. 125 & 126/Bang/2019 dated 31.01.2023, wherein it is held as under:

133. We have heard rival submissions and perused the material on record. Admittedly, the impugned payment is towards an offence of a foreign law and not any laws in India. The Co-ordinate Bench of the Tribunal in the case of Mylan Laboratories Ltd. v. DCIT (supra) had held that the amount disallowed under Explanation 1 to section 37(1) of the I.T.Act are of those for contravention of law in force in India and not in any foreign country.

136. The ITAT Hyderabad Bench in Mylan Laboratories Ltd. v. DCIT [2020] 13 com 6 (Hyd. Trib.) has held that amounts to be disallowed under Explanation 1 to section 37(1) of the Act are for those for contravention of laws in force in India and not of any foreign country. The relevant observations of the Tribunal are as under:-

8.9 Thus, from the above decisions, it is clear that what has to be disallowed under Explanation 1 to Sec. 37(1) of the Act is a payment made, for contravention of laws in force in India and not of any foreign country The laws are specific to each of the countries according to their rules and regulations and an offence in one country may not be so in another country Therefore, we agree with the contentions of Ld. Counsel for the assessee that it is only payment made for contravention of laws in force in India that disallowance under Explanation 1 to Sec.37(1) of the Act is to be made.

135. The Hon’ble Apex Court in the case of Oxford University Press v. CIT (supra) had held that the word “India” in relation to the word “law’ is implicit The Hon’ble Supreme Court in the said case interpreted the expression any law for the time being in force’ appearing u/s 10(29) of the I.T.Act. In this context, the Hon’ble Apex Court held that though the words ‘Indian law are not used in the said section, in order to claim exemption, the authority therein has to be constituted under any law for the time being in force in “India’.

136. However, the Finance Act, 2002 has introduced a new Explanation 3 to section 37 of the 1.T.Act, which reads as follows:-“Explanation 3. For the removal of doubts, it is hereby clarified that the expression “expenditure incurred by an assessee for any purpose which is an offence or which is prohibited by law” under Explanation 1, shall include and shall be deemed to have always included the expenditure incurred by an assessee,-

i. for any purpose which is an offence under, or which is prohibited by any law for the time being in force, in India or outside India; or

ii. to provide any benefit or perquisite, in whatever form, to a person, whether or not carrying on a business or exercising a profession, and acceptance of such benefit or perquisite by such person is in violation of any law or rule or regulation or guideline, as the case may be, for the time being in force, governing the conduct of such person.

or

iii. to compound an offence under any law for the time being in force, in India or outside India.”

137. The amendment clarifies that expenses incurred towards an offence under any law in India or outside shall not allowed as a deduction. The memorandum explaining the provisions of Finance Bill, 2022 gave the following reason for the aforesaid amendment-

“7. Further, some taxpayers are seen to be claiming deduction on expenses incurred for a purpose which is an offence under foreign law or for compounding of an offence for violation of foreign law, claiming that provisions of Explanation 1 to sub­section (1) of section 37 of the Act applies only to offences which are prohibited by the domestic law of the country. In some case this view has also been accepted by the tribunal. These judgements are also against the intention of the legislation as the legislation does not say that the Explanation 1 applies only to the violation of domestic law.”

138. The memorandum explicitly says that the aforesaid amendment will have effect from 01.04.2022. The Board Circular No. 23/2022 [F. NO. 370142/48/2022-TPL] dated 03.11.2022 has also stated that the aforesaid amendment takes effect from 1st of April, 2022.

139. The Hon’ble Supreme Court of India in Sedco Forex International Drill. Inc. v. CIT [2005] 149 Taxman 352/279 ITR 310 (SC) held as follows:

“18. As was affirmed by this court in Goslino Mario [2000] 241 ITR 314, a cardinal principle of the tax law is that the law to be applied is that which is in force in the relevant assessment year unless otherwise provided expressly or by necessary implication (see also Reliance Jute and Industries Ltd. v. CIT [1979] 120 ITR 921 (SC) [1980] 1 SCC 139). An Explanation to a statutory provision may fulfil the purpose of clearing up an ambiguity in the main provision or an Explanation can add to and widen the scope of the main section. If it is in its nature clarificatory then the Explanation must be read into the main provision with effect from the time that the main provision came into force. But if it changes the law it is not presumed to be retrospective irrespective of the fact that the phrases used are “it is declared” or “for the removal of doubts”.

140. The law prior to the amendment was that expenses towards offence under domestic laws of India alone would not be allowed as a deduction under section 37. This proposition was affirmed by the Tribunal which has also been noted in the Memorandum as reproduced above. Therefore, the aforesaid amendment alters the law as it stood earlier. Therefore, as per the above decision of the Hon’ble Supreme Court, the Explanation cannot be considered retrospective in nature.

141. Relying on the above judgment of the Hon’ble Supreme Court, the Hon’ble Delhi High Court in PCIT v Era Infrastructure [2022] 141 com 289 (Delhi), held that a provision in the Act which is “for the removal of doubts cannot be presumed to be retrospective if it alters or changes the law as it stood earlier. In this case, the Hon’ble High Court dealt with the amendment to section 14A by the Finance Act, 2022 by way of insertion of an Explanation to the said section. The opening portion of the newly inserted Explanation read “For the removal of doubts…”. The High Court noted that the Memorandum of the Finance Bill, 2022 explicitly stated that the amendment made to section 14A will take effect from 1st April, 2022 and will apply in relation to the assessment year 2022-23 and subsequent assessment years. Despite noting the same, the High Court observed the following:

“8. Consequently, this Court is of the view that the amendment of section 14A, which is “for removal of doubts” cannot be presumed to be retrospective even where such language is used, if it alters or changes the law as it earlier stood.”

142. The learned DR relied on the judgment of the Hon’ble Supreme Court in Checkmate Services (P.) Ltd v CIT (2022) 448 ITR 518 (SC) to contend that the provisions of section 37(1) should be interpreted bereft the newly inserted Explanation 3 to the said section. In the said case, the Hon’ble Supreme Court interpreted the existing provision of section 36(1)(va) of the I.T. Act without considering the amendment made to it by the insertion of a new Explanation 2 to the said section, which essentially clarified the same conclusion as was decided by the Hon’ble Supreme Court in that case. Further, the learned DR had contended that the provision of section 37 read with Explanation 1 and without considering the newly inserted Explanation 3, is clear to the effect that the word ‘law’ should necessarily be associated with the word ‘India’. As discussed above, the Hon’ble Supreme Court in Oxford University case and the Tribunal in Mylan’s case (supra) have clarified the said proposition.

143. For the aforesaid reasoning and judicial pronouncements on the facts and circumstances of the case and law application, we hold that settlement amount paid to US authorities amounting to Rs. 208,93,00,000 should be allowed as deduction for the relevant assessment year. It is ordered accordingly.

The conclusion that Explanation 3 operates only prospectively is not merely a matter of the commencement clause; it follows from a settled and long line of authority. It is a cardinal principle of tax law that the law to be applied is that which is in force in the relevant assessment year, unless it is otherwise provided expressly or by necessary implication. The Hon’ble Supreme Court in Sedco Forex International Drill Inc. v. CIT, (2005) 12 SCC 717, held that an Explanation to a statutory provision may either clear up an ambiguity in the main provision or may add to and widen its scope, that where it is clarificatory it must be read into the main provision from the time the main provision came into force; but that where it changes the law, it is not presumed to be retrospective, and this is so irrespective of the fact that the phrases used are “it is declared” or “for the removal of doubts”. That proposition was reiterated by the Hon’ble Supreme Court in M.M. Aqua Technologies Ltd. v. CIT, (2021) 436 ITR 582 (SC), where it was held in terms that a provision in a taxing statute which is “for the removal of doubts” cannot be presumed to be retrospective, even where such language is employed, if it alters or changes the law as it earlier stood. The same principle was expounded by the Constitution Bench of the Hon’ble Supreme Court in CIT v. vatika Township (P.) Ltd., (2014) 367 ITR 466 (SC).

8.27 The next objection raised by the Revenue is that the payment is capital in nature because it relates to a patent and brings an enduring benefit to the assessee. We are unable to accept this approach as the assessee has not paid this amount to acquire a new patent or to build an asset-earning structure in the capital field. The payment was made to clear a commercial hindrance, protect its existing business reputation, and ensure that its highly profitable generic market in the US was not disrupted by protracted litigation. Hence, the objection of the Revenue on this count is rejected and we hold that the impugned expenditure is revenue in nature. As regards the objection that the expenditure does not pertain to the assessee, the facts reveal that the Specified Undertaking of Sun Pharma Global FZE (‘SPG FZE’) was demerged into the assessee under a scheme of arrangement sanctioned by the Hon’ble High Court of Gujarat. The appointed date of the demerger was May 1, 2013. The settlement liability was finalised and crystallised in June 2013, which clearly falls after the appointed date. It is settled law, via the apex court judgment in Marshall Sons & Co. (India) Ltd. v. ITO (1997) 223 ITR 809 (SC), that post the appointed date, all business activities, liabilities, and incoming profits of the demerged unit are deemed to be carried out for and on behalf of the resulting entity. Clause 3 and Clause 5 of the sanctioned scheme explicitly transferred all liabilities, including contingent legal claims, to the assessee. A scheme approved by a High Court carries statutory force, and the Assessing Officer cannot look behind it to disconnect a validly assumed liability. The demerger was effected pursuant to a scheme duly sanctioned by the Hon’ble High Court and was supported by legitimate business and commercial objectives. In the absence of any material to demonstrate that the transaction was a sham or lacked commercial substance, the same could not be characterised as a colourable device merely because it resulted in a tax advantage. The conclusion that the liability pertains to, and was rightly discharged by, the assessee is further fortified by the manner in which the demerger was effected. The Scheme of Demerger was sanctioned by the Hon’ble Gujarat High Court after the entire statutory process had been undergone, including approval of the scheme by the requisite majority of shareholders and creditors and notice to and scrutiny by the concerned regulatory authorities, none of whom raised any objection to the vesting of the liabilities of the Specified Undertaking in the assessee. Upon sanction, the scheme attained statutory force and the settlement obligation stood vested in the assessee by operation of law. Thereafter it was incumbent upon the assessee to honour and discharge the said obligation; the assessee had no discretion in the matter and any failure to pay would have amounted to a default of an obligation assumed under a court-sanctioned scheme. The loss is also genuine beyond doubt, having arisen out of an out-of-court settlement with arother pharmaceutical multinational of international standing, negotiated at arm’s length between adversarial litigants.

8.28 In the assessee’s own case for AY 2008-09, the coordinate bench of this Tribunal in ITA Nos. 3297 & 3420/Ahd/2014, while dealing with the transfer pricing addition relating to the sale of Pantoprazole, considered and rejected the Revenue’s allegation of tax evasion through the group structure, relying upon the decision of the Hon’ble Supreme Court in Vodafone International Holdings B.V. v. Union of India [2012] 341 ITR 1, and observed, as reproduced in the impugned order itself, as under:

“82. A though full consideration of the aforementioned decision of the Hon’ble Supreme Court would show that even the Apex court has recognized that multinationals and multi entities ground company constitute subsidiaries in furtherance to their objects and to carry on their business smoothly in a competitive world. Moreover no person would arrange its affairs in such a manner which would culminate into huge losses to the extent of USD 506 millions as was suffered by the assessee group in this transaction.”

8.29 The aforesaid observation of the coordinate bench, rendered in the context of the very same Pantoprazole litigation risk, proceeds on the footing that the group in fact suffered the loss of USD 506 million in this transaction; the genuineness of the loss therefore stands judicially recognised. The learned CIT(A) has, in para 20.2.10 of the impugned order, sought to spell out a contradiction from the assessee’s stand in AY 2008-09 that the IPR/ANDA of Pantoprazole and the risks attendant thereto vested in SPG BVI. The position in the two years is thus not contradictory but consecutive: the risk which belonged to SPG BVI until the demerger devolved upon the assessee under the court-sanctioned scheme, and it is in that capacity that the assessee has borne and claimed the expenditure.

8.30 We are also unable to accept the objection of the authorities below that the expenditure lacks nexus with the business of the assessee. It is not in dispute that the profits arising from the sale of goods by the assessee to SPG FZE had been offered to tax by the assessee in the earlier years, and that the transactions between the assessee and the UAE entity were at all times subject to tax in India. The Revenue, having brought to tax the profits arising out of the very same business arrangement with the UAE entity, cannot be permitted to turn around and disown the corresponding liability arising out of that very business when it crystallised. The Revenue cannot approbate and reprobate; having accepted and taxed the gains of the arrangement, it must also accept the liabilities associated with such arrangement.

8.31 In view of the above-stated facts and settled legal positions, we find that the out-of-court settlement expenditure of Rs. 602,39,80,000/- was incurred genuinely out of commercial expediency, pertains directly to the assessee’s business, is revenue in character, and is completely outside the restrictive bars of Explanation 1 to Section 37(1).

The ground of appeal raised by the assessee on this issue is allowed.

Ground No.4 – Addition on compensation paid in pursuance of out of Court settlement with Pfiser Inc. u/s 115JB

9. Since the matter stands adjudicated at Ground No. 3, the Ground No. 4 on the issue of Section 115JB becomes infructuous and hence not adjudicated.

Ground Nos. 5 & 6 – Interest on Pfizer settlement (Normal provisions & MAT)

10. The brief facts of the case concerning this issue are similar to the ground no. 3 relating to the out-of-court patent litigation settlement with Pfizer Inc. During the previous year relevant to the assessment year under consideration, the assessee incurred Rs. 15,81,50,414/- as interest on the financing was obtained from Standard Chartered Bank and claimed it as a business deduction under Section 36(1)(iii) of the Act.

10.1 Interest being consequential to the issue raised at Ground No.3, the appeal of the assessee on this ground is liable to be allowed. Since the matter stands adjudicated at Ground No. 5, the Ground No. 6 on the issue of Section 115JB becomes infructuous and hence not adjudicated.

Ground No. 7 – Software expenditure – Rs.12.81 Crores.

11. The Ld. CIT(A) treated the software expenditure capital in nature. By this time, the entire expenditure has already been claimed/ allowed depreciation, we decline to interfere with the order of the Ld. CIT(A) on this issue.

The appeal of the assessee on this ground is dismissed. Ground No. 8 – Business promotion expenses – Rs.26,08,155/-

12. The Assessing Officer made addition of Rs.52,16,310/- on account of ineligible business promotion expenditure, which the Ld. CIT(A) restricted to 50%, i.e. Rs.26,08,155/-. This disallowance was on account of gifts distributed as part of business promotion activities. It was submitted that the assessee is engaged in the business of manufacturing, trading and export of pharmaceutical products and operates in a highly competitive business environment. It was submitted that the expenditure was incurred as part of business promotion initiatives undertaken for incentivizing and motivating customers, distributors, vendors, employees, consultants and other business partners.

12.1 In our considered view, once the expenditure is shown to have been incurred in connection with the business activities of the assessee and the genuineness of the expenditure itself is not disproved, an ad hoc disallowance of 50% merely on the ground that complete particulars of recipients were not furnished cannot be sustained. Such disallowance is not supported by any cogent material and rests largely on surmises and conjectures. We agree in principle with the contentions of the assessee and accordingly direct the Assessing Officer to delete the disallowance sustained by the Ld. CIT(A) and allow the entire amount of expenditure incurred by the assessee after due verification of the details of expenditures submitted by the assessee. This ground is thus allowed for statistical purposes.

Ground of appeal No. 8 raised by the assessee on this issue is allowed for statistical purposes.

Ground No. 10 – Foreign tax credit/deduction

13. This issue is remanded to Assessing Officer for allowing after due verification

Ground No. 11 – Education cess

14. Not pressed, hence dismissed.

Revenue Appeal

Now we take-up Revenue’s Appeal.

Ground No. 1 – TP adjustment on interest on loans

15. This issue stands covered by the order of the Tribunal in assessee’s own case for AY 2008-09 & 2009-10 in ITA No. 3297/Ahd/2014 and ITA No.1663/Ahd/2016. Since the Ld. CIT(A) relied on the order of the Tribunal, in the absence of any change in the factual matrix of the case and legal proposition, we affirm the order of the Ld. CIT(A).

Ground No. 2 – TP adjustment on sales

16. This issue also stands covered by the order of the Tribunal in assessee’s own case for AY 2008-09 & 2009-10 in ITA No. 3297/Ahd/2014 and ITA No.1663/Ahd/2016. Since the Ld. CIT(A) relied on the order of the Tribunal, in the absence of any change in the factual matrix of the case and legal proposition, we affirm the order of the Ld. CIT(A).

Ground Nos. 4, 5, & 6 – Weighed deduction

17. This issue also stands covered by the order of the Tribunal in assessee’s own case for AY 2009-10 in ITA No.1663/Ahd/2016. Since the Ld. CIT(A) relied on the order of the Tribunal, in the absence of any change in the factual matrix of the case and legal proposition, we affirm the order of the Ld. CIT(A).

Ground Nos. 12 – Weighted deduction

18. This issue also stands covered by the order of the Tribunal in assessee’s own case for AY 2010-11 in ITA No.1390/Ahd/2016 and the same has been confirmed by the Hon’ble Gujarat High Court in Tax Appeal No. 541 of 2017. Since the Ld. CIT(A) relied on the order of the Tribunal, in the absence of any change in the factual matrix of the case and legal proposition, we affirm the order of the Ld. CIT(A).

Ground No. 7 – Wealth Tax Provision made u/s 115JB of the Act.

19. This issue also stands covered by the order of the Tribunal in assessee’s own case for AY 2009-10 in ITA No.1663/Ahd/2016. Since the Ld. CIT(A) relied on the order of the Tribunal, in the absence of any change in the factual matrix of the case and legal proposition, we affirm the order of the Ld. CIT(A).

Ground Nos. 8 & 9 – Disallowance u/s 14A of the Act.

20. Dealt above in this order at Ground Nos. 2 of the assessee’s appeal.

Ground No. 10 & 11 – R&D Expenditure

21. This issue also stands covered by the order of the Tribunal in assessee’s own case for AY 2009-10 in ITA No.1663/Ahd/2016. Since the Ld. CIT(A) relied on the order of the Tribunal, in the absence of any change in the factual matrix of the case and legal proposition, we affirm the order of the Ld. CIT(A).

Ground No. 13 – Out of Court Settlement of Cephalon

22. This issue also stands covered by the order of the Tribunal in assessee’s own case for AY 2012-13 in ITA No.360/Ahd/2017. Since the Ld. CIT(A) relied on the order of the Tribunal, in the absence of any change in the factual matrix of the case and legal proposition, we affirm the order of the Ld. CIT(A).

Ground No. 14 – Gifts expenses

23. This issue is already dealt with in ground No. 8 of the assessee’s appeal.

In the result, the appeal of the Revenue is dismissed.

24. In the combined result, the appeal of the assessee is partly allowed, while the appeal of the Revenue is dismissed.

The order is pronounced in the open Court on 31.07.2026