The first impression would be that so long as an expenditure is incurred wholly and exclusively forthe purpose of the business, there should be no prohibition as to its deductibility. The appropriate status which makes such act an offence would ensure punishment of wrongdoer. Further, under the Income-tax Act, profits of the business and not gross receipts are taxed. To determine the profits, all expenditure incurred for the carrying on of the business should be deducted.

However, by judicial precedent, expenditure incurred for contravention of any law are generally not deductible. The reason is that violation of any law is not an incidental part of any lawful business. As it was stated in the classic decision of the Supreme Court in Haji Aziz and Abdul Shakoor Bros. V. CIT (1961) 41 ITR 350, "Infraction of law is not a normal incident of business and, therefore, only such disbursements can be deducted as are really incidental to the business itself. They cannot be deducted if they fall on the assessee in some character other than that of a trader." Or note what was stated more recently and emphaticallyin Maddi Venkatraman & Co.(P) Ltd. 229 ITR 534(SC), "the expenditure incurred for evading the provisions of the Act and also the penalty levied for such evasion could not be allowed as a deduction. Moreover, it would be against public policy to allow the benefit of deduction one statute of any expenditure incurred in violation of provision of another statute or any penalty imposed under another statute.... it has also to be borne in mind that evasion of law cannot be a trade wholly and exclusively laid out for the purpose of assessee's business." On this rationale, even penalty paid for infraction of law is generally not deductible.

However, a difference is made between lawful and unlawful business. Expenditure involving or resulting from violation of law would not be deductible in a lawful business but, under certain circumstances it may be deductible in unlawful one (CIT v. Piara Singh 124 ITR 43(SC) ).To the general principle that payments made for infraction of law are disallowable, are severalexceptions. An assessee may pay, by a prevalent practice in the industry, secret commission to further its business. If the fact that such payment is made can be established, though identities of the payee are not revealed, then such expenditure may be deductible (CIT v.Goodlass Nerolac 188 ITR 1 (Bom)). Penalties which are compensatory and not penal in nature are also deductible (Prakash Cotton Mills V. CIT 201 ITR 684 (SC)). Further, expenditure not involving violation of the law by the assessee himself would be deductible. The classic example may be of "protection money". Of course, if by such act, the assessee, though he is at the receiving end, could be held for violation of law, the payment could still be disallowed.

In this context, it is useful to refer to a recent Amendment. The Finance Act, 1998 introduced an explanation with the retrospective effect from 1st April 1962, that "expenditure incurred by an assessee for any purpose which is an offence or which is prohibited by law" shall not beallowed as a deduction. If the intention is to disallow payments such as extortion, etc, and some violation of law, it has backfired and is redundant on three counts. Firstly, such expenditure in any case are not allowable, as analysed earlier. Secondly, it does not cover payment for purposes which are not offences. Finally, due to the peculiar drafting, the condition is that the purpose of such expenditure should be violation of law. Arguably, the purpose of a businessman in paying, say bribes, may not necessarily be obtaining undue advantage but may be to adhere to an industry practice without which a business cannot be carried on. It is doubtful whether the "purpose" of such expenditure is an offence.

There can be an argument that a businessman has, in these times, to inevitably incur several types of expenditure which may involve some violation of law. The objective of the Act is the taxing of profits and not the enforcement of law or punishing an assesee for violation of some other law. When theeffectiveness of law and order is not fully demonstrable, as has been happening particularly in recent times on account of reports of extortion cases, a businessman can't be blamed and additionally punished by disallowing payments without which he can't run his business.

However, the line between unavoidable payments for running the business and payments for aggressively violating the law of encouraging such violation is often thin and difficult to demonstrate. A small bribe to a clerk for doing the work in the normal course is totally different from asking him to do it with undue speed or unduly favouring the payer in some way.

In any case, disallowance of such expenditure is an indirect means to discourage such activities and represents one part of the whole scheme of enforcement of the law. To conclude, the solution is not easy. Though the difficulties of businessmen in several lines of activities can not be lost sight of, in the overall scheme, allowance of expenditure as a deduction can not besupported and, perhaps would represent an additional social cost on the assessee.

The author is a Mumbai-based chartered accountant