Business loss vis a vis business expenditure -an analysis of ruling of the Supreme Court.

[DEV KUMAR KOTHARI]

Summary:

Business loss is allowable as per normal accounting and commercial principles and to derive at true profit of business or profession. Expenditure and business loss are two different things. The difference between two is usually apparent and pose no difficulty to classify an item as a loss or an expense. The provisions, rules and tests relating to allowability of expenditure are not always applicable to allowability of loss. If a loss is established and it is found to have been suffered in the course of business or profession, it will be allowable. Explanation to section 37 will not be applicable in case of business loss as recently held by the Supreme court in case of loss of stock of heroin seized under law, which was  held as an item of stock-in-trade by a medical professional Dr. T.A.Quereshi.  A brief analysis of provisions

Difference between business loss and business expenditure Business loss In a business the assessee may suffer loss of several types like -

(a) Loss in trading or manufacturing or other business operations.  Such loss occurs mainly due to high costs incurred and low price realized for the overall volume of business.  When the business operations are below the break-even level there is loss because fixed costs are not covered due to lower margin or contribution realized at low volume of activity achieved.  Sometimes the market force causing fluctuation in price of inputs and output also results into loss in the business. 

(b) Loss of trading assets - Sometimes loss may occur due to loss of trading assets like stock-in-trade, obsolescence of stock-in-trade, shortages in stock, loss due to theft, pilferage etc.  The loss can also occur due to detoriation of market value. Unrecoverable debts, loans and advances are also in nature of business loss. Loss due to theft, decoity, of materials as well as cash balance is a business loss.

(c) Other losses - Sometimes a business may suffer certain losses, which are incidental to carrying the business.  For example, loss due to fluctuation in foreign exchange in which money is receivable or payable, advances given for the purposes of business becoming unrecoverable or the supplier / service provider failing to perform the contract and fails to return advances, losses due to force measures or other reasons causing breach of contract.

We find that there is no specific provision for allowing losses of above nature except losses due to bad debts.  Various deductions provided are contained in section 30 to 37 and section 37 is a residuary and general provision.  These deductions mainly pertain to certain expenditure and amortization of certain capital or lasting expenses.  Only in section 36, we find provision for allowability of bad debts and provision for bad debts.  There is no provision specifically made for allowing loss in inventory and other similar losses.

Expenditure:

By expenditure we mean an outgo in form of cash or kind incurred in the course of business. For example a businessman may pay cash as fooding allowance to employee or may provide food at work place. The cash given away as food allowance or spent on provision of food is expenditure. In case of expenditure there is an intention and activity involved while spending money. The expenditure is in nature of employee's welfare expenses.

Suppose certain food articles are stolen from the office canteen. The cost of stolen articles is not expenditure but a loss incidental to business. This loss cannot be considered as and expenditure for employee's welfare though it is incidental to the business activity of providing food to employees. In case of loss there is no intention or desire to suffer loss it is not by actions of the businessman but it usually is due to certain external factors, which are beyond control of the businessman. Some times business loss may be suffered due to mistake of businessman or his representatives as well. If the loss is incidental to business, it will be business loss though there may be mistake of businessman or his representatives.  

Usually we find apparent difference between expenditure and a loss. However, some times circumstances may be such that there is very thin line of distinction and the item may be considered as a business loss as well as expenditure. In such case the decision will depend on all surrounding circumstances. However, to establish loss the accounting entries should be clear and distinctive. For example in case of loss of articles from kitchen, the loss should be disclosed separately by separate head or by way of note that canteen expenses include loss due to pilferage, theft or spoilage etc.

Section 28 and section 145

Section 28 prescribes taxability of various types of income, profit, receipts etc., which are chargeable to income tax under the head "profits and, gains of business or profession".  Section 29 prescribes that income referred to under section 28 shall be computed in accordance with the provisions of section 30 to 43D.  These provisions contain provision for allowability of certain expenses and deductions and they have undergone many changes from time to time according to the requirement or fiscal policies.  These provisions do not specifically cover many incomes, which can arise in the course of business, as well as many losses in a business or profession.  However, what is taxable is "income" and for computation of "income", it is well-settled that state of affairs as on the opening day of the previous year and as on the closing date is to be ascertained and in a broad sense, it can be said that increase in net-worth computed as per method of accounting is the income and decrease in net worth will be loss for the accounting period.  Therefore, for computing the profits, gains or losses of the previous year, one has to consider the state of affairs as on the first day of the previous year, which is brought forward from earlier year taking in to consideration all the transactions entered during the year and prepare a statement of affairs as on the closing day.  Therefore, not only the transactions but also incidental gains and losses are to be considered.  As per section 145, the business or professional income is to be computed as per the method of accounting regularly followed by the assessee and as per certain accounting standards.

Deductions u/s 28

Deductions, which are not specifically provided needs to be taken in to consideration while computing the business income.  For example, there is no specific provision to take into account opening stock as an item of expenditure on debit side of the profit and loss account and closing stock as an item on credit side of the profit and loss account.  However, the same are to be considered for deducing profits or gains.  Similarly, certain expenses or deductions which are not specifically provided in section 30 to 43D and are also not covered by the residuary provision of section 37 can still allowable for computing the business income and the deduction of such expenses or losses or accounting adjustments is permitted on a combined reading in sections 2 (24), 4,5, 28, and 145 of the income Tax Act As per the charging sections real income has to be computed in the prescribed manner and subject to certain specific exceptions.

Restrictions prescribed in section 37 are not applicable for deduction u/s 28

In section 37, which is a residuary or general provision and is wider yet restricted provision for allowing deductions of any kind.  We find that there are certain restrictions like that expenditure should not be capital expenditure, it should not be personal expenditure of assessee, the expenditure should have been incurred wholly and exclusively for the purpose of business or profession and the expenditure should not be illegal or against public policy etc.  Therefore, any expenditure should meet the positive and negative tests laid down in section 37(1) including the explanation thereto. Furthermore expense should not be covered by other prohibitive provisions like section 37(2B), section 40 and 40A etc.

The restrictions which covers section 37 are not applicable to business losses

The question whether the explanation to section 37(1) applies while considering business losses came before the Supreme Court in the case of DR. T.A. Quereshi v. CIT [2006] 287 ITR 547 (SC).  In this case the assessee is a doctor carrying on medical profession for the purpose of preparation of medicines, he used to hold as a stock-in-trade heroin.  The authorities under the provisions of Narcotic Drugs and Psychotropic Substances Act, 1985, seized certain quantity of heroin because holding of heroin was not permitted under law.  The assessee claimed the loss on account of heroin seized.  The assessing officer and the Commissioner (Appeal) denied the deduction.  The assessing officer did not allow the loss of heroin seized but he also added a sum of Rs.5, 50,000 being the assessed value of the heroin seized as an income from undisclosed source.  In an appeal before the Tribunal, the Tribunal vide its order dated 31^st March, 1993 reduced the value of heroin seized to Rs.2 lakhs but refused to deduct this amount from the assessee's income as a business loss taking into view that the assessee had not claimed it as a business loss.  Therefore, the assessee preferred an application u/s 254(2) before the Tribunal and the Tribunal vide its order dated April 26, 1994, accepted that the assessee had in fact claimed it as a loss and therefore, the earlier order dated 31.3.93 was recalled.  Thereafter vide order dated October 14, 1998, the Tribunal allowed the appeal of the assessee and held that the assessee is entitled to claim the deduction as a business loss.  The Tribunal relied on the decision of CIT v. Piara Singh (1980) 124 ITR 40(SC) and allowed deduction of Rs.2, 00,000.  The Revenue preferred an appeal before the High Court.

During the pendency of the matter before the High Court we find that an explanation to section 37(1) was inserted by the Finance (No.2) Act, 1998 with retrospective effect from lst April 1962. The explanation reads as follows: -

"Explanation: For the removal of doubts, it is hereby declared that 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 High Court accepted the reasoning of the Tribunal that loss of heroin held as a stock-in-trade was a business loss.  However, the High Court considered and applied the explanation to section 37(1) and observed as follows: -

"The assessee in this case was engaged in the profession of doctor.  He had nothing to do with the contraband article - heroin for carrying on his profession.  It is an admitted fact that the possession of heroin is an offence under the Narcotic Drugs and Psychotropic Substances Act.  In this view, the rigor of the Explanation to section 37 was fully satisfied and hence the question of claiming any deduction for the value of the seized article did not arise nor was the assessee entitled to claim any such deduction that was found indulging in such heinous and illegal business unconnected with this pious professional activity.  Indeed, it was a disgrace for the doctor community where on doctor was found indulging in such kind of activities against the humanity."

And with such observation the High Court denied the deduction of business loss by applying the explanation to section 37 and treating the value of heroin seized as expenditure.

High courts decision- an analysis:

The high court agreed that the finding of the Tribunal that heroin seized was a trading or business loss in other words it was a loss of a trading item. However, the high court applied section 37 read with newly inserted explanation thereto. And considering that holding of heroin was not only against law and public policy but also against humanity and it was a heinous act carried by a person engaged in pious profession of doctor. Thus the high court treated the loss as expenditure and on ground of illegality and immorality disallowed the loss.

Assesses appeal before the Supreme Court allowed:

The assessee preferred and appeal before the Supreme Court. The Supreme Court held that the loss claimed by the assessee is not an expenditure claimed or allowable u/s 37 and therefore, the explanation to section 37(1) is not applicable to the case of loss.  The business losses are allowable on ordinary commercial principles in computing profit and once it was found that heroin seized was 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 and loss of stock-in-trade has to be considered as a trading loss following the decisions of CIT v. S.N.S.A. Annamalai Chettiar [1972] 86 ITR 607; AIR 1973 SC 1032 and CIT v. Piara Singh [1980] 124 ITR 40; 3 Taxman 67 (SC).

An analysis of the reasoning and order of the Supreme Court:

a. High Court has adopted an emotional and moral approach rather than a legal approach, which was required while applying relevant provisions.

b. Agreeing with the High Court it was noted that the assessee was committing a highly immoral act in illegally manufacturing and selling heroin.

c. Courts are to decide cases on legal principles and not on one's own moral views.

d. Law is different from morality, as the positivist jurists Bentham and Austin pointed out.

e. The Tribunal and high court has considered, the facts that there was loss of stock-in-trade and such case is squarely covered by the decision of the Supreme Court in CIT v. Piara Singh [1980] 124 ITR 40.

f. 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.

g. Business losses are allowable on ordinary commercial principles in computing profits.

h. On finding 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.

i. Loss of stock-in-trade has to be considered as a trading loss vide CIT v. S.N.S.A. Annandale Chettiar [1972] 86 ITR 607;

Thus the judgment of the High Court was set aside and the order of the Tribunal was restored by the Supreme Court.

Conclusion:

Expenditure and loss are different items in accounting and commercial parlance as well as in the context of legal provisions like the income Tax Act.

The rules and exceptions applicable while considering allowability of expenditure may not applicable in case of consideration of business loss.

Business loss can be considered as per normal principles of accounting and commerce.

Other case of losses imbedded with illegality:

Some other cases of business or professional losses, which may have an element of illegality, immorality or against policy, are illustrated below:

a. loss of stocks in smuggling activity.

b.Loss of cash in profession of thief or robber.

c. Loss in business or profession of gambling prohibited speculation etc.

d. Loss of cash, stocks, or other valuable while transporting the same in the course of an illegal activity. For example, cash being carried to use for purchase of illegal stocks, or to use as bribes to officers may be lost in transit or may be seized by CBI or some other authority.

The above type of losses will be allowable as loss incidental to business or profession while computing income under section 28 read with S. 145, and cannot be considered as an item of "expenditure". Therefore, explanation to section 37(1) will not apply.