Monday, October 8, 2018

Non-Deductibility of CSR Expenditure under the IT Act 1961 The Income Tax Act, 1961 (IT Act) allows various expenses to be claimed as ‘deductions’ while computing taxable income under the head ‘profit and gains of business or profession’. It permits any business expenditure to be availed as a deduction, which is mention below:

  • Cannot be claimed as a deduction under sections 30 to 36,
  • is of revenue nature and has been expended wholly and exclusively for the purposes of business or profession, i.e. is not of personal nature.

The last of the three peaks requires that expenses can be justified for reasons of economic convenience. This means that it does not have to be directly related to commercial transactions; on the other hand, it is sufficient if the expenses indirectly guarantee the good operation of the business. In addition, the term "convenience" is not spent to generate profits once the expenses are related to the business. Expenses incurred for reasons of commercial convenience shall be subject to income tax instead of appropriation or use of profits, which is an additional condition for the use of expenditures under section 37. It should be borne in mind that each one of the above points applies the Conditions for a claim that must be claimed as a deduction according to Section 37.

If the three conditions above are met,

  • the expenses can be deducted according to Section 37, 
  • even if a company voluntarily performs them instead of being required by a specific law or contract. 
  • These expenses can be deducted even if the benefits have a positive effect not only on the companies involved but also on the members of the public. For this reason, the social expenditure of companies, eg. B. for the installation of traffic lights on public roads, classified in several cases as "totally and exclusively" for commercial purposes incurred in expenses and allowed as a deduction according to 37.

Section 135 of the Companies Act, 2013 requires a company having net worth turnover or net profits reach a certain threshold over a particular period of time to constitute a corporate social responsibility (CSR) committee. The CSR committee must the mandate to draft the company’s CSR policy at least 2% of the company’s average net profits are expended on any activity which is specified under Schedule VII of the Companies Act.

Since, prior to the enactment of section 135, certain kinds of CSR expenditure were permitted to be claimed as a deduction under section 37, ambiguity arose whether all the CSR expenses incurred under section 135 could also be claimed as deductions under section 37 once they meet all the above-mentioned three pre-conditions. Foreseeing the prospective loss in its revenues if section 135 expenditure is claimed as a deduction under section 37, the Government hastily added Explanation II to Section 37 through its Finance Act, 2014 which was to become effective from April 2015. Under the Explanation, an expenditure incurred by an assessee’s business on CSR activities in accordance with section 135 cannot be claimed as a deduction under section 37 because such expenditure is not deemed to be an expenditure incurred by the assessee for the purposes of the business or profession. Interestingly, it has been claimed that the Explanation is merely clarificatory in its nature. This post analyses if it is indeed so.

The memorandum to the Explanation states that it is merely clarificatory because CSR expenditure incurred under section 135 is an application of and not charge against profits. This argument arises due to the existence of provisions such as rule 4(1) under the Companies (Corporate Social Responsibility) Rules, 2014 (“CSR Rules”). Rule 4(1) clarifies that for the purposes of section 135, CSR expenditure shall not include an expenditure incurred on activities undertaken in the normal course of the company’s business. Further, as stated earlier, an item of expenditure which is not incurred for the purpose of business operations and thereby cannot be justified on the grounds of ‘commercial expediency’ cannot be considered as a charge on profits and cannot thereby be allowed as a deduction under section 37 of the IT Act. Therefore, on a conjoint reading of section 37 and rule 4(1) of the CSR Rules, it has been reasoned that Explanation II is only clarificatory in its nature. This is because expenditure which is not hit by rule 4(1) will be a CSR expenditure and it could anyway not have been claimed as a deduction under section 37 as it would not have been an expenditure on account of commercial expediency.

However, I do not agree with this argument. This is because, according to logic and law, a business may fall under the corporate object clause of its Association Memorandum ("MoA"), but may be outside its "normal" course. "Business in the sense that the term has" used according to Rule 4 (1) of the CSR Rules, 2014. This is because the clause of the objects has a very broad interpretation according to company law, any activity, including charitable activity, may be included in the Company 's assets as long as it contributes in any way to the Company' s core business, however, this activity may still be outside of the Company 's "normal" or routine course of business, due to the fact that a transaction is only made in is included in the "normal" course of business if it relates to normal business transactions and is executed as ordinary or ordinary business practice.

For example, the expenses a company incurs for renovating elementary schools in its neighborhood in order to collect the support of the local community there may be considered as an expense in the company's activity falling under its target clause. This is because such activity ultimately helps the company to fulfill the main objects declared in its MoA. This type of effort may, therefore, be justified for economic reasons under Article 37 and may be claimed as a deduction. On the other hand, this school renovation effort cannot be an expense incurred under a "normal" operation of the company under Rule 4 (1) and is therefore not disqualified from CSR as defined in Section 135. It would be a false suggestion that, under Rule 4 (1), expenditure on CSR under Section 135 is, for reasons of general interest, always an expense which, for reasons of commercial comfort, is in accordance with Section 37.

For such cases of CSR expenses, which are not affected by Rule 4 (1) and which otherwise could have been claimed as a deduction under § 37, because they could be justified for reasons of economic benefit, the statement II is not only explanatory nature. A complete exclusion of all types of CSR expenditure incurred in Section 135 of the deductions in Section 37, therefore, implies the creation of a completely new exception.

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