1. We can dispose of the cross-appeals together. The main issue to be decided is, whether the selling agents commission paid to a close associate of the assessee-firm is to be disallowed under Section 40A(2) of the Income-tax Act, 1961 ('the Act').
2. The assessee is a firm. They manufacture certain hygienic products.
Up to the assessment year 1973-74, the entire production was sold to a limited company by the name Balsara & Co. Ltd. There is no dispute that the assessee and the company are close associates for the purpose of Section 40A(2). The assessee was giving the company a trade discount of 35 per cent.
3. From the assessment year 1974-75, the two parties entered into a different type of agreement. Instead of selling the products directly to the company, the firm made it a selling agent. The agreement of selling agency has been renewed from time to time. We are concerned in these appeals with the assessment for 1979-80, the accounting year being the period ended 30-6-1978. For this period, the agreement dated 1-7-1977 was in force. As per this agreement, the obligations of the company given in Clause 2 are : 2. The company shall, as such selling agents, carry out and/or undertake the following : (b) secure orders on a firm basis and accept them subject to the directions of the firm including directions as to the prices at which and to the terms and conditions on which the orders are to be accepted and pass on the same to the firm : (c) do its best to increase the sales of the products of the firm including all measures necessary for promotion of sales, organization of sales campaigns in various areas and territories, etc. ; (d) after prior consultation with the firm, arrange to issue necessary advertisements in newspapers, magazines, on cinema slides, posters or by any other means/media and organize publicity campaigns in various territories in accordance with the directions of the firm ; (e) discuss from time to time and settle with the firm various steps which the company proposes to take in order to promote sales, organize sales campaigns, etc., including matters pertaining to advertisement and publicity ; (f) assist the firm in the collection of dues in respect of all goods sold by the firm, whether the orders therefor have been secured by the company or otherwise, it being understood that the firm will directly sell the goods to the various customers and it will be the primary responsibility of the firm to collect the dues in respect of the goods sold by it ; (g) carry out on the request of the firm market surveys in specified areas in respect of specified products and make available to the firm the results of these surveys, as well as report to the firm from time to time the position of the market in respect of various products.
6. The company shall be paid by the firm a commission as hereinunder mentioned, for orders procured by the company including repeated orders received directly or indirectly from the parties originally contacted by the company ; it being understood that the company shall not be entitled to any commission in respect of orders and/or enquiries secured/obtained by it, which for any reason whatsoever have not been executed or complied with by the firm, such execution or compliance being in the absolute discretion of the firm.Invoice value of Commission goods sold rate per centUp to Rs. 2.00 crores 20From Rs. 2.00 crores to Rs. 2.25 crores 21From Rs. 2.25 crores to Rs. 2.50 crores 22From Rs. 2.50 crores to Rs. 2.75 crores 23From Rs. 2.75 crores to Rs. 3.00 crores 24Rs. 3.00 crores and over 25 It has been specifically agreed that all advertisement and promotion expenses for the New Promise Toothpaste would be borne by the firm.
The company will initially incur all expenses regarding the advertisement and promotion and the same will be reimbursed by the firm at the end of the year.
A word of explanation for the latter part of Clause 6 is needed. The assessee had brought out a new product called 'Promise Toothpaste' in the accounting year ended 30-6-1976. Since this was a new product facing stiff competition from multinational companies in that field, considerable outlay was expected to be incurred for its promotion.
Hence, the agreement that advertisement expenses would be borne by the assessee.
4. The turnover of these products was Rs. 2,39,10,396 for the accounting year. The commission paid was Rs. 52,60,287. The turnover of 'Promise Toothpaste' was Rs. 58.24 lakhs, which is part of the total turnover. The advertisement expenses shared by the assessee, as per Clause 6 of the agreement, was Rs. 4,84,806.
5. The assessing authority held that the commission payment was excessive under Section 40A(2). His reasoning was : (1) no market survey had been done by the company, although this was one of its obligations and part of the commission was paid for this service ; (2) the normal market rate of commission is not more than 5 per cent; (3) the assessee's products are more or less without any competition in the field, therefore, the services of procuring orders, sales promotion and assistance in realisation of bills are really illusory and it cannot justify a high rate of commission; (4) if the assessee had incurred the expenses on advertisement and publicity, the assessee itself would be subject to disallowance under Section 37(3A) of the Act.
6. Apart from these reasonings, the assessing authority also pointed out that even without the application of Section 40A(2), the commission paid is excessive since it was not calculated on sales alone. Value of damaged goods, sales returns and sales tax levied were also considered as part of the turnover for calculation of the commission. This was not correct.
7. For these reasons, he held that payments above 5 per cent of the net turnover (excluding sales tax, goods returned, damaged goods, etc.) would only be reasonable. He allowed Rs. 11,05,334 and disallowed Rs. 41,54,953.
8. The Commissioner (Appeals) agreed with him on the reasons for the disallowance, but held that 12.5 per cent would be reasonable in respect of established products and 7.5 per cent in respect of new products. He, however, held that the commission is to be calculated on the gross invoice value, viz., inclusive of sales tax, sales returns, etc.
9. Both parties are on appeal before us against his order. The assessee's objections could be summarized somewhat like this : 1. No comparative case has been shown for pegging the rate of commission to 7.5 per cent and 12.5 per cent.
2. Any remuneration fixed must at least cover the expenses to be incurred by the selling agent. The expenses incurred by the company this year on selling the products were Rs. 47,01,195. Any payment of commission below this figure would be unreasonable. In the assessment order of the company, the department has not found any part of the company's expenses as not laid out for business purposes. Therefore, all the expenses are laid out for purpose of business, which is selling the assessee's products. If the disallowance is sustained, the company would have a loss of Rs. 21,20,840 (on the basis of assessment order) or Rs. 13,40,149 (on the basis of appellate order). The actual net profit of the company after meeting the expenses was only Rs. 39,000 approximately.
3. The assessee-firm has no selling organization. If they were to undertake the selling of the products themselves, the expenses now incurred by the company would be incurred by the assessee. But the company has rich experience of selling and has a tried and tested organization consisting of 70 employees for selling and 350 stockists. It is only a matter of prudent business that the actual selling is entrusted to such a company.
4. Neither the assessee nor the partners are benefited from the tax point of view by this arrangement. The total tax payable by the firm and partners (excluding the disputed disallowance) is Rs. 2,14,570.
If the firm were to take over the entire expenses, then the tax payable would be only Rs. 2,10,250. Therefore, it cannot be considered as a method of tax avoidance.
5. For the assessment year 1973-74, the products were sold outright at a discount of 35 per cent. A part of the advertisement expenses was, however, shared by the assessee. These assessments had been considered by the Tribunal in appeal and the assessee's submissions have been accepted. If the assessee had the same arrangement with the company for the assessment years 1973-74 and 1974-75, i.e., instead of trade discount, a commission was payable, the assessee would have to pay a commission of 29 per cent for both the years.
Compared to it, the commission of 22 per cent is very essential for maintenance of the sales.
6. Under Section 40A(2), the department has to see not only the market value of the services rendered but also the benefits derived and the needs of the business. These three are interrelated concepts. The department has seen only one aspect of it.
7. The profits of the assessee have not shown any stagnation or downward trend under this arrangement. From Rs. 16,347, net profit of 1975-76, the profits have increased to Rs. 23.02 lakhs by 1980-81.
8. Regarding the point made out that turnover representing goods returned, damaged goods and sales tax, the issue has been considered by the Tribunal for the assessment year 1978-79. The Tribunal has upheld the calculation on the gross invoice value.
1. The three requirements in Section 40A(2), i.e., market value, business needs and benefits derived are disjunctive and if one of the conditions is not satisfied, disallowance under Section 40A(2) is called for.
(i) canvassing for orders ; (ii) advertisement and publicity ; (iii) realisation of bills and (iv) market survey. Of these, the firm is actively associated with (i) and (ii) ; there is no evidence of the company having rendered any service in (iii) and (iv).
3. Although from 1974 there is a change and instead of trade discount of 35 per cent a commission of 22 per cent is being paid, it is not reflected in the profits of the assessee. If other income is excluded, there would be losses every year. These losses are directly the result of excessive commission payments. The income has now gone into the coffers of the company.
4. The assessee has a capital of about Rs. 6 lakhs. On this capital, on monopoly products, the assessee is showing losses. This is also an indication of excess payment of commission.
5. The firm has also a large establishment and incurs heavy expenses thereon. The company had large staff when they were buying the products. After they had become selling agents, the expenses should have naturally come down. But it has not. That means, the inflated expenses of the company are being met by the inflated commissions.
Not all the expenses of the company could be legitimately incurred for the work of the selling agents.
6. The expenses incurred by the company is not an indication of the reasonableness of the commission rates, especially when bulk of the expenses are for advertisements, which has a long-term benefit for the assessee.
7. Mere increase in turnover is not material for determining the reasonableness of the commission rates.
8. In a number of decided cases, the commission payments are much less. In the case of Tata Exports Ltd., a commission of maximum 3 per cent is being allowed.
9. Whether the rates of commission are reasonable, could also be tested by looking into the figures of the years ended 30-6-1980 and 30-6-1981. On 'Promise Toothpaste' on a turnover of Rs. 3 crores, the assessee incurred a loss of Rs. 21 lakhs for the year ended 30-6-1980 because of the commission payment of Rs. 35 lakhs. For the year ended 30-6-1981, there is no commission payment and profits shot up to Rs. 87 lakhs on a turnover of Rs. 5.5 crores of the toothpaste account alone.
11. We have considered the facts of the case. The only point we have to decide is, whether the selling agency commission paid by the assessee is excessive and, therefore, a part of it has to be disallowed. Both the assessee as well as the department have objections to the findings of the Commissioner (Appeals). The department's case is that the disallowance made in the assessment order should be restored, whereas the assessee's case is that the entire amount should be allowed as a deduction.
12. Selling agency is a matter of contract. Either of the contracting parties would be entering into this contract only if it is commercially profitable for them. This being a business contract, we cannot normally envisage a selling agency contract which will leave the agent at a disadvantage. In other words, no one would expect anyone to take up a selling agency if he knows that it will not bring him profit. It may be that there are some cases where on the face of it the selling agency incurs a loss. There are instances where the selling agency in effecting the main product of the principal, always ends up with a loss. But, in all these cases, the loss is more than set off by certain other benefits accruing to them under the selling agency. One has come across cases of sale of machineries, which will be always at a loss but it will be made up by the selling agency in respect of spare parts.
Again, Indian businessmen enter into export sales fully, well knowing that the exports will leave them with a loss. However, they would be more than compensated by the import entitlements, cash subsidies and other benefits. However, these are exceptions to the general rule that the selling agency should find it profitable to take up such an agency.
Whether an agency will be profitable to the selling agent, has to be only decided by the expenditure that the agency will have to incur.
Unless the agency commission is sufficient to cover the expenditure, no selling agency would be taken up in the course of a business.
Therefore, we will accept the assessee's submission that the rate of agency commission has to be fixed up in such a way that the agent makes a profit. Any rate of commission which will not cover the expenses of the selling agent per se, will not be a business proposition.
Consequently, it cannot be considered excessive or unreasonable.
Therefore, the expenses incurred by the company in this case is a very material point to decide whether the agency commission is excessive or unreasonable. We, therefore, do not accept the department's contention that the expenses of the company are not relevant to this issue.
13. This will take us to the scrutiny of the expenses of the company.
We may at once accept the department's contention that if the expenses were found to be unduly inflated or unrelated to the agency business, then such expenses should not be taken into account; but the scrutiny reveals that the expenses are all reasonable and for the purpose of selling agency. For one thing the department has not found any expenditure incurred by the company as relating to non-business purposes of the company. For the accounting year under consideration, the company had incurred a total expenditure of Rs. 47 lakhs, the break-up of which is given below :Staff expenditure 17,83,362Administrative expenditure 10,17,794Travel & business promotion 17,96,211Interest 31,253Depreciation 72,573 We have further analysed these expenses. Out of the staff expenditure, we find that the salaries paid to the staff account for more than Rs. 15 lakhs. The remuneration paid to the directors is only Rs. 66,000.
The other expenses are the contribution to the provident funds, gratuity funds and staff welfare expenditure. There are three employees, who were getting a remuneration of more than Rs. 3,000 per month. Their salary and provident fund contributions account for nearly Rs. 1.65 lakhs. It cannot be said to be excessive, considering that the company is running a business effecting a turnover of nearly Rs. 2.5 crores and having 350 dealers.
14. The advertisement and business promotion expenditure, as stated above, accounts for nearly Rs. 18 lakhs. Considering the fact that these expenses have to be incurred to promote the sales of domestic consumer products, it cannot be said to be excessive. No one has questioned the genuineness of this expenditure. It was submitted from the department's side that the products sold by the company have more or less a monopoly market. Probably, the intention is to show that so much of advertisement expenditure was not necessary. Now, it is a matter of common knowledge in commercial circles that unless there is continuous advertisement, it would not be possible to maintain the turnover or to increase the same. No company can rest on its oars merely because for the time being they have no other competitor in the market. This aspect need not be further emphasized as it is well known how the advertisements support and maintain the consumer markets.
15. The rest of the items are interest and depreciation, on which it cannot be said that it is excessive or unreasonable.
16. Therefore, as far as the accounting year is concerned, the expenditure incurred by the company amounting to Rs. 47 lakhs is a legitimate expenditure. The commission receivable by the company must at least cover this expenditure. Now, the assessee had allowed the company a total commission of Rs. 50.36 lakhs. This had been worked out on the basis of Clause 6 of the agreement mentioned earlier in para 3.
It will be very difficult to say under these circumstances that the rate of commission paid will be excessive.
17. We have checked up the matter from the point of the expenditure incurred by the assessee-firm. On a scrutiny of their profit and loss account, it is seen that they have a total expenditure of Rs. 2.23 crores. Out of this, the manufacturing expenditure alone accounts for Rs. 2.17 crores. Interest on loans including capital accounts for only Rs. 2.66 lakhs and depreciation for Rs. 1.3 lakhs. There is no item in the profit and loss account which would cover expenditure for the distribution, supply and sale of the products manufactured in India.
So, it is not a case where the assessee had sufficient staff and infra-structure for the distribution and sale. The assessee has no such base for effecting the sales themselves. We may clarify that there is some expenditure debited in the profit and loss account regarding sales but they are exports outside India. The only expenditure relating to sales is the agency commission. So, it is clear that the assessees themselves do not have the basis for making the sales themselves.
18. The rate of commission paid is reasonable, is supported by a scrutiny of the accounts for the assessment years 1973-74 and 1974-75.
It may be recalled that for these two years, there was no selling agency. The goods were sold outright to the company at a discount of about 35 per cent. Supposing instead of giving a discount there were arrangements to effect sales on commission basis, then the commission the assessee will have to pay is worked out at about 29 per cent. This shows that the rate of commission, as given by the assessee for the year under consideration, is reasonable.
19. Shri Roongta for the department had submitted that there were four types of obligations on the company and none of these was discharged fully by the company. In other words, according to him, the assessee-company itself was associated in discharging these functions.
Therefore, the case of the department is that the commission payment is excessive. We are unable to find any factual basis for this submission.
It may be true that in respect of certain matters, the assessee had also taken some steps. But we cannot say that no canvassing for orders was done by the limited company. That would be against the reality of the turnover achieved., We cannot say that they had not done any advertisement and publicity. Their expenditure on this account itself supports them. It may be that there is no overt evidence for the part played by the company in the realization of bills and market survey.
But so long as the assessee had the benefit of the work done by the company, they are entitled to make payment to them according to the agreement.
20. It was next submitted by Shri Roongta that the change in the agreement i.e., from trade discount to commission, should be reflected in increased profits of the assessee. There is no such increase in profits and, therefore, it was submitted that the expenses would be excessive. We are unable to accept this submission. It is a fact that the profits disclosed by the assessee do not show any startling change.
But the assessee is a manufacturer. The profits of the manufacturer would be varying according to the various conditions of the market, trade, interest paid, etc. We cannot accept the department's contention that the low profit or loss is the result of the excessive commission payments. It was also pointed out that on a capital of Rs. 6 lakhs, the assessee on sale of monopoly products was showing losses. We do not accept this as an indication that the commission payment is excessive.
21. The case for inflation in company's expenses has been made out by the department somewhat like this. The company when they were buying the goods from the assessee-firm, had to maintain a large staff. But, after they had become selling agents, so much of expenses would be unnecessary. This should have come down. We are unable to subscribe to this view. The work done by the company for the assessee either under the earlier agreement of outright sale or under the later agreement of a commission, remains the same. From the point of the requirements of staff for the company, therefore, there could be no change. It will not be reasonable to expect a reduction in the expenditure of the company on that account.
22. A number of cases had been cited by the department to show that the commission payments in comparative cases are much less. Lot of emphasis had been laid on the agreement entered into by Tata Exports Ltd. But these cases will be covered by their own facts. None of the cases cited dealt with the issue whether the commission payment was excessive or unreasonable. What is reasonable, will depend on the facts of each case. We are unable to agree, on the basis of the comparative cases to the submission that the expenditure is excessive.
23. We must finally deal with a submission made on the basis of the computation of profits in respect of 'Promise Toothpaste'. The department's case is that for the year ended 30-6-1981, no commission had been paid and the profit was Rs. 87 lakhs. Now, we have checked up the figures. These figures have been taken from the statement given by the assessee for deduction under Section 80J of the Act. The assessee has not shown the commission payments in respect of the sales. But that does not mean that no commission was payable on the sales of the toothpaste. Commission had been paid on that turnover also but, for some reason or other, in the computation for Section 80J, the assessee had not shown it in the statement. This error had been pointed out to the assessee's chartered accountant.
24. On the above facts, we are of the opinion that no disallowance need be made under Section 40A(2).
25 to 31. [These paras are not reproduced here as they involve minor issues.)