On 23rd April 2025, the Ministry of Finance issued Notification No. 38/2025, under the authority of the Central Board of Direct Taxes (CBDT). This notification restricts the deductibility of business expenses related to the settlement of regulatory violations under certain key laws, aimed at reinforcing compliance and ensuring that businesses cannot offset the financial impact of such settlements by claiming them as business deductions. This regulatory update has significant implications for businesses involved in the capital markets, securities regulations, and competition law.
Understanding Section 37(1) and Its Legal Context
Section 37(1) of the Income-tax Act, 1961 allows businesses to claim deductions for expenses incurred wholly and exclusively for business or profession. However, the section includes key exclusions, such as those related to illegal activities or those incurred in violation of law.
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Explanation 1 and 3 under Section 37(1) explicitly restrict the deduction of expenses incurred for illegal purposes or in contravention of any law.
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Clause (iv) of Explanation 3 empowers the Central Government to issue notifications, specifying laws under which expenses related to settlement of regulatory violations will not be eligible for tax deductions.
The Impact of Notification No. 38/2025
In a move to further tighten compliance, Notification No. 38/2025 has been issued, specifying that settlement costs arising from violations or default under the following acts will not be allowed as business deductions:
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Securities and Exchange Board of India Act, 1992 (SEBI Act)
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Securities Contracts (Regulation) Act, 1956
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Depositories Act, 1996
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Competition Act, 2002
This means that any expenditure incurred in settling proceedings related to contraventions of the above laws will now be non-deductible for tax purposes.
Key Implications for Businesses
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Non-Deductibility of Settlement Costs: The most immediate impact of this notification is the disallowance of deductions for any expenses incurred in the settlement of violations under these specific regulatory frameworks. Businesses involved in such settlements will no longer be able to claim these costs as business expenses, leading to higher taxable income and consequently, higher tax liabilities.
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Stronger Incentive for Compliance: By making settlement costs non-deductible, the government aims to discourage non-compliance and the treatment of regulatory fines as routine business expenses. This places a stronger emphasis on preventive compliance measures, as companies now bear the full financial consequences of regulatory breaches.
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Legal and Tax Strategy Adjustments: Companies operating in regulated sectors such as capital markets, competition law, and securities trading must now factor in the non-deductibility of such expenses in their tax projections. This could significantly affect tax planning strategies, and businesses must review their risk management frameworks to avoid costly regulatory violations.
Strategic Considerations for Businesses
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Revised Tax Planning: With settlement expenses now explicitly non-deductible, businesses must adjust their tax planning strategies to account for the additional tax burden. Companies should revise their taxable income projections and ensure that they are prepared for the higher effective tax rates arising from these changes.
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Strengthening Compliance Frameworks: To avoid incurring non-deductible settlement costs, companies must prioritize regulatory compliance and risk management. This means enhancing internal controls and proactively adhering to the SEBI Act, Competition Act, and other applicable laws to mitigate the risk of violations that could result in settlements or penalties.
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Proactive Risk Management: This notification underscores the need for businesses to focus on compliance and regulatory adherence, ensuring that their operations remain in line with legal frameworks to avoid unnecessary costs. Companies must reassess their internal processes, keeping a sharp focus on avoiding violations and penalties that cannot be offset by tax deductions.
Conclusion
CBDT Notification No. 38/2025 marks a significant shift towards reinforcing legal compliance by eliminating the possibility of tax deductions for settlement costs related to regulatory violations. This move aligns with the government's broader goal of promoting integrity and adherence to regulatory norms within sectors governed by securities and competition laws.
For businesses, this change is a call to action: companies in regulated industries must prioritize compliance and refine their risk management practices to minimize the possibility of violating laws. This update serves as a reminder that businesses can no longer treat regulatory fines and settlement costs as a routine part of their business expenditure—they must bear the full financial impact.
