Section 37 of the Income Tax Act, 1961 serves as a residuary provision for allowing deductions that do not fall under Sections 30 to 36. This section primarily deals with revenue expenditures that are neither capital nor personal and are laid out wholly and exclusively for business or profession. It is applicable in cases where specific provisions do not govern the deductibility of expenditure.
Sub-section (1) of Section 37 provides that any expenditure, other than those covered under Sections 30 to 36, and which is not in the nature of capital or personal expenses, shall be allowed as a deduction if it is incurred wholly and exclusively for the purpose of business or profession. This provision gives considerable flexibility but also requires careful interpretation, especially in light of its explanations.
Explanation 1 to Section 37
Explanation 1 was inserted by the Finance Act, 1998,, with retrospective effect from April 1, 1962. This explanation aims to prevent taxpayers from claiming deductions for expenditures that are incurred for purposes that constitute an offence or are prohibited by law. It clarifies that any expenditure incurred for purposes that are unlawful, either under Indian law or foreign law, shall not be considered as allowable under Section 37(1).
This explanation was introduced following judicial decisions that permitted certain expenditures related to illegal activities, provided they were incurred wholly and exclusively for business. The retrospective insertion of Explanation 1 reflects the legislature’s intention to close this loophole and align tax provisions with public policy.
Explanation 2 to Section 37
Explanation 2 was introduced by the Finance Act, 2014, and took effect from April 1, 2015. It specifically disallows any expenditure incurred on Corporate Social Responsibility (CSR) activities as mandated under Section 135 of the Companies Act, 2013. The reasoning behind this disallowance is that such expenses are not incurred for the purpose of carrying on business but are statutory obligations imposed on companies.
Though CSR expenditure may benefit society and indirectly enhance the company’s image, it is not considered a business expenditure under the purview of Section 37(1). However, certain contributions under CSR may still qualify for deduction under Section 80G, provided they meet the conditions laid out therein.
Explanation 3 to Section 37
Explanation 3 was inserted by the Finance Act, 2022, with effect from April 1, 2022. It was added to clarify and expand the scope of Explanation 1. It specifically mentions that any expenditure incurred for any purpose that is an offence under Indian or foreign law, or which provides benefits or perquisites in violation of applicable laws, shall not be allowed as a deduction.
Explanation 3 also covers compounding fees paid to settle offences, indicating that such expenses, even if incurred to resolve legal disputes, are not deductible. This clarification was introduced in response to judicial rulings that allowed deductions for certain types of penalties and expenses related to settlements.
Explanation 3 aims to eliminate ambiguity and ensures that tax benefits are not granted to those engaging in illegal or unethical practices, even if such practices are prevalent in certain industries.
Conditions for Allowability under Section 37 of the Income Tax Act
For any expenditure to be allowed under Section 37(1), it must meet the following cumulative conditions. First, the expenditure must not be of the nature described in Sections 30 to 36. These sections cover specific allowable expenditures such as rent, repairs, depreciation, insurance, and interest on borrowed capital.
Second, the expenditure must not be capital in nature. Capital expenditures usually result in the acquisition of a long-term asset or advantage and are not allowable under Section 37. Third, the expenditure should not be of a personal nature. This condition ensures that expenses incurred for personal benefit or use are not deducted from business income.
Lastly, the expenditure must be laid out or expended wholly and exclusively for business or profession. This means that there should be a direct nexus between the expenditure and the business operations. Expenditures that are even partially personal or unrelated to business are not allowed.
These conditions are to be applied collectively, and failure to satisfy even one condition can result in the disallowance of the expenditure.
Meaning of the Term ‘Any Expenditure’
The phrase ‘any expenditure’ used in Section 37(1) encompasses a wide range of outflows, provided they meet the prescribed conditions. The core idea behind this term is the act of ‘spending’, which refers to the irreversible outflow of funds. Expenditure under this section must be voluntary and involve a conscious decision to incur a cost for business purposes.
The Supreme Court in CIT vs. Woodward Governor India (P.) Ltd. clarified that ‘any expenditure’ can also include amounts that represent losses if such losses are incurred during the course of business and are not capital in nature. The broad interpretation ensures that genuine business expenditures are not denied due to technicalities.
In M. P. Financial Corporation v. CIT, the court observed that in specific cases, the term ‘expenditure’ might even include an amount that did not physically leave the assessee’s pocket but still represents a business cost, thus qualifying for deduction.
Distinction Between ‘Expenditure’ and ‘Loss’
It is important to understand the distinction between expenditure and loss. Expenditure is a conscious act involving the outflow of resources, generally through a payment. It is incurred voluntarily and with the objective of achieving some business result. Loss, on the other hand, usually arises from unforeseen or involuntary circumstances, such as theft or destruction of assets.
While both terms may involve a reduction in resources, their nature and origin are different. However, for the purpose of tax deduction, certain types of business losses may qualify as ‘expenditure’ under Section 37, provided they are incidental to business and not capital in nature.
In CIT v. J. K. Cotton Spinning & Weaving Mills Co. Ltd., it was held that business expenditure must be wholly and exclusively for business, while a business loss must be non-capital and incidental to trade. This judicial approach allows a nuanced understanding of what can be claimed under Section 37.
The court in CIT v. Woodward Governor India (P.) Ltd. also held that loss, if incidental to business, qualifies under the expression ‘any expenditure’. This reinforces that the term includes more than just cash payments and may cover business-related financial outflows under broader interpretations.
Meaning of ‘Wholly and Exclusively for Business’
The phrase “wholly and exclusively for the purpose of business” used in Section 37(1) is a key condition for allowing any expenditure. It does not mean that the expense must be necessary. Instead, the law allows the assessee to determine whether a particular expense is warranted in the conduct of business. The expenditure can be incurred voluntarily, without absolute necessity, and still qualify for deduction as long as it is wholly and exclusively for business.
The Supreme Court in State of Madras v. G. J. Coelho held that the expression does not require necessity, only that the expense be closely connected with the business and its operations. It clarified that even voluntary expenses incurred to facilitate or improve business operations are covered if done for business purposes.
In Bombay Steam Navigation Co. (1953) (P.) Ltd. v. CIT, the court accepted that an expense could qualify as revenue expenditure, laid out wholly and exclusively for the purpose of business, even if it was not compulsory or legally mandated. This interpretation supports a practical view of commercial activity and decision-making.
In S. A. Builders Ltd. v. CIT(A), the Supreme Court emphasized that the phrase “for the purposes of business” is broader than “for the purpose of earning profits.” An expenditure can be valid even if it doesn’t lead directly to immediate profits, as long as it supports business goals.
In CIT v. Delhi Safe Deposit Co. Ltd., the court laid down a three-part test to assess if expenditure was wholly and exclusively for business. The test includes whether the expense was incidental to trade, incurred to keep the trade going and productive, and whether it was incurred in the capacity of a trader and not for any personal or unrelated motive.
Questioning the Reasonableness of Expenditure
The law does not permit the Income Tax Department to question the commercial expediency of a business decision. If an expense is incurred by the assessee in the course of business, it is presumed to be for a valid business purpose, unless it is proven to be non-genuine or personal.
Judgments such as CIT v. Global Motors Service (P.) Ltd., CIT v. Sapthagiri Traders Ltd., and CIT v. Textool Co. Ltd. reiterate that the revenue authorities must respect the assessee’s judgment regarding commercial expediency. Courts have consistently upheld the view that the tax department should not step into the shoes of the businessman to decide what is prudent or appropriate.
This principle ensures that business owners retain autonomy over their operational decisions without the fear of disallowance based on subjective assessments by the tax department.
No Business, No Allowance
If the assessee is not carrying on any business during the relevant financial year, no deduction under Section 37 can be allowed. This is based on the reasoning that the expenditure must be for business purposes, and if there is no business activity, the question of business expenditure does not arise.
The Kerala High Court in S.P.V. Bank Ltd. v. CIT held that expenses incurred during a period when the business was not in operation cannot be allowed under Section 37. Similarly, in J. R. Mehta v. CIT, it was observed that where no business is carried out in a particular year, no allowance under this section can be made for the expenses incurred.
These judgments emphasize that the existence of an active business is a precondition for claiming deductions under Section 37. Dormant or suspended operations do not entitle the taxpayer to deductions, even if the expenses are business-related.
CSR Expenditure under Section 37 versus Section 80G
Corporate Social Responsibility (CSR) became mandatory for certain companies after the enactment of Section 135 of the Companies Act, 2013. As per the law, companies meeting specific financial criteria are required to spend a certain percentage of their profits on CSR activities.
Explanation 2 to Section 37(1), inserted by the Finance Act, 2014, clarifies that CSR expenditure is not deemed to be incurred for the purpose of business or profession and is therefore not allowed as a deduction under Section 37. However, such expenditure may be eligible for deduction under Section 80G if it meets the required conditions.
Section 80G falls under Chapter VI-A of the Income Tax Act, which provides deductions after the computation of total income. It allows for deductions on donations made to specified funds and institutions. Some CSR expenditures, such as contributions to the Swachh Bharat Kosh or Clean Ganga Fund, are eligible for deduction under this section.
Therefore, while CSR expenditure is not deductible under Section 37, it may still benefit the assessee if routed through approved channels that fall under the ambit of Section 80G. This distinction reinforces the principle that while CSR may be socially valuable, it is not an operational business expense.
Judicial Precedents on CSR Expenditure
Several court rulings and tribunal decisions have interpreted the application of Section 37 and Section 80G to CSR expenses. In FNF India (P.) Ltd. v. Asstt. CIT, the Bangalore Tribunal upheld that CSR expenses are disallowed under Section 37 but did not negate eligibility under other provisions.
In JMS Mining (P.) Ltd. v. Pr. CIT, the Kolkata Tribunal agreed with the disallowance under Section 37 while acknowledging that CSR expenditure might qualify under Section 80G. Similar views were taken in Societe Generale Securities India (P.) Ltd. v. Pr. CIT and Optum Global Solutions (India) (P.) Ltd. v. Dy. CIT, where tribunals distinguished between business expenditure and social responsibility under statutory compulsion.
These cases reflect the legislative intent that CSR expenses, being obligations under company law, are not considered voluntary business expenditures and hence not deductible under Section 37.
Capital Expenditure versus Revenue Expenditure
The Income Tax Act does not define the terms ‘capital expenditure’ or ‘revenue expenditure’. As a result, courts have developed tests and guidelines to distinguish between the two based on the nature and purpose of the expense.
Capital expenditure generally refers to expenses that result in the acquisition of a long-term asset or benefit. These are expenditures that provide enduring value and are not typically incurred during the ordinary course of business. They are not deductible under Section 37 but may be eligible for depreciation or other treatment under specific provisions.
Revenue expenditure, on the other hand, refers to operational costs that are incurred regularly for the running of the business. These expenses do not create enduring assets and are essential to daily operations. Such expenditures are usually allowed under Section 37 if they meet other conditions.
The factual nature and context of the expenditure are crucial in determining its classification. Courts consider the purpose of the expense, its recurrence, and whether it results in an enduring benefit to decide whether it is capital or revenue in nature.
Accounting Treatment Not Conclusive
The way an assessee records an expense in the books of accounts is not conclusive for tax purposes. An expense recorded as capital in the books may still qualify as revenue expenditure under the Income Tax Act and vice versa.
In Kedarnath Jute Mfg. Co. Ltd. v. CIT, the Supreme Court held that entries in the books of account are not decisive of the nature or allowability of an expense. What matters is the legal nature of the expense as per the Income Tax Act, not the accounting treatment adopted by the assessee.
This ruling gives precedence to substance over form and ensures that tax liabilities are determined based on legal principles rather than mere accounting entries.
Tests from Judicial Precedents on Capital and Revenue Expenditure
In Bharti Hexacom Ltd., the Supreme Court held that expenses incurred for the acquisition of a concern are capital in nature, while those incurred for running the concern are revenue. The court distinguished between enlargement of a business structure and operations of an existing apparatus.
The court also noted that the mere payment of an amount in installments does not change the nature of capital expenditure to revenue. Similarly, a single transaction cannot be artificially split into capital and revenue components if its essence is one or the other.
These principles help establish a framework for classifying expenses when there is doubt about their nature. They also guide tax authorities and taxpayers in making consistent and legally sound decisions.
Meaning of ‘Offences or Prohibited by Law’
Explanation 1 to Section 37(1) disallows any expenditure that is incurred for purposes constituting an offence or that is prohibited by law. This provision reflects the broader policy of preventing tax deductions for activities that are unlawful or against public interest.
Before the insertion of this explanation, courts had occasionally allowed deductions for payments made under illegal or dubious circumstances if they were considered necessary for business. To prevent misuse of the provision, the legislature added this explanation to make it clear that tax benefits will not be given for expenses linked to illegal conduct.
The guiding principle is that allowing such deductions would defeat the public purpose by effectively subsidizing illegal activities through tax relief. Therefore, whether the expense is incurred under Indian law or foreign law, if it is prohibited or considered an offence, it is inadmissible.
A distinction was historically drawn between compensatory and penal payments. Courts had ruled that compensatory payments, which reimburse a loss or damage, may be deductible. However, penal payments intended to punish are not allowable. For instance, in Mahalakshmi Sugar Mills Co. Ltd. v. CIT, the Supreme Court allowed a deduction for interest on delayed payments as it was compensatory and not penal. Similarly, in CIT v. Hyderabad Allwyn Metal Works Ltd., it was held that compensatory payments are not prohibited under Explanation 1 and can be claimed as a deduction.
Fallout of Explanation 3 to Section 37(1)
Explanation 3 was introduced by the Finance Act, 2022, and is effective from April 1, 2022. It clarifies and expands the scope of Explanation 1 by explicitly listing the types of expenditures considered inadmissible under Section 37.
The explanation states that any expenditure incurred for a purpose which is an offence under any law in force in India or outside India is inadmissible. This includes expenses that provide benefits or perquisites in violation of laws or are incurred for compounding offences. The intention is to ensure that companies and professionals do not indirectly benefit from non-compliant or unethical practices through tax deductions.
Clause (ii) of Explanation 3 was particularly aimed at curbing the practice of pharmaceutical companies giving freebies to doctors. Despite a circular by the CBDT, some judicial forums had allowed such deductions. Explanation 3 now makes it clear that providing such unlawful benefits is an offence and any associated expenditure is inadmissible.
Clause (iii) disallows deductions for compounding fees paid to settle legal violations. Though compounding is a legally permitted mechanism for settling minor offences, the explanation ensures that taxpayers cannot use it as a method to claim tax deductions for regulatory violations.
This clause also impacts companies governed by laws like the Companies Act and SEBI regulations, where compounding mechanisms are commonly used. Businesses now face a greater compliance burden since expenditures made to settle even minor legal infractions can no longer be claimed as business expenses.
Explanation 3 strengthens the alignment of tax policy with regulatory compliance by making it clear that no tax benefit will be available for expenses tied to any kind of unlawful or prohibited activity.
Jurisprudence on Payments Related to Offences
The judiciary has considered several cases involving expenditures that potentially fall under Explanation 1 or Explanation 3. These rulings help define the boundaries of what is considered an offence or prohibited by law.
In M/s Khemchandmotila Jain Tobacco Producers Pvt. Ltd., the High Court addressed the issue of ransom payment made during a kidnapping. Though the act of kidnapping is punishable under Indian Penal Code Section 364A, the court held that no specific law prohibits the payment of ransom, and since the director was on a business tour, the payment was considered allowable.
In CIT v. Desiccant Rotors International Pvt. Ltd., the assessee settled a patent infringement dispute and claimed the expense as deductible. The Delhi High Court ruled that the payment was compensatory and not penal, and hence allowable.
In CIT v. Airlines Hotel Pvt. Ltd., a settlement payment made to regain possession of business premises was held to be for commercial expediency and thus deductible. The court observed that such expenses, incurred to protect business interests, are not in violation of any law and do not fall under Explanation 1.
In Prakash Cotton Mills (P.) Ltd. v. CIT, the Supreme Court emphasized the importance of examining the nature of the statutory payment. It ruled that if the impost is compensatory, it is allowable; if it is penal, it is not. This case continues to guide the distinction between allowable and non-allowable expenditures.
Application of Section 37 to International Offences
With the addition of Explanation 3, the scope of inadmissibility under Section 37 now includes offences under foreign laws as well. This is particularly relevant in the context of multinational corporations and cross-border business operations.
For example, in Mylan Laboratories Ltd. v. Dy. CIT, the assessee, a pharmaceutical company, was fined by the European Commission. The assessing officer disallowed litigation costs under Explanation 1, arguing that the payment was a penalty. However, the tribunal ruled that the amount paid was in the nature of disgorgement and not penal. Therefore, it was allowable as a business expense or loss under Section 28 or Section 37.
This case illustrates the complexities of determining the nature of payments in international disputes. With Explanation 3 in force, such issues are expected to become more contentious, and taxpayers will have to carefully evaluate whether a payment violates foreign laws and whether it is compensatory or penal in nature.
Impact on Specific Industries
Certain industries are more affected by the provisions of Explanation 1 and Explanation 3. In the pharmaceutical sector, expenses related to providing gifts, hospitality, or other benefits to doctors have now been disallowed. Despite earlier judicial decisions allowing such expenditures, the new explanation makes their inadmissibility unambiguous.
Similarly, companies in regulated sectors like financial services, energy, and infrastructure must be cautious when dealing with regulatory settlements and compounding of offences. Payments made to resolve issues with regulators can no longer be assumed to be business expenditures for tax purposes.
This impacts tax planning and requires businesses to distinguish between legitimate operational costs and those arising from legal or ethical violations. Legal departments must work closely with finance teams to assess the deductibility of contentious expenses.
Effect on Freebies and Promotional Expenses
One of the most debated issues before Explanation 3 was the allowability of freebies and promotional expenses in sectors like pharmaceuticals, consumer goods, and electronics. These were often viewed as business strategies to enhance sales and build relationships.
However, if such benefits violate industry codes, regulatory guidelines, or ethical standards, they are now squarely disallowed under Explanation 3. The target is not just the illegality of the act but the nature of the benefit provided in breach of applicable laws.
This marks a significant shift in how such expenses are treated under tax laws. Even if the intent was to boost sales or brand awareness, the violation of statutory provisions renders the expenditure inadmissible under Section 37(1).
Compounding of Offences and Tax Deductibility
Compounding is a legal mechanism that allows an offender to settle a case by paying a fine or fee instead of facing full prosecution. Though it avoids the stigma of a criminal record, Explanation 3 now ensures that the amount paid for compounding cannot be claimed as a deductible expense.
This provision is particularly important in corporate governance and regulatory compliance. For example, non-compliance with procedural requirements under company law may be compounded, but the amount paid for such settlement is no longer deductible.
This legislative shift ensures that businesses are not rewarded through tax relief for resolving avoidable violations through monetary settlements. It places a higher burden on compliance and forces companies to internalize the cost of legal lapses without expecting tax offsets.
Judicial Precedents and Their Influence on Interpretation
The interpretation of Section 37 has been significantly shaped by judicial pronouncements over the years. Courts have been instrumental in clarifying the scope, limitations, and boundaries of what constitutes admissible business expenditure under this section. Various rulings have highlighted aspects such as the purpose of the expense, the nature of the business, and the connection between the expenditure and income-earning activities.
In Madhav Prasad Jatia v. CIT (1979), the Supreme Court emphasized that for an expense to be allowed under Section 37, it must be incurred wholly and exclusively for the purposes of business. This decision reiterated the principle that personal expenses or those with dual motives (business and personal) cannot be allowed.
Similarly, in CIT v. Indian Molasses Co. (P) Ltd. (1970), the Supreme Court elaborated on the meaning of “laid out or expended” and held that a mere provision or reserve would not amount to an expenditure unless it resulted in a liability or outgoing of resources.
In another landmark case, CIT v. Malayalam Plantations Ltd. (1964), the Apex Court ruled that an expenditure to be deductible under Section 37 must be incurred in the capacity of a trader and not as an owner of assets. This judgment separated the business-related nature of the expense from those related to ownership or capital assets.
These rulings, along with many others, form the judicial bedrock that guides the application and interpretation of Section 37. Courts have consistently leaned on the principle of “real income theory” and have been cautious in allowing deductions unless a direct nexus with business activity is established.
Comparative Insight: Section 37 vs. Other Deduction Sections
To critically understand Section 37, it is important to compare it with other deduction sections like Sections 30 to 36. While Sections 30 to 36 are specific in nature, dealing with expenses like rent, repairs, depreciation, and scientific research, Section 37 serves as a general provision for all business expenses not covered under those sections.
This generality provides flexibility but also invites litigation, especially when businesses try to stretch the interpretation to claim unconventional or borderline expenses. For instance, while depreciation under Section 32 is well-defined and mechanical, deduction under Section 37 may require significant subjective analysis.
Moreover, unlike Section 35 which provides specific treatment for expenditure on scientific research, Section 37 cannot be applied to expenses with long-term implications or benefits without running afoul of capital expenditure exclusion.
This comparative framework helps underline the fact that Section 37 acts as a residuary clause and, as such, requires cautious application supported by clear documentation and purpose justification.
International Perspective and Alignment with Global Practices
Globally, tax systems have similar provisions for allowing business expenditures, though terminology and structure may differ. For instance, the U.S. Internal Revenue Code allows “ordinary and necessary” expenses under Section 162. The phrase “ordinary and necessary” is conceptually similar to “wholly and exclusively for the purposes of the business” as used in India.
Similarly, the U.K. tax system provides deductions for expenses that are “wholly and exclusively” laid out for the purposes of the trade. The convergence in underlying principles across jurisdictions provides a basis for India’s alignment with global norms in evaluating business expenses.
However, India’s emphasis on statutory definitions and judicial interpretation has resulted in a more structured but also litigation-prone environment. Other countries rely more on principles-based taxation, which sometimes allows for more flexibility in interpretation. India’s rigid scrutiny, especially under anti-avoidance principles and clauses like Explanation 1 to Section 37, reflects a cautious and detailed approach to deduction claims.
Policy Considerations and Reform Suggestions
Given the growing complexity of business operations and the digital economy, Section 37 may require certain clarifications and reforms. As expenditure types evolve—such as spending on digital marketing, data analytics, cybersecurity, and environmental compliance—the tax law must ensure clarity on their treatment.
Additionally, ambiguities around what constitutes a “penalty” or “offense” under Explanation 1 to Section 37 have given rise to unnecessary litigation. Policy reforms could include:
- Clearer guidance or notification-based listing of allowable/unallowable expenses for emerging sectors.
- Amendment or elaboration of Explanation 1 to differentiate statutory levies from penal punishments.
- Facilitating presumptive disallowances only in exceptional cases, to reduce tax litigation and improve ease of doing business.
Moreover, adopting principles from international best practices, such as the OECD guidelines for deductibility of business expenses, could provide a more consistent and predictable framework.
Conclusion
Section 37 of the Income Tax Act, 1961, stands as a pivotal provision for allowing general business deductions, capturing the essence of economic expenditures that do not fall under any specific head. Its broad scope ensures that legitimate, revenue-oriented business expenditures are not denied for lack of specific provision.
However, this very breadth makes it prone to interpretational issues and litigation. Judicial pronouncements have played a major role in refining its contours, and comparative legal insights underline its alignment with global norms. Future reforms aimed at clarity and consistency could further improve its functionality while reducing tax disputes.