Section 37(1) of the Income Tax Act – Disallowance for Freebies to Doctors as the same is an Offence & Prohibited by Law

If an assessee during the course of business & profession incurs certain expenditure, which is an offence or which is prohibited by law, the said expenditure shall be disallowed while computing his income.

It would be trite to refer to Section 37(1) of the Income Tax Act which reads as under:

“37. (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.”

It is apposite  to state that the said Explanation to sub-section (1) was inserted by the Finance (No. 2) Act, 1998, with retrospective effect from April 1, 1962. The purpose for incorporation of this Explanation had been explained by the Central Board of Direct Taxes in Circular No. 772, dated December 23, 1998 ([1999] 235 ITR (St.) 35, 53) as under:

“20. Disallowance of illegal expenses.

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.”

It is relevant that the word “offence” is not defined in the Income Tax Act. However, it is defined in Section 3(38) of the General Clauses Act, 1887 as follows:  “offence” shall mean any act or omission made punishable by any law for the time being in force;”

Thus, according to the Income Tax Act, any expenditure incurred by an assessee for any purpose which is an offence or which is prohibited by any law shall not be deemed to have been incurred for the purpose of the business or profession and no allowance or deduction shall be made in respect of such expenditure. This implies that any unlawful expenditure is not allowable as deduction.For example, a transporter incurs expenditure towards payment of bribe to traffic police, the same shall not be an admissible expenditure as the said payment is prohibited by the law of the land. For the same reasoning protection money, extortion, hafta, bribes, etc. would not be admissible as business expenditure.

Since the explanation and the said circular of 1998 was not exhaustive,  another circular being Circular No. 5/2012 dated 1-8-2012 was issued by CBDT in respect of inadmissibility of expenses particularly incurred in providing freebees to Medical Practitioner by pharmaceutical and allied health sector Industry. The said circular reads as under:

“1. It has been brought to the notice of the Board that some pharmaceutical and allied health sector Industries are providing freebees (freebies) to medical practitioners and their professional associations in violation of the regulations issued by Medical Council of India (the ‘Council’) which is a regulatory body constituted under the Medical Council Act, 1956.

2. The council in exercise of its statutory powers amended the Indian Medical Council (Professional Conduct, Etiquette and Ethics) Regulations, 2002 (the regulations) on 10-12-2009 imposing a prohibition on the medical practitioner and their professional associations from taking any Gift, Travel facility, Hospitality, Cash or monetary grant from the pharmaceutical and allied health sector Industries.

3. Section 37(1) of Income Tax Act provides for deduction of any revenue expenditure (other than those failing under sections 30 to 36) from the business Income if such expense is laid out/expended wholly or exclusively for the purpose of business or profession. However, the explanation appended to this sub-section denies claim of any such expense, if the same has been incurred for a purpose which is either an offence or prohibited by law.

Thus, the claim of any expense incurred in providing above mentioned or similar freebees in violation of the provisions of Indian Medical Council (Professional Conduct, Etiquette and Ethics) Regulations, 2002 shall be inadmissible under section 37(1) of the Income Tax Act being an expense prohibited by the law. This disallowance shall be made in the hands of such pharmaceutical or allied health sector Industries or other assessee which has provided aforesaid freebees and claimed it as a deductable expense in its accounts against income.

4. It is also clarified that the sum equivalent to value of freebees enjoyed by the aforesaid medical practitioner or professional associations is also taxable as business income or income from other sources as the case may be depending on the facts of each case. The Assessing Officers of such medical practitioner or professional associations should examine the same and take an appropriate action.

This may be brought to the notice of all the officers of the charge for necessary action.”

In order to appreciate the said Circular it will be relevant to refer to Indian Medical Council (Professional Conduct, Etiquette and Ethics) Regulations, 2002 in this regard which state as under:

6.8. Code of conduct for doctors in their relationship with pharmaceutical and allied health sector industry.

6.8.1 In dealing with Pharmaceutical and allied health sector industry, a medical practitioner shall follow and adhere to the stipulations given below:—

(a) Gifts: A medical practitioner shall not receive any gift from any pharmaceutical or allied health care industry and their sales people or representatives.

(b) Travel facilities: A medical practitioner shall not accept any travel Facility inside the country or outside, including rail, road, air, ship, cruise tickets, paid vacation, etc. from any pharmaceutical or allied healthcare industry or their representatives for self and family members for vacation or for attending conferences, seminars, workshops, CME Programme, etc. as a delegate.]

(c) Hospitality: A medical practitioner shall not accept individually any hospitality like hotel accommodation for self and family members under any pretext.

(d) Cash or monetary grants: A medical practitioner shall not receive any cash or monetary grants from any pharmaceutical and allied healthcare industry for individual purpose in individual capacity under any pretext.”

There was a lot of confusion towards disallowance of expenditure incurred in providing  freebees in violation of the regulations of Indian Medical Council until it was finally decided by the Apex Court in the case of Apex Laboratories Pvt Ltd (2022) 442 ITR 1 (SC) wherein the Apex Court considered the issue as to why the expenditure of Rs. 4,72,91,159/- incurred towards gifting freebies such as hospitality, conference fees, gold coins, LCD TVs, fridges, laptops, etc. to medical practitioners for creating awareness about the health supplement ‘Zincovit’, should not be added back to the total income of the said Company.

The Apex Court dealt with the issue and held thus:

” 27. It is also a settled principle of law that no court will lend its aid to a party that roots its cause of action in an immoral or illegal act (ex dolo malo non oritur action) meaning that none should be allowed to profit from any wrongdoing coupled with the fact that statutory regimes should be coherent and not self- defeating. Doctors and pharmacists being complementary and supplementary to each other in the medical profession, a comprehensive view must be adopted to regulate their conduct in view of the contemporary statutory regimes and regulations. Therefore, denial of the tax benefit cannot be construed as penalizing the assessee pharmaceutical company. Only its participation in what is plainly an action prohibited by law, precludes the assessee from claiming it as a deductible expenditure.

28. This Court also notices that medical practitioners have a quasi-fiduciary relationship with their patients. A doctor’s prescription is considered the final word on the medication to be availed by the patient, even if the cost of such medication is unaffordable or barely within the economic reach of the patient – such is the level of trust reposed in doctors. Therefore, it is a matter of great public importance and concern, when it is demonstrated that a doctor’s prescription can be manipulated, and driven by the motive to avail the freebies offered to them by pharmaceutical companies, ranging from gifts such as gold coins, fridges and LCD TVs to funding international trips for vacations or to attend medical conferences. These freebies are technically not ‘free’ – the cost of supplying such freebies is usually factored into the drug, driving prices up, thus creating a perpetual publicly injurious cycle…. “

29. The impugned judgment, along with the judgments of Punjab & Haryana High Court (Kap Scan) and Himachal Pradesh High Court (Confederation) (supra) have correctly addressed the important public policy issue on the subject of allowance of benefit for supply of freebies. The impugned judgment’s reasoning is quoted as follows:

“A perusal of the decision of Co-ordinate Bench of this Tribunal in the assessee’s own case as also the decision of the Hon’ble Himachal Pradesh High Court clearly shows that the basic intention of the decision was that the receiving of the gifts/freebies by Professionals is against public policy as also against the law in so far as the amendment by the Medical Council Act, 1956 to the Indian Medical Council (Professional Conduct, Etiquette and Ethics) Regulations, 2002, once receiving of such gifts have been held to be unethical obviously the corollary to this would also be unethical, being giving of such gifts or doing such acts to induce such Doctors and Medical Professionals to violate the Medical Council Act, 1956.” (emphasis supplied)

Freebies to Doctors not allowable as same is an Offence & Prohibited by Law

While the Apex Court approved the dictum of the Punjab & Haryana High Court in Commissioner of Income-Tax v. Kap Scan and Diagnostic Centre P. Ltd.(2012) 344 ITR 476 (P&H HC) and Himachal Pradesh High Court in Confederation of Indian Pharmaceutical Industry (SSI) v. Central Board of Direct Taxes (2013) 353 ITR 388 (HP HC), it distinguished/overruled a number of earlier judgments of the High Courts, which ran contra to the dictum of Apex Laboratories (supra).

In Commissioner of Income-Tax v. Kap Scan and Diagnostic Centre P. Ltd.(supra), the Punjab & Haryana High Court held payment of commission to doctors as against public policy and held thus:

“18. If demanding of such commission was bad, paying it was equally bad. Both were privies to a wrong. Therefore, such commission paid to private doctors was opposed to public policy and should be discouraged. The payment of commission by the assessee for referring patients to it cannot by any stretch of imagination be accepted to be legal or as per public policy. Undoubtedly, it is not a fair practice and has to be termed as against the public policy.

19. Further, section 23 of the Contract Act equates an agreement or contract opposed to public policy, with an agreement or contract forbidden by law. section 23 of the Contract Act reads thus:

“23. What consideration and objects are lawful, and what not. —The consideration or object of an agreement is lawful, unless—

it is forbidden by law; or

is of such a nature that, if permitted, it would defeat the provisions of any law; or

is fraudulent; or

involves or implies, injury to the person or property of another; or the court regards it as immoral, or opposed to public policy.

In each of these cases, the consideration or object of an agreement is said to be unlawful. Every agreement of which the object or consideration is unlawful is void.

…..

23. Thus, the commission paid to private doctors for referring patients for diagnosis could not be allowed as a business expenditure. The amount which can be allowed as business expenditure has to be legitimate and not unlawful and against public policy. Consequently, the order passed by the Commissioner of Income-tax (Appeals) and the Tribunal whereby deduction had been allowed to the assessee cannot be sustained.”

In the case of Confederation of Indian Pharmaceutical Industry (SSI) v. Central Board of Direct Taxes (supra) held that the impugned circular 5/2012 dated 1-8-2012 is in consonance with Section 37(1) of the Income Tax Act. The Court observed thus:

“4. Shri Vishal Mohan, advocate, on behalf of the petitioner, contends that the circular goes beyond the section itself. We are not in agreement with this submission. The Explanation to section 37(1) makes it clear that any expenditure incurred by an assessee for any purpose which is prohibited by law shall not be deemed to have been incurred for the purpose of business or profession. The sum and substance of the circular is also the same…. “

It is relevant to refer to Gwalior Road Lines v. CIT, [1998] 234 ITR 230 (MP) wherein the Court dealt with the amount illegally paid to the police authorities for running their business. The Court categorically held that after insertion of the Explanation’ to section 37(1) by the Finance Act, 1998, with effect from April 1, 1962, the assessee could not claim such payment as. expended for commercial exigency and, therefore, the same was not an allowable, deduction.

Similarly, the Allahabad High Court in Pt. Vishwanath Sharmas case, [2009] 316 ITR 419 (All) while considering the issue relating to commission paid to Government doctors for prescribing the assessee’s medicines to patients held it to be contravening public policy and was therefore an inadmissible expenditure.

It would be worthwhile to refer to a recent judgment in the case of Peerless Hospitex Hospital & Research Centre Pvt Ltd Vs PCIT (2022) 137 taxmann.com 359 (Cal) wherein the Calcutta High Court dealt specifically dealt with disallowance of referral fee paid to doctors ‟for referring patients for treatment in its hospital as business expenditure under Section 37 (1) of the Income Tax Act, 1961”.

(ix) Though under the aforesaid Regulations of Indian Medical Council Regulation, 2002, there are provisions for prohibition and punishing those doctors or medical practitioners who accept freebies, commission, bonus etc. from hospitals or other allied health care industry for referring patients to them but there are no similar regulations or provisions for prohibiting and penalising or punishing these hospitals, nursing homes or diagnostic centres or allied health care industry for curbing this act of indulgence or participation by them in such prohibited and penalizing offence resulting addition of these unnecessary expenses to the bill of the patients for their treatment and are recovered from them making the medical treatment costlier for the poor and middle class patients. This Court expects that the Central Government and the State Government will take note of corruption in medical field by the hospitals, pathological laboratories, diagnostic centres and other allied health care industry as discussed in this judgment and in the interest of public and the society and to protect the poor and middle class patients from bearing the burden of these unnecessary hidden additional costs of these natures of commission, bonus, freebies etc. for their treatment, investigations etc. shall bring similar appropriate legislation or regulations like Indian Medical Council Regulations, 2002, to prevent or curb this misusing of legislative gap or loopholes by them including hospitals and to deter them from perpetuating commission of such offence since once receiving of such ‘referral to doctors’ have been held to be prohibited and unethical obviously the corollary to this would be unethical being giving of such commission/bonus/gifts etc. to induce such doctors and medical practitioners to violate the Medical Council Act, 1956 and Indian Medical Council (Professional Conduct, Etiquette and Ethics) Regulation, 2002, and they should also be equally penalized like medical practitioners who accept the same and only disallowance of such nature of expense under the Income Tax Act would not deter them from indulging and participating in these nature of prohibited, unethical and immoral act.”

It would be appropriate to refer to Apex Court case in Maddi Venkataraman & Co. (P) Ltd vs. CIT (1998) 229 ITR 534 (SC) wherein it was held that it would be against public policy to allow the benefit of deduction under one statute, of any expenditure incurred in violation of the provisions of another statute or any penalty imposed under another statute. The Court held thus:

“The High Court referred to a large number of decisions where it has been held that payments tainted with illegality cannot be claimed as deduction under the Income Tax Act. However, if an assessee is penalised under one Act, he cannot claim that amount to be set off against his income under another Act because that will be frustrating the entire object of imposition of penalty.

One exception to this rule which has been recognised by the Courts is where the entire business of the assessee is illegal and that income is sought to be taxed by the Income Tax Officer then the expenditure incurred in the illegal activities will also have to be allowed as deduction. But if the business is otherwise lawful and the assessee resorts to unlawful means to augment his profits or reduce his loss, then the expenditure incurred for these unlawful activities cannot be allowed to be deducted.”

Having dealt with Section 37(1) and the binding circular no. 5/2012 dated 1-8-2012, it should be probed as to whether the revenue as mandated in the said section is collected by the Department. Since, there was controversy regarding the disallowance between the various High Courts, the various Pharma Companies migh not have added the said disallowance in their returned incomes. The recent judgment of the Apex Court in Apex Laboratories case (supra) has finally decided the matter. It is time for action against the pharma companies to verify that the said disallowance has been made or not. It will not be out of place to mention that the Audit Report and Tax Audit provide for information for disallowance u/s 37(1) of the Income Tax Act. The Income Tax return also has specific columns soliciting this information. However, the information  for taxing the value of freebies, travel, hospitality, gifts etc. cannot be easily gathered.

It would be worthwhile to see the second limb of the said circular no. 5/2012 dated 1-8-2012, which clarifies that the value of the freebies shall be added mandatorily in the income of the medical practitioner or professional association as professional/ business income/income from other sources. An extract of the said circular is reproduced thus:

“4. It is also clarified that the sum equivalent to value of freebees enjoyed by the aforesaid medical practitioner or professional associations is also taxable as business income or income from other sources as the case may be depending on the facts of each case. The Assessing Officers of such medical practitioner or professional associations should examine the same and take an appropriate action.”

Now an important question arises from the aforesaid discussion. How does the Department come to know that a particular Doctor or Medical Association has enjoyed  freebies etc. of which amount during the particular assessment year? There appears no foolproof method for ensuring that the doctors/ medical associations show this amount in their respective income.

My suggestion in this regard is that there should be a quarterly return, which should be mandatory for all Pharma companies, Hospitals & Diagnostic Centres wherein they should be mandated to give requisite details mentioning the names & PAN of the beneficiary doctors/ associations along with the monetary value of the freebies (including commissions, gifts, travel, hospitality etc.) to enable the Department to ascertain the amounts to be added to the income of the Doctors/Medical Associations. This amount would be reflected in 26 AS & AIS of the assessees so that there is no leakage/ concealment of income on this score. Until suitable changes are made in IT forms and major changes are brought in, the revenue as contemplated u/s 37(1) & Circular no. 5/2012 dated 1-8-2012 will remain illusory. The Government can also consider subjecting the monetary value of freebies, hospitality, cash/monetary gifts, travel & commission under the ambit of TDS/TCS so that the Doctors/Medical Associations are compelled to show this in their returns of income as professional/business income or income from other sources.

In the alternative, it should be mandated that these transactions should be included in the Annual Information Return (AIR), which  discloses financial transactions carried out by assessees during the financial year. The AIR should be required to be furnished under section 285BA of the Income-tax Act, 1961 by the pharma companies, hospitals & diagnostic centres in respect of these specialized transactions.

An early action by the CBDT/ Ministry of Finance is solicited to bring to the exchequer the just and legal revenue u/s 37(1) read with Circular no. 5/2012 dated 1-8-2012 and to curb/contain tax evasion on this score.

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