Jeevan Reddy, J.:— The Income-tax Appellate Tribunal has referred the following questions for the opinion of this court, under s. 256(1) of the I.T Act, 1961:

“1. Whether, on the facts and in the circumstances of the case, the sum of Rs. 2,95,000 has to be taken into account in computing the income of the assessee from business under the provisions of section 28 of the Income-tax Act, 1961?”

If the answer to the above question is in the negative:

“Whether, on the facts and in the circumstances of the case, the claim of Rs. 2,95,000 is covered by sub-rule (j) of rule 6DD, framed under section 40A(3) of the Income-tax Act, 1961?

2. Whether, on the facts and in the circumstances of the case, the sum of Rs. 19,659 incurred as guest expenses is allowable as a deduction?”

2. The assessee is a private limited company, incorporated in 1965, to carry on business of export of tobacco. Prior to the incorporation, it was a partnership firm consisting mostly of family members. The first directors appointed at the time of incorporation are to hold office during their lifetime, or until they resign voluntarily. On the basis of an intercepted letter, written by one Shamsuddin of Linghi Chetty Street, Madras, to the assessee, a search was conducted of the assessee's premises by the Enforcement Directorate. A number of letters and other documents were seized, which disclosed that the assessee had indulged in transactions violating the provisions of the Foreign Exchange (Regulation) Act. It was found that the assessee had remitted foreign currency to a private party in Singapore, contrary to the provisions of the Act. Proceedings were taken against the assessee for violation of s. 4(2) and s. 5(1)(e) of the Foreign Exchange (Regulation) Act (FERA), and a penalty of Rs. 35,000 was levied under s. 23(1)(a), read with section 23C.

3. For the assessment year 1970-71, the assessee claimed a deduction of Rs. 2,95,000 as business loss/expenditure. According to the assessee, the claim for deduction arose in the following circumstances: By the year 1968, the assessee had accumulated 329.2 tonnes of substandard quality of tobacco, which it was not able to export over the last three years. Since it was substandard quality, no one was prepared to purchase it at the “floor price” fixed by Govt. of India for such tobacco. The export of tobacco entitles the assessee to certain import entitlements, which can be transferred by the assessee to its nominees. In this connection, it came into contact with one S.A.M Shamsuddin of Linghi Chetty Street, Madras. Further, in November-December, 1968, one of the directors of the company, Sri Maddi Venkataratnam, happened to go to Indonesia, where he contacted one Mr. Dingri of M/s. Bulsing Trading Company, Djakarta, through the Indian Embassy. Sri Dingri, while not agreeing to purchase the tobacco himself, indicated that a sister company, M/s. Bulsing Private Ltd. of Singapore, would be in a position to purchase the same. Sri Dingri also came to India later, but the transaction could not be finalized even by July, 1969, because of the fact that the Singapore party who was prepared to purchase the tobacco was willing to pay only 80% of the “floor price” because of the substandard quality of tobacco. In these circumstances, one of the directors of the assessee-company, Sri Maddi Lakshmayya, who happened to be a member of the Tobacco Promotion Council, tried to persuade the Govt. of India to reduce the floor price for the said tobacco, but was unsuccessful. It was then that a bargain was struck and an agreement arrived at between the assessee-company and the Singapore party, whereunder the Singapore party was to pay the full “floor price” for the said tobacco, and the assessee was to pass on the benefit of reduction or discount, as it may be called, i.e, 20% of the price, to the Singapore party separately. The services of Sri Shamsuddin were procured for obtaining the necessary foreign exchange, equivalent to the 20% difference, because the Singapore party wanted the said 20% to be remitted to him in Singapore currency. In pursuance of this agreement, the tobacco was exported and the full floor price received by the assessee. The assessee paid a sum of Rs. 2,88,000 to Sri Shamsuddin in cash, who remitted the equivalent amount in Singapore currency to the Singapore party. Thus, according to the assessee, it had no alternative but to enter into such a transaction with a view to dispose of the said unsold inferior quality of tobacco lying with it and, hence, the sum of Rs. 2,88,000 plus the commission paid to Sri Shamsuddin ought to be deducted as a business expenditure or business loss, as the case may be.

4. The ITO held that the payment was not genuine; that, such a payment contravened the provisions of s. 40A(3); and further that the payment did not fall under any of the exceptions provided in r. 6DD. This view was affirmed by the AAC in appeal. On further appeal, the Income-tax Appellate Tribunal arrived at the following findings: (i) that the sum of Rs. 2,95,000 was indeed paid by the assessee-company to Sri Shamsuddin, which comprised of the commission payable to Sri Shamsuddin for his services, and a sum of Rs. 2,88,000 to be remitted to the Singapore party towards the aforesaid 20% difference. The assessee was knowingly a party to the above transaction, which is in violation of the provisions of FERA; (ii) considering the said transaction as a whole, which is indeed an “integrated transaction”, the assessee's income under s. 28 of the Act must be deemed to be not the full sum of Rs. 8,86,70289, received by it from the Singapore party, but its real and true income must be deemed to be Rs. 8,86,702.89, minus Rs. 2,95,000. In this view of the matter, it is unnecessary to go into the question whether the said amount of Rs. 2,95,000 is to be treated as a deduction; and if so, under what section; and further whether it attracts s. 40A(3); (iii) that, even otherwise, the said payment does not attract, s. 40A(3), since it is covered by sub-r. (j) of r. 6DD, framed under s. 40A(3), inasmuch as the said payment to Sri Shamsuddin was made in cash due to exceptional or unavoidable circumstances; (iv) the Department's contention that the payment made to Sri Shamsuddin is illegal and cannot be taken into account for any purpose whatsoever, is unsustainable in law. The income-tax law does not recognize the distinction between legal and illegal income, or between legal and illegal expenditure; and (v) that the sum of Rs. 19,659 spent on the “guest-house” is deductible, following the decision of this court in R.C No. 93/1970, dated December 17, 1971 (Commissioner Of Income-Tax v. Sirpur Paper Mills., [1983] 144 ITR 393(AP) (Appendix) (infra)).

5. In this reference, it is contended by Sri M. Suryanarayana Murthy, learned standing counsel for the Department, that the payment of Rs. 2,95,000 being avowedly in contravention of the provisions of FERA; cannot be treated as a deduction, whether under s. 37, or under s. 28 of the Act. Counsel submitted that the theory of real income applied by the Tribunal is unsustainable, because the said payment is a payment made in pursuance of, or in furtherance of, an illegal transaction. He submitted that the entire amount was received by the assessee, and then 20% thereof was repatriated through illegal channels, which is also contrary to s. 40A(3), and is not saved by r. 6DD(j). Counsel also submitted that the Tribunal's finding on the question of deduction of the expenditure on guest house is equally unsustainable.

6. On the other hand, Sri Khazi, the learned counsel who appeared for the assessee, submitted that in view of the difficult situation in which it found itself, the assessee was obliged to enter into an illegal transaction. The transaction; however, is one and an “integrated” transaction where-under the assessee was to receive only 80% of the floor price; and only with a view to satisfy the Government rules was a device adopted, purporting to receive the full “floor price” and then remitting 20% thereof to the purchaser. Since the tobacco was of substandard quality, the assessee could not expect the full floor price for it and, therefore, had agreed to receive only 80% of the floor price as its proper value; hence, under s. 28 of the Act, the income of the assessee must be deemed to be only a sum representing the difference between Rs. 8,86,70289 minus Rs. 2,95,000. In this view it is not necessary to find out whether the said amount of Rs. 2,95,000 is a business expenditure and liable to be deducted under s. 37 or any other provisions of the Act. Equally for this reason; s. 40A too has no application to the facts of this case. Alternately, the counsel submitted that r. 6DD(j) applies to the facts of this case, as rightly held by the Tribunal and, therefore, s. 40A(3) does not come in the way of the assessee. Counsel reiterated the finding of the Tribunal that the legality or illegality of a transaction is not a relevant consideration-for the purpose of the income-tax law; and so long as it is a business transaction, or a payment made on account of a business transaction, it ought to be taken into account. Counsel justified the finding of the Tribunal on the question of deduction of the amounts spent on guest house. Both the parties relied upon a large number of cases, to which I shall presently refer.

7. Part III of the Constitution guarantees to citizens of this country the right to carry on trade, business or profession of their choice. A trade or business prohibited by law, ceases to be a trade or business; and no person has a right to, nor can be permitted to indulge in, such illegal trade or business. It should equally follow that, any income arising from an unlawful business should not also be taken into account for the purpose of income-tax. What one law has prohibited, the other law cannot recognize. But, in England the rule became well settled that, for the purpose of income-tax, even if a trade is illegal, it is still a trade and its income, profits and gains are chargeable to tax. This principle was enunciated by Rowlatt J. in Mann v. Nash, [1932] 16 TC 523 (KB), where the learned judge posed the question “it is simply a question of the construction of the words used”: is this a trade within the meaning of the Income Tax Acts, or is it not?, and proceeded to answer the question in the following words (p. 530):

“I myself cannot see why this letting out of the machines in a commercial way, with a view to the reception of profits in a commercial way, is not trade, adventure, manufacture or concern in the nature of trade. On the words, it clearly is the question really is whether as a matter of construction those words are to be cut down by an overriding consideration that the trade is tainted with illegality. The great mainstay of Mr. Field's argument, quite rightly from his point of view, was the case of Duggan, [1929] IR 406, decided in the Irish Free State, and that decision of the Supreme Court seems to have gone upon this principle, that no construction could be admitted which recognised that the State should come forward and seem to take a profit from what the State prohibited, because the State ought to have prevented it; and it was argued, if I may venture to say so, in a somewhat rhetorical style: Does the State keep its revenue eye open and its eye of justice closed? I must say, I do not feel the force of that observation at all. Would it have made any difference, I ventured to ask in the argument, if the State had kept both its eyes open and prosecuted the man for the lottery and taxed him for the profits at the same time? That would at any rate have protected the State from the reflections which were made upon it in the words I have quoted. But, in truth, it seems to me that all that consideration is misconceived. The Revenue representing the State, is merely looking at an accomplished fact. It is not condoning it; it has not taken part in it; it merely finds profits made from what appears to be a trade, and the Revenue laws happen to say that the profits made from trades have to be taxed, and they say: ‘Give us the tax’. It is not to the purpose in my judgment to say: ‘But the same State that you represent has said they are unlawful’; that is immaterial altogether and I do not see that there is any contact between the two propositions,”

8. This is also the view taken by the Privy Council in Canadian Minister of Finance v. Smith, [1927] AC 193, and followed in India. As would be evident from a review of the decisions which I shall presently refer to, the law in India is this: If a business is a lawful one, any loss arising from, or any payment made in pursuance of, or in furtherance of an illegal transaction cannot be set off against the income, profits, or gains arising from the business. If, however, the whole business itself is illegal, then the illegal payments, penalties and other fines incurred in connection with such business are liable to be deducted. In other words, a clear-cut distinction is drawn between a business which is lawful, and a business which is unlawful. If a business is a lawful business, then the deductions or losses claimed must also arise from lawful transactions. Any penalties or fines paid for indulging in illegal transactions, or payments made in pursuance of, or in furtherance of illegal transactions, cannot be taken into consideration and cannot be deducted from out of the income arising from such lawful business because infraction of law is not a normal incident of such business. But, if the State wants to tax the gains and profits from an illegal business; it should follow logically that even the illegal payments and penalties must also be deducted, because, the business itself being illegal, the payments are also bound to be illegal, and the incurring of penalties or fines must be deemed to be a normal incident of such illegal business. The three Supreme Court cases, which I shall presently refer to, do clearly lay down and recognize the above principle and distinction.

9. I shall first take up the decision in Haji Aziz and Abdul Shakoor Bros. v. CIT, [1961] 41 ITR 350 (SC), arising from a decision of the Bombay High Court in CIT v. Haji Aziz and Abdul Shakoor Bros., [1955] 28 ITR. 266 (Bom). The assessee in that case carried on the business of importing dates from abroad and selling them, in India. It imported dates from Iraq, partly by steamer and partly by country-craft, at a time when the import of dates by steamers was prohibited. The dates imported by steamer were confiscated by the customs authorities under s. 167 of the Sea Customs Act; and on the assessee opting to pay fines in lieu of confiscation, a fine was imposed and the dates released. In computing its profits, the assessee sought to deduct the amount paid as fine, as an allowable expenditure under s. 10(2)(xv) of the Indian I.T Act, 1922. After reviewing the several English and Indian cases, the Supreme Court observed as follows (p. 359):

“A review of these cases shows that expenses which are permitted as deductions are such as are made for the purpose of Carrying on the business, i.e, to enable a person to carry on and earn profit in that business. It is not enough that the disbursements are made in the course of or arise out of or are concerned with or made out of the profits of the business but they must also be for the purpose of earning the profits of the business. As was pointed out in Von Glehn's case, [1920] 2 KB 553(CA), an expenditure is not deductible unless it is a commercial loss in trade and a penalty imposed for breach of the law during the course of trade cannot be described as such. If a sum is paid by an assessee conducting his business, because in conducting it he has acted in a manner which has rendered him liable to penalty, it cannot be claimed as a deductible expense. It must be a commercial loss and in its nature must be contemplable as such. Such penalties which are incurred by an assessee in proceedings launched against him for an infraction of the law cannot be called commercial losses incurred by an assessee in carrying on his businss. Infraction of the 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. Therefore, where a penalty is incurred for the contravention of any specific statutory provision, it cannot be said to be a commercial loss falling on the assessee as a trader, the test being that the expenses which are for the purpose of enabling a person to carry on trade for making profits in the business are permitted but not if they are merely connected with the business.”

(emphasis* mine)

10. The Supreme Court also rejected the contention that, if penalty is only against the goods and is not personal to the assessee, it must be allowed as a deduction under s. 10(2)(xv), calling it an erroneous distinction. It observed (p. 360):

“The distinction sought to be drawn between a personal liability and a liability of the kind now before us is not sustainable because anything done which is an infraction of the law and is visited with a penalty cannot on grounds of public policy be said to be a commercial expense for the purpose of a business or a disbursement made for the purposes of earning the profits of such business.”

11. This decision thus makes it clear that infraction of law is not a normal incident of business and, therefore, any loss or other payment made in furtherance of, or on account of, such infraction cannot be treated as incidental to business and that, in such cases, it must be held that they have been incurred by the assessee in some character other than that of a trader. It is also emphasized that a thing done in violation of law and which is visited with penalty cannot, on grounds of public policy, be said to be a commercial expense. Mr. Khazi, the learned counsel appearing for the assessee, sought to draw a distinction between the amounts paid by way of penalties and fines, and the payments made in pursuance of or in furtherance of an illegal transaction. He submitted that, while the former cannot be treated as a permissible deduction, the latter ought to be. I am unable to see any basis in principle behind this distinction. An illegal transaction which is not visited with a penalty is, none the less, an illegal transaction, and it would equally be against public policy to treat the payments made in pursuance of, or in furtherance of, such illegal transaction as commercial expenses. This indeed has been recognized by the Supreme Court in the following passage from the decision in Commissioner Of Income Tax, Gujarat v. S.C Kothari, [1971] 82 ITR 794 (SC) at p. 801:

“The approach of the High Court, in the present case, has been that in order to arrive at the figure of profits even of an illegal business the loss must be deducted if it has actually been incurred in the carrying on of that business. It is the net profit after deducting the outgoings that can be brought to tax. It certainly seems to have been held and that view has not been shown to be incorrect that so far as the admissible deductions under section 10(2) are concerned they cannot be claimed by the assessee if such expenses have been incurred in either payment of a penalty for infraction of law or the execution of some illegal activity. This, however, is based on the principle that an expenditure is, not deductible unless it is a commercial loss in trade and a penalty imposed for breach of the law during the course of the trade cannot be described as such. Penalties which are incurred for infraction of the law are not a normal incident of business and they fall on the assessee in some character other than that of a trader: [See Haji Aziz and Abdul Shakoor Bros. v. CIT, [1961] 41 ITR 350 (SC)]. In that case this court said quite clearly that a disbursement is deductible only if it falls within section 10(2)(xv) of the Act of 1922, and a penalty cannot be regarded as an expenditure wholly and exclusively laid for the purpose of the business”

(emphasis added.)

12. I must, however, mention that the above passage has been the subject-matter of varying interpretations by both the counsel before us. Mr. Khaji for the assessee wants to read the words emphasized by me, as referring to a penalty paid in execution of some illegal activity. In other, words, his understanding of the said passage is that a penalty paid for infraction of law, or the execution of some illegal activity alone was held to be not a permissible deduction; while according to the learned standing counsel for the Department, the Supreme Court equated the payment of a penalty for infraction of law, with the payment made in execution of some illegal activity. I am of the opinion that the first two sentences in the above passage refer to the approach of the High Court, but that the observations starting with the words “It certainly seems to have been held……………” do not constitute a restatement of the approach or the decision of the High Court. It constitutes the ratio of the decision of the Supreme Court itself. I am of the opinion that in the above passage, the Supreme Court has treated both the amount paid by way of penalty for infraction of law, and the amount paid towards the execution of some illegal activity, on the same par. Indeed, as I. have pointed out above, I see no distinction in principle between both the payments—also because neither of these payments can be said to be a normal incident of business, nor can they be treated as commercial losses. In the case before the Supreme Court, it may be noticed, the assessee, a member of a recognized association, had entered into transactions for the supply of groundnut oil, with different people who were not the members of the association. It was found that it contravened s. 15(4) of the Forward Contracts (Regulation) Act, 1952, because it had not secured the consent or authority of the constituent and disclosed in the note, memorandum or agreement of sale that it had bought or sold the goods, as the case might be, on it's own account. It incurred a loss of Rs. 3,40,443 in these transactions. It had also earned a profit of Rs. 2,19,046 from speculative transactions, and wanted to set off the said loss against, the profits arising from speculative transactions. The Supreme Court held, (i) that the contracts in respect of which the loss of Rs. 3,40,443 was incurred by the assessee were illegal contracts; (ii) that the assessee was not entitled to a set-off under the first proviso to s. 24(1) of the Indian I.T Act, 1922, of the loss of Rs. 3,40,443 against its profits in speculative transactions: (the first proviso to s. 24(1) corresponds to sub-s. (1) of s. 73 of the 1961 Act); and (iii) that, however, if the business in which the loss was sustained was the same as the business in which the profit was derived, then the loss had to be taken into account while computing the profits of the business under s. 10(1). It was also held that the contract contemplated by Expln. 2 to the first proviso to s. 24(1) of the Indian I.T Act, 1922 (corresponding to s. 43(5) of the 1961 Act), has to be an enforceable contract and not an unenforceable one by reason of any taint of illegality resulting in its invalidity and that set-off cannot be allowed under the first proviso to s. 24(1), read with Expln. 2 thereto, of losses incurred in contracts which are illegal and unenforceable on account of the contravention of s. 15(4) of the Forward Contracts (Regulation) Act, 1952.

13. Finally, the decision of the Supreme Court in Cit Patiala v. Sri Piara Singh ., [1980] 124 ITR 40, gives an express recognition to the distinction pointed out by me above. It is necessary to notice the facts of this case. The assessee who was carrying on smuggling activity was apprehended by the Indian police while crossing the border into Pakistan, and a sum of Rs. 65,000 in currency notes was recovered from his person. On interrogation, he stated that he was taking the currency notes to Pakistan to purchase gold there and smuggle it into India. The Customs authorities confiscated the currency notes. The I.T authorities found that the assessee was carrying on the business of smuggling and that he was liable to income-tax on income from that business. The question then arose whether the assessee was entitled to deduction under s. 10 of the Indian I.T Act, 1922, of the loss of Rs. 65,000 arising by the confiscation of the currency notes. The Tribunal held that, since the assessee was carrying on an illegal business, the said sum confiscated must be treated as a business loss. On a reference being made, the High Court agreed with the Tribunal. The matter was then brought to the Supreme Court, which affirmed the view taken by the High Court. The Supreme Court observed (P-42):

“The I.T authorities found that the assessee was carrying on the business of smuggling; they held that he was, therefore, liable to income-tax on the income from that business. On the basis that such income was taxable, the question is whether the confiscation of the currency notes entitles the assessee to the deduction claimed. The currency notes carried by the assessee across the border constituted the means for acquiring gold in Pakistan, which gold he subsequently sold in India at a profit. The currency notes were necessary for acquiring the gold. The carriage of currency notes across the border was an essential part of the smuggling operation. If the activity of smuggling can be regarded as a business, those who are carrying on that business must be deemed to be aware that a necessary incident involved in the business is detection by the Customs authorities and the consequent confiscation of the currency notes. It is an incident as predictable in the course of carrying on the activity as any other feature of it. Having regard to the nature of the activity, possible detection by the Customs authorities constitutes a normal feature integrated into all that is implied and involved in it. The confiscation of the currency notes is a loss occasioned in pursuing the business; it is a loss in much the same way as if the currency notes had been stolen or dropped on the way while carrying on the business. It is a loss which springs directly from the carrying on of the business and is incidental to it. Applying the principle laid down by this court in Badridas Daga v. Commissioner Of Income Tax, [1958] 34 ITR 10 (SC), the deduction must be allowed.”

14. Reference was also made to the decision in Commissioner Of Income Tax, Gujarat v. S.C Kothari, [1971] 82 ITR 794 (SC). The penultimate paragraph of the judgment is, in my opinion, highly relevant, and may be set out in full (p. 43 of 124 ITR):

“Reliance was placed by the Revenue on Haji Aziz and Abdul Shakoor Bros. v. CIT, [1961] 41 ITR 350 (SC). In that case, however, the assessee carried on the lawful business of importing dates from abroad and selling them in India. The import of dates by steamer was prohibited. None the less he imported dates from Iraq by steamer, and the consignments were confiscated by the Customs authorities. But the dates were released subsequently on payment of fine. The assessee's claim to deduction under s. 10(2)(xv) of the Indian I.T Act, 1922, was rejected on the ground that the amount was paid by way of penalty for a breach of the law. An infraction of the law was not a normal incident of business carried on by the assessee, and the penalty was rightly held to fall on the assessee in some character other than that of a trader. Reference was made by the Revenue to Soni Hinduji Kushalji & Co. v. Commissioner Of Income-Tax, A.P, [1973] 89 ITR 112 (AP). The assessee's claim to the deduction of the value of gold confiscated by the Customs authorities was found unsustainable by the court. The decision in that case can be explained on the ground that the assessee was carrying on a lawful business in gold, silver and jewellery and committed an infraction of the law in smuggling gold into the country. Our attention has also been invited to J.S Parkar v. V.B Palekar, [1974] 94 ITR 616 (Bom), where on a difference of opinion between two learned judges of the Bombay High Court, a third learned judge agreed with the view that the value of gold confiscated by the Customs authorities in smuggling operations was not entitled to deduction against the estimated and assessed income from an undisclosed source. It was observed that the loss arose by reason of an infraction of the law and as it had not fallen on the assessee as a trader or businessman a deduction could not be allowed. Apparently, the true significance of the distinction between an infraction of the law committed in the carrying on of a lawful business and an infraction of the law committed in a business inherently unlawful and constituting a normal incident of it was not pointedly placed before the High Court in that case”

15. A careful reading of this passage leaves no one in doubt about the distinction between an infraction of the law committed in the carrying on of a lawful business, and an infraction of the law committed in a business inherently unlawful, and constituting a normal incident of it. More than once in this passage the Supreme Court reiterates the said distinction. Further, the words emphasized by me in the above passage show that the disallowability, pointed out by the Supreme Court, is not confined to penalties alone. Applying the above principle to the facts of the present case, it must be held that the payment made in furtherance of an illegal transaction cannot be deducted. As pointed out by the Supreme Court in Haji Aziz and Abdul Shakoor Bros. v. CIT, [1961] 41 ITR 350, with respect to the business of importing dates, the business of export of tobacco carried on by the assessee before us, is also a lawful business; but the particular transaction is an unlawful one. Since infraction of law cannot be said to be a normal incident of business, any amount lost or expended in furtherance of such illegal transaction cannot equally be treated as a business loss or business expenditure, as the case may be. The position would have certainly been different if the very business of export of tobacco were itself an illegal business. Mr. Khazi contended that the application of such a principle would indeed result in putting a premium upon persons carrying on illegal trade or business. He submitted that, while a person who carries on a business which is inherently illegal, is entitled to deduct the losses incurred by him in such illegal business, a person carrying on a lawful business but indulging in one or two illegal transactions in the course of such business, would not be entitled to deduct the losses arising from such illegal transactions, from his business profits. But, if one remembers the basis upon which even gains of an illegal business are taxed by the State, set out by Rowlatt J., in Mann v. Nash, [1932] 16 TC 523 (KB), there is no reason to despair over such a consequence. The principle is this: A business means a lawful business; and it should be carried on according to law. Violation of law is not an incident of such business. Therefore, any penalty or fine paid on account of such violation, or any payment made in furtherance of such violation, cannot be treated as a business expenditure or business loss. While committing a violation or an infraction of law, the trader or businessman, as the case may be, must be deemed to be acting in a capacity other than that of a trader or businessman and; therefore, the amounts paid by him on that account cannot be set off against the income from his business. Now, the other principle is this: True it is that an unlawful business is not a business; but, a man has already carried out such business. It is a fait accompli. For such violation he may be punished elsewhere; but, there is no reason why he should be allowed to get away with all the profits and gains made in such illegal business, and there is no reason why the State should not tax it. By doing so, it is not condoning the illegal business or trade. Indeed, if in such a case no tax is levied on the ground that the business itself is illegal, it would amount to giving further benefit to a person indulging in an illegal business.

16. Now, the above distinction applies with equal force, whether the amount, paid in furtherance of an illegal transaction is claimed by way of business expenditure under s. 37, or as a business loss, or on any other basis. The assessee cannot be allowed to achieve the same result by putting it under s. 28. The argument of Mr. Khazi is that the assessee's real income from the said transaction is not Rs. 8,86,702.89, but the said amount minus Rs. 2,95,000. According to him, the invoice charging the floor price and the subsequent repatriation of 20% of the price in Singapore dollars was only a device, or a facade, adopted to realize the true price agreed, i.e, 80% of the floor price. I am, however, unable to appreciate this contention. The very agreement to receive 80% of the floor price is illegal, and this is indeed conceded by Mr. Khazi. According to law, there can be no agreement whereunder an exporter can agree to take anything less than the floor price. The argument that the tobacco was of substandard quality is no answer, because an exporter is not supposed to export substandard tobacco. The very fact that the floor price is not allowed to be reduced, means that the tobacco exported must be of the standard quality. Further, in this case, the assessee has received the full floor price, and it is out of the said sum; that it has repatriated Rs. 2,88,000 through illegal channels, besides paying about Rs. 7,000 by way of commission to Shamsuddin. It is not a case of money being diverted under an overriding legal obligation. In any event, the said agreement being illegal and contrary to law, cannot be recognized, nor can the entering into of such transaction be treated as a normal incident of business. It cannot also be said that, while entering into this illegal transaction, the assessee was acting as a businessman, because it is no part of its business to commit a violation of law. Mr. Khaji laid stress on the fact that, according to the finding of the Tribunal, the transaction is an “integrated transaction” and that the stipulation to receive the full floor price was coupled with the stipulation to repatriate 20%. In my opinion, the said fact makes little difference to the principle. If such a course were permitted, tomorrow a contractor can well say that, though the amount received by him under a contract entered into with the Government is Rs. 10,00,000, in reality it is only Rs. 9,00,000 because, even at the time of awarding of, or entering into the contract, it was agreed between him and the authority competent to award the contract that a sum of Rs. 1,00,000 shall be paid to him by way of bribe. He too can say that the agreement to pay Rs. 1,00,000 by way of bribe and the awarding of the contract to him was an “integrated” transaction and, therefore, his real income is only Rs. 9,00,000. I need not multiply the instances to emphasize the pernicious consequences arising from permitting such pleas. Merely because an inherently illegal business is also taxed, taking into account the incidents of such illegal trade, it does not follow that a lawful trade can also be, or can be allowed to be, carried on in an illegal manner.

17. Mr. Khazi then sought to argue that this transaction must itself be treated as a separate business; and since the transaction itself is illegal, the said amount should be allowed as a deduction, or as a simultaneous outgoing. I am unable to appreciate this contention, because the assessee is seeking to set off the said loss, or amount, as the case may be, against its total income from the business of export of tobacco. At no stage has this basis been urged, nor was its return based upon such distinction such an altogether new basis cannot now be allowed to be raised, or urged.

18. MR Khazi relied upon a number of decisions, to which a brief reference would be in order. He laid substantial stress upon the observations of the Gujarat High Court in Commissioner Of Income Tax, Gujarat v. S.C Kothari, [1968] 69 ITR 1. It is, however, unnecessary for me to refer to the observations in the said judgment at any length, because the first principle—with which there can be little quarrel—enunciated in the said judgment is that “if you seek to tax gains of an illegal business, you must equally give a deduction for illegal expenses or penalties”. But, in so far as the High Court allowed the assessee to set off the loss incurred by him in illegal transactions, against his income from speculative transactions, the matter was remanded by the Supreme Court to the High Court to find out whether the transactions in which the loss was incurred and profit was made, constituted the same business, or whether they were separate businesses.

19. The next decision relied upon is of the Allahabad High Court in Nanhoomal Jyoti Prasad v. Commissioner Of Income-Tax, Kanpur., [1980] 123 ITR 269. There, the assessee had imported certain goods under an import licence. But the Customs authorities found that the goods imported were not covered by that licence and, therefore, confiscated the goods. The assessee paid a fine in lieu of confiscation, and got the goods released. Meanwhile, the goods were lying in the port and subjected to demurrage charges. He claimed the amount paid by way of demurrage charges as “business expense”, and the High Court allowed it. This decision must be explained with reference to the finding of the High Court that the Customs authorities regularized the import licence of the assessee and allowed the assessee to clear the goods imported against the import licence held by him. Once the import licence was regularized, it must be held that the illegality ceased. In my opinion, therefore, the said decision cannot come to the rescue of the assessee herein.

20. The next decision is in Apeejay (Private) Limited v. Commissioner Of Income-Tax, (Central), [1978] 114 ITR 544, a decision of the Calcutta High Court. In this case also, the assessee imported some steel sheets without a valid licence. After protracted correspondence, however, the assessee approached the Iron & Steel Controller, who issued a customs clearance permit, to enable the assessee to take possession of the material, with a clear direction to re-export the goods. The goods were, accordingly, re-exported; the assessee claimed certain amounts paid by way of freight and other expenses, as “business expenditure”. When these were disallowed, the matter came up before the High Court. The High Court held, firstly, that it was not a speculative transaction within the meaning of s. 43(5); and, secondly, that the expenditure was incurred for the purpose of carrying on of the business by the assessee and the expenditure was also incurred by him in the capacity of a trader. It was further observed that the expenditure was not a liability imposed for violation of law, while it may be that the liability has arisen for carrying on the business in a manner not in accordance with law. It was observed that not carrying on the business in accordance with law does not detract from the fact that the expenditure was incurred in the capacity of a trader, for carrying on the business. It was, therefore, held to be a permissible revenue expense. Firstly, it may be noticed that, in this case, the illegal import was validated subject to the condition of re-export, which was complied with and, therefore, it must be said that the illegality was condoned or regularized, as the case may be. Moreover, as observed by the court, the purpose of the expenditure was for carrying on the business, and the expenditure was incurred in the assessee's capacity as a trader. Secondly, the distinction between a lawful business and an inherently illegal business does not appear to have been urged, or considered by the court.

21. The next decision is Narsingdas Surajmal Properties (P.) Ltd. v. Commissioner Of Income-Tax, Assam, [1981] 127 ITR 221, a decision of the Gauhati High Court. In this case, according to the registered lease executed in 1955, the ground rent was Rs. 500 per annum. In 1961 this agreement was modified by an unregistered agreement raising the ground rent to Rs. 12,000 per annum. The authorities refused to deduct the higher amount of rent, on the ground that the subsequent agreement was an unregistered one and, therefore, inadmissible in evidence. The High Court held that the Tribunal was not justified in rejecting the document as inadmissible in evidence, and in holding that because the document was unregistered, the assessee was not entitled to claim deduction. In that connection, it was observed that, in the absence of fraud, the question whether a transaction had the effect of reducing the assessee's taxable income, or whether it was prudent or judicious or whether it was indispensable or necessary for the assessee to enter into the transaction, are all irrelevant in determining whether the expenditure relating to that transaction should be allowed under s. 37 or not. I see no principle emerging from this decision which can come to the rescue of the assessee herein. The transaction in the case before us is, undoubtedly, a fraudulent one, i.e, fraud on law.

22. The next decision cited is in CIT v. Ramakrishna Mills (Coimbatore) Ltd., [1974] 93 ITR 49 (Mad), a decision of the Madras High Court. At page 58 of the report, the court observed that, even assuming that the payment made to the managing-agent infringed s. 348 of the Companies Act, still the company was entitled to its deduction under s. 10(2)(xv). The court observed that, in considering the allowability of an expenditure under s. 10(2)(xv), one cannot travel outside the provisions of the I.T Act and deny the benefit of deduction under that section on the ground that the payment is unauthorised, or has been prohibited by some other statute. With respect to the learned judges of the Madras High Court, I am unable to agree with the said observations, in view of the decisions of the Supreme Court, referred to above.

23. The other decision relied upon is in Commissioner Of Income-Tax v. Sree Rajendra Mills Ltd. which is reported in the same volume at page 122, and again of the Madras High Court. The same principle as affirmed in the earlier decision, is reiterated. But, I find that the decision does not contain any reference to the decision of the Supreme Court, referred to above, nor does it appear that the distinction made by the Supreme Court was brought to the notice of the court. I am, therefore, unable to agree with the principle of this decision as well.

24. The decision next relied upon is of the Bombay High Court in Commissioner Of Income-Tax, Bombay South v. Pranlal Kesurdas., [1963] 49 ITR 931 (Bom). The assessee carried on the business of adatiya and speculation. During a particular year, one of his constituents incurred a loss in certain forward transactions which the ‘assessee had put through’. That constituent was unable to pay the loss suffered by him, and it fell on the assessee. In a later year, the constituent paid Rs. 4,000 in full settlement of his debt to the assessee, and the assessee wrote off the balance and claimed it as a bad debt. It was held that the circumstance that the debt owing to the assessee from his constituent was not capable of being enforced in a court of law did not prevent the debt from being considered as irrecoverable or as bad. The court observed further that if the profits of an illegal trade are liable to be taxed, then the computation of profits too will have to be done in accordance with the mode prescribed by the statute. It was observed that, in taxing an illegal business, the expenses incurred in running such business have also got to be deducted. This is a case of a business which was per se illegal.

25. Reliance is also placed upon a decision of the Madras High Court in South India Viscose Ltd. v. Commissioner Of Income-Tax., [1982] 135 ITR 206. In that case, under the export promotion scheme, a licence was granted to the assessee which carried on the business of manufacture and sale of rayon, for import of wood pulp, which was the raw material for the manufacture of rayon yarn. The condition was that the yarn was to be sold at concessional rates to certain weavers specified by the Textile Commissioner. The assessee was complying with the said condition. But, in 1965, the Textile Commissioner increased the quantities of yarn to be delivered at concessional rates to the weavers; but, on representations being made to him, the Commissioner waived the requirement of supply of yarn at concessional rates. Meanwhile, the market price of yarn had gone up, while the rate at which the assessee had to supply yarn to the weavers, remained stationary, and the assessee would have suffered losses if it were to comply with the requirements of the Textile Commissioner. The assessee, therefore, entered into a settlement with the weavers, whereunder it paid a certain amount as compensation for the non-supply of yarn, and claimed that amount as a deduction. This was not a case of payment made in pursuance of an illegal transaction. At the most, it was a violation of a condition imposed by the Textile Commissioner in terms of an export promotion scheme, which was not a law. Unfortunately, the decision of the Supreme Court in Cit Patiala v. Sri Piara Singh ., [1980] 124 ITR 40 (SC), does not appear to have been brought to the notice of the learned judges, nor even the decisions of the Supreme Court in Haji Aziz and Abdul Shakoor Bros. v. CIT, [1961] 41 ITR 350 (SC) and Commissioner Of Income Tax, Gujarat v. S.C Kothari, [1971] 82 ITR 794 (SC), cited before the court. If this decision is understood as saying that even a payment made in furtherance of an illegal transaction is to be given deduction, I am unable to agree with it, in view of the decisions of the Supreme Court.

26. In support of his argument based on s. 28 of the I.T Act, Mr. Khazi relied upon certain decisions to which I must now make a reference. Matubhai C. Patel v. CIT, [1982] 133 ITR 303 (Guj), a decision of the Gujarat High Court, says that in assessing the income of an assessee from the estate inherited by him on the death of his father, deduction must be given for the amounts paid by him towards interest on overdraft taken by his father for paying his tax liabilities. The principle of the decision is that the liabilities inherited by the assessee must equally be taken into account, while assessing the income derived by him from the assets inherited by him. Reliance was placed upon an earlier decision of that court in Udayan Chinubhai v. CIT, [1978] 111 ITR 584 (Guj), where the interest paid to unsecured creditors with a view to meet the debts incurred by the assessee's father, was held entitled to be deducted from the gross receipts of the assessee for arriving at the figure of the real income earned, for the purpose of being brought to tax under the I.T Act.

27. Reliance is then placed upon CIT v. Birla Gwalior (P.) Ltd., [1973] 89 ITR 266 (SC). That was a case where the assessee, which was a managing agent of two companies, maintained its accounts under the mercantile system. It was entitled to a certain managing agency commission, but no date for payment of the commission was stipulated in the managing agency agreement. The accounting year of the assessee as well as the managed companies was the financial year. After the end of the accounting years relevant to the assessment years 1954-55 to 1956-57, but before the accounts were made up by the managed companies, the assessee gave up the managing agency commission, and the amount so given up, was deducted as an allowable deduction under s. 10(2)(xv). The High Court affirmed the same. Neither in this case, nor in the two Gujarat cases cited above was any violation of law involved. Similarly, in Poona Electric Supply Co. Ltd. v. CIT, [1965] 57 ITR 521 (SC), the assessee who was a licensee under the Electricity Supply Act, credited certain amounts in excess of the “reasonable return” to the Consumers' Benefit Reserve Account, instead of distributing the same among the consumers, and claimed the same as a deduction. It was held that, for the purpose of s. 10(1) of the Indian I.T Act, 1922, the taxable income of the assessee is the income minus the amount credited to the said reserve account. No illegality was said to be involved in that transaction.

28. Lastly, reliance is placed upon Calcutta Company Ltd. v. Commissioner Of Income Tax, West Bengal, [1959] 37 ITR 1 (SC), a decision of the Supreme Court. In this case, the appellant (assessee) was engaged in the business of purchasing plots, developing them, and then selling the plots after providing all the amenities, including drainage system and electricity lines. The amount was recoverable from the purchasers in instalments. The assessee was maintaining its accounts on mercantile basis, i.e, on accrual basis. During the relevant accounting year, though the assessee received only a sum of Rs. 29,392 towards sale price of the lands, it credited an amount of Rs. 43,692 in accordance with the mercantile system of accounts adopted by it. At the same time, it also debited an estimated amount of Rs. 24,809 as expenditure towards the development it had undertaken to carry out, even though no part of that amount was actually spent. The Department disallowed it; but, when the matter came up to the Supreme Court, it was held that the development expenditure was an accrued liability and the estimated expenditure in that behalf was liable to be deducted from the profits and gains, in view of the method of accounting, adopted by the assessee. I am unable to see how this decision is of any help to the assessee.

29. For the above reasons, I must answer question No. 1 referred to this court, in the negative, i.e, in favour of the Department and against the assessee. In that view, it is not necessary to answer the alternative question. I must, however, indicate even on this aspect that, on the parity of reasoning adopted by me above, an illegal payment cannot be brought within the exception in cl. (j) of r. 6DD of the I.T Rules, 1962. My answer to the alternate question, if necessary, would, therefore, be again in the negative, i.e, in favour of the Department and against the assessee. Now remains the second question referred to us. This point is clearly covered by a decision of this court in Addl. CIT v. Maddi Venkataratnam & Co. Ltd., [1979] 119 ITR 514 (AP). On this question, I must say that though the order of the Tribunal proceeds on the assumption that the said amount was expended on a “guest house”, it is brought to our notice that, subsequently this portion of the order has been amended, since it is said to be an amount spent on providing tea, coffee and food, etc., to the customers. The Gujarat High Court in CIT v. Patel Brothers & Co. Ltd., [1977] 106 ITR 424, has drawn a distinction between the amounts spent on such necessities, and the amounts spent on amusement and in providing banquets and other entertainment. The said decision was followed by this court in [1979] 119 ITR 514 (Addl. CIT v. Maddi Venkataratnam & Co. Ltd.). Though it is brought to our notice that the Punjab & Haryana and Kerala High Courts have taken a contrary view, I propose to follow the view taken by this court as, indeed, we have done in a similar matter. Following the same, I answer this question in the affirmative, i.e, in favour of the assessee and against the Department.

30. The referred case is ordered accordingly, but, in the circumstances of the case, there shall be no order as to costs.