Compensation Paid for Non-Fulfilment of Contractual Obligation Deemed Non-Penal as No Infringement or Violation of Law Involved: ITAT upholds Deduction [Read Order]

The Income Tax Appellate Tribunal (ITAT), Kolkata has upheld the deduction for expenditure incurred by the appellant, for non-fulfilment of a contractual obligation, deeming it as non-penal and not in violation of any law or regulation.

The decision came in response to an appeal filed by Sugam Park against the order of the Principal Commissioner of Income Tax issued under Section 263 of the Income Tax Act,1961 for the assessment year 2018-2019.

Shri S.S. Gupta appeared on behalf of the appellant assesseee while Sri Abhijit Kundu, Commissioner of Income Tax appeared on behalf of the respondent Revenue.

The case revolved around the payment of Rs. 60,00,000/- as a compensation charge and Rs. 3,25,000/- as interest on delayed payment by Sugam Park.

The Principal Commissioner, upon reviewing the assessment records, held that these deductions should not have been allowed and that the Order of the Assessing Authority was erroneous and prejudicial to the interests of revenue.

The respondent, Deputy Commissioner of Income Tax argued that the payment of Rs. 60,00,000/- was penal in nature and should not qualify for deduction.

The crux of the case was based on Sub-Clause 9 of the agreement between the appellant, Sugam Park and Asansol Durgapur Development Authority, which outlined penalties for non-completion of a residential township project within the stipulated time.

The decision primarily hinged on the interpretation of the term “penalty” in this context.

The two-member bench comprising Shri Rajpal Yadav (Vice-President) and Shri Girish Agrawal (Accountant Member) held that even though the agreement did indeed use the term “penalty”, it was not related to any violation of law, but rather stemmed from the non-fulfilment of a contractual obligation.

The bench maintained that the penalty, in this case, was not the result of any criminal activity or infringement of the law. Rather, it was compensatory in nature due to the failure to meet the contractual obligations outlined in the agreement.

Furthermore, the bench referenced Explanation 1 to Section 37 of the Income Tax Act, 1961, which prohibits the allowance of deductions for expenditures incurred in violation of rules and regulations.

The bench clarified that while the term “penalty” was used in the agreement, it did not indicate a breach of any legal provisions but rather a consequence of non-compliance with a contractual term.

In result, the bench ruled that the payment made by the appellant for non-fulfilment of the contractual obligation could not be categorised as a penalty in the legal sense, as it did not involve any infringement of law or regulation.

Consequently, the ITAT concluded that the Principal Commissioner’s assertion that the expenditure was not deductible was misplaced.

The bench further emphasised that the assessment order issued by the Assessing Officer was not erroneous, as the term “penalty” used in the agreement did not relate to any criminal activity or violation of legal provisions.

The ITAT deemed the payment as compensatory for the contractual non-fulfilment rather than punitive, and thus, upheld the deduction for the expenditure.

The decision clarified that such payments should not be automatically considered non-deductible under Explanation 1 to Section 37 of the Income Tax Act, 1961 provided they are related to contractual non-compliance rather than legal violations thus distinguishing “punitive penalties resulting from legal violations” and “compensatory payments for contractual non-compliance”.

To Read the full text of the Order CLICK HERE

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