Breach of Contract Damages Are Not Penalties, Income Tax Deduction Allowed: ITAT:

Breach of Contract Damages Are Not Penalties, Income Tax Deduction Allowed: ITAT AXA Parenterals Limited has filed an appeal before the Income Tax Appellate Tribunal (ITAT), Delhi, challenging an order dated July 29, 2025, passed by the CIT(A)/NFAC, New Delhi. The case is related to the Assessment Year 2020-21. The impugned order had sustained an addition amounting to Rs. 3,291,211 made to the assessee's income on the grounds of a penalty imposed for late supply of goods from the assessee's income vide an assessment order dated September 23, 2022. Previously, the assessee had filed its income tax return (ITR) for the year in consideration, declaring total income at Rs. 17.36 crore. The return was successfully processed and a demand amounting to Rs. 369,860 was raised on the assessee's income. Later the case was selected for scrutiny under assessment Scheme, 2019 on the grounds of large sales promotion expenses vis-is gross receipts and huge loss from currency fluctuations.

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The Assessing Officer (AO) noticed that the assessee had claimed expenses of about Rs. 32.91 lakh as expenses for penalty due to late supply of goods. The company explained that the government deducted this amount as per the tender rules and said it was a normal business expense under Section 37. However, the AO rejected this claim, saying the company was regularly delaying supplies, which he treated like an offence under Explanation 1 to Section 37. In conclusion, the AO disallowed the expense and made an addition of the same to the assessee's income and began penalty proceedings under Section 270A. The assessee, being aggrieved with the aforesaid decision, challenged the same before the ITAT Delhi. During the hearing, the assessee explained that the deduction was part of contractual terms and not related to any crime or prohibited act. It further argued that damages for breach of contract are different from penalties for legal offences and should be permitted as business expenditure as per the law. Additionally, raised an argument that the CIT(A) upheld the AO’s decision without properly analysing the issues or giving detailed reasoning.

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When the tribunal analysed the case in depth, it noted that lower authorities misunderstood the law. The Tribunal noted that Explanation 1 to Section 37 only disallows expenses linked to illegal acts or offences, whereas delayed supply under a contract is simply a breach of contractual terms and not a crime. The payments were therefore compensatory in nature and part of regular business operations. Since the expense was incurred wholly for business purposes, it was allowable. Accordingly, the tribunal set aside the impugned order and allowed the assessee's appeal in full.