Clarification in respect of disallowance under section 14A in absence of any exempt income during an assessment year

Section 14A of the Act provides that no deduction shall be allowed in respect of expenditure incurred by the assessee in relation to income that does not form part of the total income as per the provisions of the Act (exempt income).

2. Over the years, disputes have arisen in respect of the issue whether disallowance under section 14A of the Act can be made in cases where no exempt income has accrued, arisen or received by the assessee during an assessment year.

3. CBDT issued Circular No. 5/2014, dated 11/02/2014, clarifying that Rule 8D read with section 14A of the Act provides for disallowance of the expenditure even where tax payer in a particular year has not earned any exempt income. However, still some courts have taken a view that if there is no exempt income during a year, no disallowance under section 14A of the Act can be made for that year. Such an interpretation is not in line with the intention of the legislature. To illustrate, if during a previous year, an assessee incurs an expense of ₹1 lakh to earn non-exempt income of ₹1.5 lakh and also incurs an expense of ₹20,000/- to earn exempt income which may or may not have accrued/received during the year. By holding that provisions of section 14A of the Act does not apply in this year as the exempt income was not accrued/received during the year, it amounts to holding that ₹20,000/- would be allowed as deduction against non-exempt income of ₹1.5 Lakh even though this expense was not incurred wholly and exclusively for the purpose of earning nonexempt income. Such an interpretation defeats the legislative intent of both section 14A as well as section 37 of the Act.

4. In order to make the intention of the legislation clear and to make it free from any misinterpretation, it is proposed to insert an Explanation to section 14A of the Act to clarify that notwithstanding anything to the contrary contained in this Act, the provisions of this section shall apply and shall be deemed to have always applied in a case where exempt income has not accrued or arisen or has not been received during the previous year relevant to an assessment year and the expenditure has been incurred during the said previous year in relation to such exempt income.

5. This amendment will take effect from 1st April, 2022.

6. It is also proposed to amend sub-section (1) of the said section, so as to include a non-obstante clause in respect of other provisions of the Income-tax Act and provide that no deduction shall be allowed in relation to exempt income, notwithstanding anything to the contrary contained in this Act.

7. This amendment will take effect from 1st April, 2022 and will accordingly apply in relation to the assessment year 2022-23 and subsequent assessment years. [Clause 9]

Clarifications on allowability of expenditure under section 37

Section 37 of the Act provides for allowability of revenue and non-personal expenditure (other than those failing under sections 30 to 36) laid out or expended wholly and exclusively for the purposes of business or profession. Explanation 1 of sub-section (1) of section 37 of the Act provides that if any expenditure incurred by an assessee for any purpose which is an offence or which is prohibited by law shall not be deemed to have been incurred for the purpose of business or profession and no deduction or allowance shall be made in respect of such expenditure.

2. However, it is seen that certain taxpayers are claiming deductions on expenditure incurred in offering certain benefits or perquisite to a person which are not intended to be allowed under this section, like meeting his expenditure related to travel, hospitality, conference etc. In these cases acceptance of such benefit or perquisite by such person is in violation of a law or rule or regulation or guidelines, as the case may be, governing the conduct of such person.

3. CBDT, vide circular No. 5/2012 dated 1.8.2012, noted that the Indian Medical Council in exercise of its statutory powers amended the Indian Medical Council (Professional Conduct, Etiquette and Ethics) Regulations, 2002 (the regulations) on 10.12.2009 imposing a prohibition on the medical practitioner and their professional associations from taking any Gift, Travel facility, Hospitality, Cash or monetary grant from the pharmaceutical and allied health sector Industries. Accordingly, CBDT clarified that the claim of any expense incurred in providing above mentioned or similar benefits in violation of the provisions of Indian Medical Council (Professional Conduct, Etiquette and Ethics) Regulations, 2002 shall be inadmissible under section subsection (1) of section 37 of Act being an expense prohibited by the law. This disallowance was directed to be made in the hands of such pharmaceutical or allied health sector Industries or other assessee which has provided aforesaid benefits and claimed it as a deductible expense in its accounts against income.

4. This circular was challenged in Himachal Pradesh High Court in the case of Confederation of Indian Pharmaceutical Industry Vs Central Board of Direct Taxes [(2013) 335 ITR 388 (HP)], in which the Hon’ble High Court rejected the petition and held that -

“The regulation of the Medical Council prohibiting medical practitioners from availing of freebies is a very salutary regulation which is in the interest of the patients and the public. This Court is not oblivious to the increasing complaints that the medical practitioners do not prescribe generic medicines and prescribe branded medicines only in lieu of the gifts and other freebies granted to them by some particular pharmaceutical industries. Once this has been prohibited by the Medical Council under the powers vested in it, s. 37(1) comes into play. The Petitioner’s contention that the circular goes beyond the section is not acceptable. In case the assessing authorities are not properly understanding the circular then the remedy lies for each individual assessee to file an appeal but the circular which is totally in line with s. 37(1) cannot be said to be illegal. If the assessee satisfies the assessing authority that the expenditure is not in violation of the regulations framed by the medical council then it may legitimately claim a deduction, but it is for the assessee to satisfy the AO that the expense is not in violation of the Medical Council Regulations.”

5. After this there have been various judgments of Income-tax Appellate Tribunals. Some of these judgments have held that these expenses to be not allowable under sub-section (1) of section 37 the Act, while others holding it to be allowable. The latest judgment on this issue is from ITAT Mumbai in the case of Macleods Pharmaceuticals delivered on 14th October 2021 in ITA Nos. 5168 & 5169/Mum/2018. In this judgment ITAT held that the action of the assessing officer in disallowing the expenditure deserves to succeed and then explained as to why it is a fit case for the constitution of a special bench of three or more members. ITAT arrived at its recommendations based, inter-alia, on the followings:-

i. Hon’ble Supreme Court, in the case of Keshavji Ravji& Co Vs CIT [(1990) 183 ITR 1 (SC)] has held that the burden that the Act itself through a correct interpretation of law envisages is equal to or higher than the burden envisaged by the CBDT circular, that burden of law cannot be negated because the circular also so states. Hence, the circular no 5 of 2012 is to be held as valid.

ii. Once a judicial forum higher than this Tribunal, (i.e Himachal Pradesh High Court in the case of Confederation of Indian Pharmaceutical Industry) holds that the interpretation to the scope of Explanation to sub-section (1) of section 37, as given in the circular, is a correct legal interpretation, it cannot be open to us to discard the interpretation so approved to be correct legal interpretation.

iii. In the case Kap Scan and Diagnostic Centre (P) Ltd. [(2012) 344 ITR 476 (P&H)], the Hon'ble High Court of Punjab & Haryana held that payments which are opposed to public policy being in the nature of unlawful consideration cannot equally be recognized. It cannot be held that businessmen are entitled to conduct their business even contrary to law and claim deductions of payments as business expenditure, notwithstanding that such payments are illegal or opposed to public policy or have pernicious consequences to the society as a whole. The Court further held that if demanding of such commission was bad, paying it was equally bad. Both were privies to a wrong. Therefore, such commission paid to private doctors was opposed to the public policy and should be discouraged. The payment of commission by the assessee for referring patients to it cannot by any stretch of imagination be accepted to be legal or as per public policy. Undoubtedly, it is not fair practice and has to be termed as against the public policy.

iv. ITAT noted earlier coordinate bench judgment in the case of DCIT Vs PHL Pharma Pvt Ltd (2017) 163 ITD 10 (Mum), where it was held that the disallowance could not be sustained as the MCI guidelines bind only the medical professionals and not the pharmaceutical companies. ITAT noted that this judgment was not in line with earlier co-ordinate bench judgment In the case of Liva Healthcare Ltd, (2016) 161 ITD 63 (Mum) where the Hon'ble Mumbai ITAT has held that the CBDT circular dated 01.08.2012 is merely a clarification in nature and creates a bar on such illegal payments being against public policy, the said bar always existed in the statute by virtue of the existence of Explanation of Section 37 of the Act which was inserted by Finance Act, 1998 w.e.f. 01-04-1962. It was also noted that in Hon’ble AP High Court’s full bench decision in the case of CIT Vs B R Constructions (1993) 202 ITR 222 (AP- FC) their Lordships have observed that a "precedent ceases to be a binding precedent ... (iii) when it is inconsistent with the earlier decisions of the same rank; and (iv) when it is rendered per incuriam". Clearly, therefore, the decisions which disregard earlier binding decisions on the same issue, "cease to be a binding judicial precedent".

v. ITAT also noted that Hon’ble Delhi High Court in the case of Max Hospital Vs Medical Council of India (WP No. 1334 of 2013; judgment dated 10th January 2014), in which it was held that the provisions of Medical Council of India only bind the medical professionals and not others, such as hospitals and pharmaceutical companies. ITAT explained that it was a case in which Ethics Committee of the Medical Council of India, upon a complaint alleging death of a patient due to medical negligence, passed an order punishing the erring doctors but this order also had certain adverse remarks against the Max Hospital as well.

Aggrieved by these observations, Max Hospital filed a writ petition contending that since the Medical Council of India (Professional Conduct, Etiquette and Ethics) Regulations, have been framed in exercise of the power conferred under Section 20-A read with Section 33 (m) of the Indian Medical Council Act, 1956, these regulations do not govern or have any concern with the facilities, infrastructure or running of the Hospitals and secondly, that the Ethics Committee of the MCI acting under the Regulations had no jurisdiction to pass any direction or judgment on the infrastructure of any hospital which power rests solely with the concerned State Govt. It was also contended that the Petitioner was not provided an opportunity of being heard and thus the principles of natural justice were violated. While dealing with these grievances, Hon’ble Delhi High Court has held, in its operative portion of the judgment- which was reproduced by the ITAT in entirety, as follows:

“8. It is clearly admitted by the Respondent that it has no jurisdiction to pass any order against the Petitioner hospital under the 2002 Regulations. In fact, it is stated that it has not passed any order against the Petitioner hospital. Thus, I need not go into the question whether the adequate infrastructure facilities for appropriate post-operative care were in fact in existence or not in the Petitioner hospital and whether the principles of natural justice had been followed or not while passing the impugned order. Suffice it to say that the observations dated 27.10.2012 made by the Ethics Committee do reflect upon the infrastructure facilities available in the Petitioner hospital and since it had no jurisdiction to go into the same, the observations were uncalled for and cannot be sustained.

9. Since the MCI had no jurisdiction to go into the infrastructure facilities, I need not also go into the aspect that in the year 2011, the facilities available in the hospital were inspected and were found to be in order.

10. The petition therefore has to succeed. I hereby issue a writ of certiorari quashing the adverse observations passed by the MCI against the Petitioner hospital highlighted in Para 1 above.”

ITAT thus held that in their humble understanding, the judgment of Delhi High Court does not negate, dilute, or even deal with, ratio decidendi of, or even casual observations in, Hon’ble HP High Court’s judgment in the case of Confederation of Indian Pharmaceutical Industry (discussed earlier). These judgments are in altogether in different field.

vi. ITAT thus noted that while Hon’ble HP High Court dealt with the interpretation of Explanation to sub-section (1) of section 37, Hon’ble Delhi High Court dealt with the powers of the MCI to pass an order against a Hospital in Delhi on the question of adequacy regarding infrastructure facilities by Hospitals in Delhi, and that too without affording an opportunity of hearing to the said hospital. Hon’ble Delhi High Court judgment in Max Hospitals case has no bearing on the question as to whether giving benefits to the medical professionals is in violation of law or not. ITAT further noted that it is also well settled in law, including by Hon’ble jurisdictional High Court in the case of CIT v. Sudhir Jayantilal Mulji (1995) 214 ITR 154 (Bom),that a judicial precedent is only "an authority for what it actually decides and not what may come to follow from some observations which find place therein".

vii. On the coordinate bench judgment in the case of DCIT Vs PHL Pharma Pvt Ltd (2017), ITAT noted the following:-

“The more we ponder about the rationale of PHL Pharma decision (supra), the more convinced we are that this decision calls for reconsideration by a larger bench. In our humble understanding, conclusions arrived in the said decision do not reflect the correct legal position, and the same is the position with respect to a large number of other coordinate bench decisions following the said decision or following the line of reasoning in the said decision- as discussed above. However, in all fairness, while we may or may not agree with a coordinate bench decision, it cannot be open to us to disregard the same, lest such judicial inconsistency should shake public confidence in the administration of justice and lest one of the fundamental legitimate expectations of the stakeholders, i.e. those exercising judicial functions will follow the reason or ground of the judicial decision in the earlier cases on identical matters, will stand declined. "It is, however, equally true", to borrow the words of Hon’ble Supreme Courts as articulated in the case of Union of India Vs Paras Laminates Pvt Ltd [(1990) 186 ITR 722 (SC)], "that it is vital to the administration of justice that those exercising judicial power must have the necessary freedom to doubt the correctness of an earlier decision if and when subsequent proceedings being to light what is perceived by them as an erroneous decision in the earlier case" and that "in such circumstances, it is but natural and reasonable and indeed efficacious that the case is referred to a larger bench". Taking a cue from the path so guided by Hon’ble Supreme Court in the case of Paras Laminates (supra), we recommend constitution of a bench of three or more Members to consider the question as to whether or not an item of expenditure on account of freebies to medical professionals, which is hit by rule 6.8.1 of Indian Medical Council (Professional Conduct, Etiquette and Ethics) Regulations, 2002- as amended from time to time, read with section 20A of the Indian Medical Council Act 1956, can be allowed as a deduction under section 37(1) of the Income Tax Act, 1961 read with Explanation thereto, in the hands of the pharmaceutical companies.

6. Thus, the legal position is clear that the claim of any expense incurred in providing various benefits in violation of the provisions of Indian Medical Council (Professional Conduct, Etiquette and Ethics) Regulations, 2002 shall be inadmissible under section sub-section (1) of section 37 of Act being an expense prohibited by the law. Delhi High Court decision which was relied upon by ITAT in some decisions was in completely different context as discussed by ITAT Mumbai in their judgment in the case of Macleods Pharmaceuticals. These ITAT decisions allowing such expenditure are clearly not in line with the intention of the legislation.

7. Further, some taxpayers are seen to be claiming deduction on expenses incurred for a purpose which is an offence under foreign law or for compounding of an offence for violation of foreign law, claiming that provisions of Explanation 1 to subsection (1) of section 37 of the Act applies only to offences which are prohibited by the domestic law of the country. In some case this view has also been accepted by the tribunal. These judgments are also against the intention of the legislation as the legislation does not say that the Explanation 1 applies only to the violation of domestic law.

8. In order to make the intention of the legislation clear and to make it free from any misinterpretation, it is proposed to insert another Explanation to sub-section (1) of section 37 to further clarify that the expression “expenditure incurred by an assessee for any purpose which is an offence or which is prohibited by law”, under Explanation 1, shall include and shall be deemed to have always included the expenditure incurred by an assessee, -

i. for any purpose which is an offence under, or which is prohibited by, any law for the time being in force, in India or outside India; or

ii. to provide any benefit or perquisite, in whatever form, to a person, whether or not carrying on a business or exercising a profession, and acceptance of such benefit or perquisite by such person is in violation of any law or rule or regulation or guidelines, as the case may be, for the time being in force, governing the conduct of such person; or

iii. to compound an offence under any law for the time being in force, in India or outside India.

9. This amendment will take effect from 1st April, 2022.

[Clause 12]

Full Text:

Budget 2022-23 + FINANCE Bill, 2022