One of the incidental issues arising out of source-based taxation is regarding the allowability of taxes paid on business receipts in source jurisdiction as a business deduction under Section 37(1) of the IT Act, especially in view of the exclusion carved out under Explanation 1 to Section 40(a)(ii)^[1] of the IT Act.

Section 37(1) of the IT Act provides that any expenditure, other than a capital expenditure, which is laid out wholly & exclusively for the purpose of business may be allowed as a deduction whilst computing the business income of an assessee. However, Section 40(a)(ii) of the IT Act, excludes any taxes paid on profits or gains from business or profession, from the ambit of allowable business expenditures. In addition, thereto, under Explanation 1 to Section 40(a)(ii), taxes paid in foreign jurisdictions which are eligible for relief of tax under Section 90/91 of the IT Act, have also been excluded from the purview of allowable business expenses.

In such a scenario, the issue that arises for consideration is where the taxpayer is unable to claim benefit/relief of taxes paid in foreign jurisdiction owing to the restrictions envisaged in Sections 90/91, whether the said taxes can be claimed as a deduction under Section 37(1) of the IT Act.

This issue has been a matter of judicial debate and diverse positions have been adopted by different forums. Under the erstwhile Act^[2], the word “tax” was not defined and in the absence of any definition, the Hon’ble Bombay High Court in the case of S. Inder Singh v. CIT^[3], had taken a view that taxes paid by an assessee, whether in India or outside, were not allowable as a deduction.

However, with the enactment of the IT Act (i.e., the statute presently in force), which defines the term “tax” to mean and include “income tax chargeable under the provisions of this Act”^[4], the position with respect to the allowability of the foreign taxes as a business deduction, was also altered.

The Bombay High Court, subsequently, in the case of Reliance Infrastructure Ltd^[5], allowed deduction of taxes paid by the assessee in Saudi Arabia whilst computing the income of the assessee. In this case, the assessee had executed projects in Saudi Arabia and had paid taxes in respect of income earned from these projects. Whilst filing his return of income in India, the assessee claimed relief of taxes paid in India under Section 91 of the IT Act. In the alternative, the assessee also claimed deduction of taxes paid under Section 37(1) of the IT Act. Though the claim made by assessee under Section 91 of the IT Act, was denied as the income was exempt under Section 80HHB and 35B of the IT Act respectively. However, the alternative claim seeking deduction of taxes under Section 37(1) was allowed to the assessee in view of the restrictive definition of the term “tax” under Section 2(43) of the IT Act.

The ratio laid down in the case of Reliance Infrastructure Ltd (supra) was followed by the Ahmedabad Bench of the Tribunal in their recent decision rendered in the case of Virmati Software & Telecommunication Limited^[6]. In this case, the assessee had disclosed receipts from parties in Afghanistan in lieu of software development services. These payments had been subjected to withholding at the rate of 7% in Afghanistan. In the return of income, the assessee claimed deduction of these taxes under Section 91 of the IT Act. The Assessing Officer (‘AO’), however, allowed credit of only a portion of taxes in view of formula prescribed under clause (iii) to explanation of Section 91 of the IT Act. On appeal before the Tribunal, though the position adopted by the AO with respect to allowability of foreign tax credit under Section 91 of the IT Act, was affirmed, but the alternate claim of the assessee was allowed and deduction of these taxes under Section 37(1) of the IT Act, was permitted.

However, it would be relevant to highlight here that the Ahmedabad Bench of the Tribunal in a subsequent decision rendered in the case of DCIT v. Elitecore Technologies (P.) Ltd^[7], has adopted a contrary position. The Tribunal observed that use of the word “any” as a prefix to the word “tax” under Section 40(a)(ii) of the IT Act, goes to show that even taxes paid in foreign jurisdiction would be excluded from the ambit of allowable business expenditures.

Though the judicial opinion is divided, in the absence of any contrary ruling from a High Court, the ratio laid down by the Bombay High Court would continue to have precedence over the subsequent decision of the Ahmedabad Tribunal and taxpayers may be able to claim benefit of the taxes paid by them in foreign jurisdictions, which are otherwise not eligible for relief under Sections 90/91 of the IT Act.

[1] Amounts not deductible.

40. Notwithstanding anything to the contrary in Sections 30 to 38, the following amounts shall not be deducted in computing the income chargeable under the head “Profits and gains of business or profession”,—

(a) in the case of any assessee—

(ii) any sum paid on account of any rate or tax levied on the profits or gains of any business or profession or assessed at a proportion of, or otherwise on the basis of, any such profits or gains.

Explanation 1.—For the removal of doubts, it is hereby declared that for the purposes of this sub-clause, any sum paid on account of any rate or tax levied includes and shall be deemed always to have included any sum eligible for relief of tax under Section 90 or, as the case may be, deduction from the Indian income-tax payable under Section 91.

Explanation 2.—For the removal of doubts, it is hereby declared that for the purposes of this sub-clause, any sum paid on account of any rate or tax levied includes any sum eligible for relief of tax under Section 90A.

[Explanation 3.—For the removal of doubts, it is hereby clarified that for the purposes of this sub-clause, the term “tax” shall include and shall be deemed to have always included any surcharge or cess, by whatever name called, on such tax;]”

[2] The Income Tax Act, 1922.

[3] [1963] 47 ITR 284 (Bom. HC).

[4] Refer Section 2(43) of the IT Act.

[5] [2017] 390 ITR 271 (Bombay).

[6] [2022] 145 taxmann.com 134 (Ahmedabad – Trib.).

[7] [2017] 58 ITR(T) 131 (Ahd. Trib.).