Ajay Kumar Mittal, J.:— The question that falls for judicial consideration before the Full Bench is, as to which of the two divergent views of two co-ordinate Division Benches of this Court has legal acceptability. Even more pointedly, the correctness of judgments reported in Commissioner of Income Tax v. Indo Asian Switch Gears (P) Ltd.,1 and Baldev Singh Kanwar, Barishad, Hoshiarpur v. The Commissioner of Income Tax, Jalandhar,2 is at issue in this Reference.

2. In the first instance, it deserves to be noticed as to how this controversy has arisen. Before delving on the issue involved, it would be apposite for proper appreciation of the bone of contention between the parties to put a brief look on the factual matrix. A partner of the assessee-firm visited Germany where he entered into a contract for supply of certain goods of a particular value. The agreement so arrived at, however, could not be acted upon by the assessee as it did not have the requisite import licence for the material intended to be imported. The dispute was referred to an arbitrator. In terms of the award of the Arbitration Tribunal, rendered on 29.7.1974, the assessee paid a sum of Rs. 50,000/- to the German-firm, M/s Duestsche Strahil Metail of Berlin, for failure to perform its part of the contract. Accordingly, the assessee in its return for the assessment year 1975–1976, claimed deductions of the aforesaid amount as business expenses on account of damages for breach of contract.

3. The Assessing Officer had initially allowed the amount of Rs. 50,000/- as deductions out of the total income. But lateron, a notice was issued to the assessee under Section 148 of the Income Tax Act, 1961 (for short “the Act”) on the strength of a plea that the jurisdictional High Court in Cineramas v. Commissioner of Income Tax, Amritsar-I,3 had held that infractions of law, including breaches of obligations are not normal incidents of business and penalties and the damages paid in connection with such infractions and breaches are not expenditure laid out or expended wholly and exclusively for the assessee's business. Applying the view taken in the said case, the Inspecting Assistant Commissioner of Income Tax, Assessment, Karnal, vide order dated 24.7.1980 accordingly disallowed the expenses of Rs. 50,000/- paid by the assessee for breach of the contract on its part. The view taken by the Assessing Officer was upheld by the Commissioner of Income Tax (Appeals) Chandigarh Camp at Ambala and the Income-Tax Appellate Tribunal, Chandigarh Bench vide orders dated 22.8.1983 and 23.8.1985 respectively.

4. It is in this manner the appellant preferred the instant Reference and raised the following question of law for opinion of this Court:

“Whether on the facts and in the circumstances of the case, the Tribunal was right in applying the decision of the Punjab and Haryana High Court in Cineramas v. Commissioner of Income Tax, Amritsar-I, while confirming the disallowance of Rs. 50,000/- payable to M/s Duestsche Stahil Metail of Berlin for non-performance of the contract?”

5. When the matter came to be considered by a Division Bench, of which one of us (Ajay Kumar Mittal, J.) was also a member, learned counsel appearing for the assessee by placing reliance on the decision of this Court in Commissioner Of Income-Tax v. Indo Asian Switch-Gears (P.) Ltd., submitted that in the present case the payment of damages is for breach of contract and not on account of infraction of law and, therefore, the same is admissible as expenses having been expended wholly and exclusively for the purposes of business.

6. On the other hand, learned counsel appearing on behalf of the Revenue therein stoutly controverted the submission made by the learned counsel for the assessee and placed reliance on a Division Bench judgment of this Court in Baldev Singh Kanwar Barishad, Hoshiarpur v. The Commissioner of Income Tax, Jalandhar,4 to canvass that the view taken by the Tribunal was in consonance with law. He supported the order of the Tribunal.

7. In the wake of two views on the point, totally contrary to each other it was considered appropriate by the Referral Bench to recommend that the issue deserved to be resolved by a larger Bench. The exact words by which the matter came to be referred are indicated here-in-below just with a view to make explicit on record as to how the question has come up for consideration by the Full Bench. These are:

“In our opinion, there is direct conflict between the two decisions of co-ordinate Benches in Indo Switch-Gears (P) Ltd. (supra) and Baldev Singh Kanwar's case (supra), which deserves to be resolved by a larger Bench. Accordingly, we direct the Registry to place the papers of this case before Hon'ble the Chief Justice for constituting a larger Bench to decide the controversy arising in this reference.”

8. It would be manifest from the above that the spinal issue which arises here is, whether an assessee who pays certain amount by way of damages for breach of contract is entitled to have said expenditure allowed to be deducted from the income. In other words, can the aforesaid expenditure be termed as amount expended wholly and exclusively for business purposes within the meaning of Section 37(1) of the Act?

9. With this background, a reference may be made to specific provisions of Section 37(1) of the Act on which the controversy revolves and which at the relevant time read as under:

“37. (1) Any expenditure (not being expenditure of the nature described in sections 30 to 36) and not being in the nature of capital expenditure or personal expenses of the assessee, laid out or expended wholly and exclusively for the purposes of the business or profession shall be allowed in computing the income chargeable under the head “Profits and gains of business or profession”.

10. The legal position may first be analyzed. Section 37(1) of the Act contains the general provisions for allowance as an expenditure. According to Section 37(1), for a particular item of expenditure to be an allowable deduction under this section:—

(a) it should not be an expenditure of the nature described in Sections 30 to 36;

(b) it should not be in the nature of capital expenditure; or personal expenses of the assessee; and

(c) it should have been laid out or expended wholly and exclusively for the purpose of the business or profession of the assessee;

11. The phraseology-laid out or expended wholly and exclusively for the purposes of business or profession-embraces within it ‘wholly’ which refers to the quantum of expenditure and the word ‘exclusively’ refers to the motive, objective and purposes of the expenditure. The expression ‘wholly and exclusively’ does not mean ‘necessarily’. If an amount is incurred for promoting the business and to earn profits, the assessee can claim deduction therefor even though there was no compelling necessity to incur such expenditure. The test for allowability of an expenditure as a deduction is to judge, whether the expense has been incurred with the sole object of furthering the trade or business interest of the assessee unalloyed or unmixed with any other consideration and that expenditure was necessitated or justified by commercial expediency.

12. Whenever certain damages are to be paid by an assessee for the breach of a contract, such damages are treated to be normal incidences of business. For allowability as a deduction, a claim for damages is to be tested on the touchstone of the provisions of Section 37(1) of the Act. Where an assessee has to pay damages to the other party for the failure to fulfill the contract entered into by him in the ordinary course of his business, the amount of damages so paid is an allowable deduction if it is in the ordinary course of the business, and is not opposed to the public policy.

13. A penalty imposed for breach of any law during the course of trade etc. cannot be described as a commercial loss. If an assessee while conducting his business, has acted in an unlawful manner which has rendered him liable to penalty, the surrrso paid cannot be claimed as a deductible expense. Infraction of the law is not a normal incident of business and, therefore, no expense which is paid by way of penalty for a breach of law is admissible deduction. In cases where a penalty has to be incurred, for the reason of the assessee having carried on business in an unlawful manner or in contravention of certain rules and regulations, such penalty could not be regarded as ‘wholly and exclusively’ laid out for the purposes of business as the expense has not been necessitated by the business but by the conduct of the assessee in trying to carry out the business in an unlawful manner. Under Section 37(1), only that portion of such payment having composite nature which is attributable to its compensatory character for payment as damages is to be allowed as a deduction. The other portion which is attributable to its penalty nature cannot be allowed as a deduction under Section 37(1) because such payment is for infraction of law.

14. The aforesaid interpretation has the stamp of approval by their Lordships of the Apex Court. The Supreme Court in Prakash Cotton Mills P. Ltd. v. Commissioner of Income Tax,5 while analyzing the scope of Section 37(1) of the Act observed as under:

“Therefore, whenever any statutory impost paid by an assessee by way of damages or penalty or interest is claimed as an allowable expenditure under Section 37(1) of the Income-tax Act, the assessing authority is required to examine the scheme of the provisions of the relevant statute providing for payment of such impost notwithstanding the nomenclature of the impost as given by the statute, to find whether it is compensatory or penal in nature. The authority has to allow deduction under Section 37(1) of the Income-tax Act, wherever such examination reveals the concerned impost to be purely compensatory in nature. Wherever such impost is found to be of a composite nature, that is, partly of compensatory nature and partly of penal nature, the authorities are obliged to bifurcate the two components of the impost and give deduction to that component which is compensatory in nature and refuse to give deduction to that component which is penal in nature.”

15. In Standard Batteries Ltd. v. Commissioner of Income-Tax,6 the Supreme Court followed and reiterated the view taken in Prakash Cotton Mills P. Ltd.'s case (supra).

16. This issue again came up for pointed consideration before the Supreme Court in Swedeshi Cotton Mills. Co. Ltd. v. Commissioner of Income-Tax,7. The question before the Apex Court was regarding deductibility and liability incurred by the assessee for delayed payment of employees' contribution under Section 14B of the Employees' Provident Funds Act, 1952 and the penalty levied on the assessee under the Central Sales Tax Act. The Supreme Court following the judgment in Prakash Cotton Mills P. Ltd.'s case (supra) categorically laid down that wherever an amount has been paid by way of damages, the compensatory payment made by the assessee entitles him to claim deduction from the income earned by him and where an element of penal levy is concerned, any such payment made for contravention of law is inadmissible.

17. We may now refer to cases adjudicated by the jurisdictional High Court. In Commissioner of Income Tax, Punjab v. Himalaya Rosin-Turpentine Manufacturing Company,8 a Division Bench of this Court was considering the case of an assessee who was carrying the business of extracting rosin from forest leased for that purpose and had entered into an agreement for extracting rosin according to certain terms and conditions and in the eventuality of failure to observe the same, he was liable to pay penalty/fine. The assessee having contravened the terms of the lease was saddled with fine of Rs. 5,000/- which was paid to the State. The said claim was disallowed because it was found that the payment concerned was made towards penalty imposed for breach of the rules under which the assessee was extracting rosin. The aforesaid view was adhered to by another Division Bench of this Court in Cineramas v. Commissioner of Income-Tax, Amritsar-I,.

18. In Commissioner of Income-Tax v. Murari Lal Ahuja and Sons,9 while considering the case of damages for breach of contract, this Court held that if the amount is expended as payment on account of compensation for breach of contract, the same shall be treated as commercial expediency and the loss incurred thereon shall be eligible to be deducted from the income of the assessee. In the said case, the assessee was engaged in the business of sale of cotton and it had failed to fulfill the contract for supply of cotton to the mills. The assessee settled the deal by paying certain sum as compensation/damages which was held to be an allowable deduction. That judgment has been followed in a recent judgment in Commissioner of Income Tax v. S.A Builders (P) Ltd.,10 by this Court.

19. In view of the authoritative pronouncements of the Apex Court and also of this Court, it would thus, be concluded that whenever an assessee has indicated any amount, which had been paid either by way of damages or penalty, to be an allowable expenditure under Section 37(1) of the Act, the Assessing Authority is obliged to discover the nature of such amount vis-a-vis two prominent aspects, whether it is compensatory or penal. The Assessing Authority would there upon permit the amount as an allowable deduction that may be discovered to be purely of compensatory nature as payment for damages. However any statutory amount paid by the assessee which is sought to be claimed as an allowable expenditure on account of penalty, in that eventuality, the same shall be disallowed being payment for infraction of law. A situation may arise where an assessee might have to make a composite payment being ‘compensatory’ and ‘penal character’ both. In that situation, the Assessing Authority would, of course, be required to segregate the amount containing two characters. After undertaking this exercise, the amount that is held to be of compensatory nature shall be countenanced as allowable expenditure whereas the other portion of the amount, which is penal in nature, shall be refused to be an allowable expenditure.

20. Now we advert to the cases which had necessitated the reference to the Full Bench. In Indo Asian Switch-Gears (P) Ltd's case (supra) during the assessment year 1977–1978, the assessee had to pay an amount of Rs. 4,950/- to the Punjab State Electricity Board on account of late delivery of goods. The question that arose for consideration was, whether the said amount was deductible from the income of the assessee. This Court while interpreting Section 37(1) of the Act concluded that the amount paid was not on account of any infraction of law but was by way of damages for breach of contract and was thus compensatory in nature. It was also concluded that the said amount would entitle the assessee for deduction under Section 37(1) of the Act. This Court after referring Cinaramas's case (supra) and Murari Lal Ahuja and Sons' case (supra), observed as under—

“A question about such deductibility also came up for examination before this Court in CIT v. Murari Lal Ahuja and Sons, (1989) 177 I.T.R 228. That was a case where the assessee, who carried on the business of sale of cotton, was unable to fulfill a contract of supplying cotton to the mills and, therefore, settled the dispute by paying them a sum of Rs. 48,158/-. The Income-Tax Officer disallowed the payment holding it to be a speculative transaction in terms of Section 43(5) of the Act. The Tribunal, however, took the view that payment had been made due to abnormal circumstances for the reason that the assessee had flouted the agreement of sale to save himself from a ruinous situation and, therefore, the compensation paid in the shape of settlement for breach of contract was an allowable deduction. It was held by this Court that the transaction did not amount to a speculative transaction and compensation was paid by the assessee for breach of contract. Therefore, the payment made was an allowable deduction.”

21. The conclusion of the Division Bench was recorded at page 794 of the judgment which reads thus:

“In the present case, the assessee has paid certain amount by way of penalty to the Board on account of late delivery of the goods. Obviously, this is not on account of infraction of any law. The true test is whether there is breach of law or breach of an agreement. If it was in the latter category, then damages paid would be treated to be a business or commercial loss and admissible as deduction under section 37(1) of the Act. Since it was incidental to business, it cannot be disallowed.”

22. The above was a case relating to payment of damages for breach of contract and the same was held to be an allowable expense. The said view is in consonance with law.

23. It may now be apposite to refer to the judgment in Baldev Singh Kanwar's case (supra) where the question that arose before the Division Bench was, whether the payment made by way of damages for breach of contractual obligations is an allowable expenditure, or not. The assessee therein was a rosin contractor who had taken contract for the extraction of rosin of Arnas Range during the assessment year. The assessee was required to pay Rs. 54,638/- on account of damages caused by blazes. According to terms of the agreement, the assessee was required to extract rosin by placing blazes of a standard size and shape. The assessee contractor while performing its part of the contract had failed to keep these standards and norms scrupulously. The assessee was held liable to pay damages to the other side in those circumstances. This Court while following its earlier judgment in Himalaya Rosin-Turpentine Manufacturing Company's case (supra) had held that the assessee was not entitled to claim damages. The issue before the Division Bench was regarding payment of damages for breach of contract as the assessee therein had violated the terms of the contract and was held liable for damages. That occurrence because of which the assessee was held liable for damages, being an ordinary incident of business, the amount paid on that account was an allowable expense as a business loss/expenditure. However, by taking the payment of damages for breach of agreement as penalty for infraction of law the same had been disallowed. The Division Bench had therefore, incorrectly decided the issue and we are not in a position to subscribe the said view. Accordingly we over-rule the judgment in Baldev Singh Kanwar's case (supra) which does not decide the controversy in its right perspective.

24. Having resolved the controversy, we would now take note of the facts of the present case. The facts as disclosed are that the assessee had entered into an agreement with a German firm, on a visit of its partner, for supply of certain goods. The said contract did not fructify as the assessee did not have the requisite import licence for the material intended to be imported. On a dispute being referred to the arbitrator, the assessee had to pay Rs. 50,000/- to the said German firm in terms of award dated 29.7.1974 It was this amount which was claimed as deduction by the assessee from its income. The issue was decided against the assessee by placing reliance on Cineramas v. Commissioner of Income Tax, Amritsar-I, holding that the payment made for infraction of law and breach of obligations are not normal incidents of business and thus cannot be said to have been laid out or expended wholly and exclusively for the assessee's business. The expenses incurred on that account were disallowed. As per the findings recorded by the authorities below, the amount of Rs. 50,000/- paid by the assessee was on account of damages for breach of contract on its part and not a liability incurred for contravention of any law. In the circumstances aforesaid and the clear legal position enunciated above, the said amount claimed as deduction would thus be an expense incurred for the purposes of the business and could not have been disallowed.

25. In view of the above, it is held that the Tribunal was not right in deciding the issue against the assessee and the Reference is accordingly decided in favour of the assessee and against the Revenue.

Sd/- Vijender Jain, C.J

Sd/- Rajive Bhalla, J.

R.M.S

Petition allowed.