Pharma Companies giving “freebies” to doctors allowed as expenditure

Disallowance under the Explanation to 37(1) of “freebies” to doctors by relying on CBDT Circular No 5 & the IMC (Professional Conduct, Etiquettes & Ethics) Regulation, 2002 is not justified for Pharma Companies

Section 37 of the Income Tax Act pertains to general allowability of business expenditure while computing Profits or Gains from Business or Profession. According to Section 37(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 to Section 37(1) 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.

For instance, commission paid to doctors for referring patients for diagnosis could not be allowed as a business expenditure as the amount which can be allowed as business expenditure has to be legitimate and not unlawful and against public policy.

Let us refer to the case of M/s Medley Pharmaceuticals Ltd vs Dy. Commissioner of Income, where the applicability of Section 37(1) was questioned.

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Facts of the Case:-

• The assessee company which is engaged in the business of manufacturing and trading of pharmaceutical products had filed its return of income for A.Y. 2012-13
• Original assessment in the case of the assessee was framed by the AO, vide his order passed under Sec.143(3). Subsequently, the case of the assessee was reopened under Sec.147.
• In the course of the assessment proceedings the assessee was supplied the copy of the ‘reasons to believe’ on the basis of which the case was reopened under Sec.147.
• The concluded assessment was reopened, for the reason, that the sales promotion expenses booked by the assessee company revealed that it had claimed deduction for various expenses which were clearly prohibited as per the MCI guidelines, and thus, disallowable as per Sec.37(1).
• The sales promotion expenses comprised of conference expenses for doctors, travelling expenses for doctors, other expenses related to doctors and expenses incurred on product reminders given to doctors.
• Observing, that the aforesaid expenses incurred by the assessee were not allowable as a deduction as per Sec.37(1), the AO disallowed the same.

Appeal to Commissioner of Income Tax (Appeals) [CIT(A)]

• Aggrieved, the assessee appealed the reassessment order before the CIT(A).
• The assessee had criticized the reassessment order on two grounds viz.
• that, the AO had reopened the concluded assessment of the assessee company merely on the basis of a change of opinion; and
• that, the AO had erred in disallowing the sales promotion expenses aggregating by wrongly bringing the said expenses within the realm of the Sec.37(1).
• However, CIT(A) upheld the assessment framed by the AO and dismissed the appeal.
• The assessee being aggrieved with the order of the CIT(A) has carried the matter in appeal before the ITAT

Appeal to Income Tax Appellate Tribunal [ITAT]

Observations of the ITAT on the contention of the assessee that there was no validity of the jurisdiction assumed by the AO for reopening the case

• Assessee claimed that the AO had merely on the basis of a ‘change of opinion’ reopened the concluded assessment that was framed by his predecessor under Sec. 143(3).
• According to the assessee, the reassessment proceedings were not based on any fresh material, but in fact, were resorted on the basis of a new view in respect of the same material available on record.
• ITAT found substantial force in the contention of the assessee that the entire exercise for reopening the concluded assessment was embarked upon by the AO, not on the basis of any fresh tangible material or any new information which had came to his notice subsequent to the passing of the original assessment proceedings, but on the basis of the same set of facts as were there before his predecessor while framing of the original assessment under Sec. 143(3).

• On a perusal of the ‘reasons to believe’, ITAT found, that the AO after referring to the amended IMC regulations, and also the CBDT Circular No. 5/2012, dated 01.08.2012 as well as the Explanation 1 to Sec. 37(1), had observed, that the said expenses incurred by the assessee company were to be disallowed
• But, the AO in the course of the original assessment proceedings, already had before him the bifurcated details of expenses, and also the assistance of the amended IMC regulations, and the CBDT Circular No. 5/2012, dated 01.08.2012.
• The AO while framing the regular assessment u/s 143(3), had consciously formed an opinion that out of the sales promotion expenses only the expenses incurred by the assessee for giving gifts to doctors were liable to disallowed u/s 37(1), as per the IMC regulations (as amended by the MCI on 14.12.2009) and the CBDT Circular No. 5/2012, dated 01.08.2012.
• Therefore, in the backdrop of the aforesaid observations, ITAT found substance in the claim of the assessee, that the reassessment proceedings were initiated by the AO, not on the basis of any fresh tangible material or any new information which had came to his notice subsequent to the culmination of the original assessment proceedings, but on the basis of the same set of facts as were there before his predecessor at the time of framing of the regular assessment under Sec. 143(3)

• ITAT was unable to comprehend as to what new material or information had come up before the AO, which would have justified the reopening of the concluded assessment of the assessee.
• AO could not form a justifiable basis for reopening the case of the assessee.
• Resultantly, the assessment framed by the A.O u/s 143(3) read with Section 147 was quashed for want of jurisdiction.
• Although, ITAT set aside the assessment for want of jurisdiction, however, for the sake of completeness and in order to avoid multiplicity of litigation they dealt with the contentions by the assessee on the merits of the case
• It was the claim of the assessee, that the lower authorities misconceiving the facts and the settled position of law had in the backdrop of the CBDT Circular No. 5, dated 01.08.2012 read with the IMC (Professional Conduct, Etiquettes & Ethics) Regulation, 2002, wrongly disallowed the aforesaid expenses which were incurred by the assessee wholly and exclusively for the purposes of its business, and were not in the nature of an expense that was prohibited under law.

Observations of the ITAT in the claim of the assessee that the Medical Council Regulations, 2002 would apply to medical practitioners but the same were not applicable to the pharmaceutical companies

• ITAT found, that the issue that the expenses wholly and exclusively incurred by a pharmaceutical company in the normal course of its business towards gifts, travel facility, conference expenses or similar freebies to medical practitioners or their professional associations would not be hit by the Explanation 1 to Sec. 37 of the Act, is covered by the order of a coordinate bench of the ITAT, Mumbai in the case of Aristo Pharmaceuticals Pvt. ltd. Vs. ACIT (ITA No. 6680/Mum/2012, dated 26.07.2018).
• In the said case, the ITAT had observed, that examining the provisions of the Indian Medical Council Act, 1956, revealed that the scope and ambit of the statutory provisions relating to professional misconduct of registered medical practitioners under the Indian Medical Council Act, 1956, is restricted only to the persons registered as medical practitioners with the State Medical Council and whose name is entered in the Indian Medical Register maintained under Sec. 21 of the said Act.

• It was also observed that the scheme of the Indian Medical Council Act, 1956 neither deals with nor provides for any conduct of any association/society, and only regulates the conduct of registered medical practitioners and not the pharmaceutical companies or allied health sector industries.
• ITAT also drew support from the order of the High Court of Delhi in the case of MAX Hospital., Pitampura Vs. Medical Council of India.
• In the aforesaid case, the Medical Council of India (MCI) had filed an Affidavit before the High Court, wherein it was deposed by the council that its jurisdiction was limited only to take action against the registered medical professionals under the Indian Medical Council (Professional Conduct, Etiquette and Ethics) Regulations, 2002, and it had no jurisdiction to pass an order affecting the rights/interest of the petitioner hospital.
• In the backdrop of its exhaustive deliberations the ITAT concluded that even if the assessee had incurred expenditure on distribution of freebies to doctors and medical practitioners, the same though may not be in conformity with the Indian Medical Council (Professional Conduct, Etiquette and Ethics) regulations, 2002, but then, as the same only regulates the code of conduct of the medical practitioners/doctors, therefore, in the absence of any prohibition on the pharmaceutical companies in incurring of such sales promotion expenses it cannot be held to have incurred an expenditure for a purpose which is an offence or is prohibited by law.

Observation of the ITAT on the contention of the assessee that the CBDT Circular was applicable prospectively, therefore, the same was not applicable in the case of the assessee for the year under consideration i.e A.Y. 2012-13

• ITAT was also in agreement with the alternative contention advanced by the ld. A.R, that though a benevolent CBDT Circular may apply retrospectively, but then, a circular imposing a burden on an assessee has to apply prospectively only.
• The CBDT Circular No. 5/2012 was issued only as on 01.08.2012. The same would thus not be applicable to the case of the assessee i.e for the period relevant to A.Y 2012-13.
• It was also observed that a coordinate bench of the Tribunal viz. ITAT, Mumbai in the case of Syncom Formulations (I) Ltd. Vs. DCIT, Mumbai dated 23.12.2015 for A.Ys 2010-11 and 2011-12 had concluded that the aforesaid CBDT Circular No. 5/2012, dated 01.08.2012 would not be applicable to the A.Ys 2010-11 and 2011-12, as the same was introduced w.e.f. 01.08.2012.
• ITAT in the case of Aristo Pharmaceuticals Pvt. ltd. Vs. ACIT (dated 26.07.2018), took a similar view and held that the aforementioned CBDT Circular No. 5/2012, dated 01.08.2012 would not be applicable to the case of the assessee before them for A.Y. 2011-12.

Observation of the ITAT on the contention of the assessee that the circular issued by CBDT cannot impose an obligation adverse to an assessee

• According to the ITAT, though the CBDT can tone down the harshness of law in order to ensure a fair enforcement of the provisions by issuing circulars for clarifying the statutory provisions, however, it cannot create a new impairment adverse to an assessee, or to a class of assesses, without any sanction or authority of law.
• The CBDT is divested of it powers to enlarge the scope of MCI regulation by extending the same to pharmaceutical companies without any enabling provision either under the Income tax Act or the Indian Medical Regulations.

• The same was also deliberated upon by the ITAT in the case of Aristo Pharmaceuticals Pvt. ltd. Vs. ACIT (dated 26.07.2018), wherein it was observed that circulars which are issued by the CBDT must confirm to the tax laws and though they are meant for the purpose of giving administrative relief or for clarifying the provisions of law, but the same cannot impose a burden on the assessee, leave alone creating a new burden by enlarging the scope of a regulation issued under a different act so as to impose any kind of hardship or liability on the assessee.
• Thus, ITAT was of the view that the burden imposed by the CBDT vide its aforesaid Circular No. 5/2012, dated 01.08.2012 on the pharmaceutical or allied health sector industries, despite absence of any enabling provision under the Income Tax law or under the Indian Medical Council Regulations, clearly negatively affects on the conduct of the pharmaceutical and allied health sector industries in carrying out its business.

It was thus concluded that the expenditure incurred by the assessee company on sales promotion expenses by way of distribution of articles to the stockists, distributors, dealers, customers and doctors, would not be hit by the Explanation to Sec. 37(1) of the Act and the appeal was thus allowed.

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