Analysis of Section 37

ANALYSIS OF SECTION 37

CA. Sanjay Kumar Jhabak Section.37

(1)Any expenditure (not being expenditure of the nature described in sec.30 to 36 and not be in the nature of capital expenditure or personal expenses of the assessee) laid out or expended wholly and exclusively for the purpose of business or profession shall be allowed in computing the income chargeable under the head ‘profits and gains from business and profession.’

In other words the following conditions shall be satisfied before any deduction can be claimed u/s 37(1)- a) Such expenses must not be covered under the specific section i.e. 30 to 36. b) Exp. must not be of capital nature. c) The exp. must have been incurred during the previous year. d) The exp. must not be of a personal nature. e) The exp. must have been incurred wholly or exclusively for the purpose of the business or profession.

Section 37 is a residuary section. The words expenditure, capital expenditure, personal expenses and wholly and exclusively are not defined in the Income Tax Act,1961, hence for definition of these words important judgements are given below for better analysis of sec.37.

EXPENDITURE

CIT v Woodward Governor India (P) Ltd.[2009] 179 Taxman 326 (SC) The expression ‘expenditure’ as used in sec.37 may, in the circumstances of a particular case ,cover an amount which is really a ‘loss’ even though said amount has not gone out from the pocket of the assessee.

Madras Industrial Investment Corporation Ltd. v. CIT[1997] 91 Taxman 340/225 ITR 802(SC). Expenditure is not necessarily confined to the money which has been actually paid out. It covers a liability which has occurred or which has been incurred although it may have to be discharged at a future date. However a contingent liability which may have to be discharged in future cannot be considered as expenditure.

CAPITAL EXPENDITURE

CIT v. Lake Palace Hotels & Motels (P) Ltd.[2002] 258 ITR 562(Raj) The word ‘Capital‘ connotes permanency and ‘capital expenditure’ is therefore closely akin to the concept of securing something tangible or intangible property or corporeal or incorporeal right, so that they could be of a lasting or enduring benefit to the enterprise in issue.

1 Revenue expenditure, on the other hand, is operational in its perspective and solely intended for the furtherance of the enterprise.

PERSONAL EXPENSES

State of Madras v. G.J. Coelho [1964] 53 ITR 186(SC) Personal expenses would include expenses on the person of the assessee or to satisfy his personal needs, such as clothes, foods etc. or purposes not related to the business for which the deduction is claimed.

Wholly and Exclusively

Jamna Auto Industries v. CIT[2008] 167 Taxmann 192/299 ITR 92 (Punj & Hari) (FB). The word ‘wholly’ refers to the quantum of expenditure and the word ‘exclusively’ refers to the motive, objective and purposes of the expenditure. The expression ‘wholly & exclusively’ does not mean necessarily.

COMPARATIVE STUDY of other relevant sections of Income Tax Act, 1961 for better understanding of sec.37 are as under:

For the purpose of business.

CIT v. Mahendra Sobhagchand Shah [1993] 203 ITR 178/71 Taxmann 287(Bom). There is a marked difference between the language of sec.37(1) and sec.57(iii) , both of which are residuary provisions to allow deductions in respect of certain expenses which do not fall under any of the items of expenses specifically enumerated in the provisions of the Act . In section 37(1), the expression used is ’for the purpose of the business’ whereas in sec. 57(iii), it is ‘for the purpose of making or earning such income.’ The expression used in sec. 37(1) for the purpose of business is much wider in scope than the expression for the purpose of earning profits. Its range is wide.

DONATION: Sec.37 (1) is general and Sec. 80G is specific. The provisions of sec. 37(1) are general in nature and provisions of sec. 80G are specific. Applying the maxim generalia specialibus non dero gant (general words do not derogate from special) if any amount is eligible for deduction u/s 80G then it cannot be claimed under general provisions of sec.37 (1).-Jaswant Trading Co.: Anil Trading Co. v. CIT (1995) 212 ITR 24, 27, 28 (Raj).

Exp. allowable even when part of the income is exempt In earlier there were so many judgements of H.C. and S.C. in which it had been decided that in case of indivisible business, expenses allowable even where part of the income is exempt but after insertion of provisions of sec.14A w.r.e.f. 01/04/1962 by the Finance Act, 2001 where it is provided that for the purpose of computing the total income under Chapter IV (containing sec. 14 to 59) -No deduction shall be allowed in respect of expenditure incurred by the assessee in relation to income which does not form part of the total income under this act.

2 Thus the provisions enacted in section 14A have statutorily superseded the principles of law laid down to the contrary in the earlier cases.

Sec.32 (1) Explanation 1 inserted w.e.f. 01/04/1988 that where a business or profession carried by the assessee and construction, renovation, extension and improvement on building on leasehold land, then it is treated as capital exp. towards building and would be eligible for depreciation. But in earlier years there was debate regarding whether it is revenue or capital exp.

Sec.35D Amortization of Preliminary Expenses- (1)Where an assessee incurred any exp. after 31/03/1970 specified in sub section (2) (i) before the commencement of the business or, (ii) after the commencement of the business, in connection with the extension of his undertaking or setting up a new unit, 1/5 th of such exp. will be allowable for 5 successive previous year beginning with the previous year in which business commences.

Sec.36(1)(iii) First Proviso inserted by the Finance Act ,2003. Any intt. paid on capital borrowed for acquisition of an asset for extension of existing business or profession for any period beginning from the date on which the capital borrowed till date on which asset was first put to use, shall not be allowed as deduction .In earlier years there was a lot of litigation whether intt. is deductible or not but after this amendment such intt. would be added to the cost of asset, means it is capital expenditure.

Sec 43B-It may be noted that for and from A.Y. 1984-85 the statutory liabilities covered by sec.43B are allowed not merely on accrual basis but only upon actual payment basis.

Sec.37(1) Explanation 1-inserted by Finance Act, 1998 w.r.e.f.1/04/1962- For the removal of doubts it is hereby declared that any expenditure incurred by an assessee for any purpose which is an offence or prohibited by law shall not be deemed to have been incurred for the purpose of business or profession and for no deduction or allowance shall be made in respect of such expenditure.

If the assessee resorts to unlawful means to augment his profits or reduce his loss, then the exp. incurred for these unlawful activities cannot be allowed to be deducted whether the business is lawful or otherwise. Even if the entire business of the assessee is illegal and income is sought to be taxed by the A.O., the exp. in the illegal activities is not deductible after the insertion of Explanation 1 of sec.37 (1) by the Finance Act, 1998. It has been consistently held by the courts that fines or penalties for violation of law cannot be permitted as deduction under the I.T. Act. That will be against public policy. One can carry on his trade without violation of law. In fact, sec. 37 presumes that the trade will be carried on lawfully.

Sec.37(1) Explanation 2-inserted by Finance Act, 2014 w.e.f 01/04/2015- For the removal of doubts it is hereby declared that for the purpose of sub section (1) any expenditure incurred by an assessee on the activities relating to corporate social responsibility referred to in sec.135 of the Companies Act 2013 shall not be deemed to be an expenditure incurred by the assessee for the purpose of business or profession. Insertion of Explanation 2 in sec.37 w.e.f. 1/4/2015 regarding allowability of CSR expenditure, that such exp. is not deductible for the tax purposes unless falling within sec.30 to 36 of the IT Act, 1961.

3 Private companies and certain unlisted public companies, which are otherwise not required to have an independent director are exempt from the requirement of having an independent director on their CSR committee. While this is a good development and provides relief to a lot of private companies who would have to get independent directors in their boards.

Sec.37(2B) Notwithstanding anything contained in sub section(1),no allowance shall be made in respect of expenditure incurred by an assessee on advertisement in any souvenir ,brochure, tract, pamphlet or the like published by a political party.

SOME OTHER IMPORTANT JUDGEMENTS are as under:-

Earning of income for claim of exp. not necessary-In order that an exp. may be admissible as a deduction under these provisions, it is not necessary that the primary motive in incurring it must be directly to earn income thereby, that exp. even though not directly related to the earning of the income may be still be admissible as deduction. Sree Meenakshi Mills Ltd. v. CIT (1967) 63 ITR 207 (SC).

Capital or Revenue Expenditure- Quantum of expenditure is not relevant factor. Whether the money paid is a revenue exp. or capital exp. depends not so much upon the facts as to whether the amount paid is large or small or whether it has been paid in lumpsum or by installments, as it does upon the purpose for which the payment has been made and exp. has been incurred. It is the real nature and quality of the payment and not the quantum or the manner of the payment which would prove decisive – M.K. Bros. (P.) Ltd. v. CIT (1972) 86 ITR 38 (SC)/Travancore Sugars & Chemicals Ltd. v. CIT [1966] 62 ITR 566 (SC).

Deferred Revenue Expenses- Expenditure cannot be spread over future years. The exp. on publicity and advertisement is to be treated as revenue in nature allowable fully in the year in which it is incurred. In the I.T. law there is no concept of deferred revenue exp. Once the assessee claims the deduction for the whole amount of such an expenditure, even in the year in which it is incurred, and the exp. fulfils the list laid down u/s 37, it has to be allowed- CIT v. Citi Financial Consumers Fin. Ltd. (2011) 335 ITR 29 (Delhi)

Commercial Expediency: The expression ‘commercial expediency’ is an expression of wide import and includes such expense as a prudent man may incur for the purpose of business. Few instances are as under-  Assessee borrowed from bank and lent to sister concerns without charging interest. If it is done as a measure of commercial expediency, it was held that intt. on borrowed capital can be allowed as deduction. S.A. Builders Ltd. V. CIT (Appeals) (2007) 288 ITR 1 (SC).  Job Work been done by the assessee for engineering corporation from Dec. 1988 to June 1989 and for the same bills submitted by corporation in Aug 1989 and hence, exp. held deductible in A.Y. 1990-91. CIT v. Beekay Engg. Corporation (2010) 323 ITR 252,254 (C.G.)  Though there is no provision for allowing deduction of a trading loss on account of embezzlement if the loss is directly connected with the business operation and incidental to carrying on of the business, the same has to be allowed as a deduction – CIT v. Smt Pukhraj Wati Rubber [2008]296 ITR 290,292 (Punj & Har.)

4 Businessman’s view point must be seen- The S.C. in Aluminium Corporation of India Ltd. v. CIT (1972) 86 ITR 11 (SC) case noted its earlier decisions in J.K. Woolen Manufacturers v. CIT (1969) 72 ITR 612 (SC) and CIT v. Walchand & Co. Pvt. Ltd. (1967) 65 ITR 381 (SC) and reiterated that in applying the test of commercial expediency for determining whether an expense was wholly and exclusively laid out for the purpose of the business, the reasonableness of the expense has to be adjudged from the point of view of the business and not of the revenue.

Few instances of Business Expenditure allowable by CBDT under sec.37 (1) are as under:

-Salary /Wages paid for training period to employees Letter: F.No. 27(30)-IT/59, dated 6-7-1959. -Membership fees of Indian Institute of Foreign Trade Letter F.No. 9/54/64-IT(A-I),dated 2/9/64. -Expenses incurred by a company on getting its shares listed in a stock exchange. Letter: F.No. 10/67/65-17(A-I), dated 29/8/65. -Professional Tax paid by a person carrying on business. Circular: No. 16 [F.No. 9/38/69-IT(A -II), dated 18-9-1969. -Interest payable on unpaid purchase price of plant and machinery .Letters: F.No. 10/92/64-IT(A- I),dated 13/9/65. -Expenses on Diwali and Mahurat are in the nature of business expense, it has been decided not to lay down any monetary limits for the purpose of their allowance-Letter: F.No. 13A/20/68- IT(A-II), dated 3-10-1968.

ILLUSTRATIONS OF REVENUE EXP. according to various important judgements are as under: Advertisement  Creating brand image. Dy CIT v. Core Healthcare Ltd. [2009] 308 ITR 263 (Guj) Modi Revlon (P.)  Brand promotion .CIT v Salora International Ltd. [2012] 26 taxmann.com 133/210 Taxmann 161(Mug) Delhi.  Neon Signs & Glow Signs-CIT v. Pepsico India Holdings (P.) Ltd. [2012] 21 taxmann.com 165/207 Taxmann 5 (Mug) Delhi.  Gift Articles for promotion and growth of business. Duncons Tea Ltd. v. CIT [2012]25 taxmann.com 127(Cal.)

Business/Business Assets, Protection of-Where the assessee has an existing right to carry on a business any exp. made by it during the course of business for the purpose of removal of any restriction or obstruction or disability would be on the revenue account ,provided the expenditure does not result in the acquisition of any capital asset . Bikaner Gypsums Ltd. v. CIT [1990] 53 Taxmann 279(SC)

Business Valuation-Expenses incurred on valuation of business properties is an allowable exp.- CIT v. Commonwealth Trust Ltd.[1979] 120 ITR 491 (Ker)

Demurrage -Demurrage paid to railways is not in the nature of damage or penalty and it is merely a charge paid to compensate for keeping the goods of the assessee in its custody beyond a particular time and was allowable business exp.- Mahalaxmi Sugar Mills Co. Ltd. v. CIT[1986] 157 ITR 683( Delhi)

5 Devaluation Loss- Loss suffered by the assessee maintaining accounts regularly on mercantile system and following accounting standards prescribed by ICAI, on account of fluctuation in the rate of foreign exchange in respect of foreign exchange was taken on revenue account as on the date of balance sheet is an item of expense in sec. 37(1), notwithstanding that liability has not been discharged in years in which fluctuation in rate of foreign exchange occurred. Oil & Natural Gas Corporation Ltd. v. CIT[2010]189 Taxmann 292(SC).

Education Expenses: Expenditure incurred on employee for higher studies in field related to business of assessee is allowable – CIT v. Naidunia News and Networking (P.) Ltd. [2012]23 taxmann.com 422/210 Taxmann 73 (MP).

Electricity Charges: Assessee could be allowed deduction on account of extra charges paid by it to State Electricity Board for drawing extra load in peak hours in violation of power regulations –CIT- II, Ludhiana v. Hero Cycles Ltd. [2009] 178 Taxmann 484 (Pun & Har.)

ESOP expenses: Where assessee allotted shares to its employees under Employees Staff Option Plan and Employee Staff Purchase Scheme Guidelines ,1999, difference between market value of shares and value at which shares were allotted was allowable as revenue exp. CIT v. PVP Ventures Ltd. [2012] 23 taxmann.com 286/2011 Taxmann 554 (Mad).

Exp. on issue of bonus shares- Issuance of bonus shares by capitalization of reserves is merely a reallocation of company’s fund. The total funds available with the company will remain the same. Thus the exp. incurred in connection with issuance of bonus shares is a revenue exp.-CIT v. General Insurance Corporation [2006]156 Taxmann 96(SC).

Guarantee Commission: Paid to bank is revenue exp.- CIT v. Sivakami Mills Ltd.[1997] 95 Taxmann 73 (SC).

Interest paid on sales tax arrears is deductible u/s 37(1). Lachmandas Mathuradas v. CIT[2002] 122 Taxmann 828 (SC)

ISO Certification-Exp. Incurred for acquisition of ISO certification is a revenue exp. CIT v. Infosys Technologies Ltd. [2012] 18 taxmann.com 169/205 Taxmann 59 (Kar.)

Payment by disabled partners-The amount paid by partner being physically incapable of handling his work to another person for working after his interest in the firm, is an allowable expense from the taxable income of such partner. CIT v Baburam (1982) 138 ITR 311 (Del.)

Profit Sharing-Payment made under an agreement to share net profits was paid out wholly or exclusively for the purpose of business or was only a division of profits of joint venture depends upon the intension of parties to be ascertained from the substance of the agreement and not the form of it. CIT v. Panipat Woollen & General Mills Co. Ltd.[1976] 103 ITR 66(SC).

Ransom Money-Where whole time director of assessee company was kidnapped for ransom by decoits in the course of business tour and police failed to get his release from the clutches of dacoits ,ransom money paid by assessee for release of its director and claimed as deduction could

6 not be disallowed by invoking explanation to section 37(1), since sec.36A of Indian Penal Code, 1860 only provides that kidnapping a person for ransom is an offence and any person doing or compelling to pay is liable for punishment as provided in the section, but nowhere it is provided that to save the life of a person if a ransom is paid it will amount to an offence, CIT v. Khemchand Motilal Jain Tobacco Products(P.) Ltd. [2011] 201 Taxmann 292/13 taxmann.com 27 (MP).

Software /Computer Expenses- The exp. incurred by the installation of software packages, in the present computer world which revolves on the modern communication technology enables the assessee to carry on its business operations effectively, efficiently, smoothly and profitably. However, such software itself does not work on a standalone basis. It has to be fitted to a computer system to work. Exp. incurred on software package is allowable as revenue exp. Similarly the exp. incurred on replacement of UPS system and printer is also a revenue exp.- CIT v. Southern Roadways Ltd.[2008] 304 ITR 84 (Mad)/CIT v. Varrinder Agro Chemicals Ltd. [2009] 309 ITR 272 (P&H).

Sports Tournaments- Organizing annual sports tournaments will advertise the name of the assessee and will inevitably give publicity to products marketed by the assessee. Consequently, exp. incurred on holding such tournaments would qualify as an admissible exp.- Addl. CIT v. Delhi Cloth & General Mills Co. Ltd.(1983) 144 ITR 275 (Del.)/ CIT v. Lake Palace Hotels & Motels Pvt. Ltd. [2007] 293 ITR 281 (Raj)

Website Development Exp.- The advance of technology and the widespread use of the internet has provided a very powerful mechanism to companies to publicize their activities to a larger spectrum of people at a much lower cost. Website enables companies to do what printed brochures did earlier, hence exp. incurred by the assessee on developing a website was allowable as revenue exp.- CIT v. Indian visit.com(P.) Ltd. [2009] 176 Taxmann 184 (Delhi).

Warranty-Where warranty clause is a part of the sale document and it imposes a liability on the assessee to discharge its obligation for the period of warranty, the liability could be capable of being construed in definite terms and therefore could be deducted while working out the profits and gains of business CIT v. Hewlett Packward India Ltd. [2008] 171 Taxmann 13 (Del.).

The S.C. in a landmark decision in CIT v. Compaq Computers India (Pvt.) Ltd. [2009] 314 ITR 62 reviewed a no. of decisions, It was held that it is not a contingent liability, if the present value is ascertained properly and discounted Sec.37 would cover such a provision. The fact that it would involve a substantial degree of estimate is no bar for deduction.

Illustrations of Capital Expenditure according to various important judgements are as under: Copyrights- Price paid for purchasing copyright of a book by a publisher and seller of books, is capital expenditure- Hiralal Phoolchand v. CIT[1947] 15 ITR 205 (All.)

Excess paid due to devaluation – Where loan was taken and repayable in foreign currency for the purchase of plant and machinery extra amount payable on account of devaluation of the rupees would be capital expenditure- Union Carbide India Ltd. v. CIT [1981] 130 ITR 351 (Cal.)

Expenses for new route permits- Exp. incurred in obtaining new route permit, even in case of a person engaged in the business of running other transport buses, are not exp. laid out for the

7 purposes of the business carried on by the assessee. Each route permit is a separate entity which is granted after elaborate proceedings. In respect of a new permit there can be no “business” before a permit is obtained. A route permit is property, a capital asset, and exp. incurred therefore are capital exp.- Erode Transports (P.) Ltd. v. CIT (1969) 71 ITR 283 (Mad).

Tour expense- Exp. in connection with foreign tour undertaken for initiation of new business is not allowable- CIT v. Flour & Food Ltd. [1988] 170 ITR 469(MP)

Goodwill- Acquisition of the goodwill of the business is acquisition of a capital asset and therefore its purchase price would be capital exp. Where however, the transaction is not one for acquisition of the goodwill, but for the right to us it, the expense would be revenue expense- Devidas Vithaldas & Co. v. CIT [1972] 84 ITR 277(SC).

Lease Premium and Lease rents. It is well settled that the premium paid by the lessee for the grant of lease whether payable in lumpsum or in installments over the period of the lease is normally capital expenditure. The periodical rental payment made for a lease is revenue exp.-CIT v. Muhammad Hussain [2001] 247 ITR 347 (J&K).

Share Capital / Debenture issue exp. Though the increase in the capital results in expansion of the capital base of the company and incidentally that would help in the business of the company and may also help in the profit making, the expenditure incurred in that connection still retain the character of a capital expenditure since the exp. is directly to the expansion of the capital base of the co. Therefore exp. incurred on issuing shares to increase its share capital by a company would not be allowable as revenue exp.-Punjab State Industrial Corporation Ltd. v. CIT (1997) 93 Taxmann 5(SC)/ Brooke Bond India Ltd. v. CIT [1997] 91 Taxmann 26 (SC)

CA. Sanjay Kumar Jhabak