BARMAN J. - The question of law referred by the Income-tax Appellate Tribunal to this court under section 66 (1) of the Indian Income-tax Act, 1922, for decision is :
'Whether on the facts and in the circumstances of the case the amount of Rs. 25,700 paid by the assessee by way of penalty to the Government of Orissa was an admissible deduction under section 10 (1) (sic) of the Income-tax Act, 1922 ?'
The provisions of section 10 (1) and (2) (xv) of the Indian Income-tax Act, 1922, so far as relevant for the present purpose, are these :
'10. (1) The tax shall be payable by an assessee under the head profits and gains of business, profession or vocation in respect of the profits or gains of any business, profession or vocation carried on by him.
(2) Such profits of gains shall be computed after making the following allowances, namely :...
(xv) any expenditure (not being an allowance of the nature described in any of the clauses (i) to (xiv) inclusive, and not being in the nature of capital expenditure or personal expenses of the assessee) laid out or expended wholly and exclusively for the purpose of such business, profession or vocation.'
The facts are these : The case relates to the assessment year 1955-56 for which the previous year is the calendar 1954. On May 5, 1954, the opposite party (assessee) entered into an agreement with the Director of Food Supplies on behalf of the Government of Orissa by which the assessee was appointed paddy procuring agent under the Government of Orissa for the purpose of obtaining by purpose or otherwise foodgrains for distribution to such places and at such times as best suits the needs of the people on the terms and conditions of the said agreement, the duration of the agreement commencing from December 11, 1953, and remaining in force up to November, 1954, unless otherwise determined under the provisions thereof. Under the terms of the said agreement the assessee was to supply paddy and rice of a standard quality known as F. A. Q. (fair average quality). Schedule 1 to the agreement provides that in the case of common quality boiled rice the brokens should not exceed more than 22.5%, foreign matter 2%, red, stained and discoloured grains 6% and damaged, shrivelled, chalky and weevilled grains 1%. In the case of fine quality boiled rice, the brokens were not to exceed 15%, foreign matter 1.5%, red, stained and discoloured grains 4%, damaged, shrivelled, chalky and weevilled grains 0.5%. Clause 3 (d) of the agreement provides as follows :
'3 (d). The quality of foodgrain supplied by the agent shall conform to the F. A. Q. standard as specified in Schedule I annexed hereto. The collector may, subject to the approval of the Government, levy such penalty as he may deem fit for supply of foodgrain not conforming to the F. A. Q. standard for local consumption and export, and such penalty shall be deducted from the amount or amounts due to the agent on pending or future bills submitted in accordance with clause 13 of this agreement.'
The assessee worked as paddy procuring agent in the accounting year under the Government of Orissa. In exercise of the power under clause 3 (d) quoted above, the Government levied in the course of the year penalties on the assessee amounting to Rs. 25,700. The assessee claimed to be entitled to deduct the said sum of Rs. 25,700 as allowable business expenditure under section 10 (2) (xv). This contention was rejected by the Income-tax Officer which in appeal was upheld by the Appellate Assistant Commissioner. The Income-tax Appellate Tribunal, however, accepted the assessees contention and allowed the deduction. The Commissioner of Income-tax then made an application requiring the Income-tax Appellate Tribunal to refer to the High Court the said question of law arising out of the Tribunals order allowing the deduction. The said application was granted and consequently the Tribunal has referred to this court the aforesaid question of law.
The answer to the question, in my opinion, mainly depends upon the answer to be given to another question, whether the deduction claimed was a disbursement or expenditure wholly and exclusively laid out or expended for the purpose of the assessees business within the meaning of section 10 (2) (xv).
In support of the deduction claimed, the assessees contentions are these : The penalty imposed is in effect a reduction of sale price and accordingly the deduction claimed should have been allowed. The penalties were imposed not in round figures but in rupees and annas, which show that the penalty in reality was based upon the difference between the price of F. A. Q. standard and the standard of paddy and rice supplied by the assessee to the Government and in effect the assessee got prices lesser than the contractual prices for the supplies he made. There was no dishonest intention on the part of the assessee to make more profits by dishonest methods. In the computation of profit from the business, the penalty should be deducted. The Government had accepted the deliveries although the supply did not conform to the F. A. Q. standard. Having not chosen to refuse the deliveries and having paid the assessee at the contractual rates it is evident that the Government treated the same as a breach of warranty resulting in a claim of damages. The damages were measured in terms of costs. Therefore, the real effect of levy of penalty was to reduce the price of rice and paddy paid or to be paid to the assessee. There is no evidence that the assessee either mixed foreign materials or passed off the inferior quality of paddy and rice to the Government as F. A. Q. The assessee bona fide believed that the supply he made to the Government was in conformity with the F. A. Q. standard. The alleged dishonest or criminal intention has not been proved. What are chargeable to income-tax in respect of a business are the profits or gains of a year, and in assessing the profits and gains of a year account must necessarily by taken of all losses incurred, otherwise the real profits and gains cannot be arrived at. The allowance of payment of such penalty is neither expressly nor by necessary implication prohibited by the Income-tax Act. Thus, the case for the assessee claiming the deduction was rested on the broad principle that it does not matter whether the expenditure is incurred in consequence of infraction of the law or whether it is a penalty for doing an illegal act, so long as it is something which reduces the amount which comes into his pocket as a result of his business. It was broadly on these grounds that the Income-tax Appellate Tribunal by order dated July 20, 1960, allowed the deduction claimed by the assessee.
The grounds on which the deduction was disallowed by the Income-tax Officer and the Appellate Assistant Commissioner are these : The penalties were recovered from the assessee by the Government for bad quality of stock. The penalty was imposed for supply of rice and paddy below the standard quality accepted from the assessee. The assessee was not supplying to the Government the standard quality, and consequently the Government imposed these penalties on the assessee. Such conduct by the assessee of supplying foodgrains which were below the contracted quality cannot be said to be a conduct in the regular course of business, and the penalty imposed for them cannot therefore be allowable deduction within the meaning of section 10 (2) (xv). The assessee dishonestly supplied rice and paddy below the standard quality. The penalty imposed has nothing to do with the sale price, and the assessee had to pay the same for breach of his contractual obligations. The assessee could perfectly carry on his business without any infractions of the obligations laid on him by the Government, and a penalty was imposed because of infraction of these obligations. Money paid by way of penalty was not laid out or expended for the purpose of the business which the assessee carried on. The penalty imposed is not one single item but imposed on several occasions which show that it is a case of conducting business not in a negligent manner but in a dishonest manner. In fact, one of the penalty orders (annexure 'E-24' to the statement of the case) refers to the consistent misbehaviour of the assessee regarding quality factors in matters of rice and paddy. The penalty was thus imposed for infraction of contractual obligations by the assessee. These amounts paid by the assessee by way of penalty could not be said to have been laid out or expended wholly and exclusively for the purpose of his business.
The point now is : What is the nature of this penalty imposed under clause 3 (d) of the agreement ?
The penalty is a sum which the assessee conducting the business as paddy procuring agent has had to pay, because in conducting it, he had so acted as to render himself liable to this penalty. It is not a commercial loss. The money which was paid was money paid as penalty, and it does not matter in the least that it is an imposition for breach of the agreement for not conforming to the F. A. Q. standard. It is, in fact, under clause 3 (d) of the agreement, a penalty. The penalty in such a case is imposed as a punishment upon the offender as a responsible person owing obedience to the law. Its nature severs it from the expense of trade. Penalty is not incurred by him in his character of a trader. Clause 3 (d) of the agreement is of very great stringency. The liability it creates is a liability of a penal nature.
No doubt the assessee paid the amount of Rs. 25,700 in discharge of the contractual obligation he had entered into with the Government of Orissa to pay penalty for breach of contract. The contractual obligation, the performance of which the assessee defaulted, was to supply foodgrains conforming to F. A. Q. standard. The other contracting party, director of Food Supplies, is a statutory body appointed by the State Government to administer the Orissa Foodgrains Control Order, 1951. The control the Government exercised over supply, distribution and fair prices of foodgrains had a statutory basis, namely, the Orissa Foodgrains Control Order, 1951, made under the Essential Supplies (Temporary Powers) Act, 1946, read with the relevant notifications of the Government of India. Section 3 of the Act provides that the Central Government, so far as it appears to it to be necessary or expedient for maintaining or increasing supplies of any essential commodity or for securing their equitable distribution and availability at fair prices, may be order provide for regulating or prohibiting the production, supply and distribution thereof and commerce therein. The agreement between the assessee and the Government was in pursuance of the statute and public policy to obtain by purchase or otherwise foodgrains for distribution to such places and at such times as best suits the needs of the people as mentioned in express terms in the preamble itself to the agreement. That what was broken by the assessee was a term of the contract and not an express provision of law does not, in the circumstances of this case, make any real difference to the principle to be applied. It was in exercise of the statutory duties imposed on the Government to control production, supply, distribution and availability, at fair prices, of essential commodities, in order to meet the needs of the people, that the Government, through the instrumentality of a contract, laid very stringent regulations involving penalty and even forfeiture for breach of any of the conditions specified in clause 3 of the agreement. It was that that the assessee transgressed, when he deliberately persisted in supplying foodgrains not conforming to the F. A. Q. standard. What the assessee had to pay was purposely called penalty in the agreement.
Thus the payment was a penalty for committing as act opposed to public policy, a policy that underlay the Essential Supplies (Temporary Powers) Act, 1946, read with the Orissa Foodgrains Control Order, 1951. The Act left to the Government of Orissa to enforce the public policy. The assessee could and should have carried on his business in conformity with the obligations imposed upon him, no doubt, by a contract, but under the authority of the said Act and the Control Order and in furtherance of the policy of control that underlay that Act. The assessee could have carried on the business without infraction of his obligations. That should have been his normal course of conducting his business.
The basic principles in the light of which the question is to be decided were initially laid down by Lord Davey in Strong and Co. of Romsey Limited v. Woodifield, and by Lord Sterndale in Commissioners of Inland Revenue v. Alexander von Glehn & Company Limited. The principle laid down in these English cases, so far as relevant for the present purpose, were these : The words 'for the purpose of the trade' appear to mean for the purpose of enabling a person to carry on and earn profits in the trade, etc. The disbursements permitted are such as are made for that purpose. It is not enough that the disbursement is made in course of, or arises out of, and is connected with, the trade, or is made out of the profits of the trade. It must be made for the purpose of earning the profits. A business can perfectly be carried on without any infraction of the law. Such penalty is imposed because of an infraction of the law and that does not seem to be a disbursement or expense which can be said to have been laid out or expended for the purpose of such trade, manufacture, adventure or concern. In a sense it may be said that payment of such penalty is connected with the trade, because if the trade had not been carried on, the penalty would not have been incurred; there would have been no opportunity for the breach of the law which took place; but in the sense in which the words 'for the purpose of the trade' are used in the Income-tax Act, the English courts expressed the view that this was not connected with or arising out of such trade or business nor is it a disbursement, that is to say, money wholly and exclusively laid or expended for the purpose of such trade or business. Where a businessman or a trader commits a breach of the law, he is fined, punished or levied penalty for that breach of the law. The English courts held that that was not a loss connected with the business but was a penalty imposed upon the assessee personally for a breach of the law which he had committed. It is perhaps a little difficult to put the distinction into very exact language, but there seems to be a difference between a commercial loss in trading and a penalty imposed upon a person for a breach of the law which he has committed in that trading. In von Glehns case referred to above, Lord Justice Scrutton laid down these tests : Were these penalties an expenditure necessary to earn the profits Were they paid for the purpose of earning the profits ?
The Indian Supreme Court and the High Courts have further clarified and developed these principles in the light of the language of the Indian Income-tax Acts which, in pari materia, is substantially the same as of the English Income Tax Acts. In fact, the Indian decisions are mainly based on the principles of the English decisions. After a review of all the relevant cases on the point, their Lordships of the Supreme Court in Haji Aziz and Abdul Shakoor Bros. v. Commissioner of Income-tax laid down the law as follows : The expenses which are permitted as deductions are such as are made for the purpose of carrying on the business, namely, to enable a person to carry on and earn profit in that business. It is not enough that 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 Glehns case cited above, 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 the trader. Therefore, where a penalty is incurred for the 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.
In the said judgment their Lordships of the Supreme Court noted with approval two Madras decisions, Mask & Co. v. Commissioner of Income-tax and Senthikumara Nadar & Sons v. Commissioner of Income-tax. In the latter case it was held that payments of penalty for an infraction of the law fell outside the scope of permissible deductions under section 10 (2) (xv). In that case 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.
Now what was the position here The contention on the part of the assessee involves two propositions, firstly, that if a businessman engages in trade which involves him in a serious penal liability, he can, under section 10 (2) (xv) deduct the costs and penalty he has paid as being part of the outlay which, according to him, was necessary for him to expend for the purpose of earning the income and, secondly, that because a businessman fails to carry on his business within the regulations and restrictions imposed upon him and he has to pay penalty, that is an expenditure or loss connected with and arising out of the business. The question then is : Is the payment of penalty a loss or an expenditure laid out or expended wholly and exclusively for the purpose of the business In my opinion, such loss or expenditure must, at any rate, amount to something in the nature of loss or expenditure which is contemplable and in the nature of a commercial loss or commercial expense. It is not possible to say that when a punishment - which is what the penalty in the present case amounted to - has been inflicted upon the assessee, it can be said that it involves loss or expenditure laid out or expended wholly and exclusively for the purpose of the business within the meaning of section 10 (2) (xv). The assessee was not entitled to supply foodgrains not conforming to the F. A. Q. standard for local consumption and export, that is to say, except within the limits imposed by the restrictions. Yet, in fact, the assessee did so and failed to observe the restrictions imposed. The only business which the assessee had a right to carry on was a business within the limits imposed by municipal law. The assessee cannot carry on his business as he pleases. If a person were to carry on his business in defiance of the law against adulteration and in consequence incurred a penalty, it could not be held that he would be entitled to attribute the penalties he had to pay as expenditure or losses arising out of his business. The business for this purpose must be taken to be a legitimate business. The Essential Supplies (Temporary Powers) Act and the Orissa Foodgrains Control Order provide for regulating and prohibiting the production of essential commodities and commerce therein in a particular way. The assessee failed to take care to supply foodgrains conforming to the F. A. Q. standard which was necessary in order to keep his business within the limits and restrictions imposed by the municipal law. The assessee cannot deduct the penalty as an expenditure or loss incurred in that business which he never ought to have carried on in that manner, in breach of the regulations, prohibitions and restrictions imposed upon him by municipal law.
The assessees agreement with the Government of Orissa in pursuance of the statute imposes to prevent the particular business of supply of foodgrains being done unless due and adequate care was taken for such supply conforming to the F. A. Q. standard. It is not therefore an ordinary business which was being carried on the assessee. The statute imposes a prohibition against the business being carried on except under the safeguards provides in the agreement. In order to be a loss or expenditure within the meaning of section 10 (2) (xv), it must be loss or expenditure which legitimately or ordinarily arises out of or is connected with the trade, and it is impossible to say that the penalty incurred by the assessee falls within that description.
In the circumstances of this case, it cannot be claimed by the assessee that what it did by supply of foodgrains not conforming to the F. A. Q. standard and paying penalty for such breach of condition was incidental to the business itself. Nor is it open to the assessee to contend that the profits and gains were diminished by the amount of penalties paid by him in carrying on the business or that they were an incident to the business or by way an outlay necessarily incurred in the business. The assessees business was, among other things, to supply foodgrains conforming to the F. A. Q. standard. The supply of such foodgrains was regulated by the said Act read with the control order and the Government of Orissa under the provisions of that Act. It was subject to that statutory control that the assessee had to carry on his business. Transgression of that control was not a normal incident of that business, though it was in one sense connected with his business. If he had not been a paddy procuring agent, he could not have been in a position to supply foodgrains not conforming to the F. A. Q. standard. But this connection is not enough to sustains the claim, that what the assessee had to pay the Government of Orissa by way of penalty was inextricably mixed line of business. The breach of his contractual obligation to the Government was not in the normal course of business, and the liability the assessee had to discharge for such a breach was not incidental to the business itself that he carried on.
It is thus clear that it was not a case of payment of damages for a mere breach of contract with nothing more. The Income-tax Appellate Tribunal was not correct in taking the view that the Government treated the supply not conforming to the F. A. Q standard as a breach of warranty resulting in a claim for damages, that the damages were measured in terms of costs, and that therefore the real effect of levy of penalty was to reduce the price of rice and paddy paid or to be paid to the assessee. In my opinion, the concept on which the Tribunal came to this conclusion was wrong. Of course, it was not a case of penalty paid directly under the terms of a statute for contravention of any specific statutory provision. In the circumstances of this case the penalty levied by the Government and paid by the assessee was not by way of damages suffered for breach of contract was also dishonest or consistent misbehaviour regarding quality factors in the matter of supply of rice and paddy. The assessees business could perfectly well be carried on without any infraction of the obligations laid on the assessee by the Government, entrusted with the statutory duty of regulating and prohibiting the production, supply and distribution of essential commodities and commerce therein. A penalty was imposed because of the infraction of these obligations, and the money was not expended or laid out for the purpose of the business which the assessee carried on. In my opinion, no expense which is paid by way of penalty for a breach of the law can be said to be an amount wholly and exclusively laid for the purpose of the business. The distinction sought to be drawn, between a personal liability and a liability of the kind now before us, is not sustainable because anything done which is an infraction of the law and is visited with a penalty cannot on grounds of public policy be said to be a commercial expense for the purpose of a business or a disbursement made for the purpose of earning the profits of such business. The assessee had to pay penalty incurred for an act opposed to public policy, a policy underlying the Essential Supplies (Temporary Powers) Act, 1946, read with the Orissa Foodgrains Control Order, 1951, which was left to the Government of Orissa to enforce as discussed above.
The Tribunal was not right in allowing the assessees claim for the deduction. The requirements of section 10 (2) (xv) were not satisfied. The payment by the assessee by way of penalty to the Government of Orissa was not incidental to the business itself. I am therefore of opinion that on the facts and in the circumstances of the case the amount of Rs. 25,700 paid by the assessee by way of penalty to the Government of Orissa was not an admissible deduction.
We answer the question referred to us in the negative and against the assessee. Since the assessee has failed, the assessee will pay the costs of this reference. Hearing fee Rs. 250.
NARASIMHAM C.J. - I agree. The material facts have been fully set out in the judgment of my learned brother. The main question for decision is whether the penalty imposed by the Collector on the assessee fir supply of inferior quality rice and paddy in contravention of the terms of the contract is a permissible deduction under section 10 (2) (xv) of the Income-tax Act, 1922.
One of the main objectives of the Essential Supplies (Temporary Powers) Act, 1946, was to maintain supplies of essential commodities and to secure their equitable distribution and availability at fair prices - see section 3 of that Act. It was in pursuance of this objective that the Orissa Foodgrains Control Order, 1951, was made by the Government of Orissa by which extensive control was imposed on the purchase, sale and storage of foodgrains including rice and paddy and their transport. The policy of the Government of Orissa was to purchase foodgrains through agents known as 'purchasing agents' and arrange for their distribution at various places both inside and outside the State of Orissa with a view to satisfy the needs of the people. The agreement between the Government of Orissa and the assessee dated December 11, 1953, was entered into for the purpose of effectuating this policy as stated in the preamble to the agreement itself which runs as follows :
'Whereas it is the policy of the Government of Orissa to obtain, by purchase or otherwise, foodgrains for distribution to such places and at such times as best suits the needs of the people.'
The assessee agreed to work as the purchasing agent of the Government of Orissa for the purpose of procuring rice and paddy of the quality specified in Schedule I annexed to the agreement and further agreed in sub-clause (d) of clause 3 of the agreement that if the quality of the paddy and rice supplied by him did not come up to the standard specified in that schedule (hereinafter referred to as the F. A. Q. standard) the Collector may, subject to the approval of Government, levy such penalty on him as he may deem fit. The agreement does not provide for any method of assessing penalty and leaves that matter entirely to the discretion of the Collector. He may levy it either as a lump sum according to the total value of rice and paddy supplied, or else he may levy it by way of certain deductions from the price of rice and paddy claimed by the assessee. Thus the mode of levying penalty was left to the discretion of the Collector, and merely because for the purpose of quantifying the penalty he adopted the device of deducting a certain percentage out of the total price paid to the assessee, for the paddy and rice supplied, it cannot be said that what he did was, in effect, a reduction in price and not a levy of penalty.
The standard specifications for rice, as given in the schedule to the agreement (namely, F. A. Q. standard) further show that certain percentage was allowed for broken quality of rice or admixture of foreign matter, or presence of red, stained and discoloured grains, or damaged, shrivelled, chalky, and weevilled grains. If in the rice supplied defective quality as aforesaid exceeded that percentage, the rice ceased to be of the F. A. Q. standard. Similarly, as the limit of tolerance test for extraneous matters such as sand, silica, mud, husk, etc. If this percentage was exceeded, the paddy supplied also ceased to be the F. A. Q. standard.
The learned Income-tax Tribunal incorporated along with the statement of the case, copies of penalty orders and statements of penalties imposed by the Collector against the assessee for the year in question. These show that on the basis of refraction reports of samples of rice and paddy supplied by the assessee to Government, the Collector was of opinion that the rice and paddy supplied was below the F. A. Q. standard, and hence levied penalties of varying amounts. The levy of penalty was made, not in respect of a few isolated instances but in several instances of supply spread over period of some months. In the penalty statement for the months of July, August, November and December, 1953 (annexure 'E-24') (which was also incorporated in the statement of the case), the Collector while quantifying the penalties, observed that the levy of penalty was made because of 'consistent misbehaviour regarding quality factors in the matters of rice and paddy.'
On these materials the Appellate Assistant Commissioner of Income-tax held that it was not a case of the assessee conducting his business in a negligent manner, but one of acting in a dishonest manner. I may quote his observations :
'It may also be noted that the penalty imposed is not one item, but imposed on several occasions which will indicated that it is a case of conducting business, not in a negligent manner but in a dishonest manner.'
The Tribunal however disagreed with this finding of the Appellate Assistant Commissioner and observed that as Government did not refuse to take delivery of the bad quality rice and paddy supplied, they treated the action of the assessee as a mere breach of warranty as regards the goods to be supplied for which damages alone were claimed. These damages were, according to the Tribunal, measured terms of the price of the goods. Hence it held that the real effect of the penalty was to reduce the price of paddy and rice paid to the assessee. The Tribunal further observed :
'There is no evidence that the assessee either mixed foreign materials or passed off inferior quality of rice and paddy to Government as F. A. Q. The assessee might have bona fide believed that the supply he made to Government was in conformity with the F. A. Q. standard. Dishonest or criminal intent has not been proved.'
Mr. Mohanty for the department raised two important contentions. Firstly, he urged that from a mere perusal of the agreement and the penalty orders it would be clear that inferior quality rice and paddy have been passed off as F. A. Q. standard not on isolated occasions but on innumerable occasions spread over several months and that consequently the Appellate Assistant Commissioners finding that the action of the assessee was dishonest should not have been disturbed by the Tribunal. According to him, such interference with findings of fact would amount to an error of law inasmuch as the Tribunal finding on this point is based on a misreading of the evidence adduced by the parties. Secondly, he contended that in any view of the case, even if the assessee be held not to have acted dishonestly, levy of penalty was not for mere breach of contract but for a breach which is opposed to public policy inasmuch as the equitable distribution of such an essential commodity as rice or paddy which was required to be done under the provisions of the Orissa Foodgrains Control Order was adversely affected. In my opinion, both these contentions must prevail.
If the action of the assessee be held to be dishonest, then this case would come within the principles laid down in Mask & Co. v. Commissioner of Income-tax. In that case it was held that where an assessee conducted his business in a dishonest manner, in consequence of which he was directed to pay damages to a party against whom he committed breach of contract, the damages could not be deducted as a permissible deduction under section 10 (2) (xii) of the Income-tax Act. Their Lordships of the Supreme Court also cited the aforesaid decision, with approval, in Haji Aziz and Abdul Shakoor Bros. v. Commissioner of Income-tax. Here the Tribunals finding to the effect that there was no dishonest intention on the part of the assessee is obviously based on a misreading of the various penalty orders. The correctness of the levy of penalty by the Collector was not challenged at any stage. Hence it must be held that the paddy and rice supplied by the assessee were not of the standard prescribed in the schedule attached to the agreement. In other words, the paddy supplied must be held to have contained more than the permissible percentage (three per cent.) of extraneous matters like sand, silica, mud, husk, etc., and similarly, the rice supplied must be held to have contained more than the permitted percentage of either broken rice, or red or discoloured grain, or damaged or shrivelled or weevilled grain, or foreign matter. These were ascertained by the refraction report. Hence, it is clear that the assessee passed off either inferior quality rice and paddy, or paddy and rice mixed with foreign matter, as conforming to the F. A. Q. standard, systematically over a period of several months. It was for this reason that in the penalty statement (annexure 'E'), his conduct was described as 'consistent misbehaviour regarding quality factors'. This description of the conduct of the assessee by the Collector was not challenged and hence, the finding of the Appellate Assistant Commissioner that his action was dishonest should not have been interfered with by the Tribunal, even though the Tribunal is the ultimate authority on questions of fact. The Tribunals comment that the conduct of the Government in accepting deliveries although the goods did not conform to the F. A. Q. standard would indicate that they treated the action of the assessee as mere breach of warranty resulting in a claim of damages is based on a failure to construe the agreement properly. There is no provision in the agreement for refusing to take delivery if the quality of rice and paddy supplied was below the standard specified. All that sup-clause (d) of clause 3 of the agreement provides for is the levy of penalty be the Collector. This is obviously because the quality of rice and paddy supplied is ascertained on the basis of refraction reports on samples relating to stock after dispatch to the place of destination and acceptance of the same by the consignee. In my opinion, therefore, an error of law arises out of the finding of the Tribunal on account of its misreading of the terms of the agreement and also of the various penalty orders and penalty statements kept with the record. The finding of the Appellate Assistant Commissioner should have been maintained and if this had been done, the principle of Masks case would directly apply.
Alternatively, even if it be held that the erronous finding of the Tribunal that there was no dishonest intention on the part of the assessee cannot be interfered with by this court, 'however gross and inexcusable' the error may be, nevertheless, I think the principle laid down in Senthikumara Nadar & Sons v. Commissioner of Income-tax would apply. That case is very similar to the present case. There also, there was a statute known as the Coffee Market Expansion Act, 1942, which was primarily intended to control the export of coffee. The India Coffee Board was constituted under that Act and the assessee entered into a contract with the board undertaking to export certain quantity of coffee outside India. In view of that undertaking, he was given a specific quota and the coffee was also sold to him by the Board at a concessional rate. But, in breach of the undertaking, he sold the coffee in India at a very high price and made handsome profits. Under the terms of the contract, the Coffee Board assessed him to damages for breach of contract. The learned judges of the Madras High Court held that such damages would not constitute permissible deductions. Their decision did not rest on the view that the action of the assessee was dishonest - in which case the principle of Masks case would have applied - but on the view that though the assessee did not commit a breach of any provision of law, nevertheless, he deliberately committed an act which was opposed to the public policy underlying the Coffee Market Expansion Act, 1942 which the India Coffee Board was required to enforce. Hence, they observed that it was not a case of mere breach of contract but something more, namely, a breach of contract which had the effect of preventing a statutory body from enforcing the policy underlying the Act. In the instant case also, the contract between the assessee and the Collector was entered into for the purpose of implementing a very important matter of policy, namely, to provide for equitable distribution of an essential commodity like rice or paddy. That policy is based on the Essential Supplies (Temporary Powers) Act, 1946, and the Orissa Foodgrains Control Order, 1951. By committing systematic breach of contract as regards the quality of paddy and rice to be supplied, the assessee prevented the authorities concerned from effectively implementing the aforesaid policy. Hence, the aforesaid decision would apply with equal force. This decision was also cited with approval by their Lordships of the Supreme Court in Haji Aziz and Abdul Shakoor Bros. v. Commissioner of Income-tax. It is true that the aforesaid Supreme Court decision dealt with a case where the assessee transgressed the provisions of a statute, namely, the Sea Customs Act. This was pointed out as a distinguishing feature by Mr. Ray for the assessee. But their Lordships of the Supreme Court while pointing out that the two leading English decisions, cited by them, namely, Commissioners of Inland Revenue v. Warnes & Co. and Inland Revenue Commissioners v. von Glehn & Co. Ltd., related to contravention of statutes, nevertheless cited the aforesaid two cases of the Madras High Court (Masks case and Senthikumaras case) with approval, noticing that in those two cases the assessee did not contravene a statute but merely committed breach of contract. In paragraph 15 of their judgment, their Lordships of the Supreme Court, after reviewing all the previous decisions, both Indian and English, observed that disbursements, to be permissible deductions, must be shown to have been made 'for the purpose of earning profits of the business' and that it would not suffice if they were shown to have been made in the course of, or arose out of, or concerned with, or made out of, the profits of the business. Hence also, it cannot be held that the penalty which the assessee had to pay for supplying the bad quality rice and paddy against the express terms of the agreement was for the purpose or earning profits out of his business.
The question of law referred by the Income-tax Tribunal must therefore be answered in the negative.