High Court of Punjab and Haryana

Jamna Auto Industries

v.

Commissioner of Income-tax, Yamunanagar

VIJENDER JAIN, CHIEF JUSTICE

RAJIVE BHALLA AND AJAY KUMAR MITTAL, JJ.

INCOME TAX REFERENCE NO. 56 OF 1987

January 30, 2008

Section 37(1) of the Income-tax Act, 1961 - Business expenditure - Allowability of - Assessment year 1975-76 - Whether 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), assessing authority is obliged to discover nature of such amount vis à vis two prominent aspects, whether it is compensatory or penal; he would thereupon permit amount as an allowable deduction that may be discovered to be purely of compensatory nature as payment for damages - Held, yes - Whether, however, any statutory amount paid by assessee which is sought to be claimed as an allowable expenditure on account of penalty, in that eventuality, same shall be disallowed being payment for infraction of law - Held, yes - Whether in a situation where an assessee might have to make a composite payment being compensatory or penal character both, assessing authority would, of course, be required to segregate amount containing two characters and after undertaking that exercise, amount that is held to be of compensatory nature shall be countenanced as allowable expenditure whereas other portion of amount, which is penal in nature, shall be refused to be an allowable expenditure - Held, yes

FACTS

The assessee-firm’s partner, during the visit abroad, entered into a contract with a foreign for supply of certain goods of a particular value. The agreement so arrived at, however, could not be acted upon by the assessee since it did not have the requisite import licence for the material intended to be imported. The dispute was referred to an arbitrator and in terms of said award, the assessee paid certain amount 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 deduction of the amount as business expenses on account of damages for breach of contract. The Assessing Officer disallowed the same relying on the decision of the Punjab and Haryana High Court in Cineramas v. CIT [(1977) 110 ITR 762 wherein it was held that infraction of law, including breaches of obligations are not normal incidents of business and penalties and the damages paid in connection with such infractions and breaches are not expenditure laid out or expended wholly and exclusively for the assessee’s business. On appeal, the Commissioner (Appeals) upheld the impugned order, which was further upheld by the Tribunal.

On reference, 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. On the other hand, the revenue stoutly controverted the submission made by the assessee and placed reliance on a judgment of the Punjab and Haryana High Court in Baldev Singh Kanwar v. CIT (1998) 96 Taxman 507 to canvass that the view taken by the Tribunal was in consonance with law. In view of 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.

HELD

According to 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 expended wholly and exclusively for the purpose of the business or profession of the assessee. [Para 10]

The phraseology-laid out or expended wholly and exclusively for the purposes of business or profession - embraces within it ‘wholly’ which refers to the quantum of expenditure and the word ‘exclusively’ 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 deduction therefore even though there was no compelling necessity to incur such expenditure. The test for allowability of an expenditure as a deduction is to judge, whether the expense has been incurred with the sold object of furthering the trade or business interest of the assessee unalloyed or unmixed with any other consideration and that expenditure was necessitated or justified by commercial expediency. [Para 11]

Whenever certain damages are to be paid by an assessee for the breach of a contract, such damages are treated to be normal incidences of business. For allowability as a deduction, a claim for damages is to be tested on the touchstone of the provisions of section 37(1). Where an assessee has to pay damages to the other party for the failure to fulfil the contract entered into by him in the ordinary course of his business, 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 the public policy. [Para 12]

A penalty imposed for breach of any law during the course of trade etc. cannot be described as a commercial loss. If an assessee while conducting his business has acted in an unlawful manner which has rendered him liable to penalty, the sum so paid cannot be claimed as a deductible expense. Infraction of the law is not a normal incident of business and, therefore, no expense which is paid by way of penalty for a breach of law is admissible deduction. In cases where a penalty has to be incurred, for the reason of the assessee having carried on business in an unlawful manner or in contravention of certain rules and regulations, such penalty could not be regarded as ‘wholly and exclusively’ laid out for the purposes of business as the expense has not been necessitated by the business but by the conduct of the assessee in trying to carry out the business in an unlawful manner. Under section 37(1), only that portion of such payment having composite nature which is attributable to its compensatory character for payment as damages is to be allowed as a deduction. The other portion which is attributable to its penalty nature cannot be allowed as a deduction under section 37(1) because such payment is for infraction of law. [Para 13]

In view of the authoritative pronouncements of the Apex Court and also of the Punjab and Haryana High Court, it would, thus, be concluded that 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), 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 the amount as an allowable deduction that may be discovered to be purely of compensatory nature as payment for damages. However, any statutory amount paid by the assessee which is sought to be claimed as an allowable expenditure on account of penalty, in that eventuality, the same shall be disallowed being payment for infraction of law. A situation may arise where an assessee might have to make a composite payment being ‘compensatory’ and ‘penal character’ both. In that situation, the assessing authority would, of course, be required to segregate the amount containing two characters. After undertaking this exercise, the amount that is held to be of compensatory nature shall be countenanced as allowable expenditure whereas the other portion of the amount, which is penal in nature, shall be refused to be an allowable expenditure. [Para 19]

In the circumstances and the clear legal position, the amount in question claimed as deduction would, thus, be an expenses incurred for the purposes of the business and could not have been disallowed. [Para 29]

In view of the above, the Tribunal was not right in confirming the disallowance of amount in question payable to foreign firm for non-performance of the contract.