1. This is a reference under section 66(1) of the Income-tax Act at the instance of the assessees. Two questions arise in this reference. The first is as to the proper interpretation of clause 3 of the managing agency agreement dated August 2, 1950, entered into between the assessees and the Baroda Spinning and Weaving Co. Ltd., Baroda, and the second is whether the assessees were right in claiming the sum of Rs. 2,32,234 as depreciation for deducting that amount from the profits of the managed company while calculating the commission due to the assessees under the said managing agency agreement.
2. The assessment year is 1950-51 of which the relative previous year is the calendar year 1950. The assessees, assessed in the status on an association of persons, were at the relevant time the managing agents of the Baroda Spinning and Weaving Co. Ltd., Baroda. The entity composed of the then members of the said association of persons was appointed as managing agents under an agreement entered into a January 21, 1906. Under that agreement, it was provided that the managed company should pay to the managing agents three pies per every pound of yarn and cloth manufactured and sold by the company and further, ten per cent. commission of the amount of bills for all other work done by the managed company, except that of yarn and cloth. The said agreement further provided that if, in any year, the managed company's profits were less than six per cent. payable on its paid up capital, the managing agents should forgo their commission to the extent of one-third in order to make up the six per cent. The capital of the managed company at that time was made up of 5,839 ordinary shares of Rs. 100 each. Thereafter, certain changes took place in the entity of the managing agents, as a result of which a fresh agreement of managing agency was entered into on April 25, 1921. Clause 3 of that agreement provided that the managed company should pay to the agents four per cent. on the profits of yarn and cloth manufactured in the company's factory, and ten per cent. commission on the net profits arising from the work of ginning cotton and any other work. That clause further provided that if, in any year, the income of the managed company did not amount to ten per cent. of the paid up capital, that is, in the year in which the dividends to the shareholders fell short of ten per cent., the managed company should pay to the agents less commission to the extent of one-third and the agents should accept such lesser commission. These provisions were also incorporated in sub-clause (14) of clause 7 of the articles of association. On September 10, 1948, the relevant clause, i.e., sub-clause (14) of clause 7 of the articles of association, was further amended and the amendment was to the effect that the managing agents were to be paid as their commission four per cent. on the sales of yarn and cloth manufactured and sold by the managed company and further, commission at the rate of ten per cent. on the net profits of the work of cotton ginning or any other work done by the managed company. The amended clause further provided that, in any year, if the managed company did not distribute dividend of Rs. 58,390, the commission payable to the managing agents should be paid less, so as to make-up the deficit and that such recoupment should be only to the extent of one-third of the commission. A resolution to the same effect was also passed on that very day in an extraordinary general meeting of the managed company. On the same day, i.e., on September 10, 1948, the managed company passed a resolution transferring a sum of Rs. 2,50,000 from the reserve fund and Rs. 9,17,800 from the depreciation fund, totaling to Rs. 11,67,800 to the share capital, and 5,839 ordinary shares of the face value of Rs. 100 each were, by that resolution, converted into shares of the face value of Rs. 200 each and 5,839 preference shares of the face value of Rs. 100 each were issued to the existing shareholders of ordinary shares. This was done without calling for any capital from the shareholders. After this variation in the capital structure was brought about, a fresh agreement of managing agency was entered into on August 2, 1950, between the assessees on the one hand and the managed company on the other. Clause 3 of that agreement, which is the only clause which is relevant for our purposes, as translated, ran as follows :
'In consideration of the party of the other part working as secretary, treasurers and agents of the company of the first part the company of the first part shall pay to the agents of the other part commission at the rate of (4%) four per cent. of the value of the yarn and piece goods, which will be sold after being manufactured in the factory of the company of the first part as also commission at the rate of ten per cent. on the net profits made in respect of the work of ginning cotton as well as for any other kind of work. But it is further provided that, for the year, during which the company is not able to distribute Rs. 58,390 by way of dividends, the company of the first part shall pay to the agents less commission at the most to the extent of one-third, that is to say, up to one-third share, in order to make up the deficit amount during that year and the agents shall receive less commission to that extent'.
3. During the calendar year 1950, the gross profit of the managed company, without deduction deprecation and the managing agent's commission, came to Rs. 5,96,938 and under clause 3 of the said agreement, the commission payable to the managing agents came to Rs. 4,43,346. The balance profit, therefore, came to Rs. 1,53,592. The case of the assessees was that out of this balance of Rs. 1,53,592, certain deductions had to be made in order to find out whether under the provision as to recoupment by the managing agents, the managing agents had to forgo their commission and, if so, the extent thereof. The deductions claimed were :
Rs.1. Depreciation as originally allowed in the case ofthe managed company by the income-tax department ... 2,32,2342. Provision for dividend on preference shares ... 26,2763. Provision for dividend on ordinary shares as perclause 3 ... 58,390
4. The total being Rs. 3,16,900. It was claimed that as these deductions exceeded one-third of the managing agent's commission, the managing agent had to forgo their commission to the extent of the maximum, namely, one-third, and, therefore, the assessees offered for assessments Rs. 2,96,651 as and by way of their commission, and not the amount of Rs. 4,43,476. The assessees were actually paid the amount of Rs. 2,95,461 only by the managed company and that was also the amount which was deducted from the assessment of the managed company as commission paid to the managing agents.
5. The Income-tax Officer negatived the claim of the assessees and held that they were liable to pay tax on the entire amount of Rs. 4,43,476. On an appeal by the assessees, the Assistant Commissioner held that the only amount upon which the assessees could be taxed was Rs. 2,95,651. The department, aggrieved by that order, carried the matter in appeal before the Tribunal, contending that the sum of Rs. 1,47,825, being the one-third of the remuneration payable to the managing agents, was not properly excluded from the assessment and that the entire amount should have been brought to tax. The Tribunal partially upheld the claim of the department and held that, on a proper interpretation of clause 3 of the managing agency agreement, the managing agents were entitled to receive a further sum of Rs. 56,784 and had to forgo only Rs. 91,041 and that, therefore, an amount of Rs. 56,784 should be added to the sum of Rs. 2,95,651. Aggrieved by this order, the assessees applied to the Tribunal to refer the question of law arising from clause 3 in the managing agency agreement, and the question thereupon referred to us by the Tribunal is as follows :
'Whether, on the facts and in the circumstances of the case, and on a true interpretation of the provisions of clause 3 of the managing agency agreement dated August 2, 1950, between the assessee-company and the Baroda Spinning and Weaving Mills Co. Ltd., Baroda, the assessee-company is liable to be assessed on an amount of Rs. 56,784 in addition to the remuneration of Rs. 2,95,661 ?'
6. On the question as to the proper interpretation of clause 3 of the managing agency agreement, the contention placed before us on behalf of the assessees was that the minimum amount of dividend guaranteed under that clause was for dividend on 5,839 ordinary shares and that the Tribunal was not correct in considering that provision to be for the minimum dividend for both the kinds of shares, namely, preference and ordinary shares. Therefore, the managed company was right in deducting Rs. 26,275 as dividend which it was liable to pay in respect of the preference shares. This contention was founded on two arguments : (a) that when the agreement dated August 2, 1950, was entered into, the managed company knew that there were at that time subsisting two types of shares and the company was bound to make provision for dividend on the preference shares before providing for dividing on ordinary shares and that, therefore, if the amount of Rs. 58,390 was intended for dividend for both the types of shares, clause 3 should have specifically mentioned that fact. Therefore, the amount of Rs. 58,390, on a proper construction of clause 3, must be taken to be the minimum of the dividend guaranteed in respect of ordinary shares only, and (b) that looking to the history of the agreements entered into by the managed company and the managing agents right from 1906 and onwards, it would be found, at least from the year 1921, that the managed company had insisted that at least Rs. 58,390, i.e., ten per cent. on the subscribed capital of the company, should be paid as dividend on the shares of the company. That being so, it was argued that when the agreement of August 2, 1950, was entered into, the managed company could not have changed its consistent policy and agreed to the amount of Rs. 58,390 as being dividend for both the types of shares, that is to say, less than ten per cent. on its ordinary shares.
7. Two factors, however, militate against these submissions. The first is that although the managed company had, by its resolution passed at its extraordinary general meeting held on September 10, 1948, raised its capital structure by transferring a large amount from its reserves to the capital fund and altered the face value of ordinary shares from Rs. 100 to Rs. 200 and distributed 5,839 preference shares of the face value of Rs. 100 each amongst the holders of the ordinary shares without making the shareholders contribute anything towards either the increased value of the ordinary shares or for the value of the preference shares distributed to them, no specific provision for deducting dividends on preference shares from the profits of the company for the purpose of computing the commission payable to the managing agents was made. While entering into the agreement dated August 2, 1950, the managed company could not have been oblivious of the fact that it would have to pay dividend on preference shares according to the terms and conditions of the issue of those shares. A reasonable view of clause 3 of the managing agency agreement, therefore, would be that when the amount of Rs. 58,390 was provided as minimum dividend in that clause, it was intended as a total minimum for both the types of shares. This conclusion is fortified by the fact that the managing agents would not ordinarily agree, and cannot be taken to have agreed, to increase their burden of recoupment under the provisions of clause 3 unless there is some indication in the agreement or otherwise to an increase in the minimum amount of dividends which, in its turn, would increase their obligation under the clause as to recoupment by them of any deficit in the profits. If it was intended that the managed company was to guarantee Rs. 58,390 as dividend for its ordinary shares and in addition was to guarantee to pay dividend on its preference shares and that the managing agents were to recoup any deficit by forgoing to the extent of that deficit, not exceeding of course one-third of their total commission, such a clause would obviously increase their obligation and, in such a case, it is inconceivable that clause 3 would be silent as to the amount of dividend payable on preference shares being over and above the amount of Rs. 58,390.
8. The second factor which equally militates against the contention urged on behalf of the assessees is that, right from 1921, the agreement between the managed company and its managing agents was that the latter should forgo their commission to the maximum extent of one-third of it, if in any year the company was not able to pay at least ten per cent. or Rs. 58,390 as dividend on its subscribed capital. The idea, therefore, consistently held by the managed company was that it should pay at least ten per cent. on its paid up capital. It is, therefore, again reasonable to think that that idea prevailed also at the time when the agreement dated August 2, 1950, was entered into. But, as we have already pointed out, by its resolution dated September 10, 1948, the managed company changed its capital structure by resorting to its reserve fund and without taking any contribution from its shareholders, the company benefited the shareholders, first by doubling the face value of the ordinary shares and, secondly, by distributing amongst them an equal number of preference shares as and by way of bonus shares, so that the holder of one ordinary share received one preference share. Having done so, it is unthinkable that the managed company would have thought of giving ten per cent. dividend at least on ordinary shares over and above its liability to pay dividend on the preference shares. The agreements of managing agency entered into from time to time indicate an anxiety on the part of the managed company to pay to its shareholders dividend at least at the rate of ten per cent. on the paid up capital. Mr. Shah on behalf of the assessees stated before us, though it is not on record, that the preference shares issued by the managed company in September, 1948, were four and half a per cent. cumulative preference shares. It appears that the amount of Rs. 26,275 was provided for by the managed company during the calendar year 1950 as dividend on preference shares which, on calculation, would be at the rate of four and a half per cent. If out of the amount of Rs. 58,390 the managed company were to pay the rest of that amount as dividend to the holders of ordinary shares, that dividend would be at the rate of five and a half per cent. and the total would make up ten per cent. on the subscribed capital. That appears to be the object when clause 3 of the managing agency agreement stated that the managing agents should recoup any deficit from their commission if the managed company was not able in any year to pay at least Rs. 58,390 as and by way of dividend. The recoupment clause, in our view, therefore applies to the dividends for both the types of shares. The shareholders would have no grievance because they continue to receive ten per cent. on the capital actually subscribed by them, namely, Rs. 100 each on the 5,839 ordinary shares, they not having contributed to the value of the preference shares. Apart from these factors, clause 3 of the agreement merely provides Rs. 58,390 to be the minimum amount to be distributed by the managed company by way of dividend. No distinction is made in that clause between the ordinary shares and the preference shares and there is no indication either in that clause or in any other clause of the managing agency agreement to show that the minimum amount of dividend distributable by the managed company was over and above the amount of Rs. 58,390 mentioned in clause 3. If the contention of Mr. Shah on behalf of the assessees were to be accepted, it would be reading in clause 3 something more than what that clause actually provides. The amount of Rs. 58,390 has been set out in clause 3 as a lump sum for the minimum dividend because consistently with the past policy of the managed company, that amount came to ten per cent. on the capital subscribed by the shareholders. For these reasons, we are unable to accept the construction of clause 3 of the agreement as suggested on behalf of the assessees.
9. As regards the contention as to the amount of depreciation, the assessees claim that the managed company was entitled to deduct the amount of Rs. 2,32,234 from out of its profits for the purpose of computing the amount of commission payable under clause 3 to the assessees. It is not in dispute that Rs. 2,32,234 were actually allowed to be deducted as and by way of depreciation in the assessment of the managed company by the department. The contention of Mr. Shah on this part of the case was that though that amount consisted of Rs. 1,86,143 as and by way of normal depreciation and the rest as initial and additional depreciation, there was no reason why the managed company should be permitted to deduct that very amount for the purpose of computing its divisible profits so as to ascertain whether the managing agents, under clause 3, were liable to recoup the deficiency, if any. Mr. Shah contended that the Tribunal was bound to allow the same amount of depreciation, namely, Rs. 2,32,234, for the purpose of arriving at the figure of divisible profits as the department had actually allowed during the assessment of the managed company that very same amount for arriving at its assessable profits. Mr. Shah's contention was that the entire figure of Rs. 2,32,234 was depreciation, whether it was normal or initial or additional depreciation and, therefore, the Tribunal was in error in allowing only the normal depreciation calculated under the provisions of the Income-tax Act, namely, Rs. 1,86,143.
10. It appears from the order passed by the Tribunal that this was the very contention raised before it on behalf of the assessees. This contention, however, was rejected by the Tribunal and, while rejecting it, the Tribunal observed :
'The company has been allowed depreciation of Rs. 2,32,234 of which the normal depreciation is only Rs. 1,86,143 according to the departmental representative. The depreciation in excess of the normal depreciation is not strictly depreciation but an inducement to set up new machinery. We consider that normal depreciation is alone allowable in the computation of profits.'
11. In our view, the Tribunal was not correct in the way it looked at its question, and the error was in not appreciating the distinction between the depreciation calculated on the bases of the statutory provisions of the Income-tax Act for the purpose of computing assessable profits on the one hand and depreciation computed by a business concern for the purpose of arriving at its true commercial profits. It is the latter which has to be taken into account for the purpose of computing divisible profits, and not the former. This distinction has been well brought out in Commissioner of Income-tax v. Bipinchandra Maganlal and Co. Ltd., where it has been observed that there is no definable relation between assessable income and profits of a business concern in a commercial sense and that the computation of income for the purpose of assessment of income-tax based on a variety of artificial rules and takes into account several fictional receipts, deductions and allowances; commercial profits, on the other hand, as stated in Commissioner of Income-tax v. Ahmedbhai Umarbhai and Co., are profits of a trade or business gained by the business. They are arrived at by a comparison between the state of business at two specific dates separated by an interval of an year and the fundamental margin is the amount of gain made by the business during the year and can only be ascertained by a comparison of the assets of the business at the two dates; any increase generally at the latter date, compared to the earlier date, represents the profits of a business. Therefore, depreciation calculated for the purpose of dividend would be the one shown in the balance-sheet of the business concern and that is not to be confused with depreciation permissible under the artificial and statutory rules contained in Income-tax Act which rules are resorted to by the department for arriving at the true assessable profits. It is the depreciation shown in the balance-sheet for computing commercial profits arrived at by a particular system followed by the business concern which would be the standard for determining whether the managed company suffered any loss or was otherwise not able in any particular year to distribute Rs. 58,390 as dividend and whether the assessee should be called upon to forgo their claim to the extent of that deficiency by virtue of clause 3 of the managing agent agreement.
12. Unfortunately, the assessees did not bring on record the depreciation shown by the managed company in its balance-sheet for the relevant year. Neither did the Tribunal, though we are told that the balance-sheet of the managed company was actually on record. The position, therefore, is that whereas the Tribunal has allowed Rs. 1,86,142 which, it is true, represents the normal depreciation computed under the provisions of the Income-tax Act, Mr. Shah for the assessees wants a higher amount of depreciation, namely, Rs. 2,32,234 would be the amount of depreciation for the purpose of computing commercial profits of the managed company. The mere fact that the Tribunal accepted an incorrect standard, that is, the standard provided in the Income-tax Act, and not the one for computing true commercial profits, would not mean that the assessees would be entitled to the whole of the depreciation permissible under the Income-tax Act by way of different types of depreciations calculated on fictional and artificial notions provided for in the statute. In this view of the matter, it does not become necessary for us to go into the argument advanced by the learned Advocate-General before us, namely, that depreciation other than normal depreciation, i.e., initial and additional depreciation, is the only depreciation in the real sense of the term. That being the position, we would not be justified in interfering with the amount of Rs. 1,86,143 allowed by the Tribunal as depreciation.
13. The learned advocate for the assessees then contended that the assessees had actually received only the amount of Rs. 2,95,651, that the managed company has actually debited in its profit and loss account that amount only and it was only that amount that was deducted in the assessment of the managed company as commission paid by it to its managing agents. His contention was that these three facts would cumulatively show that the sum of Rs. 2,95,651 was the only real income of the assessees and that that real income only should be taxed in the hands of the assessees. In support of his contention, Mr. Shah relied upon the decision in H. M. Kashiparekh and Co. Ltd. v. Commissioner of Income-tax. The recoupment clause in the case was almost similar to the clause 3 of the managing agency agreement in the present case. The assessee in that case maintained its accounts in the mercantile system and was the managing agent of a paper mill company. Under the managing agency agreement, it was provided that the assessee would have to forgo up to the one-third of his commission where the profits of the managed company were not sufficient to pay a dividend of six per cent. For the accounting year ending March 31, 1950, the assessee earned a commission of Rs. 1,17,644, but as a result of separate resolutions passed by the managed company and the assessee company, the assessee gave up a sum of Rs. 97,000 in December, 1950. The Appellate Tribunal held that the maximum amount the assessee was bound to forgo was only Rs. 39,215 and included the balance of the amount forgone, namely, Rs. 57,785, in the taxable income. The Tribunal, however, found as a fact that this amount of Rs. 57,785 had been given up by the assessee for reasons of commercial expediency. It was, therefore, held that it was real income of the assessee-company for the assessment year that was liable to tax and that the real income could not be arrived at without taking into account the amount forgone by the assessee. The court also observed that, in ascertaining the real income, the fact that the assessee followed the mercantile system of accounting did not have any bearing. The accrual of the commission, the making of the accounts, the legal obligation give up part of the commission, and the forgoing of the commission at the time of making of accounts were not disjointed facts and there was a dovetailing about them which could not be ignored. The real income of the assessee was, therefore, Rs. 27,644 and the amount of Rs. 97,000 forgone by the assessee could not be included in the real income of the assessee for the accounting year. Mr. Shah submitted that this case was on all fours with the instant case and that following the reasoning in that case, we must also come to the conclusion that the real income in the present case was only Rs. 2,95,651, the rest of the amount having been forgone by the assessees from out of the total commission payable by them under clause 3 of the agreement. At page 720 of the report, the learned judges, however, emphasized that if the fact of forgoing or surrendering the amount of Rs. 57,000 and odd were to be regarded as of cogency in the context of the question as to the real income and if it were remembered that the surrender was made at the time of ascertaining the quantum of the commission payable to the assessee-company and further if it were to be remembered, as was actually found by the Tribunal in that case, that the surrender was made bona fide and on the grounds solely of commercial expediency, it appeared difficult to see how the revenue would be justified in contending that the real income of the assessee was something different than the amount of Rs. 20,000, which was shown by it at the time of assessment as its income from the managing agency commission. At page 722, the learned judges again stressed the fact that the surrender of commission in that case had been made bona fide and as a matter of commercial expediency and at an early point of time when accounts were made up, and observed that it would not be right that the principle of real income should be so subordinated as to amount virtually to a negation of it when a surrender or concession or rebate in respect of managing agency commission was made, agreed to or given up on grounds of commercial expediency simply because it took place some time after the close of an accounting year. In the case before us, it will be apparent that the facts are different from those in the case of Kashiparekh and Co. Ltd. The case of the assessee before us is not, and was never at any stage, that, on making up of accounts of the managed company, a particular figure of commission payable to them was arrived at and thereafter they surrendered a part of it on grounds of commercial expediency. On the contrary, the case of the assessees has been all throughout that, under the agreement, they were only entitled to Rs. 2,95,651 and no more, and, therefore, there can be no case of any surrender on grounds of commercial expediency. On the other hand, if they accepted the figure of Rs. 2,95,651 on a calculation based on an incorrect view of the agreement, it is impossible to say that Rs. 2,95,651 represented the real income and not the correct figure calculated on a correct interpretation of the agreement. Mere forbearance from insisting upon payment of the correct amount of commission would not mean surrendering it and that too on the ground of commercial expediency, claimable as a deduction under section 10(2) (xv). In our view, the decision in the case of Kashiparekh and Co. Ltd., therefore, cannot be availed of by the assessees.
14. The last contention urged by Mr. Shah on behalf of the assessees was that when the assessees agreed to accept the lesser amount, namely, Rs. 2,95,651, and the managed company paid that amount to the assessees, there resulted a modification of the provisions of clause 3 of the managing agency agreement amounting to a novatio arrived at by the parties by mutual consent. The contention on the basis of a novatio cannot stand, for, in the first instance, no consideration for such a modification was either pleaded at any stage, much less proved and, in the second place, such a case was never put forward on behalf of the assessees at any stage of these proceedings. Even Mr. Shah put forward the case of novatio somewhat half-heartedly. For the reasons aforesaid, it must necessarily be rejected. These were the only submissions made before us and we regret that we are not in a position to accept any one of them.
15. In the result, our answer to the question referred to us will be in the affirmative. The assessees will pay to the Commissioner the costs of this reference.
16. Question answered in the affirmative.