Pharmaceutical companies incur huge expenses in launching and promoting their products by way of gifts to medical professionals, holding conferences and distribution of promotional material. Tax deductibility of such expenses has been a contentious issue in certain recent tribunal decisions. Revenue authorities contend that these expenses are in contravention of law and not allowable as deduction in view of the Explanation 1 to Section 37. This article seeks to trace the jurisprudence governing the matter and apply it to this burning issue.
General principles governing such deductions
In first place, every revenue expense incurred wholly and exclusively for the purposes of business is deductible and it is not for the Revenue Authorities to dictate as the nature and quantum of expense that shall be deductible in arriving at taxable business profits (see end note 1 and 2). However, an expenditure involving infraction of law cannot be said to be incurred for the purposes of business as violation of law is not a normal incidence of business; even on grounds of public policy it cannot be said to be a commercial expense (see end note 3) . No distinction can be drawn between penalties payable on infraction of law and payments in furtherance of illegal transactions. An illegal transaction which is not visited with a penalty, will none the less remain an illegal transaction and it would equally be against public policy to treat the payments made in pursuance of, or in furtherance of such illegal transaction as commercial expenses (see end note 4). It is against public policy to allow the benefit of deduction under one statute, of any expenditure incurred in violation of the provisions of another statute (see end note 4). Distinction is however necessary between an expense tainted with illegality incurred for furthering lawful business and expenses incurred in an illegal business. In latter, the denial of all expenses on the ground of illegality will result in taxation of gross receipts which is impermissible as taxman can only tax profits arrived at after deducting incidental expenses (see end note 5).
Legislative background of specific provisions governing the matter
Section 37 of the Income tax Act is a residuary provision permitting deduction of all revenue expenses. Promotional expenses by pharma companies were held as allowable under this section in several rulings (see end note 6).
In the year 1997 Mumbai Bench of Income Tax Appellate Tribunal (see end note 7) faced an issue pertaining to deductibility of protection money. The Tribunal took notice of the vulnerable situation of builders and allowed the deduction. With a view to overrule this decision and deny deduction of payments towards protection money, extortion, hafta, bribes, etc. as business expenditure (see end note 8) an explanation was added to Section 37 which reads as under:
“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.” [emphasis supplied]
On 10 December 2009, Medical Council of India (MCI) issued a notification exercising its powers under Section 33 of Medical Council Act, 1956 (‘MCA’) amending the Indian Medical Council (Professional Conduct, Etiquette and Ethics) Regulations, 2002 (‘the Regulations’) and inserted clause 6.8 therein. That clause prohibited medical practitioners from receiving any gift, travel facility for vacations or for attending conferences, hospitality from pharma industry or endorsing publicly any drug. By inserting such a provision medical practitioners became exposed to adverse action by MCI for deviations. Such disciplinary actions were to be decided on case to case basis. Vide Notification dated 28 January 2016 MCI provided for punishments in case of specified deviations. This ensured uniformity in disciplinary action as against a case to case decision.
CBDT issued a Circular No. 5 in year 2012 (‘the Circular’) clarifying that expense on freebies in violation of the provisions of the Regulations shall be inadmissible under Section 37(1) of the Income Tax Act, 1961 being an expense prohibited by the law. Himachal Pradesh High Court (see end note 9) upheld the validity of this Circular holding that:
- The Circular does not go beyond the Explanation;
- In sum and substance both the Explanation and the Circular have same effect; and
- It is for the taxpayer to satisfy the assessing officer that the expense is not in violation of the Regulations
Analysis of the decisions rendered in the context of Pharma sector
The Hyderabad Bench (see end note 10) of the ITAT dealt with deductibility of expenses on travel, stay, participation fee in pharmaceutical conferences and following its earlier orders remanded the matter to the AO for examining as to whether the expenses are incurred for the purpose of business of the assessee without clearly expressing its views on infraction of the Regulations and its consequences. The Panaji Bench (see end note 11) allowed the claim of the taxpayer as the revenue authorities failed to pin-point as to how the expenses incurred by taxpayer were covered by CBDT Circular. Mumbai Bench in the case of Syncom (see end note 12) held that CBDT Circular is prospective in nature and will not apply to AY 2011-12. Without much discussion on contravention of Regulations it allowed the deduction holding that small gifts bearing company logo are mere advertisement expenses and hospitality expenses for medical conferences is to help doctors in gaining contemporary knowledge. This has been followed in the case of UCB (see end note 13) wherein expenses on gift of pens, watches, household appliances and sponsoring doctors meet overseas has been allowed for AY 2004-05.
In the case of PHL Pharma (see end note 14) the Tribunal allowed deduction of freebies placing heavy emphasis on the point that the Regulations govern only medical practitioners and have no bearing on the conduct of pharmaceutical companies i.e. it does not impose ‘prohibition’ on pharmaceutical companies (see end note 15). It opined that only when payment constitutes an offence by the taxpayer the deduction can be denied and CBDT transgressed its authority by issuing the said Circular. It also held that articles like free samples (see end note 16); diaries, pen sets, calendars, paper weights, injection boxes etc. embossed with bold logo of brand name of the company do not constitute ‘gift’ for the purpose of the Regulation. The bench considered HP HC case of Confederation v. CBDT and opined that the same does not suggest an absolute denial to deduction of such expenses.
Delhi Bench held the distribution of free samples to be out of the Explanation 1 to Section 37 as well as CBDT Circular especially when the same were given based on specific requests of medical practitioners (see end note 17).
Chennai Bench recently denied deduction of expenses on laptops, LCDs, TVs, etc. gifted to doctors (see end note 18) holding the same to be in contravention of the Regulations disagreeing to the theory that Regulations do not apply to pharma companies. In the case of Vishwanatha Sharma (see end note 19) commission to private doctors for prescribing specific medicines was allowed by tax authorities and disallowance was restricted to commission paid to government doctors. Issue before HC confined to the latter and disallowance was upheld by applying the retrospective Explanation.
Author’s analysis of the issues involved
Relevance of payer’s perspective
The reason that pharma companies are not prohibited from giving gifts and incurring other specified expenses is not supported by the text of the section. Language of the section is not confined to “payments / expenditure prohibited by law” rather it extends to “expenditure for any ‘purpose’ which is prohibited by law. If, what is achieved by the expenditure is prohibited by law then the same is not allowable. Clearly the purpose of the Regulations is to prevent receipt of such gratifications by doctors. Even the Explanatory Memorandum of the Budget and Explanatory Circular by CBDT (see end note 8) on Finance Act introducing Explanation suggest that payment of protection money will be disallowed as per amended law. Thus, the legislative intent is also clear to cover those cases where the payer cannot be charged with an offence. Punjab & Haryana High Court in KAP Scan (see end note 20) held both payer and recipient to be privies to a wrong and denied deduction on the ground of public policy. It held that payments opposed to public policy being unlawful consideration as per section 23 of Indian Contract Act cannot be allowed to be deducted for ascertaining taxable profits. A payment to achieve a purpose which defeats or contravenes a law was held to be disallowable even in year 1961 by Punjab High Court (see end note 21). It held that an expense having proximate connection with an act which is an infringement of law cannot be allowed as deduction. Delhi High Court (see end note 22) has held that an expense to defeat government policy cannot be allowed as deduction. Therefore, in Author’s view this argument may not pass muster with higher appellate authorities.
Even if one were to believe that the prohibition has to be on payer, the payment will still be opposed to public policy because its receipt is prohibited by law. Even before introduction of the Explanation, the law was well settled by Apex Court3 that expenses opposed to public policy cannot be allowed. The Karnataka High Court (see end note 23) has gone to the extent of saying that expenses tainted with immorality should not be allowed. It justified its statement by drawing support from illustration (j) to Section 23 of Indian Contract Act holding that immorality in certain cases coincides with illegality and a gratification to non-government officials seeking their undue influence is hit by that provision and disallowable being an unlawful consideration. Certainly, one needs to develop stronger arguments to support the deductibility.
Retrospectivity of the Circular
As the Circular does not go beyond the scope of enactment (see end note 24) there is no gainsaying that it is prospective. It merely clarifies the enactment. The disallowance therefore can operate qua any expense incurred after 10 December 2009.
Scope of disallowance
Free samples help the doctor in ascertaining the efficacy of the medicine. Diaries, pen sets, calendars, paper weights, injection boxes etc. embossed with bold logo of brand name of the company ensure brand promotion. It can also be argued that expenses on arranging conference for promoting the product and sharing field developments cannot be said to be a gift or perquisite
Considering their essential characteristic and predominant function, these expenses cannot be said to impair the independence of a medical practitioner. However gifting household items, travel, stay etc., could well be in breach of the Regulations. A distinguishing line between the two categories may be difficult to draw but must be drawn.
[The author is a Director, Direct Tax Practice, Lakshmikumaran & Sridharan, Bangalore]
- CIT v. Dhanrajgiri  91 ITR 544 (SC)
- CIT v. Walchand  65 ITR 381 (SC)
- Haji Aziz v. CIT  41 ITR 350 (SC)
- CIT v. Maddi Venkataraman  144 ITR 373 (Mad) approved in 229 ITR 534 (SC)
- CIT vs. S.C. Kothari  82 ITR 794 (SC) followed in CIT v. Piara Singh 124 ITR 40 (SC) 3JB
- Life Sight Surgicals Pvt. Ltd. v. DCIT  133 TTJ 27 (Ahd) ; Samir Surgitech (P) Ltd. in ITA No. 4560/Ahd/2003
- Pranav Construction v. ACIT  61 TTJ 145 (Mum)
- CBDT Circular 772 dated 23 December 1998 explaining the provisions of Finance (No.) Act 1998
- Confederation of Indian Pharmaceutical Industry (SSI) v. CBDT CWP No. 10793 of 2012-J.
- Dr. Reddy’s Laboratories v. ACIT ITA.No.294/Hyd/2014
- ACIT v. Geno Pharmaceuticals Ltd. ITA No. 12/PNJ/2014
- Syncom Formulations India Ltd. v. DCIT ITA No.6429&6428/Mum/2012
- UCB India Pvt. Ltd. v. ITO I.TA No. 6681/Mum/2013
- DCIT v. PHL Pharma Ltd. ITA No.4605/Mum/2014
- Relying on Max Hospital v. Medical Council of India W.P.(C) 1334/2013 though rendered in different context
- Relied on Eskayef (Now SmithklineBeecham) Pharmaceuticals (I) Ltd v. CIT (2000) 111 Taxman 561(SC)
- Eli Lilly & Co. v. ACIT ITA No.788/Del./2015
- Apex Laboratories v. ACIT 80 Taxmann.com 236 (Chennai)
- CIT v. Pt. Vishwanatha Sharma  316 ITR 419 (All)
- CIT v. KAP Scan (2012) 344 ITR 476 (P&H)
- Raj Woolen Industries v. CIT  43 ITR 36 (Punjab)
- IT v. Orissa Cement  258 ITR 365 (Del)
- J.K. Panthaki v. ITO  344 ITR 329 (Kar)
- Confederation of Indian Pharmaceutical Industry (SSI) v. CBDT CWP No. 10793 of 2012-J