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During my study of both direct tax and indirect tax law, I saw quite a few instances where although the activity in question was illegal or prohibited, that fact was not considered for the purpose of tax law. That does seem a bit strange that tax law does not recognize the constraints imposed by other civil/criminal law, but on closer reflection it does make sense because both laws operate in different spheres, and also because tax does not concern itself with moralities/strict legal form, and therefore even illegal income can be taxed. 

1. Physician samples of patent/proprietary medicine is statutorily prohibited from being sold under the Drugs & Cosmetics Act 1940, and therefore a pharma company contended that since those samples were not 'marketable', excise duty could not be charged. But in Medley Pharmaceuticals Vs CCE(Daman) 2011SC, the Supreme Court held that despite the statutory prohibition, the samples were capable of being sold, and that restrictions under one law could not result in revenue loss. Therefore, excise duty was held to be chargeable.

2. Under wealth tax however, if a plot of urban land is vacant due to land planning prohibitions, then its value is not considered for purpose of charging wealth tax.

3. Smuggled goods(if detected!) cannot be given benefit of exemption notification:- In CCus (Preventive) v M Ambalal & Co, the Supreme Court held that since the Customs Act had one of the primary objectives as curbing smuggling, it would be contrary to the purpose of exemption notification to accord the benefits of 'imported goods'(entering through legal channels) to those smuggled goods as well. 

4. Under the Indian income tax transfer pricing laws, any revision in transfer price(it will be always upwards IF made) cannot entitle the other party to the transaction to reduce its taxable income. Also, the party affected by transfer price that increases its taxable turnover, cannot claim export benefits/other benefits under law. This provision recognizes the commercial reality that despite the transfer pricing adjustment, the funds have left India(in case of international transactions). In case of domestic transactions under Section 43/80IA-ID, I guess the rationale is not to reward those who cook the books..

5. Under wealth tax law(again!), cash, to the extent recorded in books, is not subject to wealth tax. This means that questionable accounting practice/sloppy accounting of having unrecorded tax, would lead to its being taxed for wealth tax purposes. 

6. Charitable trusts ordinarily enjoy income tax exemption, but in case the tax authorities recompute the business profits and find concealed income, or make other additions to the income due to related party transactions, those additions are not eligible for that favorable tax treatment

7. The tax avoidance provisions under 69A-D subject unexplained expenditure to tax under the presumption that that would have been from undisclosed income(i,e black money). To avoid the claim of net zero income(gross income minus that expenditure), the law expressly debars any tax deduction of those expenses even under business income

8. Payments seemingly contrary to law still deductible-heroin drugs stock-in-trade of an doctor assessee and ransom payments. The loss of heroin drugs was held as tax deductible by the Supreme Court, which reversed the verdicts of the lower courts, stating that moral considerations did not belong to jurisprudence. Hence in 2006, the case Dr. T.A. Quereshi v. Commissioner of Income-tax, Bhopal stated that although the law had barred business expenditure incurred contrary to law, it did not state anything about business losses. In the K.M Jain case, the MP High Court held that where a company had paid a ransom money of Rs 5.5 lakh to the dacoits and secured the release of their director(who had spent 20days in captivity), the payment was deductible because the law did not expressly prohibit payment of ransom. Hence, this is seemingly contrary to the intent of the explanation to Section 37(1) that no allowance shall be made in respect of expenditure incurred by an assessee for any purpose which is an offence or which is prohibited by law. But technicalities and deep legal interpretation allowed tax deduction in the above cases. 

The point of the above examples is that sometimes tax law works in interesting ways.

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