Section 37 of the Income Tax Act, 1961 serves as a residuary provision under the head “Profits and Gains of Business or Profession” (PGBP). It allows deduction for revenue and non-personal expenditure that is not expressly covered under Sections 30 to 36 of the Act. This section is essential for determining the allowability of various expenses not specifically dealt with elsewhere under the Act. Sub-section (1) of Section 37 permits deductions for business expenditure provided they are not capital in nature, not personal, and are incurred wholly and exclusively for business or profession.
Legislative Clarifications Through Explanations
Over the years, the legislature has inserted multiple explanations to Section 37(1) to clarify its intended scope and eliminate ambiguities.
Explanation 1 to Section 37(1)
Inserted by the Finance Act, 1998, with retrospective effect from April 1, 1962, Explanation 1 states 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 business or profession. This explanation was introduced to curtail deductions claimed on expenses related to unlawful activities such as fines, penalties, bribes, or other similar transactions.
Explanation 2 to Section 37(1)
Inserted by the Finance Act, 2014 with effect from April 1, 2015, Explanation 2 makes it explicitly clear that any expenditure incurred by an assessee on the activities relating to Corporate Social Responsibility (CSR), referred to in Section 135 of the Companies Act, 2013, shall not be deemed to be an expenditure incurred for business or profession.
Explanation 3 to Section 37(1)
Inserted by the Finance Act, 2022, with effect from April 1, 2022, Explanation 3 was introduced to further clarify the scope of Explanation 1. It clarifies that any expenditure incurred for any purpose which is an offence or is prohibited by law includes and shall be deemed to include any expenditure incurred for purposes which are an offence under any law in India or outside India, or which results directly or indirectly in any benefit or perquisite which violates any law, rule, or regulation. It also includes any expenditure incurred to compound an offence under Indian or foreign law.
Conditions for Allowability of Expenditure under Section 37
For an expense to be deductible under Section 37(1), the following cumulative conditions must be satisfied:
The expenditure should not be of the nature described in Sections 30 to 36. It should not be capital in nature. It should not be personal. It should have been laid out or expended wholly and exclusively for business or profession. Additionally, all three explanations appended to Section 37(1) must be considered in determining the deductibility of the expense.
Meaning and Scope of the Term ‘Any Expenditure’
The allowance under Section 37 is granted to ‘any expenditure’ that satisfies the cumulative conditions stated in the section. The term ‘expenditure’ broadly implies the act of spending or paying out money. It refers to an irreversible outflow of funds from the assessee’s control or possession. The Supreme Court in the case of CIT vs. Woodward Governor India Pvt. Ltd. held that the term ‘any expenditure’ includes both expenses incurred and losses, even when such losses have not led to an actual cash outflow.
Distinction Between ‘Expenditure’ and ‘Loss’
There exists a clear distinction between expenditure and loss. Expenditure typically refers to a conscious act of spending money for business purposes. It is a deliberate choice, reflecting an intention to incur a cost for a perceived commercial advantage. On the other hand, a loss generally arises from unforeseen or involuntary circumstances. It is not a result of the taxpayer’s deliberate decision but rather an incidental or accidental occurrence. However, jurisprudence has established that under certain circumstances, a loss may also fall within the ambit of ‘expenditure’ for Section 37.
The decision in CIT v. J. K. Cotton Spinning & Weaving Mills Co. Ltd. affirms that while business expenditure must be incurred wholly and exclusively for business to be allowed, a business loss, to be eligible, must be non-capital and closely connected or incidental to the business.
Similarly, in M. P. Financial Corporation v. CIT, it was observed that an amount representing a loss may be treated as expenditure even if it has not resulted in a cash outflow. Thus, the meaning of ‘any expenditure’ within Section 37 encompasses a broader range of financial transactions, including those categorised as business losses.
Understanding the Phrase ‘Wholly and Exclusively for Business’
The phrase “wholly and exclusively for business” is central to the interpretation and application of Section 37(1). It does not imply that the expenditure must be necessary in the absolute sense. Courts have consistently held that it is the assessee who is best suited to determine the necessity of incurring an expense in the context of its business operations.
In State of Madras v. G. J. Coelho, the Supreme Court held that any expenditure incurred as part of a transaction closely intertwined with the business could be considered an integral part of the business itself. This view was echoed in Bombay Steam Navigation Co. (1953) (P.) Ltd. v. CIT, where the Court concluded that an expense may qualify as a revenue expenditure even if it is not strictly essential, as long as it is incurred wholly and exclusively for business purposes.
The Supreme Court in S. A. Builders Ltd. v. CIT held that the phrase “for the business or profession” has a broader connotation than merely “to earn profits.” An expenditure may be allowable even if it is not directly linked to profit generation but is still made in the course of carrying on business.
In CIT v. Delhi Safe Deposit Co. Ltd., the Court laid down the true test to determine if an expenditure was incurred wholly and exclusively for business purposes. The test considers whether the expenditure was incidental to the trade, whether it was made to keep the trade going, and whether it was made in the capacity of a trader.
Can the Revenue Question the Commercial Expediency?
It is well-settled law that the tax authorities cannot sit in judgment over the business decisions of an assessee. The concept of ‘commercial expediency’ has been accepted as a legitimate rationale for incurring expenses. Courts have consistently held that it is not the function of the revenue to question the reasonableness of an expense incurred by the assessee if it is otherwise legitimate.
In CIT v. Global Motor Service Pvt. Ltd., the court ruled that commercial expediency is a subjective matter best left to the assessee’s judgment. The same principle was reaffirmed in CIT v. Sapthagiri Traders Ltd. and CIT v. Textool Co. Ltd., where it was concluded that as long as the expense was incurred in the course of business, its wisdom or profitability is not open to scrutiny by tax authorities.
No Business, No Deduction
An important condition for the allowability of an expense under Section 37(1) is that the assessee must be engaged in business during the relevant assessment year. If the business was not operational during the period in question, then any expense claimed under Section 37 would not be allowable.
This principle was upheld in S.P.V. Bank Ltd. v. CIT and J. R. Mehta v. CIT, where the courts held that expenses incurred during periods when the business was not functional cannot be claimed as deductions under Section 37(1).
Corporate Social Responsibility Expenditure under Section 37 versus Section 80G
The concept of Corporate Social Responsibility (CSR) was formalised under Section 135 of the Companies Act, 2013. It mandates companies meeting certain financial thresholds to undertake CSR activities. The question arises whether such expenditure qualifies for deduction under Section 37(1) of the Income Tax Act. Explanation 2 to Section 37(1), introduced by the Finance Act, 2014, and effective from April 1, 2015, answers this definitively by stating that any CSR expenditure referred to in Section 135 of the Companies Act shall not be deemed to be an expenditure incurred to carry on business or profession. Therefore, it is not allowable under Section 37(1).
Comparative Analysis of Section 37(1) and Section 80G
Section 37(1) pertains to the deduction of business expenditure that is incurred wholly and exclusively for business or profession. Section 80G, on the other hand, deals with deductions available after computing gross total income. It permits certain contributions and donations to be deducted, including some forms of CSR expenditure, but only to the extent and for purposes explicitly stated within the section.
Section 37(1) falls under the computation mechanism of income under the head “Profits and Gains of Business or Profession” as per Section 14. Deductions under Section 80G, however, come into play only after the total income is computed and fall under Chapter VI-A of the Act. Therefore, even if CSR expenditure is disallowed under Section 37(1), it may still be claimed under Section 80G if it qualifies under specified sub-clauses such as donations made to the Swachh Bharat Kosh or Clean Ganga Fund.
Judicial Precedents on CSR Expenditure
The issue of CSR expenditure and its allowability has been dealt with in several judicial pronouncements. In FNF India Pvt. Ltd. v. Assistant Commissioner of Income Tax, the Bangalore Tribunal held that CSR expenditure cannot be allowed under Section 37(1) because of Explanation 2, but can be considered for deduction under Section 80G if the donation qualifies.
In JMS Mining Pvt. Ltd. v. Principal Commissioner of Income Tax, the Kolkata Tribunal reiterated that CSR expenses incurred under a statutory obligation cannot be claimed under Section 37(1) due to the specific exclusion by Explanation 2. However, donations made to eligible funds under Section 80G remain allowable.
Another notable case is Societe Generale Securities India Pvt. Ltd. v. Principal Commissioner of Income Tax ,,where the Tribunal ruled that CSR expenses are not deductible under Section 37(1) but acknowledged that certain components might still be eligible under other provisions, such as Section 80G or Section 35AC if applicable.
In Optum Global Solutions India Pvt. Ltd. v. Deputy Commissioner of Income Tax, the Hyderabad Tribunal dismissed the assessee’s claim of treating CSR expenses as voluntary contributions and reaffirmed its ineligibility under Section 37(1) due to the overriding impact of Explanation 2.
Capital Expenditure versus Revenue Expenditure
Section 37(1) allows only revenue expenditure. Capital expenditure, by nature, is not deductible under this section. However, the Income Tax Act does not define the terms ‘capital’ and ‘revenue’ expenditure. Courts have thus played a vital role in interpreting these terms.
Capital expenditure is generally understood to mean expenditure incurred to acquire or improve a fixed asset, which yields enduring benefits. It may be tangible or intangible. Revenue expenditure, on the other hand, is incurred in the day-to-day functioning of the business and is operational in perspective.
The key difference lies in the nature and purpose of the expense. While capital expenditure results in the acquisition of an asset or enhancement of the earning capacity of a business, revenue expenditure is meant for maintaining existing assets or generating revenue within the normal business cycle.
Importance of the Nature and Purpose of the Transaction
The nature and purpose of the transaction are critical in determining whether an expense is capital or revenue in nature. The same transaction can have different implications depending on the factual context. Courts have repeatedly stressed that a rigid test cannot be applied, and the determination must be made based on facts and circumstances.
For example, payments made to acquire a business or any part of it are generally capital in nature. On the other hand, payments made to continue business operations or settle commercial disputes may be treated as revenue expenditure.
Relevance of Accounting Treatment
The treatment given to an expense in the assessee’s books of accounts is not conclusive for income tax purposes. Courts have held that the accounting treatment does not determine the allowability or character of the expenditure under tax laws. What is relevant is the substance and real nature of the transaction, not how it is recorded in the books.
In Kedarnath Jute Manufacturing Co. Ltd. v. Commissioner of Income Tax, the Supreme Court ruled that merely because a liability was not recorded in the books of accounts did not mean that it could not be claimed as a deduction, provided it was a legal and enforceable liability. Thus, legal principles take precedence over book entries in determining allowability under the Act.
Tests Derived from Judicial Decisions
Several tests have emerged through judicial pronouncements to distinguish between capital and revenue expenditure. One such decision is Bharti Hexacom Ltd., where the Supreme Court held that expenses incurred towards the acquisition of a concern are capital in nature, while those incurred for carrying on an existing concern are revenue in nature.
The Court further held that enlargement of the structure of business is a capital expenditure, whereas the mere operation of an existing apparatus is revenue in nature. Also, the payment structure does not determine the nature of the expense. A capital payment made in instalments does not convert it into revenue expenditure. Additionally, splitting a single transaction into multiple parts does not alter its capital nature if the original intent was capital acquisition.
These principles guide in determining the correct classification of expenditure for deduction under Section 37.
Expenses Related to Offences or Prohibited Activities
Explanation 1 to Section 37(1) specifically disallows any expenditure incurred by the assessee for any purpose which is an offence or which is prohibited by law. The rationale behind this explanation is to ensure that no tax benefit is granted for any unlawful activity or prohibited transaction. This explanation applies even if the expense is incurred in the course of business or profession.
Before the insertion of Explanation 1, courts made a distinction between compensatory and penal payments. Compensatory payments, even if arising from a legal infraction, were allowed as deductions, while penal payments were disallowed. This was affirmed by the Supreme Court in Mahalakshmi Sugar Mills Co. Ltd. v. Commissioner of Income Tax, where interest on delayed payments to the government was held to be compensatory and therefore allowable.
A similar principle was followed in CIT v. Hyderabad Allwyn Metal Works Ltd., where penalties of a compensatory nature were allowed, and those of penal nature were disallowed. The legislative intent behind Explanation 1 is to codify the disallowance of expenses arising from offences or illegal conduct.
Explanation 3 and Its Impact on Section 37(1)
Explanation 3 was introduced to address certain ambiguities left by Explanation 1 and to expand its coverage. It clarifies that the expression “expenditure incurred for any purpose which is an offence or which is prohibited by law” includes expenditure incurred for purposes that constitute offences under Indian law or foreign law.
It also includes expenditure incurred to provide benefits or perquisites to a person in violation of laws, rules, or regulations. In addition, it covers expenditure incurred to compound offences. This means that even if the assessee has chosen to settle a legal violation by paying a compounding fee instead of facing prosecution, the expenditure would still be disallowed.
The Explanation also addresses industry-specific issues. For instance, Clause (ii) of Explanation 3 directly impacts the pharmaceutical industry, where companies often providefreebies to doctors. Despite CBDT circulars disallowing such deductions, some judicial forums allowed the claim. Explanation 3 overrules such positions by deeming these as expenses incurred for an unlawful purpose.
Clause (iii) clarifies that compounding fees paid to regulatory authorities such as the Ministry of Corporate Affairs or SEBI for minor lapses are also not deductible. This has posed compliance challenges, especially in regulated industries.
Judicial Decisions Clarifying the Application of Explanations
In M/s Khemchand Motilal Jain Tobacco Producers Pvt. Ltd., the Madhya Pradesh High Court examined whether ransom payment could be allowed as business expenditure. While the payment was for securing the release of a director during a business tour, and no law specifically prohibited ransom payment, the court allowed the claim, distinguishing it from penal or prohibited expenses.
In CIT v. Desiccant Rotors International Pvt. Ltd., the Delhi High Court allowed expenditure incurred to settle a patent infringement dispute. Since the payment was compensatory and not a penalty, it was held to be allowable under Section 37(1).
In CIT v. Airlines Hotel Pvt. Ltd., a settlement payment to secure possession of business premises and legal expenses incurred during a dispute over management were allowed, as the court accepted the justification based on commercial expediency.
Judicial Pronouncements and Interpretation
Indian courts have played a pivotal role in shaping the understanding and application of Section 37. Several landmark judgments have defined the scope of “wholly and exclusively for business,” clarified what constitutes capital versus revenue expenditure, and addressed other contentious issues.
CIT v. Indian Molasses Co. (P) Ltd. (1959)
In this case, the Supreme Court clarified that an expenditure cannot be allowed under Section 37 unless it is incurred for business purposes alone. The judgment reiterated the requirement that any deduction under this section must be solely for business, without any personal or non-commercial motives. This ruling laid down the foundation for the “wholly and exclusively” test.
Sassoon J. David & Co. Pvt. Ltd. v. CIT (1979)
The court held that for expenditure to be deductible under Section 37, it need not be compulsory or inevitable. What is necessary is a genuine nexus between the expense and the business activity. This broadened the scope of Section 37 by including even voluntary expenditures, provided they were incurred for business purposes.
CIT v. Malayalam Plantations Ltd. (1964)
In this decision, the court explained that if an expenditure is incurred for preserving or promoting the business interest, it would qualify for deduction under Section 37. However, it emphasized that expenses incurred in discharging statutory obligations or for social/charitable reasons, with no connection to business interests, would not be deductible.
CIT v. H. R. Sugar Factory (P) Ltd. (1991)
The court denied a deduction for a donation made to a political party, even though it was argued to be for fostering business goodwill. The judgment clarified that expenses of a personal, political, or social nature are disallowed under Explanation 1 to Section 37(1).
CIT v. Chandulal Keshavlal & Co. (1960)
Here, the Supreme Court stated that the Revenue cannot substitute its view of commercial expediency for that of the assessee. If the assessee can establish that the expenditure was incurred for the benefit of the business, it is not for the Revenue to challenge the wisdom of the expense.
Empire Jute Co. Ltd. v. CIT (1980)
This case helped in distinguishing capital and revenue expenditure. The Supreme Court held that if the advantage obtained by incurring an expense is not enduring in nature, or is confined to facilitating the carrying on of business more profitably, the expenditure can still be classified as revenue.
Relevance of the Principle of Commercial Expediency
One of the most important principles that has evolved through judicial interpretation is “commercial expediency.” The courts have consistently held that if an expense is incurred due to commercial expediency—meaning that a prudent businessman would have made such an expenditure in the ordinary course of business—it qualifies for deduction under Section 37.
The judiciary has emphasized that the tax authorities should not judge the reasonableness or necessity of the expenditure but should only verify its authenticity and business connection. This approach protects the business judgment of the assessee from undue scrutiny, as long as the expense is neither bogus nor fictitious.
Capital vs. Revenue Expenditure
One of the persistent challenges in applying Section 37 has been differentiating between capital and revenue expenditure. Section 37 explicitly excludes capital expenditures from its ambit, but the line between the two is often blurred.
For example:
- Expenses incurred on acquiring a license or a long-term lease are generally treated as capital expenditures due to their enduring nature.
- On the other hand, recurring payments like salaries, rent, or maintenance are treated as revenue expenses.
Judicial pronouncements such as Alembic Chemical Works Co. Ltd. v. CIT (1989) have provided guidelines for this classification. The Supreme Court observed that not all expenditures that provide an enduring benefit are capital in nature; the intention and context matter.
Another example is Assam Bengal Cement Co. Ltd. v. CIT (1955), where the court laid down tests like enduring benefit, ownership of asset, and fixed versus circulating capital to differentiate the two types of expenses.
Disallowances under Explanation to Section 37(1)
The Explanation to Section 37(1), inserted by the Finance (No.2) Act, 1998, has become a major ground for disallowance of deductions. It disqualifies any expenditure incurred for purposes that are either illegal or against public policy.
This includes:
- Bribes and illegal payments
- Expenditures for violating laws and regulations
- Corporate social responsibility expenses are not allowed under other specific sections
For instance, in Kap Scan and Diagnostic Centre Pvt. Ltd. v. CIT (2012), the court disallowed commission paid to doctors as a business promotion expense, as it was considered unethical and against the regulations of the Medical Council of India.
This judicial approach reinforces the idea that Section 37 cannot be used to provide a tax shield for illegal or unethical activities, regardless of their contribution to business profits.
Judicial Trends Shaping the Interpretation of Section 37
The interpretation of Section 37 has undergone significant evolution due to consistent judicial scrutiny. The courts have provided a refined understanding of what constitutes “wholly and exclusively” incurred expenses for business or professional purposes. A critical examination of landmark cases reveals the nuanced boundaries of this provision. One of the most cited cases, CIT v. Indian Molasses Co. (P.) Ltd. (1959) clarified that only expenditures which are not of a capital or personal nature, and incurred wholly for business purposes, are deductible under Section 37. Courts have also consistently upheld the principle that an expense need not result in immediate benefit or profit but must be incurred with the intention to further business interests. In Sassoon J. David and Co. (P.) Ltd. v. CIT (1979), the Supreme Court emphasized that the test is not whether the expenditure was profitable but whether it was incurred for business expediency.
Judicial decisions have also drawn a line between “commercial expediency” and “personal motivations”. For instance, in CIT v. Malayalam Plantations Ltd. (1964), the Supreme Court held that the term “for business” includes acts incidental to the business. However, if an expense is motivated by personal relationships or considerations unrelated to the business, it would be disallowed. This judicial approach reinforces the objective test of whether a rational businessman would have incurred the expense in the course of business. Thus, case law remains central to decoding Section 37’s application in varying commercial contexts.
Controversial Areas: Legal and Ethical Debates
Section 37 has attracted legal controversies and ethical debates, especially where expenses lie in grey areas. Payments such as “speed money”, “lobbying expenses”, or “corporate social responsibility (CSR)” spending often raise questions about deductibility. The explanation inserted into Section 37(1) by the Finance Act, 1998, disallows expenses incurred for any purpose that is an offence or prohibited by law. This has led to debates over what constitutes an “offence” under various laws. For example, expenditure incurred on gifts or hospitality to government officials may be legal under company law but could be disallowed under Section 37 if considered prohibited under the Prevention of Corruption Act.
There is also ethical ambiguity in classifying expenses that might provide indirect personal benefits. Employee welfare expenses or luxury retreats can straddle the line between business promotion and personal gratification. Further, expenditures on CSR, though mandatory under the Companies Act, 2013, are not deductible under Section 37 as clarified by Explanation 2. This dichotomy between statutory compulsion and tax disallowance reflects a need for harmonisation of fiscal and corporate laws. These grey areas continue to challenge tax professionals and businesses in interpreting compliance with both the letter and the spirit of the law.
Policy Recommendations and the Way Forward
To address ambiguities and evolving business realities, several policy reforms can be considered for Section 37. First, clearer guidelines from the Central Board of Direct Taxes (CBDT) on specific types of expenditures, such as sustainability or ESG-related costs, could help businesses claim legitimate deductions without fear of litigation. Second, the scope of disallowance for expenditures deemed “prohibited by law” should be clarified, possibly with a standardized list or criteria to reduce subjectivity. Third, harmonising provisions between the Income Tax Act and other legislations like the Companies Act could remove conflicts, especially in the area of CSR spending.
Judicial precedents must be integrated into administrative circulars to ensure consistency in assessments across jurisdictions. Moreover, evolving business practices such as digital marketing, influencer payments, and data acquisition costs must be recognized in the context of Section 37. The concept of “commercial expediency” should be periodically reviewed to keep pace with modern economic realities. Simplified compliance frameworks and reduced litigation risk would benefit both taxpayers and the revenue department.
Conclusion
Section 37 of the Income Tax Act, 1961, plays a vital role in defining the scope of deductible business expenditures. Its wide applicability and flexible wording have allowed it to evolve through judicial interpretations and administrative policies. However, this flexibility has also led to disputes, especially in areas involving ethical considerations and legal grey zones. A robust policy framework, harmonisation with other laws, and judicial guidance are crucial for maintaining its relevance. As businesses grow more complex and regulations evolve, Section 37 must be dynamically interpreted and possibly amended to reflect the changing contours of economic activity and taxpayer expectations.