Advocate Akhilesh Kumar Sah
A LIGHT AT THE END OF THE TUNNEL VIS-À-VIS EXPLANATION-1 TO SECTION 37
In view of the Explanation-1 inserted by the Finance (No.2) Act, 1998 to the section 37(1) of the Income Tax Act, 1961(herein referred to as ‘the Act’), with retrospective effect from 1-4-1962, 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.
Therefore, in view of above retrospective amendment, illegal expenses of a legal business cannot be allowed as a deduction under section 37(1) of the Act.
Recently, in Shyam SEL Ltd. vs. DCIT, CC XIII, Kolkata [ITA No. 850 of 2008, decided on 19.07.2016] a different situation arose, the question before Kolkata High Court was whether the expenditure of a sum of Rs.12,50,000/- incurred by the assessee consequent to invocation of the bank guarantee furnished in favour of the West Bengal Pollution Control Board was an allowable expenditure.
The Assessing Officer(AO) had disallowed the expenditure for the following reasons:
In the course of assessment proceedings the assessee was asked to explain the nature of penalty charges debited in the Profit & Loss account. The amount of Rs.12,50,000/- was on account of penalty charges paid to Pollution Control Board for non installation of pollution control equipment at the factory premises. The assessee claimed that this amount was deducted by Pollution Control Authorities on account of failure of the assessee for installation of pollution control equipment. The submission of the assessee was pursued and a sum of Rs.12,50,000/- on account of penalty charges claimed in the Profit & Loss account for non performance of statutory obligation of Pollution Control Board was disallowed. The said amount had already been disallowed in earlier Asst. Year also.
The CIT(A), however, reversed the order of the AO for the following reasons:-
“On a perusal of the relevant records it is seen that the payment for installation of pollution control equipment has been made in response to the direction of the Senior Law Officer of W. B. Pollution Control Board failing which the Board had decided to issue a Closure Order with disconnection of electricity without any further reference. In view of such facts, it is apparent that the payment was not exactly made in way of penalty but in response to the order of the government.”
The learned ITAT, however, reversed the order of the CIT(A) for the following reasons:-
“It is very clear that the amount of Rs.12,50,000/- was levied as penalty by the West Bengal Pollution Control Board because the assessee had failed to comply with the order of the Pollution Control Board to fulfill its statutory obligation of installing the pollution control equipment before the prescribed time limit. The submission of the assessee that it could not fulfill its statutory obligation because of lack of funds and there was no intention to violate the statutory provisions or that the pollution control equipment was finally installed, are of no relevance to the issue because the State Govt. had levied the penalty after considering all the relevant facts and circumstances of the case and what is relevant for us is to decide whether the payment was in the nature of statutory penalty “ imposed by way of punishment for breach or infraction of the law” or compensation in exercise of an option, as held by the Hon’ble Supreme Court in the case of Ahmedabad Cotton Mfg. Co. Ltd. [CIT vs. Ahmedabad Cotton Mfg. Co. Ltd. and Ors. (1993) 115 CTR (SC) 401]. Since in this case neither any option was given to the assessee nor there was any commercial expediency involved and the penalty was levied for violation of the statute, the amount of Rs.12,50,000/- had been rightly disallowed as inadmissible expenditure and added back to the income of assessee by the A.O. We, therefore, reverse the order of the ld. CIT(A) on this issue and restore the order of the ld. A.O. This ground of appeal of the revenue is allowed.”
The learned advocate appearing for the appellant/ assessee submitted that payment of a sum of Rs.12,50,000/- was by way of compensation because the assessee had failed to install the requisite devise within the prescribed time, as per the performance guarantee furnished by him.
In support of his submission that the amount recovered from the assessee was in the nature of compensation and not penalty, he submitted that being punitive is the essence of ‘penalty’. It is in clear contradistinction to ‘remedial’ and/or ‘compensatory’. ‘Penalty’ essentially has to be for result of a default and imposed by way of punishment. On the contrary, ‘compensatory’ may be resulting from a default for the advantage already taken by that person and is intended to remedy or compensate the consequences of the wrong done.
The learned advocate, appearing for the Revenue drew attention to the judgment of the learned Tribunal and reiterated that the payment made by the assessee was in the nature of a penalty and, therefore, should not be deductible under section 37 of the Act.
After considering the rival submissions Hon’ble judges of the Kolkata High Court observed that the payment of the sum of Rs.12,50,000/- would not be deductible if the same had been made for the purpose of achieving an illegal object or for an illegal purpose. Such payment is opposed to public policy which presumably is the reason why the same is not deductible. The payment in this case was for the purpose of compensating the damage to the environment and this compensation has been recovered on the “polluter pays principle” adopted by the Organization for Economic Cooperation and Development. It is nobody’s case that the business pursued by the assessee was illegal. The compensation was paid because the assessee had failed to install the pollution control device within the time prescribed. Therefore, payment of the sum of Rs.12,50,000/- is not hit by Explanation-1 to Section 37 of the Act. The Hon’ble judges of the Kolkata High Court by setting aside the orders of ITAT held that payment was undoubtedly for the purpose of business or was in consequence of business carried on by the assessee and is thus covered by section 37 of the Act.
Expenses incurred not for the purpose of achieving an illegal object and not for an illegal purpose, not violating the statutory provisions or public policy are out of the domain of the Explanation-1 to Section 37 of the Act.