Compounding fee under FEMA treated as compensatory, not penal, so deduction under section 37(1) was allowed.

Compounding fee paid to RBI for contravention of FEMA, in relation to external commercial borrowing regulations, was treated as a compensatory monetary consequence of regulatory non-compliance rather than a penalty for an offence. On that basis, the Explanation to section 37(1) of the Income-tax Act, 1961, was held inapplicable because the expenditure did not arise from an offence or from a purpose prohibited by law. The claim was therefore allowable as a business deduction, and the disallowance was set aside in favour of the assessee.

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Issues: Whether the compounding fee of Rs. 45 lakhs paid to the Reserve Bank of India for contravention under FEMA was an allowable deduction under section 37(1) of the Income-tax Act, 1961, or was hit by the Explanation as expenditure incurred for an offence or for a purpose prohibited by law.

Analysis: The payment was made pursuant to a compounding order for contravention of FEMA regulations relating to external commercial borrowings. The compounding framework contemplated by FEMA treated such payments as a monetary consequence of regulatory non-compliance, and the authority itself had taken a lenient view while determining the amount. The amount was therefore characterised as compensatory in nature and not as a penalty for an offence. Since the expenditure did not arise from an act constituting an offence or from a purpose prohibited by law, the Explanation to section 37(1) was held inapplicable. The distinction between compensatory and penal imposts governed the allowability of the claim.

Conclusion: The compounding fee was held to be allowable as a deduction under section 37(1) of the Income-tax Act, 1961, and the disallowance was set aside in favour of the assessee.

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