Mr. Deepak Parakul Khurana v. The Comissioner Of Income Tax

IN THE HIGH COURT OF PUNJAB AND HARYANA AT CHANDIGARH --- B E N C H F U L L *** Income Tax Reference No. 56 of 1987 Date of decision: 30.1.2008 --- M/s. Jamna Auto Industries Yamunanagar --- Applicant through Mr. Pankaj Jain and Mr. Deepak Parakul Khurana, Advocates Versus The Comissioner of Income Tax Haryana, Rohtak --- Respondent through Mr. Yogesh Putney, Advocate === CORAM: Hon’ble the Chief Justice Vijender Jain Hon’ble Mr. Justice Rajive Bhalla Hon’ble Mr. Justice Ajay Kumar Mittal … 1. Whether Reporters of Local Newspapers may be allowed to see thejudgment? 2. To be referred to the Reporters or not? 3. Whether the judgment should be reported in the Digest? ****** AJAY KUMAR MITTAL, J. The question that falls for judicial consideration before the FullBench is, as to which of the two divergent views of two co-ordinateDivision Benches of this Court has legal acceptability. Even morepointedly, the correctness of judgments reported in Commissioner ofIncome Tax Versus Indo Asian Switch Gears (P) Ltd.(1996) 222 ITR 772 and M/s. Baldev Singh Kanwar, Barishad, Hoshiarpur Vs. TheCommissioner of Income Tax, Jalandhar(1997) Indian Taxation Reports640 is at issue in this Reference. 2. In the first instance, it deserves to be noticed as to how thiscontroversy has arisen. Before delving on the issue involved, it would beapposite for proper appreciation of the bone of contention between the parties to put a brief look on the factual matrix. A partner of the assessee-firm visited Germany where he entered into a contract for supply of certaingoods of a particular value. The agreement so arrived at, however, couldnot be acted upon by the assessee as it did not have the requisite importlicence for the material intended to be imported. The dispute was referredto an arbitrator. In terms of the award of the Arbitration Tribunal, renderedon 29.7.1974, the assessee paid a sum of Rs. 50,000/- to the German-firm,M/s. Duestsche Strahil Metail of Berlin, for failure to perform its part of thecontract. Accordingly, the assessee in its return for the assessment year1975-76, claimed deductions of the aforesaid amount as business expenseson account of damages for breach of contract. 3. The Assessing Officer had initially allowed the amount of Rs.50,000/- as deductions out of the total income. But lateron, a notice wasissued to the assessee under Section 148 of the Income Tax Act, 1961 (forshort “the Act”) on the strength of a plea that the jurisdictional High Courtin Cineramas vs. Commissioner of Income Tax, Amritsar-I(1977) 110 ITR762 had held that infractions of law, including breaches of obligations arenot normal incidents of business and penalties and the damages paid inconnection with such infractions and breaches are not expenditure laid outor expended wholly and exclusively for the assessee’s business. Applying the view taken in the said case, the Inspecting Assistant Commissioner ofIncome Tax, Assessment, Karnal, vide order dated 24.7.1980 accordinglydisallowed the expenses of Rs. 50,000/- paid by the assessee for breach ofthe contract on its part. The view taken by the Assessing Officer wasupheld by the Commissioner of Income Tax (Appeals) Chandigarh Camp atAmbala and the Income-Tax Appellate Tribunal, Chandigarh Bench videorders dated 22.8.1983 and 23.8.1985 respectively. 4. It is in this manner the appellant preferred the instant Reference and raised the following question of law for opinion of this Court: “Whether on the facts and in the circumstances of the case, the the view taken in the said case, the Inspecting Assistant Commissioner ofIncome Tax, Assessment, Karnal, vide order dated 24.7.1980 accordinglydisallowed the expenses of Rs. 50,000/- paid by the assessee for breach ofthe contract on its part. The view taken by the Assessing Officer wasupheld by the Commissioner of Income Tax (Appeals) Chandigarh Camp atAmbala and the Income-Tax Appellate Tribunal, Chandigarh Bench videorders dated 22.8.1983 and 23.8.1985 respectively. 4. It is in this manner the appellant preferred the instant Reference and raised the following question of law for opinion of this Court: “Whether on the facts and in the circumstances of the case, the Tribunal was right in applying the decision of the Punjab andHaryana High Court in 110 ITR 762 while confirming thedisallowance of Rs. 50,000/- payable to M/s. Duestsche StahilMetail of Berlin for non-performance of the contract?”Haryana High Court in 110 ITR 762 while confirming thedisallowance of Rs. 50,000/- payable to M/s. Duestsche StahilMetail of Berlin for non-performance of the contract?” 5. When the matter came to be considered by a Division Bench, ofwhich one of us (Ajay Kumar Mittal, J.) was also a member, learned counselappearing for the assessee by placing reliance on the decision of this Courtin Commissioner of Income-Tax vs. Indo Asian Switch-Gears (P.) Ltd.(1996) 222 ITR 772 submitted that in the present case the payment ofdamages is for breach of contract and not on account of infraction of lawand, therefore, the same is admissible as expenses having been expended wholly and exclusively for the purposes of business. 6. On the other hand, learned counsel appearing onbehalf of the Revenue therein stoutly controverted the submissionmade by the learned counsel for the assessee and placed relianceon a Division Bench judgment of this Court in M/s. Baldev SinghKanwar, Barishad, Hoshiarpur vs. The Commissioner of Income Tax,Jalandhar, (1997) Indian Taxation Reports 640 to canvass that theview taken by the Tribunal was in consonance with law. Hesupported the order of the Tribunal. 7. In the wake of two views on the point, totally contraryto each other it was considered appropriate by the Referral Bench torecommend that the issue deserved to be resolved by a largerBench. The exact words by which the matter came to be referred areindicated here-in-below just with a view to make explicit on record asto how the question has come up for consideration by the FullBench. These are: “In our opinion, there is direct conflict between the two-decisions of co-ordinate Benches in Indo SwitchGears(P) Ltd.(supra) and M/s. Baldev Singh Kanwar’s case(supra), which deserves to be resolved by a largerBench. Accordingly, we direct the Registry to place the papers of this case before Hon’ble the Chief Justice forconstituting a larger Bench to decide the controversyarising in this reference.” 8. It would be manifest from the above that the spinal issue whicharises here is, whether an assessee who pays certain amount by way ofdamages for breach of contract is entitled to have said expenditure allowedto be deducted from the income. In other words, can the aforesaidexpenditure be termed as amount expended wholly and exclusively forbusiness purposes within the meaning of Section 37(1) of the Act? 9. With this background, a reference may be made to specificprovisions of Section 37(1) of the Act on which the controversy revolvesand which at the relevant time read as under: “37. (1) Any expenditure (not being expenditure of the naturedescribed in sections 30 to 36) and not being in the nature ofcapital expenditure or personal expenses of the assessee, laidout or expended wholly and exclusively for the purposes of the business or profession shall be allowed in computing theincome chargeable under the head “Profits and gains ofbusiness or profession”. 9. With this background, a reference may be made to specificprovisions of Section 37(1) of the Act on which the controversy revolvesand which at the relevant time read as under: “37. (1) Any expenditure (not being expenditure of the naturedescribed in sections 30 to 36) and not being in the nature ofcapital expenditure or personal expenses of the assessee, laidout or expended wholly and exclusively for the purposes of the business or profession shall be allowed in computing theincome chargeable under the head “Profits and gains ofbusiness or profession”. 10. The legal position may first be analyzed. Section 37(1) of the Act contains the general provisions for allowance as an expenditure. According to Section 37(1), for a particular item of expenditure to be anallowable deduction under this section:- (a) it should not be an expenditure of the nature described in Sections 30 to 36; (b) it should not be in the nature of capital expenditure; orpersonal expenses of the assessee; and (c) it should have been laid out or expended wholly andexclusively for the purpose of the business or profession of theassessee; 11. The phraseology-laid out or expended wholly and exclusively for the purposes of business or profession- embraces within it ‘wholly’which refers to the quantum of expenditure and the word ‘exclusively’refers to the motive, objective and purposes of the expenditure. Theexpression ‘wholly and exclusively’ does not mean ‘necessarily’. If anamount is incurred for promoting the business and to earn profits, theassessee can claim deduction therefor even though there was no compellingnecessity to incur such expenditure. The test for allowability of anexpenditure as a deduction is to judge, whether the expense has beenincurred with the sole object of furthering the trade or business interest of the assessee unalloyed or unmixed with any other consideration and thatexpenditure was necessitated or justified by commercial expediency.12. Whenever certain damages are to be paid by an assessee for thebreach of a contract, such damages are treated to be normal incidences ofbusiness. For allowability as a deduction, a claim for damages is to be testedon the touchstone of the provisions of Section 37(1) of the Act. Where anassessee has to pay damages to the other party for the failure to fulfil thecontract entered into by him in the ordinary course of his business, theamount of damages so paid is an allowable deduction if it is in the ordinarycourse of the business, and is not opposed to the public policy. 13. A penalty imposed for breach of any law during the course oftrade etc. cannot be described as a commercial loss. If an assessee whileconducting his business has acted in an unlawful manner which hasrendered him liable to penalty, the sum so paid cannot be claimed as adeductible expense. Infraction of the law is not a normal incident ofbusiness and, therefore, no expense which is paid by way of penalty for abreach of law is admissible deduction. In cases where a penalty has to beincurred, for the reason of the assessee having carried on business in anunlawful manner or in contravention of certain rules and regulations, suchpenalty could not be regarded as ‘wholly and exclusively’ laid out for thepurposes of business as the expense has not been necessitated by the business but by the conduct of the assessee in trying to carry out thebusiness in an unlawful manner. Under Section 37(1), only that portion ofsuch payment having composite nature which is attributable to itscompensatory character for payment as damages is to be allowed as adeduction. The other portion which is attributable to its penalty naturecannot be allowed as a deduction under Section 37(1) because such paymentis for infraction of law. business but by the conduct of the assessee in trying to carry out thebusiness in an unlawful manner. Under Section 37(1), only that portion ofsuch payment having composite nature which is attributable to itscompensatory character for payment as damages is to be allowed as adeduction. The other portion which is attributable to its penalty naturecannot be allowed as a deduction under Section 37(1) because such paymentis for infraction of law. 14. The aforesaid interpretation has the stamp of approval by theirLordships of the Apex Court. The Supreme Court in Prakash Cotton MillsP. Ltd. v. Commissioner of Income Tax(1993) 201 ITR 684 whileanalyzing the scope of Section 37(1) of the Act observed as under: “Therefore, whenever any statutory impost paid by an assesseeby way of damages or penalty or interest is claimed as anallowable expenditure under Section 37(1) of the Income-taxAct, the assessing authority is required to examine the schemeof the provisions of the relevant statute providing for paymentof such impost notwithstanding the nomenclature of the impostas given by the statute, to find whether it is compensatory orpenal in nature. The authority has to allow deduction undersection 37(1) of the Income-tax Act, wherever such examination reveals the concerned impost to be purelycompensatory in nature. Wherever such impost is found to beof a composite nature, that is, partly of compensatory natureand partly of penal nature, the authorities are obliged tobifurcate the two components of the impost and give deductionto that component which is compensatory in nature and refuseto give deduction to that component which is penal in nature.”15. In Standard Batteries Ltd. v. Commiossioner of Income-Tax(1995) 211 ITR 444, the Supreme Court followed and reiterated the viewtaken in Prakash Cotton Mills P. Ltd. ‘s case(supra). 16. This issue again came up for pointed consideration before theSupreme Court in Swedeshi Cotton Mills Co. Ltd. v. Commissioner ofIncome-Tax(1998) 233 ITR 199. The question before the Apex Court wasregarding deductibility and liability incurred by the assessee for delayedpayment of employees’ contribution under Section 14B of the Employees’Provident Funds Act, 1952 and the penalty levied on the assessee under theCentral Sales Tax Act. The Supreme Court following the judgment in Prakash Cotton Mills P. Ltd.’s case(supra) categorically laid down thatwherever an amount has been paid by way of damages, the compensatorypayment made by the assessee entitles him to claim deduction from the income earned by him and where an element of penal levy is concerned, anysuch payment made for contravention of law is inadmissible. 17. We may now refer to cases adjudicated by the jurisdictional-High Court. In Commissioner of Income Tax, Punjab v. Himalaya Rosin Turpentine Manufacturing Company, (1953) 24 ITR 132, a Division Benchof this Court was considering the case of an assessee who was carrying thebusiness of extracting rosin from forest leased for that purpose and hadentered into an agreement for extracting rosin according to certain terms andconditions and in the eventuality of failure to observe the same, he wasliable to pay penalty/fine. The assessee having contravened the terms of thelease was saddled with fine of Rs. 5,000/- which was paid to the State. Thesaid claim was disallowed because it was found that the payment concernedwas made towards penalty imposed for breach of the rules under which theassessee was extracting rosin. The aforesaid view was adhered to by anotherDivision Bench of this Court in Cineramas v. Commissioner of Income-Tax,Amritsar-I, (1977) 110 ITR 762. 18. In Commissioner of Income-Tax v. Murari Lal Ahuja and sons(1989) 177 ITR 228, while considering the case of damages for breach ofcontract, this Court held that if the amount is expended as payment onaccount of compensation for breach of contract, the same shall be treated as 18. In Commissioner of Income-Tax v. Murari Lal Ahuja and sons(1989) 177 ITR 228, while considering the case of damages for breach ofcontract, this Court held that if the amount is expended as payment onaccount of compensation for breach of contract, the same shall be treated as commercial expediency and the loss incurred thereon shall be exigible to bededucted from the income of the assessee. In the said case, the assessee wasengaged in the business of sale of cotton and it had failed to fulfil thecontract for supply of cotton to the mills. The assessee settled the deal bypaying certain sum as compensation/ damages which was held to be anallowable deduction. That judgment has been followed in a recent judgmentin Commissioner of Income Tax v. S.A. Builders (P) Ltd.(2007) 211 CTR473 by this Court.19. In view of the authoritative pronouncements of the Apex Courtand also of this Court, it would thus, be concluded that whenever anassessee has indicated any amount, which had been paid either by way ofdamages or penalty, to be an allowable expenditure under Section 37(1) ofthe Act, the Assessing Authority is obliged to discover the nature of suchamount vis-à-vis two prominent aspects, whether it is compensatory orpenal. The Assessing Authority would there upon permit the amount as anallowable deduction that may be discovered to be purely of compensatorynature as payment for damages. However any statutory amount paid by theassessee which is sought to be claimed as an allowable expenditure onaccount of penalty, in that eventuality, the same shall be disallowed beingpayment for infraction of law. A situation may arise where an assessee might have to make a composite payment being ‘compensatory’ and ‘penalcharacter’ both. In that situation, the Assessing Authority would, of course,be required to segregate the amount containing two characters. Afterundertaking this exercise, the amount that is held to be of compensatorynature shall be countenanced as allowable expenditure whereas the otherportion of the amount, which is penal in nature, shall be refused to be anallowable expenditure. 20. Now we advert to the cases which had necessitated the’reference to the Full Bench. In Indo Asian Switch-Gears (P) Ltds case(supra) during the assessment year 1977-78, the assessee had to pay anamount of Rs. 4,950/- to the Punjab State Electricity Board on account oflate delivery of goods. The question that arose for consideration was,whether the said amount was deductible from the income of the assessee. This Court while interpreting Section 37(1) of the Act concluded that theamount paid was not on account of any infraction of law but was by way ofdamages for breach of contract and was thus compensatory in nature. It wasalso concluded that the said amount would entitle the assessee for deductionunder Section 37(1) of the Act. This Court after referring Cinaramas’s case (supra) and Murari Lal Ahuja and sons’case (supra), observed as under:- “A question about such deductibility also came up for examination before this Court in CIT v. Murari Lal Ahuja andSons (1989) 177 ITR 228. That was a case where the assessee,who carried on the business of sale of cotton, was unable tofulfil a contract of supplying cotton to the mills and, therefore,settled the dispute by paying them a sum of Rs., 48,158/-. TheIncome-Tax Officer disallowed the payment holding it to be aspeculative transaction in terms of section 43(5) of the Act. The Tribunal, however, took the view that payment had beenmade due to abnormal circumstances for the reason that theassessee had flouted the agreement of sale to save himself froma ruinous situation and, therefore, the compensation paid in theshape of settlement for breach of contract was an allowablededuction. It was held by this Court that the transaction did notamount to a speculative transaction and compensation was paidby the assessee for breach of contract. Therefore, the paymentmade was an allowable deduction.” 21. The conclusion of the Division Bench was recorded at page 794 ofthe judgment which reads thus: “In the present case, the assessee has paid certain amount byway of penalty to the Board on account of late delivery of the goods. Obviously, this is not on account of infraction of anylaw. The true test is whether there is breach of law or breachof an agreement. If it was in the latter category, then damagespaid would be treated to be a business or commercial loss andadmissible as deduction under section 37(1) of the Act. Sinceit was incidental to business, it cannot be disallowed.” 22. The above was a case relating to payment of damages for breachof contract and the same was held to be an allowable expense. The saidview is in consonance with law. 23. It may now be apposite to refer to the judgment in M/s.Baldev Singh Kanwar’s case(supra) where the question that arose beforethe Division Bench was, whether the payment made by way of damages forbreach of contractual obligations is an allowable expenditure, or not. Theassessee therein was a rosin contractor who had taken contract for theextraction of rosin of Arnas Range during the assessment year. Theassessee was required to pay Rs. 54,638/- on account of damages caused byblazes. According to terms of the agreement, the assessee was required toextract rosin by placing blazes of a standard size and shape. The assessee-contractor while performing its part of the contract had failed to keep thesestandards and norms scrupulously. The assessee was held liable to pay damages to the other side in those circumstances. This Court while-following its earlier judgment in Himalaya RosinTurpentine ManufacturingCompany’s case (supra) had held that the assessee was not entitled to claimdamages. The issue before the Division Bench was regarding payment ofdamages for breach of contract as the assessee therein had violated the termsof the contract and was held liable for damages. That occurrence because ofwhich the assessee was held liable for damages, being an ordinary incidentof business, the amount paid on that account was an allowable expense as abusiness loss/expenditure. However, by taking the payment of damages forbreach of agreement as penalty for infraction of law the same had beendisallowed. The Division Bench had therefore, incorrectly decided the issueand we are not in a position to subscribe the said view. Accordingly weover-rule the judgment in M/s. Baldev Singh Kanwar’s case(supra) whichdoes not decide the controversy in its right perspective.24. Having resolved the controversy, we would now take note ofthe facts of the present case. The facts as disclosed are that the assessee hadentered into an agreement with a German firm, on a visit of its partner, forsupply of certain goods. The said contract did not fructify as the assesseedid not have the requisite import licence for the material intended to beimported. On a dispute being referred to the arbitrator, the assessee had to pay Rs. 50,000/- to the said German firm in terms of award dated29.7.1974. It was this amount which was claimed as deduction by theassessee from its income. The issue was decided against the assessee byplacing reliance on Cineramas vs. Commissioner of Income Tax, Amritsar-I(1977) 110 ITR 762, holding that the payment made for infraction of lawand breach of obligations are not normal incidents of business and thuscannot be said to have been laid out or expended wholly and exclusively forthe assessee’s business. The expenses incurred on that account weredisallowed. As per the findings recorded by the authorities below, theamount of Rs. 50,000/- paid by the assessee was on account of damages forbreach of contract on its part and not a liability incurred for contravention ofany law. In the circumstances aforesaid and the clear legal positionenunciated above, the said amount claimed as deduction would thus be anexpense incurred for the purposes of the business and could not have beendisallowed. 25. In view of the above, it is held that the Tribunal was not right indeciding the issue against the assessee and the Reference is accordinglydecided in favour of the assessee and against the Revenue. (Vijender Jain) (Rajive Bhalla) (Ajay Kumar Mittal)Chief Justice Judge Judge *RKMALIK*