Section 28 of the Income Tax Act, 1961, deals with the chargeability of income from profits and gains of a business or profession to income tax – under the head “Profits and gains of business or profession”.
There are certain types of income which are not taxable as income under this head.
Partner
KR Chawla & Co
According to section 37(1) of the act, for a particular item of expenditure to be an allowable deduction under this section, it should not be a capital expenditure or personal expense (or another expenditure described in sections 30 to 36 of the act) of the assessee; and it should have been laid out or expended wholly and exclusively for the purpose of the business or profession of the assessee.
[ihc-hide-content ihc_mb_type=”show” ihc_mb_who=”3″ ihc_mb_template=”2″ ]
In a recent case of Jamna Auto Industries v Commissioner of Income tax, the full bench of the Punjab and Haryana High Court on 30 January 2008 gave an important judgment on business expenditures considered allowable expenditures.
The brief facts of the case are as follows:
The assessee firm’s partner, during a visit abroad, entered into a contract with a foreign firm for the supply of certain goods of a particular value.
The agreement could not be acted upon by the assessee, which did not have the requisite import licence for the material intended to be imported.
The dispute was referred to an arbitrator, which set out an award to be paid by the assessee to the foreign firm for failure to perform its part of the contract.
In its return for the assessment year 1975-76, the assessee claimed a deduction of the amount of the payment as a business expenses on account of damages for breach of contract.
The Assessing Officer disallowed the claim, relying on the decision of the Punjab and Haryana High Court in Cineramas v CIT ([1977] 110 ITR 762) in which the court held that infractions of law, including breaches of obligations, are not normal incidents of business and penalties and damages paid in connection with such infractions and breaches are not expenditures laid out or expended wholly and exclusively for the assessee’s business.
The assessee, by placing reliance on the decision of the Punjab and Haryana High Court in CIT v Indo Asian Switch-Gears (P) Ltd ([1996] 222 ITR 772/[1997] 92 Taxman 86) submitted that the payment of damages was for breach of contract and not on account of infraction of law and, therefore, the same was admissible as expenses having been expended wholly and exclusively for the purposes of business.
In view of the two conflicting judgments given by two co-ordinate division benches of the Punjab and Haryana High Court on the issue, the matter was referred to a larger bench.
The Full Bench of Punjab and Haryana High Court observed that the wording in section 37(1) of the Income Tax Act – “laid out or expended wholly and exclusively for the purposes of business or profession” – includes the word “wholly”, which refers to the quantum of expenditure and the word “exclusively”, which refers to the motive, objective and purposes of the expenditure.
The expression “wholly and exclusively” does not mean “necessarily”. If an amount is incurred for promoting the business and to earn profits, the assessee can claim a deduction, even though there was no compelling necessity to incur the expenditure.
The test for allowability of an expenditure as a deduction is to judge whether the expense has been incurred with the sole object of furthering the trade or business interest of the assessee independently of any other consideration and that the expenditure was necessitated or justified by commercial expediency.
The court held that whenever an assessee has indicated any amount that had been paid either by way of damages or penalty, to be an allowable expenditure under section 37(1), the assessing authority is obliged to discover the nature of such amount vis à vis two prominent aspects, whether it is compensatory or penal.
The assessing authority would thereupon permit as an allowable deduction the amount that may be discovered to be purely of compensatory nature as payment for damages.
However, any statutory amount paid by the assessee on account of penalty shall be disallowed being payment for infraction of law.
A situation may arise where an assessee might have to make a composite payment that is both “compensatory” and of “penal character”.
In that situation, the assessing authority would be required to segregate the amount that matches each description.
After undertaking this exercise, the amount that is held to be of compensatory nature shall be deemed to be an allowable expenditure while the other portion of the amount, which is penal in nature, will not be considered an allowable expenditure.
[/ihc-hide-content]
Sumes Dewan is a partner at KR Chawla & Co Advocates & Legal Consultants. The firm is headquartered in New Delhi and has offices in Chennai and Bangalore as well as a representative office in Singapore.
KR Chawla & Co
Head Office
7th Floor, Kailash Building
26, Kasturba Gandhi Marg
New Delhi – 110 001
India
Tel: +91 11 2335 7658-61
Fax: +91 11 2331 9997
Email: krclo@krcco.com
Singapore
9 Temasek Boulevard
#32-01 Suntec Tower 2
Singapore – 038989
Tel: +65 6432 5220
Fax: +65 6332 1485
Email: krlcosingapore@krcco.com
