1. The assessee is a private limited company with 21 share-holders, and a fully subscribed capital of one lakh of rupees. The company carries on business in the manufacture and sale of water proof paper, roofing felt, tarpaulins etc. In view of some large orders it received from the military authorities, the company required further money for its business.
There was a statutory restriction in 1944 on any further increase of the capital issue of companies. The only alternative was to borrow the required amount. At the General body meeting of the share-holders of the company held on 31-12-1944 the company resolved that
"..... in view of the large sums required for the business the Managing Agent he authorised to borrow money from the shareholders of the company who are willing to advance as loan to the extent of the paid-up value of the holdings by two Instalments, i. e., 50 per cent. by the end of February 1945 and 50 per cent. by the end of March 1845 which will bear a minimum interest of six per cent, or at the same rate as the dividend the directors may recommend for the period during which such loans are used in the business of the company, whichever is higher.
Such loan will be returned as and in the manner the directors may think fit, provided that such loans shall be repayable within three years from the date of the loans. If any share-holders does hot advance any portion of the money that he is entitled to advance within the prescribed time, such moneys the managing agent may at his discretion receive from any other shareholders over and above the amounts they are entitled to advance, such loans shall bear interest at the same term as above and the same was unanimously passed."
2. Out of the 21 share-holders only 17 availed themselves of the offer made by the company to borrow money from the share-holders. A sum of Rs. 75.000 was borrowed by 31-3-1945 in the year of account of 1945. Under a resolution of the general body of the meeting held on 21-3-1948 a further sum of Rs. 25,000 was borrowed on similar terms in the year of account of 1948.
3. The assessee's year of account was the calendar year. In 1947, 1948 and 1949, the company declared a dividend of 10 per cent., 20 per cent. and 12 per cent. respectively. Interest at the corresponding rates were paid on the loans borrowed from the 17 share-holders.
4. In the relevant assessment years 1948-49, 1949-50 and 1950-51, the company claimed that the total amount expended in the corresponding accounting years by payment of interest at the rates mentioned above should be deducted in computing its assessable income. The departmental authorities declined to allow anything more than 6 per cent; In the appeal the assessee preferred to the Tribunal, its claim for deduction was based alternatively on Section 10 (2) (iii) and Section 10 (2) (xv).
The Tribunal held "a payment of anything more than 6 per cent. on loans cannot be justified on any commercial considerations." It fur-ther held
"The additional payments which are linked with the declaration of dividends and the profits earned is nothing but a mere device to distribute the profits made in this form amongst the shareholders of this private limited company."
5. Under Section 66 (2) of the Act, the Tribunal referred the following question to this court,
"Whether on the facts and in the circumstances of this case the disallowance of the interest in excess of 6 per cent. out of the amounts paid in respect of the borrowed capital is justified in law."
6. The claim of the assessee both before the Tribunal and before us was rested on alternative grounds, Section 10 (2) (iii) and Section 10 (2) (xv) of the Act. If the claim falls under Section 10 (2) (iii), that by itself would bar recourse to Section 10 (2) (xv). Section 10 (2) (xv) specifically excludes "the allowance of the nature described in any of clauses (1) to (xiv) inclusive of Section 10 (2)". So the real question for determination is, is the deduction claimed by the assessee permissible under Section 10 (2) (iii) of the Act.
7. The allowance that Section 10 (2) (iii) pro-vides for is "in respect of capital borrowed for the purpose of the business, profession or vocation the amount of the Interest paid." We can leave out of account the proviso and the explanation to this sub-clause.
8. No decided case has been brought to our notice where an identical question arose for consideration. Before we deal with the cases cited before us, we shall set out our conclusions about the nature of the transaction, which was the basis of the assessee's claim.
9. The sum of one lakh of rupees was the amount borrowed by the assessee to provide working capital for its expenses. What, it paid annually was interest. Learned counsel for the department could not dispute that the relationship between the share-holders of the company that lent moneys to the company on the one hand and the company on the other which borrowed these moneys was that of the creditors and debtor.
The genuineness of the loan and that of the payments made by the assessee were never in issue it was only on that basis that the Tribunal could allow and did allow six per cent towards interest charges. Once the factors mentioned above were established, there was no scope for limiting the deduction to what the Tribunal considered was a reasonable rate of interest. Section 10 (2) (iii) did not provide for such a limitation.
All that Section 10 (2) (iii) requires is (i) that the money, the capital, must be borrowed by the assessee; (ii) the amount should have been borrowed for the purpose of the business of the assessee and (iii) the assessee should have paid as interest tha amount claimed as allowance under Section 10 (2).
10. Were there any factors that militated against the acceptance of the contention of the assessee, that the transaction was one of loan, is the next question.
11. The assessee borrowed money from its share-holders. While all the creditors were shareholders of the borrowing company, not all the share holders were creditors. Pour out of the 21 share-holders declined to advance any money. Naturally those four were not paid anything by way of interest by the assessee. Though the assessee was prepared to borrow only from its share-holders, no obligation was laid on any of the shareholders to advance moneys to the company.
The rights of the share-holders qua shareholders were in no way curtailed if they did not lend. Both classes, for Instance, were entitled to participate in the profits at a uniform rate of dividend. Though, of course, only a share-holder could lend, thereafter the rights of the lender were distinct from those of the share-holder. There was nothing to prevent a share-holder from parting with his rights as a share-holder, while retaining the rights as a creditor who had advanced moneys to the company.
Nor was there anything to prevent the share-holder-cum-creditor from assigning his debt to one who was not a share-holder. The right to receive interest at the stipulated rate was based wholly on the loan advanced and not on the continued possession of shares. It was only the right to lend that was correlated to the possession of shares, but that did not affect the real nature of the transaction. It was only a loan. What was repayable by the assesses under the terms of the contract was the principal, and till the principal was repaid, the assessee was bound to pay interest at the stipulated rate.
12. That the stipulated rate of interest, was variable and was made dependent upon the rate of dividend the company declared in the relevant year did not again alter the nature of the transaction, and make it anything other than a loan. Suppose the company had contracted to pay Interest at 10 per cent. above the Bank rate that prevailed on the 31st December each year, it would have been a legally enforceable obligation and it would retain unimpaired the jural relationship of a creditor and a debtor.
Again, if the contractual obligation was to pay interest at the same rate as the dividend payable by a named bank, that would not have made the transaction any the less a loan. The contractual obligation in this case was to pay interest at the same rate as the dividend declared by the company, subject to minimum of six per cent. The rate of dividend only provided the basis for computation of interest. What was payable and what was paid was interest and not dividend.
13. Was the contract the assessee entered into with 17 of its share-holders a device to screen the real nature of the transaction? The Tribunal recorded, "the additional payments which are linked with the declaration of dividends and the profits earned is nothing but a mere device to distribute the profits .made in this form amongst the share-holders of this private limited company."
In our opinion, there was no basis for that finding. We have pointed out that not all the share-holders advanced moneys to the assessee-company. The right of each of the share-holders, who had lent moneys, to receive the interest, depended on the money that he had advanced, and not on the number of shares he held. No dividend could be withheld from a share-holder who did not advance moneys.
The dividend could not depend on anything other than the number of shares the share-holder held. Only the lender could get interest on the moneys he had advanced, and not the shareholder, who did not lend anything. It was not a scheme to distribute dividends under the guise of payment of interest.
14. Besides, the declaration of dividend in a given year does not necessarily imply that the profits in that year alone were distributed as dividend. What Section 10 (2) (iii) provides for is a deduction of interest charges incurred in that year of account. If the dividend declared was higher than what the profits of that year warranted, still the lender would have to be paid interest at the same rate irrespective of the quan-tum of profits of that year.
It was not a scheme to distribute dividends. It, was not a scheme to distribute profits. As we stated, the rate of dividends only provided the basis for the computation of the interest, that was payable on the loan. What was paid was only interest. It is the quality of that payment that matters, and not Its admeasurement, in de-ciding whether the claim is permissible under Section 10 (2) (iii).
15. In our opinion, the claim of the asses-see was within the scope of Section 10 (2) (iii) and should have been allowed in full.
16. A review of the cases cited before us does not detract from the conclusion we have re-corded above.
17. Learned counsel for the department relied to a considerable extent on the decision in the -- 'Commissioner of Taxation v. Boulder Perseverance Ltd.', 58 CLR 223 (A), which turned oh the statutory provisions of the Dividend Duties Act, which did not contain anything analogous to Section 10 (2) (iii) of the Indian Income-tax Act. The learned Judges pointed out at page 231 "The purpose of the Act (the Dividend Duties Act) is to tax in the hands of companies all profits they make in the State without regard to the manner in which the profits are dealt with. In this view it becomes, we think immaterial whether the profits are earned by the employment of share capital or debenture capital. It is not denied that the fixed interest charges on debenture capital constitutes a prior deduction in the calculation of the profits made by company. Such charges are regarded as an ordinary business expenditure.
But, when the debenture contract lets the debenture holder into participation in the "trading profits" over and above his fixed interest charge, it gives his debenture capital an additional characteristic, a characteristic inconsistent with that of a simple external loan by a creditor looking only for security for his capital and a certain regular remuneration for its use .....
The share in the profits appears to us to represent a right to the distribution of the fund finally earned by the business, the taxable fund."
Earlier at pages 229-230 the learned Judges laid down, "..... when money is borrowed for use in the business the reward of the lender, in the form of interest is regarded as a necessary or proper deduction for the purpose of ascertaining the profits of the business, and the fact that the reward is made to vary with the success of the business ought not to affect its character as an expenditure incurred for the purpose of earning profit.
Yet capital may be invested in a business in order to obtain a share in the profits indistinguishable from that of the proprietor. The solution of the difficulty must in every case be found in determining the point at which the ascertainment of net profits is required, and this depends upon the purpose for which they are to be computed. Profits may be regarded as a fund composed of receipts which must be applied to various purposes is succession.
In this view it is a fund subject to diminution by an indefinite succession of disbursements or outgoings until it is finally dissipated. In its course ffom the initial receipt to its final distribution, the fund may be computed at different points for different purposes. If the purpose is to find what the business returns to its proprietors in a form which they can enjoy as they choose, a point must be taken at which every other expenditure to which the fund must, be applied has already been deducted.
But, to illustrate the difference which the nature of the purpose makes in the point at which profits are computed, an imaginary example of an opposite extreme may be taken. Suppose the purpose were to find what amount was to be provided by a business for the remuneration of labour in order to fulfil an obligation to reward all those who contributed their labour to an enterprise by dividing profits among them.
In such a supposed case no deductipn would be allowable on account even of wages, still less of remuneration calculated as a percentage upon the earnings of the business."
18. While we are in respectful agreement with the principle underlying these observations, we have again to point out that the language of the Income-tax-Act, especially Section 10 (2) (iii) is not in pari materia with the statutory provisions of the Dividend Duties Act, though even in Australia, the learned Judges pointed out that when money is borrowed for use in the business, the reward of the lender in the form of interest Is regarded as a necessary or proper deduction for the purpose of ascertaining the profits of the business.
19. Learned counsel for the department referred to 'A. W. Walker and Co. v. Commissioner of Inland Revenue', (1920) 12 Tax Cas 297 (B), the principles laid down in which were followed by the same learned Judge in the -- 'Commissioners of Inland Revenue v. Mashonaland Railway Co. Ltd.', (1926) 12 Tax Cas 1159 (C). Walker's case was referred to with approval in 58 CLB 223 (A). What was payable under the terms of the contract in Walker's case (B) was a sum of 200, per half year which worked out to five per cent, of the amount advanced as a loan, plus a further 3/20th parts of the profits in excess of 1000 up to but not exceeding 3000. The excess came to 300.
The claim for 200 was allowed, and the claim for the additional 300 was negatived. Row-latt J., observed, with reference to the 300 that it was nothing but giving the lenders a share of the profits eo nomine. The learned Judge observed further:
"They both of course are in consideration of the loan, that is why they are paid, there is no doubt about that, but they are different things, and the people who have lent this money have, got interest and they have got ft share of the profits -- that is the long and short of it. They have got interest which is payable to them as a debt, it matters not whether the concern prospers or languishes; they have got the other thing, which is a share of what the business earns, and that is not interest, that is simply a share of the profits.
If there are profits they get a share, if there are ho profits they do - not get anything. It is simply, as it says in the agreement, a share of the profits."
20. But the contract between the lenders and the assesses, we have to consider in this case, is quite different. In this case, if the assesses company declared a dividend, whether or not there were profits that year, the lenders were entitled to be paid as interest at the same rate as the dividend. It is conceivable that the company did not declare a dividend in a given year, even though profits were available.
If no dividend was declared, the lender would get nothing more than six per cent. As a further measure of caution in following the principles laid down under the English Income-tax Act, we should point out that there was nothing in that Act to correspond to Section 10 (2) (iii) of our Act, the scope of which was denned with precision by the Act itself,
21. In 'Lock v. Queensland Investment and Land Mortgage Co. Ltd.', 1896 AC 461, at p. 468 (D), Lord Herschell pointed out
"..... I think it is a fallacy to speak of this payment of interest as being a payment made to a member in his character of member. As member he has no right to have that interest paid to him; he could not claim it. As member he was under no obligation to make the payments in consideration of which the company undertook to pay the interest.
When, therefore, the company, although they received the money from a member, received it from him without any obligation upon him as a member to pay it, and undertook to make a payment to him in consideration of it which they were not under any obligation to make to him as a member, it seems to me that it is manifestly erroneous to describe this as a payment made to a member in his character of member."
That, if we may respectfully say so, describes the position of the 17 share-holders of the assessee-company who advanced the moneys to it.
22. In the 'Union Cold Storage Co. Ltd. v. Adamson', (1932) 16 Tax Cas 293 (E), the company leased lands and premises abroad under a deed reserving a rent of 960,000, per annum. The deed provided that, if at the end of any financial year it was found that after providing for this rent the result of the Company's operations was insufficient to pay both interest on its charges and debentures and dividends at fixed rates on its preference shares and also at least ten per cent., on its ordinary shares, the rent for the year was to be abated to the extent of the deficiency, repayment already paid being made if necessary.
In 1922 a sum of 630,000, was paid as rent, and in 1923 the full sum of 960,000 was paid. It was held that the payments were not payable out of the profits or gains and that they were allowable deductions. Lord Hanworth M. B. pointed out at page 322.
".....it is important to bear in mind that it is not alleged by the Crown that this indenture of lease Is not a valid and effective document, a specious device or strategy to cloak the true facts; it is accepted as a good agreement, and that carries one a very long way; it is no use to say the lease must be accepted as a lease, but must be looked at with the eye of suspicion; you havo got to take its terms, and I think Mr. Justice Rowlatt is right in saying that once the Crown have admitted that it is a real transaction, then the case has to be decided upon the tenor of the document as it stands, without an ingenious effort to get round it because one may hold that it has the effect of withdrawing some profits from tax."
23. At page 324, the learned Master of the Rolls observed,
"I have already stated that the Crown do not attack the lease; they only attack the effect of it. When one comes to measure the true effect of it in the light of the surrounding facts, it appears to me that Mr. Justice Bowlatt was quite right in holding that this payment was, accord-ing to the tenor of the document, a sum payable for the purpose of seeking profits; and thus a proper deduction made ....."
Thus the effect of the contract the assessee-company entered into with such of its shara-hol-ders as were prepared to advance moneys in no way affected the real nature of the transaction or the real nature of the relationship between the asses-see-company and its lenders, or the real nature of the payments in discharge of the contractual obligations the assessee-company undertook. What was paid, as we pointed out above, was interest.
24. A payment made contingent on the quantum of profits was not a payment out of taxable profits was what was laid down in '(1932) 16 Tax Cas 203 (E). All that was done in this case was not to make the payment of interest contingent on the profits of the year but on the rate of dividend declared for that year.
25. Learned counsel for the assesses also referred us to the decision in the Indian. Turpentine and Rosin Co. Ltd. v. Commissioner of Income-tax, U. P.', 3 ITC 219: (AIR 1929 All 118) (F), the principle laid down in which was analogous to that laid down by the House of Lords in 1896 AC 461 (D), The Government of the U. P. was a share-holder of the assessee-company. It also undertook to supply crude resin required by the company from the Forest Department for which the company had to pay a royalty. The contract provided
"If the profits of the company in any year exceed 15 per cent. of the capital of the company ranking for dividend then the company will pay the Forest department as additional royalty such proportion of 40 per cent. of the amount by which the profits exceed the abovementioned 15 per cent. as the number of maunds of crude resin either supplied by the Forest department to the company or collected and extracted by the company from the channels made available by the Forest department in the preceding tapping season ..... bears to the total number of maunds of crude resin received by the company in that period."
It was held by the Income-tax Officer that, as this royalty was dependent on the earnings of profits, therefore, it was an allocation of profits, to one of the biggest share-holders of the company. That decision was, however, abandoned in appeal, because it was pointed out that, if the Government sold all its share in the company, the company would still have to pay the same amount of royalty.
"Therefore the payment could in no sense-be regarded as an allocation of profits, to one of the co-sharers in the company. It is merely an unconnected fact that Government are at present share-holders in the company." To the extent. to which the character in which the additional royalty was received was differentiated from that of a share-holder, the principle laid down in that case is, as we said, analogous to that laid down by the House of Lords in 1896 AC 461 (D).
But we must also point out that in 3 ITO 219: (AIR 1929 All 118) (P), it was not the scope of Section 10 (2) (iii) that arose for determination.
26. Devarajulu Chettl and Co. v. Commissioner of Income-tax', (G), the learned Judges pointed out "It is the
quality of the payment that is the test and not its admeasurement." With that principle we are in entire agreement.
27. Once the true nature of the transaction is realised, there is no scope afforded in Section 10 (2) (iii) to reduce the quantum paid as interest, to anything considered reasonable by the taxing authorities on subjective or objective standards.
28. We answer the question referred to us in the negative and in favour of the assessee-com-pany. The assessee will be entitled to the costs of this reference. Counsel's fee Rs. 250.