When illegal income is taxed, questions about deduction of expenditure tainted with illegality arise.
Possession of heroin is an offence under the Narcotic Drugs and Psychotropic Substances Act, 1985. Quereshi is a doctor by profession. The CBI and the Income-Tax Department raided his residential premises in 1985. In this raid, one clandestinely-run laboratory manufacturing heroin, along with several contraband drugs, was discovered.
All these contraband articles were seized and proceedings under the Narcotic Drugs and Psychotropic Substances Act, 1985 were initiated against the assessee.
In the income-tax assessment 1986-87, the doctor claimed that the value of the contraband article seized from his possession worked out to Rs 5.50 lakh. Since the heroin seized from him formed part of stock-in-trade, his loss on account of seizure was an allowable deduction while computing the profits and gains of business and profession.
The assessing officer (AO) rejected this claim and added the Rs 5.5 lakh as income from undisclosed sources. The Tribunal allowed the doctor's appeal and the Department took up the matter in appeal before the Madhya Pradesh High Court. For the doctor, reliance was placed on the Supreme Court ruling in the Piara Singh (124 ITR 40) case.
The Madhya Pradesh High Court took the view that the ruling in the Piara case was superseded by the Explanation to Section 37 of the I-T Act, 1961 inserted by the Finance (No. 2) Act, 1998, retrospectively with effect from April 1, 1962.
The Explanation laid down that for the removal of doubts, any expenditure incurred by an assessee for any purpose which is an offence or which is prohibited by law shall not be deemed to have been incurred for the purpose of business or profession and no deduction or allowance shall be made in respect of such expenditure.
The court was of the view that the rigour of the Explanation to Section 37 was fully satisfied and, hence, the question of claiming deduction for the value of the seized article did not arise; the assessee was not entitled to claim any such deduction since he was found indulging in such heinous and illegal business unconnected with his pious professional activity. It was a disgrace for the doctor community where one doctor was found indulging in such kind of activities against humanity.
The doctor went on appeal to the Supreme Court.
The Supreme Court ruling
The court opined that the facts were squarely covered by the decision in the Piara case (supra), where the court had held that loss arising out of confiscation of currency notes must be allowed as business loss. It observed: "The Explanation to Section 37 has really nothing to do with the present case, as it is not a case of business expenditure, but of business loss. Business losses are allowable on ordinary commercial principles in computing profits. Once it is found that the heroin seized formed part of the stock-in-trade of the assessee, it follows that the seizure and confiscation of such stock-in-trade has to be allowed as a business loss. Loss of stock-in-trade has to be considered as a trading loss."
According to the Supreme Court, the Madhya Pradesh High Court has adopted an emotional and moral approach rather than a legal approach. Law is different from morality. Cases are to be decided by courts on legal principles and not on one's own moral views. Quereshi succeeded before the Supreme Court in spite of being found to be an offender under the Narcotic Act.
Several vital issues emerge from the Supreme Court ruling (287 ITR page 547 SC) delivered by eminent jurist Markandey Katju. The apex court itself had held that the term "expenditure" in Section 37 would cover both losses and expenditure (Indian Molasses Ltd 37 ITR 66 SC). A watertight distinction may not always be possible between the two terms. The second issue concerns the taxability of income tainted with illegality. When such tainted income is taxed, questions about deduction of expenditure tainted with illegality arise.
The Cofeposa Act provides for confiscation of the smuggler's property. Probably a similar provision must be inserted in the I-T law to provide for confiscation of incomes earned from criminal and illegal activities. It looks odd that a person carries on criminal activities and he is still left with some incomes to be enjoyed on his own after paying the relevant income-tax due on his income.
The apex court said that the Explanation to Section 37 does not apply to the Quereshi case. Obviously the law requires to be amended further to bring out the fact that the Piara ruling is no longer valid. This is what the Madhya Pradesh High Court specifically pointed out in the Quereshi case (275 ITR 352).
If there is no such amendment in the ensuing Finance Bill, it will only mean that the insertion of the Explanation to Section 37 has not met the purpose for which it was intended. The 1998 amendment appears to have been defeated.
T. C. A. Ramanujam (The author is a former Chief Commissioner of Income-Tax.)