Apex Laboratories

In a recent decision of M/s Apex Laboratories vs. Deputy Commissioner of Income Tax[1], the Supreme Court yesterday held that expenditure incurred by a pharmaceutical company towards distribution of incentives (freebies) to doctors cannot be claimed as expenditure under Section 37(1) of the Income Tax Act, 1961 (“IT Act”), since the same is illegal in nature.

Section 37(1) of the Act is a residuary provision, which allows taxpayers to claim deductions on expenditure laid out wholly and exclusively for the purposes of business or profession. Explanation 1 to the provision provides that no deduction or allowance shall be made in respect of expenditure incurred by the taxpayer “which is an offence, or which is prohibited by law”.

Indian Medical Council (Professional Conduct, Etiquette and Ethics) Regulations, 2002 (‘Medical Council Regulations’), regulates the professional conduct of doctors in India. Regulation 6.8 of the Medical Council Regulations prohibits a doctor from receiving gifts, travel facilities, hospitality, cash or monetary grants from a pharmaceutical company. Acceptance of such freebies can lead to penal consequences on the part of the doctor – to the maximum extent, such that the doctor may be removed from the Medical Register for a period from three months to one year.

Given that the Medical Council Regulations do not penalise pharmaceutical companies, they continue to claim deductions on expenditure incurred by them on these freebies. Therefore, the Central Board of Direct Tax (‘CBDT’) issued a circular on August 1, 2018, clarifying that any expenditure incurred on freebies, which is in violation of the Medical Council Regulations shall be inadmissible under Section 37(1).

In the instant case, the taxpayer contended that deduction on expenditure incurred towards freebies should be allowable since there was no corresponding sanction on pharmaceutical companies, prohibiting the grant of freebies to doctors. On the other hand, the Income Tax Department (“ITD”) submitted that even if the practice did not constitute an ‘offence’, the Medical Council Regulations made the practice illegal and therefore the deductions should be unallowable, being ‘prohibited by law’.

The SC noted that Explanation 1 was inserted in Section 37(1) to disallow a taxpayer from claiming deductions on expenditure on illegal activities. It observed that if pharmaceutical companies are able to claim expenses incurred by them on activities that are prohibited by law, it would be inconsistent and also reward erring pharmaceutical companies.

Explanation 1 to Section 37(1) disallows deduction on any expenditure which is “an offence or which is prohibited by law”. The scope and ambit of Explanation 1 is significantly broader and includes acts that are illegal/prohibited by law and/or punishable. The SC also held that doctors and pharmacists are ‘complementary and supplementary to each other in the medical profession’ and, therefore, a ‘comprehensive view’ has to be taken of the regulations/ regimes in question. Given that the acceptance of freebies is prohibited and subject to penal sanction under the Medical Council Regulations, the Court held that the grant of such freebies should also be considered as ‘prohibited by law’.

The Hon’ble Apex Court also briefly touched upon the rationale underlying the illegality of such freebies and consequent disallowance. The SC referred to the report of the Parliamentary Standing Committee on Health and Family Welfare, which had observed that gifting of freebies leads to medical practitioners prescribing medicines that are sold at a significant mark up (over effective generic counterparts). The SC also noted that the grant of freebies would further enhance drug prices, thereby creating a ‘perpetual publicly injurious cycle’.

In conclusion, the SC held that the prohibition on the part of the doctors to accept freebies was also a prohibition on pharmaceutical companies. Therefore, pharmaceutical companies would not be allowed to claim expenditure prohibited under the Medical Council Regulations as tax deductible expenses.

Significant takeaways

 The decision of the Supreme Court gives finality to the question of allowability of deduction on expenditure laid out by pharmaceutical companies on benefits and amenities provided to doctors that are prohibited by the Medical Council Regulations.

It is pertinent to note that some of these issues have been litigated for a long time and pharmaceutical companies were trying to contend before the tax authorities that since providing benefits to doctors is not an illegal activity per se, they should not be disallowed. Even after the Medical Council Regulations were revised, clarifying that no such benefits should be extended to doctors, pharmaceutical companies continued to provide the same. Hopefully, the clarity provided by the extant SC decision will put a stop to this practice.

The Finance Bill, 2022, also proposes to insert a new Explanation 3 to Section 37 of the IT Act, which provides that expenses incurred to provide any benefit or perquisite or otherwise, in violation of any law, shall be inadmissible as expenditure under Section 37 of the IT Act. The memorandum to the Finance Bill specifically mentions that freebies given by pharma companies to doctors and professionals are deemed to be in violation of the medical conduct regulations and hence, shall not be allowed as an expense.

Thus, it is clear that pharmaceutical companies cannot claim the freebies given to medical professionals as expenditure any more, in light of this SC decision as well as based on the proposed amendment under the Finance Bill, 2022.

[1] M/s Apex Laboratories vs. Deputy Commissioner of Income Tax, SLP (C) No. 23207 OF 2019. The bench constituted Justice UU Lalit and Justice Ravindra Bhatt.