There is a distinction between an infraction of the law committed in the course of carrying on of a lawful business and an infraction of law committed in a business inherently unlawful and constituting a normal incident of it. In the former case no deduction is possible whereas in the later case the deduction is possible of the penalty levied.
The Supreme Court in CIT v. S. C. Kothari  82 ITR 794 held that for the purpose of section 10(1) of the Indian Income-tax Act, 1922 (corresponding section 28 (i) of the 1961 Act), a loss incurred in carrying on an illegal business must be deducted before the true figure of profits brought to tax can be computed. Mr. Justice Grover, then speaking for the court, observed as under (page 802):
“If the business is illegal, neither the profits earned nor the losses incurred would be enforceable in law. But, that does not take the profits out of the taxing statute. Similarly, the taint of illegality of the business cannot detract from the losses being taken into account for computation of the amount, which can be subjected to tax as ‘profits’ under section 10(1) of the Act of 1922. The tax collector cannot be heard to say that he will bring the gross receipts to tax. He can only tax profits of a trade or business. That cannot be done without deducting the losses and the legitimate expenses of the business.”
In the case of Fakr Mohmed Haji Hasan v. CIT (2002) 120TAX11 the assessee was found carrying gold bars and currency notes in his car during a search by a raiding party. On failure to explain the source the customs authorities seized such gold and currency. On this basis the ITO subjected such cash and value of gold to tax. The assessee made a claim for deduction of the confiscated sum as trading loss but failed. In upholding such addition the Gujarat High Court held that such deduction for trading loss could be allowed only if the assessee could justify that he is carrying on smuggling business.
In an exception note the High Court explained that unexplained investments, moneys, unexplained expenditure etc. are deemed incomes and such deemed incomes will not fall under either of the heads of income including income from other sources. And it is for this reason the corresponding deductions, which are applicable to the incomes under any of the heads of income, will not have application in case of deemed incomes.