Explanation to S. 37(1): No disallowance for compensatory payments

The assessee, a manufacturer of garments, was granted an entitlement by the Apparel Export Promotion Council (APEC) for export of garments and knit wares. In consideration for the export entitlement the assessee furnished a bank guarantee in support of its commitment that it shall abide by the terms and conditions and produce proof of shipment. It was also provided that failure to fulfill the export obligation would render the bank guarantee to being forfeited/encashed. The assessee did not utilize the export entitlement which led APEC to encash the bank guarantee. The assessee recorded the said payment as penalty in its books of account and claimed deduction u/s 37(1). The AO rejected the claim on the ground that as the payment was by way of “penalty” it could not be allowed under the Explanation to s. 37(1). However, the CIT(A) and ITAT allowed the claim. On appeal by the department to the High Court, HELD dismissing the appeal:

The assessee took a business decision not to honour its commitment of fulfilling the export entitlement in view of loss being suffered by it. The genuineness of the claim of expenditure being for business purpose is not disputed. The assessee has not contravened any provision of law and the forfeiture of the bank guarantee is compensatory in nature and does not attract the Explanation to s. 37(1).