The Finance (No.2) Act, 2024 introduced a new clause (iv) within Explanation 3 to Section 37(1) of the I-T Act, inter alia granting the Central Govt. authority to notify specific laws under which expenditure incurred in connection with settlement proceedings pursuant to contravention of such laws, would be considered as expenditure for any purpose which is an offence or which is prohibited by law.

In this insightful column, Mr. Anand Eriwal (Assistant Vice President - Group Direct Taxation, Welspun Group) presents a detailed analysis of the recent CBDT Notification on notified laws as per Explanation to Section 37(1). Outlining the expenditures that might be caught under this CBDT Notification, and further elaborating on the impact of the amended Section 37(1), the author remarks that “The “plug-and-play” framework under the amended Explanation 3 transforms Section 37(1) from a static rule into a dynamic compliance tool.” While signing off, he posits that, by allowing the Central Govt. to simply plug in new statutes via Gazette notification, and have those disallowances play out immediately - taxpayers gain clear, advance visibility on what settlement or compounding payments are off-limits.

“Section 37(1) Disallowance by Prescription: The Era of Plug-and-Play Tax Rules”

Introduction:

A New Era of Tax Rules —But Does It Bring Certainty or Spark Litigation?

The Finance (No.2) Act, 2024 introduced a new clause (iv) within Explanation 3 to Section 37(1) of the Income-tax Act, 1961 (‘Act’), granting the Central Government authority to notify specific laws under which expenditure incurred in connection with settlement proceedings pursuant to contravention of such laws, would be considered as expenditure for any purpose which is an offence or which is prohibited by law.  Consequently, such expenditure shall not be considered as incurred for the purpose of business or profession. Thus, such expenses are to be disallowed i.e. not allowable as deduction u/s 37(1) of the Act.

CBDT Notification No. 38/2025 dated 23 April 2025, is the first exercise of that power. Yet, while advance lists promise transparency, could they also generate fresh legal challenges over what “settlement” really covers?

Tracing the Evolution: From Broad Principles to Targeted Lists

• Original Principle:

Section 37(1) allowed “wholly and exclusively” business expenses except as covered by Sections 30–36.  Further, the expenses should not be capital in nature and should not be personal in nature.  The expenses should be wholly and exclusively expended for the purpose of business or profession so that it can be claimed as an allowable expenditure under the head profits and gains or business or profession.

• Judicial Boundaries:

Landmark rulings affirmed that expenses for offences or law

 (Maddi Venkataraman & Co. (P.) Ltd. vs. CIT [229 ITR 534)] = [TS-5102-SC-1997-O] violations are non-deductible.

Enter amendment to Explanation 3:

Rather than leave taxpayers guessing until a court decision, the government now issues notifications listing precise statutes—and pre-empts disputes by spelling out the rules in advance.

CBDT Notification No. 38/2025: Which Four Acts Are In-Focus?

Under Explanation 3, the first notified statutes are:
1. SEBI Act, 1992;
2. Securities Contracts (Regulation) Act, 1956;
3. Depositories Act, 1996; and
4. Competition Act, 2002
Any payment to settle proceedings under these Acts is expressly excluded from deduction under Section 37(1).

Illuminating Settlement Expenditures: What Might Be Caught under the CBDT Notification?

1. SEBI Act, 1992

Under the SEBI Act, entities can resolve alleged defaults through a consent mechanism, where they pay a settlement amount without admitting or denying guilt. Examples of such settlement expenditures may include Consent fees paid to SEBI to settle proceedings without admission of guilt.

The above settlement expenditure may be subject to disallowance consequent to the aforesaid CBDT Circular.

2. Securities Contracts (Regulation) Act, 1956

The Securities Contracts (Regulation) Act provides for the settlement of proceedings initiated under sections 12A or 23-I through a written application proposing settlement, subject to the Board's approval.

Examples of settlement expenditures under this Act may include:​

• Settlement application fees: Fees paid to the Board for processing the settlement application.

• Settlement charges: Charges levied by the Board for the settlement of proceedings.

• Compliance costs: Expenses incurred to ensure compliance with the terms of the settlement.​

The above settlement expenditure may be subject to disallowance consequent to the aforesaid CBDT Circular.

3. Depositories Act, 1996

The Depositories Act does not explicitly provide for settlement procedures akin to those in the SEBI Act or the Securities Contracts (Regulation) Act. However, any payments made under this Act, such as:​

• Settlement fees: Fees paid to the depository for settling disputes or proceedings.

• Penalty payments: Payments made to settle penalties imposed under the Act.

• Legal expenses: Costs incurred for legal representation in settlement proceedings.​

• The above settlement expenditure may be subject to disallowance consequent to the aforesaid CBDT Circular.

4. Competition Act, 2002

The Competition Act does not have a specific provision for settlement of proceedings. However, the Competition Commission of India has the authority to impose penalties for contraventions of the Act. Payments made to settle such proceedings, including:​

• Settlement fees: Fees paid to the Commission to settle proceedings.

• Penalty payments: Payments made to settle penalties imposed under the Act.

• Legal and advisory fees: Costs incurred for legal counsel and advisors to facilitate the settlement process.

• The above settlement expenditure may be subject to disallowance consequent to the aforesaid CBDT Circular.

“Plug -and-Play” Tax Rules

In the context of amendment to Section 37(1) of the Act, “Plug-and-Play” refers to a modular notification mechanism built into Explanation 3.  Instead of waiting for a full-fledged Finance Act or court ruling to disallow a new category of expenses, the Central Government can simply “plug-in” an additional law (via Official Gazette notification) under clause (iv) of Explanation 3 – and that disallowance  will “play” i.e. will take immediate effect for the relevant assessments.

“Yet, without further guidance, could taxpayers challenge whether a given expense truly falls within the notified scope?

Tax Auditor’s Action Points: Staying Ahead of the Curve

1. Secure Settlement Documents: Obtain compounding or settlement orders under the four Acts—plus any related fee breakdowns.
2. Obtain Management Declarations: Confirm in writing that no such payments were claimed as deductions.
3. Report Under Clause 21(a) of Form 3CD: Flag any outlays caught by the notification, detailing your rationale.
Sharp documentation will be essential—otherwise, auditors may find themselves answering objections rather than closing audits.

Spotlight on Section 271J: Why Auditors Can’t Afford Misses

Under Section 271J of the Act, submitting an incorrect tax-audit report can trigger a ₹10,000 penalty per report. If an auditor overlooks a non-deductible settlement cost, that lapse could become costly.

Conclusion: Embracing Plug-and-Play Tax Rules for Strategic Advantage

The “plug-and-play” framework under the amended Explanation 3 transforms Section 37(1) from a static rule into a dynamic compliance tool. By allowing the Central Government to simply plug in new statutes via Gazette notification—and have those disallowances play out immediately—taxpayers gain clear, advance visibility on what settlement or compounding payments are off-limits. Yet, with certainty comes a fresh frontier of interpretation: defining the bounds of “settlement,” distinguishing legal fees from compounding levies, and ensuring exhaustive audit reporting under Form 3CD.

For businesses and their advisors, there are two important takeaways:​

1. Implement Strong Controls: Ensure that any payments related to the SEBI Act, Securities Contracts Act, Depositories Act, or Competition Act are carefully monitored and managed.​

2. Stay Informed: Regularly check for new notifications that may expand the list of disallowed deductions.​

By doing this, you can avoid unexpected tax issues and use these rules to your advantage, turning compliance into a competitive edge.​

In today's fast-changing regulatory environment, understanding and applying these rules proactively can help you make confident decisions for your business.