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Punitive charges

By Gayatri Sridharan
“Statute law is the will of the legislature; and the object of all judicial interpretation of it is to determine what intention is either expressly or by implication conveyed by the language used, so far as necessary for the purpose of determining whether a particular case or state of facts which is presented to the interpreter fall within it.” - These were the opening words of the first edition of P.B. Maxwell’s great work, the Interpretation of Statutes in 1875. These words were dropped from the subsequent editions. Maxwell was reminding us of the monumental role played by the judiciary in shaping our laws very much in keeping with the democratic tradition.               

One subject which has received considerable judicial interpretation is damages or penalty. Breach of law is not a normal incident of business and courts have time and again wrestled with the dichotomy in interpretation of the word ‘penalty’. The expression ‘punitive’ implies involving or inflicting punishment. It is intended to punish a defendant for his or her conduct to provide a deterrent to the future commission of such acts as distinguished from compensatory charges the primary function of which is to put the injured party as far as possible in the position in which he would have been had the contract been performed as intended.                

Punitive or exemplary damages are awarded against the defendant as a punishment so that the assessment goes beyond the mere compensation of the claimant. These are over and above such sums as will compensate a person for his actual loss. In addition damages may be liquidated or unliquidated. The term liquidated damages apply to situations where the damages have been fixed by contract or statute. Unliquidated damages on the other hand include damages which are at large and are left to the courts to determine. A single contract may give rise to both liquidated and unliquidated damages. The parties to a contract may fix a sum as liquidated damages in the event of one specific breach, and leave the claimant to sue for unliquidated damages in the ordinary way if other types of breach occur.              

Section 37 of the Income-tax Act, 1961 allows, in computing the income charged under ‘profits and gains of business or profession’, any expenditure not being personal or capital in nature provided it is laid out ‘wholly and exclusively’ for the purposes of the business. ‘Penalty’ as we all know could be the natural concomitant of a breach of law or a breach of contract. While the latter is deemed to be an incident of business being compensatory in nature, the former is not and consequently, any expense on account of the former will not be eligible for a deduction from the profits of business.           

The view of the Supreme Court in the case of Haji Aziz & Abdul Shakoor Bros. reported in 41 ITR 350 was that no expense which is paid  by way of penalty for breach of the law can be said to be an amount wholly and exclusively laid for the purpose of the business. A distinction was sought to be drawn by the appellants between a liability in personam and a liability in rem by averring that a confiscation of goods is a proceeding in rem because an option is given to the owner of the goods to pay in lieu of confiscation such fine as the officer thinks fit for the enforcement of the levy of and safeguarding the recovery of the sea customs duties, and therefore ought to be treated as revenue expenditure only. This argument was rejected by the Apex Court as not sustainable.           

In the case of Prakash Cotton Mills Pvt. Ltd.  v. Commissioner of Income Tax - [1993] 201 ITR 68, however, the Supreme Court, in agreement with its earlier decision in the case of Mahalakshmi Sugar Mills Co. reported in [1980] 123 ITR429 and the decision of the Andhra Pradesh High Court in Hyderabad Allwyn Metal Works Ltd. reported in [1988] 172 ITR 113, held that 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) of the Income-tax Act, 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. If the impost be of compensatory nature the assessing authority has to allow deduction under Section 37(1) and, where the impost is found to be of composite nature, the authorities are bound to bifurcate the two components and give relief to the compensatory component of the impost.             

In a recent decision [ACIT v. Taurian Iron & Steel Co. Pvt. Ltd. - ITA 1613/Mum/2010] the Mumbai Bench of the Income Tax Appellate Tribunal had an occasion to examine the issue of punitive charges levied by the Indian Railways for overloading of iron ore by the assessee and, by applying the aforesaid decisions of the Apex Court, held that the punitive charges so levied were compensatory in nature and thus entitled to deduction under Section 37(1) of the Income-tax Act. The Tribunal noted that the Railways permitted overloading and relied on the earlier decision of the Nagpur Bench of the Tribunal in Western Coalfields Ltd. v. ACIT in ITA Nos. 289 & 290 /Nag/2006 for AY 2002-03 & 2003-04 and ITA no. 261/Nag/2008 for AY 2003-04  dated 30-6-2009 in an identical case where it held that it was not in dispute that the quantity treated as overloaded was unloaded by the railways nor was it a case of violation of safety rules/norms, hence, the overloading charges could only be compensatory in nature.  

Might we say that Maxwell’s faith in the judiciary stands vindicated?  

[The author is Head, Direct Tax Team, Lakshmikumaran & Sridharan, Bangalore]
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