This article has been written by Ayush Tiwari, a student of Symbiosis Law School, Noida. This article aims to provide you with all the information regarding the expenditures allowable to be deducted when calculating taxable business profits with the case laws supporting them.
It has been published by Rachit Garg.
The Income Tax Act, 1961 has two types of provisions: one that determines what types of expenditures are acceptable; and another that defines what types of expenditures are not authorised, with the latter provision superseding the former. Overriding rules should always be implemented first and then the allowability of expenditures may be evaluated. If the expense is not allowed by any provision, it is prohibited. The provisions restricting costs can be specific or generic. An expenditure is defined as activities carried out within an accounting period or income collected over a period, the gains of which do not extend beyond this period.
Allowing an expense while calculating profit and gains for a firm or business suggests that the tax authorities would not accept the advantages of such spending, and the assessee would be required to pay taxes on such expenditures by remitting them back to net profits. Any expense can be not allowed to be deducted for one of two reasons:
- The tax amount is not deducted while making the payment which must be deducted from certain expenses.
- Commercial or professional behaviour has no explicit relationship to the expenditure.
Any disallowed spending is taxed at a 30% rate (25% for specific corporations), but interest, liability, and conviction provisions are often included. The first step in determining whether or not a certain expense is deductible is to examine if the deduction is clearly mandated by any section of the “Income Tax Act.” Alternatively, Section 37 might be used to determine if the expenditure is allowed.
What is Section 37 of the Income Tax Act
Section 37 provides that any expenditure (other than capital expenditure or personal expenses of the assessee) set out or spent entirely and solely for the purposes of the company or profession shall be allowed in calculating the income liable to be paid under the “profits and gains of business or profession.”
It should also be understood through the Section that, for the avoidance of any doubt, any expenses incurred by an assessee for any purpose that constitutes an offence or is legally prohibited shall not be considered to have been incurred for the purpose of the company or profession, and no deduction is to be made with regard to such expenses.
Also, it is mentioned for the avoidance of any doubt that, for the specific purpose of sub-section (1), any expenses incurred by an assessee on corporate social responsibility activities as given under Section 135 of the Companies Act, 2013 shall not be considered to be an expense incurred by the assessee for the objectives of the company or profession.
Conditions for allowance under Section 37
Expenditures not covered by Sections 30 to 36
It should be guaranteed that the expenditure is not of the kind indicated in Sections 30 to 36 before claiming a deduction under Section 37(1). If an item of expenditure is covered by any of the aforementioned provisions, it cannot be claimed under the residuary section.
Expenditure should not be capital in nature
As the Act does not define the words “Capital Expenditure” and “Revenue Expenditure,” one must rely on their inherent meaning as well as circumstances as described below:
Acquisition of fixed assets vs. routine expenditure
Revenue expenditure is incurred in the usual course of business as a routine business expense, whereas capital expenditure is incurred in the acquisition, extension, or improvement of a fixed asset.
Several previous years vs. one previous year
Capital spending generates advantages over multiple years, whereas revenue expenditure is used in a single year.
Maintenance vs. improvement
Capital spending increases a company’s earning power. Revenue spending, on the other hand, keeps a company’s profit-making ability intact.
Recurring vs. non-recurring
Typically, capital expenditure is a one-time spend, whereas revenue expenditure is an ongoing expense.
Periodic payment vs. lump sum payment
The fact that an expenditure is a lump sum payment or a recurring payment is irrelevant in determining whether it is capital or revenue in nature.
Personal expenses should not be incurred
Personal expenditures are clearly prohibited under Section 37(1). Personal expenditures are those incurred to meet personal requirements such as food, clothing, and housing that are unrelated to the business. In other words, money spent for domestic or private purposes, as opposed to trade or profession, is not deductible.
The expenditure should have been expended in the preceding year
To be eligible for a deduction, the money must have been set aside or spent in the preceding year.
The expenditure should have been expended fully for the purpose of the business or profession
The essential criteria of Section 37(1) are that the expenditure is incurred wholly or solely for the purpose of the business.
Expenses should be in relation to the assessee’s business
For the purpose of claiming a deduction under Section 37(1), expenditure must have been incurred for the purpose of the assessee’s business in the preceding year, the profits of which must be estimated and assessed, and expenditure must have been incurred after the business is established.
Any expenditure incurred by an assessee for any purpose that is an offence or is restricted by law is not regarded as incurred for the purpose of the business or profession, and no allowance or deduction is granted in regard to such expenditure. Unlawful expenditures are not deductible. These regulations apply solely to “business expenditures,” not “business losses.” Therefore, the loss resulting from the seizure and confiscation of unlawful stock-in-trade is admissible as a business loss against earnings from illicit conduct.
Amendment to Section 37
Background of the Amendment
According to Explanation-1 to Section 37(1), expenditures expended by an assessee for any purpose prohibited by law are not allowable as business expenditures. However, it has been observed that various taxpayers in the medical and health sectors have claimed deductions in respect of expenditures incurred in providing certain benefits and perquisites to a person that are not intended to be allowed, such as meeting his expenditures related to travel, hospitality, conferences, and so on, or even allowing cash or other incentives. These expenditures were in breach of the Indian Medical Council’s rules.
The CBDT also issued a circular on August 1, 2012, stating that the Indian Medical Council (Professional Conduct, Etiquette, and Ethics) Regulations, 2002 prohibit medical practitioners and their professional associations from accepting any gift, travel facility, hospitality, cash, or monetary grant from the pharmaceutical and allied health sector industries. As a result, the aforementioned circular stated that no deduction shall be permitted in respect of these expenditures undertaken by any assessee since they are in breach of the Indian Medical Council’s norms. This circular, however, was challenged in the Himachal Pradesh High Court in the matter of Confederation of Indian Pharmaceutical Industry vs. CBDT (2013), in which the High Court dismissed the petition and confirmed the legality of the CBDT circular.
However, several tribunals have authorised the assessee’s expenditure, while other tribunals and courts have disallowed it as well. In this case, there was a need for a clear legal position on this matter. The proposed amendment to the Finance Bill, 2022, attempts to clarify the position on the aforementioned issue.
As a result, a new Explanation-3 to Section 37(1) to explain the expression “expenditure incurred by an assessee for any purpose which is an offence or which is prohibited by law” is added.
Explanation 3 was added for the avoidance of ambiguity, as it is expressly clarified that the word “expenditure spent by an assessee for any activity that constitutes an offence or an act prohibited by law” in Explanation-1 must include and be considered to have always included the assessee’s expenditure, –
- For any conduct that is an offence under or restricted by any law now in effect in India or elsewhere; or to compound an infraction under any legislation already in effect, in India or elsewhere.’
- To offer any advantage or perquisite to a person, whether or not carrying on a business or practising a profession, and acceptance of such benefit or perquisite by such person is in contravention of the provisions, rule, regulation, or guideline, as the situation may be, currently in force governing such person’s conduct; or
Analysis of the Amendment
The amendment to the Section has provided a resolution to several issues that people were facing due to the ambiguity and vagueness of the provision. The amendment has provided resolution in the following ways:
- Clause (ii) of Explanation-3 resolves the issue of unauthorised benefits or perquisites being provided by the medical & health industries and as a result, no exemption shall be allowed for any expenditure incurred in the form of gifts, travel facilities, perquisites, cash or other financial rewards provided to medical practitioners and their professional organisations.
- It should also be noted that the aforementioned amendment has a retrospective effect due to the usage of the phrase “deemed to have always been included” in the explanation.
- Explanation 3 additionally states that no deduction shall be permitted for spending for any purpose that is an offence under foreign law or for the compounding of an offence for violation of foreign law. Prior to this amendment, it was argued that Explanation-1 to sub-section 37(1) only related to offences prohibited by domestic law in the country. On a retrospective basis, Explanation-3 has now overruled this position.
List of expenditures allowable as a deduction under Section 37(1) from business income
As in the case of Devendra Exports (P.) Ltd. v. ACIT during the assessment procedures, the Assessing Officer denied the assessee’s claim for a commission paid to foreign agents. On appeal, it was stated that the need to pay commission occurred as a result of sales in the relevant fiscal year. In this view, realising the sale amount in the next fiscal year would make little difference because the duty to pay commission had crystallised in the year of the sale itself. In light of the above, the Tribunal determined that the assessee’s claim for a deduction for commission payments should be granted.
In the case of CIT v. Gitanjali Mills Limited (1986), expenditures on replacing outdated machinery were categorised as “accumulated repairs” rather than ongoing repairs. As a result, the High Court permitted such a deduction under Section 37 rather than Section 31. Furthermore, in the case of CIT v. Modi Industries Limited (1957), where the assessee purchases pieces of larger equipment, such spending is allowable as revenue expenditure.
Similarly, the replacement of moulds did not result in the creation of a new capital asset or a benefit of an enduring nature in CIT v. Malerkotla Steels & Alloys (P.), (2015) and the mere fact that moulds were used in the production process could not be conclusive as to the nature of expenditure; thus, expenditure on mould replacement was revenue expenditure.
In Aswath N. Rao (Dr) v. ACIT (2010), where the assessee used a cash accounting system, the expenditure incurred for the purchase of used machinery for the purpose of using its spare parts is revenue expenditure and is deductible in the year in which the sale consideration was paid, even though the machinery was received in India after the end of the relevant year.
Similarly, in Mahindra & Mahindra v. JCIT (2016), the amount paid to a foreign company for the purpose of improving the performance of its existing utility vehicles and developing a concept of a clay model for its utility vehicles was allowable under Section 37 because the expenditure was incurred to improve the performance of an existing product (1).
Compensation to tenant
According to CIT v. Lucky Bharat Garage (1988), the sum paid by the assessee, who acquired the plot of land, to the tenant inhabiting the structure constructed by the tenant on such property for obtaining vacant possession is a capital expenditure. However, in Sap Labs India Pvt. Ltd. v. ACIT (2016), the assessee entered into an agreement for the acquisition of land for infrastructural facilities for business, but the assessee cancelled the agreement and paid compensation, which was deemed as capital and not allowable as revenue expenditure, hence not deductible.
In the case of ITO v. RSG Media (P.) Ltd, where the assessee-company expended travel expenses for its director in order for him to attend board meetings and file different papers before various authorities, the assessee’s claim for deduction was approved.
Expenses were not allowable in the case of Munish Gupta v. Deputy CIT (2019) because the assessee was unable to produce a logbook or record to establish the use of the car for activities of a proprietary business. The assessee had provided on record a certificate from the diamond institution showing that his wife had undertaken a course in polished diamonds and held a diploma in jewellery technique. More information about the wife’s overseas trip expenses, including the foreign exchange she purchased, was also provided. According to the court, the assessee’s wife was qualified and had travelled to several locations for the purpose of the spouse’s proprietary concern’s business. As a result, the assessee’s expenditure for business purposes was to be granted as a deduction.
Report on feasibility
In the case of KJS India (P) Ltd. vs. Dy. CIT (2012), it was concluded that the assessee, a soft drink producer, had done a market study utilising the services of a professional agency to identify its brand performance with price, measure consumer demand at the existing price or a reduced price, and know whether its brand may adopt different pricing between the basic flavours and the new flavours, and the costs were expended for investigating the conditions as to how the assessee can carry on its business more effectively. As the assessee has just paused its manufacturing operation but has not closed down its trading activity, it is not a case of company closure, and hence the expenditures made by it for employee severance are acceptable as revenue expenditures.
It was held in the case of CIT v. Williamson Tea (Assam) Ltd. (2001) that it was customary in European countries for wives to accompany their spouses and that the wives’ travel with their spouses could not be said to be personal visits of the wives but had to be regarded as having been undertaken for the purpose of the company’s business. Foreign travel costs were deductible. Sponsoring programmes such as Cotton College’s Centenary Celebrations, the State Level National Children Congress and programmes of clubs in which the director was a member lead in advertisement and increased recognition of the assessee and its goods. Since the assessee’s banners as event sponsors were displayed at the festivities, such an expense could only be deemed to have been made for the purpose of increasing the company’s income and thus allowed.
In the matter of Lenovo India P. Ltd. v. ACIT (2016), the assessee had purchased IBM India’s personal computer and laptop division and continued to trade and manufacture PCs and MCs. It offered a one-year or three-year guarantee on PCs and laptops sold to Indian clients. The assessee credited actual warranty expenditure incurred throughout the year and also made extra provision to the profit and loss account based on the assessment of warranty obligations on sales made for unexpired time and claimed it as a deduction. It was held that because IBM was doing business in India in previous assessment years and making warranty provisions based on worldwide data, the assessee may use the data used by IBM in previous years for calculation, and if the assessee had made a provision on a scientific foundation, it had to be granted as a deduction.
In the case of Russian Technology Centre P. Ltd. v. Deputy CIT (2008), it was determined that the assessee was not given registration as a vendor by the Ministry of Defence as a supplier and so no supply occurred. As a result, because the firm had not yet been established, the spending was rightly disallowed. However, expenses accrued after registration were allowable.
But, in the instance of CIT v. Samsung India Electronics Ltd. (2013), all assessees were ready to begin commercial operations before the date of incorporation by recruiting key individuals, engaging in agreements, and beginning the required infrastructure and commercial activities on October 1, 1995. Expenditures incurred before this date are not pre-commencement expenses and are thus permitted.
Advancement or repairs
In CIT v. H.P. Global Soft Ltd. (2018), it was determined that precise guidelines for differentiating capital expenditure from revenue expenditure could not be created. The dividing line is narrow. Certain broad tests, however, have been established. Each case is determined by its unique facts. The purpose and intent of the spending would establish whether it is a capital expenditure or a revenue expenditure. When an expense is made to acquire or create an asset or an advantage for the long-term benefit of the firm, it is appropriately attributed to capital and is of the capital expenditure type. The amount spent on providing wooden partitions, painting leased premises, carrying out repairs to make the premises usable, and replacing glasses is considered revenue expenditure. Expenditure on electricity, civil works, and interior design, with the issue remanded to determine the nature of the expenditure.
In the case of APL India (P.) Ltd. v. Add. CIT, (2017), parts like CD ROM drives, hard disc drives, and RAM, which are parts of a computer’s central processing unit, are not deemed separate and independent machinery; consequently, expenditure on such parts is permissible as revenue expenditure. However, because a printer, scanner, and web camera are distinct and different machines, investment in such gadgets is capitalistic in nature. Revenue expenditure includes spending incurred by the assessee to make office premises appropriate for commercial usage without the creation of a new capital asset. Expenditure on split AC is capital in nature since the assessee created a new asset.
List of expenditures not allowable as a deduction under Section 37(1) from business income
The assessee in Gurudas Mann v. Dy. CIT (2012) is a filmmaker and event organiser. The assessee used the project completion method, resulting in a loss for the film company and a profit from music records. In addition, the assessee provided earnings from past movies, i.e., royalties, film broadcast rights, film satellite rights, and corresponding expenditures with respect to each of her projects individually. In addition, the assessee claimed common expenses such as Diwali expenses, printing and stationery, professional fees, conveyance, credit card charges, depreciation, clothing and costumes, interest on the loan, miscellaneous expenses, and telephone charges. The Assessing Officer determined that the expenditure recorded for professional fees, publicity, business marketing, dress and costume, and so on, was unrelated to old film income and hence not permissible. The Assessing Officer’s ruling was affirmed by the Commissioner (Appeals). On appeal, the Tribunal determined that costs and title registration fees that are not related to ordinary business expenses are not acceptable. The Tribunal also determined that expenditures on purchasing new furniture that is not a replacement are not allowable. The Tribunal further determined that there was insufficient evidence to demonstrate the replacement of an electric installation or the nature of the electric equipment replaced, hence the deduction was denied.
According to the judgement in CIT v. United Breweries Ltd. (2007), a payment made by the assessee company to discharge the guarantee obligations owed to certain companies by two subsidiaries of the assessee company that amalgamated with the latter had no direct proximity or relationship to the assessee’s business and thus was not allowable as a deduction.
In Orchid Chemicals & Pharmaceuticals Ltd. v. ACIT (2019), the non-compete fee paid by the assessee on the purchase of a pharmaceutical firm that resulted in the assessment of a new line of goods is not admissible as a revenue expenditure in one go. The expenditure is to be recognised as a deferred revenue expenditure and is authorised over a four-year pro-rata period beginning with the relevant assessment year.
In Real Image Tech (P) Ltd. (2012), non-compete fee payments submitted as revenue expenditures were regarded as capital expenditures. The assessee’s alternative petition to regard it as an intangible asset under Section 32 and hence grant depreciation on it was upheld.
In the case of A.M. Mathur v. Dy. Commissioner of Income Tax (2007) assessee, an advocate made a contribution to a charitable trust with the specific request that the interest be used to acquire books and magazines and to give other incentives to advocates practising in court. The Tribunal ruled that because there was no evidence to show that the contribution was directly related to the assessee’s company or profession, it was not permitted as business expenditure.
Prior period expenses
In Cadila Pharmaceuticals Ltd. v. ACIT, the assessee sought a deduction for audit fees and raw material purchases. The Assessing Officer denied the assessee’s claim, stating that the charges were prior-period expenses. The Tribunal determined that because the audit was performed in prior years, even if the bill was not received in the previous year, the expenditures should have been evaluated in that year, and so the deduction was not admissible in the year under examination. Regarding raw material costs, because the assessee failed to bring any material on record to support its case that there was any dispute regarding payment to be made to the supplier and said the dispute was settled in the relevant year, no case was made for the deduction, and thus disallowance was deemed justified.
Generally, Section 37(1) states that an expense made entirely and solely for the sake of business is allowed as a deduction. However, based on the preceding discussion, it is obvious that the scope of the aforementioned provision is broad enough to allow for the claim of a specific deduction, provided certain requirements set out therein are met.
The revenue department’s jurisdiction is limited to determining the actuality of the expenditure, that is, whether the amount claimed for deduction was actually spent or not and whether it was completely and solely for business purposes. Once a decision is rendered in favour of the assessee, the whole amount should be deducted as a matter of course. It is well established that the deductions permitted in assessing income under the Act are not exhaustive. Income tax is not recognised as an expense incurred in order to produce a profit; rather, it is regarded as an application of gains after they have been earned, and so it is not deductible. Personal costs, such as those incurred by an assessee for food and clothes, are also not allowed as deductions under Section 37(1).
The test for determining whether a particular expenditure is wholly or partly justified for the purpose of the business is not to determine whether it was necessary, nor is it appropriate to determine whether any other similarly situated person would have thought it reasonable to incur expenditures up to that limit. The genuine test is to determine if the businessman, when he spent the money, was behaving reasonably in the interests of his own business, not influenced by any irrelevant and external considerations, and if the expenditure was planned for the purpose of the assessee’s regular business activity.
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