Contractual Penalties Incurred in Normal Course of Business are Allowable as Business Expenditure Under Section 37(1).

Issue:

Whether ‘penalties’ and late fees deducted by government authorities from a road construction company’s bills for reasons like non-deployment of machinery, delayed commencement, or slow progress, are allowable as business expenditure under Section 37(1) of the Income-tax Act, 1961, given that they arise from contractual terms in the normal course of business and are intended to preserve business relationships.

Facts:

The assessee-company is engaged in the business of road construction for government authorities.
During the execution of contracts, various government departments/authorities deducted amounts from the assessee’s bills, classifying them as ‘penalties’. These deductions were for issues such as non-deployment of requisite machinery, delayed commencement of work, and slow progress.
For the assessment year 2018-19, a total of Rs. 45.92 lakhs was deducted as such penalties.
In some instances, the assessee recovered a portion of these penalties from the salaries of its engineers and project managers.
The assessee claimed the net balance of Rs. 42.45 lakhs as a deductible business expense under Section 37(1).
The Assessing Officer disallowed this claim.

Decision:

The court held that the expenses incurred by the assessee towards penalty and late fees arose from contractual terms in the normal course of business and were intended to preserve and facilitate business relationships with government entities. Thus, the disallowance made by the Assessing Officer under Section 37(1) was not sustainable. The decision was in favor of the assessee.

Key Takeaways:

Nature of “Penalty” under Section 37(1): Not all payments termed “penalties” are disallowable under Section 37(1). The crucial distinction lies in whether the payment is for an infraction of law or is compensatory/contractual in nature, arising from normal business operations.
Contractual Penalties vs. Statutory Penalties: Penalties paid for a breach of law or statutory regulations (e.g., traffic fines, penalties for violation of pollution norms) are generally not allowable as business expenditure, as they are considered to be for an “offence” or “prohibited by law” under the Explanation to Section 37(1). However, penalties arising from a breach of contract between commercial parties, which are essentially compensatory or liquidated damages for non-performance or delayed performance of a contractual obligation, are often considered allowable.
Commercial Expediency: The court recognized that these deductions were part of the contractual terms in a government contract, and paying them was essential for maintaining business relationships and continuing to secure future contracts. This aligns with the principle of “commercial expediency,” where expenditure incurred for the purpose of carrying on business, even if it appears to be a penalty, is deductible if it is not for an illegal act.
Preserving Business Relationships: The judgment highlights that expenses incurred to ensure smooth operation and continuation of business, even if termed penalties, can be allowable if they are a necessary incident of the trade and not a punishment for a legal infraction.

IN THE ITAT MUMBAI BENCH ‘G’

G.L. Construction (P.) Ltd.

ACIT/National Faceless Appeal Centre/DCIT

ANIKESH BANERJEE, Judicial Member
and MISS. PADMAVATHY S., Accountant Member

IT Appeal No. 1884 (Mum.) of 2025
[Assessment year 2018-19]

MAY 9, 2025

N.R. Agrawal for the Appellant. Rajesh Sakhardande, Sr. AR for the Respondent.

ORDER

Anikesh Banerjee, Judicial Member. – The instant appeal of the assessee was filed against the order of the National Faceless Appeal Centre (NFAC) Delhi [for brevity, ‘Ld.CIT(A)’] passed under section 250 of the Income-tax Act, 1961 (in short, ‘the Act’), for Assessment Year 2018-19, date of order 18.03.2025.The impugned order was emanated from the order of the National e-Assessment Centre, Delhi (in short, ‘the A.O.’) passed under sectionpassed under section 143(3) read with section 143(3A) read with section 143(3B) of the Act, date of order 05/04/2021.

2. The brief facts of the case are that the assessee-company is engaged in the business of road construction for government authorities such as the Municipal Corporation of Greater Mumbai (MCGM), Navi Mumbai Municipal Corporation (NMMC), and the Mumbai Metropolitan Region Development Authority (MMRDA). During the course of execution of such contracts, various departments/authorities deducted certain amounts from the assessee’s bills, classifying them as “penalties” for reasons including, but not limited to, nondeployment of requisite machinery, delayed commencement of work, slow progress, incorrect or missing barricades, cracks or damage observed during quality inspections, non-maintenance of mandatory measurement records, failure to remove debris, inconvenience caused to the public due to delayed completion, failure to timely submit technical reports such as mix design/job mix formula for asphaltic material, and non-compliance with tender conditions.

During the year under consideration, the parties deducted a total amount of Rs.45,91,698/- towards such penalties against certified bills. In certain instances, the assessee recovered a portion of these penalties from the salaries of engineers and project managers. The typical project size ranges from Rs.100 to Rs.250 crores. These defects were identified by the Chief Officer of the concerned authority and penalties/fines were imposed as a measure to maintain discipline and ensure quality. Given the scale and nature of operations, such lapses relating to materials, labour, subcontractors, or execution are inevitable and form a part of the normal business operations of road construction. These expenses, therefore, are not in the nature of penalties for offences or acts prohibited by law within the meaning of Explanation 1 to Section 37(1) of the Act.

However, the Ld. AO, interpreting the said deductions as being violative of section 37(1), disallowed a sum of Rs.42,44,859/- claimed as business expenditure. Aggrieved by this disallowance, the assessee preferred an appeal before the Ld.CIT(A), who upheld the order of the Ld. AO. Being further aggrieved, the assessee has preferred the present appeal before this Tribunal.

3. During the course of hearing, the Ld. AR submitted a Paper Book comprising pages 1 to 30, which was taken on record. The Ld. AR referred to pages 1-2 of the APB which contain a summary of the so-called “penalty” payments made to MCGM and other authorities, such as HPCL, as well as certain payments made through credit card and towards car insurance. A portion of the amount was recovered from employees’ salaries. The total expenditure incurred towards penalty and late fee was Rs.44,95,698/-, out of which Rs.2,50,839 was recovered from employees, and the net balance of Rs.42,44,859 was claimed as a deductible business expense under Section 37(1).The Ld. AR submitted a detailed break-up of the payments in pages 2 to 26 of the APB. In support of the claim, reliance was placed on the decision of the Coordinate Bench of the ITAT, Delhi Bench “E” in Dy. CIT v. Mahavir Multitrade (P) Ltd. ITD 730 (Delhi – Trib.), wherein it was held that non-fulfilment of contractual obligations by an assessee cannot be equated with an offence or infraction of law so as to invoke Explanation 1 to Section 37(1), merely because the deduction was termed as “penalty” for non-compliance with contract terms.

Further reliance was placed on the decision of the Coordinate Bench of the ITAT, Kolkata Bench “C” in Dy. CIT v. Ripley & Co Ltd [IT Appeal No. 1301(Kol.) of 2015, dated 23-9-2016] where it was held that payments made by way of demurrage or punitive charges to the Railways are not hit by Explanation 1 to Section 37(1), as they are in the nature of compensation for delay and not for any criminal or unlawful act. Similar reliance was also placed on Farseen Rubber Industries Ltd v. Dy. CIT ITD 765 (Kolkata – Trib.), where it was held that payments made to JK Tyre for continuing work under a job contract did not constitute infraction of law, but were commercial expenditures incurred in the ordinary course of business.

4. The Ld. DR relied upon the orders of the revenue authorities.

5. We have heard the rival submissions and perused the material available on record. Upon considering the submissions of both parties, we find that the expenses incurred by the assessee towards penalty and late fees do not constitute an infraction of law. Rather, such payments arose from contractual terms in the normal course of business and were intended to preserve and facilitate business relationships with government entities. The Coordinate Benches of the Tribunal, in the cases cited above, Mahavir Multitrade (P.) Ltd (supra), Farseen Rubber Industries Ltd (supra), and Ripley & Co Ltd (supra) have consistently held that such payments do not attract disallowance under Explanation 1 to Section 37(1) of the Act.

Accordingly, we are of the view that the disallowance made by the Ld. AO under Section 37(1), amounting to Rs.42,44,859/-, is not sustainable. The impugned appellate order is therefore set aside, and the disallowance is directed to be deleted.

6. In the result, the appeal of the revenue bearing ITA No.1884/Mum/2025 is allowed.