DAMODARAM SANJIVAYYA NATIONAL LAW

UNIVERSITY

VISAKHAPATNAM, A.P., INDIA

INTERPRETATION & ANALYSIS OF SECTION 37 OF INCOME TAX

ACT, 1961

TAXATION LAW-I

VISHNU KUMAR

G. NAGA LAHARI

ROLL NO: 2013048

VII SEMESTER

1
 ACKNOWLEDGEMENT

I consider myself lucky that I got the chance to do a work on this topic that was to
“Interpretation and Analysis of Section 37 of the Income Tax Act, 1961”.

I thank the subject teacher, Mr. Vishnu Kumar, for letting me choose the topic.

2
 ABSTRACT

Section 37 of the Income Tax Act, 1961 defines the general clause of profits and Gains of
Business or Profession. Any expenditure laid out or expended wholly or exclusively for the
purposes of the business or profession shall be allowed in computing the income chargeable
under the head, “profits and gains of business or profession”. However, the expenditure, to
be deductible under this section must be expenditure incurred wholly or exclusively for the
purpose of business or profession during the relevant previous year and the expenditure must
not be of capital nature and must not be an expenditure covered under sections 30 to 36.

Section 37, clause 1 of the Act defines that any expenditure (not being expenditure of the
nature described in sections 30 to 36 and not being in the nature of capital expenditure or
personal expenses of the assessee), laid out or expended wholly or exclusively for the
purposes of the business or profession shall be allowed in computing the income chargeable
under the head profits and gains of business or profession. The interpretation of the above
clause, 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. According to sub-section (2B) inserted by the Taxation Laws
(Amendment) Act, 1978 w.e.f. 1-4-1979, no allowance shall be made in respect of an
expenditure incurred by an assessee on advertisement in any souvenir, brochure, tract,
pamphlet or the like published by a political party.

3
 TABLE OF CONTENTS

TITLE PAGE No.

ACKNOWLEDGMENT 02
ABSTRACT 03
1. OBJECTIVE 06
2. INTRODUCTION 06
3. HYPOTHESIS 06
4. REVIEW OF LITERATURE 07
5. RESEARCH METHODOLOGY 08
6. CONDITIONS FOR 09
ALLOWANCE OF BUSIINESS
AND PROFIT EXPENDITURES
UNDER SECTION 37 OF THE
ACT
7. TESTS FOR EXPENDITURE 13
INCURRED UNDER SECTION 37
OF THE ACT
CONCLUSION 14
BIBLIOGRAPHY 15
Books
Journals
Webliography

4
LIST OF ABBREVIATIONS

Art. Article

Arts. Article

CIT Commissioner of Income Tax

Etc. Etcetera

Ed. Edition

Id. Ibid

IT Income tax Tribunal

Ltd. Limited

ROC Registrar of Company

SC Supreme Court

SCC Supreme Court Cases

Sec. Section

VAT Value Added Tax

Vol. Volume

www World Wide Web

5
 1. OBJECTIVES

The paper deals with the interpretation and analysis of section 37 of Income Tax Act, 1961.

2. INTRODUCTION

The central analysis of this paper would be section 37(1) of the Income Tax Act, 1961. Prior
to the introduction of Section 37 of the Act, there had been a catena of judicial
pronouncements to the effect that would be considered a part of business expenditure under
S. 37 (1). Before examining this position of the law, it would be pertinent to have a brief
conceptual understanding of Section 37(1) of the Income Tax Act.

37 (1) states that any expenditure which does not qualify under revenue expenditure within
Ss. 30-36 or is a capital expenditure or personal expenses of the assessee shall be considered
to be business expenditure if it is wholly and exclusively for the purposes of business or
profession shall be allowed as business expenditure while computing income from profits and
gains from business or profession. Herein the phrase “wholly and exclusively for the
purposes of business” is important. There have been some varied judicial views relating to
when expenditure would be classified as wholly and exclusively for the purpose of business
over the years. However, the crux of these decisions can be summarized in two points –
firstly, the fact that a particular transaction was prudent or indispensible or necessary for the
assessee to enter into are irrelevant factors in determination of this question1 as it is a well
settled doctrine that the businessman is the best judge for business expediency2; secondly, the
foregoing does not prevent the Assessing Officer from inquiring into the reality of the
transaction i.e. whether it was entered into purely business purposes and not extraneous
considerations. Therefore it can be seen that this is a question of fact and would be
determined accordingly.

3. HYPOTHESIS

The section interprets that any expenditure which does not qualify under revenue expenditure
within Ss. 30-36 or is a capital expenditure or personal expenses of the assessee shall be
considered to be business expenditure if it is wholly and exclusively for the purposes of
business or profession shall be allowed as business expenditure while computing income
from profits and gains from business or profession. Herein, the phrase “wholly and
1
Narsingdas Surajmal Properties Pvt.Ltd v. CIT, (1981) 127 ITR 221 (Gau)
2
Jaipur Electro Pvt.Ltd v. CIT, (1996) 134 CTR 237 (Raj)

6
exclusively for the purposes of business” is important. There have been some varied judicial
views relating to when expenditure would be classified as wholly and exclusively for the
purpose of business over the years. However, the crux of these decisions can be summarized
in two points – firstly, the fact that a particular transaction was prudent or indispensible or
necessary for the assessee to enter into are irrelevant factors in determination of this question
as it is a well settled doctrine that the businessman is the best judge for business expediency
secondly, the foregoing does not prevent the Assessing Officer from inquiring into the reality
of the transaction i.e. whether it was entered into purely business purposes and not extraneous
considerations. Therefore it can be seen that this is a question of fact and would be
determined accordingly.

4. REVIEW OF LITERATURE

Federal Income Tax. By George E. Holmes. 1923 Edition. Indianapolis, BobbsMerrill

Company, 1923. pp. lviii, 1847: The vastness of the government's taxing business is well-
nigh appalling and since the governing law is capable of such varying interpretations, with
slight variations affecting even single taxpayers into the thousands of income, the task of
interpretation and administration seems rather to increase than diminish in difficulty with the
passage of time. Rulings grow on top of rulings until the basic foundation of law is entirely
hidden. Thus for example, the Revenue Acts of i918 and i92i did not expressly exempt from
taxation income received from a state or its subdivisions. Since, however, the Supreme Court
in what is thought to be an entirely unsound conclusion, has clearly intimated that such
income cannot be taxed by the business expenditure.

The Law And Practice Of Income Tax by kanga & palkhivala’s, 10th ed.,: " Some of the
salient features of the book are: • The edition is not just a compilation but includes critical
analysis by the author for all important cases covered • Contains approximately more than
18,000 cases, from Supreme Court and High Court jurisprudence, covering upto 358 ITR •
Provides completely new commentary, for important sections, in line with the changes in law.
• Provides commentary on the legislative history for all important sections • Bare Act has
been reproduced with all amendments since the inception of the Act, 1961 • Includes
references to relevant rules and forms • Also contains exhaustive references in CD format: 1.
Indian Income-tax Act, 1922 2. Indian Income-tax Act, 1922 amended as at 1961 3. Income-
tax Rules, 1962 and allied rules and schemes 4. Double Taxation Avoidance Agreements 5.

7
All Finance Act circulars, since 1961 6. Important explanatory circulars 7. All allied acts to
the Income-tax Act"

Taxation of Income: An International Comparison by Indu Jain; Manohar Publishers

and Distributors: Tax literature has proliferated in recent years with most publications
making the taxpayer none the wiser. This book makes an ambitious attempt to digest income
tax laws of six countries— the U.S., the U.K., Australia, India, Pakistan and Malaysia. A
broad conclusion that emerges from the study is that the systems are not materially different
with exceptions only for taxes like capital gains tax, tax on book profits and now fringe
benefit tax, which are not adopted by all. Elaborate as the book is, it spares the readers the
author's judgment on desirability or efficacy of the tax measures dealt with as to their impact
on trade and industry. While accountability of the taxpayer has been ensured in all these
statutes, there is no discussion as to how the accountability of the tax assessor, if at all, is
ensured. Efficacy of grievance procedure in law and practice is another area of study in
greater detail, which should be useful, but missing.

Das-Gupta, Arindam Taxation; Ghosh, Shanto; Mookherjee, Dilip, 2004: Tax

compliance can be improved by implementing simple reforms in personnel policy in Indian
income tax administration. Taxpayers voluntarily disclosing higher income are currently
assigned to special assessment units. Therefore, taxpayers understate their income. Empirical
evidence consistent with this hypothesis is found. If staff employment is increased and there
are changes in assignment procedures for staff and taxpayers, it will lead to higher tax
compliance and lower tax evasion by Indians.
5. RESEARCH METHODOLOGY
5.1. Research Questions
1) What is the general interpretation and analysis of section 37 of the Income Tax Act,
1961?
2) What are the general deductions permissible under section 37 of the Income Tax Act,
1961?
3) What are the instances of the expenses which are not deductible under section 37?
5.2. Sources of Data

The primary sources of data are internet source and books.

5.3. Method of Writing

8
The research paper is in theoretical in nature.

5.4. Mode of Citation

The mode of citation used in this paper is Harvard Blue Book Citation.

6. CONDITIONS FOR ALLOWANCE OF BUSINESS AND PROFITS

EXPENDITURE UNDER SECTION 37 OF THE ACT

The conditions which are allowable under section 37 of the Act are a residuary section for the
allowance of business and profits expenditure. The section 37(1) of the Act defines that any
expenditure (not being expenditure of the nature described in section 30 to 36) and not being
in the nature of capital expenditure or personal expenses of the assessee, laid out or expended
wholly and exclusively for the purposes of the business or profession shall be allowed in
computing the income chargeable under the head “profits and gains of business or profession.
The section explains that 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.

The conditions for allowance under section 37 of the Act:

 Such experience should not be covered under the specific section i.e., section 30 to 36
 Expenditure should not be of capital nature.
 The expenditure should be incurred during the previous year
 The expenditure should not be of personal nature
 The expenditure should have been incurred wholly or exclusively for the purpose of
the business or profession,
 The business should be commenced.

Some of the judicial pronouncements, which are decided by various courts and tribunals of
the country, are:

1. Expenses covered under section 30 to 36: If any expense is covered under section
30 to section 36 of the Income tax Act, 1961 and could not be allowed due to non

9
 satisfying condition laid down under section, same cannot be allowed under this
residuary section.3
2. Fees paid to ROC: It has been decided by the Rajasthan High Court that fees paid
to the registrar of Companies for bringing about change in the memorandum and
Articles should not be allowed.4 Further, fees paid for increasing authorized capital is
a capital expenditure.
3. Bank Guarantee: The Gujarat High Court in CIT v. Bharat Suryodaya Mills Co.
Limited5 decided that any payment of bank charges related towards bank guarantee
required for purchase of machinery should not be allowed as revenue expenditure.
4. Replacement of Machinery: Expenditure on replacement of old machines is in the
nature of accumulated repairs and not current repairs. Therefore, the High court
allowed such deduction under section 37 in place of section 31. As, in case of CIT v
Gitanjali Mills Limited6 Further, where parts of larger machines are purchased by the
assessee, expenditure on such parts is allowable as revenue expenditure. The assessee
company was engaged in printing and publication of various periodicals. It got
repaired an empty derelict hall which was converted into a recreation room and was
used by assessee’s staff. The aforesaid deduction was allowed to the assessee as the
repairs did not constitute a capital expenditure and hence were allowable under
section 37(1) of the Act. In Aswanth N.Rao v ACIT7, the repair expenses incurred by
the assessee on the rented premises is allowable u/s. 37(1) of the Act. Also, in Alkem
Laboratories (P) Ltd.8, the replacement of machinery in a textile mill neither amounts
to a current repairs nor revenue expenditure as each separate machine is an
independent entity which brings an enduring benefit to the assessee.
5. Lease on permanent basis: Amount paid in installments for obtaining a lease on
permanent basis is a capital expenditure. In DCIT v SUN Pharmaceuticals
Limited9 Similarly as long as expenditure is incurred bona fide in pursuit of business
and not by way of diversions of funds, it has to be allowed as a deduction. Entire lease
rent paid by the assessee for hiring the dozers for using them in its business was
allowable as business expenditure even though assessee did not actually use 3 out of

3
Laxman serjam v. CIT, 54 ITR 763 (1964) Gujarat.
4
CIT v. Aditya mills, 181 ITR 195 (1990)
5
202 ITR 942 (1993)
6
265 ITR 681 (2004).
7
326 ITR 188.
8
28 DTR 11
9
329 ITR 479.

10
 the hired dozers. CIT v. Salitho Ores Ltd.10 Similarly, Royalty paid for getting non-
assignable license, right and privilege to manufacture on the licensed mark, and
distribute the licensed product in India and use expression “Benetton”, without
becoming owner or acquiring any right in licensed trade mark, was held to be a
revenue expenditure.
6. Compensation to Tenant: Amount paid by the assessee, who purchased the plot of
land, to the tenant occupying the structure erected by the tenant on such land for
getting vacant possession is a capital expenditure. In CIT v Lucky Bharat Garage11.
However, assessee entered into an agreement for purchase of property for
infrastructural facilities for business, assessee terminated the agreement and paid
compensation, payment to be treated as capital in nature and not allowable as revenue
expenditure.
7. New Project Report: Expenditure incurred on project report for setting up a new unit
is a capital expenditure. In CIT v J.K. Chemicals Limited12., However, Consultation
charges paid by the assessee in connection with the expansion of assessee’s existing
project were held to be allowable as revenue expenditure.
8. Expenses on Issue of Shares: Expenditure incurred by a company in connection with
issue of shares with a view to increase its share capital is directly related to the
expansion of the capital base of the company, and is capital expenditure , even
though, it may incidentally help in the business of the company and in profit
making.13
9. Legal expenses: Deductibility of Legal Expenses will depend on Nature & purpose of
legal proceeding in relation to business whose profits are under computation and
cannot be affected by final outcome of those proceedings. In Vivek P Talwar v
ACIT.14However, Legal charges incurred for defending criminal proceedings which
has get nothing to do with Assessee profession is definitely of personal nature and
such expenditure cannot be allowed against income from business and Profession.
10. Advertisement: In Dy CIT v Godrej Tea Ltd.15 expenditure on advertisement to
create brand image, partly debited in profit and loss account and balance deferred over

10
236 CTR 53 / 46 DTR 377
11
174 ITR 526 (1998)
12
207 ITR 985 (1994)
13
Brook Bond India Limited 225 ITR 798 (1997)
14
8 Taxmann.com 268
15
4 ITR (Tri) 649

11
 a period of three years, expenditure allowable as revenue expenditure, entry or
absence of entry does not determine allowability of expenditure.
11. Family Expenditure: In CIT v Mahesh Bhupathi,16 Agreement entered into between
the father and son wherein the son has agreed to reimburse the amount spent by his
father towards his maintenance and education is unheard of under the provisions of
the Hindu law and therefore son cannot claim for such payments.
12. Premature Termination Compensation: In Microsoft Corporation of India case17
the amount paid to landlord for premature termination of lease is expenditure on
account of commercial expediency and hence entitled for deduction u/s. 37.
13. Prior Period Expenses: In Urban Improvement Co. (P) Ltd. ITA18 During the year
the Assessee cancelled the MOU and refunded the amounts received under MOU
along with interest as per the terms of the MOU. The AO disallowed the interest paid
for the period covering earlier years on the ground that it was prior period expense.
Held that the liability to pay interest had accrued in the year under consideration when
the resolution was passed and not prior to that. The liability under consideration was
contractual liability and was crystallized and ascertained only when the decision to
refund the earnest money along with interest was taken and hence the deduction is
allowable.
14. Employees Home: In Niko Resources Ltd.,19 the expenditure in providing residential
facility to engineers at work site is wholly for the purposes of business and allowable
as business expenditure in toto.
15. Agriculture: In Kancor Flavours & Extracts Ltd. v. Dy. CIT20, the expenses relating
to agricultural operations could not be allowed as expenditures in computing the
business incomes for the simple reason that agricultural income did not form part of
the total income under the Act.

7. TESTS FOR EXPENDITURE INCURRED UNDER SECTION 37 OF THE

INCOME TAX ACT.

There are two tests classifies under section 37 of the Income Tax Act, 1961. The tests under
section 37 clarifies that the expenditure would bring profits, expansion of business or in

16
43 DTR (Kar)163
17
210 Taxation 161
18
No. 3246/Mum/2006, Bench – D, A.Y. 2003–04, dt. 5-9-2008
19
123 TTJ 310.
20
123 ITD 97

12
 negative aspects etc., the tests also clarify that what expenditures are necessary and what are
not.

Positive Tests: If the expenditures are incurred:

1. with a view to bring profits or monetary advantage today or tomorrow;

2. to render the assessee immune from impending or reasonably apprehended litigation;
3. in order to save losses in foreseeable future;
4. for effecting economy in working which may pay dividends today or tomorrow;
5. for increasing efficiency in working;
6. for removing inefficiency in the working;
7. where the expenditure incurred is such as a wise, prudent, pragmatic and ethical man of the
world of business would conscientiously incur with an eye on promoting his business
prospects subjects to the expenditure being genuine and within reasonable limits;
8. where it is incurred solely by way of a civil duty owed by the assessee to the society having
regard to the nature of his business which brings him profits but results in some detriment to
the public at large either by way of health hazard or ecological pollution or serious
inconvenience to the citizens with a view to mitigate the aforesaid evil consequences and
consequences of a like nature, subject to its being genuine and within reasonable limits.

Negative Tests: If the expenditure is incurred:

1. for a mere altruistic consideration;

2. mainly in order to satisfy his philanthropic urges;
3. mainly in order to win applause or public appreciation;
4. for illegal, immoral or corrupt purposes or by any such means or for any such reasons;
5. mainly in order to oblige a relative or an official;
6. to earn the goodwill of a political party or a politician;
7. to show off or impress others with his affluence or for ostentatious purposes.
8. apparently for a factor listed as a positive factor but in reality for one of the obnoxious
purpose listed as a negative factor;
9. on a nebulous plea or pretext but really for one or the other of the purposes listed as negative
tests;
10. it must not be a bogus, fictitious or sham transaction;
11. is must not be unreasonable and out of proportion;

13
12. it must not be an expenditure merely with a view to avoid tax liability without any genuine
purpose or reason in good faith; and
13. the advantage to be secured by incurring the expenditure must not be of the nature of a
remote possible advantage depending on “ifs’ and “buts” and, if at all, to be secured at an
uncertain future date which may be considered too remote.

CONCLUSION

All expenditures which are incurred wholly and exclusively for the purpose of business or
profession are allowable under the provision 37 of Income Tax Act, 1961. It is clear that
scope of the abovementioned section is wide enough for claiming a particular deduction, if
certain conditions laid down therein are satisfied. While allowing deduction under section
37(1), it is always open for assessing officer to question allowably of payments/expenditure
considering whether the expenditure is wholly and exclusively for the purpose of business or
profession. The expression “wholly” in section 37(1) has been used with reference to the
quantum, while the expression ‘exclusively’ refers to the nature or the purpose of the activity
in which the expenditure is incurred.

“The mere existence of an agreement between the assessee and its selling agents or payment
of certain amounts as commission, assuming there was such payment, does not bind the
Income Tax Officer to hold that the payment was made exclusively and wholly for the
purpose of the assessee’s business. Although there might be such an agreement in existence
and the payments might have been made. It is still open to the Income tax Officer to consider
the relevant facts and determine for himself whether the commission said to have been paid
to the selling agents or any part thereof is properly deductible under Section 37 of the Act.”

BIBLIOGRAPHY

Books

Rosanne Altshuler et. al., Capital Income Taxation and Progressivity in Global Economy, 30
Va. Tax Rev. 355 (2010).

Federal Income Tax. By George E. Holmes. 1923 Edition. Indianapolis, BobbsMerrill

Company
The Law And Practice Of Income Tax by kanga & palkhivala’s, 10th ed.,

14
Taxation of Income: An International Comparison by Indu Jain; Manohar Publishers and
Distributors
Das-Gupta, Arindam Taxation; Ghosh, Shanto; Mookherjee, Dilip, 2004
Neil Brooks & Thaddeus Hwong, Tax Levels, Structures, and Reforms: Convergence or
Persistence, 11 Theoretical Inquiries Law 791 (2010).

Seven-Olof Lodin, The Making of Tax Law: The Development of the Swedish Tax System (
2011, 1st ed., IBFD and Iustus Forlag AB, Sweden).

Co-operation and Dev. (OECD), Tax Policy Reform and Economic Growth 20 at Box 1.1
(2010).

Journals

Michael S. Knoll, The Connection Between Competitiveness and International Taxation, 65

Tax L. Rev. 349, 363 (2012)

Dani Rodrik, Sense and Nonsense in the Globalization Debate, Foreign Policy, Summer 1997

Rosanne Altshuler et. al., Capital Income Taxation and Progressivity in Global Economy, 30
Va. Tax Rev. 355 (2010)

Sagit Leviner, The Intricacies of Tax and Globalisation, Columbia Law Review, 5, 207.

Webliography
http://www.investorwords.com/4879/tax.html
http://www.internetlivestats.com/internet-users/

http://www.investopedia.com/terms/t/tobin-tax.asp

https://books.google.co.in/books?id=H8JLgYcK3fYC&printsec=frontcover#v=onepage&q&f
=false
http://www.oecd.org/ctp/tax-policy/taxpolicystudyno20-taxpolicyreformandeconomicgrow-
th.htm
http://www.internetlivestats.com/internet-users/
http://www.incometaxindia.gov.in/tutorials/disallowance-of-business-expenditure-theory.pdf

http://www.lawctopus.com/academike/impact-of-finance-act-2014-csr/

15