1. The assessee firm consisted of three partners, Venkatesam Chetti, Sreenivasalu Chetti arid Manickam Gupta. Each was the kartha of his undivided family. Each of the partners had a third share. Venugopal Chetti and Venkatamuni Cheti were the Managers of the firm and its business. Venugopal was in charge of the office at Madras. Venkatamuni undertook the necessary touring. Venugopal was the undivided son of Sreenivasalu, while Venkatamuni was the undivided brother of Venkatesam. Venugopal and Venkatamuni were all along paid remuneration for the services they rendered to the firm, but the remuneration paid to them was consistently disallowed by the departmental authorities under Section 10(4) (b), Income-tax Act.
2. In the assessment year 1946-47, the claim preferred by the assessee for the deduction of the remuneration it had paid to its two managers, Venugopal and Venkatamuni, was again disallowed by the Income-tax Officer and on appeal by the Appellate Assistant Commissioner. The disallowance was again under Section 10(4) (b) of the Act. The Tribunal confirmed that disallowance but on different grounds. The Tribunal referred to this Court under Section 66(2) of the Act the following question:
'Whether on the facts of the case, there is material on record to justify the disallowance of the payment of commission of 121/2 per cent of the net profits to the managers.'
3. The remuneration paid by the assessee in the year of account ending with 31-3-1946 to its two managers, Venugopal and Venkatamuni was on the basis of the agreements it had entered into with each of them on 2-4-1945 at the commencement of the year of account. Clause 10(a) of the agreement secured for each of the two managers a monthly salary of Rs. 325. Venugopal was entitled in addition to a house rent allowance of Rs. 100 a month; he resided in Madras. Clause 10(b) of each of the two agreements ran:
'By way of further remuneration, a commission of 121/2 per cent on the net profits of the business carried on by the firm at all places.'
In the year of account 1945-46, Rs. 32,840 was computed as the net profits of the firm, 121/2 per cent of which had to be paid to each of the managers Venugopal and Venkatamuni under the agreement, dated 2-4-1945. The Income-tax Officer pointed out that though 25 per cent of the computed not profits came to only Rs. 8210, each of the managers was paid Rs. 4589. The total paid as commission thus amounted to Rs. 9178 and it was the expenditure of Rs. 9178 that was claimed by the assessee as deduction from its assessable income. The Income-tax Officer held:
'The agreement appears to be merely a make believe, not strictly adhered to.'
In his order of assessment the Income-tax Officer further observed:
'The commissions to those two persons are deliberately made with a view to reduce the taxable profit. Apart from this aspect. It has been repeatedly held on appeals in earlier years, that these two persons were engaged in the business in the capacity of representatives of the Hindu undivided families which were the real partners in the firm. There is no change in the constitution of the partnership and in the status of these two persons. The execution of a service agreement stipulating salary and 121/2 per cent, net profits is a colourable and collusive act and a fake deliberately intended to get over the objections till now raised in income-tax proceedings. There is no change in the real status of these persons. When it is found that these persons are in the capacity of partners themselves, any remuneration paid to them is inadmissible notwithstanding the existence of any agreement. . The payments to these persons will be disallowed as in previous years.'
4. Thus, even the finding, that the agreements dated 2-4-1945 were not genuine, was linked up by the Income-tax Officer with his finding that the payments made to Venugopal and Venkatamuni were really payments to the parties and were, therefore, inadmissible under Section 10(4)(b) of the Act.
5. The Appellate Assistant Commissioner to whom the assessee appealed recorded:
'But the service agreement has not brought about any change in the status of the two, persons, namely, 'Messrs. Venugopal and Venkatamuni.'
The Appellate Assistant Commissioner concluded:
'Unless the finding given in previous years, viz. that the two persons received the sums as representatives of their joint Hindu families was displaced, the execution of any number of documents would not alter the position. The officer's finding therefore that the payments were in effect to partners in the firm will be upheld. The disallowance of a sum of Rs. 18178 will be sustained.'
The Income-tax Officer and the Appellate Assistant Commissioner disallowed all the three items of remuneration, salary, the 121/2 per cent commission as also the house rent allowance paid to Venugopal. The assessee appealed to the Tribunal. The Tribunal held that the payments to the two managers did not fall within the scope of Section 10(4) (b) of the Act. The Tribunal upheld the claim of the asses-see to deduct the payments made to the managers as salary and house rent allowance. With reference to the payment of the commission under the terms of the agreements dated 2-4-1945 the Tribunal recorded:
'The only question that remains is as to the reasonableness of the claim. The claim for commission is something now put forward in the year of account. There is absolutely no material to justify it. Nor is it usual in the line of business of the assessee to pay commission to its employees. Moreover, when commission payments of Rs. 25,000 were claimed and allowed to canvassers and selling agents, they can be no warrant for claiming commission for the managers also. We accordingly disallow the commission payment.'
The Tribunal also recorded that the claim for salary and apparently for t e house rent allowance also, was not unreasonable in view of the large turnover and the conduit our of business.
6. The genuineness of the agreement, though even that was doubted by the Inco 'e-t x Officer, and the genuineness of the payments to the managers under these agreements were this accepted by the Tribunal. The only question to which the Tribunal addressed itself was the reasonableness of the payment. The Tribunal was of the view that the payment of 121/2 per cent of the net profits as commission to each of the two managers was not reasonable.
7. The leaded counsel for the assessee contended that the claim for deduction of the sums expended as commission paid to the two managers fell under Section 10(2) (xv) of the Act. He pointed out that Clause 10(b) of the agreements made a further payment calculated at 121/2 per cent, of the net Profits part of the remuneration payable to the managers. In our opinion the learned counsel for the respondent was right in the contention, that the claim of the assessee could fall only under Section 10(2)(x). The tests to be satisfied before the claim of an assessee, that the payment of commission to its employee was reasonable and should be allowed, are those specified 'by the proviso to Section 10(2) (x) which runs:
'Provided that the amount of the bonus on commission is a reasonable amount with reference to -- (a) the pay of the employee and the conditions of his service; (b) profits of the business, profession or vocation for the year in question; and (c) the general practice in similar business, profession or vocation.'
It is, however, well settled now that the reasonableness of the payment has to be judged not on any subjective standard of the assessing authorities but from the view point of commercial expediency. The learned counsel for the assessee was in our opinion, well founded in his contention that that was not the approach of the Tribunal. The Tribunal observed:
'Nor is it usual in the line of business of the assesses to pay commission to its employees.'
It was no doubt for the assessee who claimed what was in effect an exemption, to make out his claim. But there was nothing in the material on record before the Tribunal to indicate that there was really any comparable case to show that what the assessee did in the year in question was something unusual in its line of business. Linking part of the remuneration of an employee, holding a managerial post, with the net profits of the employer firm would certainly appear to be a prudent act of management in this or any other line of business, far more prudent than a contract for a high fixed basic salary, which would have to be paid whether or not there are profits. That the arrangement to correlate the remuneration to profits provides an incentive to the employee to help his employer to earn more profits, is one of the factors to be taken into account in deciding whether the arrangement is a prudent act of management.
8. The learned counsel for the respondent urged that the nature of the work of the two managers, Venugopal and Venkatamuni remained unchanged even after the agreements dated 2-4-45. There are obvious limits to the exaltation of that plea to a rigid and inflexible principle in deciding on the basis of commercial expediency of what constitutes reasonable expenditure, even for purposes under Section 10(2) (x) of the Act. Under the argument put forward by the learned counsel for the respondent pushed to its logical extreme, even an annual increment of salary would become unreasonable. The learned counsel's argument also ignores what we pointed out earlier, an incentive on the part of the employee to help to make larger profits.
9. No doubt the salaries of the two managers were increased every year after 1941-42 as the statement of the case submitted by the Tribunal showed. On 2-4-1945 it was open to the assessee to grant a further increase in the salaries payable to the two managers. What the assessee firm did was to stabilise the salary, no doubt subject to revision if necessary at Rs. 325 a month and to grant by way of additional remuneration a percentage of the net profits. That arrangement was entered into at the commencement of the year of account, when no one was in a position to guage the future with any degree of precision, whether there would be any profits at all, that year. As we pointed out earlier, it would certainly appear to have been an act of prudent management on the part of the assessee firm as an employer. .
10. The learned counsel for the respondent pointed out that 25 per cent, of the net profits, though each of the managers got only 121/2 per cent, constituted a very large share of the net profits of the assessee firm. It should, however, be remembered that the view of the Tribunal was that nothing was permissible by way of commission, The Tribunal had, therefore, no occasion to go into the question, what percentage of the net profits, or what quantum of the net profits could have been reasonably paid to the two managers. The Tribunal was of the view, that there was no justification to pay any commission to the managers when the assessee firm expended Rs. 25,000 In payment of commissions to the canvassers. That commission was apparently calculated on the gross turnover of the business secured by the canvassers.
That did not really affect the question the Tribunal had to consider, was it a reasonable remuneration that the assessee firm contracted to pay its employees the two managers. Judged by the test of commercial expediency, the only view point to adopt in applying the tests prescribe ed by the proviso to Section 10(2)(x), the contracts dated 2-4-1945 and the payments thereunder' appear to be quite reasonable. It is not the percentage of the net profits that concludes the Issue, nor the quantified sum. It may be that in some cases even both taken together may not be conclusive. All the circumstances specifically referred to in the proviso, to Section 10(2)(x), Judged from the view point of a normal prudent business man, will have to be taken into account in deciding whether the remuneration paid to an employee by way of commission constitutes a reasonable expenditure of the employer in the conduct of his business.
11. Our answer to the question referred to this Court is in the negative and in favour of the assessee. The respondent shall pay the assessee its costs of this reference. Counsel's fee Rs. 250. We have, however, to point out that we have answered the question as it has been framed, with reference to the percentage of commission and not with reference to the quantum claimed by the assessee: any disallowance on the ground that the quantum claimed was not arithmetically correct will be left untouched by our answer.