Disallowance of settlement amounts being paid to settle contraventions

Disallowance of Settlement Amounts:

Section 37 of the Act, stipulates that expenditures must be incurred solely for business or professional purposes to be considered allowable.

Explanation 1 of subsection (1) of Section 37 states that any expenses incurred by an assessee for activities that constitute an offense or are prohibited by law will not be recognized as business or professional expenditures, and thus, no deductions or allowances will be granted for such expenses.

Explanation 3 of subsection (1) of Section 37 further clarifies that the term “expenditure incurred by an assessee for any purpose which is an offense or which is prohibited by law,” as mentioned in Explanation 1, inter alia encompasses expenses related to any illegal activities or violations of laws, whether enacted in India or abroad.

However, there was need of clarification in case of payments made to settle legal contraventions. Whether these payments which are associated with violations of the law should qualify as deductible business expenses?

Finance Act 2024 clarified the above issue by making an amendment to Explanation 3 of subsection (1) of Section 37 which explicitly adds one more clause stating that “any expenditure incurred by an assessee to settle proceedings initiated in relation to a contravention under any law for the time being in force, as may be notified by the Central Government in the Official Gazette in this behalf.” The amendment is proposed to be made effective from the 1st day of April, 2025 and will accordingly apply from assessment year 2025-2026 onwards.