On April 23, 2025, the Central Board of Direct Taxes (CBDT) issued Notification No. 38/2025, which significantly modifies the treatment of settlement expenses under Section 37 of the Income-tax Act, 1961. These amendments introduce clarity on the non-deductibility of expenses related to settlements under specific regulatory frameworks, impacting the tax treatment of such costs. This will be effective from Assessment Year 2025-26 onwards.
Understanding the Legal Framework: Section 37 of the Income-tax Act
Section 37(1) of the Income-tax Act, 1961 provides that an expense will be allowed as a deduction if it is wholly and exclusively incurred for the purpose of the taxpayer's business or profession. However, expenses related to illegal activities or prohibited by law are explicitly disallowed.
Explanation 1 and Explanation 3 to Section 37
Explanation 1 to Section 37 ensures that illegal expenses or those incurred in activities prohibited by law cannot be claimed as business expenses.
Explanation 3, introduced through the Finance (No. 2) Act, 2024, broadens this provision by specifically including expenses incurred to settle proceedings initiated due to contraventions under certain specified laws. This clarification impacts regulatory proceedings under the following acts:
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Securities and Exchange Board of India Act, 1992 (SEBI Act)
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Securities Contracts (Regulation) Act, 1956 (SCRA)
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Depositories Act, 1996
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Competition Act, 2002
Key Impact of CBDT Notification No. 38/2025
The CBDT Notification No. 38/2025, issued on April 23, 2025, formally incorporates the SEBI Act, SCRA, Depositories Act, and Competition Act into the non-deductible expense category. This means that any expenses incurred by businesses in settling proceedings initiated due to violations or defaults under these laws will no longer be deductible under Section 37 of the Income-tax Act.
Practical Implications for Businesses
Non-Deductibility of Regulatory Settlement Expenses
Businesses involved in regulatory settlements related to the above-mentioned laws must account for settlement expenses in a manner consistent with the new tax treatment. These expenses will be treated as non-deductible and will increase the taxable income, leading to a higher tax liability.
Required Amendments to Tax Audit Reporting
From Assessment Year 2025-26, businesses must ensure proper disclosure of non-deductible settlement expenses in their Tax Audit Reports. This is done under Clause 21(b) of Form 3CD, which has been updated per CBDT Notification No. 23/2025 dated March 28, 2025.
Steps for Businesses to Ensure Compliance
To ensure compliance with the updated provisions, businesses should follow these steps:
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Identify Non-Deductible Settlement Expenses
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Review any expenses incurred in settlements under SEBI, SCRA, Depositories Act, or the Competition Act.
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Ensure such expenses are flagged as non-deductible in accounting records.
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Update Financial Records and Tax Calculation
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Adjust your taxable income calculations to reflect the non-deductible nature of these expenses.
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Ensure these expenses are clearly excluded from deductions in your tax filings.
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Amend Tax Audit Disclosures (Form 3CD)
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Disclose the non-deductible settlement expenses under Clause 21(b) of Form 3CD as per the updated CBDT notification.
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Ensure the updated disclosures are submitted accurately to avoid non-compliance.
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Revise Standard Operating Procedures (SOPs)
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Update SOPs to incorporate these new guidelines and ensure future settlements are accounted for correctly with regard to tax implications.
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Training for Internal Teams
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Conduct training for your finance and compliance teams to familiarize them with the new amendments.
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Ensure auditors are briefed on how to handle these expenses in light of the latest regulations.
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Illustrative Checklist for Compliance
| Action | Description | Responsible Department |
|---|---|---|
| Identify Non-Deductible Expenses | Review past and current regulatory settlement expenses. | Finance & Compliance |
| Flag Expenses in Accounting Records | Mark settlement-related expenses as non-deductible. | Accounting |
| Tax Audit Disclosures (Form 3CD) | Disclose non-deductible expenses in Clause 21(b) of Form 3CD. | Tax Auditors |
| Update SOPs | Revise SOPs to ensure tax-compliant handling of future settlements. | Management & Finance |
| Team Training & Awareness | Train finance teams and auditors on the new tax treatment. | HR & Compliance |
Conclusion
CBDT Notification No. 38/2025 introduces crucial changes for businesses involved in regulatory settlements under specific laws. By disallowing the deduction of settlement expenses under the SEBI Act, SCRA, Depositories Act, and Competition Act, the notification ensures that these costs cannot be used to reduce taxable income, leading to an increase in overall tax liability.
For businesses, understanding and implementing the changes outlined in this notification is essential to remain compliant. Proper financial record-keeping, tax audit disclosures, and internal process updates are key steps to mitigate any risks of non-compliance. Businesses should also ensure that finance teams and auditors are fully aware of these changes, enabling them to handle the updated provisions effectively from Assessment Year 2025-26 onwards.
