V.S. Desai, J.
1. The question referred to us on this reference under section 66(1) of the Indian Income-tax Act at the instance of the Commissioner of Income-tax is as follows :
'Whether, on the facts and circumstances of the case, the amount of Rs. 23,732 in the case of Shri D. R. Sathe and the amount of Rs. 22,832 in the case of Shri. N. R. Sathe was exempt from tax in their hands in view of the Notification No. 878-F dated April 21, 1922, as amended by Notification No. 8 dated March 21, 1928, issued by the Central Government under section 60 of the Indian Income-tax Act ?'
2. The question arises out of the assessment of the assessees for the assessment year 1947-48. The two assessees, viz., D. R. Sathe and N. R. Sathe, who are brothers, were employed by their third brother, G. R. Sathe, in his biscuit and chocolate factory, which was run under the name and style of 'Sathe Biscuit and Chocolate Works'. D. R. Sathe was a mechanical engineer and N.R. Sathe was a chemist and both of them were looking after the manufacturing side of the biscuit factory. In the assessment year 1947-48 the regular salary of D. R. Sathe was Rs. 5,700 for the year and that of N. R. Sathe was Rs. 4,980. During that year, however, a further sum of Rs. 34,382 was paid to each of them as additional remuneration by way of share of profits calculate at four annas share of the profits under an agreement entered into by them with the employer. In the assessment of the employer, G. R. Sathe, for the assessment year 1947-48, the entire amounts which were paid to D. R. Sathe and N.R. Sathe by way of remuneration inclusive of the payment of Rs. 34,382 to each of them by way of share of profits were claimed by G. R. Sathe as a deduction under section 10(2)(xv) of the Income-tax Act. The Income-tax Officer took the view that the entire amount so claimed as paid to the two employees by way of remuneration could not be allowed as the increased salary granted was quite abnormal and out of all proportion to the services rendered by them. According to him only Rs. 9,000 could be allowed as an expense of salary in respect of each of them. Allowing, therefore, a sum of Rs. 18,000 for the salary of the two brothers, he disallowed the rest of the amount claimed as deduction under section 10(2)(xv). In the appeal against this order of assessment by the Income-tax Officer, the Appellate Assistant Commissioner allowed salary to each of the two brothers at the rate of Rs. 1,000 per month. He, therefore, allowed a further deduction of Rs. 6,000 and disallowed the rest. In the second appeal to the Income-tax Appellate Tribunal, salary to each of the two brothers was allowed at Rs. 1,500 per month and the rest was disallowed. The Tribunal observed that they considered the balance of the payment made to the brothers as expenditure incurred not wholly and exclusively for the purpose of the assessee's business.
3. In the returns, which the assessees, D. R. Sathe and N. R. Sathe, submitted to the income-tax authorities, each of them included the amount of Rs. 34,382 under the head 'salary' in addition to the regular salary received by them. Thus, in the return of D. R. Sathe under the head 'salary and remuneration' the amounts shown were Rs. 7,350 and Rs. 34,382 and in the return of N. R. Sathe the amounts shown under the said head were Rs. 6,450 and Rs. 34,382. Both of them contended before the Income-tax Officer that out of the said amounts only Rs. 18,000 could be brought to tax and the excess over the said sum was exempt under the Finance Department Notification No. 878-F dated 21st April, 1922, as amended by the Notification No. 8 of 24th March, 1928. The claim of the assessees was not accepted by the Income-tax Officer. They, accordingly, appealed to the Appellate Assistant Commissioner. The Appellate Assistant Commissioner in that appeal held that inasmuch as in the assessment of G. R. Sathe, who was the employer of the assessees, it was held that the amounts paid by him to the assessees as remuneration in excess of Rs. 1,500 per month did not constitute expenditure incurred wholly and exclusively for the purpose of the business and were disallowed, it would follow from the Tribunal's decision in the said case that the said amounts had been paid out of the profits of the business and, consequently, the assessees would be entitled to exemption under the notification relied on by them in respect of the said amounts. He, therefore, allowed the appeals filed by the assessees and directed the Income-tax Officer to modify the assessment in accordance with his decision. Against the said appellate orders, the department went in appeal to the Appellate Tribunal. The Tribunal agreed with the view taken by the Appellate Assistant Commissioner and dismissed the appeals. Thereafter, at the instance of the department, it drew up a statement of the case and referred the question of law which arose out of its order, which we have already stated.
4. The notification under which the exemption was claimed by the assessees so far as it is material stands as follows :
'The following classes of income shall be exempt from the tax payable under the said Act, but shall be taken into account in determining the total income of an assessee for the purposes of the said Act :
(1) Sums received by an assessee on account of salary, bonus, commission or other remuneration for services rendered or in lieu of interest on money advanced, to a person for the purposes of his business, where such sums have been paid out of, or determined with reference to, the profits of such business, and by reason of such mode of payment or determination, have not been allowed as a deduction but have been included in the profits of the business on which income-tax has been assessed and charged under the head `business'.'
5. As observed by their Lordships of the Supreme Court in Commissioner of Income-tax v. M. K. Kirtikar in order to claim exemption under the notification, the three cumulative conditions specified in the said notification had to be fulfilled and the said three conditions were :
(i) that the sum had been paid out of or determined with reference to the profits of the business ;
(ii) that by reason of such mode of payment or determination of the said sum, the same must not have been allowed as a deduction, but must have been included in the profits of the business; and
(iii) that on the sum so disallowed in the computation of the profits of the business, income-tax must have been assessed and charged under the head 'business'.
6. Now, in the present case, there is no doubt whatever that the first and third of these three conditions have been satisfied. The payment of Rs. 34,382, which was made by the employer to each of the assessees in the assessment year was on the basis of four annas share of the profits. It was clearly, therefore, determined with reference to the profits and also paid out of profits. There is also no dispute that the payment made by G. R. Sathe to each of his brothers for salary and remuneration in excess of Rs. 1,500 per month, which was disallowed, had been assessed and charged under the head 'business' in the assessment of the employee. The only dispute is whether the second condition has or has not been fulfilled in the present case. That condition, as we have stated, is that by reason of the mode of payment or determination of the sum with reference to the profits of the business, it must not have been allowed as a deduction but must have been included in the profits of the business.
7. Mr. Joshi, learned counsel for the revenue, has very strongly urged that the second condition has not been fulfilled in the present case and since all the three conditions are cumulative, all of them have to be satisfied before the assessee is entitled to the benefit of the exemption under the notification. The assessees in the present case, therefore, would not be entitled to claim exemption under the said notification. According to Mr. Joshi the reason for the disallowance of these amounts in the assessment of the employer was that the sums disallowed were not expenditure incurred wholly and exclusively for the purpose of the assessee's business. It is not by reason of the mode of payment or determination of the sum with reference to the profits of the business that the sums have been disallowed in the assessment of the employer. In support of his contention he has cited Commissioner of Income-tax v. M. K. Kirtikar, Commissioner of Income-tax v. Mulraj Karsondas, V. Narayanaswami Iyer v. Commissioner of Income-tax and Ramanlal C. Parekh v. Krishnamachari, Commissioner of Income-tax.
8. Now, in the employer's assessment the amount of Rs. 34,382 paid to each of the assessees, D. R. Sathe and N. R. Sathe, was claimed as increased salary paid to them during the year of assessment. This amount was said to have been paid in pursuance of an agreement arrived at between the employer and these two persons to pay a four annas share of the profits to each one of them by way of additional salary. The Income-tax Officer took the view that, although an increased salary may have been due to each one of the employees, the increase in salary granted was quit abnormal and out of all proportion and what could be allowed as reasonable salary to each of the employees would be an amount of Rs. 9,000 per year only. He, accordingly, allowed a total amount of Rs. 18,000 for the salary of the two employees and disallowed the rest of the amount claimed under that head. In the appeal before the Appellate Assistant Commissioner, it was contended that the entire amount should have been allowed as by way of salary. In dealing with this contention the Appellate Assistant Commissioner observed :
'This method of calculation by itself clearly shows that the real intention was to treat these two persons as working partners for the purposes of remuneration. Obviously the remuneration was dependent on the profits and was to be appropriated out of the profits already earned by the assessee. Under such circumstances, I agree with the Income-tax Officer that the additional remuneration as claimed could not be allowed, firstly, because it was of the nature of appropriation of profits and, secondly, because it was out of all proportion to the salaries paid in the past.'
9. He, however, took the view that the payment by way of salary could be allowed to each of the two employees at the rate of Rs. 1,000 per month instead of Rs. 9,000 per year as held by the Income-tax Officer. He accordingly allowed a further deduction to the extent of Rs. 6,000 in respect of the salaries. When the matter went before the Tribunal, the Tribunal took the view that although the payments were stated to have been made to the two employees in pursuance of an agreement entered into with them modifying the terms of their employment, whereby the employer agreed to give them each a four annas share out of the net profits of the factory and the works, the agreement did not appear to be a genuine one, since in the first place, it had been executed very late and, secondly, there was no reason shown why it was necessary to pay the employees as much as eight annas share in the net profits in addition to their regular salaries. They also pointed out that in the year of assessment profits have increased considerably on account of war contracts. The Tribunal further pointed out that, even if the agreement was regarded as genuine, in other words, even if the additional payment s were made as and by way of remuneration, it appeared to them that the only salary which could be allowed as reasonable would be Rs. 1,500 per month to each of the brothers and the rest would constitute expenditure incurred not wholly and exclusively for the purpose of the business. In our opinion, on reading this order of the Tribunal, the view that the Tribunal took was that, although the assessee purported to show these two brothers and had purported to put forward an agreement to that effect, the payments were made not by way of additional remuneration to the brothers but as giving them a share of the profits which had increased in those years on account of war contracts. In the alternative, the view of the Tribunal was that, even if they held to have been paid as by way of salary or by way of additional remuneration, the payments would not be a justifiable or reasonable expenditure falling within the ambit of section 10(2)(xv). On Reading the order of the Tribunal, it appears to us that the reason for disallowing the said payments was that they did not come within the category of expenditure wholly and exclusively laid out for the purpose of the assessee's business but were appropriation of the profits between the assessee and his brothers. In our opinion, therefore, the second condition of the three cumulative conditions of the Notification has also been satisfied in the present case. All the three conditions, therefore, having been satisfied, the assessees before us are entitled to the exemption under the Notification.
10. Mr. Joshi has argued that the reason for the disallowance was solely that the expenditure incurred was not wholly and exclusively for the purpose of the assessee's business and the said reason was in no way co-related to the facts that the payments made were determined with reference to the profits and were also made out of the profits. Whatever may be the actual position, says Mr. Joshi what we have to consider in view of the conditions laid down in the Notification is as to what is the reason given for the disallowance, and the reason which states that an item is disallowed as not being an expenditure incurred wholly and exclusively for the purpose of the assessee's business, is not a reason which satisfies the second of the three cumulative conditions.
11. Now, as we have already pointed out, our view on reading the order of the Tribunal has disallowed the payments as not expenditure wholly coming within section 10(2)(xv) of the Income-tax Act because it is really an appropriation of the profits and not payments made by way of reasonable salary. The reason given by the Tribunal is, in our opinion, co-related to the mode of payment or determination thereof. Even otherwise we are not in agreement with Mr. Joshi when he submits that, when the Tribunal states that the reason for disallowance of the item is because it is not wholly and exclusively laid out for assessee's business, there can be no question of regarding it as having been disallowed by reason of being paid out of or determined with reference to profits. When deduction is claimed under section 10(2)(xv) as being an expenditure wholly incurred or laid out for the assessee's business and the same comes to be disallowed, the finding has to be that it is not an expenditure which is wholly incurred or laid out for the assessee's business. But the reasons for arriving at that finding will have to be looked at for ascertaining why the expenditure is not held as falling within section 10(2)(xv) and not being wholly incurred or laid out for the assessee's business. These reasons, when looked into, may show that the item has not been considered as an item of deductible expenditure because it really is an appropriation of profits. In such a case it can well be said that the reason for the disallowance of the item is the mode of payment or the determination thereof. Where the expenditure incurred has no relation to the profits and is not paid out of the profits or determined with reference thereto and has been disallowed as not falling under section 10(2)(xv), the reason stated that the item is disallowed as not incurred wholly and exclusively for the purpose of the assessee's business will no doubt constitute a reason which is outside the condition No. 2 in the three cumulative conditions. But where, as in the present case, the payment is made out of the profits and is determined with reference thereto but is still claimed as an expenditure wholly and exclusively laid out for the assessee's business and is disallowed on that ground, the disallowance will necessarily have reference to the mode of payment and determination thereof. In our opinion, therefore, the decision of the Tribunal is right and the assessees are entitled to the exemption claimed by them.
12. The cases referred to by Mr. Joshi, in our opinion, do not help him. In Commissioner of Income-tax v. M. K. Kirtikar, there was a clear absence of the third condition and the decision of the Supreme Court was that three conditions being cumulative and the third condition clearly not having been satisfied, the assessee was not entitled to the exemption claimed by him.
13. In Commissioner of Income-tax v. Mulraj Karsondas, the question was considered as regards part of the salary of the employee, which was disallowed as unreasonable in the employer's assessment. The salary paid was a fixed monthly salary and was not determined with reference to the profits or paid out of the profits, the payment of salary being irrespective of whether there were profits or not. The expenditure was disallowed as not having been incurred wholly and exclusively for the assessee's business. It was held that neither the first not the second condition was fulfilled and the benefit claimed under the Notification was not available. Now, it would be seen that in that case the first condition not having been fulfilled, there was no question of the second condition being fulfilled at all. The reason for disallowance, viz., that the expenditure was incurred not wholly and exclusively for the company's business, could have no relation in that case to the mode payment or the determination thereof out of the profits of the assessee. The reason, therefore, given in that case could not come within condition No. 2 of the three cumulative conditions.
14. The next case in V. Narayanaswami Iyer v. Commissioner of Income-tax, is also similar. There again the first condition was not satisfied because the remuneration paid to the employee was not of the profits nor was it determined with reference thereto. The item was disallowed as not being an expenditure wholly and exclusively laid out for the assessee's business and the court held that, as the disallowance in the employer's assessment was on the basis of section 10(2)(xv), a ground other than that for which alone the Notification provided, and was not correlated to the mode of payment to the petitioner, the claim was rightly disallowed : the mode of payment to the petitioner under the agreement has nothing to do with the profits of the employer's business and it was not on the ground of the mode of payment that the sum was disallowed in the employer's business.
15. In Ramanlal C. Parekh v. Commissioner of Income-tax a part of the salary and bonus paid to the employee was disallowed in the employer's assessment. The employee in his assessment claimed refund to tax in regard to the excess of salary and bonus disallowed in the company's assessment, under the Finance Department Notification No. 878-F, dated March 21, 1922. It was held that the petitioner could not claim exemption as regards the excess of bonus it was held that, in the absence of finding recorded to the contrary, it had to be presumed that the payment of bonus to the petitioner was made out of the company's profits and the petitioner was exempt from payment of income-tax on Rs. 1,500 being the excess of bonus disallowed in the company's assessment. The decision of this court in respect of the bonus would appear to support the assessees rather than the department Mr. Joshi, however, has relied on certain observations in this case in support of his argument that, when an item is disallowed on the ground of its not coming under section 10(2)(xv), it could not be said to have been disallowed on the ground of mode of payment or determination there of with respect to the profits of the business.
16. We do not think that the observations to which Mr. Joshi has invited our attention in this case support the submission that he is making. It was argued on behalf of the department in that case that the disallowance even of the bonus was only on the ground that the expenditure was not incurred wholly and exclusively for the purpose of the company's business without any reference as to whether the payment in fact was made out of the profits or determined with reference thereto. It was in that connection pointed out that there was in the first place no clear or specific finding of any income-tax authorities that the disallowance of the payment was on the ground that it was not a permissible deduction under section 10(2)(xv) of the Act. It was pointed out that a part of the payment had been as a matter of fact allowed as a permissible deduction and when the rest was disallowed it was disallowed as having come out of the profits. In our opinion, therefore, not only the decision in the said case with regard to bonus but the observations also to which Mr. Joshi has invited our attention do not support him.
17. Our answer to the question referred to us is in the affirmative. The assessee will be entitled to get his costs from the department.
18. Question answered in the affirmative.