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Commissioner of Income-tax, Kerala Vs. Travancore Sugars and Chemicals Ltd. - Court Judgment

LegalCrystal Citation
SubjectDirect Taxation
CourtKerala High Court
Decided On
Case NumberIncome-tax Referred Case No. 16 of 1962
Reported in[1969]71ITR385(Ker)
AppellantCommissioner of Income-tax, Kerala
RespondentTravancore Sugars and Chemicals Ltd.
Cases ReferredEastern Investments Ltd. v. Commissioner of Income
Excerpt:
- - still, since the supreme court has directed us to consider that question as well, i proceed to consider the same. looking at the question in this way (and, in my opinion, this is only way how the question can be looked at), i feel that the amount is an allowable deduction under section 10(2)(xv) of the income-tax act as well. therefore, i reject this contention as well. , as well as the government distillery at nagercoil and the government tincture factory at trivandrum, and that the government shall sell to this new company to be floated their entire assets in the above three concerns for a cash consideration in respect of the assets of each concern, and subject to the terms and conditions contained in the said agreement. and (3) in the third place, the high court has to examine.....raghavan j. - this reference came before a division bench of this court (m. s. menon c.j. and madhavan nair j.) in august, 1963; and this court answered the question referred 'whether, on the facts and in the circumstances of the case, the payment of rs. 42,480 by the assessee to the travancore government under the agreements dated june 18, 1937, and january 28, 1947, was allowable under section 10 of the income-tax act ?' in the negative against the assessee - company. the company took up the matter before the supreme court; and the supreme court allowed the appeal. this court, relying mainly on the preamble to the agreement between the company and the government of travancore which contained an expression that the payment was 'also in consideration' held that the expenditure was not of.....
Judgment:

RAGHAVAN J. - This reference came before a Division Bench of this court (M. S. Menon C.J. and Madhavan Nair J.) in August, 1963; and this court answered the question referred 'Whether, on the facts and in the circumstances of the case, the payment of Rs. 42,480 by the assessee to the Travancore Government under the agreements dated June 18, 1937, and January 28, 1947, was allowable under section 10 of the Income-tax Act ?' in the negative against the assessee - company. The company took up the matter before the Supreme Court; and the Supreme Court allowed the appeal. This court, relying mainly on the preamble to the agreement between the company and the Government of Travancore which contained an expression that the payment was 'also in consideration' held that the expenditure was not of a revenue nature, but of a capital nature, in other words, towards the unpaid portion of the purchase price. In view of that, this court did not consider the other contention raised by the revenue that the agreement showed only a payment by way of division of earned profits of a common venture between the company and the Government. The Supreme Court held that the payment was not in the nature of a capital payment, but was in the nature of a revenue payment. Still, the Supreme Court observed that since the other question, (1) whether the company was right in the contention that the payment was tantamount to a diversion of profits by paramount title, (2) whether the contention of the revenue that the transaction should be treated as a joint venture with an agreement to share profits was right, and (3) whether section (10)(2)(xv) of the Income-tax Act of 1922 applied to the payment, were not decided by this court, the Supreme Court could not give an answer to the question referred. For considering those questions, and answer to the question referred, the Supreme Court has remanded the case. The judgment of the Supreme Court is reported as Travancore Sugars and Chemicals Ltd. v. Commissioner of Income-tax. The case comes up before us for fresh consideration on the lines pointed out by the Supreme Court.

Though it appears that the revenue contended both before this court and before the Supreme Court that the payment would be a division of earned profits of a common venture between the company and the Government, the counsel for the revenue submits before us that the revenue has no such case and that the said question need not be considered. I, therefore, proceed to consider only questions Nos. 1 and 3 pointed out by the Supreme Court, namely, whether the company is right in its contention that the payment was in effect a diversion of profits by paramount title, and whether section 10(2)(xv) of the Income-tax Act applies to the payment.

The assessee is a limited company carrying on business of manufacturing sugar, running a distillery and running a tincture factory. The company purchased three concerns from the Government of Travancore, (1) the Travancore Sugars Ltd., (2) the Government Distillery at Nagercoil, and (3) the Government Tincture Factory at Trivandrum. The original document of the purchase was on 18th June, 1937, clause 7 of which relating to the payment before us, runs :

'(7) The Government shall be entitled to twenty per cent. of the net profits earned by the company in every year subject however to a maximum of rupees forty thousand per annum, such net profits for the purposes of this clause to be ascertained by deduction of expenditure from gross income and also after -

(i) Provision has been made for depreciation at not less than the rates of allowances provided for in the income-tax law for the time being in force, and

(ii) payment of the secretaries and treasures remuneration.'

This clause was substituted by another agreement dated 28th January, 1947; and the substituted clause reads :

'The Government shall be entitled to ten per centum of the net profits of the company in every year. For the purpose of this clause net profits means the amount for which the companys audited profits in any year are assessed to income-tax in the State of Travancore.'

For the assessment year 1958-59 the amount payable under this clause to the Government came to Rs. 42,480; and the nature of this payment is the question at issue before us. The Appellate Assistant Commissioner held, relying on Pondicherry Railway Co. Ltd. v. Commissioner of Income-tax, that the amount was not an allowable deduction, while the Income-tax Appellate Tribunal held, relying on British Sugar . v. Harris (Inspector of Taxes), that the expenditure was made in order to earn profits and hence an allowable deduction.

This court held that since the preamble to the agreement of January, 1947, mentioned that the payment was 'also in consideration', it was 'part of the purchase price', in other words, it was 'for the purpose of acquiring' the concerns, naturally it was a payment in the nature of a capital payment : and that was what this court held. The Supreme court reversed that decision. Ramaswami J., who spoke for the court, observed at pages 570-571 (of I.T.R.) :

'It is often difficult, in any particular case, to decide and determine whether a particular expenditure is in the nature of capital expenditure or in the nature of revenue expenditure. It is not easy to distinguish whether an agreement is for the payment of price stipulated in instalments or for making annual payments in the nature of income. The Court has to look not only into the documents but also at the surrounding circumstances so as to arrive at a decision as to what was the real nature of the transaction from the commercial point of view. No single test of universal application can be discovered for a solution of the question. The name which the parties may give to the transaction which is the source of the receipt and the characterization of the receipt by them are of little consequence. The court has to ascertain the true nature and character of the transaction from the covenants of the agreement tested in the light of surrounding circumstances.'

His Lordship then examined the transaction in the light of the aforesaid principles. Under the agreement of 1937 the cash consideration fixed for the assets of the Travancore Sugars was 3.25 lakh of rupees; the cash consideration for the Government distillery was to be fixed by joint valuation by the engineers to be appointed by the parties; and the cash consideration for the assets of the Government tincture factory was to be the value according to the books. Thus, the cash part of the consideration for the three concerns was ascertained or was at least ascertainable. It was over and above these cash payments that the annual payments contemplated by clause 7 had to be made. Considering this aspect, Ramaswami J. observed again at page 571 :

'With regard to the second part of the consideration there are three important points to be noticed. In the first place, the payment of commission of twenty per cent. On the net profits by the appellant in favour of the Government is for an indefinite period and has no limitation of time attached to it. In the second place, the payment of the commission is related in the annual profits which flow from the trading activities of the appellant-company and the payment has no relation to the capital value of the assets. In the third place, the annual payment of 20 per cent. commission every year is not related to or tied up, in any way, to any fixed sum agreed between the parties as part of the purchase price of the three undertakings. There is no reference to any capital sum in this part of the agreement. On the contrary, the very nature of the payments excludes the idea that any connection with the capital sum was intended by the parties. It is true that the purchaser may buy a running concern and fix a certain price and the price may be payable in a lump sum or may be payable by instalments. The mere fact that the capital sum is payable by instalments spread over a certain length of time will not convert the nature of that payment from the capital expenditure into a revenue expenditure, but the payment of instalments in such a case would always have some relationship to the actual price fixed for the sale of the particular undertaking. As we have already mentioned, there is no specific sum fixed in the present case as an additional amount of price payable in addition to the cash consideration and payable by instalments or by any particular method.'

These were the considerations which weighed with the Supreme Court in holding that the annual payments under clause 7 were not in the nature of capital expenditure, but were only in the nature of revenue expenditure. For this conclussion the Supreme Court relied on a decision of the Court of Appeal in Commissioners of Inland Revenue v. 36/49 Holdings Ltd. (in liquidation) and Supreme Court also referred with approval to the decision of the Bombay High Court in Commissioner of Income-tax v. Kolhia Hirdagarh Co. Ltd.

From the above reasoning of the Supreme Court what appears is that, in its opinion, the payment was not towards purchase price, because the unpaid purchase price was neither a fixed sum nor an amount which could be ascertained by any method. In other words, if the unpaid purchase price was a fixed amount and that fixed or ascertained amount was to be paid in instalments, the payment would be towards unpaid purchase price and consequently capital payments : or even if the unpaid purchase price was not a fixed figure, still, if the instalments were to continue for a definite term, then also the payment would be towards unpaid purchase price, because the unpaid purchase price in such a case was ascertainable. If on the other hand, the paymant bore no proportion to the unpaid purchase price, if the payments were based on a proportion of the income and were to continue for an indefinite period - for all time as in this case - then the payment were not towards the unpaid purchase price and hence not capital payments : and in such a case, the payments could only be revenue payments.

Now about the question whether the payment concerned was in effect a diversion of profits by paramount title of the Government. The decisions relied upon by the company before the Supreme Court were the decision of the Privy Council in Raja Bejoy Singh Dudhuria v. Commissioner of Income-tax and the decision of the Supreme Court in Poona Electric Supply Co. Ltd. v. Commissioner of Income-tax. The same decisions have been cited before us; and a few other decisions have also been cited. The counsel for the revenue relies mainly on the decision of the Privy Council in Pondicherry Railway Co.s case and a few other decisions. All the decisions cited before us were considered by Subba Rao J., who spoke for the Court, in the decision of the Supreme Court already referred to, namely, Poona Electric Supply Co. Ltd. v. Commissioner of Income-tax. excepting Commissioner of Income-tax v. Sitaldas Tirathdas and Murlidhar Himatsingka v. Commissioner of Income-tax. Therefore, I proceed to consider mainly the said decision of the Supreme Court and its applicability to the present case; and I shall also consider the two other decisions of the Supreme court not considered by Subba Rao J.

In the first case the Poona Electric Supply Co. Ltd. carried on the business of distribution of electricity under a licence issued by the Government.

Under the Electricity (Supply) Act of 1948 the companys 'clear profit' in any year should not exceed 'reasonable return' as defined under the Act; and the excess, if any, the company had to distribute among its consumers in the form of rebate. The company claimed deduction of amounts said to have been credited on this score to the 'consumers benefit reserve account'; and the question before the Supreme Court was whether those amounts were allowable deductions. Subba Rao J. observed at page 525 :

'Under section 10 (1) of the Income-tax Act, tax shall be payable by an assessee under the head profits and gains of business in respect of profits and gains of any business carried on by him. The said profits and gains are not profits regulated by any statute, but profits in a business computed on business principles. They are business profits and not statutory profits. They are real profits and not notional profits. The real profit of a businessman under section 10 (1) of the Income-tax Act cannot obviously include the amounts returned by him by way of rebate to the consumers under statutory compulsion. It is as if he received only from the consumers the original amount minus the amount he returned to them.'

The learned judge then considered the several decisions cited before the Supreme Court and ultimately summarised the conclusions thus at page 530 :

'Income-tax is a tax on the real income, i.e., the profits arrived at on commercial principles subject to the provisions of the Income-tax Act. The real profit can be ascertained only by making the permissible deductions. There is a clear-cut distinction between deductions made for ascertaining the profits and distributions made out of profits. In a given case whether the outgoings fall in one or the other of the heads is a question of fact to be found on the relevant circumstances, having regard to business principles. Another distinction that shall be borne in mind is that between the real and the statutory profits, i.e., between the commercial profits and statutory profits. The latter are statutorily fixed for a specified purpose.'

The same principle was laid down by the Supreme Court in Commissioner of Income-tax v. Sitaldas Tirathdas. In that case Sitaldas Tirathdas, the assessee, had to pay under a consent decree a certain amount every year to his wife and children by way of separate maintenance. He claimed that amount as a deduction, and relied on the decision of the Privy Council in Raja Bejoy Singh Dudhurias case already referred to. There, the step-mother of the Raja had a suit for maintenance and a compromise decree was passed for Rs. 1,100 per month to her. The Judicial Committee held :

'In the present case the deree of the court by charging the appellants whole resources with a specific payment to his step-mother has to that extent diverted his income from him and has directed it to his stepmother : to that extent what he receives for her is not his income. It is not a case of the application by the appellant of part of his income in a particular way, it becomes income in his hands.'

The Supreme Court held that this observation of the Privy Council did not apply to the case before it. At pages 374 - 375, Hidayatullah J. observed :

'In our opinion, the true test is whether the amount sought to be deducted, in truth, never reached the assessee as his income. Obligations, no doubt, there are in every case, but it is th nature of the obligation which is the decisive fact. There is a difference between an amount which a person is obliged to apply out of his income and an amount which by the nature of the obligation cannot be said to be a part of the income of the assessee. Where by the obligation income is diverted before it reaches the assessee, it is deductible; but where the income is required to be applied to discharge an obligation after such income reaches the assessee, the same consequence, in law, does not follow.'

Thus, in the opinion of the Supreme Court, the maintenance payment made by Sitaldas Tirathdas to his wife and children was an obligation he had to discharge from out of his income, while the maintenance paid by Raja Bejoy Singh Dudhuria to his stepmother was a diversion of income out of his revenue before it became income in his hands. The principle is the same as the same as the one laid down by Subba Rao J. in Poona Electric Supply Co.s Case.

Now, about the other decision of the Supreme Court in Murlidhar Himmatsingkas case. M. H. was a partner in firm A and he entered into a sub-partnership, firm B, with his sons and grandson, under which his sons and grandson, under which is share of the profit and loss in firm was to belong to firm B. The question arose whether the share of profit of M. H. in firm had to be assessed in his individul name or to be included in the assessment of firm B; and the Supreme Court held that by an overriding obligation, the sub-partnership agreement, the profit became the income of firm B, though it passed through the hands of M. H. This again confirmed the principle that 'it is the nature of the obligation which is the decisive fact.'

In the light of the above principles laid down by the Supreme Court, when I consider the facts of the case before us, what emerges is this. The amount payable to the Government under the agreement can in no sense be called profits of the company computed on business principles. No businessman will include this amount as part of the real profits or commercial profits of the company on business principles. What has been characterised as 'statutory profits' by Subba Rao J. applies to the amount before us, which really forms part of the 'contractual profits', if I may use that expression : in the case before the Supreme Court it was regulated by the Electricity (Supply) Act, while in the case before us it is being controlled or regulated by the contract between the company and the Government. This amount really belonged to the Government, but was collected by the company to be paid over to the Government. Again, what was the nature of the obligation of the company under which it paid this amount to the Government If the payment were towards unpaid purchase price, it was an obligation which the company was bound to discharge from its moneys. The Supreme Court held that the payment was not towards purchase price. Under the agreement between the Government and the company the latter was bound to pay it : obviously, by this contractual obligation a part of the income of the concerns was diverted to the Government before it became income in the hands of the company : therefore, it was a deduction by superior title, as it were, of the Government.

The counsel for the revenue relies mainly on the following passage from the decision of Lord Macmillan in Pondicherry Railway Co.s case :

'A payment out of profits and conditional on profits being earned cannot accurately be described as a payment made to earn profits. It assumes that profits have first come into existence. But profits on their coming into existence attract tax at that point, and the revenue is not concerned with the subsequent application of the profits.'

This passage was considered by Subba Rao J., and his Lordships also pointed out that Lord Macmillan himself explained this observation in the later decision in Union Cold storage Co. Ltd. v. Adamson. Therefore, this case cannot be pressed into service in support of the contention of the revenue that this amount formed part of the real profit of the company.

In this view the other question, namely, whether section 10(2)(xv) applies, does not arise. Still, since the Supreme Court has directed us to consider that question as well, I proceed to consider the same. Even assuming that the amount forms part of the real or commercial profit of the company, will it be an allowable deduction under section 10(2)(xv) as an amount expended or laid out for earning profits Under the contract between the company and the Government, the amount is to be paid to the Government if the company works the concerns and earns profit. At this stage I may remind that the revenue has no case that the working of the concerns is a joint venture between the company and the Government with an agreement to share profits. It is a venture of the company alone; and the question is whether the payment is essential too make or earn it real profits. If, under the agreement between the company and the Government, the company cannot work the concerns and earn profits without paying the amount to the Government, I do not know how it is not an expenditure incurred or laid out for the purpose of the companys business in order to earn profits - for working the concerns and earning profits. Looking at the question in this way (and, in my opinion, this is only way how the question can be looked at), I feel that the amount is an allowable deduction under section 10(2)(xv) of the Income-tax Act as well.

The decisions relied upon by the company before the Supreme Court on this question were Indian Radio and Cable Communications Co. Ltd. v. Commissioner of Income-tax and British sugar . v. Harris (Inspector of Taxes) and the decision cited by the revenue before the Supreme Court was again Pondicherry Railway Co.s case. These three decisions were considered by Subba Rao J. in Poona Electric Supply Cos case already refered to, though the Supreme Court did not consider the question of application of section 10(2)(xv) in that case. The passage strongly relied upon by the counsel for the revenue in Pondicherry Railway Co.s case is the one already extracted by me; and Subba Rao J. considered the same. His Lordship observed at page 526 :

'The distinction between payment out of profits and a payment to earn profits is unexceptionable. The difficulty is to ascertain in each cases whether a particular payment falls under one or other of the two categories.'

Then His Lordship considered Indian Radio and Cable Communications Co. Ltd. v. Commissioner of Income-tax and pointed out that it was not universally true that a payment, the making of which was conditional on profits being earned, could not properly be described as an expenditure incurred for the purpose of earning such profits; the typical exception was that of a payment to a director or a manager of a commission on the profits of a company. The payment with which I am concerned in this reference is also one of that type - a payment to earn profits; and hence it becomes allowable under section 10(2)(xv).

I may advert to one more argument of the counsel for the revenue before I close. The counsel argues that one sentence from clause 7 of the agreement of 1947 shows that the payment is out of the real profits of the company. The sentence is :

'For the purpose of this clause net profits means the amount for which the companys audited profits in any year are assessed to income-tax in the State of Travancore'.

The counsel lays stress on the word 'assessed'. He argues that the real or commercial profits of the company alone are assessed; and it is only after such assessment that a part of the profits are to be paid to the Government. I do not agree. As I have already stated, the real profits of the company cannot include this amount. What the sentence extracted above shows is only that for the purpose of fixing the share of the Government the net profits have to be taken as the assessable income of the company; and the real profits of the company are what remain after the payment of the 10 per cent. due to the Government. In this connection, I would only extract the passage.

'Once you realise that as a matter of construction the word profits may be used in one sense for one purpose and in another sense for another purpose, I think you have the real solution of the difficulties that have arisen in this case.'

from the judgment of Greene M. R. in British Sugar . v. Harris already referred to. Subba Rao J. considered this passage and also another passage for the same judgment of the Master of the Rolls which said that there were 'two funds of so-called profits' which came into the picture, the first one, the fund which had too be ascertained for calculating the amount payable, which, once that amount had been ascertained, ceased to have any further usefulness, and the other, the one necessary to ascertain the divisible profits, for which purpose it was necessary to take another account, which would also take into account the sum that had been paid (vide page 528 of Poona Electric Supply Co.s case). All this applies to the present case : the audited profits assessed to income-tax mentioned in clause 7 is the first fund; and that amount less the amount paid to the Government is the second fund. Therefore, I reject this contention as well.

For the foregoing reasons, I answer the question in the affirmative in favour of the assessee.

ISAAC J. - I regret I am unable to agree with the judgment of my learned brother. I shall briefly state the facts of the case, and the reasons which persuaded me to differ from him.

This reference has been made by the Income-tax Appellate Tribunal Madras Bench, under section 66(1) of the Indian Income-tax Act, 1922 (hereinafter referred to as the Act), on the application of the Commissioner of Income-tax, Kerala. The question of law referred for the opinion of this court is :

'Whether, on the facts and in the circumstances of the case, the payment of Rs. 42,480 by the assessee to the Travancore Government under the agreements dated June 18, 1937, and January 28, 1947, was allowable under section 10 of the Income-tax Act ?'

This question was answered in the negative and in favour of the Commissioner by a Division Bench of this court by its judgment dated 20th August, 1963. But, in Civil Appeal No. 324 of 1965, it was set aside by the Supreme Court by judgment dated 20th September, 1966; and the case was remanded for being re-heard and dealt with by this court in accordance with the directions given in the said judgment. Accordingly, the case has come before us.

The reference arose out of the order of the Appellate Tribunal in I.T.A. No. 10000 of 1959-60 dated the 18th February, 1961; and it relates to the assessment year 1958-59. The assessee is the Travancore Sugars and Chemicals Ltd. There was another company incorporated in Travancore called 'Travancore Sugars Ltd.', in which the Government of Travancore held the largest number of shares. Steps were taken too wind up that company; and an agreement was entered into between the Travancore Government and Messrs. Parry & Co. Ltd., Madras, on the 18th day of June, 1937, by which it was agreed that M/s. Parry & Co. Ltd shall float another company, the object of which would be, among other things, to purchase the entire assets of the Travancore Sugar Ltd., as well as the Government Distillery at Nagercoil and the Government Tincture Factory at Trivandrum, and that the Government shall sell to this new company to be floated their entire assets in the above three concerns for a cash consideration in respect of the assets of each concern, and subject to the terms and conditions contained in the said agreement. The agreement provided that the cash consideration for the sale of the assets in Travancore Sugar Ltd. would be Rs. 3.25 lakhs, and that the cash consideration for the sale of the assets in the concerns would be amount arrived at in the manner stated therein. Clauses 6 and 7 of the agreement are important for the purpose of this case; and they read as follows :

'6. The company shall maintain separate books of account in respect of sugar business, distillery and tincture factory and such books of account and all connected documents shall be open to inspection by the officers of Government authorised in that behalf.

7. The Government shall be entitled to twenty per cent. of the net profits earned by the company in every year subject however to a maximum of rupees forty thousand per annum, such net profits for the purposes of this clause to be ascertained by deduction of expenditure from gross income and also after :

(i) provision has been made for depreciation at not less than the rates of allowances provided for in the income-tax law for the time being in force, and

(ii) payment of the secretaries and treasures remuneration.'

The above agreement was implemented by the parties, as a result of which the assessee-company was floated, and the assets of the Travancore State in the three concerns mentioned therein were purchased by the assessee. On the 28th day of January, 1947, the assessee and the State of Travancore entered into another agreement by which it was agreed that the terms of the agreement dated 18th June, 1937, would be continued as from 1st August, 1945, except that clause 7 thereof shall be deleted and the following be substituted therefor :

'The Government shall be entitled to ten per centum of the net profits of the company in every year. For the purpose of this clause net profits means the amount for which the companys audited profits in any year are assessed to income-tax in the State of Travancore.'

In the previous year ending April 30, 1957, relevant for the assessment year 1958-59, the assessee paid, pursuant to clause 7 of the agreement, a sum of Rs. 42,480 to the State of Kerala, who is the successor of the State of Travancore. In the computation of income for the assessment year, the assessee did not claim this amount as an allowanced. But, in the course of the hearing before the Appellate Assistant Commissioner, the assessee filed an additional ground, claiming the said amount as an expenditure under section 10(2)(xv) of the Act. He allowed the ground to be raised but rejected the claim. The assessee filed n appeal before the Appellate Tribunal, which held that the payment made to the Government is 'expenditure made in order to earn the profits of the business and not expenditure out of earned profits.'

This court, in its judgment dated 20th August, 1963, extracted the following part of the preamble to the agreement executed between the assessee and the State of Travancore on 28th January, 1947 :

'Whereas on the 18th June, 1937, an agreement (hereinafter called the principal agreement) was entered into between M. R. Ry. Rao Bahadur Rajyasevanirata N. Kunjan Pillai Avl., Chief Secretary to Government acting for and on behalf of the said Government of His Highness the Maharaja of Travancore of the one part, and Sir William Wright, Kt., C. B. E., of Messrs. Parry & Co. Ltd., Madras, acting for and on behalf of said Messrs. Parry & Co. Ltd. of the other part, whereby the said Government should sell sand the company should purchase the assets including the lands of the Travancore Sugars Ltd., with the buildings, outhouses, machinery and other things attached thereto and more particularly described in schedule A annexed to the said principal agreement, the factory known as the Government Distilleries situate at Negercoil in South Travancore with lands, buildings, machinery and other things attached thereto and more particular described in the schedule B annexed to the principal agreement, and all the asset s of the factory known as the Government Tincture Factory situated at Trivandrum and more particularly described in the schedule C annexed to the principal agreement for the cash consideration in the said principal agreement mentioned and also in consideration inter alia that the said Government should be entitled to 20% (twenty per cent.) of the net profits earned by the company in every year subject however to a maximum of Rs. 40,000 per annum, such net profits for purposes of the said agreement to be ascertained after the deductions set out in clause 7 of the said agreement.'

And the court said :

'It is clear from the above extract that the payment under clause 7 is part of the purchase price and if such is the case, the amounts paid in pursuance of that clause will constitute an expenditure not of a revenue but of a capital nature. In other words, they were spent not for the purpose of carrying on the concern but for the purpose of acquiring it.'

The correctness of both of the findings contained in the above judgment, namely, (1) that the payment under clause 7 is part of the purchase price, and (2) that it will constitute an expenditure not of a revenue but of a capital nature was canvassed before the Supreme Court. Dealing with this contention the Supreme Court said :

'The court has to ascertain the true nature and character of the transaction from the covenants of the agreement tested in the light of surrounding circumstances. Examining the transaction from this point of view, it is clear in the present case that the consideration for the sale of the three undertakings in favour of the appellants was :

(1) the cash consideration mentioned in the principal agreement, viz., clauses 3, 4(a) and 5(a), and

(2) the consideration that Government shall be entitled to twenty per cent. of the net profits earned by the appellant in every year subject to a maximum of Rs. 40,000 per annum.'

Then, the court dealt with the second part of the consideration; and it said :

'With regard to the second part of the consideration there are three important points to be noticed. In the first place, the payment of commission of twenty per cent. on the net profits by the appellant in favour of the Government is for an indefinite period and has no limitation of time attached to it. In the second place, the payment of the commission is related to the annual profits which flow from the trading activities of the appellant-company and the payment has no relation to the capital value of the assets. In the third place, the annual payment of 20 per cent. commission every year is not related to or tied up, in any way, to any fixed sum takings. There is no reference to any capital sum in this part of the the agreement. On the contrary, the very nature of the payments excludes the idea that any connection with the capital sum was intended by the parties. It is true that the purchaser may buy a running concern and fix a certain price and the price may be payable in a lump sum or may be payable by instalments. The mere fact that the capital sum is payable by instalments spread over a certain length of time will not convert the nature of that payment from the capital expenditure into a revenue expenditure, but the payment of instalments in such a case would always have some relationship to the actual price fixed for the sale of the particular undertaking. As we have already mentioned, there is no specific sum fixed in the present case as an additional amount of price payable in addittion to the cash consideration and payable by instalments or by any particular method. In view of these facts we are of opinion that the payment of the annual sum of Rs. 42,480 in the present case is not in the nature of capital expenditure but is in the nature of revenue expenditure and the judgment of the High Court of Kerala on this point must be overruled.'

Finally, the Supreme Court held that 'even if the payment of the commission to the Government by the assessee is not capital but revenue payment, certain other question arise for consideration in this case'. Those questions, as formulated in the judgment of the Supreme Court, are the following :

'(1) in the first place, it has to be determined whether the appellant is right in his argument that the payment of the commission is tantamount to diversion of profits by a paramount title......

(2) in the second place, the repondent has contended that the transaction should be treated as a joint venture with an agreement to share profits between the appellant and the Government; and

(3) in the third place, the High Court has to examine whether the requirements of section 10(2)(xv) have been satisfied in this case.'

These are the questions which the Supreme Court has directed this court to consider in dealing with this reference afresh. At the hearing before us, the learned counsel for the revenue submitted that the income-tax department has no case that the transaction between the assessee and the Travancore Government is a joint venture, and that the second question formulated by the Supreme Court does not arise and need not be considered. Hence, only the remaining two questions fall for consideration.

The question has a often arisen before courts, when a person pays a share of the profits of his business to another under an obligation arising under law or contract, whether the said payment is an application of the profits, or a diversion of the same by overriding obligation arising under law or contract, whether the said payment is an application of the profits, or a diversion of the same by overriding obligation or a paramount title. In the former case, he received the whole income, and he is taxable thereon. In the latter case, the income which is diverted does not reach him; it is not his income, and he is not taxable on the income thus diverted. The principle too be applied for determining this question is well-settled, though its application to the particular facts of a case may not always be easy. The principle is stated by the Supreme Court in Commissioner of Income-tax v. Sitaldas Tirathdas as follows :

'There is a difference between an amount which a person is obliged to apply out of has income and an amount which by the nature of the obligation cannot be said to be a part of the income of the assessee. Where by the obligation income is diverted before it reaches the assessee, it is deductible; but where the income is required to be applied to discharge an obligation after such income reaches the assessee, the same consequance, in law, does not follow. It is the first kind of payment which can truly be excused and not the second. The second payment is merely an obligation to pay another a portion of ones own income, which has been received and is since applied. The first is a case in which the income never reaches the assessee, who even if he were to collect it, does so, not as part of his income, but for and on behalf of the person to whom it is payable.'

The application of the above principle presents no difficulty too the facts of this case. The assessee has no case, nor is it possible to contend, that the business is a joint venture of the assessee and the Government. Naturally, the whole profit of the business goes to the assessee. There is nothing in the agreement to support the contention that the whole profits do not reach the assessee, and that a part of it is diverted and goes to the Government. On the other hand, clause 7 of the agreement, under which the payment is made, states in definite terms that what the Government is entitled to get is 'ten per cent. of the net profits of the company in every year', and that, for the purpose of this clause, 'net profits' means 'the amount for which the companys audited profits in any year are assessed to income-tax in the State of Travancore.' This again means that what the Government gets is a percentage of the 'total income' of the assessee on which it is assessed to income-tax. In making the payment, the assessee is only discharging its obligation to satisfy one part of the consideration for the sale of the three undertakings by the State of Travancore to the assessee, in the manner provided in the agreement. This is, therefore, a very clear case of application by the assessee of its income pursuant to a contract, which it has entered into with the Government.

The learned counsel for the assessee, however, contended that the above decision has no application to the facts of this case, and that, on a true construction of the agreement, this is really a case of diversion of part of the profits of the business by a paramount title. In support of this contention, the learned counsel first cited the decision of the Supreme Court in Poona Electric Supply Co. Ltd. v. Commissioner of Income-tax. The assessee in that case was a company, which carried on the business of distribution of electricity under a licence issued by the Government. Under the Electricity (Supply) Act, 1948, the companys 'clear profit' in any year should not exceed the amount of 'reasonable return' as defined under the Act. The excess, if any, after making some deductions has to be distributed to its consumers in the form of rebate. The question which arose for determination was whether the amount received by the company in excess of the 'clear profit' and credited by the company to the 'consumers benefit reserve account' was deductible in computing the assessable income of the company. There is a very instructive discussion of the case law by Subba Rao J. in that case; and his Lordship stated that the decisions lead to the following result :

'Income-tax is a tax on the real income, i.e., the profits arrived at on commercial principles subject to the provisions of the Income-tax Act. The real profit can b e ascertained only by making the permissible deductions. There is a clear-cut distinction between deductions made for ascertaining the profits and distributions made out of profits. In a given case whether the outgoings fall in one or the other of the heads is a question of fact to be found on the relevant circumstances, having regard to business principles. Another distinction that shall be borne in mind is that between the real and the statutory profits, i.e., between the commercial profits and statutory profits. The latter are statutorily fixed for a specified purpose.'

In applying the above propositions to the facts of that case, his Lordship said :

'The appellant-company is a commercial undertaking. It does business of the supply of electricity subject to the provisions of the Act. As a business concern its real profit has to be ascertained on the principles of commercial accountancy. As a licensee governed by the statute its clear profit is ascertained in terms of the statute and the schedule annexed thereto. The two profits are for different purposes - one is for commercial and tax purposes and the other is for statutory purposes in order to maintain a reasonable level of rates. For the purposes of the Act, during the accounting years the assessee credited the said amounts to the consumers benefit reserve account. They were a part of the excess amount paid to it and reserved to be returned to the consumers. They did not form part of the assessees real profits. So, to arrive at the taxable income of the assessee from the business under section 10 (1) of the Act, the said amounts have to be deducted from its total income.'

It is clear from the passage extracted above that this decision has no application to the facts of the present case, distinguishing features of which have been already indicated.

The assessees learned counsel next referred to another decision of the Supreme Court in Murlidhar Himatsingka v. Commissioner of Income-tax. In that case, M, who was a partner in a registered firm, A, entered into a sub-partnership, firm B, which provided, among other things, that the profits and losses of M in firm A shall belong to firm B, and shall be borne and divided in accordance with there shares specified therein. The question for decision was whether the whole of Ms share of the profits in firm A was assessable in his individual income, or only part thereof, which alone he got as a result of the division of the same among the partners of firm B. In dealing with this question, the court quoted with approval the test laid down by Hidayatullah J. in Commissioner of Income-tax v. Sithaldas Tirathdas for determining whether a payment by a person of a share of his profits too another amounts to diversion of income by a paramount title. The relevant passage from his Lordships judgment has been extracted above. Then, after a detailed discussion of the case law, the court dealt with the question which arose for determination in that case as follows :

'The question then arises whether the interest of the sub-partnership in the profits received from the main partnership is of such a nature as diverts the income from the original partner to the sub-partnership. Suppose that A is carrying on a business as a sole proprietor and he takes another person, B, as a partner. There is no doubt that the income derived by A after the date of the partnership cannot be treated as his income; it must be treated as the income of the partnership consisting of A and B. What difference does it make in principle where A is not carrying on a business as a sole proprietor but as one of the partners in a firm There is no doubt that there is this difference that the partners of the sub-partnership do not become partners of the original partnership. This is because the law of partnership does not permit a partner, unless there is an agreement to the contrary, to bring strangers into the firm as partners. But as far as the partner himself is concerned, after the deed of agreement of sub-partnership, he cannot treat the income as his own. Prior to the case of Cox v. Hickman sub-partners were even liable to the creditors of the original partnership. Be that as it may, and whether he is treated as an assignee within section 29 of the Indian Partnership Act, as some cases do, a sub-partner has definite enforceable rights to claim a share in the profits accrued to or received by the partner.'

And the court held :

'In our view, in the case of a sub-partnership, the sub-partnership creates a superior title and diverts the income before it becomes the income of the partner. In other words, the partner in the main firm receives the income not only on his behalf but on behalf of the partners in the sub-partnership.'

The facts of the above case and the principles applied for determination of the question raised therein have no application to the case of the assessee in this case for the reasons already stated.

Reliance was placed by the assessee before the Supreme Court on the decision of the Privy Council in Raja Bejoy Singh Dudhuria v. Commissioner of Income-tax. The assessees learned counsel cited that decision also before us. In that case, the assessee succeeded to the family ancestral estate on the death of his father. His stepmother obtained a consent decree for monthly payment of a fixed sum by the assessee for her maintenance, declaring that it was a charge on the estate. Upholding the assessees claim that the amount paid too the stepmother as maintenance should be excluded from the income, the Privy Council said :

'But their Lordships do not agree with the learned Chief Justice in his rejection of the view that the sums paid by the appellant to his stepmother were not income of the appellant at all. This in their Lordships opinion is the true view of the matter.

When the Act by section 3 subjects to charge all income of an individual, it is what reaches the individual as income which it is intended to charge. In the present case the decree of the court by charging the appellants whole resources with a specific payment to his stepmother has to that extent diverted his income from him and has directed it to his stepmother; to that extent what he receives for her is not his income. It is not a case of the application by the appellant of part of his income in a particular way, it is rather the allocation of a sum out of his revenue before it becomes income in his hands.'

The above decision was sought to be applied in the case of Commissioner of Income-tax v. Sitaldas Tirathdas, wherein the assessee claimed that an amount payable by him to his wife and children under a maintenance decree should be excluded in computing the assessable income. In rejecting this claim, the Supreme Court said :

'In our opinion, the present case is one in which the wife and children of the assessee who continued to be members of the family received a portion of the income of the assessee, after the assessee had received the income as his own. The case is one of application of a portion of the income to discharge an obligation and not a case in which by an overriding charge the assessee became only a collector of anothers income. The matter in the present case would have been different, if such an overriding charge had existed either upon the property or upon its income, which is not the case.'

Bejoy Singh Dudhurias Case does not, therefore, give any support for the contention of the assesses learned counsel. Some more decision were cited at the hearing; but it is unnecessary to refer to them, in view of the authoritative pronouncement on the question of law involved in the case, in the decisions already cited.

The next question for consideration is whether the payment of a part of the business to the Government under clause 7 of the agreement is an allowable deduction under section 10(2)(xv) of the Act. This provision reads as follows :

'10. (2) Such profits or gains shall be computed after making the following allowing 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.'

As already stated, the payment of the share of the profits is a part of the consideration for the purchase of the three concerns of the state of Travancore by the assessee. Such payment is not an expenditure, but only a discharge of the assesses own liability; and even if it is considered an expenditure, it can under no circumstances be an expenditure 'laid out wholly or exclusively for the purpose of such business' within the meaning of the above provision. The assessees learned counsel, therefore, presented the case in a different form. He submitted that what is paid to the Government is the Governments share of the income from the business, that the assesse gets only the balance, and the assesses income is only what the assesse gets from the business. In support of this contention, the learned relied on the decision of the Travancore-Cochin High Court in Travancore Minerals Co. Ltd. v. Commissioner of Income-tax. The assessee in that case took a mining lease from the State of Travancore, undertaking to pay to the lessor a certain rate of royalty, and also a percentage of the assessees profits. The question for decision was whether the percentage of profits paid to the Government was an allowable expenditure. The court held that,on a true construction of the contract between the parties, the payment did not amount to a sharing of the profits; but it was an additional royalty in consideration of the lease, and it is an allowance to be made in computing the assesees profits. Such a payment is obviously an expenditure incurred wholly and exclusively for the purpose of the business. This case does not, therefore, support the contention of the assessees learned counsel in this case.

The assessees learned counsel also cited the decision of the Court of Appeal in British Sugar . v. Harris (Inspector of Taxes). In that case, a company carrying on a manufacturing business agreed with two other companies to pay them a stated percentage of its net profits in consideration of their giving to the company the full benefit of their technical and financial knowledge and experience. It was held that, in computing the profits of the company for the purpose of income-tax, the company was entitled to deduct the sums so paid to the other companies. This is also, as held by their Lordships, a clear case of 'money wholly and exclusively laid out or expended for the purposes of the trade'. This decesion does not, therefore, help the assessee.

The learned counsel for the revenue relied on the decision of the Privy Council in Tata Hydro-Electric Agencies Ltd. v. Commissioner of Income-tax, in support of the contention that the payment made by the assessee to the Government under clause 7 of the agreement is not liable for deduction in computing the assessable income. In that case, the Tata Power Co. entered into an agency agreement with Tata Sons Ltd. agreeing to pay Tata Sons Ltd. for services to be rendered by them a commission of 10% on the annual net profits of the Tata Power Co. Subsequently, two other persons advanced funds to the Tata Power Co. on condition that, in addition to interest payable to them by the Tata Power Co. on the money advanced, they should each of them get from Tata Sons Ltd.12 1/2% of the commission earned by the Tata Sons Ltd. under the agency agreement. The rights under the agency agreement were purchased by the assessee from Tata Sons Ltd. Accordingly, the Tata Power Co. entered into a new agency agreement with the assessees; and the assessees also entered into new agreements with the two persons who had advanced funds to the Tata Power Co. The question we whether the payment of a part of the commission, which the assessees got from the Tata Power Co., to the two persons who had advanced funds to the company, was an expenditure incurred for earning profits. The Privy Council answered it in the negative and against the assessees. The following passage appearing in the judgment of the Privy Council is instructive; and it states the reason for the decision :

'Their Lordships recognise and the decided cases show how difficult it is to discriminate between expenditure which is, and expenditure which is not, incurred solely for the purpose of earning profits or gains. In the present case their Lordships have reached the conclusion that the payments in question were not expenditure so incurred by the appellants. They were certainly not made in the process of earning their profits; they were not payments to creditors for goods supplied or services rendered to the appellants in their business; they did not arise out of any transactions in the conduct of their business. That they had to make those payments no doubt affected the ultimate yield in money to them from their business but that is not the statutory criterion. They must have taken this liability into account when they agreed to take over the business. In short, the obligation to make these payments was undertaken by the appellants in consideration of their acquisition of the right and opportunity to earn profits, that is, of the right to conduct the business, and not for the purpose of producing profits in the conduct of the business. If the purchaser of a business undertakes to the vendor as one of the terms of the purchase that he will pay a sum annually to a third party, irrespective of whether the business yields any profits or not, it would be difficult to say that the annual payments were made solely for the purpose of earning the profits of the business. It would seem to make no difference that the annual sum should be made payable out of a particular receipt of the business, irrespective of the earning of any profit form the business as a whole.'

It is unnecessary to refer to more decided cases, as the reasons stated by the Privy Council in the above decision for disallowing the claim of the assessees in that case fully apply to this case. It follows that the amount paid by the assessee to the Government under clause 7 of the agreement cannot be excluded from its profits, nor is the said amount liable for deduction under section 10(2)(xv) of the Act in computing the assessees taxable income.

In the result, I answer the question referred in this case again in the negative, and in favour of the Commissioner of Income-tax, Kerala.

BY COURT

Since we are not agreed on the answer to be sent to the Appellate Tribunal, we place the case before our Lord Chief Justice for directions regarding further hearing under the proviso to section 66A(1) of the Income-tax Act.

K. K. MATHEW J. - The assessee here is a limited company incorporated under the Travancore Companies Regulation and is carrying on the business of manufacturing sugar. It also runs a distillery and a tincture factory. The assessee-company was floated with a view to taking over the business assets of a company called Travancore Sugars Ltd., which was being wound up and in which the State Government held the largest number of shares, the Government Distillery at Nagercoil and the business assets of the Government Tincture Factory at Trivandrum. An agreement was entered into between the Government of Travancore and Sir William Wright on behalf of Parry & Co. Ltd., the promoters of the assessee company. Under the said agreement, the assets of all the three concerns were agreed to be sold by the Government of Travancore to the assessee-company. It is not necessary to set out all the clauses in the agreement. Apart from the cash consideration for the transfer of the assets, clause 7 of the agreement provided that :

'the Government shall be entitled to twenty per cent. of the net profits earned by the company in every year subject however to a maximum of rupees forty thousand per annum, such net profits for the purposes of this clause to be ascertained by deduction of expenditure from gross income and also after -

(i) provision has been made for depreciation at not less than the rates of allowances provided for in the income-tax law for the time being in force, and

(ii) payment of the secretaries & treasurers remuneration.'

On the 28th January, 1947, clause 7 was substituted by another clause, which reads :

'The Government shall be entitled to ten per centum of the net profits of the company in every year. For the purpose of this clause net profits means the amount for which the companys audited profits in any year are assessed to income-tax in the State of Travancore.'

For the assessment year 1958-59, the corresponding previous year being 1st May, 1956, to 30th April, 1957, the amount payable to Government under the aforesaid clause came to Rs. 42,480. The Appellate Assistant Commissioner disallowed the claim of the assessee for deduction of this amount on the ground that the clause virtually provided for sharing the profits after they came into existence. On appeal by the assessee, the Income-tax Appellate Tribunal held that the case will come within the principle of the decision in British Sugar . v. Harris (Inspector of Taxes) and that the payment was an expenditure made to earn the profits of the business and not an expenditure out of the earned profits, and allowed the appeal. At the instance of the department, the Tribunal referred the following question to the High Court :

'Whether, on the facts and in the circumstances of the case, the payment of Rs. 42,840, by the assessee to the Travancore Government under the agreements dated June 18, 1937, and January 28, 1947, was allowable under section 10 of the Income-tax Act ?'

This court held that the payment of the aforesaid amount constituted capital expenditure and was not an allowable deduction under section 10(2)(xv) of the Income-tax Act. Against this judgment, an appeal was preferred by special leave to the Supreme Court. The Supreme Court held that the amount is not capital expenditure but revenue payment and sent back the case to this court for decision of certain questions, namely, whether 'the payment of the commission is tantamount to diversion of profits by a paramount title', whether 'the transaction should be treated as a joint venture with an agreement to share profits' between the assessee and the Government, and whether 'the requirements of section 10(2)(xv) have been satisfied in this case'.

When the case came before the Division Bench the question whether the transaction should be treated as a joint venture with an agreement to share the profits between the assessee and the Government was not pressed by the revenue. Raghavan J. answered the other two questions in the affirmative and in favour of the assessee, whereas Isaac J. answered them in the negative and in favour of the revenue.

So, the two questions which require consideration are : (1) whether payment of the amount is a diversion of profits before they reached the assessee by an overriding title and (2) whether the amount is an allowable deduction under section 10(2)(xv) of the Income-tax Act.

The Supreme Court has held that the payment of the amount was not towards purchase price because the unpaid purchase price was neither a fixed sum nor an amount which could be ascertained by any method and so it is not in the nature of capital expenditure.

Whether the payment concerned is a diversion of the profits by a paramount title has to be decided keeping in view the principle laid down by the Privy Council in Raja Bejoy Singh Dudhuria v. Commissioner of Income-tax,and by the Supreme Court in Commissioner of Income-tax v. Sitaldas Tirathdas and Murlidhar Himatsingka v. Commissioner of Income-tax.

In Raja Bejoy Singh Dudhuria v. Commissioner of Income-tax, the assessee succeeded to the family ancestral estate on the death of his father. Subsequently his step-mother brought a suit for maintenance against him in which a consent decree was made directing the assessee to make a monthly payment of a fixed sum to his step-mother and declaring that the maintenance was a charge on the ancestral estate in the hands of the assessee. In computing his income, the assessee claimed that the amounts paid by him to the step-mother under the decree should be excluded. It was held by the Judicial Committee that the sums paid by the assessee to his step-mother were not 'income' of the assessee at all and that the decree of the court by charging the appellants whole resources with a specific payment to his step-mother had to that extent diverted his income from him and had directed it to his step-mother, and to that extent what he received for her was not his income. At the moment when the estate passed on to him there was liability on the estate which was not quantified and when it was so done by the decree of the court the entirety of the estate became, so to speak, charged with it and that portion of the income payable to the step-mother had to be treated as the income of the step-mother and not of the assessee.

In Commissioner of Income-tax v. Sitaldas Thirathdas, the assessee had to pay under a consent decree a certain amount every year to his wife and children by way of separate maintenance. He claimed a deduction of the amount form the income and relied on the decision of the Privy Council in Raja Bejoy Singh Dudhuria v. Commissioner of Income-tax. Hidayatullah J., as he then was, said :

'In our opinion, the true test is whether the amount sought to be deducted, in truth, never reached the assessee as his income. Obligations, no doubt, there are in every case, but it is the nature of the obligation which is the decisive fact. There is a difference between and amount which a person is obliged to apply out of his income and an amount which by the nature of the obligation cannot be said to be a part of the income of the assessee. Where by the obligation income is diverted before it reaches the assessee, it is deductible; but where the income is required to be applied to discharge an obligation after such income reaches the assessee, the same consequence, in law, does not follow.'

The maintenance paid by Sitaldas Tirathdas to his wife and children under the consent decree was an obligation he had to discharge from out of his income while the maintenance paid by Raja Bejoy Singh to his step-mother was a diversion before it became income in his hands. The difficulty in drawing the line between the two types of cases is illustrated by the decision of the Supreme Court in Murlidhar Himatsingka v. Commissioner of Income-tax. In the case, M. H. was a partner in firm A, and he entered into a sub-partnership with his sons and grandson in firm B, under which his share of the profit and loss in firm A were to belong g to firm B. The question arose whether the share of profit of M.H. in firm A had to be assessed in his individual name or to be included in the assessment of firm B. The Supreme Court held that by an overriding obligation, namely, the formation of the sub-partnership agreement, the profit became the income of firm B, though it passed through the hands of M. H.

Let us look at the nature of the obligation in this case. The obligation to pay the amount arose outof an agreement, which is a part and parcel of the agreement under which the assese became entitled to the assets of the three concerns. Although the payment of the amount is not part of the consideration for the purchase of the three concerns, it is apayment whcih the assessee has agreed to make. It might be remembered that in addition to selling the assets of the three concerns, the Government undertook the obligation enumerated in clauses 4(b) and (c) and clause 5(c) of the agreement (see annexure 'A'). And the Government could have enforced by action the payment in case the assessee refused to pay. It is said that by the clause in question, there is no diversion of the profits of the assessee but only an application of a part of a part of the profits, that the profits are earned by the assessee and then a percentage of it paid over by the assessee to the Government. Reliance was placed on the observation of Lord Macmillan in Pondicherry Railway Co. Ltd. v. Commissioner of Income-tax to support the contention. It that case, the assessee-company, incorporated in the United Kingdom, obtained a concession for constructing a railway in the territories of Pondicherry. The assessee-company was to pay to the French Government half of its net profits. The French Government on its part gave land on which the railway was to be built free of charge and also agreed to pay a subsidy. The question for decision was whether the monies paid by the assessee-company to the French Government were allowable deduction under the provision corresponding to section 10(2)(XV). Lord Macmillan observed at page 170 :

'A payment out of profits and conditional on profits being earned cannot accurately be described as a payment made to earn profits. It assumes that profits have first come into existence. But profits on their coming into existence attract tax at that point and the revenue is not concerned with the subsequent application of the profits.'

But these observations have been explained in later cases. In Union Cold Storage Co. Ltd. v. Adamson, the assessee leased lands and premises abroad reserving a rent of pounds 960,000. It was provided in the deed that if at the end of the financial year it was found that after providing for the rent the result of the companys operations was insufficient to pay interest or charges and debentures, etc., the rent for the year was to be abated to the extent of the deficiency. In computing its profits the assessee-company claimed the sum of rent paid in the two respective years. They were held not payable out of the payable out of the profits or gains and were allowable deductions. Rowlatt J. said that the sum which was to be paid by the company was a recompense in respect of possession and use of the premises abroad and the company had entered into some liabilities by way of payment for their premises and that payment was an outgoing of the business which has to be provided for and allowed before of the business could be ascertained. In the House of Lords, Lord Macmillan distinguished the Pondicherry Railway Company case by saying that in that case the ascertainment of profits preceded the coming into operation of the obligation to pay and when profits had been ascertained the obligation was to make over half thereof to the French Government. Dealing with the passage above referred to, Lord Macmillan said pages 331-332 :

'...I was dealing with a case in which the obligation was, first of all, to ascertain the profits in a prescribed manner, after providing for all outlays incurred in earning them, and then to divide them. Here the question is whether or not a deduction for rent has to be made in ascertaining the profits, and the question is not one of the distribution of profits at all'.

The same question was considered in Vithaldas Thakordas & Co. v. Commissioner of Income-tax. There, the facts were : After the death of V, who had during his lifetime carried on in his own name a bullion business, the assesssees, a firm of partners, entered into an arrangement with the widow of V, for the use of Vs name for their bullion business. Under the arrangement, in consideration of the widow having agreed to allow the partners to use the name of V for the purpose of the partnership business the partners agreed to pay to her out of the net profits of the business in the first instance an amount equivalent to two annas in the rupee of the et profits. The partners also agreed that neither she nor the estate of V would be liable for the debts or losses of the partnership and that she would not be deemed a partner in the business. The partnership deed provided that after payment of the aforesaid amount to the widow, the balance of the net profits was to be divided between the partners in certain proportions. No term was fixed for the duration of the use of the goodwill. In the accounting year the assessees made a net profit of Rs. 40,470 and widow was paid Rs. 5,059, being her share in the profits. In considering the question whether the amount was an allowable deduction, the court said :

'Therefore, in every case the court has got to consider what are the real profits of the assessee and what are the apparent profits. It is only the real profits that attract the tax; and even though the language used in he material documents may be net profits, the court must look to the substance of the transaction and not the form. In this case the two documents I have referred to provide that Bai Tarabai has got to be paid two annas in the rupee of the net profits. But the two annas in the rupee have to be paid for the use of the goodwill which is essential for the carrying on of the business. Therefore, first, the apparent profits of the partnership are ascertained and two annas in the rupee are paid out to Bai Tarabai out of those profits; and after those payments are made, the real profits are ascertained which attract the tax; and it is these real profits that are distributed among the partners in the proportion laid down in the partnership agreement, making up what is described as a unit of 14 annas.'

The observations of Lord Macmillan in Pondicherry Railway Company case were considered in British Sugar . v. Harris (Inspector of Taxes). In that case, a company carrying on a manufacturing business agreed with two other companies to pay them a stated percentage of its net profits. 'Net profits' were to be ascertained after payment of all expenses of the company, and after providing for interest on debentures, but before making any provision for depreciation. The Court of Appeal held that in computing its profits for the purposes of income-tax, the company was entitled to deduct the sums so paid as being 'money wholly and exclusively laid out or expended for the purposes of the trade'. Lord Greene, the Master of the Rolls, pointed out the 'net profits' were to be arrived at upon a conventional basis, not the basis upon which the company would ascertain its profits for commercial purposes or the basis upon which it would ascertain its profits for income-tax purposes; and the percentage was to be paid out of these conventional profits and not out of the profits which were liable to tax. Dealing with the Pondicherry Railway Company case the learned Master of the Rolls said :

'It is to be observed that Lord Macmillan in that paragraph was quite clearly using the word profits in one sense and one sense only; he was using it in the sense of the real net profit to which Lord Maugham referred. That he was doing that is, I think, abundantly clear when the nature of the contract that is in question is considered, which was merely a contract under which a percentage of profits was payable by the railway company to the french Government. There was no question of services or any thing of that kind in the case; it was merely a sum payable out of profits. I do not find myself constrained by that expression of opinion, because it must be read, as Lord Macmaillan said in a subsequent case, Union Cold Storage Co Ltd. v. Adamson, in relation to the particular subject-matter with which he was dealing.'

The court finally held that the sum is an allowable deduction holding that it is not an appropriation of the profits of the partnership after they had been ascertained, that the agreement was not in the nature of a joint venture or a quasi partnership, and that the payment was a revenue expenditure wholly and exclusively incurred for the purpose of the business and was admissible as a deduction under section 10(2)(xii) of the Income-tax Act.

In Poona Electric Supply Co. Ltd. v. commissioner of Income-tax the company carried on the business of distribution of electricity under a licence issued by the Government. Under the Electricity (Supply) Act, 1948, the companys 'clear profits' in any year should not exceed 'reasonable return' as defined under the Act; and the excess, if any, the company had to distribute among its consumers in the form of rebate. The company claimed deduction of the amounts said to have been credited to the 'consumers' benefit reserve account', and the question before the Supreme Court was whether those amounts were allowable deductions. Subba Rao J., as he then was, observed that under section 10(1) of the Income-tax Act, tax shall be payable by an assessee under the head 'profits and gains of business' in respect of profits and gains of any business carried on by him, and that the said profits and gains are not profits regulated by any statute but profits in a business computed on business principles, that what is to be ascertained is the business profit and not statutory profit. He further observed that the real profit of a businessman under section 10 (1) of the Income-tax Act cannot obviously include the amounts retrained by him by way of rebate to the consumers under statutory compulsion and that it is as if he received only from the consumers the original amount minus the amount he returned to them. His Lordship summarised his conclusions at page 530 thus :

'Income-tax is a tax on the real income, i.e., the profits arrived at on commercial principles subject to the provisions of the Income-tax Act. The real profit can be ascertained only by making the permissible deductions. There is as clear-cut distinction between deductions made for ascertaining the profits and distributions made out of profits. In a given case whether the outgoings fall in one or the other of the heads is a question of fact to be found on the relevant circumstances, having regard to business principles. Another distinction that shall be borne in mind is that between the real and the Statutory profits, i.e., between the commercial profits and statutory profits. The latter are statutorily fixed for a sepcified purpose.'

In Poona Electric Supply Companys case computation of the profits was regulated by the Electricity (Supply) Act, whereas in the case in hand it is regulated by the contract between the company and the Government. In computing the real profits of the assessee here, I think, the payment made to the Government had to be deducted. The fact that in the substituted clause, 7, it is said that out of the net profits of the company, the Government will be entitled to 10% would not make it a payment out of the real profits of the company. We must remember the distinction between apparent profits and real profit. What is taxed under the Income-tax Act is only the profits of the Company calculated on commercial principles. In the Privy Council case of Indian Radio & Cable Communications Co Ltd. v. commissioner of Income-tax, Lord Maugham said :

'.... it is not universally true to say that a payment the making of which is conditional on profits being earned cannot properly be described as an expenditure incurred f or the purpose of earning such profits. The typical exception is that of a payment to a director or a manager of a commission on the profits of a company. It may, however, be worth pointing out that an apparent difficulty here is really caused by using the word profit in more than one sense. If a company having made an apparent net profit of pounds 10,000 has then to pay pounds 1,000 to directors or managers as the contractual recompense for their service during the year it is plain that the real net profit is only pounds 9,000.'

When a trader makes a payment which is computed in relation to profits, the question that arises is : Does the payment represent a mere division of profits with another party, or is it an item of expenditure the amount of which is ascertained by reference to profits. The payment would be allowable in the second case, but not in the first.

Now let us see whether the payment is an expenditure wholly and exclusively laid out for the purpose of the business and ascertained with reference to profits.

Viscount Cave L. C. observed in Atherton v. British Insulated & Helsby Cables Ltd. :

'.... a sum of money expended, not of necessity and with a view to a direct and immediate benefit to the trade, but voluntarily and on the grounds of commercial expediency, and in order indirectly to facilitate the carrying on of the business, may yet be expended wholly and exclusively for the purposes of the trade.....'

What is money wholly and exclusively laid out for the purposes of business must be determined upon the principles of commercial trading. Thus, remuneration of commission payable to directors, managers, agents or other employees, and ascertained by reference to profits, is deductible as a business expense (See the decision in Commissioner of Income-tax v. Bombay Burma Trading Corporation).

Reliance was placed by the revenue upon the decision in Tata Hydro Electric Agencies Ltd. v. Commissioner of Income-tax, and it was contended that the payment is not an expenditure laid out wholly and exclusively for the purpose of the business. In that case, the Tata Power Company entered into an agency agreement with Tata Sons Ltd. agreeing to pay to Tata Sons Ltd. a commission of 10% on the annual net profits of Tata Power Co. subject to a minimum, whether any profits were made or not. Later on, two persons, D and S, advanced funds to Tata Power Company on the condition that, in addition to the interest payable to them by Tata Power Company, they should each receive from Tata Sons Ltd. 12 1/2% of the commission earned by Tata Sons Ltd. Tata Sons Ltd. assigned their entire right to the assessee-company and the Tata Power Company entered into a new agency agreement with he assessee-company and the assessee company received a commission, and out of that paid 1/4 to D and S. Relying on Pondicherry Railway Co. case the Bombay High Court held that that was not an allowable deduction as expenditure incurred solely for earning profits. On appeal the Privy Council held that the Pondicherry Railway Co. case did not govern the case. The nature of the transaction was held to be this that the obligation to make the payments was undertaken by the assessee-company in consideration of its acquisition of the right to property to earn profits, i.e., of the right to conduct the business, and not for the purpose of producing profits in the conduct of the business. Lord Macmillan observed :

'In the present case their Lordships have reached he conclusion that the payments in question were not expenditure so incurred by the appellants. They were certainly not made in the process of earning their profits; they were not payments to creditors for goods supplied or services rendered to the appellants in their business; they did not arise out of any transactions in the conduct of their business. That they had to make those payments no doubt affected the ultimate yield in money to them form their business but that is not the statutory criterion. They must have taken this liability into account when they agreed to take over the business. In short, the obligation to make these payments was undertaken by the appellants in consideration of their acquisition of the right and opportunity to earn profits, that is, of the right to conduct the business, and not for the purpose of producing profits in the conduct of the business.'

It might be observed that the decision turned upon the interpretation of clause 10(2)(XV) before it was amended in 1939. Before this clause was amended in 1939, allowance was given in respect of any non-capital expenditure 'incurred solely for the purpose of earning such profits of gains'. Now, under the amended law, the expenditure should be laid out 'wholly and exclusively for the purpose of such business'. The two expressions are not synonymous; the latter is wider than former. Expenditure may be for the purpose of the business although it may not be incurred for the purpose of earning the profits of the business (See the decision in Commissioner of Income-tax v. Jagannath Kisonlal).

Section 10(2)(XV) requires that the expenditure should be wholly and exclusively laid out for the purpose of the business, but not that it should be necessarily laid out for such purpose. Therefore, expenses wholly and exclusively laid out for the purpose of trade should, subject to the fulfilment of the other conditions, be allowed under this clause even though the outlay is unnecessary or unnecessarily large, unless the case falls under section 10(4A) q.v. The further test of necessity is, by contrast, imposed under section 4(3)(vi) and 7(2)(iii).

The judgment of the Supreme Court in Eastern Investments Ltd. v. Commissioner of Income-tax establishes that, in the absence of fraud, the questions whether a transaction had the effect of diminishing the assessees taxable income, whether it was a prudent or wise transaction, and whether it was necessary for the assessee to enter into that transaction, are irrelevant in determining whether expenditure relating to that transaction should be allowed under section 12(2); and the same considerations would apply under this clause. I think, the payment in question was an expenditure laid out wholly and exclusively for the purpose of the business and ascertained with reference to profits.

I agree with the opinion of Raghavan J. and hold that the amount is an allowable deduction and would answer the question in the affirmative and in favour of the assessee.

By Court after the expression of opinion by the third Judge.

In conformity with the majority opinion, we answer the question referred in the affirmative and in favour of the assessee. We also direct both parties to bear their respective costs.

A copy of this order will be sent to the Income-tax Appellate Tribunal as required by law.


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