Section 37 of the Income Tax Act

Part of Chapter IV-D: Computation of Profits and Gains of Business or Profession

Section 37 is present in Chapter IV-D, dealing with the calculation of income from business or profession. Although Sections 30 to 36 specifically specify deductible expenses like rent, repairs, depreciation and insurance, Section 37 of the Income Tax Act serves as the portal for all other revenue expenditures not mentioned separately elsewhere in the chapter.

Applicability: For Expenses Not Covered Under Sections 30–36

Sections 30 to 36 enumerate specific deductible expenses like rent, repairs, insurance, depreciation and wages. Special provisions separately cover these expenses; Section 37 provides a residuary clause for all other legitimate expenses not explicitly covered in these sections.

This ensures that only real, operational expenses directly attributable to the business or profession are allowed under Section 37.

Allowability Conditions under Section 37(1)

To deduct under Section 37(1) of the Income Tax Act, the following requirements must be met:

• The expense should not be of a capital nature.
• It should not be for personal expenditure.
• The expenditure cannot fall under Sections 30 to 36.
• The expense should be spent wholly and exclusively for the business or profession.
• The expenditure should not be incurred for any purpose that is an offence or is against the law, such as bribes, fines, or penalties.
• The expenses must be incurred in the relevant previous year for deduction.

If any of these conditions are not met, the deduction under Section 37(1) of the Income Tax Act will be disallowed.

Explanation to Section 37(1): Disallowance of Certain Expenses

The Act has clear provisions to Section 37(1) that specify disallowances:

• Explanation 1: No deduction can be made for any expense incurred on purposes that are an offence or prohibited under the law. This clearly removes bribes, penalties, fines or any penalties for tax evasion from being deductible.
• Explanation 2: Corporate Social Responsibility (CSR) costs, which are mandatory and required under Section 135 of the Companies Act 2013, will not be deductible even if they are obligatory for the company. This disallowance was clarified through amendments introduced post-2014 to prevent CSR expenses from being claimed as business deductions.
• Explanation 3: Reiterates that any expenditure incurred directly or indirectly for illegal or prohibited purposes is disallowed under Section 37 of the Income Tax Act.

These explanations safeguard the Act against misuse of Section 37 for illegitimate expenses.

Types of Expenses Typically Allowed Under Section 37

Section 37 income tax provides an allowance for a broad spectrum of revenue expenses, including but not limited to:

• Fees for Professional and Legal: Payments made to auditors, lawyers, consultants and other professionals for professional services.
• Audit Fees: Statutory and tax audit fees paid to accountants or auditors.
• Advertising and Marketing: Advertising expenses made in print, digital media and other media (excluding political campaign advertisements).
• Rent, Travelling, Communications: Rent for offices, travelling for business purposes, telephone and internet expenses, if business-related.
• Insurance Premiums: Premiums on insuring business assets or liabilities.
• Interest on Business Loans: Interest on loans borrowed solely for business (excluding capital asset purchase loans).
• Employee Welfare and Salaries: Salaries, wages, bonuses and welfare expenses paid to employees.
• Loan Raising Expenses: Brokerage, stamp duty and registration costs incurred while obtaining business loans.
• Repairs and Maintenance: Cost of maintaining business assets minus capital improvements.

These costs are regularly accepted under Section 37 of the Income Tax Act, subject to the conditions prescribed.

Capital vs Revenue Expenditure under Section 37

Treatment of Deferred Revenue Expenditure

Some expenses, such as major advertisements for the launch of a new product, are classified as deferred revenue expenditures. Suppose they are revenue-based and are incurred only for business purposes. In that case, they can be deducted by amortisation spread over time, usually up to 5 years, instead of being brought to account immediately.

Disallowances Under Section 37: Common Mistakes

A few typical mistakes result in disallowances according to Section 37 of the Income Tax Act:

• Mixing Personal with Business Expenditure: Charging family travel or personal telephone expenses as business expenditure is disallowed.
• Claiming CSR Costs Incorrectly: As much as CSR expenditure under the Companies Act is compulsory, it is not deductible according to Section 37.
• Claiming Fines or Costs Connected with Illegal Acts: Fines, penalties or bribes, despite the business context, are purely non-deductible.

Avoiding these errors is critical for compliance and effective tax planning.

How to Claim - Documentation and Best Practice

In order to effectively claim under Section 37(1) of the Income Tax Act:

• Retain Vouchers, GST Invoices, Bank Statements and Proof of Payment: Proper documentation is crucial in order to prove expenses claimed.

• Ensure Clear Linkage to Business Activity: All expenses must directly link to business activity.
• Ensure Consistency Throughout Financial Years: Proper accounting of the relevant previous year is required both in books and tax returns.
• Reporting in ITR: Fill out the correct Income Tax Return form (ITR-3 for individuals/HUFs, ITR-5 for firms/LLPs and ITR-6 for companies) and report expenses under the head "Profits and Gains of Business or Profession."

Proper documentation and a clear business purpose minimise the risk of disallowance during assessments and help avoid costly reassessments or disputes with tax authorities.

Conclusion

Section 37 of the Income Tax Act is a foundational provision that allows the deduction of genuine business expenses not allowed in Sections 30 to 36. It seeks to ensure that costs of working incurred entirely for business or professional purposes reduce taxable income, thus reducing the overall tax liability and ensuring accurate taxable income.

To have effective tax compliance and maximise benefits under Section 37, it is necessary to keep careful records and consult experts. This approach helps guide complex disallowances and compliance challenges, guarantees adherence to statutory needs and protects against disallowance and penalty.