I paid a sum to settle a patent infringement suit abroad. The Commissioner (Appeals) applied Explanation 3 to s.37(1) to disallow it for an earlier year. Can Explanation 3 be applied retrospectively?
No. The Ahmedabad Tribunal held that Explanation 3 to s.37(1), inserted by the Finance Act 2022 with effect from 1 April 2022, widens the scope of the disallowance to the detriment of the assessee and cannot be applied to AY 2014-15. It also held on the merits that 'prohibited by law' in s.37(1) covers an act or omission which is an offence or is declared illegal as being against public policy, societal welfare, ethical standards or the common good, and does not extend to an out-of-court settlement of a private civil dispute.
Decided by the ITAT (Sanjay Garg JM and Annapurna Gupta AM (ITAT Ahmedabad 'A' Bench)) on 2025-10-01, reported as ITA No.565/Ahd/2025 (by Revenue) and ITA No.351/Ahd/2025 (by assessee); assessment year 2014-15. It bears on section 37(1), section Explanation 1 to 37(1), section Explanation 3 to 37(1) of the Income Tax Act 1961, in Deductions & Disallowances and How Tax Law Is Read matters.
Two things make this the entry to reach for on Explanation 3. First, it decides the prospectivity question directly, and it does so against the argument that the amendment is clarificatory — the Bench applied CIT v Vatika Township (P) Ltd 367 ITR 466 (SC) and M.M. Aqua Technologies Ltd v CIT (2021) 436 ITR 582 (SC) and pointed to the Memorandum to the Finance Act 2022 stating the amendment takes effect from 1 April 2022. That matters because the text of Explanation 3 itself says the expression 'shall include and shall be deemed to have always included', which reads retrospectively; the Bench nevertheless held it prospective, and a practitioner should expect the Revenue to press the 'deemed to have always included' words. Second, the merits reasoning gives a workable construction of 'prohibited by law' that a bona fide contested civil claim does not satisfy — otherwise, as the Bench pointed out, every assessee who loses a contested suit would be denied the cost of defending it. The same Ahmedabad Bench applied this order in Sun Pharmaceutical Industries Ltd (31 July 2026), also in this library. For AY 2022-23 onwards the position changes: Explanation 3(i) expressly covers a purpose which is an offence under, or prohibited by, any law in force in India OR OUTSIDE INDIA. And from AY 2025-26 there is a second change, which this order itself flags: clause (iv) of Explanation 3, substituted by the Finance (No. 2) Act 2024 with effect from 1 April 2025, disallows expenditure to settle proceedings initiated in relation to contravention of a law notified by the Central Government — and CBDT Notification No.38/2025 dated 23 April 2025 notifies only the SEBI Act 1992, the Securities Contracts (Regulation) Act 1956, the Depositories Act 1996 and the Competition Act 2002, so a patent settlement of the kind decided here is still outside the clause. That is the Bench's own point at paras 23.1 and 23.2, and it cuts in the assessee's favour.
Binding on the AO and CIT(A) within the Tribunal's jurisdiction. Persuasive elsewhere.
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The assessee paid Rs 31,11,00,000 (USD 6 million) to Magneco/Metrel, Inc. to settle a patent infringement suit in the United States. The District Court had first decided in the assessee's favour by invalidating the patent; that judgment was reversed by the Federal Court, whereupon the assessee filed a post-trial motion and deposited USD 7,228,544.64 as security, the District Court observing that it could not conclude the plaintiff had no reasonable possibility of success on the merits of its post-trial motions or appeals. The parties then compromised for USD 6,000,000, a lesser sum than the security already deposited. Clause 2 of Article V of the settlement agreement recorded that the parties agreed the settlement was a mutual compensatory settlement to avoid litigation and that no representation was made that the consideration represented an underlying royalty of the patent infringement. The Assessing Officer and the Commissioner (Appeals) disallowed the payment as made for a purpose prohibited by law within Explanation 1 to s.37(1), the Commissioner (Appeals) additionally applying Explanation 3 inserted by the Finance Act 2022 to AY 2014-15, and reasoning that by settling and paying, the assessee had in principle accepted that it violated the patent rights.
The payment of Rs 31,11,00,000 was a compensatory payment made out of commercial expediency to settle a civil dispute and protect the assessee's business interests; it was not a penalty for an offence or for a purpose prohibited by law under Explanation 1 to s.37(1), and Explanation 3 to s.37(1) is not applicable to the year under consideration. The disallowance was held unsustainable and ordered to be deleted, and grounds 1 and 2 of the assessee's appeal were allowed (para 23.3). In the result, the appeal of the Revenue was dismissed and the appeal of the assessee was allowed (para 29).
The Bench first read the US Patent Act provisions it had set out: s.281 gives a patentee a remedy by civil action, s.283 an injunction and s.284 damages adequate to compensate, while only false marking under s.292 attracts a fine, and there was neither an allegation of nor any proceeding for false marking. On the facts, the assessee had succeeded at first instance, had a live post-trial motion which the District Court itself would not say was hopeless, and settled for less than the security already deposited — which showed the plaintiff too was unsure of success. With the settlement agreement recording a mutual compensatory settlement to avoid litigation, the payment was neither a fine imposed by a court nor on account of any offence, and the purpose of the payment was settlement of civil litigation, which purpose was neither an offence nor prohibited by law (para 21.1). The Bench then construed 'prohibited by law' in the context of s.37(1) as covering an act or omission which is an offence or is declared illegal because it is against public policy, societal welfare, ethical standards, common good or is unconscionable, and held that individual or private disputes between parties fall outside; otherwise every assessee whose claim was rejected in contested litigation would be denied the cost of pursuing bona fide litigation to protect or defend its business rights (para 21.2). On authority, the issue was held squarely covered by CIT v. Desiccant Rotors International P. Ltd. 347 ITR 32 (Del), that a payment made under a settlement to avoid the expenses and uncertainty of exorbitant litigation is compensatory and not penal, and that the remedy for patent infringement under both US and Indian law is a civil action for damages and not a penalty (para 22); the attempt to distinguish that case on the ground that patent rights there were granted post-settlement was rejected as not determinative (para 22.1). On the amendment, the Bench held that any amendment widening the scope of a provision to the detriment of the assessee cannot be applied retrospectively unless the statute expressly so provides, applying Vatika Township and M.M. Aqua Technologies, and noted the Memorandum to the Finance Act 2022 stating the amendment takes effect from 1 April 2022; the Commissioner (Appeals) had erred in applying Explanation 3 to AY 2014-15 (para 22.2).
The individual or private disputes between the parties would not fall within this scope an ambit of section 37(1) of the Act.
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Handle my notice → Ask a CA on WhatsAppNo. The Ahmedabad Tribunal held that Explanation 3 to s.37(1), inserted by the Finance Act 2022 with effect from 1 April 2022, widens the scope of the disallowance to the detriment of the assessee and cannot be applied to AY 2014-15. It also held on the merits that 'prohibited by law' in s.37(1) covers an act or omission which is an offence or is declared illegal as being against public policy, societal welfare, ethical standards or the common good, and does not extend to an out-of-court settlement of a private civil dispute. This was decided by the ITAT (Sanjay Garg JM and Annapurna Gupta AM (ITAT Ahmedabad 'A' Bench)) and bears on section 37(1), section Explanation 1 to 37(1), section Explanation 3 to 37(1) of the Income Tax Act 1961. It is reported as ITA No.565/Ahd/2025 (by Revenue) and ITA No.351/Ahd/2025 (by assessee); assessment year 2014-15. Two things make this the entry to reach for on Explanation 3. First, it decides the prospectivity question directly, and it does so against the argument that the amendment is clarificatory — the Bench applied CIT v Vatika Township (P) Ltd 367 ITR 466 (SC) and M.M. Aqua Technologies Ltd v CIT (2021) 436 ITR 582 (SC) and pointed to the Memorandum to the Finance Act 2022 stating the amendment takes effect from 1 April 2022. That matters because the text of Explanation 3 itself says the expression 'shall include and shall be deemed to have always included', which reads retrospectively; the Bench nevertheless held it prospective, and a practitioner should expect the Revenue to press the 'deemed to have always included' words. Second, the merits reasoning gives a workable construction of 'prohibited by law' that a bona fide contested civil claim does not satisfy — otherwise, as the Bench pointed out, every assessee who loses a contested suit would be denied the cost of defending it. The same Ahmedabad Bench applied this order in Sun Pharmaceutical Industries Ltd (31 July 2026), also in this library. For AY 2022-23 onwards the position changes: Explanation 3(i) expressly covers a purpose which is an offence under, or prohibited by, any law in force in India OR OUTSIDE INDIA. And from AY 2025-26 there is a second change, which this order itself flags: clause (iv) of Explanation 3, substituted by the Finance (No. 2) Act 2024 with effect from 1 April 2025, disallows expenditure to settle proceedings initiated in relation to contravention of a law notified by the Central Government — and CBDT Notification No.38/2025 dated 23 April 2025 notifies only the SEBI Act 1992, the Securities Contracts (Regulation) Act 1956, the Depositories Act 1996 and the Competition Act 2002, so a patent settlement of the kind decided here is still outside the clause. That is the Bench's own point at paras 23.1 and 23.2, and it cuts in the assessee's favour. If it applies to you, the first step is this: Fix the assessment year first: for years up to AY 2021-22, Explanation 3 does not apply and Explanation 1 must be read as it stood, which the Bench held was confined to laws in force in India.
The assessee paid Rs 31,11,00,000 (USD 6 million) to Magneco/Metrel, Inc. to settle a patent infringement suit in the United States. The District Court had first decided in the assessee's favour by invalidating the patent; that judgment was reversed by the Federal Court, whereupon the assessee filed a post-trial motion and deposited USD 7,228,544.64 as security, the District Court observing that it could not conclude the plaintiff had no reasonable possibility of success on the merits of its post-trial motions or appeals. The parties then compromised for USD 6,000,000, a lesser sum than the security already deposited. Clause 2 of Article V of the settlement agreement recorded that the parties agreed the settlement was a mutual compensatory settlement to avoid litigation and that no representation was made that the consideration represented an underlying royalty of the patent infringement. The Assessing Officer and the Commissioner (Appeals) disallowed the payment as made for a purpose prohibited by law within Explanation 1 to s.37(1), the Commissioner (Appeals) additionally applying Explanation 3 inserted by the Finance Act 2022 to AY 2014-15, and reasoning that by settling and paying, the assessee had in principle accepted that it violated the patent rights. The matter was decided on 2025-10-01 by the ITAT (Sanjay Garg JM and Annapurna Gupta AM (ITAT Ahmedabad 'A' Bench)). On those facts the ITAT held as follows. The payment of Rs 31,11,00,000 was a compensatory payment made out of commercial expediency to settle a civil dispute and protect the assessee's business interests; it was not a penalty for an offence or for a purpose prohibited by law under Explanation 1 to s.37(1), and Explanation 3 to s.37(1) is not applicable to the year under consideration. The disallowance was held unsustainable and ordered to be deleted, and grounds 1 and 2 of the assessee's appeal were allowed (para 23.3). In the result, the appeal of the Revenue was dismissed and the appeal of the assessee was allowed (para 29).
The Bench first read the US Patent Act provisions it had set out: s.281 gives a patentee a remedy by civil action, s.283 an injunction and s.284 damages adequate to compensate, while only false marking under s.292 attracts a fine, and there was neither an allegation of nor any proceeding for false marking. On the facts, the assessee had succeeded at first instance, had a live post-trial motion which the District Court itself would not say was hopeless, and settled for less than the security already deposited — which showed the plaintiff too was unsure of success. With the settlement agreement recording a mutual compensatory settlement to avoid litigation, the payment was neither a fine imposed by a court nor on account of any offence, and the purpose of the payment was settlement of civil litigation, which purpose was neither an offence nor prohibited by law (para 21.1). The Bench then construed 'prohibited by law' in the context of s.37(1) as covering an act or omission which is an offence or is declared illegal because it is against public policy, societal welfare, ethical standards, common good or is unconscionable, and held that individual or private disputes between parties fall outside; otherwise every assessee whose claim was rejected in contested litigation would be denied the cost of pursuing bona fide litigation to protect or defend its business rights (para 21.2). On authority, the issue was held squarely covered by CIT v. Desiccant Rotors International P. Ltd. 347 ITR 32 (Del), that a payment made under a settlement to avoid the expenses and uncertainty of exorbitant litigation is compensatory and not penal, and that the remedy for patent infringement under both US and Indian law is a civil action for damages and not a penalty (para 22); the attempt to distinguish that case on the ground that patent rights there were granted post-settlement was rejected as not determinative (para 22.1). On the amendment, the Bench held that any amendment widening the scope of a provision to the detriment of the assessee cannot be applied retrospectively unless the statute expressly so provides, applying Vatika Township and M.M. Aqua Technologies, and noted the Memorandum to the Finance Act 2022 stating the amendment takes effect from 1 April 2022; the Commissioner (Appeals) had erred in applying Explanation 3 to AY 2014-15 (para 22.2). In the words reproduced by the source cited on this page: "The individual or private disputes between the parties would not fall within this scope an ambit of section 37(1) of the Act." The decision followed or applied CIT v. Desiccant Rotors International P. Ltd. 347 ITR 32 (Del) — followed; CIT v. Vatika Township (P.) Ltd. 367 ITR 466 (SC) — applied on prospectivity; M.M. Aqua Technologies Ltd. v. CIT (2021) 436 ITR 582 (SC) — applied on prospectivity.
It was decided by the ITAT on 2025-10-01 and is reported as ITA No.565/Ahd/2025 (by Revenue) and ITA No.351/Ahd/2025 (by assessee); assessment year 2014-15. Binding on the AO and CIT(A) within the Tribunal's jurisdiction. Persuasive elsewhere. A Tribunal decision binds the assessing officer and the Commissioner (Appeals) within that Tribunal's jurisdiction, and is persuasive before other benches. It is not binding on a High Court, and a contrary co-ordinate bench decision will be argued against you, so check whether the point has been taken the other way before you build a reply around it. On section 37(1), section Explanation 1 to 37(1), section Explanation 3 to 37(1), the practical question is whether the facts of your own notice match the facts of this case closely enough for the same rule to apply.
It helps the taxpayer. The payment of Rs 31,11,00,000 was a compensatory payment made out of commercial expediency to settle a civil dispute and protect the assessee's business interests; it was not a penalty for an offence or for a purpose prohibited by law under Explanation 1 to s.37(1), and Explanation 3 to s.37(1) is not applicable to the year under consideration. The disallowance was held unsustainable and ordered to be deleted, and grounds 1 and 2 of the assessee's appeal were allowed (para 23.3). In the result, the appeal of the Revenue was dismissed and the appeal of the assessee was allowed (para 29). It arises in Deductions & Disallowances and How Tax Law Is Read matters, on section 37(1), section Explanation 1 to 37(1), section Explanation 3 to 37(1) of the Income Tax Act 1961, and was decided by Sanjay Garg JM and Annapurna Gupta AM (ITAT Ahmedabad 'A' Bench). Before relying on it, read the source linked on this page and check whether it has since been distinguished, overruled or overtaken by an amendment to the Income Tax Act. In practice the steps that follow from it are these. Characterise the payment from the governing foreign statute: here s.281 of the US Patent Act gives the patentee a remedy by civil action, s.284 gives damages, and only false marking under s.292 carries a fine — that structure is what showed the payment was compensatory. Put the settlement agreement on record and point to any clause recording that the settlement is compensatory and that the consideration does not represent a royalty for infringement; that clause was decisive here. Meet the argument that settling amounts to admitting the breach: the Bench held that inference was factually incorrect where the assessee had won at first instance and had a live post-trial motion. Where the year IS AY 2022-23 or later, do not rely on this reasoning for a foreign-law infraction; argue instead that the payment is not for a purpose which is an offence or prohibited by law at all. For AY 2025-26 onwards, check clause (iv) of Explanation 3 separately: it reaches expenditure to settle proceedings for contravention of a NOTIFIED law, and CBDT Notification No.38/2025 dated 23 April 2025 notifies only the SEBI Act 1992, the Securities Contracts (Regulation) Act 1956, the Depositories Act 1996 and the Competition Act 2002 — so identify the law under which the proceedings were initiated and check it against that list before conceding anything.
Still good law. The citation graph shows nothing, but the Ahmedabad Bench has treated this order as controlling. In DCIT v. Sun Pharmaceuticals Industries Ltd. (31 July 2026) the Bench held the whole controversy covered by it and applied both limbs - that Explanation 3 to s.37(1) operates prospectively and so does not reach AY 2014-15, and that 'prohibited by law' takes in only acts that are offences or are declared illegal as against public policy, not private disputes between parties. Nothing overruling or doubting the order was found and no s.260A appeal to the Gujarat High Court was traced. No source could be cited for that finding. Checking whether an authority still stands matters as much as knowing what it held: a decision may be overruled on one point and survive on another, or the provision it interprets may have been amended since. Read the source and the editor's note on this page before relying on it in a reply to an Assessing Officer or in an appeal.
Paragraphs 23, 23.1, 23.2 and 23.3 of the order deal with the "newly inserted clause (iv) to Explanation 3 to section 37(1)". Clause (iv) is real. Explanation 3, as inserted by the Finance Act, 2022 with effect from 1 April 2022, had three clauses, (i) to (iii). A fourth clause was added by the Finance (No. 2) Act, 2024 — Act No. 15 of 2024 — with effect from 1 April 2025, that is from assessment year 2025-26, and it reads: "to settle proceedings initiated in relation to contravention under such law as may be notified by the Central Government in the Official Gazette in this behalf". Paragraphs 23, 23.1 and 23.2 of this order say the same thing, and they record CBDT Notification No. 38/2025 dated 23 April 2025 notifying, for the purposes of that clause, the SEBI Act 1992, the Securities Contracts (Regulation) Act 1956, the Depositories Act 1996 and the Competition Act 2002. The Patents Act is not in that list, which is why clause (iv) would not have reached a patent settlement even in a year to which it applied. There is a point on the text that the Bench did not take up. Explanation 3 opens with the words 'shall include and shall be deemed to have always included', which is in tension with the conclusion that it operates prospectively. The Bench did not quote or address those words. What it addressed, at para 22.2, was the Revenue's claim that the amendment is clarificatory, and it rejected that claim by applying Vatika Township and M.M. Aqua Technologies and by pointing to the Memorandum. So an opponent who argues retrospectivity will start from the deeming words, and the answer this order supplies is the Memorandum and the two Supreme Court authorities rather than any construction of the deeming clause itself. That is worth knowing before the order is cited as though it had disposed of the deeming language. Two practical cautions. First, the order runs to 29 numbered paragraphs and the disposal is at para 29, but the paragraph numbering used by later orders that quote this one is not reliable — the same passage has been cited under two different numbers — so take paragraph numbers from this order itself and not from an order quoting it. Second, the year decides the argument. For a year up to assessment year 2024-25 the question is whether Explanation 3 applies at all, and this order says it does not. From assessment year 2025-26 clause (iv) is on the statute book, and the argument moves to whether the law under which the proceedings were initiated is one the Central Government has notified for the purpose. This library shows the verification state of every entry openly. This entry has not yet been read in full by a chartered accountant. The summary reflects the sources listed on this page. Read the source before you rely on it in a reply to an Assessing Officer or in an appeal before the Commissioner (Appeals) or the Income Tax Appellate Tribunal.
The payment of Rs 31,11,00,000 was a compensatory payment made out of commercial expediency to settle a civil dispute and protect the assessee's business interests; it was not a penalty for an offence or for a purpose prohibited by law under Explanation 1 to s.37(1), and Explanation 3 to s.37(1) is not applicable to the year under consideration. The disallowance was held unsustainable and ordered to be deleted, and grounds 1 and 2 of the assessee's appeal were allowed (para 23.3). In the result, the appeal of the Revenue was dismissed and the appeal of the assessee was allowed (para 29).
TaxSphere, “DCIT v AIA Engineering Ltd”, https://taxnotice.vittsphere.com/caselaw/case/aia-engineering-explanation-3-to-37-1-is-prospective/ (validity last checked 2026-09-08)
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