The Hindu Business Line : Simple truths about compounding

MAXIMUM number of case law relates to the deductibility of expenditure claimed to have been incurred for business. Section 37 of the Income-Tax Act, 961 allows such deduction if it is wholly and exclusively incurred for business and where no part of it is either personal to the taxpayer or capital in nature.

The Finance (No. 2) Act, 1998 introduced an Explanation to Section 37, which reads thus:

"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."

The Explanation was made retrospective from the inception of the Act, that is, with effect from April 1, 1962. Before the Explanation was enacted, court rulings, such as in the Haji Aziz and Abdul Shakoor Bros (1961 41 ITR 350) case, governed the issue.

The court had ruled in the Haji Aziz case that no deduction can be allowed for a penalty incurred for contravention of any specific statutory provision; it cannot be said to be a commercial loss falling on the assessee as a trader.

But controversy still raged over fines and penalties and there were grey areas. The Explanation sought to put the matter beyond reasonable doubt and barred deduction of any expenditure incurred for any purpose considered an offence or prohibited by law. Such an expenditure shall be deemed not to have been incurred for business or profession.

Compounding fees

Mamta Enterprises was a builder carrying on business in building apartments and selling the same. It had violated building regulations of the Bangalore City Corporation. It had constructed the 8th floor without a sanctioned plan. Section 436 of the City Corporation Act made such violations an offence.

The Corporation Act permitted the Commissioner of the Corporation to make an order for the demolition of the building if it is constructed without obtaining permission.

At the same time, the Corporation Commissioner was empowered to compound the offence committed in breach of the provisions of the Act, rules, bye-laws or regulations. The Government had made such violations compoundable. The circumstances under which the Commissioner can compound the offence were also set out in the bye-laws. Mamta Enterprises chose to compound the offence and paid Rs 89,960 as compounding fine to the Bangalore City Corporation.

This was claimed as an expenditure under Section 37 of the Income-Tax Act, 1961. The claim was disallowed by the assessing officer (AO).

The first and second appellant authorities decided the matter in favour of the assessee. The Revenue took up the matter in reference before the Karnataka High Court.

The court decided in favour of the Revenue (266 ITR 356). It pointed out that the Explanation to Section 37 had itself declared that such an expenditure shall not be deemed to have been incurred for business and no deduction or allowance shall be made in respect of such expenditure. The court observed:

"When the section is clear and unambiguous, it is not permissible for the courts to stretch the meaning attached to the provision of law to extend the benefit to a person who violates the law or the regulations/rules made by the corporation or the municipal authorities with impunity.

Under these circumstances, the expenditure incurred to pay the penalty cannot be treated as loss in business to get the benefit.

In our view, the penalty paid has enured to the benefit of the assessee to have the additional construction put up in violation of the provisions of the Act and bye-laws framed there under and also consequences of the penal provision provided under the Corporation or the municipal law."

There have been any number of cases on the deductibility of expenditure incurred in violation of the statutes. For instance, the Delhi High Court, in CIT vs Loke Nath and Co (Construction) (1984 147 ITR 624), allowed compounding fine, taking the view that it must be regarded as an integral part of the profit-earning process of the builder.

Similarly, the Madras High Court, in CIT vs N. M. Parthasarathy (1994 Tax LR 785 Madras), had ruled that redemption fine under the Customs Act in lieu of confiscation of goods is deductible. The Bombay High Court, in CIT vs Pannalal Narrottamdas & Co (1968 67 ITR 667), also took the same view.

These decisions were rendered before the insertion of the Explanation to Section 37 and, therefore, are no longer good law.

The Explanation deems the expenditure not to have been incurred if it is related to the commission of an offence even though the compounding fine might have been paid for the purpose of business.

The Karnataka High Court clarifies that expenditure to be deductible must not only be for the purpose of business but also in conformity with the law and rules.

The law has been categorically clarified in no uncertain terms.