The Indian economy is heavily dependent on oil and natural gas imports. Given the hazards and uncertainties involved in petroleum exploration, specific provisions were introduced by the government to promote this subsection of industry. One of these crucial sections is Section 42 in the Income Tax Act, 1961.
It incorporates special provisions for the allowance of deductions where business is prospecting, exploring or producing mineral oil. These deductions prevent companies engaged in high-cost and high-risk exploration work from being taxed unfairly. Section 42 has been one of the major incentives in bringing domestic and foreign investment to India’s oil and gas sector.
What is Section 42 in Income Tax Law?
Section 42 is a deduction in respect of business for prospecting or method of use, etc., for mineral oil.
The provision acknowledges that the oil and gas industry is distinct. Unlike more conventional businesses, oil discovery is resource intensive & technologically advanced — often through multinationals sharing reserves. The usual method of calculating income does not consider true costs and risks. Accordingly, Section 42 provides for special deductions and allowances in the instance of companies that are involved in such activities.
Special Allowances under Section 42
The section offers special deductions for the company’s tax purposes in oil & mineral drilling. These include:
- Cost of exploration or drilling – All expenses in prospecting, mining and well-drilling are deductible.
- Abortive exploration expenditure – You can claim as a deduction the cost of an abandoned project, even if the exploration is not successful.
- Special arrangement with the Government of India – Deductions are permissible for certain contracts entered into with Central Govt. for extraction or exploration."
- Export oriented spending – Expenses incurred in foreign undertakings if any are also included under this.
This flexible regime enables companies to remain financially sound when they have to spend enormous amounts on exploration.
Also Read: Deduction for Scientific Research Contributions
Example of Section 42 in Practice
Take the case of an oil company that spends ₹500 crore in offshore drilling. The project consists of exploration, drilling & infrastructure. If the drilling is a failure, Section 42 permits deductions for that expense even though it does not produce the anticipated product.
The investment architecture is to make the venture less risky and attract companies to bid for India’s exploration programs.
Why Section 42 is Significant
- Stimulates investment – Encourages entry into high-risk sectors like oil & gas.
- Promotes foreign interest – Assures fair tax treatment for foreign oil companies.
- Balances risk & reward – Relief on even failed ventures.
- Enhances energy security – Helps reduce import dependency.
Penalty for Failure to Deliver Return in Respect of Foreign Income
Although there are tax incentives under Section 42, companies need to do a lot of documentation of compliance.
Penalty for failure to furnish return of foreign income or in connection with mineral oil exploration can result in stiff fines and loss of deductions.
This combination of relief plus accountability promotes investor protection & government supervision.
Link with Other Deduction Provisions
- Scientific Research Expenses – deductions allowed for research & development.
- Section 33B (rehabilitation allowance) – relief for rebuilding businesses.
- Other tax-advantaged provisions build an ecosystem for investment and risk-taking.
Also Read: Development Rebate and Deductions
Section 42 vs General Deductions
Contrary to Secs 30 - 37, Section 42 applies only to businesses prospecting, exploring or mining petroleum.
- Example: Drilling costs cannot be claimed by a manufacturer, but are deductible under Section 42 for oil companies.
- Both successful & unsuccessful drilling costs are deductible.
This focus makes Section 42 unique.
International Perspective
Nations such as the US, UK, Norway also provide special tax allowances for oil & gas exploration.
India’s Section 42 aligns with global standards, making it feasible for foreign participation in petroleum projects.
Judicial Pronouncements on Section 42
- ONGC vs. CIT – held that expenditure on failed projects is deductible.
- Cairn Energy cases – deductions must align with government-approved contracts.
Courts affirm that Section 42 is not a loophole, but a legitimate incentive.
Practical Guidance for Companies
- Keep Section 42 accounts separate.
- Ensure contracts with Government of India are well documented."
- Retain proof of expenses (even failed projects).
- File returns carefully, especially foreign income reporting.
- Consult tax professionals for compliance.
Also Read: The Special Tax Deduction for Tea, Coffee & Rubber Businesses
Conclusion
Section 42 of the Income Tax Act, 1961 is a special provision for deductions in business for prospecting, exploring, or producing mineral oil. It recognizes the unusual risks of oil exploration and provides special allowances. At the same time, it enforces penalties for non-provision of foreign income returns.
This support accountability balance makes Section 42 one of the most consequential provisions for India’s energy sector.
✅ Need to know if your organization will receive special allowances under Section 42 or for other deductions? Connect with us at Callmyca.com – making compliance easier & increasing tax savings.
