I paid liquidated damages for late delivery and the AO disallowed it as a penalty. What is the actual test?
Whether the payment is compensatory or penal in substance. Explanation 1 to s.37(1) bites only where the expenditure was incurred for a purpose which is an offence or which is prohibited by law; damages for breaching your own contract are ordinarily neither. Where a statutory impost is in issue, the officer has to examine the scheme of the statute that imposed it and, if the levy is composite, bifurcate it.
Explanation 1 is short and its scope is narrower than the way it is usually invoked. It reads: "For the removal of doubts, it is hereby declared that 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." It was inserted by the Finance (No. 2) Act 1998 with effect from 1 April 1962. Two words carry the whole provision: 'purpose', and 'offence or prohibited by law'. The question it asks is what the expenditure was incurred for, not whether it arose out of something that went wrong.
Breaching a commercial contract is not an offence and is not prohibited by law. A contract that fixes damages for late delivery, short supply or an unmet export obligation is providing for a commercial consequence, and paying it is a cost of doing business. So the ordinary liquidated damages claim is not answered by Explanation 1 at all, and an officer who cites the Explanation should be asked to identify the law that prohibits the conduct.
Where the payment is a statutory impost — interest for late payment of a tax, damages under a welfare enactment, a charge under a regulatory statute — the governing test is the one in Prakash Cotton Mills Pvt. Ltd. v. CIT. Whenever such an impost is claimed under s.37(1), the assessing authority has to "examine the scheme of the provisions of the relevant statute providing for payment of such impost" and decide whether it is compensatory or penal in substance, whatever the levying statute calls it. If it is purely compensatory the deduction has to be allowed. If it is composite — part compensation for the exchequer being kept out of money, part punishment — the authority is obliged to bifurcate and allow the compensatory part. That case was decided in 1993, five years before Explanation 1 was inserted, so it does not construe the Explanation; the two tests run alongside each other and a payment has to pass both.
Where Explanation 1 does bite is illustrated by the corpus entry on Apex Laboratories Pvt. Ltd. v. DCIT, in which the Supreme Court held that the cost of freebies given to medical practitioners is not deductible because acceptance is prohibited for the doctor and a prohibition on the recipient is equally a prohibition on the giver. That is the shape of a genuine Explanation 1 case: a rule of law forbids the very thing the money was spent on. 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 to have always included expenditure for a purpose which is an offence under or prohibited by any law in force in India or outside India, expenditure to provide a benefit or perquisite whose acceptance violates any 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 — expenditure "to settle proceedings initiated in relation to contravention under such law as may be notified by the Central Government" — and CBDT Notification No. 38/2025 dated 23 April 2025 notified the Securities and Exchange Board of India Act 1992, the Securities Contracts (Regulation) Act 1956, the Depositories Act 1996 and the Competition Act 2002. From assessment year 2025-26 a settlement payment under any of those four laws is inside Explanation 1 whatever its compensatory character, which is exactly the payment this page otherwise teaches you to defend.
So the reply to a liquidated damages disallowance has three steps. First, characterise the payment: what was it compensating for, and how was the amount arrived at? A pre-estimate of loss recorded in the contract is strong evidence of compensation. Second, if the payment is under a statute, take the officer to the scheme of that statute rather than to its nomenclature, and offer a bifurcation where the levy has both characters. Third, meet Explanation 1 separately and on its own terms by showing that the purpose was not an offence and not prohibited by law.
The evidence for the first step is contractual and contemporaneous: the clause itself, the correspondence in which the deduction was claimed by the counterparty, the debit note, and the working showing the loss the counterparty said it had suffered. Where the amount was simply withheld from a running bill, the reconciliation showing what was withheld and against which milestone is what carries the point.
The disallowance costs the whole amount, and it is usually made on the strength of the word 'penalty' appearing somewhere — in the contract clause, in the debit note or in the levying statute. Both the compensatory-versus-penal test and the narrow reading of Explanation 1 are available answers, but they answer different objections, and a reply that runs them together tends to lose both.
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