Compensatory damages for breach of contract deemed deductible as business expenditure when not criminal or prohibited by law.

Whether sums withheld by a government purchaser for late supply are penal or deductible business expenditure: ITAT applied the principle that only expenditure incurred for an offence or prohibited by law is excluded from deduction under the tax rule, and found the withholdings arose from contractual damages under tender terms rather than statutory or criminal penalties; the lower authorities relied on unsupported assertions of habitual default. Outcome: the additions were set aside and the amounts held deductible as compensatory business expenditure.

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Issues: Whether the amounts deducted by government from payments to the assessee for late supply of goods (claimed as penalty/damages of Rs. 32,91,211) are expenses falling within Explanation 1 to Section 37 of the Income-tax Act, 1961 (i.e., expenditure incurred for an offence or prohibited by law) and therefore non-deductible, or whether they are deductible business expenditure as damages for breach of contract.

Analysis: Explanation 1 to Section 37 of the Income-tax Act, 1961 excludes from deduction only those expenditures that are incurred for an offence or are prohibited by law. The impugned additions treated the sums as arising from an offence on the basis that late payments were habitual. The facts show the amounts were deducted pursuant to tender terms as consequences of delayed supply and represent contractual damages/short payments by government departments rather than penalties imposed by statute or criminal sanction. The authorities below did not point to any statutory prohibition or crime rendering the payments penal in the sense contemplated by Explanation 1, and relied on conjecture about habit without legal support. Precedents distinguish between compensatory damages for breach of contract (deductible if laid out wholly and exclusively for business) and penalties arising from criminal or prohibited activities (non-deductible under Explanation 1).

Conclusion: The sums of Rs. 32,91,211 represent contractual damages/compensatory adjustments for delayed supply and are deductible under Section 37 of the Income-tax Act, 1961. Explanation 1 to Section 37 does not apply because the expenditure was not incurred for an offence nor was it prohibited by law. The addition confirmed by the lower authorities is set aside and the appeal is allowed in favour of the assessee.

Final Conclusion: The decision restores the deductibility of the claimed amount as a business expense arising from breach of contract and negates the application of Explanation 1 to Section 37; the appeal is allowed.

Ratio Decidendi: Expenditure that constitutes compensatory damages for breach of contract, not incurred for an offence or prohibited by law, is deductible as a business expense under Section 37 of the Income-tax Act, 1961, and Explanation 1 to Section 37 applies only to expenditures that are penal or criminal in nature.

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