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Legal principles versus moral views
January, 06th 2007
Explanation to Section 37(1) makes claiming deduction for expenses for infraction of law more difficult.

Tax laws are designed to collect taxes and administer the set-up created to achieve the same. Despite changes in provisions and court rulings, the scheme of the Income-Tax Act 1961(the Act) remains the same. An average assessee would like to pay as minimum a tax as possible and the average assessing officer would like to collect as much as possible. This is the root-cause of the friction between the two.

Technology may reduce the interface over a period but the basic attitudinal difference cannot be cured with or without technology. Is there room for moral views in interpreting the tax laws? Recently, this question came up before the Supreme Court in Dr T. A. Quereshi vs Commissioner of Income Tax (2006 287 ITR 547 December 18, 2006).

Facts, issues

The appellant, a doctor by profession, was arrested by CBI sleuths while he was transporting huge quantities of a contraband (heroin) in a jeep. This led tohis residential premises being raided. In the raid, a laboratory manufacturing heroin and several other contraband drugs was discovered. All the contraband articles were seized and proceedings under the Narcotic Drugs and Psychotropic Substances Act, 1985 were initiated against the assessee. The appellant filed his return for the assessment year 1986-87.

In his assessment, the assessee claimed that as the heroin seized from him formed part of his stock-in-trade, its loss on account of seizure is an allowable deduction while computing his profits and gains of business/profession.

The assessment officer did not accept the assessee's contention of Rs 5,50,000 being the assessed value of the heroin seized, as income from undisclosed source. In an appeal filed by the assessee, the Commissioner of Income-Tax (Appeals) upheld the order of the assessment officer. The assessee then filed a second appeal before the Tribunal, which allowed the appeal and held that the assessee was entitled to claim the deduction as a business loss.

In other words, the Tribunal was of the view that as the seizure resulted in loss-in-trade, relying on the law laid down in CIT vs Piara Singh (1980 124 ITR 40), the deduction out of the gross total income of the assessee was allowable. The Revenue then went on appeal, and the High Court allowed it holding that an expenditure incurred for an offence prohibited by law was not allowable. The matter reached the Supreme Court.

Apex Court decision

The Supreme Court held that the assessee was entitled to claim the amount in question as a business loss based on ordinary commercial principles in computing profits. Interestingly, the court reasoned that though the assessee was committing an immoral act in illegally manufacturing and selling heroin, the deduction as a business loss is independent of the act, which is otherwise illegal.

The apex court held that "Cases are to be decided by courts on legal principles and not on one's own moral views. Law is different from morality." These are telling and quite interesting observations coming as it were from the highest court of the land. The purist may disapprove of any illegal action, including the need to claim deductions for an illegal activity. A hardcore businessman blames the environment for various acts bordering on illegality and, hence, the need for recognition of such acts at least in the tax laws.

The explanation added to Section 37 of the Act in 1998 with retrospective effect, stating that expenditure incurred for any purpose which is an offence and prohibited by law cannot be allowed as a deduction applies only to an expenditure and not to a business loss.

This would effectively mean that there would be scramble to somehow try to fit in such types of loss under Section 28 itself based on the apex court ruling and stay away from the explanation to Section 37 as far as possible. One hopes that the new I-T Act will settle this issue.

Law relating to offences

The ordeal of getting deduction for expenses for infraction of law is rendered more difficult in view of Explanation to Section 37(1), which disallows any payment which would constitute offence in computation of taxable income. What is hit by the Explanation are expenses in direct violation of law as in the case of payment of bribes, which were not allowable even in pre-existing law, but not those cases of innocent violations of regulatory provisions.

A somewhat reasonable view was taken under English law in Minister of Finance vs Smith, where it was pointed out that in allowing an expenditure, what is illegal as expenditure admissible as a business expenditure, the court "does not condone or take part in the illegal enterprise".

When the Revenue finds that it is entitled to tax profits from an illegal business, even those businesses in trafficking in drugs, gun running, smuggling, running gambling house, brothels, etc., it is odd that there should be hesitancy in allowing penalties or fines in the course of carrying on business.

Some of these contraventions may not be wilful and may have occurred because of the complexities in our laws, especially those relating to imports, Customs, excise, company law or foreign exchange. Some of these contraventions may not involve any moral turpitude.

Still the fact remains that a decision on what is a fair and legitimate business oriented though illegal expense and what is not so fair can at best be decided by the spin of the coin.

On the oft-debated question of moral views vis--vis legal principles one cannot help remember the famous observations of late Justice Sabahaschi Mukherji: "It is true that tax avoidance in an underdeveloped developing economy should not be encouraged on practical as well as ideological grounds. One would wish, as noted by Reddy, J., that one could get the enthusiasm of Justice Holmes that taxes are the price of civilisation and one would like to pay that price to buy civilisation. But the question which many ordinary taxpayers very often ask, in a country of shortages with ostentatious consumption and deprivation for the large masses, is: Does he with taxes buy civilisation or does he facilitate the waste and ostentatiousness of the few? Unless wastes and ostentatiousness in government's spendings are avoided or eschewed, no amount of moral sermons would change people's attitude to tax avoidance."

R. Anand
(The author is Chennai-based chartered accountant.)

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