The Hindu Business Line : Compensation for breach of contract

In several business deals, one of the parties alleges breach of contract in order to claim compensation or damages. Where any amount is paid as compensation or damages, the question that arises for tax purposes is whether such amount can be claimed as a business expense under section 37 of the Income-tax Act, 1961.

The tax department seeks to disallow this amount on the ground that such payment is in the nature of penalty and therefore cannot be allowed as a deduction. The Courts have generally taken a liberal view and held that the amount is deductible.

Under section 37(1), for a particular item of expenditure to be an allowable deduction under this section: (a) it should not be an expenditure of the nature described in sections 30 to 36; (b) it should not be in the nature of capital expenditure or personal expenses of the assessee; and (c) it should have been laid out or expanded wholly and exclusively for the purpose of the business or profession of the assessee.

The phraseology “laid out or expended wholly and exclusively for the purposes of the business or profession” embraces within it “wholly” which refers to the quantum of expenditure and the word “exclusively,” which refers to the motive, objective and purpose 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 deduction therefor even though there was no compelling necessity to incur such expenditure.

Test of allowability

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, unalloyed or unmixed with any other consideration, and that the expenditure was necessitated or justified by commercial expediency.

Whenever damages are to be paid by an assessee for a breach of contract, such damages are treated to be normal incidents of business. For allowability as a deduction, a claim for damages is to be treated on the touchstone of the provisions of section 37(1) of the Act. Where an assessee has to pay damages to the other party for failure to fulfil the contract entered into by him, the amount of damages so paid is an allowable deduction if it is in the ordinary course of the business, and is not opposed to public policy.

A penalty imposed for breach of any law during the course of trade cannot be described as a commercial loss. Infraction of the law is not a normal incident of business. Therefore, no expense that is paid by way of penalty for a breach of law is an admissible deduction. Whenever an assessee has indicated any amount, which had been paid either by way of damages or penalty, to be an allowable expenditure under section 37(1) of the Act, the assessing authority is obliged to discover the nature of such amount vis-À-vis two vital aspects, whether it is compensatory or penal.

Court rulings

A situation may arise where an assessee might have to make a composite payment being both “compensatory” and “penal” in character. In that situation, the assessing authority would be required to segregate the amount. After undertaking this exercise, the amount that is held to be of compensatory nature should be treated as allowable expenditure, whereas the other portion of the amount, which is penal in nature, would be disallowable.

This point was considered by the Punjab and Haryana High Court in C.I.T. v. S. A. Builders P. Ltd. (299 I.T.R. 88). The facts in this case were that the assessee in the present case is a contractor executing various works. While computing the income for the assessment year in question, the assessee claimed a deduction of Rs 16.27 lakh on account of compensation paid to the contractee for delay in execution of the works. The claim was rejected by the Assessing Officer. However, in appeal, the Commissioner of Income-tax (Appeals), while relying upon a judgment of the Supreme Court in C.I.T. v. Amalgamated Development Ltd. (65 I.T.R. 395), held that the amount, being on account of compensation for breach of contract and not a penalty for breach of law, was allowable.

Counsel appearing for the assessee submitted that there is a distinction culled out by various judicial pronouncements in respect of penalty for breach of law and penalty or compensation for breach of contract. Whereas the penalty leviable on account of breach of law is not a permissible deduction, penalty that is on account of breach of contract is certainly a business loss and has to be allowed. He referred to C.I.T. v. Murari Lal Ahuja and Sons (177 I.T.R. 228), Prakash Cotton Mills P. Ltd. v. C.I.T. (201 I.T.R. 684) and C.I.T. v. Indo Asian Switch-Gears P. Ltd. (222 I.T.R. 772).

While considering a similar issue, the Supreme Court in Prakash Cotton Mills P Ltd’s case held that deduction is to be allowed where the amount is wholly compensatory in nature and where the amount is composite, which contains elements of compensation and penalty, it is only the compensatory part that is allowable.

The Punjab and Haryana High Court in Murari Lal Ahuja’s case held that where an assessee, engaged in the business of sale of cotton, having failed to fulfil the contract for supply of cotton to certain mills, settled the deal by paying a sum as compensation, the amount of compensation paid by the assessee was held to be allowable deduction.

The Court held in the case of S.A Builders P Ltd that the compensation paid by the assessee did not fall in the category of payment of penalty for breach of any law but would be compensation for breach of contractual obligations. Accordingly, it will fall in the category of allowable deduction. This point has also been considered by the Full Bench of the Punjab and Haryana High Court in Jamna Auto Industries v. C.I.T. (299 I.T.R. 92).

(The author, a Mumbai-based advocate specialising in tax laws, can be contacted at ranina@bom2.vsnl.net.in)

The facts in this case were that the assessee had entered into an agreement with a German firm for supply of certain goods. The contract did not fructify as the assessee did not have the requisite import licence for the material intended to be imported.

On a dispute being referred to the arbitrator, the assessee had to pay Rs 50,000 to the German firm in terms of the award dated July 29, 1974. The assessee claimed deduction of the amount. The Assessing Officer allowed the claim of the assessee but withdrew the deduction in reassessment proceedings. This was upheld by the Commissioner of Income-tax (Appeals) and the Tribunal.

On a reference, the Full Bench held that the amount of Rs 50,000 paid by the assessee was on account of damages for breach of contract on its part and not a liability incurred for contravention of any law. The amount was deductible.

Thus, compensation for breach of contract would be deductible as revenue expenditure. The Tax Department should accept the view of Courts and refrain from litigation on a settled issue of law.

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