On 23rd April 2025, the Central Board of Direct Taxes (CBDT) issued Notification No. 38/2025, invoking its powers under clause (iv) of Explanation 3 to Section 37(1) of the Income-tax Act, 1961. The notification marks a significant development in tax policy, especially concerning expenditure incurred by businesses to settle legal proceedings.
⚖️ Understanding Section 37 of the Income-tax Act, 1961
Section 37(1) allows deduction of any expenditure (not being personal or capital in nature) incurred wholly and exclusively for the purpose of business or profession. However, this is subject to Explanation 1, which restricts deductions for any expenditure that is:
- An offence, or
- Prohibited by law
In other words, if an assessee spends money to violate laws, or to escape penal consequences, such expenses cannot be claimed as tax-deductible.
🧾 What Changed in Explanation 3 via the Finance (No. 2) Act, 2024?
The Finance (No. 2) Act, 2024 expanded the scope of Explanation 3 under Section 37. Now, it explicitly includes:
Any expenditure incurred by an assessee to settle proceedings initiated in relation to a contravention under any law, as may be notified by the Central Government.
This means even out-of-court settlements or compromise payments made under certain laws—if notified—are also not deductible.
📄 Notification No. 38/2025: Specified Laws
Under this notification, the following laws have been brought under the scope of disallowed expenditure for settlement proceedings:
- Securities and Exchange Board of India (SEBI) Act, 1992
- Securities Contracts (Regulation) Act, 1956
- Depositories Act, 1996
- Competition Act, 2002
Any payment made—whether by way of fines, penalties, compounding fees, or compromise amounts—to settle cases under these laws will not be allowed as a business deduction under the Income-tax Act.
📅 Effective Date
The notification is effective from 1st April 2025, and the new rules apply from Assessment Year (AY) 2025-26 onwards.
📋 Amendment in Form 3CD (Tax Audit Report)
To ensure better reporting and compliance, Form 3CD under the Income-tax Rules, 1962 (used for tax audit reporting) has also been updated via CBDT Notification No. 23/2025 dated 28.03.2025.
Now, businesses and auditors must disclose such expenses explicitly during tax audit.
⚠️ Implications for Businesses and Professionals
- ❌ No deduction will be allowed for payments made to settle proceedings under the four notified laws.
- 🧾 Tax audits must now report such expenses separately, making tax positions more transparent.
- ⚖️ Businesses need to review their litigation strategies and disclosures, especially in regulatory matters.
- 💼 This is a compliance tightening measure and sends a clear message: Violations, even if settled, won’t get tax shelter.
🧩 FAQ
Click here to read FAQ release for this
The CBDT’s move is aligned with the government’s broader goal of ensuring that the tax system does not incentivize or indirectly support non-compliance with regulatory laws. This notification under Section 37 emphasizes that any amount paid to regularize, settle, or escape from legal contraventions in notified domains shall bear full tax cost.
Visit www.cagurujiclasses.com for practical courses
