Allowability of Expenditure towards Corporate Social Responsibility

Issue for Consideration

Explanation 2 to Section
37(1) declares that, for the removal of doubts, any expenditure incurred by an
assessee on the activities relating to corporate social responsibility referred
to in section 135 of the Companies Act, 2013 shall not be deemed to be an
expenditure incurred by the assessee for the purposes of business or
profession.

Companies Act, 2013 has made it mandatory for certain
companies to spend at least 2% of the average net profits towards Corporate
Social Responsibility (‘CSR’) as per the policy formulated by the CSR committee
of the company in this regard. While this is the first time a statutory
obligation has been cast upon companies to incur expenditure in the social or
charitable sphere, it is not uncommon for corporate as well as non-corporate
assessees to voluntarily incur charitable expenditure, which may or may not
have a direct nexus to their business operations.

Where such expenditure is expected to benefit the business in
some manner, either by benefitting its employees or by creating goodwill within
the community at large, it is usually claimed as business expenditure under
section 37(1). The issue has arisen on the allowability of such expenditure, on
account of conflicting decisions of the Tribunal. While the Raipur Tribunal has
upheld the claim in the specific facts of the case, the Bengaluru Tribunal has
taken a contrary view, disallowing the claim in respect of charitable expenses.

Jindal Power Limited’s case

The issue came up before
the Raipur Tribunal in the case of ACIT vs. Jindal Power Ltd. 179 TTJ 736.

In the said case, during
assessment year 2008-09, the company had claimed deduction in respect of
expenditure incurred on construction of school building, devasthan/temple,
drainage, barbed wire fencing, educational schemes and distributions of clothes
etc. voluntarily. Without much of a discussion on the factual aspects, the AO
observed that no material had been placed to substantiate the claim or in
support of existence of the facts of development activities. The AO also placed
reliance on the decision of the Patna Tribunal in the case of Central
Coalfields Ltd. for assessment years 1983-84 to 1986-87, wherein it was held
that the expenses were in the nature of charity and though laudable, they could
not be said to have been incurred for the purpose of business.

The CIT(A) made detailed observations on CSR stating that
“CSR policy functions as a built-in, self-regulating mechanism whereby a
business monitors and ensures its active compliance with the spirit of the law,
ethical standards, and international norms. The goal of CSR is to embrace
responsibility for the company’s actions and encourage a positive impact
through its activities on the environment, consumers, employees, communities,
stakeholders and all other members of the public sphere who may also be
considered as stakeholders. CSR is titled to aid an organization’s mission as
well as a guide to what the company stands for and will uphold to its
consumers.” Further, the CIT(A) noted the CSR policy of the assessee company
and that the expenses incurred on water supply for perennial availability of
portable water, roads and culverts, toilets and others, water tanks, other
community works, temple renovation, school building renovation etc. in the
villages for up-gradation as well as expenses for the welfare of the employees
were a part of implementation of CSR policies of the company. The assessee
relied upon various decisions including the decisions in the case of SECL 85
ITD 608 (Nag.) and Madras Refineries Ltd. 266 ITR 170 (Mad.).
Applying the ratio of the said decisions, the CIT(A) held that the expenditure
under the above heads incurred by the appellant company as a good corporate
citizen and as measure of gaining goodwill of the people living in and around
its industries through the aforesaid activities were admissible expenditures.
Only those expenses, which were neither substantiated with proper evidences nor
had any nexus with the CSR policies of the appellant company, were disallowed.

In the appeal before the Tribunal, the fundamental objection
of the AO was that the expenses were voluntary, not mandatory and not for
business purposes. In respect of the contention that expenses, which were
voluntary in nature and not mandatory, were not admissible as deduction, the
Tribunal referred to the judgment of House of Lords in the case of Atherton
v. British Insulated & Helsbey Cables Ltd. 10 Tax Cases 155 (HL), which
has been approved by the Supreme Court in the case of Chandulal Keshavlal &
Co. 38 ITR 601, wherein it was held that a sum of money expended not with a
necessity and with a view to direct immediate benefit to the trade, but
voluntarily and on the grounds of commercial expediency and in order to
indirectly facilitate carrying on of business, may yet be expended wholly and
exclusively for the purpose of the trade and hence be admissible. The Tribunal
also considered the decision of the Supreme Court in the case of Sassoon J
David & Co. (P) Ltd. 118 ITR 261, which laid down the principle that
the fact that somebody other than the assessee also benefited by the
expenditure should not come in the way of an expenditure being allowed by way
of deduction if it otherwise satisfied the tests laid down by law.

Further, on the contention of whether such expenses were for
the purpose of business or not, the Tribunal referred to the decision in the
case of Hindustan Petroleum Corporation Ltd 96 ITD 186 (Mum.) which held
that there could be certain amounts, though in the nature of donations, which may
be deductible under section 37(1) as well and merely because an expenditure was
in the nature of donation, or ‘promoted by altruistic motives’, it did not
cease to be an expenditure deductible under section 37(1). It also took into
consideration the decision in the case of Madras Refineries Ltd. (supra),
wherein it was observed that monies spent by the assessee as a good corporate
citizen and to earn the goodwill of the society help creating an atmosphere in
which the business can succeed in a greater measure with the help of such
goodwill, and therefore, were required to be treated as business expenditure
eligible for deduction under section 37(1) of the Act.

The Tribunal noted that Explanation 2 to Section 37(1) was
introduced with effect from 1^st April 2015 and observed that it
could not be construed to the disadvantage of the assessee in the period prior
to this amendment. It further noted that this disabling provision referred only
to such CSR expenses incurred under Section 135 of the Companies Act, 2013,
and, as such, it could not have any application for the period not covered by
this statutory provision, which itself came into existence in 2013. It also
placed reliance on the principle of lex prospicit non respicit (law looks
forward not backward) laid down in the Supreme Court’s five judge
constitutional bench’s landmark judgment, in the case of Vatika Townships
Pvt Ltd 367 ITR 466 (SC), that unless a contrary intention appeared,
legislation was presumed not to be intended to have a retrospective operation
and that law passed today could not apply to the events of the past. The
Tribunal also reiterated the well settled legal position that when a
legislation conferred a benefit on the taxpayer by relaxing the rigour of
pre-amendment law, and when such a benefit appeared to have been the objective
pursued by the legislature, it would be a purposive interpretation giving it a
retrospective effect, but when a tax legislation imposed a liability or a
burden, the effect of such a legislative provision could only be prospective.

Interestingly, the
Tribunal observed that the disallowance was restricted to the expenses incurred
by the assessee under a statutory obligation under section 135 of Companies Act
2013, and thus, there was now a line of demarcation between the expenses
incurred by the assessee on discharging CSR under such a statutory obligation
and under a voluntary assumption of responsibility. The Tribunal further held
that for the former, the disallowance under Explanation 2 to Section 37(1) came
into play, but, as for the latter, there was no such disabling provision as
long as the expenses, even in discharge of corporate social responsibility on
voluntary basis, could be said to be “wholly and exclusively for the
purposes of business”.

Thus, based on all the
aforesaid arguments, since the expenses in question were not incurred under the
statutory obligation, as also for the basic reason that Explanation 2 to
Section 37(1) came into play with effect from 1st April 2015, the Tribunal
concluded that the disabling provision of the said Explanation did not apply to
the facts of this case.

Kanhaiyalal Dudheria’s case

The issue once again came
up for consideration before the Bengaluru Tribunal in the case of Kanhaiyalal
Dudheria v. JCIT 165 ITD 14 

In this case, during assessment year 2011-12, the assessee
firm claimed deduction in respect of expenditure incurred on construction of
houses under an MOU with the Government of Karnataka, that were later handed
over to the Government for helping the people affected by floods. The assessee
claimed that the said expenditure was incurred to yield benefit in the form of
goodwill and therefore, the same was allowable as business expenditure. The AO,
after referring to the MOU, came to the conclusion that the said expenditure
was not incurred wholly and exclusively for the purpose of business and
therefore held that the same was not allowable as deduction u/s 37(1) of the
Act. The CIT(A) upheld the order of the AO.

In the appeal before the Tribunal, the assessee firm relied
on the decisions in the case of Jindal Power Ltd. (supra) and Infosys
Technologies Ltd. 360 ITR 714 (Kar.) stating that on account of incurrence
of expenditure, goodwill was created in the people in the surrounding villages,
which would help in carrying out business and thus,
the expenditure should be allowed as a deduction. On behalf of the revenue, it
was argued that the said expenditure was towards charity and it was nothing but
application of income. The revenue drew support from the decision in the case
of Badrinarayan Shrinarayan Akodiya 101 ITR 817 (MP).

The Tribunal, relying on the decision in the case of Sassoon
J. David & Co. (P.) Ltd. (supra), emphasized that although for claiming
deduction u/s 37(1), it was not required to establish the necessity of
incurring of such expenditure, the onus lay on the assessee to prove that the
expenditure was incurred for the purpose of business. Since in the facts of the
case, the assessee did not establish that the expenditure was incurred for business
purpose, the Tribunal held that the expenditure amounted to application of
income voluntarily towards charity which could not be allowed as a deduction.

The Tribunal also noted that it cannot be said that the
appellant had incurred this expenditure wholly and exclusively for the purpose
of business since there was no nexus between the expenditure incurred and the
benefit derived by the business of the assessee.

Observations

Prior to insertion of
Explanation 2, section 37(1) along with Explanation 1 laid down a four-fold
test for any expenditure to be allowable in computing the income under the head
“Profits and gains of business or profession” –

–    it must
not be of the nature described in sections 30 to 36;

–    it must
not be capital or personal in nature;

–    it must
be laid out or expended wholly and exclusively for the purposes of business or
profession; and

–    it must
not be incurred for a purpose which is an offence or which is prohibited by
law.

There was no requirement,
however, to prove the necessity of incurring such expenditure. In other words,
whether the expenditure was incurred on account of a statutory obligation or
otherwise, did not have a bearing on the allowability of the expenditure.
Expenses in the nature of CSR were considered to be allowable or not allowable
as a deduction in light of the above tests.

It is common for many
taxpayers to contribute to the betterment of their employees and their
families, or the community or society, or the locality where their business
operations are based, etc. in a variety of ways. In most of the cases, there is
some perceived benefit to the business operations, either in the form of better
morale and productivity of employees or through generation of goodwill and
reputation for the business. As a result, in all such cases, the expenditure is
considered to have been spent for the purposes of the business and claimed as
deduction against the business profits. However, in cases where the spending is
not connected with the business of the assessee in any manner whatsoever, it
partakes the character of donation or charity and is not an allowable
expenditure under section 37(1).

At the same time, the mere
fact that a particular expenditure is in the form of donation, more
particularly eligible for deduction under section 80G, would not by itself
imply that it is not deductible under section 37(1). In the case of Mysore
Kirloskar Ltd. v. CIT 166 ITR 836 (Kar.), which was referred to in the case
of Infosys Technologies Ltd. (supra), it was held that if the contribution
by an assessee was in the form of donations of the category specified under
section 80G, but if it could also be termed as an expenditure of the category
falling under section 37(1), then the right of the assessee to claim the whole
of it as allowance under section 37(1) could not be denied if it was “laid
out or expended wholly and exclusively for the purpose of business”.

The debate on the
voluntary nature of the expenses and the necessity of incurring such
expenditure has been definitively settled in the case of Sassoon J. David
and Co. (P.) Ltd. (supra), where the issue arose on deductibility
under section 10(2)(xv) of the Income-tax Act, 1922 (corresponding to section
37(1) of the Income-tax Act, 1961) of expenditure on retrenchment compensation
incurred voluntarily. The Apex Court in the said case has observed as under –

“It has to be observed here that the expression “wholly and
exclusively” used in section 10(2)(xv) of the Act does not mean
“necessarily”. Ordinarily it is for the assessee to decide whether
any expenditure should be incurred in the course of his or its business. Such
expenditure may be incurred voluntarily and without any necessity and if it is
incurred for promoting the business and to earn profits, the assessee can claim
deduction under section 10(2)(xv) of the Act even though there was no
compelling necessity to incur such expenditure. It is relevant to refer at this
stage to the legislative history of section 37 of the Income-tax Act, 1961
which corresponds to section 10(2)(xv) of the Act. An attempt was made in the
Income-tax Bill of 1961 to lay down the “necessity” of the
expenditure as a condition for claiming deduction under section 37. Section
37(1) in the Bill read “any expenditure. . . . laid out or expended wholly,
necessarily and exclusively for the purposes of the business or profession
shall be allowed” The introduction of the word “necessarily” in
the above section resulted in public protest. Consequently when section 37 was
finally enacted into law, the word “necessarily” came to be dropped.
The fact that somebody other than the assessee is also benefited by the
expenditure should not come in the way of an expenditure being allowed by way
of deduction under section 10(2)(xv) of the Act if it satisfies otherwise the
tests laid down by law.”

Although the facts in the
above case were different and the issue under examination was in respect of
retrenchment compensation, the ratio laid down by the Supreme Court in respect
of allowability of voluntary expenditure under section 10(2)(xv) of the 1922
Act and section 37(1) of the 1961 Act would be applicable even in case of CSR
expenditure incurred by taxpayers without any statutory requirement or any
other compulsion.

The issue that remains
disputed then is, in which cases or under what circumstances, will the
expenditure be considered to be “wholly and exclusively for the purposes of the
business or profession”? Here again, the courts have agreed that the words
“for the purpose of business” used in section 37(1) should not be
limited to the meaning of “earning profit alone” and that business
expediency or commercial expediency may require providing facilities like
school, hospital, etc., for the employees or their families. It has also been
held that any expenditure laid out or expended for their benefit, if it
satisfied the other requirements, must be allowed as deduction under section
37(1) of the Act. However, the onus of establishing the nexus between the
expenditure incurred and the business and proving that the expenditure
“satisfies the other requirements” must be discharged by the assessee. The
Supreme Court in the case of Chandulal Keshavlal & Co. (supra) has laid
down certain tests in this regard as under –

“Another fact that
emerges from these cases is that if the expense is incurred for fostering the
business of another only or was made by way of distribution of profits or was
wholly gratuitous or for some improper or oblique purpose outside the course of
business then the expense is not deductible. In deciding whether a payment of
money is a deductible expenditure one has to take into consideration questions
of commercial expediency and the principles of ordinary commercial trading. If
the payment or expenditure is incurred for the purpose of the trade of the
assessee it does not matter that the payment may inure to the benefit of a
third party—Usher’s Wiltshire Brewery v. Bruce 6 TC 399 (HL). Another test is
whether the transaction is properly entered into as a part of the assessee’s
legitimate commercial undertaking in order to facilitate the carrying on of its
business ; and it is immaterial that a third party also benefits thereby —
[Eastern Investments Ltd. v. CIT [1951] 20 ITR 1 (SC)]. But in every case it is
a question of fact whether the expenditure was expended wholly and exclusively
for the purpose of trade or business of the assessee.”

[Emphasis supplied]

The above principle
emerges in both the cases discussed in this article. In the case of Jindal
Power Limited (supra), even though CSR expenses were allowed based on an
understanding of the need for CSR by businesses and that these expenses were a
part of the implementation of the CSR policy of the company, the Tribunal
disallowed those expenses which were not substantiated with evidence and were not
in line with the company’s CSR policy. Similarly, in the case of Kanhaiyalal
Dudheria (supra), deduction of expenses was not allowed on account of failure
on part of the assessee to establish that the expenditure was incurred for
business purpose.

The introduction of
statutory provisions for CSR in Companies Act, 2013 and a corresponding
amendment in the Income-tax Act, 1961 has added another dimension to the
existing controversy.

Section 135 of the
Companies Act, 2013 mandates that every company having –

–    net
worth of Rs. 500 crores or more, or

–    turnover
of Rs. 1,000 crores or more, or

–    net
profit of Rs. 5 crores or more

during any financial year,
shall spend, in every financial year, at least 2% of its average net profits
towards CSR activities as per the CSR policy of the company. It further states
that the company shall give preference to the local area and areas around where
it operates for the CSR spending.

On the one hand, the above
provisions make it mandatory for certain Companies to undertake charitable
spending, while, on the other hand, Finance (No. 2) Act, 2014 introduced
Explanation 2 to section 37(1) with effect from 1st April 2015, to read as
under –

“For the removal of doubts, it is hereby declared that for the purposes
of sub-section (1), any expenditure incurred by an assessee on the activities
relating to corporate social responsibility referred to in section 135 of the
Companies Act, 2013 (18 of 2013) shall not be deemed to be an expenditure
incurred by the assessee for the purposes of the business or profession.”

The above explanation
states that CSR expenditure shall not be deemed to have been incurred for the
purposes of business. Consequently, such expenditure is not allowable as a
deduction. The Explanatory Memorandum to the Finance Bill states that the
objective of CSR is to share the burden of the Government in providing social
services by companies having net worth/turnover/profit above a threshold and if
such expenses are allowed as tax deduction, this would result in subsidising of
around one-third of such expenses by the Government by way of tax expenditure.
However, it also states that the CSR expenditure which is of the nature
described in section 30 to section 36 of the Act shall be allowed as a
deduction under those sections subject to fulfillment of conditions, if any,
specified therein.

By declaring that
statutory CSR expenditure is not deemed to have been incurred for the purpose
of business, rather than clarifying that such expenditure is not an allowable
expense, Explanation 2 to section 37(1) may end up adding another angle to the
issue. It may be possible to take a view that Explanation 2 to section 37(1)
merely clarifies that the statutory CSR expenditure is not automatically deemed
to have been incurred for the purpose of business on account of the legislative
obligation (as was the presupposition in the arguments against allowability of
voluntary CSR expenses). In other words, statutory CSR expenditure would also
be considered to be incurred for the purposes of business and therefore be
deductible, so long as it satisfies the other tests and requirements discussed
earlier. The fact that the legislature intends to allow CSR expenditure of the
nature described in sections 30 to 36 would imply that the expenditure ought to
be allowed as a deduction if it is otherwise deductible.

Nevertheless, it is
pertinent to note that the explanation only makes a reference to the
expenditure incurred on CSR activities referred to in section 135 of the
Companies Act, 2013 and not to all expenditure in the nature of CSR. Further,
the explanation has been prospectively inserted with effect from 1^st April
2015. Interestingly, the case of Jindal Power Limited (supra) pertains
to the period prior to the amendment. The Raipur Tribunal had rightly held that
since Explanation 2 was inserted prospectively and as it was a disabling
provision, it did not apply in that case to the expenditure incurred prior to
the amendment. This clearly implies that CSR expenditure, whether statutory or
voluntary, incurred prior to assessment year 2015-16 would be allowable,
provided it meets the other requirements of section 37(1). Additionally, the
Tribunal observed that there was now a clear distinction between statutory and
voluntary CSR expenditure and that the restriction placed in Explanation 2 to
section 37(1) would at best apply to the CSR expenditure incurred under the
statutory requirements. In other words, if any assessee – company or other than
company – voluntarily spends on CSR activities, whether prior to or after the
Companies Act, 2013 became applicable, the said expenditure would be allowable,
as long as it can be demonstrated to be incurred “wholly and exclusively for
the purposes of business or profession”.

Also noteworthy is the
fact that the CSR expenditure is mandated in the Companies Act, 2013 only for
companies and any expenditure of similar nature by non-corporates will always
be of a voluntary character, as in the case of Kanhaiyalal Dudheria (supra). As
the explanation makes a specific reference to section 135 of the Companies Act,
2013, the question of invoking the same for CSR expenditure incurred by
non-corporate entities does not arise. Quite aptly, therefore, Explanation 2
has not been considered in Kanhaiyalal Dudheria’s case and the allowability of
the CSR expenditure has been decided on the basis of settled principles in
respect of section 37(1) prior to the amendment.

Last but not the least, a
question may arise regarding the validity of the restriction imposed by
Explanation 2 to section 37(1). Where an expenditure is required to be
statutorily incurred and failure to comply with such statutory requirements
could attract penalties, it has a direct nexus to the business of the taxpayer.
In our view, deeming such an expenditure to not be for the purpose of business
or profession is inappropriate. In fact, if similar expenses incurred before
the imposition of the statutory obligation have been held to be deductible, the
deeming fiction was not desired in view of the existing safeguards in place in
section 37(1). Ironically, even after the amendment, the following category of
expenditures will still be allowable as a deduction –

–    CSR
expenses incurred by non-corporate entities, which are demonstrated to be laid
out for the purposes of business or profession;

–    CSR
expenses incurred voluntarily by companies; and

–    CSR expenses incurred by companies in
discharge of the obligation under section 135 of the Companies Act, 2013, which
are covered under section 30 to 36 of the Income-Tax Act, 1961.