Analysis of expenses allowable under section 37 of Income Tax Act, 1961

CA Susheel Kumar Gupta

Section 30 to 36 lists out certain deductions, which are allowed while computing the profit and gains from business or profession. Deductions under these sections are allowed subject to certain conditions mentioned in those section. Further, these sections do not list down all types of expenses. For these expenses, deduction can be claimed under section 37. Therefore, section 37 is considered residuary section for claiming deductions. 

Section 37 reads as under:

1) 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”. 

Explanation 1.—For the removal of doubts, it is hereby declared that any expenditure incurred by an assessee for any purpose which is an offence or which is prohibited by law shall not be deemed to have been incurred for the purpose of business or profession and no deduction or allowance shall be made in respect of such expenditure.

Explanation 2.—For the removal of doubts, it is hereby declared that for the purposes of sub-section (1), any expenditure incurred by an assessee on the activities relating to corporate social responsibility referred to in section 135 of the Companies Act, 2013 (18 of 2013) shall not be deemed to be an expenditure incurred by the assessee for the purposes of the business or profession.

2) ***********

2B)  Notwithstanding anything contained in sub-section (1), no allowance shall be made in respect of expenditure incurred by an assessee on advertisement in any souvenir, brochure, tract, pamphlet or the like published by a political party. 

Conditions provided in section 37 can be summarized as below:

i) Deduction is allowed for expenditure;

ii) Such expenditure should not be covered under sections 30 to 36;

iii) Expenditure incurred should not be of capital nature;

iv) Expenditure incurred should not be of personal nature;

v) The expenditure should have been incurred wholly or exclusively for the purpose of the business or profession;

vi) The expenditure should be incurred during the previous year;

vii) Expenditure should not have been incurred for an offence or which is prohibited by law;

viii) Expenditure incurred for Corporate Social Responsibility are not allowed; and

ix) expenditure incurred by an assessee on advertisement in any souvenir, brochure, tract, pamphlet or the like published by a political party 

Analysis of terms used in section 37:

The term expenditure has not been defined in the Act. Expenditure can be revenue in nature or capital in nature. In common parlance, revenue expenditure is incurred for carrying out day to day activities of a business, does not brings into existence any new assets, does not enhances the capacity/usability of the assets and the benefit derived from the expenditure are not of enduring nature. 

Expenses not deductible under sections 30 to 36 should alone be considered:

Expenditures allowed under section 37 should not be deductible under section 30 to 36. It is quite possible that with regard to some expenses there may be overlapping between sections 30 to 36 and section 37.  In such cases, if the expenses are deductible under sections 30 to 36, then section 37 is not to be resorted to. But if the said expenses are not deductible under sections 30 to 36 and the conditions prescribed under section 37 are satisfied, then the said expenses are required to be deducted while computing the income unless there is a specific prohibition. Khimji Visram and Sons (Gujarat) (P.) Ltd. v. CIT [1994] 209 ITR 993 (Gujrat).

Wholly and exclusively for the purposes of the business or profession:

Expression ‘wholly and exclusively’ does not denote ‘necessarily’. The word ‘wholly’ refers to quantum of expenditure. The word ‘exclusively’ refers to motive, objective or purpose with which the particular expense has been incurred. Ordinarily, it is for the assessee to decide whether any expenditure should be incurred in the course of its or his business. Such expenses can be incurred voluntarily and without necessity. If it is incurred for promoting the business and to earn the profits, the assessee can claim the deduction. (Commissioner of Income Tax vs Rajasthan Spg. And Wvg. Mills Ltd. (2005) 198 CTR Raj 96)

The expression “for the purpose of the business” is essentially wider than the expression “for the purpose of earning profits”. It covers not only the running of the business or its administration but also measures for the Preservation of the business and protection of its assets and property. Commissioner of Income Tax, West V. Birla Cotton Spinning & Weaving (1972 AIR 19, 1972 SCR (1) 283)

Analysis of allowability of certain expenses:

1) Section 37 was amended in 1998 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. After this amendment, the deductions claimed towards payments on account of protection money, extortion, hafta, bribes etc. as business expenditure are not allowed. 

2) Liability in praesenti and liability de futuro: 

There is no doubt that expenditures incurred and paid during the year are allowable expenses. At year end, there are expenses which are incurred but not paid and in some cases provisions are made while following the accrual method of accounting consistently adopted by the assessee.

It is trite law that expenses which are not contingent upon happening or non-happening of future event are allowable. 

In Madras Industrial Investment Corpn. Ltd. v. CIT [1997] 91 Taxman 340 (SC), it was held that ‘Expenditure’ is not necessarily confined to the money which has been actually paid out. It covers a liability which has accrued or which has been incurred although it may have to be discharged at a future date. However, a contingent liability which may have to be discharged in future cannot be considered as expenditure.

What constitute provisions and its allowability was discussed by Hon’ble Supreme Court in Rotork Controls India (P.) Ltd. V. Commissioner of Income Tax, Chennai ([2009] 180 Taxman 422 (SC)). It was held that: 

A provision is a liability which can be measured only by using a substantial degree of estimation. A provision is recognized when:

(a) an enterprise has a present obligation as a result of a past event;

(b) it is probable that an outflow of resources will be required to settle the obligation; and

(c) a reliable estimate can be made of the amount of the obligation. If these conditions are not met, no provision can be recognized.

In Calcutta Co. Limited v. Commissioner of Income Tax [1959] 37 ITR 1 (SC), it was held that the difficulty in the estimation thereof would not convert an accrued liability into a conditional one, because it is always open to the Income-tax authorities concerned to arrive at a proper estimate thereof having regard to all the circumstances of the case.

3) Provision for Leave Encashment: Provision made for meeting the liability under the leave encashment scheme proportionate with the entitlement earned by employees of the company would be allowable as deduction out of the gross receipts for the accounting year during which the provision was made for the liability. The liability was not a contingent liability. Bharat Earth Movers Commissioner of Income-tax [2000] 112 Taxman 61 (SC).  

4) Foreign Exchange Loss: Where assessee had debited to its profit and loss account certain unrealized loss due to foreign exchange fluctuation in foreign currency transaction on revenue items, on the last date of the accounting year, it is an allowable expenses. Commissioner of Income-tax, Delhi Woodward Governor India (P.) Ltd. [2009] 179 Taxman 326 (SC) 

5) Provision for Warranty: Provision for warranty on products sold is allowable under section provided the data is systematically maintained by the assessee. Rotork Controls India (P.) Ltd. V. Commissioner of Income Tax, Chennai ([2009] 180 Taxman 422 (SC)).

6) Pay Revision: Provision made by assessee PSU for revision of pay of its employees as per recommendation of committee appointed by Government, is an allowable business expenditure under section 37(1). Housing & Urban Development Corporation Ltd. v. Additional Commissioner of Income-tax Range – 12, New Delhi [2020] 115 taxmann.com 166 (Delhi).

7) Club membership fee for employees incurred by the assessee is a business expense and liable to be deducted under Section 37(1) of the Income Tax Act, 1961 Commissioner of Income Tax United Glass Mfg. Co. Ltd. [2012] 28 taxmann.com 429 (SC).

8) Advertisement on neon signs and glow sign boards: By putting the neon signs and glow signs, no asset of permanent nature is created. Simply because shelf-life of such neon signs is more, may not be of any significance once we keep in mind the important aspect on which the expenditure is incurred i.e. on advertising and marketing. Commissioner of Income-tax-V Pepsico India Holdings (P.) Ltd [2012] 21 taxmann.com 165 (Delhi).

9) Non-compete fees is an allowable business expenditure of revenue expenditure. Income Tax Officer Smartchem Technologies Ltd. [2019] 103 taxmann.com 359 (Gujarat) (Matter pending at Supreme Court). 

10) Freebies to Medical Practitioners: Circular No. 5/2012 [F. NO. 225/142/2012-ITA.II], dated 1-8-2012 read with section 37(1) disallow expenditure incurred on Gifts, Travel facility, Hospitality, Cash or monetary grant from the pharmaceutical and allied health sector Industries to medical practitioner and their professional associations. Validity of the circular has been upheld by Hon’ble Himachal Pradesh High Court in Confederation of Indian Pharmaceutical Industry (SSI) V Central Board of Direct Taxes and Union of India 2013 (7) TMI 387.

11) Keyman Insurance Policy: Premium of keyman insurance policy taken on the life of partner in an allowable business expenditure.Circular No. 38/2016 [F. NO.279/MISC./140/2015-ITJ], dated 22-11-2016.

12) Interest on delayed payments to Small Scale and Ancillary Industrial undertakings under the Small Scale and Ancillary Industrial Undertaking Act, 1993 (32 of 1993) is not an allowable business expenditure. Instruction No. 4/2003, dated 29-5-2003.

13) Foreign Travel Expenses of relatives of directors: Expenses incurred must also stand to the test of commercial expediency. Unless and until, it is shown that it is customary for the directors or the employees to attend such business meetings or so with wives and minor children, foreign travel expenses in respect of the wives, minor children and others fail the test of commercial expediency. Therefore such expenses are not allowable. Emmsons International Ltd. Assistant Commissioner of Income Tax [2019] 112 taxmann.com 205 (Delhi – Trib.). 

14) Education expenses of director: Overseas education expenses of the newly inducted director, without any relevant education, qualification or experience and in the absence of nexus between higher education expense and business of assessee are not allowable. JBM Industries Ltd. Commissioner of Income Tax, New Delhi [2019] 111 taxmann.com 99 (Delhi). 

15) Contributions by professionals to associations: Contributions paid by assessee firm to International Fiscal Association, in which one of its partners was a member of Executive Body, towards constructing a meeting hall in its name to hold meetings, conferences and publish material for creating greater awareness of assessee’s activities, was an expenditure incurred for purposes of profession and thus was an allowable expenditure. Commissioner of Income-tax-III Vaish Associates [2015] 63 taxmann.com 90 (Delhi). 

16) Enhanced License Fees: Railway demanded enhanced license fees for land used by assessee. Assessee contested the enhanced fees and paid only original license fees. However, in books enhanced license fees was charged to profit and loss account following accrual method of accounting. Assessee is entitled to claim enhanced license fees since liability to pay enhanced license fee would arise in year in which demand was made or to which it related irrespective of when enhanced fee was actually paid by assessee. Jagdish Prasad Gupta Commissioner of Income-tax [2017] 85 taxmann.com 105 (Delhi). Department SLP dismissed by Hon’ble Supreme Court. 

17) Contribution to State Government: Where assessee made contribution to State Government towards construction of a bridge which would be used by assessee for transportation of its goods. Since bridge was not owned by assessee and assessee, by spending for construction of new bridge, had not acquired any property or right of permanent character, amount paid by assessee was to be treated as revenue expenditure and allowable under section 37(1). [2019] 108 taxmann.com 116 (Bombay).

18) RoC fee for increase of authorized share capital: Since fee paid for increasing the authorized share capital is directly related to the expansion of the capital base of the company it is capital expenditure and therefore not allowable expenditure. Brooke Bond India Ltd. v. Commissioner of Income-tax [1997] 91 Taxman 26 (SC)

19) RoC fee for increase of authorized share capital for issuance of bonus shares: Issuance of bonus shares does not result in any inflow of fresh funds or increase in the capital employed. Issuance of bonus shares by capitalization of reserves is merely a reallocation of company’s fund and it cannot be held that the company has acquired a benefit or advantage of enduring nature. Thus, the expenditure incurred in connection with issuance of bonus shares is a revenue expenditure. Commissioner of Income-tax, Mumbai v. General Insurance Corporation [2006] 156 Taxman 96 (SC). 

20) Damages paid to customers: Damages in the nature of the compensation paid to customers for late supply of the goods are allowable expenditure are allowable expenditure. However, where payment is made for the breach of the agreement or for refusal to carry out the contractual agreement, it is not allowable expenditure. Mahalakshmi Sugar Mills Co. v. Commissioner of Income-tax [1980] 123 ITR 429 (SC).