1. The main question which arises in this reference is whether the assessee company, while computing profits or gains derived from its newly established industrial undertaking, which are exempt under section 15C(1) of the Income tax Act, 1922, is entitled to claim the actual cost to it rather than the market value of the raw materials manufactured by its existing industrial undertaking and used by the new undertaking. The question arises from the following facts :
The assessee is a public limited company originally formed for manufacturing and sale of industrial starch. It started production of starch some time in the year 1939. In the year 1956, the assessee company set up another plant for producing dextrose, a pharmaceutical product, of which starch is the raw material. During the assessment for the assessment year 1960-61, the question arose whether the profits or gains made by the new industrial undertaking established for producing dextrose were exempt under section 15C(1) of the Act, as claimed by the assessee. The Income-tax Officer held against the assessee company in the view he held that the new industrial undertaking did not conform to the requirements of section 15C and that both the undertakings formed one and the same business carried on by the assessee company for producing starch in the first instance and by extending the activities of that business to producing dextrose as ultimate product. He was also of the view that, in any event, if the cost of the raw material, i.e., starch, debitable to the new industrial undertaking were to be taken at market value, even on the contention of the assessee that the new industrial undertaking was independent of the old industrial undertaking there would be no profits made by the new industrial undertaking which could be exempted under the provisions of section 15C. The assessee company carried the matter in appeal before the Appellate Assistant Commissioner. The Appellate Assistant Commissioner accepted the contention of the assessee company and held that for purposes of section 15C, the new industrial undertaking, the starch supplied by the old industrial undertaking should be valued at the market price and not at its cost of production, since the profits of the new industrial undertaking under section 15C had to be computed separately from the profits of the old industrial undertaking. The Appellate Assistant Commissioner held that if that were done, there would be no profits to be exempted under section 15C of the Act. The Appellate Assistant Commissioner observed that there was no question of regarding the assessee company selling industrial starch to itself at profit, but that the question really was of ascertaining what were the true and correct profits or gains earned by the dextrose plant. He further observed : 'The final profits that the appellant company makes by selling dextrose is really made up of two items profits earned by the starch plant and profits earned by the dextrose plant. If the final profit is, say Rs. 100 per tone of dextrose sold, it would be made up of Rs. 80 being profit attributable to the working of the starch plant and Rs. 20 to that to the dextrose plant. Now, what the appellant company is entitled to claim is exemption on the profit earned by the dextrose plant. The several processes undertaken in the two factories (which, as per the appellant's own claim are distinct and separate units) contribute to the final profit that is realised on selling dextrose. It would, therefore, be only fair, reasonable and proper to find out how much of the final profit is attributable to the starch manufacturing process, and how much to the dextrose manufacturing process. There could be no ground for claiming that the profit earned by the old starch factory should also be exempt under section 15C along with that earned by the dextrose plant. This is not a question of selling goods to one self at a profit. It is a question of allocating the final profit to the various processes involved in obtaining the final product.'
2. When the case was taken to the Tribunal, the assessee company contended that the view taken by the Appellate Assistant Commissioner was not sustainable on the principle that no person could trade with him self and make profit out of any such transaction in a commercial sense. The Tribunal rejected this contention and confirmed the view taken by the Appellate Assistant Commissioner. The Tribunal observed that the question involved in the case was, when profits of two different activities, both admittedly trading activities, of the same assessee have to the separately computed, what should be the mode of computing such profits The answer which the Tribunal gave was :
'In this connection the fact that the profits of one of the trading activities is exempt from tax will have really no important consideration. Shri Palkhivala's argument was that it was open to the assessee to supply starch produced by the old industrial undertaking, at cost, to the new industrial undertaking for the purpose of producing 'dextrose'. The assessee could not be compelled to supply the starch produced by it to the new industrial undertaking at market price as and by way of a commercial transaction. In this connection he made very attractive argument. He said if instead of the assessee itself some stranger were to supply starch to the assessee's new industrial undertaking at cost, the supplier could not have been taxed on the notional profit, that is to say, the profit that he did not make, on the footing that such sales should be considered to have been made at market price, though in fact made at cost price. But this is again really not the question before us and is beside the point too. In our opinion, the real point which we have consider, as we have already mentioned, is, where as in the present case, the same assessee is carrying on two different trading activities, how are the profits of each trading activity to be separately determined No doubt, no difficulty would have arisen if the profits of one of the trading activities were not exempt under secretion 15C, as in this case, or even otherwise required to be separately computed since the profits of both the trading activities belong to the same assessee. But since the Act itself requires computation of the profits of the new industrial undertaking eligible for exemption under secretion 15C to be separately made, it has to be made only following the commercial principles.'
3. The Tribunal, in dealing with the contention urged by the assessee company, further observed that if that contention were to be accepted, the result would be that no profits at all will have been made by the old industrial undertaking producing starch as hitherto made and a much larger profit would have to be shown as having been made by the new industrial undertaking producing dextrose out of the same profit making product since made available to it at cost. According to the Tribunal, the assessee company was not entitled, while seeking exemption under section 15C, to so arrange its affairs as to claim maximum exemption. The Tribunal held that the profits of the new industrial undertaking could only and correctly be computed on the basis of the market value of the starch used by it as raw material and the profit of the old industrial undertaking could also be computed only on the basis of the transfer of starch being made to he new industrial undertaking at the market price, even though shown in the accounts as actual cost. Section 15C(1) of the Act provides as follows :
'15C. (1) Save as otherwise hereinafter provided, the tax shall not be payable by an assessee on so much of the profits or gains derived from any industrial undertaking to which this section applies as do not exceed six per cent. per annum on the capital employed in the undertaking, computed in accordance with such rules as may be made in this behalf by the Central Board of Revenue.'
4. Sub-section (3) of that section provides that the profits or gains of an industrial undertaking to which section 15C applies shall be computed in accordance with the provisions of section 10. Since exemption is given on so much of the profits or gains derived from an industrial undertaking as do not exceed six per cent. per annum on the capital employed in such undertaking, sub-section (3) had to be introduced to provide that such profits or gains should be computed in accordance with the provisions of section 10. It is clear that the object of this section is to promote new industrial undertakings, and sub section (6) shows that relief would be available for the first five years from the commencement of manufacture or production. It would appear that since the computation of 'so much of the profits or gains' derived from the new industrial undertaking is to be made in accordance with the provisions of section 10, profits to be computed would be the profits or gains in their natural and proper sense. As Lord Halsbury put it in Gresham Life Assurance Society v. Styles, they should be computed in a sense, which no commercial men would misunderstand. Thus, profits or gains have to be ascertained on ordinary principles of commercial trading and commercial accounting except where there are any specific provisions to the contrary in the Act. Ordinarily, where both the undertakings are carried on by the same assessee, the question as to how the raw materials used in the production of the final product produced by one and used by the other should be debited to the latter, would not arise. But such a question arises because it is profits or gains to the extent provided in section 15C(1) of the new industrial undertaking which are exempted and for the purpose of claiming exemption are required to be computed in accordance with section 10 under which profits or gains of the entire unit comprising of both are also to be computed.
5. The contention of Mr. Kaji, who appears for the assessee company, was that the assessee company was entitled to value the starch at its own cost and that there was no provision in the Act which could compel the assessee company to debit the new industrial undertaking at the market price realisable at the time of its use for the production of the ultimate product, dextrose. The argument was that if the assessee company had purchased starch at a concession value, the company would have been entitled to the starch at cost, that is to say, the price actually paid by it. On the other hand, if the company had paid the price in excess of the prevailing market price, it would have again been entitled to the starch at cost, i.e., the price actually paid by it. Thus, where an assessee buys goods from an outsider or from the market, the price which he would enter would be his cost price. There is no difference in principle, he argued, between the value to be entered in the case of stock-in-trade of a particular trading company and when raw materials are used as the base of its ultimate produce. There is also no difference in the case of an assessee when artificial division has to be made between his two manufacturing activities because there is factually no transaction of purchase by one and sale by the other. In such a case, whether the assessee enters the goods at cost or the market price, both the prices are in a sense unreal as there is no actual sale or purchase. What the assessee in such a case does is to utilise the business assets of one activity or department as business assets of the other activity or department. In other words, he is withdrawing business assets from one activity for utilizing them in the other activity, and that being so the argument was that the proper method of accounting would be to enter goods at cost to the assessee. If that cost is 'X', it cannot be anything else, namely, 'Y', merely because the goods are placed in another industrial activity of the same unit. Mr. Kaji argued that the if the assessee were to enter the goods at the price realisable in the market, he would not be right because he could then be introducing the concept of a notional sale and trade with himself. Instead of trading with himself, what the assessee in substance does is to exploit the business assets of one activity for the purpose of the second activity. Therefore, the argument proceeded, unless there is something in the Act to treat the user of a business asset for another activity as a notional sale at market value, the principle which must rule would be that an assessee cannot trade with himself so as to make profit and he would be entitled to rearrange his business in a manner which imposes the least tax burden upon him. In such a case, there is no element of profit making because the process involved is the transfer of a business asset from one of his activities to another activity. Even if such a transfer takes place in order that he may derive a larger profit in future, the Income tax Act does not tax in anticipation a potential future advantage.
6. In this connection, Mr. Kaji referred to the Supreme Court decision in Kikabhai Premchand v. Commissioner of Income tax, where the assessee was a dealer in silver and shares and was the sole proprietor of the business. He maintained his accounts according to mercantile system and valued his stock at cost price, both at the beginning and at the end of the year. During the relevant accounting year, he withdrew some silver bars and shares from the business and settled them on certain trusts in which he was the managing trustee. In his books he credited the business with the cost price of the bars and shares so withdrawn. The income tax authorities held that the assessee derived income from the stock in trade thus transferred and assessed him on a certain sum being the difference between the cost price of the silver bars and shares and their market value at the date of their withdrawal from the business. Before the Supreme Court, the revenue argued that as the bars and shares were brought into the business, any withdrawal of them from the business must be dealt with along ordinary and well known business lines, namely, that if a person withdrew an asset from a business, he must account for it to the business at the market rate prevailing at the date of such withdrawal. The revenue also argued that if the act of withdrawal was at a time when the market price was higher than the cost price, then the State was deprived of a potential profit. The Supreme Court negatived these contentions and observed that the assessee was right in entering the cost value of the silver and shares at the date of withdrawal because it was not a business transaction and by that act the business made no profit or gain, nor had it sustained a loss, and the assessee derive no income from it. The assessee might have stored up a future advantage for himself, but as the transactions were not business ones and a he derived no immediate pecuniary gain, the State could not tax them, for under the Income tax Act the State had no power to tax a potential future advantage. At page 509 of the report, the Supreme Court observed that 'in revenue cases regard must be had to the substance of the transaction rather than to its mere form, and that disregarding technicalities it was impossible to get away from the fact that the business was owned and run by the assessee himself. In such circumstances we are of opinion that it is wholly unreal and artificial to separate the business from it owner and treat them as if they were separate entities trading with each other and then by means of a fictional sale introduce a fictional profit which in truth and in fact is non existent. Cut away the fictions and you reach the position that the man is supposed to be selling to himself and thereby making a profit out of himself which on the face of it is not only absurd but against all canons of mercantile and income tax law. And worse. He may keep it and not show a profit. He may sell it to another at a loss and cannot be taxed because he cannot be compelled to sell at a profit. But in this purely fictional sale to himself he is compelled to sell at a fictional profit when the market rises in order that he may be compelled to pay to Government a tax, which is anything but fictional.' In arriving at this decision, three factors seem to have weighed with the learned judges, (1) that the withdrawal of the business assets was not a business transaction, (2) that nothing having been realised by the assessee, there was no question of any profit arising in the accounting year which alone could be taxed, and (3) that what had to be considered was the substance of the transaction and not a notional sale. The principle recognised in this decision was that when a business asset is withdrawn for a non business transaction in the middle of the accounting year, the entry in respect of such an asset would be the cost shown in the books in the beginning of the year and not its market value, for that would be introduction the concept of a fictional sale. This case was, therefore, undoubtedly a case of a nonbusiness transaction. It will be observed that the Supreme Court in this decision did not have to consider the question as to what would be the position if the transaction was a business transaction. The principle there laid down was that the income tax law did not warrant assessment on the basis of business profits that an assessee might have made but did not choose to make. A case converse to Kikabhai's case is to be found in Commissioner of Income tax v. Bai Shirinbai K. Kooka where the question was not whether the revenue could tax potential future profits but as the how, where a real sale has taken place and actual profits have resulted from such sale, profits should be computed. In this decision, the Supreme Court distinguished Kikabhai's case on the ground that there was no business sale or actual profits in that case whereas in the case dealt with by them, there were profits liable to tax and the only question was how and on what basis they should be calculated. The facts in Shirinbai K. Kooka's case were that the assessee held certain shares by was on investment. These shares were purchased by her in or about 1939-40, at a cost price which was less than the market value on April 1, 1945. During the year of account 1945-46 (i.e., in the assessment year 1946-47), the assessee converted these shares into stock in trade and carried on a trading activity, i.e., business in shares, and sold those shares. The question, in these facts, was how should the profits for the assessment year 1946-47 be computed Whether the profits should be computed as being the difference between her actual cost price when the assessee had purchased those shares in 1939-40 and the sale price, or between the market price on April 1, 1945, and the sale price realised by her The Supreme Court, by a majority judgment, held that the assessable profits on the sale of shares was the difference between the sale price and the market price of the shares prevailing at the date when the shares were converted into stock in trade of the business in shares and not the difference between the sale price and the price at which the shares were originally purchased by the assessee. At page 95 of the report, the Supreme Court considered the House of Lords decision in Sharkey v. Wernher, where, on facts somewhat similar to those in Kikabhai's case, the House of Lords took a different view. But in view of the fact that the case which the Supreme Court was dealing with was distinguishable from Kikabhai's case, the learned judges said that they did not think it necessary to re-examine the ratio in Kikabhai's case. The Supreme Court came to the conclusion that the basis of computing profits must be ordinary commercial principles, i.e., that commercial profits out of the transaction of sale of an article must be the difference between what the article cost the business and what it fetched on sale. But then the question would be, what would be the cost of the article to the business of trading activity was concerned, the market value of the shares as on April 1, 1945, was what it cost the business, and in considering that cost there was no question of any legal fiction of sale being introduced in the process of computation. In coming to this conclusion, the Supreme Court accepted with approval the language of Lord Radcliffe in Sharkey v. Wernher that the only fair measure of assessing trading activities in such circumstances was to take the market value at the one hand and the actual sale price at the other, the difference between the two being the profit or loss, as the case might be. The Supreme Court observed that in a trading or commercial sense, this seemed to accord more with reality that with fiction. In Sharkey v. Wernher, the assessee's wife carried on a status farm, an activity which was a taxable activity. She also carried on another activity of racing stables which was a recreational enterprise not taxable. Horses were brought on the stud farm for the racing stables. Five horse were transferred in the assessment year from the stud farm to the racing stables, i.e., from a taxable activity to a non taxable activity. The question was, how was the value of these five horses to be credited in the accounts of the stud farm. The House of Lords held that the amount to be credited to the stud farm account on such transfer must be the market value and not the cost of breeding them. Dealing with the suggested proposition that where there were transfers of stock in trade interdepartmentally, it was the cost of production which represented the real figure whereas the cost plus the figure of conventional profit was unreal, Lord Radcliffe at page 984 of the report observed as follows :
'What do 'real' and 'unreal' mean in this connexion If reality depends on the existence of a genuine contract of sale between two independent parties, neither figure is more real than the other. Whether the transfer is between two departments of one legal entity or between two limited companies under the same control, the transfer is effected either by an entry in account or by a dictated sale at a prescribed price. On the other hand, if cost is supposed to be more real than cost plus as a transfer figure because it represents (or by sufficient analysis of general overheads can be thought to represent) expenditure actually incurred, this seems to me a very unsatisfactory test of reality. When transfer is in question it is the current realizable value of what is transferred that presents itself as the natural figure to enter rather than the historical record of what has previously been spent upon it. It is the article, having a current monetary equivalent, that is disposed of, not the previous expenditure. I do not doubt that either figure could be defended as reasonable business practice, but I do demur to a preference for the cost figure being supported by the plea that it somehow enjoys a greater measure of reality.'
7. At page 986 he concluded that in a situation where everything was to some extent fictitious, he thought that he would prefer the third alternative of entering as a receipt a figure equivalent to the current realisable value of the stock item transferred, and said that the case of Watson Brothers v. Hornby was rightly decided and the principle laid down there was applicable to all those cases in which the income-tax system required that part of a taxpayer's activities should be isolated and treated as a self-contained trade. The principle laid down in Sharkey's case, however, cannot be relied on in view of the fact that the decision in Kikabhai's case was distinguished by the Supreme Court in Shirinbai Kooka's case and left unchanged.
8. But Mr. Kaji next referred to us the decision in Briton Ferry Steel Co. v. Barry, where the business of the assessee-company consisted in making steel parts and selling them to outside customers as also to certain subsidiary companies which had them converted into blackplate and tinplate and sold them. These subsidiary companies having been wound up in 1934 and the company, having acquired their undertakings and their assets, was subsequently assessed to income-tax on the footing that it had succeeded to the trade carried on by each of them within the meaning of rule 11(2) of the rules applicable to Cases I and II of Schedule D as amended by the Finance Act, 1926, section 32. It was held there that there had been a succession since the business carried on by the subsidiaries would have been no different had they made the steel bars themselves and that for the purpose of computing the profits attributable to the succession, there need not be introduced any notional rule or notional profit realised inter-departmentally but that the sum to be treated as being the cost of making the steel bars for the business acquired should be ascertained, and the difference between the actual sale price of plate and the actual cost of producing plate through each process was the actual profit attributable to the succession. Mr. Kaji relied upon this decision in support of his contention that if market price were to be accepted as the basis of computation in the present case, it would be introducing a concept of notional sale and a notional profit which was disapproved in this decision, and that the proper and the correct basis for such computation, therefore, would be the cost of production of the article transferred inter-departmentally. It must however be noted that, in the second place, the principle laid down in this decision as also in Laycock v. Freeman, Hardy and Willis was expressly disapproved by the House of Lords in Sharkey's case. Referring to this decision, Lord Radcliffe at page 984 in Sharkey v. Wernher in specific terms stated that he was not in a position to accept the point of view expressed therein, and added : 'I do not regard those decisions as having any true bearing at all upon this appeal. As decisions, obviously, they have not. They are decisions upon the difficult and, often, unsatisfactory question of what constitutes succession to a trade for the purpose of the relevant section of the income-tax code. That is a long way from the question now before us. But even the expository passages upon which reliance was placed appear to me to fall short of suggesting any general principle that should guide us, unless it be that if inter-departmental transfers of stock are made at cost that, somehow, represents a 'real' figure, whereas a transfer at cost plus a figure of conventional profit represents an unreal one. I am afraid that I do not think that metaphysical distinctions of this sort assist to solve the problem.' Lastly, Mr. Kaji referred to Gangadhar Babulal v. Commissioner of Income-tax, where the Allahabad High Court on the facts of that case came to the conclusion that computation of profits could be made on the basis of the cost price of the stock-in-trade of the assessee's business. The facts, however, in that case were that a Hindu undivided family carried on money-lending business as well as a business in purchase and sale of silver. On a partition of the family the assessee who was a member of the family got the money-lending business as well as the stock of silver valued at Rs. 27,710 in the family account. The method of valuing which was adopted by the family was at cost price and not at market price. The assessee debited the silver in his silver account thus : 'to balance b/f 27,710'. Thereafter, the assessee sold the entire stock between March 1, 1945, and April 9, 1945, to different purchasers for Rs. 60,438. The income-tax authorities assessed the difference between Rs. 60,438 and Rs. 27,710 as business income of the assessee. The assessee contended that on partition the stock of silver had become capital in his hands and the surplus was accretion to capital, and at any rate the stock must be valued at market rate in determining the profits made. The High Court held that though it was open to the assessee to treat the stock which he got on partition as a capital asset and to make appropriate entires, and to enter the stock at the market value in his accounts, as he did not do so but, on the other hand, treated the silver received by him as the stock-in-trade of a continuing business and also entered the stock at its cost price in his accounts after partition and the manner in which the assessee disposed of the silver also showed that he had continued to carry on the same business, the income-tax authorities were justified in treating the profits as income from business. As the assessee had continued the same business and had also valued the stock received by him at cost price in opening his own accounts, it was not open to him to claim that cost of the stock must be valued at its market price in computing the profits.
9. It will be observed that the assessee in this case treated his share of the silver as his stock-in-trade and the business was held to be a continuing business in which he brought the stock-in-trade, valuing that stock-in-trade at the price of Rs. 27,710 which was the cost price of the joint family. The facts, therefore, were quite different from those in Shirinbai's case, where the shares were brought in as stock-in-trade at a later stage in a new trading activity commenced by the assessee. In both the cases, however, the question involved was, what was the cost to the business. In Gangadhar Babulal's case the cost, as held by the High Court, was the one which he entered in the books when he brought in the silver bars as stock-in-trade of the continuing business, whereas in Shirinbai's case the cost of the business was the cost of the shares at the time when she introduced the shares as the stock-in-trade in the new trading activity, i.e., the price of the shares realisable at the time when they were brought in as stock-in-trade in the trading activity. This was in fact the way in which the Allahabad High Court distinguished the case of Commissioner of Income-tax v. Bai Shirinbai K. Kooka. It is difficult to see how on these facts Mr. Kaji can seek to support his contention by what has been laid down in Gangadhar Babulal's case. Lastly, he referred to Watson Bothers v. Hornby, where the court held that the proper basis would be the reasonable price, i.e., the market price, and not the cost price, and which was approved by the House of Lords in Sharkey's case. No doubt, the reasoning there was based upon the concept of a notional sale, but that part of it, as we have already seen, was not accepted in Sharkey's case.
10. The question before us, however, is not what value of the raw materials the assessee might enter in his accounts, but how profits are to be computed. Considering the authorities referred to above, the principle that really emerges from them is that computation of profits must be done on commercial basis, that is to say, what is the cost to the new undertaking where a business asset or stock-in-trade has been transferred inter-departmentally. As Lord Radcliffe in Sharkey's case and the Supreme Court in Shirinbai Kooka's case have observed, the realistic way of doing so would be to enter the actual cost that the new undertaking has borne, i.e., the price which was realisable at the time, when the transfer of such business asset took place from one department or from one trading activity to another. In computing the profits, as provided by section 15C, whatever may have been done by the assessee so far as his books of accounts are concerned, the revenue would still be entitled to enquire, where exemption under this section is sought for, whether the profits shown by the assessee in his books are realistic or not, and that can only be ascertained by acting on commercial principles, that is, by computing the profits on the basis of the realistic value of the business asset transferred from one activity to another.
11. What then is the factual position in the instant case The starch which is manufactured by one department of the company's manufacturing unit and which the assessee-company also sells at profit has been transferred to its another department for being used as raw material in the manufacture of dextrose which is the ultimate product. Dextrose is actually sold by the assessee-company and that is an actual commercial activity, as was the case in Commissioner of Income-tax v. Shirinbai Kooka. The question is, in computing the profits of the new industrial undertaking, which, for the purpose of section 15C, is to be treated as an independent and a distinct undertaking, what is to be the basis of the value of the raw materials, cost price to the company as canvassed by Mr. Kaji, or their value currently realisable at the time when they were diverted When starch was produced, it would form the stock-in-trade of the assessee-company. When that is removed for use in another undertaking of the same assessee-company, what value is to be credited there, for some value has to be credited in the accounts of the old under taking and debited in the accounts of the new undertaking. The alternatives suggested are (1) the cost, and (2) the market value. The making of the credit entry in the one and debit entry in the other would not constitute a notional or a fictional trading by the assessee-company with self. The question of computation does not involve that principle, but it involves the principle of true accounting and computation. By crediting only the cost, the assessee-company would not be representing the correct and the true picture in the accounts of its starch manufacturing business, and by debiting the cost only in the account of dextrose it would also not be giving a correct picture of the true profits made on the sale of dextrose. In both the cases the accounts would not be realistic. The correct method of computation, therefore, is the one laid down in Commissioner of Income-tax v. Shirinbai Kooka, where the Supreme Court has approvingly cited the observations of Lord Radcliffe in Sharkey's case. Our answer to question No. 1, therefore, is that the starch produced by the old industrial undertaking and used as raw material in the production of dextrose in the new industrial undertaking should be taken at the market price for the purpose of section 15C of the Act.
12. So far as question No. 2 is concerned, that is concluded by the judgment of this court in I. T. R. No. 13 of 1962 decided on August 18, 1964. In view of that decision, our answer to that question would be in the affirmative.
13. The assessee-company will pay to the Commissioner the costs of this reference.