Allowability of Losses incurred for earning illegal income under the Income Tax Act, 1961

An assessee earning any income from an illegal source cannot escape taxation of such income on the plea that it is illegal income. Besides being taxed under the Income-tax Act, he is also subject to prosecution separately under the relevant law for the crime of carrying on illegal business. However, any expenses or losses incurred by the assessee in carrying on such business are not admissible in accordance with the Explanation to section 37(1) which provides that any expenditure incurred by an assessee for any purpose which is an offence or which is prohibited by law shall not be deemed to have been incurred for the purpose of business or profession and no deduction or allowance shall be made in respect of such expenditure.

The Finance (No. 2) Act, 1998 with retrospective effect from 01.04.1962 inserted an Explanation to Section 37(1) of the Income-tax Act, 1961 that for the removal of doubts it was declared that any expenditure incurred by an assessee for any purpose which was an offence or which was prohibited by law would not be deemed to have been incurred for the purpose of business or profession and no deduction or allowance had to be made in respect of such an expenditure.

Text of Explanation 1 of Section 37

^[1][^[2][ Explanation 1. - For the removal of doubts, it is hereby declared that any expenditure incurred by an assessee for any purpose which is an offence or which is prohibited by law shall not be deemed to have been incurred for the purpose of business or profession and no deduction or allowance shall be made in respect of such expenditure.

KEY NOTE

1.   Inserted by the Finance (No. 2) Act, 1998 with retrospective effect from 01.04.1962.

2.   Explanation numbered as “Explanation 1” by the Finance (No. 2) Act, 2014 with effect from 01.04.2015

No illegal activity can be perpetuated under any provisions of law nor benefit out of it. Law will miss its paramount object if it is not consistent with morality and any interpretation by courts cannot lead to a result where continuation of illegal activity or benefit attached to it is given recognition.

Loss incurred during course of business, even if same was illegal, was required to be compensated - Cost of imported items seized during raid by custom authorities was to be allowed as business expenditure

The Ice factory premises of the assessee was raided by the revenue conjointly with the police. Since, at the premises of the assessee certain imported items, such as computer parts, air conditioners etc., were found, the personnels from Custom Authorities were called and they seized the aforesaid goods, amounting to total Rs. 31,70,000. Pursuant thereto, the residence of the brother of the assessee, was also raided, from where electrical items, i.e. wrist-watches and other electrical goods worth Rs. 39,385 in all were seized. The Assessing Officer assessed the total income of the assessee at Rs. 1,39,69,385. On appeal, the Commissioner (Appeals) upheld the order of the Assessing Officer. On further appeal, the Tribunal also upheld the order of the Commissioner (Appeals). On appeal to the High Court:

In view of the decision of the Apex Court in the case of Dr. T.A. Quereshi v. CIT (2016) 287 ITR 547 : 157 Taxman 514 (SC), the loss which was incurred during the course of business even if the same is illegal is required to be compensated. In view of the aforesaid decision, since the present appeal is also governed by the same set of facts, this appeal also deserves to be answered in favour of the assessee and against the revenue. [In favour of assessee] (Related Assessment year : 1994-95) – [Rama Natha Gadhavi v. ITO (2017) 393 ITR 590 : 79 taxmann.com 130 (Guj.)]

Loss incidental to illegal business is allowable

The assessee deals in bullion and gold jewellery.  On 12.01.1999, a search was carried out on the residential as well as the business premises of the appellant and substantial quantities of bullion was found and seized by  the Income Tax Department. On 18.01.1999, notice under Section 158BC was issued and in response, the return for the block period was furnished on 04.03.1999 by the appellant disclosing the total undisclosed income at Rs.1,39,75,834/-.

It is the case of the appellant that the Assessing Officer did not accept the figure of undisclosed income as stated in the computation of income furnished by the appellant for the block assessment period and additions/disallowances were made alongwith charging of interest under section 158BFA(1) of the Income Tax Act, 1961.

One of the disallowance was pertaining to the claim of deduction of Rs.40,34,898/- on account   of gold seized by the Custom Authorities. The appellant preferred first appeal before the learned CIT (Appeals) who confirm the allowances by rejecting the contentions of the appellant. The appellant preferred second appeal before the Tribunal and raised the contentions and explanations supported by documentary evidence on record to impress upon the Hon’ble Tribunal that claim for deduction of Rs. 40,34,898/- on account of gold seized by the Custom Authorities was an allowable business expenditure under  the Income Tax, However, the Tribunal dismissed the appeal of the appellant. On Appeal, it was held that in view of the decision of the Hon’ble Apex Court in the case of Dr. T.A. Quereshi v. CIT, Bhopal (2006) 287 ITR 547 : 206 CTR 489 : 157 Taxman 514 (SC), the loss which was incurred during the course of business even if the same is illegal is required to be compensated and for the loss suffered by the assessee. [In favour of the assessee] - [Bipinchandra K. Bhatia v. DCIT - Date of Judgement : 16.10.2014 (Guj.)]

Loss incurred by assessee-jeweller on account of confiscation of its silver stock by customs department would be allowable as business loss

Assessee had been in the jeweller business for a number of years. In 1993, there was a search in assessee’s business premises and certain silver claimed to have been purchased by assessee from NRIs was confiscated by customs officials. Claim was disallowed by the Assessing Officer as well as the Commissioner (Appeals). The Customs Tribunal upheld order of confiscation by customs officers. Said order was received by assessee in April, 1996. The assessee claimed the loss in the year under consideration, because the CEGAT order dated 19.03.1996 was received by him in April, 1996 and, accordingly, the assessee reasonably apprehended that the stock confiscated would be irrecoverable. The business loss on account of confiscation could be claimed and allowed in the year in which the assessee prima facie loses the hope for recovery of the goods. In this background, the claim of loss crystallized in the year under consideration when assessee received the order of CEGAT in April, 1996. Silver confiscated was the business stock of the assessee and the assessee is in this business for years together. Considering the assessee’s business line, silver was acquired as stock in course of business. Accordingly, the business of a trader is set up when the first purchase is made. The business losses are to be allowed as a deduction which occurred in course of its business. [In favour of assessee] (Related Assessment year :  1997-98) – [Rajmal Lakhichand v. ACIT (2012) 150 TTJ 111 : (2013) 57 SOT 50 : 32 taxmann.com 248 (ITAT Pune)]

Payment of commission to Government doctors for obtaining a favour therefrom by prescribing medicines in which assessee is dealing will come within category of ‘illegal gratification’ or ‘bribe’ and, therefore, cannot be allowed as business expenditure under section 37

The assessee was dealing in Ayurvedic medicines. During the relevant assessment year, he paid commission to various private as well as the Government doctors, who were prescribing his medicines to the patients and claimed deduction of the same as business expenditure. The Assessing Officer disallowed the assessee’s claim. On appeal, the Commissioner (Appeals) allowed payment made to private doctors but disallowed the payment made to the Government doctors. On second appeal, the Tribunal allowed the payment made to the Government doctors also observing that the payment was not disputed by the revenue, and since such payment was made over the years, it was a business necessity and was allowable as business expenditure. On reference :

Held : Section 37(1) allows an expenditure wholly and exclusively incurred for the purpose of the business or the profession in computing the income chargeable under the head, ‘Profits or gains of business or profession.’ The Explanation thereto disallows an expenditure which is incurred by an assessee for a purpose which is an offence or which is prohibited by law. The Explanation to section 37(1), thus, makes it clear that such an expenditure shall not be treated to be a business or professional expenditure. It is not in dispute that a Government servant is not entitled to receive any amount in consideration of discharge of his official duty, unless provided/permitted by the rules and regulations applicable to his conditions of service. Therefore, the Government doctors were not entitled to realize such amount for the purpose of prescribing medicines of the assessee and thereby promoting his business interest. The amount paid to the Government doctors by the assessee clearly came within the category of ‘illegal gratification’ or ‘bribe’. An illegal gratification or bribe is an offence under the Prevention of Corruption Act, 1988. Earlier, it was an offence under section 161 of the Indian Penal Code. The Conduct Rules applicable to the Government servants also prohibits such realization of money by the Government servant and receipt of any amount, if so received by such Government servant, is a serious misconduct. Thus, the commission paid by the assessee to the Government doctors was an offence in law. Both the persons, namely, one who is tendering or giving illegal gratification/bribe as well as one, who is receiving it, are offenders and commit offence in law. That being so, by virtue of the Explanation to section 37, the aforesaid expenditure incurred by the assessee could not be treated to be an expenditure incurred for the purpose of business or profession.

Therefore, the payment of commission to the Government doctors for obtaining a favour therefrom by prescribing medicines in which the assessee was dealing with could not be said to be a ‘business expenditure’ and no deduction could be allowed thereof under the Act. (Related Assessment year : 1989-90) - [CIT v. Pt. Vishwanath Sharma (2009) 316 ITR 419 : 182 Taxman 63 (All.)]

Business losses are allowable on ordinary commercial principles in computing profits - Where it was found that heroin drugs seized formed part of stock-in-trade of an assessee, it followed that seizure and confiscation of such stock-in-trade had to be allowed as a business loss

Subsequent to the recovery and seizure of huge quantity of heroin drugs from the assessee-doctor’s possession, he filed his return claiming that since the heroin seized from him formed part of his stock-in-trade, hence, its loss on account of seizure was an allowable deduction while computing his profits and gains of business/profession. The Assessing Officer, however, disallowed the assessee’s said claim. On appeal, the Commissioner (Appeals) upheld the impugned disallowance. On second appeal, the Tribunal allowed the assessee’s appeal holding that he was entitled to claim the deduction as a businessloss. On revenue's appeal, the High Court set aside the ITAT’s order. On appeal to the Supreme Court :

Held : No doubt, the assessee had contended that he was only earning income from his medical profession and was not doing any illegal activity of manufacturing and selling of heroin. However, the finding of fact of the Tribunal in its order dated 31.03.1993 was that the assessee was engaged in manufacture and selling of heroin. Thus, the income-tax authorities themselves had recorded a finding that the assessee was engaged in manufacture and selling of heroin. No doubt the order of the Tribunal dated 31.03.1993 was subsequently recalled by the Tribunal, but since with ultimate order dated 14.10.1998 the Tribunal had held that the heroin seized was the assessee’s stock-in-trade, it was implicit that the Tribunal reiterated the view that the assessee was doing the business of manufacture and sale of heroin.

Once the income-tax authorities recorded such a finding of fact, it followed that any loss from such a business was a business loss. In the order of the Tribunal there was a finding of fact to the effect that the heroin formed part of the stock-in-trade of the assessee. In view of said finding, the Tribunal allowed the assessee’s claim of deducting the loss of 5 kg. of heroin whose value was assessed by the Tribunal at Rs. 2 lakhs as a business loss. The view taken by the Tribunal was to be sustained.

The High Court had adopted an emotional and moral approach rather than a legal approach. The High Court was right in opining that the assessee was committing a highly immoral act in illegally manufacturing and selling heroin. However, cases are to be decided by the Court on legal principles and not on one’s own moral views.

The Explanation to section 37 has really nothing to do with the instant case as it was not a case of a business expenditure, but of business loss. Business losses are allowable on ordinary commercial principles in computing profits. Once it was found that the heroin seized formed part of the stock-in-trade of the assessee, it followed that the seizure and confiscation of such stock-in-trade had to be allowed as a business loss. Loss of stock-in-trade has to be considered as a trading loss. Consequently, the impugned judgment of the High Court could not be sustained and it was to be set aside and the order of the Tribunal would stand restored. The appeal was to be allowed. (Related Assessment year : 1986-87) - [Dr. T.A. Quereshi v. CIT, Bhopal (2006) 287 ITR 547 : 206 CTR 489 : 157 Taxman 514 (SC)]

Custom authorities seized certain sum of foreign currency from custody of assessee and confiscated same - ITO treated said sum as unexplained income of assessee and rejected assessee’s claim for treating said amount as business loss on ground that assessee was not a smuggler and not carrying any illegal business or smuggling - Subsequently, assessee was detained under COFEPOSA and was declared as a member of a gang involved in smuggling activity - Subsequent detention of assessee under COFEPOSA confirmed that business of assessee was that of smuggling - In view of said fact, it could be said that foreign currency recovered from assessee was amount involved in smuggling activity and, therefore, confiscation of said amount was to be treated as business loss suffered by assessee in conducting his business of smuggling

The customs authorities seized foreign currency from the custody of the assessee while he was proceeding abroad. On being questioned by the custom authorities, the assessee denied the ownership of foreign currency seized and also denied that he was carrying on the business of smuggling. The Additional Collector of Customs, thus, confiscated the foreign currency from the assessee. He further imposed fine on the assessee for contravening the law. The Customs Excise and Gold Control Appellate Tribunal (CEGAT) confirmed the order of confiscation. The ITO treated the sum of foreign currency seized as unexplained income of the assessee under section 69A and also rejected the assessee’s claim for treating the said amount as business loss suffered by him. On appeal, the Commissioner (Appeals) upheld the order of the ITO on the ground that the assessee was admittedly not a smuggler and not carrying any illegal business or smuggling. On further appeal, the Tribunal held that there was no justification for disallowance of loss of foreign currency which was confiscated and directed that the confiscated foreign currency be allowed as a loss to the assessee. Subsequently, the assessee was detained under COFEPOSA and was declared as a member of a gang involved in smuggling.

Although the assessee had before the customs authorities denied that he was carrying on the business of smuggling and that foreign currency seized belonged to him, the fact remained that the assessee was treated as a smuggler, and his subsequent detention under COFEPOSA confirmed that he was treated as a smuggler and the business of the assessee was that of smuggling and, therefore, the foreign currency recovered from the assessee was the amount involved in the smuggling activity and the confiscation of the said amount was, therefore, business loss suffered by the assessee in conducting his business of smuggling. It was not the case of the revenue that the assessee was carrying on any other business, lawful as otherwise, for which the foreign currency was being illegally transported out of the country. The business of the assessee was smuggling of foreign currency and the confiscation of foreign currency equivalent in value to Indian Rupees was, therefore, a loss of stock-in-trade of the assessee. The revenue while bringing to tax the sum as income of the assessee under section 69A, could not deprive the assessee of the benefit of treating the said amount as a business loss. (Related Assessment year : 1982-83) - [CIT v. Anil M. Geni (2006) 284 ITR 338 : 200 CTR 172 : (2005) 148 Taxman 645 (Bom.)]

Where business was carried on by assessee in a legal manner and while carrying on said business he indulged in infraction of law, losses suffered due to such infraction of law could not be allowed while computing income of lawful business

The assessee carried on the business as a goldsmith. During the relevant assessment year the Customs and Central Excise Authorities raided the residence of the assessee and seized certain gold, which was confiscated by the said authorities. The assessee claimed that since he had suffered loss in carrying on the business of goldsmith, the same was incidental to his business and should be deducted in determining his total income. The assessee’s claim was disallowed by the Tribunal. On reference :

It was found that the Supreme Court had made a distinction for allowing losses incurred while indulging in infraction of law committed in carrying on lawful business and infraction of law committed in the business inherently unlawful. If lawful business is carried on by the assessee while carrying on the aforesaid business, the assessee commits infraction of law in smuggling gold resulting in confiscation of the said gold and loss occurs, in such an event no deduction can be allowed for carrying on a lawful business. The said deduction from an illegal business cannot be allowed as a loss in its lawful business. The instant case fell under the category where a business was carried on by the assessee in a legal manner and he indulged in infraction of law and the losses suffered due to such infraction could not be allowed while computing the income of the lawful business. [In favour of the revenue] (Related Assessment year : 1971-72) - [Ishwar Das v. CIT (2000) 244 ITR 146 : (1999) 155 CTR 373 (All.)]

Assessee carried on illegal business of smuggling gold - Some gold was confiscated from him by customs authorities - ITO added value of confiscated gold as income under section 69 - Value of confiscated gold was allowable as deduction by way of business loss

The assessee was carrying on illegal business of smuggling of gold. Some gold was confiscated from him by the customs authorities. The ITO added the value of the seized gold as income under section 69 on account of unexplained investment. The first appellate authority confirmed the addition. On second appeal before the Tribunal the assessee contended that the value of the gold so seized and confiscated should have been allowed as a deduction by way of businessloss from the amount proposed to be included by the department.

Held : After considering the Supreme Court’s judgment in the case of CIT v. Piara Singh (1980) 124 ITR 40 : 3 Taxman 67 (SC), the Madhya Pradesh High Court came to this conclusion in the case of Vishnu Kumar Soni v. CIT (1985) 155 ITR 34 (MP) that the taint of illegality of a business could not detract from the losses being taken into account while computing taxable profits. The High Court observed that the taxing authorities could tax not gross receipts but only profits of a trade or business, which could not be done without deducting losses and legitimate expenses. For these reasons, on facts similar to those of the instant case, the High Court held that the loss suffered by the assessee in that case as a result of confiscation of gold was allowable as a loss in the business. In the instant case, since all the facts indicated that the assessee had been carrying on the illegalbusiness of smuggling, the loss due to confiscation of gold had to be deducted from the amount included as unexplained investment. – [Hiranand v. ITO (1986) 29 Taxman 208 (ITAT Jaipur)]

Assessee, an exporter and importer of cloth, tampered with licence available to it and illegally imported cloth - penalty imposed by customs authorities for said act - Penalty so paid was not deductible under section 37(1)

Certain penalties were imposed by the customs authorities on the assessee-firm, engaged in the business of export and import of cotton yarn, since it had tampered with an import licence available to it and made illegal imports. The ITO rejected its claim for deduction under section 37(1) of the amount of penalty so paid. The AAC and the Tribunal sustained the ITO’s order since the impugned penalty was paid for contravention of the Customs Act.

Held : The impugned penalty did not represent loss suffered by it in commercial transaction. It was not deductible under section 37(1), since it was paid for infraction or breach of law. The matter would have stood on a different footing had the assessee suffered loss on account of improperly imported yarn. However, payment of the impugned penalty would not stand on the same footing as such loss. - [Garden Silk Weaving Factory v. CIT (1983) 144 ITR 613 : (1982) 9 Taxman 179 (Guj.)]

Currency notes confiscated by custom authorities from a gold smuggler - Consequential loss was an allowable deduction while computing business income

The assessee was carrying on a regular smuggling activity which consisted of taking currency notes out of India and exchanging them with gold in Pakistan which was later smuggled into India. While crossing the Indo-Pakistan border into Pakistan, the Indian Police recovered from him currency notes worth Rs. 65,500 which were admittedly being taken for purchasing gold there with a view to smuggling it into India. The custom authorities ordered their confiscation. Out of the said amount, the ITO added an amount of Rs. 60,500 in the assessee’s taxable income as income from undisclosed sources. His appeal before the AAC was unsuccessful. On further appeal, the assessee represented that, if he was regarded as engaged in the business of smuggling gold, he was entitled to a deduction under section 10(1) of the entire sum of Rs. 65,500 as a loss incurred in the business on the confiscation of the currency notes. The Tribunal upheld the claim for deduction and deleted the impugned addition. The High Court sustained the Tribunal’s conclusion. On appeal:

Held : The currency notes carried by the assessee across the border constituted the means for acquiring gold in Pakistan, and subsequently selling the same in India at a profit. If the smuggling activity could be regarded as a business, the person carrying on the same must be deemed to be aware that a necessary incident involved-in the business was detection by the custom authorities and the consequent confiscation of the currency notes. It was an incident as predictable in the course of carrying on the activity as any other feature of it. Having regard to the nature of the activity, possible detection by the custom authorities constituted a normal feature integrated into all that was implied and involved in it. Therefore, the confiscation of the currency notes was a loss occasioned in pursuing the business; it was a loss in much the same way as if the currency notes had been stolen or dropped on the way while carrying on the business; and it was a loss which sprung directly from the carrying on of the business and was incidental to it. There was a significant distinction between the infraction of the law committed in the carrying on of a lawful business and an infraction of the law committed in a business inherently unlawful and constitute a normal incident of it. The assessee was, accordingly, entitled to a deduction of Rs. 65,500 under section 10(1). – [CIT v. Piara Singh (1980) 124 ITR 40 : 17 CTR 111 : 3 Taxman 67 (SC)]

Losses - In speculation business - Hedging loss being in respect of banned contract under Forward Contracts (Regulation) Act, 1952 cannot be set off against profits of other business of previous year - Speculation loss in commodity banned under statutory provisons cannot be carried forward for set off in following year

Section 73 of the Income-tax Act, 1961 [Corresponding to section 24 of Indian Income-tax Act, 1922] - The assessee was carrying on business by running an oil mill, and also doing business in sales and purchase of groundnuts, groundnut seeds and oil; speculation business in groundnuts, groundnut oil and groundnut seeds; and speculation business in cotton, erranda, etc. While determining the income of the assessee the ITO disallowed loss in forward contracts in groundnut oil, groundnuts and groundnut seeds on the ground that it arose out of illegal contracts on account of the same being banned under section 15(4) of the Forward Contracts (Regulation) Act, 1952. The AAC affirmed the order of the ITO. On a second appeal, the Tribunal held that notwithstanding the illegality of the transactions the loss could be set off and carried forward in accordance with the provisions of section 24(1) and 24(2) respectively of the 1922 Act. The Tribunal, accordingly, directed that the loss in hedging transactions of forward business in the banned contracts should be set off against the other profits of the assessee for the relevant accounting year under section 24(1) of the 1922 Act and that the balance loss relating to the speculative transaction in the banned contracts should be carried forward to the following year under section 24(2) of 1922 Act to be set off against profits of the following year from speculative business. On reference:

Held : The hedging loss being in respect of a banned contract under section 15(4) of the Forward Contracts (Regulation) Act, 1952, could not be set off against the profits of other business of the previous year. It was also admitted that the contract for speculation in the commodity in question was banned under the 1952 Act. It also appeared that the said loss could not be set off in the previous year against profit in the same business in that year. To allow such a claim was to permit a benefit of adjustment of loss from an illegal business to spill over and continue in the following year even in a lawful speculative business. A speculative business which is carried on in the following year must be a business of lawful speculation pertaining to lawful and enforceable contracts. The assessee carrying on a lawful speculative business in the following year cannot derive benefit by carrying forward and setting off a loss from an illegal speculative business of the earlier year. Law will assume an illegal business to die out of existence with all its losses to the assessee in the year of loss itself. The assessee can derive no benefit on account of the unlawful business in the following year. The matter will be different if a lawful speculative business after incurring loss is discontinued and loss therefrom is carried forward for set off against any other lawful speculative business in the following year. This is the true legal effect of section 24(2)(i) of the 1922 Act.

It is inconceivable that law can permit an illegal activity to be carried on from which a benefit could be obtained. The concept of carry forward is not the same thing as the setting off of loss in a particular illegal business against profit of that illegal business in a particular year. The two concepts have to be kept distinctly separate even in a taxing statute. There is no express warrant for the submission either under section 24(2) of the 1922 Act, or under any other provision of the Act, far less on general principles.

It is true that by earning income from illegal trading activity the income does not get tainted so far as exigibility to tax is concerned. While computing income from illegal activity in a particular year all losses incurred in earning that particular income are also taken into account for computation of real profits even in the illegal business. That does not mean that fines imposed on the illegal activities detected, prosecuted and punished or otherwise penalised, will be taken into account for ascertainment of real profits. There is, therefore, a marked distinction between computation of a particular year's profit from illegal trading activity and carry forward of a loss to set it off against income in subsequent years even assuming that such illegal activity is continued against the provisions of law. No illegal activity can be perpetuated under any provisions of law nor benefit out of it. Law will miss its paramount object if it is not consistent with morality and any interpretation by courts cannot lead to a result where continuation of illegal activity or benefit attached to it is given recognition. Therefore, the assessee was not entitled to carry forward the speculation loss to the next year. [In favour of revenue] (Related Assessment year : 1957-58) - [CIT v. Kurji Jinabhai Kotecha (1977) 107 ITR 101 (SC)].

Penalty by way of confiscation of contraband gold is not a commercial loss so as to be allowed as a permissible deduction

The assessee-firm carried on business in gold, silver and jewellery. The Custom authorities seized gold of the value of Rs. 56,978 which was being smuggled. The Collector of Customs, ordered the confiscation of the smuggled gold. In the assessment proceedings, the assessee claimed value of the gold seized towards loss in vattay account. The ITO rejected the claim of the assessee that this amount represented loss in the business of the firm to claim deduction, on the ground that it did not relate to the business carried on by it, but it was due to the confiscation of the gold under the Sea Customs Act. The subsequent appeals preferred by the assessee-firm to the AAC and to the Tribunal were also dismissed. On reference :

Held : What are chargeable to tax in respect of a business carried on by the assessee are the profits or gains of a particular assessment year. While assessing the profits, necessarily loss incurred in the business during the year should be taken into account, as otherwise it is not possible to arrive at the true profits earned by the assessee. It is well-settled that the taint of illegality associated with profits or income is immaterial for the purpose of taxation. Income-tax Acts are not necessarily restricted in their application to lawful business only. One who contravenes a statute and trades in business prohibited by law while being liable for prosecution for the offence committed by him will, at the same time, be liable to pay tax out of the income or profits earned from the illegal trade or business.

Here was a specific claim made by the assessee for deduction of the value of the gold confiscated by the Central Government on the ground that it was a trading or commercial loss, though the trade was an illegal one. It should not be lost sight of, when a claim for deduction is made, that the loss must be one that springs directly from the business or trade which the assessee carries on or is incidental to the business that he carries on and not every sort or kind of loss, which has absolutely no nexus or connection with his trade or business. It is well to remember that confiscation of contraband gold is an action in rem and not a proceeding in personam. Confiscation is no doubt one of the penalties which the customs authorities can impose but that is more in the nature of proceedings in rem than proceedings in personam, the object being to confiscate the offending goods which have been dealt with contrary to the provisions of the law. A proceeding in rem, in the strict sense of the term is an action taken directly against the property (in instant case the smuggled gold) and even if the offender is not known, the customs authorities have the power to confiscate the contraband gold. Therefore, by no process of reasoning could the confiscation of the contraband gold by the customs authorities be said to be a trading or commercial loss connected with or incidental to the assessee’s business. It was not even a case where it could be said that there was any sort of remote connection between the business carried on by the assessee-firm and the confiscation made by the customs authorities under the provisions of the Sea Customs Act. The loss sustained by confiscation of the smuggled gold was absolutely foreign to the vocation or business of the assessee-firm. It was a loss incurred in some character other than that of a trader. The confiscation of the gold, being the result of a proceeding in rem, fell completely outside the trade or business which the assessee was carrying on. Confiscation of contraband goods is one of the penalties provided under the Sea Customs Act and the penalty is enforced against the goods irrespective of the fact whether the offender is known or not traced. Infraction or violation of the law is not a normal incident of a trade or business and, therefore, the penalty by way of confiscation of the contraband gold is not a commercial loss as to be allowed as a permissible deduction. Therefore, the Tribunal was justified in law in disallowing the sum of Rs. 56,978 claimed as a business loss. [In favour of revenue] (Related Assessment year : 1963-64) – [Soni Hinduji Kushalji & Co. v. CIT (1973) 89 ITR 112 (AP)]

If a business is illegal neither the profits earned nor the losses incurred would be enforceable, in law, but that does not take the profits out of the taxing statute

The Supreme Court in CIT v. S.C. Kothari, observed that for the purpose of section 10(1) of the Income-tax Act, 1922, (corresponding to section 28 of Income-tax Act, 1961) the losses which have actually been incurred in carrying on a particular illegal business must be deducted before the true figure relating to profits which have to be brought to tax can be computed or determined. If a business is illegal neither the profits earned nor the losses incurred would be enforceable, in law, but that does not take the profits out of the taxing statute. Similarly, the taint of illegality of the business cannot detract from the losses being taken into account for computation of the amounts which can be subjected to tax under section 10(1) (corresponding to section 28 of the Income-tax Act, 1961). – [CIT v. S.C. Kothari (1971) 82 ITR 794 (SC)]