Critical Analysis of Section 37 of the Income Tax Act, 1961

Section 37 of the Income Tax Act pertains to the deduction of expenses incurred in the production of income. It states that any expenditure not being capital expenditure or personal expenses of the assessee, laid out or expended wholly and exclusively for the purposes of the business or profession shall be allowed in computing the income chargeable under the head "Profits and gains of business or profession."

This means that for an expense to be deductible under this section, it must meet several criteria:
– The expense should not be capital in nature.
– The expense should not be a personal expense of the assessee.
– The expense should be incurred wholly and exclusively for business or professional purposes.

This section is crucial for businesses and professionals as it outlines the types of expenses that can be claimed as deductions from their taxable income, thereby lowering their overall tax liability. It covers a broad range of expenses including rent, wages, utility costs, and more, provided they are directly related to the business activity.

By Rohan Sogani

Table of Contents

1. Overview of Section 37 of the Income Tax Act
2. Conditions for Allowability under Section 37 of the Income Tax Act
3. Meaning of ‘Wholly and Exclusively for the Purpose of Business’
4. CSR Expenditure – Section 37 vs. Section 80G
5. Capital Expenditure vs. Revenue Expenditure
6. Meaning of ‘Offences/Prohibited by Law’
7. Fallout of Explanation 3 to Section 37(1)
8. Case Laws

1. Overview of Section 37 of the Income Tax Act

• Section 37 is a “Residuary Provision”.
• Sub-section (1) allows deductibility of Revenue and Non-Personal Expenditure, excluding those covered under Specific Sections.

Explanations to Section 37(1) inserted from time to time for clarifying the intent of the legislature.

Explanation 1

• Inserted vide Finance Act, 1998 w.r.e.f. 1-4-1962.
• Expenses related to offences or prohibited activities are inadmissible.

Explanation 2

• Inserted vide Finance Act, 2014 w.e.f. 1-4-2015.
• CSR Expenditure not allowable.

Explanation 3

• Inserted vide Finance Act, 2022 w.e.f. 1-4-2022.
• Further Clarification on Explanation 1.

2. Conditions for Allowability under Section 37 of the Income Tax Act

Expenditure shall be allowed in computing the income chargeable under the head “PGBP“, if it satisfies following conditions Cumulatively:

• it is Not an expenditure of the nature described in Sections 30 to 36
• it is Not in the nature of Capital Expenditure
• it is Not in the nature of Personal Expenses
• it is laid out or expended Wholly and Exclusively for the purposes of the business or profession

Explanations 1, 2, 3 to be Considered

2.1 Meaning of Term ‘Any Expenditure’

• Allowance under Section 37 is granted to ‘Any Expenditure’ that meets the criteria outlined in Section 37(1).
• Core definition of ‘expenditure’ revolves around the concept of ‘Spending‘ indicating the act of ‘Paying Out or Away’ of money. In essence, ‘expenditure’ denotes the Irreversible Outflow of Funds.

2.2 ‘Expenditure’ vs. ‘Loss’

Distinction exists between “disbursement/expenditure” and a “loss”.

Expenditure: 

1. Conscious act of paying out or spending.
2. Deliberate choice for outflow of resources.

Loss:

1. Fortuitous or arises from external factors.
2. Entirely involuntary i.e. loss occurs irrespective of a person’s will.

• Business Expenditure must be incurred “Wholly and Exclusively” for business for allowance, while a Business Loss, to qualify, must be of a Non-capital Nature and not only connected with the trade but also incidental to the trade itself.

[CIT v. J. K. Cotton Spinning & Weaving Mills Co. Ltd. [1980] 4 Taxman 1/123 ITR 911 (All.)

• In the case of M. P. Financial Corporation v. CIT [[1986] 26 Taxman 42/[1987] 165 ITR 765 (MP)], it has been observed that the term “expenditure” may, under specific circumstances, encompass:

1. 1. an amount that essentially represents a loss;
   2. even if that amount has not gone out of assessee’s pocket.

• The phrase ‘any expenditure’ within Section 37 of the Income Tax Act is interpreted to include both:

1. 1. ‘expenses incurred’ and
   2. amount classified as ‘losses’,

even if such amount has not gone out of assessee’s pocket

[CIT vs. Woodward Governor India (P.) Ltd. [2009] 179 Taxman 326/312 ITR 254 (SC)].

3. Meaning of ‘Wholly and Exclusively for the Purpose of Business’

• Phrase “Wholly And Exclusively” does not equate to “Necessarily”
• Assessee to determine Whether a Particular Expenditure is Warranted in the conduct of business.
• Expenditure may be undertaken Voluntarily and Without Absolute Necessity.
• State of Madras vs. G. J. Coelho [(1964) 53 ITR 186 (SC)] – established test stating that expenditure incurred under a transaction closely intertwined with the business can be considered an integral part of conducting the business.
• Bombay Steam Navigation Co. (1953) (P.) Ltd. vs. CIT (1965) 56 ITR 52 (SC) – Expenditure may qualify as revenue expenditure, laid out wholly and exclusively for the purposes of the business.
• S. A. Builders Ltd. vs. CIT(A), [2007] 158 Taxman 74/288 ITR 1 (SC) – Phrase “for the purposes of the business or profession” as employed in Section 37(1) encompasses a broader scope than the expression “for the purpose of earning profits”.
• CIT v. Delhi Safe Deposit Co. Ltd. [1982] 8 Taxman 1/[1982] 133 ITR 756 (SC) – True test of an expenditure laid out wholly and exclusively for the purposes of trade or business is it is incurred by the assessee:

1. 1. as Incidental to his Trade;
   2. for the purpose of Keeping the Trade Going and of making it pay and;
   3. Not in Any Other Capacity Than That of a Trader.

3.1 Questioning Expenditure’s Reasonableness: Possible?

• It is not for the revenue to question the Commercial Expediency of the expenditure.
• Commercial Expediency is a matter entirely left to the judgment of the assessee [CIT vs. Globald Motor Service (P.) Ltd. (1975) 100 ITR 240 (Mad.); CIT vs. Sapthagiri Traders Ltd. [2009] 180 Taxman 605/[2008] 305 ITR 438 (Mad.); CIT vs. Textool Co. Ltd. [2009] 184 Taxman 217/315 ITR 91 (Mad.)].

3.2 No Business, No Allowance

If during the relevant period, there was no business, the question of allowability of expenses would not arise [S.P.V. Bank Ltd. vs. CIT [1981] 5 Taxman 155/[1980] 126 ITR 773 (Ker.); J. R. Mehta vs. CIT [1980] 4 Taxman 522/126 ITR 476 (Bom.)].

4. CSR Expenditure – Section 37 vs. Section 80G

• Section 135 of the Companies Act, 2013 – Applicability

To Be Seen With Reference to Immediately Preceding Financial Year

• Explanation to Section 37(1)
  • Expenditure incurred on the activities related to CSR referred to in Section 135 shall be not deemed to be incurred for the purpose of PGBP.

Case Laws

5. Capital Expenditure vs. Revenue Expenditure

• Capital or the Revenue expenditure has Not Been Defined in the Act.
• A clear-cut dichotomy cannot be laid in respect of Revenue or Capital expenditure in the absence of statutory definition.
• ‘Capital’ Denotes ‘Permanency’ and, therefore, it refers to getting something tangible or intangible, property, corporeal or incorporeal rights, so that they could be of lasting or enduring benefit to the enterprise.
• ‘Revenue expenditure’ on the other hand is Operational in perspective and solely intended for the Furtherance of the enterprise Nature/Factual Position of transaction is important.

5.1 Accounting Treatment of Expenditure – Not Relevant

• Entries in the books of accounts are Not Decisive of the nature and character of expenses.
• Legal right is not Self Estopped by the Accounting Treatment adopted by the assessee.
• It is not material and relevant how the company treated these expenses in its books of accounts but what is material and relevant is the Allowability of These Expenses as Revenue Expenses as per provisions of the Income Tax Act, 1961.

[Kedarnath Jute Mfg. Co. Ltd. v. CIT [1971] 82 ITR 363 (SC)]

5.2 Tests Emerging from Judicial Precedence

Bharti Hexacom Ltd. [2023] 458 ITR 593 (SC)[16-10-2023]

• Expenses towards “acquisition of concern” is capital in nature; “carrying on a concern” is revenue in nature
• Enlargement of Structure vs operation of existing apparatus
• Mere Payment of an amount in instalment does not convert or change capital payment into revenue payment
• Single Transaction cannot be split in an artificial manner into capital and revenue

6. Meaning of ‘Offences/Prohibited by Law’

Explanation 1 to Section 37(1), any expenditure which is:

• Offence,
• Prohibited by Law

are inadmissible expenses under PGBP.

• A key pre-amendment principle was Compensatory Payments were allowed, Penal Payments were not, as affirmed by the Supreme Court in cases like Mahalakshmi Sugar Mills Co. Ltd. vs CIT [1980] 123 ITR 429 (SC) and CIT vs Hyderabad Allwyn Metal Works Ltd. [1988] 36 Taxman 88/172 ITR 113 (AP).

7. Fallout of Explanation 3 to Section 37(1)

• Explanation 3 was inserted to further clarify Explanation 1 to Section 37(1). It clarifies that “expenditure incurred by an assessee for any purpose which is an offence or prohibited by law” includes expenditure:

1. 1. for purposes considered Offences Under Current Laws in India or Outside India;
   2. providing Benefits or Perquisites, Violating applicable laws by the recipient.
   3. to Compound an Offence under prevailing laws In India or Outside India.

• Section 37(1) not only prohibits expenditures related to offenses under Indian law but also extends to Offenses Under Laws Outside India.
• Explanation 1 was introduced retrospectively by the Finance Act, 1998, w.e.f. 01.04.1962. Explanation 3 has been specified to be effective from 01.04.2022.
• Clause (ii) in this Explanation mainly aimed to address issues related to Freebies Given to Doctors in the Pharma Industry, which were previously allowed in some ITAT judgments, despite a CBDT circular deeming such favours against medical code of conduct.
• Clause (iii) in the Explanation 3 disallows Compounding Fees. Compounding involves settling an offence by paying compensation instead of facing penal consequences.
• Laws Like the Companies Act and SEBI, where compounding mechanisms exist for minor lapses, and penalizing businesses for claiming deductions on such levies, pose challenges in navigating the extensive compliance regime.

8. Case Laws