Role of Compensatory Penalties in Business Regulation and the Pitfalls of Punitive Measures

The question asked many times is whether all penalties are disallowed under the Income tax Law as being expenses made for violations of a law. Prior to Explanation 1 of Sec 37 of The Income Tax Act, there were a catena of decisions dealing with the allowability of expenditure u/s 37, whether illegal or not, treated on a case-by-case basis. One principle to note which seems to be present right from reamendment days is that if the amounts paid were compensatory in nature, they were allowable. If they were penal in nature, it wasn't to be allowed.

The Department wanted to enshrine in law that illegal expenditure cannot be a deduction under the ambit of Income Tax. Thus Explanation 1 was inserted by the amendment by Finance Act, 1998 and was given retrospective effect from April 1, 1962. The legislative intent behind the insertion of this explanation as given in memorandum of Finance Bill 1998 being as follows:

"It is proposed to insert an explanation after sub section (i) of section 37 to clarify 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. This proposed amendment will result in disallowance of the claim made by certain taxpayers of payment on account of protection money, extortion, hafts, bribes, etc. as business expenditure."

Further, the CBDT clarified this position vide Circular 722 dated 23/12/1998 whose extract reads as follows: Section 37 of the Income-tax Act is amended to provide 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 purposes of business or profession and no deduction or allowance shall be made in respect of such expenditure. This amendment will result in disallowance of the claims made by certain assesses in respect of payments on account of protection money, extortion, hafts, bribes etc. as business expenditure. It is well decided that unlawful expenditure is not an allowable deduction in computation of income.

In this backdrop, the issue in the case of AMALSAD VIBHAG KELVANI MANDAL Vs I.T.O [2023-VIL-1600-ITAT-SRT] was whether the penalty paid for violation of provision of Foreign Contribution (Regulation) Act, 2010 is allowable as a deduction under Income Tax Act.

The assessee's contention was that the penalty was levied on acceptance of foreign donation. Such donation was received in earlier years for building fund. Such penalty was paid as the assessee was not having permission of Ministry of Home Affairs to receive such funds. Further, the penalty was not paid for any offence rather it was paid for regularization of fund received from foreign remittance. Hence such incurring such expenses provided an understanding to the assessee as to how to deal with such compliances in future. Hence the expenses were claimed as educational expenses i.e. capital in nature and were compensatory in nature.

The argument was accepted and hence the point re-asserted is that penalty is allowed if it is compensatory in nature and disallowed if it is a punishment for intentional violation of a law.