True nature of statutory impost governs deduction: compensatory reserve-default interest is deductible, but repeated-default interest is not.

Deductibility under section 37 turns on the true character of the statutory payment, not on the label used in the banking law. The statutory scheme for cash reserve and reserve balance defaults showed a compensatory element in the first default, because the payment operated as an incidence of banking business and the Reserve Bank could waive it for sufficient cause; that component was deductible. The same scheme treated repeated defaults more severely through fines and prosecution, showing a penal character for second and subsequent defaults; that component was not deductible. The assessments therefore had to be split between compensatory and penal elements, with deduction allowed only for the former.

---

---

Issues: Whether penal interest paid by scheduled banks for default in maintaining cash reserve and statutory balances under the banking laws is deductible as business expenditure under section 37 of the Income-tax Act, 1961, and whether the levy is compensatory or penal in nature.

Analysis: Deductibility under section 37 depends not on the label used by the statute but on the true nature of the impost. The governing test is whether the statutory payment is compensatory, penal, or a composite levy containing both elements. The relevant provisions of the Reserve Bank of India Act, 1934 and the Banking Regulation Act, 1949 showed that the first default in maintaining the prescribed balances attracted a payment having a compensatory element, because the levy operated as an incidence of banking business and compensated the Reserve Bank for the shortfall. The scheme also vested discretion in the Reserve Bank to waive or not demand the amount for sufficient cause, which supported the compensatory character for the initial default. However, the same statutory scheme created stricter consequences for repeated default, including fines and prosecution of directors and officers, showing that later defaults were penal in character.

Conclusion: Penal interest for the first default in complying with the prescribed reserve requirements is not a penalty for infraction of law and is deductible, but penal interest for the second and subsequent defaults is penal in nature and is not deductible.

Final Conclusion: The assessments were required to be reconsidered by separating the compensatory component from the penal component and allowing deduction only to the extent of the former.

Ratio Decidendi: For the purpose of section 37 of the Income-tax Act, 1961, the true nature of a statutory impost must be determined from the scheme of the relevant enactment, and where the levy is compensatory it is deductible, but where the levy becomes penal on account of repeated default or statutory sanctions, deduction must be refused to that extent.

---