GST Council | Goods & Services Tax Council | Indian GST CouncilIncome TaxTaxExpenditure Incurred by Pharmaceutical Companies in Gifting Freebies to Doctors is not Deductible under Section 37

The Supreme Court in M/s Apex Laboratories Pvt. Ltd. v. Deputy Commissioner of Income Tax, Large Tax Payer Unit-II [Special Leave Petition (Civil) No. 23207 of 2019] decided on 22.02.22, held that the expenditure incurred by pharmaceutical companies in gifting freebies to doctors is not deductible under Section 37 of the Income Tax Act, 1961, for being against public policy.

FACTS

The Appellant in the present case has filed a special leave petition before the Hon’ble Supreme Court of India (“the Supreme Court“) under Article 136 of the Constitution of India to set aside a judgment of the Hon’ble Madras High Court (“the High Court“) which upheld an order of the Income Tax Appellate Tribunal (“the ITAT“).

The ITAT upheld an order of the Commissioner of Income Tax (Appeals) (“the CIT(A)“) partially allowing an order of the Respondent, whereby the Respondent had partially allowed amounts claimed by the Appellant as ‘business expenditure’ under Section 37(1) of the Income Tax Act, 1961 (“the IT Act“).

The Central Board of Direct Taxes (“the CBDT“) published a clarifying circular on 01.08.2012 (“the Circular“), whereby expenses incurred by pharmaceutical and allied health sector industries for the purposes of incentivising medical practitioners through distribution of freebies, was disallowed from the provision laid down under Section 37(1) of the IT Act, in light of Explanation 1 of the same. The relevant part of the provision is reproduced below for easy reference:

“(1) Any expenditure (not being expenditure of the nature described in Sections 30 to 36 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 shall be allowed in computing the income chargeable under the head ‘Profits and gains of business or profession’.

Explanation 1.- …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 and allowance shall be made in respect of such expenditure…”.  [Emphasis supplied]

Consequently, the CBDT issued a notice on 22.11.2012 under Section 142(1) of the IT Act to the Appellant. In the notice, the Appellant was asked to explain reasons for exclusion of expenditure to the tune of Rs. 4,72,91,159/- from its total income.

The said expenditure was incurred by the Appellant to distribute freebies to medical practitioners in the nature of hospitality, conference fees, electronics such as TVs and laptops etc. to create awareness about the Appellant’s product ‘Zincovit’.

In light of the Circular read with Explanation 1 to Section 37(1) of the IT Act, the said expenditure could not be deducted as a business expense.

The had partially allowed the expenditure to be deducted from the Appellant’s total income. The reason for this partial allowance was that the Indian Medical Council (Professional Conduct, Etiquette and Ethics) Regulations, 2002 (“the IMC Regulations“), which prohibits medical practitioners from accepting emoluments and levies sanctions for default, was published in the Official Gazette on 14.12.2009.

Therefore, only the expenditures incurred by the Appellant before the date of publication of the IMC Regulations was allowed for benefit under Section 37(1) of the IT Act.

Aggrieved by this order for partial allowance, the Appellant, after a series of appeals to the CIT (A), the ITAT and the High Court, filed a special leave petition before the Supreme Court challenging the order of the High Court.

ISSUE BEFORE THE SUPREME COURT

Whether expenditure incurred by pharmaceutical companies in gifting freebies to medical practitioners is a deductible business expenditure under Section 37(1) of the IT Act?

CONTENTIONS OF THE PARTIES

The Appellant contended that the prohibition and sanction under the IMC Regulations did not bind pharmaceutical companies, as they only prohibited medical practitioners from accepting emoluments, whereas no corresponding prohibition was placed on pharmaceutical companies regarding gifting such emoluments.

Further, relying on the decision of Max Hospital Pitampura v. Medical Council of India [W.P. (C) No. 1334/2014 / ILR (2014) 1 Delhi 620] (“the Max Hospital case“) the Appellant pleaded that the IMC Regulations were not enforceable against pharmaceutical companies, but only against medical practitioners.

The Appellant also placed reliance on the judgment of Dr. Anil Gupta v. Addl. Commissioner of Income Tax [Income Tax Appeal No. 485/2008, decided on 18.07.2017] wherein Division Bench of the Rajasthan High Court held that the contentions based on Explanation 1 to Section 37(1) of the IT Act could not be raised by the Respondents for the first time at an appellate stage, and observed as under:

“Even otherwise in income tax proceedings the medical ethics will not be taken into consideration. At the most even if it is a professional misconduct, it is to be dealt with by Medical Council of India. The income tax authority cannot decide the medical ethics when the original authority has partly allowed the expenses”

The Appellant further contended that a tax benefit could not be denied by the revenue on the ‘nature’ of the expenditure. In this regard, the Appellant relied on the judgment of T.A. Qureshi v. Commissioner of Income Tax, Bhopal [(2007) 2 SCC 759] (“the T.A. Qureshi case“) wherein it was held that law and morality are different from each other, and cases have to be decided on legal principles as opposed to moral views, allowing the Appellant to deduct the cost of heroin seized as a business loss.

The Appellant submitted that along similar lines of the T.A. Qureshi case, in Commissioner of Income Tax v. M/s Khemchand Motilal Jain [2011 (4) MPLJ 691] (“the K.M. Jain case“), a Division Bench of the Madhya Pradesh High Court held that ransom paid to kidnappers of an employee of the Respondent on a business trip was an allowable business expense under Section 37(1) of the IT Act as there was no provision in law prohibiting payment of ransom, thereby barring applicability of Explanation 1 to Section 37(1) of the IT Act.

The Appellant also contended that on the basis of the Memorandum explaining the provisions of the Finance (No. 2) Bill, 1998 stating that Explanation 1 to Section 37(1) would result in disallowance of protection money, extortion, hafta, bribes etc. as business expenses; that the Parliament intended to bring under the ambit of Explanation 1 only such activities where are regarded as ‘offenses’ under statutes.

The Appellant’s act of distributing freebies is not recognised as an illegal act or offense by any law in force, and hence cannot be included in Explanation 1, if it is interpreted in the strict sense.

The Appellant argued that the Circular in essence enlarged the scope of application of the IMC Regulations without any enabling provision empowering it.

The Appellant pleaded that even if the Circular had to be made applicable, it could be done only from the date of its publication, i.e. 01.08.2012, and not from the date of publication of the IMC Regulations, i.e. 14.12.2009, as oppressive circulars like the present cannot be made applicable with retrospective effect.

The Respondent contended that distribution of freebies by pharmaceutical companies may not be an offense under any law, but Explanation 1 to Section 37(1) included such an act within it’s ambit by using the phrase ‘prohibited by law’, as the same was specifically prohibited by the IMC Regulations.

The Respondent further contended that the Parliament intended to stop incentivisation of prescribing dearer branded medications instead of their equally efficient and effective generic counterparts, in exchange for luxurious freebies. This intention is clear not only from the IMC Regulations, but also from the provision in the Prevention of Corruption Act, 1988 (“the PC Act“) which provides that a government doctor who receives any illegal gratification amounting to malpractice or any other offence may be charged under the PC Act, as well as the Indian Penal Code.

The Respondent argued that practices like prescription of branded medications in the place of generic ones have a direct effect on public policy, and the scope of the IMC Regulations was broad enough to cover situations which had not been specifically listed under them.

The Respondent relied on Commissioner of Income-Tax v. Kap Scan and Diagnostic Centre P. Ltd. [(2012) 344 ITR 476 (P&H HC)] (“the Kap Scan case“) wherein it was held that demanding commission for referring patients to a particular diagnostic centre and paying such commission to medical practitioners were equally bad, and no benefit was allowed in this regard.

The Respondent submitted that as per Confederation of Indian Pharmaceutical Industry (SSI) v. Central Board of Direct Taxes [(2013) 353 ITR 388 (HP HC)] (“the CIPI case“), prohibition laid down in the IMC Regulations regarding prescription of branded medications in exchange for gifts and freebies warrants the application of Section 37(1) of the IT Act. It was also held that the Circular was legally valid and the onus was on the assessee to establish that the expenditure brought into question did not violate the IMC Regulation.

Lastly, the Responded pleaded that fully allowing the Appellant to claim deduction under Section 37 of the IT Act would deprive the revenue considerable amount of tax.

DECISION AND FINDINGS

The Supreme Court pointed out that Section 37 of the IT Act is a residuary provision, and not absolute in nature, as evidenced by Explanation 1, which brings in its ambit all activities that are illegal, or prohibited by law and/or punishable under any statute.

The Supreme Court observed that a bare perusal of Regulation 6.8 of the IMC Regulations makes it clear that acceptance of freebies from pharmaceutical companies by medical practitioners is an offense on the latter’s part, and comes with consequences.

The Supreme Court held that the Circular lays down in unambiguous terms that not only is expenditure incurred by pharmaceutical companies is inadmissible under Section 37(1) of the IT Act for being an expense prohibited by law, but even the sum equivalent to the monetary value of such freebies accepted by medical practitioners is taxable as business income or income from other sources, as per the relevant facts.

Further, the Supreme Court re-visited ITAT’s judgment in Dy. CIT 8(2) Mumbai v. PHL Pharma P. Ltd. [ITA No. 4605/Mum/2014, dated 12.01.2017], which relied on the Max Hospital case to arrive at the conclusion that the IMC Regulations were not applicable to pharmaceutical companies, and in the absence of any enabling provision, the CBDT was not empowered to bring pharmaceutical companies within the purview of the IMC Regulations, that too with retrospective effect.

The Supreme Court further observed that the ITAT also discussed judgments in the Kap Scan case and the CIPI case, and held that these rulings did not place a blanket ban on pharmaceutical companies from claiming deduction under Section 37(1) of the IT Act, but merely subjected the same to the satisfaction of the Assessing Officer on a case-to-case basis.

After duly considering the ITAT’s judgement, the Supreme Court in the present case opined that:

“…such a narrow interpretation of Explanation 1 to Section 37(1) defeats the purpose for which it was inserted, i.e., to disallow an assessee from claiming a tax benefit for its participation in an illegal activity. Though the memorandum to the Finance Bill, 1998 elucidated the ambit of Explanation 1 to include “protection money, extortion, hafta, bribes, etc.”, yet, ipso facto, by no means is the embargo envisaged restricted to those examples. It is but logical that when acceptance of freebies is punishable by the MCI (the range of penalties and sanction extending to ban imposed on the medical practitioner), pharmaceutical companies cannot be granted the tax benefit for providing such freebies, and thereby (actively and with full knowledge) enabling the commission of the act which attracts such opprobrium.”

In this regard, the decision of P.V. Narasimha Rao v. State (CBI/SPE) [(1998) 4 SCC 626] was referred to wherein the Constitution Bench of the Supreme Court held that bribe-givers must be criminally prosecuted, even though the PC Act before its 2018 amendment only punished the bribe-taker.

Even if there was no provision directly implicating the Appellant and categorising its act of giving freebies as an offence, such an act without any doubts falls within the ambit of ‘prohibited by law’ in Explanation 1 to Section 37(1) of the IT Act.

Next, invoking the rule of implied prohibition, the Supreme Court referred to the decision of Jamal Uddin Ahmad v. Abu Saleh Najmuddin & Anr. [(2003) 4 SCC 257] which stipulated that:

“An affirmative statute introductive of a new law directing a thing to be done in a certain way mandates, even if there be no negative words, that thing shall not be done in any other way.”

Therefore, the provisions of the IMC Regulations and Explanation 1 to Section 37(1) clearly prohibit pharmaceutical companies from distributing freebies to medical practitioners, even if the absence of any explicit statutory provision in this regard.

The Supreme Court held that a settled legal principle of ex dolo malo non oritur action, i.e. no Court will lend its aid to a party that roots its cause of action in an immoral or illegal act, also comes into picture in the present case.

Taking into consideration, medical practitioners and pharmacists are complementary and supplementary to each other in the medical profession; the Supreme Court asserted that a comprehensive view must be adopted to regulate their conduct in view of the contemporary statutory regimes and regulations. The Appellant here is participating in an act which is prohibited by law, and hence, it precludes its claim of deductibility of expenditure incurred in distribution of freebies.

Dwelling on the aspect of violation of public policy, the Supreme Court pointed out that doctors have a quasi-fiduciary relationship with patients. Hence, likelihood of a doctor’s prescription being manipulated driven by the motive of getting freebies, is a matter of great public importance and concern.

It was further observed that:

“These freebies are not technically ‘free’- the cost of supplying such freebies is usually factored into the drug, driving prices up, thus creating a perpetual publicly injurious cycle”.

The importance of public policy issue on the matter at hand has been correctly taken into consideration in the impugned judgment of the High Court, as well as in the judgements of the Kap Scan case and the CIPI case.

One arm of the law cannot be used to defeat its other arm, and any attempt to do otherwise would be against public policy, bringing the law into ridicule. Therefore, allowing deduction under one law of any expense which has been incurred in violation to another law is against public policy.

Any agreement between a pharmaceutical company and a doctor regarding gifting freebies in exchange for prescription of the pharmaceutical company’s drug would also be hit by Section 23 of the Contract Act, 1872.

The Supreme Court differentiated the judgments of the T. A. Qureshi case and the M/s K.M. Jain case. In the former, the deduction allowed was in the nature of a business ‘loss’ and not a business ‘expenditure’, and in the latter, the ransom money paid was allowed as a deductible expense because the assessee was helpless and was coerced into paying the amount to save a life. It cannot be placed on the same level as wilfully participating in the commission of an offense.

The Appellant’s argument that Explanation 1 to Section 37(1), being a provision of a taxing statute, should be interpreted strictly; was also rejected by the Supreme Court as the requirement of strict interpretation cannot be sustained if such interpretation results in an absurdity which goes against the intention of the Parliament.

Further, it is also a settled legal principle that what cannot be done directly, cannot be achieved indirectly. While interpreting any law, it should not be interpreted in a manner which allows attempts to do in an indirect manner the same thing that law seeks to prohibit.

Hence, based on the foregoing discussion, the Supreme Court, while dismissing the appeal, held that the expenditure incurred by pharmaceutical companies in giving freebies to medical practitioners is not a deducible business expenditure under Section 37(1) of the IT Act.

AMLEGALS REMARKS 

The Supreme Court in the present case has brought in the notion of public policy in interpretation of taxing statues, re-affirming the country’s position as a welfare state.

This is likely to have interesting implications on the other taxation statues in force, as well. Under the Central Goods and Services Tax Act, 2017 (“CGST Act“), input tax credit (“ITC“) is allowed on supply of any goods or services, used or intended to be used, in the course of or in furtherance of business, subject to other provisions in this regard.

The moot question arises that will this judgement of the Supreme Court act as a bar in availing input credit of freebies supplied to pharmaceutical companies which are further used by them in the course of or in furtherance of their business?

Section 17(5) of the CGST Act, which stipulates cases where ITC is not available; does not make any provision in this regard. However, in light of this judgement, we might see an amendment in the aforesaid provision explicitly barring pharmaceutical companies from availing input tax credit in the stipulated situation.

In the meantime, it unclear whether ITC may be declined on the grounds of violation of public policy, as an extension of this judgement. If yes, this will be an important segue from the hitherto literal interpretation of Section 17(5) of the CGST Act, 2017.