This article critically examines the ITAT Ahmedabad ruling in AIA Engineering Ltd. v. DCIT [2025] 179 taxmann.com 152, which addresses the deductibility of settlement payments made in foreign civil litigation under Section 37(1) of the Income-tax Act. The Tribunal upheld the claim, distinguishing compensatory payments from penal ones and reaffirming the principle of commercial expediency. It further clarified that Explanation 1 does not apply to civil settlements, and Explanation 3—introduced in 2022—cannot be applied retrospectively to earlier assessment years. Through a doctrinal analysis supported by key judicial precedents, including Desiccant Rotors, M.M. Aqua Technologies, and Vatika Township, the article explores the evolving contours of Section 37(1) and its implications for cross-border legal compliance. The discussion underscores the need for statutory interpretation grounded in business realities, legislative intent, and judicial clarity.
I. Introduction
In a significant ruling, the Ahmedabad Bench of the Income Tax Appellate Tribunal (ITAT) in AIA Engineering Ltd. v. DCIT addressed whether a payment made to settle a foreign civil litigation could be disallowed under Section 37(1) of the Income-tax Act, 1961. The Tribunal’s decision clarified the scope of Explanation 1 and Explanation 3 to Section 37(1), particularly in the context of offshore settlements and patent disputes.
This article examines the Tribunal’s reasoning and evaluates whether such payments can be considered “prohibited by law” or hit by the expanded disallowance provisions under Explanation 3.
II. Factual Background
AIA Engineering Ltd., a manufacturer of wear-resistant castings, exported its Sintercast products to the US. Magotteaux International (MI), a Belgian company, filed a suit before the US International Trade Commission alleging infringement of its US patent RE39998. The litigation spanned multiple rounds, including a summary judgment in AIA’s favour, a reversal by the Federal Court, and post-trial motions.
Faced with escalating litigation costs and uncertainty, both parties entered into a Settlement Agreement. AIA paid USD 6 million (₹31.11 crore) to MI to amicably resolve the dispute. This amount was claimed as a business expenditure under Section 37(1). The Assessing Officer disallowed the claim, treating the payment as penal under Explanation 1. The Commissioner (Appeals) upheld the disallowance and also invoked Explanation 3.
III. Tribunal’s Findings
The Tribunal reversed the disallowance and allowed the deduction. Its reasoning rests on three doctrinal pillars:
A. Nature of the Payment: Compensatory, Not Penal
The Tribunal held that the payment was made to settle a civil dispute and was not a fine or penalty imposed by any court. The US Patent Act (35 USC §§ 281–284) provides civil remedies—injunctions and damages—for infringement. No criminal proceedings or false marking allegations were involved.
“The payment of USD 6 million was neither on account of any fine imposed by any Court nor on account of any offence committed by the assessee.” — ITAT, Para 21.1
The fact that MI accepted a lower amount than the court-ordered security indicated uncertainty in its claim and reinforced the compensatory nature of the payment.
B. Explanation 1: “Prohibited by Law” Must Be Narrowly Construed
Explanation 1 to Section 37(1) disallows expenditure incurred “for any purpose which is an offence or which is prohibited by law.” The Tribunal clarified that this phrase must be interpreted contextually:
- It covers acts against public policy, societal welfare, or ethical standards.
- It does not include bona fide private disputes over civil rights.
- Settlement of such disputes is a legitimate business decision.
“The words ‘prohibited by law’ cannot be given such a narrow interpretation to include in its ambit and scope every bona fide claim litigated before the courts.” — ITAT, Para 21.2
The Tribunal emphasized that in every civil litigation, both parties assert legal rights in good faith. A settlement does not imply guilt or illegality. Therefore, the payment was not for a purpose prohibited by law.
IV. Explanation 3 to s. 37(1): Scope, Timing, and Applicability
A. Legislative Background
Explanation 3 was inserted by the Finance Act, 2022 (w.e.f. 1 April 2022) to extend Explanation 1 to violations of laws outside India. Clause (iv), inserted by the Finance (No. 2) Act, 2024 (w.e.f. 1 April 2025), further disallows settlement payments made in relation to contraventions of notified foreign laws.
B. Temporal Applicability
The Tribunal rightly held that Explanation 3 cannot be applied retrospectively. The relevant assessment year was AY 2014–15. Applying Explanation 3 to this year would violate the principle laid down in CIT v. Vatika Township (P.) Ltd. [2014] 367 ITR 466 (SC), which held that provisions that widen the scope of disallowance must be applied prospectively, unless expressly stated otherwise.
“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 1-4-2022.” — ITAT, Para 22.2
Summing up: Explanation 3 does not apply to AY 2014–15.
C. Substantive Applicability
Even if Explanation 3 were to apply prospectively, the nature of the payment must still fall within its scope. The key question is:
Was the payment made “for any purpose which is an offence or which is prohibited by law” in the foreign jurisdiction?
- The payment was made to settle a civil patent infringement dispute in the US.
- US Patent Law provides civil remedies—injunctions and damages—not criminal penalties.
- There was no finding of guilt, no criminal prosecution, and no regulatory violation.
- The settlement was mutual and compensatory, not penal.
The Tribunal emphasized that such civil settlements are part of legitimate legal strategy and commercial risk management.
Summing up: The payment does not fall within the mischief of Explanation 3, even if it were applicable.
D. Clause (iv): Notified Laws and Legislative Intent
Clause (iv) to Explanation 3 targets settlements of contraventions under laws notified by the Central Government. Notification No. 38/2025 dated 23 April 2025 lists:
- SEBI Act, 1992
- Securities Contracts (Regulation) Act, 1956
- Depositories Act, 1996
- Competition Act, 2002
Patent law is not included in this list. The Tribunal inferred that this exclusion reflects a deliberate legislative choice to exclude civil patent disputes from disallowance.
“The Patent Act is conspicuously absent from this list. This makes the legislative intent clear that settlement payments in relation to patent disputes are not intended to be disallowed.” — ITAT, Para 23.2
Summing up: Even under clause (iv), the payment is not disallowable.
V. Supporting Precedents
1. CIT v. Desiccant Rotors International (P.) Ltd. [2011] 347 ITR 32 (Delhi) / [2011] 12 taxmann.com 373
In this case, the Delhi High Court dealt with the allowability of a payment made by the assessee to settle a patent infringement dispute. The assessee had entered into a settlement agreement to avoid prolonged litigation and paid a sum to the patent holder. The Assessing Officer disallowed the payment, treating it as penal in nature. However, the High Court held that the payment was made out of commercial expediency and was compensatory, not penal. It emphasized that patent infringement under Indian law is a civil wrong, and the remedy lies in damages, not penalties. Therefore, the expenditure was allowable under Section 37(1), as it was incurred wholly and exclusively for business purposes.
2. M.M. Aqua Technologies Ltd. v. CIT [2021] 436 ITR 582 (SC) / [2021] 129 taxmann.com 145
The Supreme Court in this case clarified the scope of commercial expediency under Section 37(1). The assessee had made payments to settle disputes and claimed them as business expenditure. The Revenue argued that such payments were not allowable as they were not mandatory under law. The Court rejected this view and held that the test of commercial expediency is subjective and must be judged from the perspective of a prudent businessman. If the expenditure is incurred to protect or further the business interests, it qualifies for deduction. This case reinforced that voluntary settlements, even if not legally mandated, can be deductible if they serve a legitimate business purpose.
3. CIT v. Vatika Township (P.) Ltd. [2014] 367 ITR 466 (SC) / [2014] 49 taxmann.com 249
This landmark judgment by the Supreme Court laid down the principle that tax provisions which impose a burden or expand the scope of disallowance must be applied prospectively. The case involved retrospective application of a provision that affected the assessee’s tax liability. The Court held that unless a statute explicitly states retrospective operation, amendments that are substantive in nature cannot be applied to past assessment years. This precedent was crucial in AIA Engineering Ltd., where the Tribunal relied on it to hold that Explanation 3 to Section 37(1), inserted in 2022, could not be applied to AY 2014–15.
These cases reinforce the Tribunal’s conclusion that the payment was allowable under Section 37(1).
Vi. Implications for Taxpayers
The ruling has far-reaching implications:
- Civil settlements arising from bona fide disputes are not disallowable under Section 37(1).
- Foreign law violations are covered only prospectively under Explanation 3.
- Patent settlements remain outside the scope of disallowance unless the law is specifically notified.
- Commercial expediency remains a valid ground for deduction.
Taxpayers must carefully document the nature of disputes, settlement terms, and business rationale to substantiate such claims.
VII. Conclusion
The ITAT Ahmedabad’s decision in AIA Engineering Ltd. is a robust reaffirmation of doctrinal clarity in interpreting Section 37(1). It distinguishes between penal and compensatory payments, emphasizes the importance of commercial expediency, and resists retrospective application of expansive amendments. Most importantly, it preserves the deductibility of genuine business expenditure arising from civil litigation, even in foreign jurisdictions.
From a statutory perspective, Explanation 1 to Section 37(1) does not apply to bona fide civil settlements, as such payments are neither offences nor prohibited by law. Explanation 3, which extends disallowance to violations of foreign laws, was inserted only with effect from 1 April 2022. The Tribunal rightly held that it cannot be applied retrospectively to AY 2014–15. Even if Explanation 3 were applicable, the payment in question—made to settle a civil patent dispute—is not covered under any notified law under clause (iv), as the Patent Act is conspicuously absent from Notification No. 38/2025. Thus, the payment remains outside the scope of disallowance under both Explanation 1 and Explanation 3.
This decision reinforces the principle that tax law must be interpreted in light of business realities, legislative intent, and judicial precedent. It provides valuable guidance for taxpayers navigating the complexities of cross-border litigation and expenditure deductibility.
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