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Facts
The assessee, a road construction company, incurred penalties for various reasons during the execution of government contracts. The Assessing Officer (AO) disallowed these penalties as business expenditure under Section 37(1) of the Income Tax Act, 1961. The CIT(A) upheld the AO's order.
Held
The Tribunal held that the penalties incurred by the assessee were not in the nature of offences or acts prohibited by law, but rather arose from contractual terms in the normal course of business. Citing previous judgments, the Tribunal found the disallowance unsustainable.
Key Issues
Whether penalties incurred by a road construction company due to contractual breaches are to be considered as business expenditure under Section 37(1) of the Income Tax Act.
Sections Cited
37(1), 250, 143(3), 143(3A), 143(3B)
AI-generated summary — verify with the full judgment below
Income Tax Appellate Tribunal, MUMBAI BENCH “G”, MUMBAI
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
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, non- deployment 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, G L Construction Pvt Ltd 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.
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 DCIT vs. Mahavir Multitrade (P) Ltd, (2019) 180 ITD 730 (Del), 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.
G L Construction Pvt Ltd Further reliance was placed on the decision of the Coordinate Bench of the ITAT, Kolkata Bench “C” in DCIT vs. Ripley & Co Ltd, dated 23.09.2016, 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 vs. DCIT, (2023) 203 ITD 765 (Kol), 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.
The Ld. DR relied upon the orders of the revenue authorities.
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 G L Construction Pvt Ltd appellate order is therefore set aside, and the disallowance is directed to be deleted.