Balakrishna Eradi, C.J.
1. In these two connected references made under Section 256(1) of the I.T. Act, 1961 (for short 'the Act'), at the instance of the Commissioner of Income-tax, Kerala, the Income-tax Appellate Tribunal, Cochin Bench (hereinafter called 'the Tribunal'), has referred to this court the following question of law as arising out of the common order dated December 31, 1977, passed by it in ITA No. 232 (Coch)/76-77 and ITA No. 173 (Coch)/77-78:
'Whether, on the facts and in the circumstances of the case, the Appellate Tribunal was justified in holding that the managing directors of the company are not employees of the company and so the provisions of Section 40A(5) will not apply?'
2. The assessee is a public limited company. The assessment years concerned are 1972-73 and 1973-74. During those two years, the assessee-company had two managing directors, namely, Sri K. Narayanaswamy and Sri S. Srinivasan. Each of these managing directors have received remuneration from the company in excess of Rs. 60,000 in both the aforementioned years.
3. In the return filed by the assessee-company for 1972-73, the assessee claimed that the remuneration paid to the two managing directors amounting to Rs. 72,000 each was fully allowable. The ITO allowed the said deduction in full. The Commissioner took up the matter in suo motu revision and held that the deduction allowed by the ITO in excess of Rs. 60,000 which is the ceiling limit specified under Section 40A(5) of the Act, could not be sustained in law. Accordingly, the Commissioner directed the ITO to modify the assessment by withdrawing the excess deduction.In passing the said order the Commissioner had taken the view that there was an employer-employee relationship between the company and the managing directors and, hence, the provisions of Section 40A(5) were attracted. The assessee carried the matter in second appeal before the Tribunal byfiling ITA No. 232/76-77.
4. For the assessment year 1973-74, the ITO had initially allowed in full the deduction claimed by the assessee in respect of the entire amounts paid to the two managing directors by way of remuneration. Subsequentlythe assessment was, however, reopened by the ITO under Section 147(b) and theexcess deduction that could be allowed beyond the ceiling of Rs. 60,000specified in Section 40A(5) was withdrawn by the ITO. The assessee thereuponfiled an appeal before the AAC, Trivandrum. That appeal was allowedby the AAC holding that the managing directors in this case were notemployees of the company and hence the provisions of Section 40A(5) were notattracted. The department thereafter took the matter in appeal beforethe Tribunal by filing ITA No. 173/77-78. The two appeals were jointlyheard by the Tribunal and were disposed of by the common order dated31st December, 1977, referred to above. The Tribunal allowed the assessee's appeal in respect of the assessment year 1972-73, and dismissed thedepartment's appeal relating to the year 1973-74, holding that the twomanaging directors were not employees of the company and consequently, Section 40A(5) did not apply to the case.
5. There is no agreement of service between the assessee-company and the two managing directors and the relationship between the company and the managing directors is governed only by the provisions contained in the articles of association of the company. A copy of the articles of association of the company has been appended to the statement of the case as annex. A. Article 64 provides, inter alia, that the management of the business of the company shall be vested in the directors who in addition to the powers and the authorities conferred on them by the articles, may exercise all such powers, acts and things as are not expressly directed or required by its articles or by a statute to be exercised of done by the company in general meetings. Article 65 contains an enumeration of the powers of the directors. Clause (e) thereof provides that the board of directors may from time to time, with such sanction of the Central Govt., if any, as may be required by law, appoint one or more of their body to the office of the managing director or managing directors. Clause (f) states that the directors may from time to time resolve that there shall be either one or two or more managing directors. Clause (g) of Article 65 lays down that in the event of any vacancy arising in the office of the managing director or if the directors resolve to increase the number of the managing directors the vacancy shall be filed by the board of directors and the managing director so appointed shall hold the office for such period as the board of directors may fix. Clause (h) enjoins that if the managing director ceases to hold office as director he shall ipso facto and immediately cease to be a managing director. Clause (i) deals with the subject of remuneration of the managing directors and it is in the following terms :
'Subject to the provisions of the Act and subject to such sanction of the Central Government as may be required for the purpose, the managing directors shall receive such remuneration (whether by way of salary, commission or participating in profits or partly in one way and partly in another) as the company in general meeting may from time to time determine.'
6. Clause (j) of Article 65 provides, inter alia, that if two or more managing directors are appointed then they shall he entitled to exercise all the powers conferred on the managing director or managing directors by the articles of association or by law either jointly or severally unless otherwise directed by the board of directors.
7. It is laid down by Article 66 that, if at any time, there is a managing director holding office, he shall, subject to the supervision, control and directions of the board of directors and subject to the restrictions and conditions that may be imposed by the board, have the charge and management of the whole of the affairs of the company and shall have the power to do all acts, matters and things necessary and proper or expedient for carrying on the business of the company. It is necessary also to refer to Article 52 which provides that the company may remove any director except the ex officio director by an extraordinary resolution and may appoint another in his stead.
8. The appointments of Sri Narayanaswamy and Sri Srinivasan as managing directors of the company are governed by the aforesaid provisions contained in the articles of association. The board of directors of the company at their meeting held on September 20, 1967, decided to appoint these two persons as managing directors and it was also decided to allow to each of them by way of remuneration 2 1/2% of the net profits subject to a minimum of Rs. 2,000 per month. The company applied to the Company Law Board for approval of the appointments under Section 269 of the Companies Act. The Company Law Board by its order dated May 1, 1968, gave approval subject to the condition that the remuneration payable to Sri Srinivasan by way of salary and commission shall not exceed Rs. 1,80,000 per annum and that the remuneration payable to Sri Narayanaswamy by way of salary and commission shall not exceed Rs. 1,35,000 per annum. The company's proposal to pay a minimum remuneration of Rs. 2,000 per month to each of the managing directors was not approved by the Company Law Board and the approval granted by the board was only for payment of remuneration to the two managing directors at 2 1/2% of the net profits subject to the limits indicated above.
9. The ceiling limits specified in Sub-section (5) of Section 40A of the Act will get attracted only if the expenditure incurred by the assessee had resulted directly or indirectly in the payment of any salary to an employee or former employee or in the provision of any perquisite to an employee or a former employee. Sub-section (5)(a) of Section 40A of the Act in so far as it is relevant for our present purpose lays down that where the assessee incurs any expenditure which results directly or indirectly in the payment of any salary to an employee or a former employee or in the provision of any perquisite (whether convertible into money or not) to an employee, then, except in cases falling within the scope of Clause (b) of the said section, the assessee would be entitled to a deduction in respect of such expenditure only subject to the ceiling limit specified in Clause (c).
10. The question to be considered is whether the two managing directors of the assessee-company were employees of the company during the relevant accounting period so as to attract the applicability of Clauses (a) and (c) of Sub-section (5) of Section 40A. For ascertaining whether a person is a servant or an agent of another a rough and ready test is whether under the terms and conditions governing their mutual relationship a supervisory control is exercised by the latter in respect of the work entrusted to the former. A servant acts under the direct control and supervision of his master. An agent, on the other hand, in the exercise of his work, is not subject to the direct control or supervision of the principal, though he is bound to exercise his authority in accordance with all lawful orders and instructions which may be given to him from time to time by his principal. But, as pointed out by the Supreme Court in Ram Prashad v. CIT : 86ITR122(SC) , this test is not universal in its application. In determining whether a relationship of employer and employee exists, due regard must also be had to the nature of the particular business, the terms of the engagement and the nature of the duties to be performed by the person in respect of whom the question has arisen as to whether he is an employee. In the aforementioned case, the Supreme Court had to consider whether the amount paid to the managing director of a company as commission at 10% of the gross profits under the terms of the agreement appointing him as the managing director was liable to be assessed as salary or under the head 'Income from business'. The following observations of Jaganmohan Reddy J. furnish clear guidelines as to the principles and tests to be applied by courts in determining such a question (p. 127) ;
'Though an agent as such is not a servant, a servant is generally for some purposes his master's implied agent, the extent of the agency depending upon the duties or position of the servant. It is again true that a director of a company is not a servant but an agent inasmuch as the company cannot act in its own person but has only to act through directors who, qua the company, have the relationship of an agent to its capacity. A managing director may have a dual capacity. He may both be a director as well as an employee. It is, therefore, evident that in the capacity of a managing director he may be regarded as having not only the capacity as persona of a director but also has the persona of an employee, or an agent depending upon the nature of his work and the terms of his employment. Where, he is so employed, the relationship between him as the managing director and the company may be similar to a person who is employed as a servant or an agent, for the term 'employee' is facile enough to cover any of these relationships. The nature of his employment may be determined by the articles of association of a company and/or the agreement, if any, under which a contractual relationship between the director and the company has been brought about, whereunder the director is constituted an employee of the company, if such be the case, his remuneration will be assessable as salary under Section 7. In other words, whether or not a managing director is a servant of the company apart from his being a director can only be determined by the articles of association and the terms of his employment.'
11. After a detailed advertence to the earlier rulings of the Supreme Court in Dharangadhra Chemical Works Ltd. v. State of Saurashtra : (1957)ILLJ477SC , Laxminarayan Ram Gopal and Son Ltd. v. Government of Hyderabad : 25ITR449(SC) , Qamar Shaffi Tyabji v. CEPT [I960] 39 ITR 611 and Piyare Lal Adishwar Lal v. CIT : (1966)IILLJ759SC , the legal position was summed up by the learned judge thus (p. 130):
'A detailed consideration of all the cases cited and the passages from text books referred to before us do not assist us in coming to the conclusion that the test for determining whether the person employed by a company is a servant or agent is solely dependent on the extent of supervision and control exercised on him. The real question in this case is one of construction of the articles of association and the relevant agreement which was entered into between the company and the assessee. If the company is itself carrying on the business and the assessee is employed to manage its affairs in terms of its articles and the agreement, he could be dismissed or his employment can be terminated by the company if his work is not satisfactory, it could hardly be said that he is not a servant of the company.'
12. On an examination of the articles of association of the company concerned in that case and the terms and conditions contained in the agreement entered into between the company and the managing director the Supreme Court held that the amounts paid by the company to the managing director calculated at 10% of the gross profits of the company 'was salary'. The reasons which weighed with the court to arrive at the said conclusion are contained in the following passage extracted from the judgment (p. 131):
'A perusal of the articles and terms and conditions of the agreement definitely indicates that the assessee was appointed to manage the business of the company in terms of the articles of association and within the powers prescribed therein. Reference may particularly be made to Articles 139 and 142 to ascertain the nature of the control imposed by the company upon the managing director. Under the former the additional work which he can do as an agent or manager of the company can be done on terms and conditions and on such remuneration as can be agreed upon between him and the directors of the company and under the latter he had to execute the decisions that may be arrived at by the board from time to time. The very fact that apart from his being a managing director he is given the liberty to work for the company as an agent is indicative of his employment as a managing director not being that of an agent. Several of the Clauses of Article 140, as pointed out by the High Court, specifically empower the board of directors to exercise control over the managing director, such as, for instance, to accept the title of the property to be sold by the company, providing for the welfare of the employees, the power to appoint attorneys as the directors think fit, etc. As pointed out earlier, under the terms of the agreement, he can be removed within the period of 20 years for not discharging the work diligently or if he is found not to be acting in the interest of the company as managing director. These terms are inconsistent with the plea that he is an agent of the company and not a servant. The control which the company exercises over the assessee need not necessarily be one which tells him what to do from day to day. That would be too narrow a view of the test to determine the character of the employment. Nor does supervision imply that it should be a continuous exercise of the power to oversee or superintend the work to be done. The control and supervision is exercised and is exercisable in terms of the articles of association by the board of directors and the company in its general meeting. As a managing director he functions also as a member of the board of directors whose collective decisions he has to carry out in terms of the articles of association and he can do nothing which he is not permitted to do. Under Section 17(2) of the Indian Companies Act, 1913, regulation No. 71 of Table A, which enjoins that the business of the company shall be managed by the directors is deemed to be contained in the articles of association of the company in identical terms or to the same effect. Since the board of directors are to manage the business of the company they have every right to control and supervise the assessee's work whenever they deem it necessary. Every power which is given to the managing director, therefore, emanates from the articles of association which prescribes the limits of the exercise of that power. The powers of the assessee have to be exercised within the terms and limitations prescribed thereunder and subject to the control and supervision of the directors which, in our view, is indicative of his being employed as a servant of the company.'
13. In the case before us Article 65(e) vests in the board of directors the power to appoint any one or more of the directors to the office of managing director or managing directors. Clause (g) specifically states that the managing director shall hold the office for such period as the board of directors may fix. Clause (h) lays down that if the managing director ceases to hold the office of director he shall ipso facto and immediately cease to be a managing director. It is in this context that we have to advert to Article 52 which states that the company may remove any director except the ex officio directors by an extraordinary resolution and may appoint another in his stead. Thus, on the company passing an extraordinary resolution removing him from the office of director, the managing director would automatically cease to hold the office.
14. Clause (i) of Article 65 states that subject to the provisions of the Act and subject to such sanction of the Central Govt. as may be required for the purpose the managing directors shall receive such remuneration (whether by way of salary, commission or participating in profits or partly in one way and partly in another) as the company in general meeting may from time to time determine. The use of the expression 'salary' while describing the nature of the remuneration payable by the company to the managing director furnishes a clear indication of the existence of employer-employee relationship. Clause (j) of Article 65 which lays down, inter alia, that if two or more managing directors are appointed they are to exercise all the powers conferred by the articles or by law on the managing director either jointly or severally unless otherwise directed by the board of directors, clearly shows that the board of directors are to direct and control the functioning of the managing directors. Article 66 states in clear and specific terms that the managing directors are to discharge their functions subject to the supervision, control and directions of the board of directors and subject to the restrictions and conditions that may be imposed by the board. The managing directors are appointed to manage the business of the company in terms of the articles of association within the powers prescribed therein and their relationship with the company is governed only by the provisions contained in the articles of association. Every power which is given to the managing directors emanates from the articles of association which prescribe the limits of the exercise of that power. The aforesaid provisions contained in the articles of association make it clear that the management of the company is vested in the board of directors, the managing director or managing directors appointed by the board is/are to hold office for such period as the board of directors may fix, that a managing director may be removed from the directorship by the company by an extraordinary resolution whereupon he has to automatically cease to be managing director and that in the discharge of their duties and functions the managing directors are subject to the supervision, control and directions of the board of directors who shall have power to impose restrictions and conditions subject to which alone the management of the affairs of the company is to be carried on by the managing directors. There is also the further provision that the managing directors shall receive such remuneration (whether by way of salary, commission or participating in profit or partly in one way and partly in another) as the company in general meeting may from time to time determine.
15. In our opinion, these provisions contained in the articles of association of the company clearly indicate that the relationship between the company and the managing directors is that of employer and employees.
16. The reasons stated by the Tribunal for holding that the two managing directors were not employees of the company are that there is no provision for enforcing disciplinary proceedings against the managing directors, that 'neither the articles of association nor the resolution nor the proposals sent by the assessee to the Company Law Board contain any clause which gives the assessee powers over the managing directors of either terminating the agreement without notice or inflicting punishment' and that the managing directors 'are not entitled to any bonus or leave privileges as in the case of an ordinary employee' and they are not even entitled to a minimum remuneration. As already noticed by us, provision is contained in; the articles of association empowering the company in general meeting to remove from office any director (including the managing directors) and on such action being taken against them the managing directors automatically cease to hold office as such. Thus, under the articles of association, the company is vested with the power to terminate the services of the managing directors by removing them from their office as directors. Unfortunately, the Tribunal has omitted to notice this salient aspect. The Tribunal was also not correct in thinking that unless the terms of the contract of engagement contained a provision conferring power to take disciplinary action and impose a punishment no relationship of employer and employee can be said to exist. The reasoning of the Tribunal is based on an erroneous assumption that in every contract of service there should be provision conferring a power to take disciplinary action and impose punishment on the person whose services are engaged. The articles of association in the case before us has reserved to the company the power to remove from office any director, including the managing directors, by an extraordinary resolution passed by the company. It is without adverting to this provision that the Tribunal has wrongly observed in its order that there is no power reserved with the company to remove the managing directors if they are found to be not discharging their work diligently or not acting in the interest of the company. The further reasons stated by the Tribunal, namely, that the managing directors are not members of the provident fund and that they are not entitled to any bonus, leave privileges or even to a minimum remuneration are, in our opinion, totally irrelevant for determining the nature of the relationship that exists between the company and managing directors. In Gestetner Duplicators P. Ltd, v. CIT : 117ITR1(SC) , the Supreme Court has held that where, under the terms of the contract of employment, remuneration or recompense for the services rendered by an employee is determined at a fixed percentage of the turnover achieved by him, then such remuneration or recompense will partake of the character of salary, the percentage basis being the measure of the salary. The same is the legal position when, under the terms of the contract of employment, the employee is to receive remuneration at a fixed percentage of the net profits of the company.
17. In the light of the foregoing discussion, we hold that the two managing directors were employees of the company and hence the company is entitled to claim a deduction in respect of the remuneration paid to them only subject to the provisions of Section 40A(5). Accordingly, we answer the question referred in the negative, that is, against the assessee and in favour of the department. The parties will bear their respective costs.
18. A copy of this judgment under the seal of the court and the signature of the Registrar will be forwarded to the Tribunal as required by law.