Understand the deduction of Penalty expense under the Income tax act.

 Under Section 37(1) of the Income Tax Act, any expenditure that is incurred for the purpose of an offense or is prohibited by law cannot be considered as incurred for the purpose of business, and therefore, is not allowed as a business expenditure. It is important to note that this provision applies to both Indian and foreign expenditures.

It is mandatory for auditors to report such disallowed expenses in their tax audit report. However, it is necessary to differentiate between interest & fine with a penalty. The amount paid for any breach of contract or infraction of the law, as ruled by the Supreme Court in the case of Haji Aziz, is not allowed as a business expenditure. On the other hand, as decided by the Bombay High Court in the case of Pannalal Narottam Das & Co., any expenditure required to be paid as a penalty when goods are confiscated by the customs department is allowed.

Further clarity was provided through the Finance Bill of 1998, which specified that payments made on account of protection money, extortion, hafta bribes, etc., are not allowed as business expenditures.

However, the Madhya Pradesh High Court, in the case of Khemchand Motilal Jain, ruled that ransom paid to kidnappers is allowed as a business expenditure when the police failed to trace the kidnappers.

It is important to note that the nomenclature of the terms of payment is not significant; the nature of payment is what matters. If the payment is compensatory in nature, it is allowed as a business expenditure. On the other hand, if the payment is penal in nature, it is not allowed.

 

Given below few examples of penalty payments that are compensation & hence allowed as business expenditure.

·       Interest charged for delayed payment of Sales tax (CIT vs HP State Forest Corporation)

·       Same in the case of service tax (Gilico Developers)

·       Penalty for violation of NSE rules (Goldcrest capital markets ltd vs ITO)

·       Interest paid to DFGT to meet export obligations (Enchanted Jewelry Ltd)

·       Penalty to the government for delay in execution of contract

·       Settlement of dispute

Given below are a few examples of penalties that are penal in nature & hence require to be disallowed.

• Interest in delayed payment to MSME is not allowed vide instruction no 12/2006 dated December 14, 2006.   
• Damages paid for delay in payment of EPF & ESI
•  Traffic fines
•  Compounding fees.