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Commissioner of Income-tax Vs. J.K. Cotton Spinning and Weaving Mills Co. - Court Judgment

LegalCrystal Citation
SubjectDirect Taxation
CourtAllahabad High Court
Decided On
Case NumberIncome-tax Reference No. 59 of 1977
Judge
Reported in(1980)16CTR(All)131; [1980]123ITR911(All); [1980]4TAXMAN1(All)
ActsIncome Tax Act, 1922 - Sections 10; Income Tax Act, 1961 - Sections 28
AppellantCommissioner of Income-tax
RespondentJ.K. Cotton Spinning and Weaving Mills Co.
Appellant AdvocateR.K. Gulati and ;A. Gupta, Advs.
Respondent AdvocateV.B. Upadhya, Adv.
Cases ReferredAlien v. Farquharson Bros.
Excerpt:
- - following that order, in the subsequent year as well, he disallowed the claim. the second submission made was that the disputed claim was only in the nature of a contingent liability because the assessee could make good the shortfall in the subsequent years. the department in its appeal before the appellate tribunal tried to make out a case that the assessee failed to make any export and, therefore, in terms of the agreement it was ordered to pay rs. that being the position it cannot be said that the failure on the part of the assessee to export such percentage of cloth as required under the agreement was an act against public policy or that the assessee was carrying on business in contravention of any statutory provision of law. the tribunal found as well that the loss was.....rastogi, j. 1. this is a reference under section 256(1) of the i.t. act, 1961 (hereafter 'the act'), made at the instance of the commissioner of income-tax. the assessment years are 1967-68 and 1968-69 and the question referred for opinion is :' whether, on the facts and in the circumstances of the case, the tribunal was correct in allowing deduction of penalty of rs. 50,651 in assessment year 1967-68 and rs. 67,801 in assessment year 1968-69 '2. the assessee is a public limited company engaged in the manufacture of cloth. it follows the calendar year as its year of account. during the years under consideration, the assessee was recognised as a registered user of trade mark no. 100387 (sanforized) of m/s. cluett peabody & company by the government of india, vide trade mark registry letter.....
Judgment:

Rastogi, J.

1. This is a reference under Section 256(1) of the I.T. Act, 1961 (hereafter 'the Act'), made at the instance of the Commissioner of Income-tax. The assessment years are 1967-68 and 1968-69 and the question referred for opinion is :

' Whether, on the facts and in the circumstances of the case, the Tribunal was correct in allowing deduction of penalty of Rs. 50,651 in assessment year 1967-68 and Rs. 67,801 in assessment year 1968-69 '

2. The assessee is a public limited company engaged in the manufacture of cloth. It follows the calendar year as its year of account. During the years under consideration, the assessee was recognised as a registered user of trade mark No. 100387 (Sanforized) of M/s. Cluett Peabody & Company by the Government of India, vide Trade Mark Registry letter No. P.R. (RU-Sanforized)/2400 dated 26th November, 1962. One of the conditions laid down for the use of the aforesaid trade mark was the export of a certain percentage of sanforized fabrics manufactured by the companies using that trade mark and such percentage was to be determined by the Government of India. It was five per cent. during the period July, 1963 to 1965. Thereafter, when the trade mark registration was revalidated for a further period of seven years to extend up to 1972, the quantum of export obligation was raised to 10 per cent. and that was by letter dated 30th April, 1966. In the event of non-fulfilment of the export obligation, the mills were to pay certain penalty. Clause (v) of that letter reads as under;

' (v) Mills failing to fulfil the export obligation shall pay a penalty at the rate of 10 p. per linear yard to the extent of the annual shortfall, while mills will be permitted to discharge their export obligation reckoned in the manner prescribed above cumulatively during the period 1966-72, the performance of each mill in relation to its obligation shall be reviewed annually (in February of the year following the one to which the export obligation relates) and an amount shall be deposited in Government account by the defaulting mill by way of penalty as prescribed above. At the end of the seven year period a final review will be made of the cumulative performance of the mills against its total obligation and, where admissible, a refund of deposits will be made. '

3. In the calendar year 1966, relevant to the assessment year 1967-68, the assessee produced 50,65,081 yards of sanforized cloth. It should have exported 5,06,508 yards of this cloth but did not export any and hence was directed to pay Rs. 50,651 by the Textile Commissioner as penalty. Similarly, in the calendar year 1967, the assessee did not export any cloth out of sanforized cloth manufactured by it and was required to pay Rs. 67,801 by way of penalty. The assessee claimed deduction of these amounts from the profits and gains of these years, respectively. The ITO, in so far as the assessment year 1967-68 was concerned, discussed the matter in detail and, relying on a decision of the Madras High Court in the case of M.S.P. Senthikumara Nadar & Sons v. CIT : [1957]32ITR138(Mad) , held that the assessee being under a contractual obligation to the Textile Commissioner, Ministry of Commerce, Govt. of India, New Delhi, to export the stipulated quantity of sanforized cloth, committed breach of that obligation and such breach could not be treated as one in the course of normal trading activity of the assessee. In his opinion, the amount required to be paid by way of penalty for such breach cannot be said either to have been expended or paid out for the purposes of the assessee's business or to have been incidental to the business itself and hence it was not an allowable expenditure. He, therefore, rejected the claim. Following that order, in the subsequent year as well, he disallowed the claim.

4. The assessee appealed and before the appellate court it was not disputed that the claim was not admissible for deduction under Section 10(2)(xv) of the 1922 Act or under similar provisions of the new Act in view of the decision in Haji Aziz and Abdul Shakoor Bros. v. CIT : 1983ECR1942D(SC) . The deduction was, however, claimed under Section 28(1) of the Act. The AAC accepted the contention and gave the relief for both the years under consideration. The revenue appealed to the Appellate Tribunal. The Tribunal confirmed the view taken by the AAC and held that the liability for the payment of the aforesaid amounts arose during the course of the assessee's normal trading activities and further that it was not a contingent liability because in case at some future date the assessee obtained refund of those amounts or any part thereof, such amount could be brought to tax as income of the year of receipt.

5. Two submissions were made before us on behalf of the revenue by Sri R.K. Gulati, advocate. Firstly, that the obligation of the assessee toexport a certain percentage of sanforized cloth produced by it was on the basis of an order made by a statutory authority and business carried on in breach of such order would be on the same footing as business carried on in contravention of a statutory provision and hence the action of the asses-see was against public policy. According to Sri Gulati, this obligation was not on the basis of any agreement because no agreement had been entered into by the assessee as required by Article 299 of the Constitution. The second submission made was that the disputed claim was only in the nature of a contingent liability because the assessee could make good the shortfall in the subsequent years. Reliance was placed on certain decisions in support of these contentions. After hearing counsel for the parties, we do not find there is much substance in the submissions made before us by Sri Gulati.

6. About the nature of the obligation, the assessee's explanation before the ITO was that it was under an obligation to export ten per cent. of the production of the sanforized cloth every year according to the terms of the agreement regarding the use of Sanforized Trade Mark of M/s. Cluett Peabody & Company and this obligation was effective from 1st of January, 1966, and for that reference was made to letter No. 1(3)/67-P & C/1478 dated April 19, 1967, received from the Textile Commissioner, Ministry of Commerce, Govt. of India, Bombay. It was said that in view of that letter it was a definite and contractual liability of the assessee to pay the disputed amount to the Textile Commissioner by way of penalty for non-fulfilment of export obligation. The ITO treated this obligation as a contractual obligation and according to him the breach of a contractual obligation cannot be treated as a normal trading activity. As noted above, the AAC accepted the assessee's claim. The department in its appeal before the Appellate Tribunal tried to make out a case that the assessee failed to make any export and, therefore, 'in terms of the agreement it was ordered to pay Rs. 50,651 as penalty by the Textile Commissioner, Government of India'. It would be seen, therefore, that all along the case was that the obligation to export a certain percentage of sanforized cloth produced by the assessee was on the basis of an agreement. It has never been the case of the department that this obligation was in the nature of a statutory obligation. That being the position it cannot be said that the failure on the part of the assessee to export such percentage of cloth as required under the agreement was an act against public policy or that the assessee was carrying on business in contravention of any statutory provision of law.

7. Sri Gulati also drew our attention to certain provisions of the Trade and Merchandise Marks Act, 1958. Section 49 of that Act provides for application for registration as registered user. According to Sub-section (1) ofthis section, where it is proposed that a person should be registered as a registered user of a trade mark, the registered proprietor and the proposed registered user shall jointly apply in writing to the Registrar in the prescribed manner. There are certain particulars required to be furnished with such an application. Sub-section (3) gives power to the Central Govt. to direct the Registrar to accept the application either absolutely or subject to any conditions, restrictions or limitations which the Central Government may think proper to impose. The Registrar is required to dispose of the application in accordance with the direction so issued by the Central Govt. According to Sri Gulati, the Central Govt., in the instant case, did impose certain conditions in regard to the use of this trade mark and, hence, carrying on of the business in breach of such a condition would tantamount to not carrying on business according to law and the decision of the Supreme Court in Haji Aziz and Abdul Shakoor Bros. v. CIT : 1983ECR1942D(SC) would be applicable. We do not find any substance in this submission either because breach of a condition imposed by the Central Govt. has not been made an offence under this Act. Chapter X of this Act has made provision for offences, penalties and procedure. In none of the sections occurring in this Chapter it has been provided that the breach of a condition imposed by the Central Govt. under Section 49(3) would be an offence. Therefore, even if the assessee committed any breach of such a condition imposed by the Central Govt., it would not amount to an offence under this Act.

8. Now, the law in this behalf stands almost crystallised and in Haji Aziz and Abdul Shakoor Bros. : 1983ECR1942D(SC) , after referring to various English and Indian cases, it was laid down at page 359 :

' A review of these cases shows that expenses which are permitted as deductions are such as are made for the purpose of carrying on the business i.e., to enable a person to carry on and earn profit in that business. It is not enough that the disbursements are made in the course of or arise out of or are concerned with or made out of the profits of the business but they must also be for the purpose of earning the profits of the business. As was pointed out in von Glehn's case [1920] 2 KB 553, an expenditure is not deductible unless it is a commercial loss in trade and a penalty imposed for breach of the law during the course of trade cannot be described as such. If a sum is paid by an assessee conducting his business, because in conducting it he has acted in a manner which has rendered him liable to penalty, it cannot be claimed as a deductible expense. It must be a commercial loss and in its nature must be contemplable as such. Such penalties which are incurred by an assessee in proceedings launched against him for an infraction of the law cannot be called commercial losses incurred by an assessee in carrying on his business. Infraction of the law is not a normal incident of business and, therefore, only such disbursements can be deducted as are really incidental to the business itself. They cannot be deducted if they fall on the assessee in some character other than that of a trader. Therefore, where a penalty is incurred for contravention of any specific statutory provision, it cannot be said to be a commercial loss falling on the assessee as a trader, the test being that the expenses which are for the purpose of enabling a person to carry on trade for making profits in the business are permitted but not if they are merely connected with the business.'

9. It would be seen that the ratio laid down in the above case is that if an expenditure has been incurred for the purpose of carrying on the business, that is, to enable a person to carry on and earn profit in that business it would be treated as a permissible deduction. In other words, to be an. expenditure and qualify for deduction it has to be a commercial loss in trade and also contemplable by the parties. However, a penalty imposed for breach of the law during the course of trade cannot be regarded as an allowable expenditure. Therefore, it has to be seen whether the disputed amounts paid by the assessee for the two years under consideration were in the nature of a commercial loss in trade and were contemplable by the parties or were in the nature of penalty for breach of law during the course of trade. We have already indicated above that these payments were not in the nature of a penalty incurred for the contravention of any statutory provision. These payments were made because of the breach of certain conditions of the agreement and such breach was in the contemplation of the parties as would be clear from para. (V) of letter dated 30th April, 1966, quoted above. For the shortfall in the export of sanforized cloth in any year of the six year period damages were to be deposited at a certain rate by the defaulting company and on a final review of the cumulative export performance against its total obligation necessary adjustments were to be made. The Tribunal found as well that the loss was incidental to the assessee's business and arose during the course of its normal trading activities. We may add that without making these payments in the year or years of default the assessee would not have been allowed the user of this trade mark, that is, it could not have carried on the manufacture of sanforized cloth.

10. Considerable reliance was placed on the decision of the Madras High Court in M. S. P. Senthikumam Nadar and Sons : [1957]32ITR138(Mad) . This case was considered by the Supreme Court in the case of Haji Aziz and Abdul Shakoor Bros. : 1983ECR1942D(SC) and this is what their Lordships had to say on it at pages 358-359 :

' In that case the assessee had to pay liquidated damages which was akin to penalty incurred for an act opposed to public policy, a policy underlying the Coffee Market Expansion Act, 1942, and which was left to the Coffee Board to enforce. '

11. It would be seen that that was a case of payment of penalty for an infraction of the law and as such it was held as falling outside the scope of permissible deductions under Section 10(2)(xv) of the 1922 Act. We feel that some distinction is to be drawn in a claim made for deduction of a payment by way of penalty or damages as a business expenditure laid out or expended wholly and exclusively for the assessee's business under Section 37(1) of the Act and as a business loss under Section 28(1). This distinction between the business expenditure and business loss was thus explained by Finlay J. in Alien v. Farquharson Bros. & Co. [1932] 17 TC 59 at page 64):

' That expenditure or disbursement means something or other which the trader pays out; I think some sort of volition is indicated. He chooses to pay out some disbursement; it is an expense ; it is something which comes out of his pocket. A loss is something different. That is not a thing which he expends or disburses. That is a thing which, so to speak, comes upon him ab extra. '

12. A business expenditure is allowable if it is laid out or expended wholly and exclusively for the assessee's business while a business loss is allowable if it is of a non-capital nature and is not only connected with the trade but is incidental to the trade itself.

13. It is now well settled that the list of allowances under Section 10(2) of the 1922 Act is not exhaustive of all allowances which could be made in ascertaining profits taxable under Section 10(1) and that if there was any loss which, from the commercial point of view, can be considered as trading loss that loss is to be deducted under Section 10(1) before the true profits of the business are ascertained. Reference may be made to the decision of the Supreme Court in Calcutta Co. Ltd. v. C1T : [1959]37ITR1(SC) , wherein their Lordships held that the expression ' profits and gains ' in Section 10(1) of the 1922 Act has to be understood in its commercial sense and there can be no computation of such profits and gains until the expenditure which is necessary for the purposes of earning receipts is deducted therefrom. In Badridas Daga v. CIT : [1958]34ITR10(SC) , this is what the Supreme Court had to say in this behalf (at page 15):

' The result is that when a claim is made for deduction for which there is no specific provision in Section 10(2), whether it is admissible or not will depend on whether, having regard to accepted commercial practice and trading principles, it can be said to arise out of the carrying on of the business and to be incidental to it. If that is established, then the deduction must be allowed, provided of course there is no prohibition against it, express or implied, in the Act. '

14. In CIT v. Nainital Bank Ltd. : [1965]55ITR707(SC) , the respondent, a public company, which carried on the business of banking, had a branch situated at Ramnagar. In the usual course of its business large amountswere kept in various safes in the premises of that branch. At about 7 p.m. on June 11, 1951, there was a dacoity and the dacoits carried away cash amounting to Rs. 1,06,000 and some ornaments, etc., pledged with the bank. In the assessment year 1952-53, the bank claimed the said amount as a deduction in computing its income from the banking business on the ground that it was a trading loss. The claim was disallowed by the taxing authorities as also by the Income-tax Appellate Tribunal while it was accepted on reference by the High Court. On appeal by certificate by the Commissioner, the Supreme Court agreed with the view taken by this court and held that the loss incurred in dacoity was incidental to the carrying on of the business of banking and was deductible as a trading loss in computing the income of the respondent from banking business. The legal position was summarised thus at page 715 :

'Under Section 10(1) of the Act, the trading loss of a business is deductible for computing the profit earned by the business. But every loss is not so deductible unless it is incurred in carrying out the operation of the business and is ' incidental to the operation'. Whether a loss is incidental to the operation of a business is a question of fact to be decided on the facts of each case, having regard to the nature of the operations carried on and the nature of the risk involved in carrying them out. The degree of the risk or its frequency is not of much relevance but its nexus to the nature of the business is material. '

15. In our opinion, on the facts found by the Appellate Tribunal that the loss was incurred in carrying out the operation of the business and was incidental to the business, the disputed payments were clearly deductible as trading loss.

16. A submission in the alternative was made by Sri Gulati that if the disputed payments were made as a result of a breach of the agreement, that would not amount to trading loss and reliance was placed on certain decisions in support of this submission.

17. In Mask & Co. v. CIT : [1943]11ITR454(Mad) , the claim to deduction was in respect of payment made as damages for breach of contract, but it was found that the assessee's conduct was palpably dishonest and the award of damages was not incidental to the trade carried on by it. This case is digtinguishable as in the present case it has been found by the Appellate Tribunal:

'The assessee's contention that these amounts were payable by it in the normal course of its trade appears to be correct. The assesses did not export because it was unprofitable to do so and paid the penalties. The payment was, therefore, in the course of the assessee's business. '

18. The Tribunal rejected the department's contention and held that the liability for the payment of these amounts arose in the normal course of the trading activities of the assessee.

19. Cineramas v. CIT is another case of payment of penalty for breach of a contractual obligation. In that case, the assessee who carried on business in exhibition of films was a member of the East Punjab Motion Picture Association. Under the bye-laws of the association a member is obliged to carry out the 'award and directives' of the association arising out of all disputes between members or upon complaints received by the association. A member failing to carry out the directive of the association would be suspended from the membership of the association and would be eligible to be reinstated on payment of a specified sum of penalty in addition to 'reinstatement circulation charges'. During the accounting year relevant to the assessment year 1970-71, the assessee paid a sum of Rs. 4,300 by way of penalty to the association and claimed it as business expenditure. The Tribunal disallowed the expenditure and on reference that view was affirmed. The principle laid down in that case was as follows (at page 764):

'All that is necessary for us to say is that the expenditure must, in some way, be connected with trade, it must be an ordinary or contemplable incident of trade. There must be a discernible nexus between the expenditure and the trade. There must be something commercial about it. We are of the view that infractions of law, including breaches of obligations, are not normal incidents of business and penalties and damages paid in connection with such infractions and breaches are not expenditure ' laid out or expended wholly and exclusively for the assessee's business '. '

We, however, find that there is a string of cases in which a different view has been taken.

20. This court had an occasion to consider an almost similar question as is involved in the instant case in the case of Central Trading Agency v. CIT : [1965]56ITR561(All) . In that case, the assessee, a registered firm, carrying on contract business in the supply of dehydrated vegetable products to the Government entered into a contract in 1943, for the supply of 100 tons of dehydrated onions to the Government by December 31, 1943. There was a clause in the contract stipulating that in the event of the assessee failing to deliver supplies in accordance with the terms of the contract, it would be liable to a penalty of 2 annas per pound on the quantity which it failed to deliver by the due date, unless its failure was due to reasons beyond its control. By December 31, 1943, the assessee could supply only 15 tons of onion and hence the Government cancelled the contract and imposed a penalty at the rate of 1 anna per pound on the balance remaining undelivered. On the application of the assessee, theGovernment extended the date for the delivery of supplies to August 31, 1944, upon condition that the assessee paid liquidated damages at 2 per cent. The assessee accepted those terms and the damages totalling Rs. 17,240 and claimed that amount as business expenditure in its assessment for the assessment years 1945-46 and 1946-47. This claim was disallowed by the ITO as also by the AAC and the Income-tax Appellate Tribunal on appeals. On a reference this court held that the amount paid by way of liquidated damages was merely an amount paid by the assessee for the purpose of keeping the contract alive and was in reality a payment made for the purpose of enabling the assessee to completely execute the contract. ' It is not, as contended on behalf of the Commissioner, a payment made as damages for breach of contract......But it seems to us plainthat the payment under consideration was made not as a penalty or as damages for breach of contract, but merely in fulfilment of the condition agreed to between the parties enabling the assessee to fulfil the contract and earn profits therefrom upon making the payment which was described as liquidated damages '.

21. It was thus held that it was payment made by the assessee as a trader and not in any other capacity and the purpose was to enable it to carry on its business.

22. In CIT v. Prafulla Kumar Mallick : [1969]73ITR119(Orissa) , the assessee, who worked as a paddy procuring agent, entered into an agreement with the Government of Orissa for supply of paddy and rice of fair average quality. There was a clause in the agreement that in case the supply of foodgrains did not conform to the fair average quality, penalty could be deducted from amounts due under bills submitted by the assessee. During the previous year relevant to the assessment year 1955-56, penalties amounting to Rs. 25,700 were imposed and realised by deductions from the bills and the assessee claimed deduction of the same under Section 10(1) of the 1922 Act. The view taken by the Orissa High Court was that it was an inevitable consequence of the assessee's business as a paddy procuring agent that as a result of the goods delivered not being of the contracted quality, breach of warranty, with the risk of liability to pay damages, would at times be committed and payment of such damages as a result of breach of warranty in the course of or as a consequence of earning. profits and gains, was incidental to the carrying on of the assessee's business. It was an unavoidable loss arising as one of the consequences of carrying on such business. On this view, the claim was admitted as a contemplable deduction in computing the profits under Section 10(1).

23. There is another case of the Orissa High Court oh almost similar facts and it is the case of Govind Choudhury and Sons v. CIT : [1971]79ITR493(Orissa) , There the assessee, a registered firm, which carried on business in iron, cement, paddy, etc., claimed, in computing its profits, deduction of a sum of Rs. 1,233 paid as penalty to the Govt. of Orissa for supply of inferior quality of paddy and rice. The claim was rejected by the assessing authority as also by the appellate authorities. On a reference the view taken by the Orissa High Court was that though the penalty would not come within the ambit of Section 10(2)(xv) it would certainly be deductible from the income itself under Section 10(1) of the 1922 Act because it was integrally connected with the carrying on of the business of supplying paddy.

24. There are a few decisions of the Gujarat High Court which are on absolutely similar facts. In Addl. CIT v. Rustam Jehangir Vakil Mills Ltd. : [1976]103ITR298(Guj) , the assesses, who were manufacturers of cotton textiles, received certain, directions in the previous years relevant to the assessment years 1969-70 to 1971-72, from the Textile Commissioner whereby they were required to pack minimum of the particular types of cloth as mentioned therein. That was not done and hence by different orders the Textile Commissioner directed the assessees to pay certain amounts in respect of the relevant assessment years under Clause 21C(1)(b) of the Cotton Textiles (Control) Order, 1948, and the amounts were so paid by the asses-sees. They claimed those amounts in the relevant assessment years as deductible expenses. Their claim was accepted by the Appellate Tribunal as a legitimate deduction under Section 28 of the Act. On a reference the view taken by the Gujarat High Court was that by failing to produce the whole or part of the minimum quantity of cloth specified in the directions issued by the Textile Commissioner, that particular manufacturer did not commit any infraction of law. The words used in Clause 21C, namely, that ' producer may, in lieu of packing the whole or part of the minimum quantity......make payment ' go to indicate that the option has been given to the producer to decide whether he would produce any part of the minimum quantity specified or not and decide to make the payment to the Textile Commissioner as prescribed. It was further held that the demand is an incident of production of cloth by the manufacturer, depending upon the exercise of option which he will do in view of the technical or technological reasons of his own production machinery. These payments made, it was held, could never be said to be by way of payment extracted or required for an infraction of law and there was no question of any amount being paid as penalty or akin to penalty.

25. In the present ease also, it was mentioned in para, (v) of the letter, dated 30th April, 1966, of the Textile Commissioner that in the event of failure on the part of the mills to fulfil the export obligation they shall pay a penalty at the rate of 10 p. per linear yard to the extent of the annual shortfall, Such mills were to be permitted to discharge their export obligation and make good the shortfall in the following years, for, the period for which this communication was issued was seven years from 1966, and in the event of the defaulting mill doing so, necessary adjustment was to be given at the time of the final review to be made at the end of the seven years period and, if admissible, refund of deposits was to be made. In order to carry on its business in the production of sanforized cloth, in the event of such default, the defaulting mill was thus required to make the necessary deposit with the Government and then alone it could carry on the business. In the present case, as has been noted above, it has been found as a fact by the Appellate Tribunal that the assessee did not find it profitable to make the export and chose to pay the amount of penalty. Such payment was certainly not for any infraction of the law but was an incident of the production of cloth by the assessee depending upon the exercise of the aforesaid option.

26. There is another decision of the Gujarat High Court in Addl. CIT v. Arvind Mills Ltd. : [1977]109ITR212(Guj) . The assessee-company in that case had imported automatic looms under special permission which was granted by the Textile Commissioner in exercise of powers under the Cotton Textiles (Control) Order, 1948. One of the conditions of this special permit was that the assessee should execute a bond in favour of the President of India agreeing to expert an agreed quantity of cloth and in default thereof to pay a sum calculated at the rate of 11 paise per metre to cover the shortfall. The assessee exported rag cloth amounting to 90% of the target and paid a sum of Rs. 35,193 towards the shortfall and claimed that amount as a business loss under s 28 or business expenditure under Section 37. The view taken by the Gujarat High Court in reference was that the aforesaid payment was riot in the nature of penalty for infraction of law or violation of public policy but was a loss connected with and arising out of trade. The decision in Rustam Jehangir Vakil Mills : [1976]103ITR298(Guj) was followed.

27. In Saraya Sugar Mills (P.) Ltd. v. CIT : [1979]116ITR387(All) , when the case of Addl. CIT v. Arvind Mills Ltd. : [1977]109ITR212(Guj) was cited before the Full Bench of our court, this is what the court observed about it (at p. 395);

'Learned counsel for the assessee placed reliance on Addl. CIT v. Arvind Mills Ltd. : [1977]109ITR212(Guj) . In that case, the assessee paid a sum of money to cover the shortfall in the export of the agreed quantity of cloth. It was held by the Gujarat High Court that the payment was to cover the shortfall which was contemplated by the parties. It was not in the nature of penalty for infraction of law or violation of public policy. It was a loss connected with and arising out of the trade and was clearly distinguishable.'

28. It may be noted that though on facts that case was distinguished, the proposition laid down therein was cited with approval. In that case (Saraya Sugar Mills' case) the question involved was whether the arrears paid on sugarcane purchase tax could be claimed as business expenditure and the answer was given in the negative on the view that such payment is not a loss incidental to business and that penalty is a civil sanction and so is interest. It was further held that the payment of interest and penalty under the Sugarcane (Purchase Tax) Act is in the nature of civil sanction and the provision for the same has been made to deter delay in payment of tax in violation or infraction of law and to compensate the Government for damages so caused.

29. In CIT v. Tarun Commercial Mills Co. Ltd. : [1977]107ITR172(Guj) , the facts were exactly similar to the facts as in the instant case. In that case, the assessee, a textile mill, was a registered user of sanforized trade mark and was under an obligation to export ten per cent. of its sanforized cloth as required by the letter of the Ministry of Commerce of the Govt. of India, dated 30th April, 1966, and in the event of its failure to do so was to pay 10 paise per linear yard to the extent of the annual shortfall as penalty. The assessee also executed a bond in favour of the President of India. In the previous year relevant to the assessment year 1968-69, it debited in its account books an amount of Rs. 18,247, being provision for payment to the Textile Commissioner for non-fulfilment of the aforesaid export obligation, and claimed this amount as business expenditure. The claim was disallowed by the ITO, but was accepted by the AAC as also by the Appellate Tribunal and on a reference the Gujarat High Court agreed with that view. It followed its earlier decision in Rustam Jehangir Vakil Mills Ltd. : [1976]103ITR298(Guj) and held that the payment was an 'expenditure wholly and exclusively laid out for the business. It was in the context of the scheme as contained in the letter dated 30th April, 1966, and the bond executed by the assessee, that the view taken was that the claim was in reality and substance not a liquidated damage for infraction of the law. No doubt the word used in the scheme for the sum to be paid in default of fulfilling the export obligation had been described as ' penalty ' but in the ultimate analysis it is the substance of transaction between the parties to be considered for the purpose of determining what is the nature and import of the scheme and the bond executed in pursuance thereof. The view taken was that in the interest of business and such other things the textile manufacturers could opt for payment of compensation or damages to cover up the shortfall in the export obligation. In our opinion, this decision squarely applies to the present case and we are inclined to take the same view. The only difference in facts is that there a bond had also been executed by that textile mill in favour of the President of India,while no such bond had been executed by the present assessee. That, however, does not make much difference because the export obligation arose from the condition imposed by the Central Government for the use of this trade mark. A breach of that condition, as already discussed, would not amount to an infraction of the law.

30. There is also a decision of the Madras High Court in the case of Hind Mercantile Corporation Ltd., v. CIT : [1963]49ITR23(Mad) . In that case damages paid for breach of contract for export of goods before the announcement of the export policy by the Government were held allowable under Section 10 of the 1922 Act and the contention of the revenue that the entering into of such a contract and the giving of a guarantee for its performance before the export policy for the relevant. period was announced by the Government was unlawful and against public policy, was repelled. Also see R. C.Jain v. CIT : [1973]91ITR557(Delhi) .

31. After a brief review of the case law referred to above it would be seen that under Sections 10(1)/28(i) tax is payable by an assessee in respect of profits and gains of a business carried on by him. In computing such profits and gains, the loss, if any, suffered in carrying on the, business is to be deducted out of the profits. The loss claimed should have been incurred in carrying on the business and should be incidental to the business. Whether such loss is incidental to the operation of the business, is a question of fact to be decided on the facts of each case and, in the instant case, as we have noted above, it has been found as a fact by the Appellate Tribunal that the assessee had paid these disputed amounts in the normal course of its trade and that the assessee did not discharge its export obligation because it was unprofitable to do so. The payments were, therefore, made in the course of the assessee's business. Further, as we have shown above, there was clear nexus between these payments and the trade and that nexus was that without having made those payments the assessee could not have been allowed the use of the sanforized trade mark in the remaining years of 6 years period. This payment was certainly not made for infraction of law and was as such not against public policy. It was made on account of breach of a contractual obligation or of a condition imposed by the Central Govt., but such breach was in the contemplation of the parties and, therefore, amounted to a risk in the carrying on of the business. In our opinion, therefore, the disputed payments amounted to commercial loss and the Appellate Tribunal was right in allowing deduction of the same under Section 28(1) of the Act.

32. A half-hearted attempt was made by Sri Gulati, in contending before us, that it was only a contingent liability because the assessee could make good the shortfall in the subsequent years. We do not find any substance in this submission either. Clause (v) of the letter dated 30th April, 1966,dearly provided that the performance of each mill in relation to its export obligation shall be reviewed annually and in the event of default in discharging the export obligation, the defaulting mill would have to deposit a certain amount in the Government account. Thus, as soon as any of the mills concerned made the default, a liability arose in praesenti and it was also an ascertained liability. The mere fact that the defaulting mill could make good the shortfall in the subsequent years would not change the nature of this liability and render it a contingent liability. We need hardly emphasise that the computation of the net profit is to be made on the basis of the method of accounting followed by an assessee. If he follows the mercantile system, the loss becomes deductible at the time when it accrues. All that is necessary in this behalf, therefore, is to see that the loss or the liability accrued in the relevant previous year and, secondly, that it was an ascertained liability. In our opinion, there can be no doubt whatsoever that in the instant case the disputed liability accrued in the relevant previous years and that it was an ascertained liability in each of these two years and since the assessee follows the mercantile system of accounting, the loss became deductible in these two years, respectively, in the manner as claimed.

33. We, therefore, answer the question referred to us in the affirmative, against the department and in favour of the assessee. The respondent-assessee is entitled to its costs which we assess at Rs. 200, Counsel's fee is assessed at the same figure.


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