1. This is a reference on a case state under s. 256(1) of the I.T. Act, 1961 (referred to hereinafter as 'the said Act'). the question referred to us for our determination is as follows :
'Whether, on the facts and in the circumstances of the case, the said sum of Rs. 2,73,513 paid by the assessee to the Government was an admissible deduction under the Income-tax Act, 1961 ?'
2. We may now set out briefly the facts giving rise to the reference. The assessee is a company incorporated under the Companies Act, 1956, and it carries on the business of manufacturing chemical fibres. The relevant assessment year is 1968-69, for which the relevant previous year is the one ended on September 30, 1067. On January 19, 1965, the assessee was granted an advance import license of the c.i.f. value of Rs. 15,00,000, under the Art Silk Export promotion Scheme, by the Central Govt., for importing raw materials, subject to certain conditions. For the compliance with the said conditions, the assessee on November 9, 1965, executed a bond in favor of the President of India for the sum of Rs. 13,67,565.79, and National and Grindlays Bank Ltd. stood as surety in respect of the said bond. Under the said bond, which was entered into by the assessee in favor of the President of India as aforesaid, the assessee bound itself to pay to the Government the sum of Rs. 13,67,565.79. The recitals in the bond show that the consideration of the bond was that the Joint Chief Controller permitted the assessee to import and clear the goods specified in the schedule thereto. The relevant provisions of the bound run as follows :
'If the said importers shall within six months or such further time as may be granted by the said Joint Chief Controller, export art silk fabrics of the value equal to 143 per cent. of the c.i.f. value of the imported goods to foreign countries excluding Nepal, Tibet, Sikkim, Bhutan and former Portuguese possessions in India or fulfill our (sic) obligation here under by transfer of import entitlements from other manufactures exporters of art silk fabrics as per condition 3 of the license mentioned above. Secondly, if the said importers and/or their surety shall procure and deliver or cause to be procured and delivered to the Joint Chief Controller within one month from the date of expiry of the aforesaid period evidence to prove that the said art silk fabrics of the value equal to 143 per cent. of the c.i.f. value of the imported goods have been exported as aforesaid and also evidence such as bills of landing, invoices, bank certificates, etc., showing that the rupee equivalent of the foreign exchange received in payment of the f.o.b. value of the goods so exported is not less than 143 per cent. of the c.i.f. value of the imported goods against the aforesaid licenses, then the above written bond shall be void and of no effect. Otherwise, the bond will be and remain in full force and effect.'
3. Declaration (c) in the said bond is to the effect that the said bond is entered into under the orders of the Central Govt., for the performance of an act in which the public are interested.
4. As per the license granted to the assessee, the assessee was allowed total imports of Rs. 14,95,266 and was under an obligation to export art silk fabrics under the said bound of the value of Rs. 21,43,235, which exports were to be completed by November 8, 1966. The assessee fulfilled a major part of its obligation through its own exports within the due date, except for a shortfall amounting to Rs. 2,73,513. The assessee did not consider it necessary to approach the Central Govt. for a formal extension of the time for discharging its obligations regarding the balance of the export, as the assessee felt that a modest delay would be acceptable to the government. The Central Govt., however, forfeited the guaranteed amount to the extent of Rs. 2,73,513. The said amount was deposited by the National and Grindlays Bank Ltd. with the Government and the assessee later on reimbursed the said bank in respect of the said amount. The facts found by the Tribunal are that the assessee completed the entire amount of export required by the said bond by December, 1966, that is after a delay of about a month. In the course of the assessment proceedings for the said assessment year the assessee claimed a deduction in respect of the sum of Rs. 2,73,513 on the ground that it was expenditure incurred wholly and exclusively by the assessee for the purposes of its business and was an expenditure incurred in connection with the infraction of administrative regulations. The ITO disallowed this expenditure in the computation of the assessee's income. This view of the ITO was upheld by the AAC on an assessee's income. This view of the ITO was upheld by the AAC on an appeal preferred by the assessee. The assessee then preferred a second appeal to the Income-tax Appellate Tribunal. The Tribunal took the view that the said a mount paid by the assessee, namely, the amount of Rs. 2,73,513, was not paid by the assessee by way of a penalty but only by way of damages. The Tribunal also held that no violation of public policy was involved in the transaction and that the assessee had not committed any breach of the law of the land and, on the basis of these reasons, the Tribunal allowed the appeal of the assessee and held that the said amount of Rs. 2,73,513 was an allowable deduction. It is from this decision of the Tribunal that the aforesaid question has been referred to us.
5. Chapter IV of the said Act deals with the computation of the total income for the purpose of the said Act. Section 37 is a section dealing with deductions which are to be allowed in the computation of the total income of an assessee for the purpose of assessment. It is not at all necessary to set out the provisions of that section here. Suffice it to say that it grants a deduction of expenditure, not being of the nature described in ss. 30 to 36 and s. 80VV and not being in the nature of capital expenditure or personal expenses of the assessee laid out or expended wholly and exclusively for the purposes of the business or profession of the assessee. The submission of Mr. Joshi, learned counsel for the Commissioner, is that the assessee has to pay the said amount by way of penalty as the assessee committed a breach of his statutory obligation, as the assessee had failed to export art silk fabrics to foreign countries as it had agreed to do under the said bound, and there was a shortfall in export in the said amount in terms of the bond. It was urged by him that the assessee had to pay the said amount as it had committed a breach of law or a regulation having statutory force and the payment of such an amount could not be regarded as normal expenditure incidental to business. It was submitted by Mr. Joshi that this amount paid by the assessee could not be regarded as having been paid by way of damages for the breach of a contract and, in any even, it could not be regarded as expenditure laid out or made wholly and exclusively for the purposes of the business or profession of the assessee. It might be connected with the business of the assessee but was in no way incidental to it. It was on the other hand contended by Mr. Vyas that the said amount which the assessee had to pay was an amount which it had to pay by reason of a breach of a condition of the bond which was, in its nature, a contract. It was submitted by him that the bond was executed by the assessee as normal incident of its business and in order to earn import entitlements. It was not as if the bond could be said to have any statutory force. It was merely a contract entered into pursuant to the export policy of the Government, even the said policy having no statutory force. The facts found, according to Mr., Vyas, are that the assessee had committed this breach not deliberately but it was unable to fulfill the export quota in time, and that, in fact, the assessee had, within one month of the period prescribed by the bond, completed its entire export obligation. It was urged by him that, in these circumstances, the said amount which the assessee had to pay was amount which it had to pay by way of damages for a breach of contract and that the said breach was purely incidental to and connected with the trade or business of the assessee.
6. Before going into a discussion of the submissions urged by the counsel and the case law on the subject, we may point out that as observed by Lord Loreburn in Strong and Co. of Romsey Ltd. v. Woodifield  5 TC 215, it is impossible to frame any formula which shall describe what is a loss connected with or arising out of a trade. Certain general principles can be derived from the decided cases, but it is next to impossible to evolve any formula which would enable a person to decide definitely and finally as to whether an item of expenditure can be said to be business expenditure or not. It is possible to give illustrations by way of cases where the expenditure concerned must be regarded as business expenditure and similarly it is equally possible to give illustrations where the expenditure would not be refunded as business expenditure, but it is difficult to formulate precisely a principle on which the two could be distinguished in all cases. However, the distinction between that which is business expenditure and that which is not, has to be observed. It is, therefore, on the facts and circumstances of each particular case, that these questions will have to be approached.
7. Before considering the case law, we may point out that it appears to us that no material has been produced to show that when the Export Promotion Scheme had any statutory force. In fact, the decision of the Tribunal would show that the departmental representative was asked by the Tribunal to produce the rules in connection with the Art Silk Export Promotion Scheme, but he was unable to do so. In any event, whatever may be the nature of that scheme, it is clear that the scheme by itself did not prescribe any penalty for any shortfall in the export liability but provided merely that import licenses were granted under the said scheme, and the persons to whom such licenses were granted had to execute a bound. In out view, the said bond cannot be regarded as anything more than a contract. The bond in the present case could not be said to have created any statutory obligation but created merely contractual obligations. Great emphasis was placed by Mr. Joshi on the recital that the said bond had been executed under the orders of the Central Govt. for the purposes of an act in which the public are interested. As we have already pointed out, however, it appears to us that this would not make much difference because most of the contracts entered into by the Central Govt. must be intended for public benefit and hence the public would be interested in the same. This cannot, however, lead to the conclusion that a person committing a breach of such a contract acts against public policy, particularly where the breach is not deliberate, but appears to be by reason of an inability on the part of the person executing the bond to comply with the strict terms thereof, as appears to be the case in the reference before us. The bond was executed by the assessee clearly for the furtherance of its business, because, by reason of the said bond, the assessee obtained the import entitlements under which it got its raw material. It would, therefore, appear to us that the damages which the assessee had to pay by reason of a breach of the condition of the bound, the said breach not being a deliberate one, prima facie must be regarded as a payment made by the assessee in the course of its business and incidental thereto.
8. We now come to come of the cases cited before us. Mr. Joshi, learned counsel for the Commissioner, first drew our attention to the decision of a Division Bench of the Punjab and Haryana High Court in Cinerama's v. CIT . In that case it was held that the commercial expediency is not always a correct or conclusive test to determine whether expenditure is laid out wholly and exclusively for purposes of the assessee's business. All that is necessary is that the expenditure must be in some way connected with the trade. It must be an ordinary or contemplable incident of trade. But, infractions of law, including breaches of obligation, are not normal incidents of business. Penalties and damages paid in connection with such infractions and breaches cannot be expenditure laid out or expended wholly and exclusively for the assessee's business. The facts in that case were that the assessee who carried on business in exhibition of films was a member of the East Punjab Motion Pictures association. A member failing to carry out the directives of the association could be suspended from the membership of the association but was eligible to be reinstated on payment of a specified sum of penalty and other charges. During the accounting year relevant to the assessment year 1970-71 the assessee paid a sum of Rs. 4,300 by way of penalty to the association and claimed it as business expenditure. The Tribunal disallowed the expenditure. On a reference, the decision of the Tribunal was upheld by the Division Bench. We find that strong reliance has been placed by the Division Bench deciding this case on the decision of the Madras High Court in Mark & Co. v. CIT : 11ITR454(Mad) , where the assessee committed a breach of contract, and in a suit filed by the other party, he was obliged to pay a sum of Rs. 5,000 by way of damages. Negativing the assessee's claim for deduction of the said amount in computing the assessee's income. Leach C.J. and Lakshmana Rao J., after referring to IRC v. E. C. Warnes & Co. Ltd,  12 TC 227 and IRC v. Alxander von Glehn & Co. Ltd.  12 TC 232 , said at p. 462 :
'In the present case, the assessee was not fined for a breach of law, but was made to pay damages for a breach of the contract entered into. The assessee's action in disregarding the undertaking given was palpably dishonest and we are of the opinion that the award of damages which followed did not constitute an expenditure falling within section 10(2)(xii), It was not incidental to the trade.'
9. Although the decision of the Division Bench of the Punjab and Haryana High court does not make it clear, it appears from the reliance which has been placed on the decision of Mask & Co. : 11ITR454(Mad) , that they must have taken the view that in the case before them the breach of the rules by the assessee was a deliberate one. With great respect, we fail to see how it could be contended that wherever there is any breach of contract by an assessee, the amount paid as damages could never be allowed as deduction in the computation of his assessable income, although the contract in question might have been entered into in the course of the assessee's business and the breach might have been made because of the exigencies of that business, or even because the performance of the contract might have become impossible. We may here point out that in CIT v. Vasantha Mills Ltd. : 120ITR321(Mad) , a Division Bench of the Madras High Court agreed with the view of the Tribunal that the assessee before it had been given an option either to produce cloth of a particular variety or to make the payment of Rs. 30.872 and there was nothing wrong in the assessee thinking that it was advantageous to make the payment rather than produce the cloth and suffer a loss and hence the payment could not cease to be one made wholly and exclusively for the purpose of the business. This decision was arrived at after taking into account the aforesaid decision of the Punjab and Haryana High Court. Moreover, as pointed out by a Division Bench of the Allahabad High Court in CIT v. J. K. Cotton Spg. and Wvg. Mills Co : 123ITR911(All) , there is a string of cases in which a view has been taken different from the one taken by the Punjab and Haryana High Court in Cinerama's case . In the case before the Allahabad High Court, the assessee, which was engaged in the manufacture of cloth, was recognised as a registered user of a trade mark. Once of the conditions laid down for the use of the trade mark was the export of a certain percentage of fabrics manufactured under the trade mark. The user of the trade mark was authorised for the period 1963 to 1965. Thereafter, when the trade mark registration was revalidated for a further period of seven years, the quantum of the export obligation was increased. In the event of non-fulfillment of the export obligation, the assessee was to deposit in Government account a penalty of 10 paise per liner yard of the annual shortfall in the export. At the end of the seven-year period a final review of the cumulative performance of the assessee was to be made and where admissible a refund of the deposit was to be made. The assessee claimed deduction of the amounts paid by it as penalty during the assessment years 1967-68 and 1968-69. It was held that the payments were made not for infraction of law but on account of a contractual obligation imposed by by the Government. The breach was in the contemplation of the parties and amounted to a risk in the carrying on of the business and was a commercial loss. In our view, therefore, the decision in Cinerama's case , in so far as it takes the view that the penalty paid by the assessee for a breach of the rules of the East Punjab Motion Pictures Association committed by the assessee cannot be regarded as a business expenditure, has no relevance to the case before us and, if it is construed as taking the wider view that in no case can damages paid on account of a breach of a contract be regarded as an allowable business expenditure, we are in respectful disagreement with that view.
10. Mr. Joshi next relied on the decision of the Supreme Court in Haji Aziz & Abdul Shakoor Bros. v. CIT : 1983ECR1942D(SC) . In that case the assessee carried on the business of importing dates from abroad and selling them in India. The assessee imported dates from Iraq partly by steamer and partly by country craft, at a time when import of dates by steamer was prohibited. The dates which were imported by steamer were confiscated by the Customs authorities under s. 167 of the sea Customs Act (item8) and the assessee, being given an option under s. 183 of that Act to pay a fine, the assessee paid the fine and had the dates released. In computing its profits the assessee sought to deduct the amount paid as fine as an allowable expenditure under s. 10(2)(xv) of the Indian I.T. Act, 1922. It was held that no expense which was paid by way of penalty for a breach of the law, even though it might involve no personal liability, could be said to be an amount wholly and exclusively laid out for the purpose of the business of the assessee within the meaning of s. 10(2)(xv) of the Indian I.T. Act. 1922, and the fine paid by the assessee was not an allowable deduction under the section. It was held that it was not enough that the disbursements are made in the course of or arise out of or are concerned with or made out of the profits of the business but they must also be for the purpose of earning the profit of the business. They cannot be deducted if they fall on the assessee in come character other than that of a trader. If a sum is paid by an assessee conducting his business because in deducting it he has acted in a manner which has rendered him liable to penalty for an infraction of the law, it cannot be claimed as a deductible expense, as it cannot be called a commercial loss incurred in carrying on his business. Infraction of the law is not a normal incident of business. The principles laid down in this decision could undoubtedly apply in the case of all legitimate businesses, but they are of no assistance to Mr. Joshi in the present case, because we are of the view that in the case before us the assessee has not committed any infraction of the law, and, as we have already pointed out, has merely committed a breach of one of the conditions of the bond which was in the nature of contract.
11. Mr. Joshi finally relied upon the decision in M. S. P. Senthikumara Nadar & Sons v. CIT : 32ITR138(Mad) . In that case a Division Bench of the Madras High Court held that payments of penalties for infraction of law fall outside the scope of permissible deductions under s. 10(2)(xv) of the India I.T. Act. 1922. For the purpose of deduction under s. 10(2)(xv) it is not enough if the loss sustained or expenditure incurred is in some sense connected with the business. Only such losses can be deduced as are connected with the business, in the sense that they are really incidental to the business itself. in that case the assessee-firm, which carried on business in coffee, entered into contracts with the Indian Coffee Board and purchased coffee in the accounting year 1942-43 at a rate far below the price of coffee to be sold within India under a contractual obligation to export the whole of the coffee so purchased to places outside India. The assessee, in addition, purchases coffee from others out of their export quota, which also it was under an obligation to export. The assessee, however, exported only a part of the coffee and sold the balance within India in contravention of its obligations. When the coffee Board came to now in 1946 of the sales made by the assessee within India and called upon the assessee to explain, the assessee admitted that it had failed to export part of the coffee purchased and agreed to pay liquidated damages in accordance with one of the three alternatives provided in the contract. It was, inter alia, held that although what the assessee paid to the coffee Board was called liquidated damages, the payment was really akin to a penalty for committing an act opposed to public policy, a policy that underlay the coffee Market Expansion Act, 1942, and which the Act left it to the Coffee Board to enforce; the breach of its contractual obligations to the Board was not in the course of the normal trading activities of the assessee the money was no expended or paid out for the purpose of the assessee's business and the payment was not even incidental to the business itself; therefore, the amount was not an expenditure allowable under s. 10(2)(xv) of the Indian I.T. Act, 1922. In our view, this decision again is not very helpful in the case before us. In that case, the assessee deliberately committed a breach of the obligation to export coffee to the extent that it had agreed to do and it was found that the penalty imposed for doing this, by way of liquidated damages, was really in the nature of a penalty for committing an cat opposed to public policy. In the present case, however, as we have already pointed out, there is nothing to show that the breach of the export obligation under the bond committed by the assessee was deliberate. In fact, the facts suggest that it occurred by reason of the sheer inability of the assessee to complete its export obligation in time and the assessee completed that obligation within one month after the prescribed time. Moreover, in the present case, it could not be said that the action of the assessee in failing to complete its export liability within the prescribed time was an act opposed to public policy, because within one month after the period provide under the bond, the assessee, in fact, competed its export obligation. In these circumstances, in our view, the principle laid down in this decision has no application to the case before us.
12. We find that the view which we take is to some extent supported by the decision of a Division Bench of the Gujarat High Court in Addl CIT v. Arvind Mills Ltd. : 109ITR212(Guj) . In that case the assessee had imported automatic looms under a special permit. The permission was granted by the Textile Commissioner in exercise of his powers under the Cotton Textiles (Cotrol) Order, 1948, issued in exercise of the powers conferred by the Essential Supplies (Temporary powers) Act, 1946. One of the conditions of this special permit was that the assessee should execute a bond in favour of the President of India agreeing to export an agreed quantity of cloth, and in default thereof to pay a sum calculated at the rate of 11 paise per metre to cover the shortfall. The assessee exported rag cloth amounting to 90% of the target and paid a sum of Rs. 35,193 towards the shortfall. The assessee claimed this sum as a business loss under s. 28 or a business expenditure under s. 37 of the said Act. It was held that the nature of the payment cannot be decided by its mere description be the parties. In order to be a penalty, a payment must, in substance, amount to penalty. There was nothing which could be classified as a statutory or legal export obligation and penalty for its noncompliance either in the Essential Supplies (Temporary Powers) Act, 1946, or in the Cotton Textiles (Control) Order, 1948. If it were a statutory obligation, there was no need to require the importer to enter into a bond. The scheme for import of automatic looms indicated that the Government wanted to encourage voluntary effort by the mill companies. The parties to the agreement clearly contemplated that there might be a shortfall in the export target for various reasons. The assessee had achieved 90 percent. of its target. The sum calculated at a fixed rate to cover the shortfall which was contemplated was not in the nature of penalty for an infraction of law or a violation of public policy. It was a loss connected with and arising our of trade. Therefore, the sum of Rs. 35,193 was deductible. As in the said case before the Gujarat High Court, in the case before us also, we find that the liability to export art silk fabrics up to the quantity specified and within the time stipulated in that bond could not be regarded as a statutory liability. It was a contractual liability. The assessee completed over 80 per of its export obligation within the time prescribed by the bond and completed its entire export obligation, although within one month after the time prescribed under the bond expired. The amount which the assessee had to pay under the bond was calculated on the footing of the shortfall. In these circumstances, it can hardly be looked upon as a penalty for an infraction of the law or any statutory obligation of of public policy, but must be regarded as damages paid under a contract.
13. Some other cases were cited by Mr. Vyas which contained observations, which according to him helped the case of the assessee, but in the view which we have taken, it is not necessary to discuss those cases because they do not carry the matter any further.
14. In the result, the question referred to us is answered in the affirmative and in favour of the assessee. The Commissioner to pay to the assessee the costs of the reference.