The AO disallowed a payment because the statute calls it a penalty. Does the label decide it?
No. Where a statutory impost paid as damages, penalty or interest is claimed under s.37(1), the officer has to examine the scheme of the statute that imposed it and decide whether it is compensatory or penal in substance, whatever it is called. If it is purely compensatory the deduction must be allowed; if the impost is composite, the compensatory and penal parts have to be separated and only the compensatory part allowed.
Decided by the Supreme Court (Supreme Court of India — B.P. Jeevan Reddy and N. Venkatachala, JJ; the judgment was delivered by Venkatachala J) on 1993-04-06, reported as (1993) 201 ITR 684 (SC); (1993) 111 CTR 389; (1993) 67 Taxman 546; 1993 AIR 2174; 1993 SCC (3) 452 — Civil Appeal No. 1279 (NT) of 1977. It bears on section 37(1), section 37(2), section 37(2B), section 256, section 256(1), section 256(2), section 10(2)(xv) of the Indian Income-tax Act, 1922 of the Income Tax Act 1961, in Deductions & Disallowances and How Tax Law Is Read matters.
It is the standing answer to a disallowance that rests on nomenclature — the officer reads the word 'penalty' in the levying statute and stops there. The case requires him to go to the scheme of that statute instead, and it puts the bifurcation exercise on him rather than on the assessee. Practitioners use it for interest and damages on delayed statutory payments and, by extension, for contractual liquidated damages. The department's usual counter is Explanation 1 to s.37(1); that Explanation came five years after this decision and answers a different question — whether the purpose was an offence or prohibited by law — not whether an impost is compensatory.
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The assessee was a company manufacturing textile goods. For assessment year 1966-67 — the previous year being 1 July 1964 to 30 June 1965 — it claimed Rs 19,635, being interest paid for delayed payment of sales tax under the Bombay Sales Tax Act and damages paid for delayed payment of contribution under the Employees' State Insurance Act, as revenue expenditure under s.37(1), and Rs 3,865 of entertainment expenditure under s.37(2). The Income Tax Officer treated the Rs 19,635 as penal interest and disallowed it, and of the Rs 3,865 allowed Rs 1,365 while disallowing Rs 2,500 as expenditure on the directors. Appeals to the Appellate Assistant Commissioner and the Tribunal failed. The Tribunal refused a reference under s.256(1) and the Bombay High Court refused one under s.256(2), so the assessee came to the Supreme Court by special leave against those orders.
The appeal was allowed in part. On the first question the Court held that deductibility of a statutory impost paid by way of damages, penalty or interest turns on whether it is compensatory or penal in substance and not on the nomenclature the levying statute gives it; the assessing authority must examine the scheme of the provisions of that statute, must allow the deduction under s.37(1) where the impost is purely compensatory, and where it is composite must bifurcate the two components and allow only the compensatory part (para 9). Because the Income Tax Officer and the appellate authorities had refused the claim without any such examination of the Bombay Sales Tax Act or of the statute under which the damages were paid, the question was remitted to the Tribunal, Bombay, to decide the claim in the light of that answer (paras 10, 12). On the second question the Court held that what portion of the miscellaneous expenses was deductible entertainment expenditure was for the fact-finding authorities, so no question of law arose where they had recorded a concurrent finding on the material; that question was answered against the assessee (para 11).
The Court first decided to answer the questions itself rather than remit them to the High Court under s.256, because the case was a 25 year old one relating to assessment year 1966-67, because the questions could be dealt with on the facts found by the Tribunal, and because it intended in any event to send the first question back to the Tribunal with its answer (para 3). On the substance it took the law to be settled by two decisions with which it expressed complete agreement: its own decision in Mahalakshmi Sugar Mills Co. v. CIT, where interest under s.3(3) of the U.P. Sugarcane Cess Act was held compensatory and allowable because that Act separately provided for imprisonment or fine under s.4 and for a penalty under s.3(5); and the Andhra Pradesh High Court in CIT v. Hyderabad Allwyn Metal Works Ltd., which read the passage of A.P. Sen J in Organo Chemical Industries v. Union of India treating damages under s.14B of the Employees' Provident Funds Act as serving both a penal and a reparatory purpose, and which held that whether an impost is compensatory or penal must be decided from the provisions under which it is imposed and the circumstances of its imposition, the nomenclature not being conclusive and a fixed rate of interest not being conclusive either (paras 5-8). From those the Court drew the general rule: the assessing authority must examine the scheme of the levying statute notwithstanding the name the statute gives the impost, allow the deduction where the impost is purely compensatory, and bifurcate and allow only the compensatory part where it is composite (para 9). Applied to these facts, no such examination had been carried out at any stage, so the matter went back to the Tribunal (para 10). On the entertainment expenditure the Court declined to interfere because the apportionment was a question of fact on which the authorities had reached a concurrent finding (para 11).
Therefore, whenever any statutory impost paid by an assessee by way of damages or penalty or interest, is claimed as an allowable expenditure under section 37(1), the assessing authority is required to examine the Scheme of the provisions of the relevant statute providing for payment of such impost notwithstanding the nomenclature of the impost as given by the statute, to find whether it is compensatory or penal, in nature. The authority has to allow deduction under section 37(1) wherever such examination reveals the concerned impost to be purely compensatory in nature. Wherever such impost is found to be of a composite nature, that is, partly of compensatory nature and partly of penal nature, the authorities are obligated to bifurcate the two components of the impost and give deduction to that component which is compensatory in nature and refuse to give deduction to that component which is penal in nature.
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Handle my notice → Ask a CA on WhatsAppNo. Where a statutory impost paid as damages, penalty or interest is claimed under s.37(1), the officer has to examine the scheme of the statute that imposed it and decide whether it is compensatory or penal in substance, whatever it is called. If it is purely compensatory the deduction must be allowed; if the impost is composite, the compensatory and penal parts have to be separated and only the compensatory part allowed. This was decided by the Supreme Court (Supreme Court of India — B.P. Jeevan Reddy and N. Venkatachala, JJ; the judgment was delivered by Venkatachala J) and bears on section 37(1), section 37(2), section 37(2B), section 256, section 256(1), section 256(2), section 10(2)(xv) of the Indian Income-tax Act, 1922 of the Income Tax Act 1961. It is reported as (1993) 201 ITR 684 (SC); (1993) 111 CTR 389; (1993) 67 Taxman 546; 1993 AIR 2174; 1993 SCC (3) 452 — Civil Appeal No. 1279 (NT) of 1977. It is the standing answer to a disallowance that rests on nomenclature — the officer reads the word 'penalty' in the levying statute and stops there. The case requires him to go to the scheme of that statute instead, and it puts the bifurcation exercise on him rather than on the assessee. Practitioners use it for interest and damages on delayed statutory payments and, by extension, for contractual liquidated damages. The department's usual counter is Explanation 1 to s.37(1); that Explanation came five years after this decision and answers a different question — whether the purpose was an offence or prohibited by law — not whether an impost is compensatory. If it applies to you, the first step is this: Take the officer to the provisions of the statute under which the impost was levied and show what they are designed to do — compensate for delay, or punish.
The assessee was a company manufacturing textile goods. For assessment year 1966-67 — the previous year being 1 July 1964 to 30 June 1965 — it claimed Rs 19,635, being interest paid for delayed payment of sales tax under the Bombay Sales Tax Act and damages paid for delayed payment of contribution under the Employees' State Insurance Act, as revenue expenditure under s.37(1), and Rs 3,865 of entertainment expenditure under s.37(2). The Income Tax Officer treated the Rs 19,635 as penal interest and disallowed it, and of the Rs 3,865 allowed Rs 1,365 while disallowing Rs 2,500 as expenditure on the directors. Appeals to the Appellate Assistant Commissioner and the Tribunal failed. The Tribunal refused a reference under s.256(1) and the Bombay High Court refused one under s.256(2), so the assessee came to the Supreme Court by special leave against those orders. The matter was decided on 1993-04-06 by the Supreme Court (Supreme Court of India — B.P. Jeevan Reddy and N. Venkatachala, JJ; the judgment was delivered by Venkatachala J). On those facts the Supreme Court held as follows. The appeal was allowed in part. On the first question the Court held that deductibility of a statutory impost paid by way of damages, penalty or interest turns on whether it is compensatory or penal in substance and not on the nomenclature the levying statute gives it; the assessing authority must examine the scheme of the provisions of that statute, must allow the deduction under s.37(1) where the impost is purely compensatory, and where it is composite must bifurcate the two components and allow only the compensatory part (para 9). Because the Income Tax Officer and the appellate authorities had refused the claim without any such examination of the Bombay Sales Tax Act or of the statute under which the damages were paid, the question was remitted to the Tribunal, Bombay, to decide the claim in the light of that answer (paras 10, 12). On the second question the Court held that what portion of the miscellaneous expenses was deductible entertainment expenditure was for the fact-finding authorities, so no question of law arose where they had recorded a concurrent finding on the material; that question was answered against the assessee (para 11).
The Court first decided to answer the questions itself rather than remit them to the High Court under s.256, because the case was a 25 year old one relating to assessment year 1966-67, because the questions could be dealt with on the facts found by the Tribunal, and because it intended in any event to send the first question back to the Tribunal with its answer (para 3). On the substance it took the law to be settled by two decisions with which it expressed complete agreement: its own decision in Mahalakshmi Sugar Mills Co. v. CIT, where interest under s.3(3) of the U.P. Sugarcane Cess Act was held compensatory and allowable because that Act separately provided for imprisonment or fine under s.4 and for a penalty under s.3(5); and the Andhra Pradesh High Court in CIT v. Hyderabad Allwyn Metal Works Ltd., which read the passage of A.P. Sen J in Organo Chemical Industries v. Union of India treating damages under s.14B of the Employees' Provident Funds Act as serving both a penal and a reparatory purpose, and which held that whether an impost is compensatory or penal must be decided from the provisions under which it is imposed and the circumstances of its imposition, the nomenclature not being conclusive and a fixed rate of interest not being conclusive either (paras 5-8). From those the Court drew the general rule: the assessing authority must examine the scheme of the levying statute notwithstanding the name the statute gives the impost, allow the deduction where the impost is purely compensatory, and bifurcate and allow only the compensatory part where it is composite (para 9). Applied to these facts, no such examination had been carried out at any stage, so the matter went back to the Tribunal (para 10). On the entertainment expenditure the Court declined to interfere because the apportionment was a question of fact on which the authorities had reached a concurrent finding (para 11). In the words reproduced by the source cited on this page: "Therefore, whenever any statutory impost paid by an assessee by way of damages or penalty or interest, is claimed as an allowable expenditure under section 37(1), the assessing authority is required to examine the Scheme of the provisions of the relevant statute providing for payment of such impost notwithstanding the nomenclature of the impost as given by the statute, to find whether it is compensatory or penal, in nature. The authority has to allow deduction under section 37(1) wherever such examination reveals the concerned impost to be purely compensatory in nature. Wherever such impost is found to be of a composite nature, that is, partly of compensatory nature and partly of penal nature, the authorities are obligated to bifurcate the two components of the impost and give deduction to that component which is compensatory in nature and refuse to give deduction to that component which is penal in nature." The decision followed or applied Mahalakshmi Sugar Mills Co. v. CIT [1980] 123 ITR 429 (SC); CIT v. Hyderabad Allwyn Metal Works Ltd. [1988] 172 ITR 113 (AP).
It was decided by the Supreme Court on 1993-04-06 and is reported as (1993) 201 ITR 684 (SC); (1993) 111 CTR 389; (1993) 67 Taxman 546; 1993 AIR 2174; 1993 SCC (3) 452 — Civil Appeal No. 1279 (NT) of 1977. Binding on every court and authority in India. A Supreme Court decision binds every assessing officer, every Commissioner (Appeals), every bench of the Income Tax Appellate Tribunal and every High Court in India. An officer who declines to follow it is acting contrary to law, and that refusal is itself a ground of appeal. On section 37(1), section 37(2), section 37(2B), section 256, section 256(1), section 256(2), section 10(2)(xv) of the Indian Income-tax Act, 1922, 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 cuts both ways and is cited by both sides. The appeal was allowed in part. On the first question the Court held that deductibility of a statutory impost paid by way of damages, penalty or interest turns on whether it is compensatory or penal in substance and not on the nomenclature the levying statute gives it; the assessing authority must examine the scheme of the provisions of that statute, must allow the deduction under s.37(1) where the impost is purely compensatory, and where it is composite must bifurcate the two components and allow only the compensatory part (para 9). Because the Income Tax Officer and the appellate authorities had refused the claim without any such examination of the Bombay Sales Tax Act or of the statute under which the damages were paid, the question was remitted to the Tribunal, Bombay, to decide the claim in the light of that answer (paras 10, 12). On the second question the Court held that what portion of the miscellaneous expenses was deductible entertainment expenditure was for the fact-finding authorities, so no question of law arose where they had recorded a concurrent finding on the material; that question was answered against the assessee (para 11). It arises in Deductions & Disallowances and How Tax Law Is Read matters, on section 37(1), section 37(2), section 37(2B), section 256, section 256(1), section 256(2), section 10(2)(xv) of the Indian Income-tax Act, 1922 of the Income Tax Act 1961, and was decided by Supreme Court of India — B.P. Jeevan Reddy and N. Venkatachala, JJ; the judgment was delivered by Venkatachala J. 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. Where the levy has both characters, propose the bifurcation yourself with a workable basis rather than leaving the officer to disallow the whole. Do not rest on the label used in the levying statute or in your own books; the case says the nomenclature does not decide it. Deal with Explanation 1 to s.37(1) separately — show the payment was not for a purpose that is an offence or prohibited by law, which is a different test from compensatory versus penal.
Still good law. Applied by the Gujarat High Court in Saurashtra Cement & Chemical Industries Ltd. v. CIT [1995] 80 Taxman 61 / [1995] 213 ITR 523 (Guj.), decided 12 October 1994, which quoted the passage and then decided against the assessee who relied on it: interest under s.220 for late payment of income-tax may be compensatory, but because the primary liability — income-tax — is a personal liability and not a business expense, the interest on it is not expenditure laid out wholly and exclusively for the purposes of the business. That case marks the real limit of this decision, which is that the compensatory character of an impost is not by itself enough; the underlying liability must be one that is deductible. The ground has also narrowed by statute. Explanation 1 to s.37(1), inserted by the Finance (No. 2) Act 1998 with effect from 1 April 1962, denies a deduction for expenditure incurred for any purpose which is an offence or which is prohibited by law. Explanation 3, inserted by the Finance Act 2022 with effect from 1 April 2022, declares that the expression in Explanation 1 includes and shall be deemed always to have included expenditure for a purpose which is an offence under or prohibited by any law in India or outside India, expenditure to provide a benefit or perquisite whose acceptance violates a law, rule, regulation or guideline governing the recipient's conduct, and expenditure to compound an offence; the Finance (No. 2) Act 2024 added a fourth clause with effect from 1 April 2025 covering expenditure to settle proceedings for contravention of a notified law. A payment can be compensatory on this test and still fail under the Explanations. 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.
The judgment was read in full. Three points on the text of the report. It names the statute under which the damages were paid as the Employees' State Insurance Act at paras 1 and 2 but as the Provident Fund Act at para 10, where the remit is directed; the authority the Court adopted, Hyderabad Allwyn, was itself about s.14B of the Employees' Provident Funds and Miscellaneous Provisions Act 1952. It gives the sales tax statute as the Bombay Sales Tax Act, 1951, while the Gujarat High Court, describing this decision a year later, gives it as the Act of 1959. And it dates the Employees' State Insurance Act to 1947. Those are the report's own renderings and have not been corrected here. On the substance: the Court did not decide whether the particular payments were compensatory; it remitted that to the Tribunal, Bombay. The case was decided in 1993, before Explanation 1 was inserted in s.37(1) by the Finance (No. 2) Act 1998 with retrospective effect from 1 April 1962, so the Court was not applying that Explanation and the decision cannot be read as construing it. The separate entertainment expenditure disallowance under s.37(2) was upheld as a concurrent finding of fact. It does not tell you how to bifurcate a composite impost in practice — it says only that the authorities are obliged to do it. It is about a statutory impost rather than contractual liquidated damages, so the extension to a contractual payment rests on the same reasoning rather than on the decision itself. And it does not decide the anterior question of whether the primary liability is itself deductible: the Gujarat High Court in Saurashtra Cement & Chemical Industries Ltd. v. CIT held that where the underlying liability is income-tax, a compensatory interest on it is still not a business expense, and the reader should not take this decision as authority the other way. What ultimately happened on the remit to the Bombay Tribunal is not recorded here. 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 appeal was allowed in part. On the first question the Court held that deductibility of a statutory impost paid by way of damages, penalty or interest turns on whether it is compensatory or penal in substance and not on the nomenclature the levying statute gives it; the assessing authority must examine the scheme of the provisions of that statute, must allow the deduction under s.37(1) where the impost is purely compensatory, and where it is composite must bifurcate the two components and allow only the compensatory part (para 9). Because the Income Tax Officer and the appellate authorities had refused the claim without any such examination of the Bombay Sales Tax Act or of the statute under which the damages were paid, the question was remitted to the Tribunal, Bombay, to decide the claim in the light of that answer (paras 10, 12). On the second question the Court held that what portion of the miscellaneous expenses was deductible entertainment expenditure was for the fact-finding authorities, so no question of law arose where they had recorded a concurrent finding on the material; that question was answered against the assessee (para 11).
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