Punjab & Haryana HC holds deductibility of ”secret commission” and free specimen distribution require consideration in light of Explanation to S. 37

This Tax Alert summarizes a recent decision of the Punjab & Haryana High Court (HC) in the case of CIT v. Dhanpat Rai & Sons (Taxpayer) on the issue of deductibility of secret commission and expenditure incurred on distribution of free specimen books by a taxpayer engaged in the publication of books.

The HC noted that the Income Tax Appellate Tribunal (Tribunal) had not considered the Explanation to Section 37(1) of the Indian Tax Laws (ITL), inserted by Finance (No. 2) Act, 1998 retroactively from tax year 1961-62, which provides that expenditure incurred by a taxpayer for any purpose which is an offence or which is prohibited by law shall not be allowed as deduction from business income. Therefore, the HC remitted the matter to the Tribunal for considering the impact of the Explanation. However, while remitting the matter, the HC observed that expenditure incurred on secret commission and/or any secret transaction/payment made to secure unfair advantage is likely to fall within the scope of the Explanation.

The scope and impact of Explanation to S. 37 is a contentious issue and is a subject on which the law is getting judicially evolved. In the present case, while the HC has remitted the matter to the Tribunal for considering the impact of the Explanation on payment of secret commission and free distribution of specimen copies, the observations of the HC on the scope of the Explanation vis-à-vis secret payments are likely to have significant overbear on the lower authorities. The present ruling does not appear to throw light on the aspect of whether it is necessary to identify the law/statutory provision under which the “‘purpose” of a particular payment is an offence or prohibited, as also the aspect of whether the offence or prohibition should be qua the payer (and not the payee) to attract the Explanation. It also does not throw light on whether the concern on deductibility of secret commission and free distribution is on account of lack of transparency of such expenditure and/or whether they constitute an offence.