2025 (5) TMI 1317 - AT - Income Tax

Disallowance u/s 37(1) - payments characterized as penalties or late fees incurred by the assessee during the course of executing government contracts - HELD THAT - As we find that the expenses incurred by the assessee towards penalty and late fees do not constitute an infraction of law. Rather such payments arose from contractual terms in the normal course of business and were intended to preserve and facilitate business relationships with government entities. The Coordinate Benches of the Tribunal in the cases cited above Mahavir Multitrade (P) Ltd 2019 (12) TMI 29 - ITAT DELHI Farseen Rubber Industries Ltd 2023 (12) TMI 452 - ITAT KOLKATA and Ripley Co Ltd 2017 (4) TMI 164 - ITAT KOLKATA have consistently held that such payments do not attract disallowance under Explanation 1 to Section 37(1) of the Act. Disallowance made by the AO u/s 37(1) is not sustainable. Decided in favour of assessee.

1. ISSUES PRESENTED and CONSIDERED

The core legal questions considered by the Tribunal in this appeal include:

Whether the amounts deducted by government authorities from the assessee's bills, characterized as "penalties" for various contractual non-compliances, qualify as penalties within the meaning of Explanation 1 to Section 37(1) of the Income-tax Act, 1961, thereby rendering them non-deductible business expenses.
Whether such payments, despite being termed as penalties, constitute ordinary business expenditure deductible under Section 37(1) of the Act.
The applicability of judicial precedents relating to the deductibility of contractual penalties or punitive charges under Section 37(1) and the interpretation of Explanation 1 therein.

2. ISSUE-WISE DETAILED ANALYSIS

Issue 1: Nature of the "penalty" payments and their deductibility under Section 37(1)

Relevant legal framework and precedents: Section 37(1) of the Income-tax Act allows deduction of any expenditure (other than those specifically disallowed) incurred wholly and exclusively for the purpose of business. Explanation 1 to Section 37(1) excludes from deduction any expenditure incurred as a penalty or fine for violation of any law. The key question is whether the payments characterized as penalties by the government authorities constitute fines or penalties within the statutory meaning.

Several judicial precedents were relied upon by the assessee to support the contention that contractual penalties or charges imposed for non-fulfillment of contract terms do not amount to penalties or fines within the meaning of Explanation 1. These include:

DCIT vs. Mahavir Multitrade (P) Ltd: Held that non-fulfillment of contractual obligations cannot be equated with an offence or infraction of law so as to invoke Explanation 1 to Section 37(1), even if the deduction is termed a "penalty".
DCIT vs. Ripley & Co Ltd: Payments made as demurrage or punitive charges to Railways were held to be compensatory and not penalties for criminal or unlawful acts, thus deductible.
Farseen Rubber Industries Ltd vs. DCIT: Payments made to a contractor for continuing work under a job contract were held to be commercial expenditures and not penalties under Explanation 1.

Court's interpretation and reasoning: The Tribunal examined the nature of the payments deducted by the Municipal Corporation of Greater Mumbai (MCGM), Navi Mumbai Municipal Corporation (NMMC), and Mumbai Metropolitan Region Development Authority (MMRDA). These deductions were made on grounds such as non-deployment of machinery, delayed commencement, slow progress, poor quality, failure to maintain records, and other contractual defaults. The Tribunal observed that these deductions were imposed as a disciplinary and quality control measure in the normal course of executing large-scale government contracts, which inherently involve complex operations and occasional lapses.

The Tribunal emphasized that these payments do not arise from violation of any statutory provision or criminal law but are contractual penalties designed to ensure compliance with contract terms. Therefore, these do not fall within the ambit of penalties or fines prohibited from deduction under Explanation 1 to Section 37(1).

Key evidence and findings: The assessee submitted a detailed break-up of payments totaling Rs. 44,95,698/- towards penalties and late fees, of which Rs. 2,50,839/- was recovered from employees' salaries, leaving Rs. 42,44,859/- claimed as deductible business expenditure. The payments were documented as arising from contractual defaults identified by the authorities through quality inspections and project monitoring. The Tribunal found no evidence that these were statutory penalties or fines imposed for illegal acts.

Application of law to facts: Applying the legal principles from the cited precedents, the Tribunal concluded that the payments were compensatory or disciplinary in nature, related to the ordinary course of business, and thus deductible under Section 37(1). The Explanation 1 exclusion did not apply as there was no infraction of law or criminal offence involved.

Treatment of competing arguments: The Revenue contended that these deductions were penalties within the meaning of Explanation 1 and thus not allowable as business expenses. However, the Tribunal found the Revenue's interpretation overly broad and inconsistent with judicial precedents that distinguish contractual penalties from statutory fines or penalties for unlawful acts.

Conclusions: The Tribunal held that the disallowance of Rs. 42,44,859/- made by the Assessing Officer under Section 37(1) was not sustainable and directed deletion of the disallowance. The appellate order upholding the disallowance was set aside.

3. SIGNIFICANT HOLDINGS

The Tribunal established the following core principles and determinations:

"The expenses incurred by the assessee towards penalty and late fees do not constitute an infraction of law. Rather, such payments arose from contractual terms in the normal course of business and were intended to preserve and facilitate business relationships with government entities."
"Non-fulfilment of contractual obligations by an assessee cannot be equated with an offence or infraction of law so as to invoke Explanation 1 to Section 37(1), merely because the deduction was termed as 'penalty' for non-compliance with contract terms."
"Payments made by way of demurrage or punitive charges are not hit by Explanation 1 to Section 37(1), as they are in the nature of compensation for delay and not for any criminal or unlawful act."
"The disallowance made by the Ld. AO under Section 37(1), amounting to Rs. 42,44,859/-, is not sustainable."

Accordingly, the Tribunal allowed the appeal and directed that the disallowance be deleted.

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