📘 Settlement Payments Allowed as Business Expenditure: Karnataka HC’s 2025 Ruling Explained

🔍 Introduction

The Karnataka High Court’s 2025 judgment in CIT vs Karnataka State Industrial & Infrastructure Development Corporation has settled a long-standing dispute on whether settlement payments made during commercial disputes can be disallowed as “penalty”. This decision is highly relevant for businesses facing litigation, supplier disputes, contract cancellations, or compensation claims — and it confirms that such payments are fully allowable under Section 37(1) when supported by commercial necessity.

This blog breaks down the ruling, supporting case laws, and how taxpayers can use this judgment during scrutiny assessments.

📘 Background of the Case

The assessee made a negotiated settlement payment to resolve long-pending commercial disputes that were affecting business continuity. The Assessing Officer disallowed the expense, claiming it was a “penalty” and therefore not allowable under Section 37(1). The assessee argued that the payment was purely commercial, not penal, and necessary to protect business interests.

The dispute reached the Karnataka High Court, which examined whether such expenditure is deductible when it helps avoid litigation or restore business functioning.

⚖️ What the Karnataka High Court Held

The Court held that settlement amounts paid to resolve contractual disputes, avoid prolonged litigation, or maintain business relationships are legitimate business expenditure. Such payments are not penalties, because they do not arise from any offence or breach of law.

The Court emphasized that Section 37(1) only disallows expenses that are prohibited by law. Civil settlements, being commercial decisions, fall well within the scope of “wholly and exclusively for business”.

📚 Supporting Case Laws That Strengthen This Ruling

🏛️ Supreme Court

🔹 S.A. Builders Ltd. v. CIT — established the principle of commercial expediency, stating that business decisions must be assessed from the viewpoint of the businessman.🔹 Birla Cotton Spinning & Weaving Mills — held that expenses made to preserve goodwill or protect business operations are allowable.🔹 Mahalakshmi Sugar Mills Co. — clarified that civil settlements are not penalties.

🏛️ High Courts

🔹 CIT v. Bombay Dyeing (Bombay HC) — compensation to settle disputes and avoid business disruption was allowed.🔹 PCIT v. Softbrands India Pvt Ltd (Karnataka HC) — tax authorities cannot question the wisdom of commercial decisions taken to reduce litigation exposure.

Together, these judgments form a strong legal foundation supporting the deductibility of settlement payments.

🧾 Example: How This Applies in Practice

A company disputes a supply contract with a vendor. Legal proceedings drag on for years. To avoid further costs, delays, and business uncertainty, the company pays a negotiated settlement amount of ₹35 lakhs.

Under this ruling:

✔️ The payment is not a penalty

✔️ It is made for commercial reasons

✔️ It qualifies as business expenditure under Section 37(1)

✔️ The AO cannot disallow the expense without proving it relates to an offence

This example mirrors real assessments and is extremely useful during scrutiny.

❗ What You Can and Cannot Claim

Action	Allowed?
Settlement of commercial disputes	✅ Allowed
Payment to avoid litigation and protect business	✅ Allowed
Penalty for breach of law	❌ Not allowed
Payments prohibited by statute	❌ Not allowed
Contractual compensation to maintain relationships	✅ Allowed

⚠️ When Will a Settlement NOT Be Allowed?

Settlement payments are disallowed only if:

• They arise from an offence (fraud, crime, tax evasion)

• They violate public policy

• They are imposed as statutory penalties

This case clarifies that normal business settlements are not penalties.

🧠 Frequently Asked Questions

Q1. What if the AO still treats settlement as penalty?Use this ruling + the Supreme Court precedents to justify the expenditure.

Q2. Can settlement expenses be claimed in the same year?Yes, they are deductible in the year the liability is crystallised.

Q3. Is documentation required?Yes — keep settlement agreements, board notes, legal opinions, and payment proofs.

📋 Action Plan for Businesses

🔹 Immediately:

• Review all compensation/settlement payments made in recent years

• Classify them correctly as business expenditure

• Keep documentation ready for scrutiny

🔹 During Assessment:

• Explain the commercial rationale

• Cite this Karnataka HC ruling with supporting SC cases

• Show that payment is not penal

This approach significantly strengthens your case.

📝 Conclusion

The Karnataka High Court’s 2025 ruling is a major relief for businesses dealing with disputes. It confirms that settlement payments made for commercial reasons are legitimate deductions, not penalties. Supported by multiple Supreme Court and High Court judgments, this decision ensures that genuine dispute resolution expenses cannot be arbitrarily disallowed by tax authorities.

For companies handling complex contractual relationships, this judgment acts as a powerful tool in assessments and litigation management.