RAJAGOPALAN, J. - The assessee company has been a private limited company from 1915. Even during the period from December, 1936, to June, 1938, when it was in form a public company, no shares were issued to the public. After June, 1938, it reverted to its status as a private company. J. M. Smith was in management all through till March, 1950, and it was never in dispute that the present sound position of the company was largely due to his management of its affairs.
The assessee company entered into a managing agency agreement, evidenced by annexure A, with Smith Ltd. Smith Ltd. consisted only of Smith and his wife as shareholders, with a nominal capital of Rs. 300. Under that agreement Smith continued to manage the affairs of the assessee company. Clause (1) of the agreement provided :
'The said private company, namely, Smith Ltd. and its assigns and successors in business notwithstanding any change in the name, style or constitution of the said private company, hereinafter called also the said managing agents, shall be managing agents of the company for a period of twenty years certain from the date of P. Orr and Sons Ltd. becoming a public limited company, i.e., from the twenty-fourth day of December, one thousand nine hundred and thirty-six until the twenty-third day of December one thousand nine hundred and fifty-six, and thereafter unless and until the said managing agents shall resign of their own accord or be removed from office by a special resolution of the company....... it being expressly agreed that no question of removal from office of the said managing agents before the expiry of the period of twenty years aforesaid shall arise under any circumstances whatsoever save and except on the said managing agents being found guilty in a competent court of law of fraud in the management of the business of the company or in the discharge of their duties as the managing agents of the company.'
In addition clause 9 of the agreement provided :
'The said managing agents shall be entitled to delegate or sub-delegate all or any of the powers, authorities and discretions for the time being vested in them in particular from time to time to provide by the appointment of an attorney or attorneys for the management and transaction of the affairs of the company in such manner as they may deem fit.'
The remuneration payable to Smith Ltd. as managing agents was (1) a monthly allowance of Rs. 3,000 plus (2) 25 per cent. of the annual net profits of the company.
The managing agents allowance and commission paid between 1943 and 1947 were as follows :
Year ended 31st March.1943
Up to 31st March, 1947, Smith and his wife held between them a large block of shares (27,200) in the assessee company, which however was not enough to give them a controlling interest.
When exactly the directors of the assessee company, which included Smith, first entertained the idea of converting the company again to a public company is not clear. Nor does the evidence on record indicate whether the directors contemplated any increase in the issue of the subscribed capital, even after converting the company into a public company. The directors obviously came to the conclusion that the termination of the managing agency agreement was desirable before any steps to that end could be taken. There must have been a general measure of agreement between Smith and the other directors before the formal correspondence commenced between them with the letter marked annexure B, dated 16th August, 1948.
Annexure B was the letter the directors addressed to Smith Ltd. The first paragraph of that letter ran :
'The directors of this company have been considering for some time the advisability of your continuing as managing agents under the agreement entered into with you, dated the 15th February, 1937, in view of the proposal to make an offer of sale of shares to the public in the near future.'
What was required of Smith was (1) the termination of the managing agency with retrospective effect from April 1, 1948, which necessarily involved the loss of the managing agents remuneration and commission payable for the year which commenced with April 1, 1948, and (2) waiver of the right to the 25 per cent. commission earned during the year that ended with 31st March, 1948 : In return Smith was offered a lump sum of Rs. 1,25,000. Smith was further offered a life directorship of the company, with charge of the London office on a remuneration of pound 1,200 per year. By the time this letter was sent, the commission payable to Smith for 1947-48 had not been ascertained. It was estimated at Rs. 31,000 but eventually it was found that Rs. 89,214 would have been payable under this head. Smith accepted the terms offered to him (annexure B1). The directors thereupon informed the shareholders of the proposal to terminate the managing agency (annexure-B-2 dated August 26, 1948). There was no reference in that letter, B-2, to any proposal to convert the company into a public company. The relevant portion of that letter ran :
'Subject to the approval of the members, your directors have proposed a capital payment as compensation for loss of office of Rs. 1,25,000 in return for the termination of the managing agency agreement with effect from the 1st April, 1948.
We are pleased to advise that this offer has been accepted by the managing agents.......
It will be seen that the offer of Rs. 1,25,000 is approximately equal to the commission paid and payable for the three years ended 31st March, 1948, and is considered an excellent offer from the companys point of view as the agreement would not normally expire until the 23rd December, 1956.'
These proposals were accepted by the shareholders of the company at the meeting held on September 30, 1948. The shareholders decided further that after the death of Mr. Smith his wife should get a pension for her life at pound 100 per month.
Thus the managing agency came to an end with effect from April 1, 1948. Smith Ltd. were credited with the sum of Rs. 1,25,000 in the assessees books on October 30, 1948. The assessee maintained its accounts on a mercantile basis. The sum itself was actually paid out later in instalments between January 25, 1949, and September 28, 1950.
In the assessment year 1949-50, for the year of account that ended with March 31, 1949, the assessee claimed this payment of Rs. 1,25,000 as an allowable deduction under section 10 (2) (xv) of the Income-tax Act. That claim was disallowed by the Income-tax Officer. The assessee appealed with success to the Assistant Commissioner. The appeal preferred by the Department was allowed by the Tribunal. The Tribunal, however, referred the following question under section 66 (1) of the Act.
'Whether in the circumstances of the case the payment of Rs. 1,25,000 to the managing agents of the assessee company represented compensation for loss of office and not deductible under the provisions of section 10 (2) (xv) of the Act.'
In the appeal before the Tribunal it pointed out that two questions arose for consideration : (1) whether the payment of Rs. 1,25,000 constituted an item of capital expenditure, and (2) if it was a an item of revenue expenditure, whether it was incurred wholly and exclusively for the purposes of the assessees business. The Tribunal answered the first of these questions against the assessee, and it refrained from considering the second question. When the reference under section 66 (1) came up first before this court, it directed by its order dated April 17, 1956, the submission of a further statement of the case with a specific finding on the second of the questions mentioned above. In the further statement of the case submitted by the Tribunal it recorded :
'In the ultimate analysis we find that the reasons for the payment of the compensation in question are not business reasons motivated by any commercial consideration that was the urge to the transaction. The amount in question cannot therefore....... be said to have been wholly and exclusively laid out for the purpose of the assessees business for the year ended 31st March, 1949.......'
Apparently the Tribunal was of the view that no portion of this sum of Rs. 1,25,000 was expended wholly and exclusively for the business of the assessee. Had even a portion of that expenditure been incurred out of business considerations alone, an apportionment would have had to follow, on which the Tribunal did not embark.
In our opinion neither of the findings of the Tribunal was justified by the material it had to consider.
The approach to a problem of this kind is that laid down by the Supreme Court in Assam Bengal Cement Co. Ltd. v. Commissioner of Income-tax :
'The aim and object of the expenditure would determine the character of the expenditure whether it is a capital expenditure of a revenue expenditure. The source or the manner of the payment would then be of no consequence. It is only in those cases where this test is of no avail that one may go to the test of fixed or circulating capital.. It has been rightly observed that in the great diversity of human affairs and the complicated nature of business operations it is difficult to lay down a test which would apply to all situations. One was therefore got to apply these criteria one after the other from the business point of view and come to the conclusion whether on a fair appreciation of the whole situation the expenditure incurred in a particular case is of the nature of capital expenditure or revenue expenditure in which latter event only it would be a deductible allowance under section 10 (2) (xv) of the Income-tax Act.'
Mr. Rama Rao Sahib, learned counsel for the Department, was right when he pointed out that the object, to achieve which the assessee expended the sum in question (Rs. 1,25,000), should be gathered in this case from the circumstances attendant on the decision to pay, which was in August, 1948, and not from the subsequent events. In form and in substance the payment was to secure the termination of the managing agency held under a binding contract by Smith on behalf of Smith Ltd. Annexure B-2, which placed the proposal before the shareholders, made that quite specific. Annexure B-2 pointed out that eight years were still left of the 20 year period for which the contract provided, and that the proposed payment represented but three years commission payable to the managing agents. We shall leave out of account the fact, that while the commission payable for the year ending March 31, 1948, was then estimated at about Rs. 31,000 it actually worked out to over Rs. 89,000. The proposal to pay Rs. 1,25,000 was no doubt part of a composite arrangement, but none the less, as we have stated, that payment in form and in substance was only to secure the termination of a recurring liability, an annual payment of the managing agents remuneration, plus 25 per cent. of the net profits for eight years certain, and for an indefinite period thereafter. Another proposal was that Smith should serve as managing director up to the end of March, 1949, on a monthly salary of Rs. 3,000. He would have had the same amount as Smith Ltd., if the managing agency were not terminated with retrospective effect from April 1, 1948. No doubt Smith actually continued as managing director for a year more, up to March 1950, but that was not, and could not have been contemplated in August, 1948.
Yet another item of the arrangement was that when Smith quitted India after ceasing to be the managing director, he should be employed by the assessee company as a director in charge of the London office and its buying organisation on an annual salary of pound 1,200. The Tribunal appears to have misconstrued the scope of the expression 'retire'. Smith did not intend to retire altogether from the business of the assessee company. He was to continue in the service of the company, but a London and not in India. That this arrangement benefited him did not alter the fact, that from the point of view of the assessee company it was an arrangement to its considerable advantage.
Ultimately the shareholders decided to grant a pension to Mrs. Smith after the lifetime of Mr. Smith, but that too can be left out of further account in deciding what the payment of Rs. 1,25,000 was intended to achieve.
Mr. Rama Rao Sahib submitted that, though annexure B-2, the notice to the shareholders, made no reference to that point, annexure B, which had been addressed to Smith, made it clear that what the directors had in view was the reconstitution of the company as a public company. We have already pointed out that the material on record did not disclose any intention at that stage of increasing the share capital. Annexure B only referred to the shares being made available for sale to the public in the near future. We are unable to accept the further contention of the learned counsel, that the expenditure was incurred only to facilitate the proposes conversion of the company from a private to a public company. Even if that was one of the objects in view, that did not in any way affect the profit earning structure of the assessee company; not could a mere conversion itself be viewed in the circumstances of this case as an acquisition of a capital asset. It should be remembered that even before the commencement of the negotiations with Smith for the termination of the managing agency Cormac and Wood had been appointed as managing directors, obviously to continue the business built up by Smith.
We come back to the position, that the payment of Rs. 1,25,000 was to secure the termination of the managing agency and its attendant recurring annual liability to the company. It was not intended to bring in any capital asset; not did it result in the acquisition of any capital asset. It was not an item of capital expenditure which section 10 (2) (xv) of the Act excludes.
The case law on the subject of what amounts to a capital expenditure or revenue expenditure has been reviewed so often, that we do not consider it necessary to embark on a similar exhaustive investigation at this stage.
In Nevill and Co., Ltd. v. Federal Commissioner of Taxation ( Latham, C.J., observed at page 301 :
'It is urged however that in so far as the expenditure was directed towards reducing current and future expenses.......... it did not increase assessable income.......... The mere reduction of expenditure though it decreases the expenditure side of an account, does not increase the receipts side of the same account. In my opinion the answer to this contention is to be found in a recognition of the fact that it is necessary for income-tax purposes, to look at a business as a whole set of operations directed towards producing income. No expenditure, strictly and narrowly considered, in itself actually gains or produces income. It is an outgoing, not an incoming. Its character can be determined only in relation to the object which the person making the expenditure has in view. If the actual object is the conduct of the business on a profitable basis with that due regard to economy which is essential in any well conducted business, then the expenditure (if not a capital expenditure) is an expenditure incurred in gaining or producing the assessable income. If it is not a capital expenditure it should be deducted in ascertaining the taxable income of the taxpayer.'
In Noble Ltd. v. Mitchell, a sum of pound 19,200 was paid to a retiring director. The company claimed that as a deduction from its profits for income-tax purposes. In upholding that claim Lord Hanworth, M. E., observed at pages 420-421 :
'It is a payment made in the course of business, dealing with a particular difficulty which arose in the course of the year, and was made not in order to secure an actual asset to the company but to enable them to continue, as they had in the past, to carry on the same type and high quality of business unfettered and unimperilled by the presence of one who, if the public had known about it, might have caused difficulty to their business and whom it was necessary to deal with and settle with at once.'
Lawrence, L. J., said :
'I agree that the sum in question was wholly and exclusively expended by the company for the purpose of its business, in the sense that the sole object with which the company made the payment made the payment was to enable the company to continue to carry on and earn profits in its business.'
In that case it was an unwanted director, whose connection with the business had to be terminated in the interest of the business of that company. That in the present case Smiths services, both his past services and his services expected for the future, were valued highly should make no real difference in the principle to apply. To adapt the words of the learned Master of the Rolls it was a payment made in the course of business, dealing with a particular situation which arose in the course of the year, and was made not in order to secure a capital asset to the company but to enable them to continue as they had in the past, carry on the same type and high quality of business, unfettered by the obligation under the managing agency agreement to pay remuneration at a high rate (Rs. 3000 a month plus 25 per cent. of the net profits) to the managing agents.
Among the reported cases, the case which comes nearest to the assessees which we have to consider is Anglo-Persian Oil Co. Ltd. v. Dale, the headnote of which runs :
'By agreements made in 1910 and 1914 the appellant company (the assessee) appointed another limited company as its agents in Persia and the East, for a period of years, upon terms (inter alia) that the agents should be remunerated by commission at specified rates.
With the passage of time the amounts payable to the agents by way of commission increased far beyond the amounts originally contemplated by the company, and, after negotiation between the parties, the agreements were cancelled in 1922, the agent company agreeing to go into voluntary liquidation and the company agreeing to pay to the agents pound 300,000 in cash. This sum was in fact paid and the company contended.... that it was an admissible deduction in computing the companys profits.....'
That claim was upheld by Rowlatt, J., and his decision was confirmed on appeal. Lord Hanworth, M. R., said this at page 268 :
'The company had appointed Messrs. Strick, Scott & Co. as their agents. They have now withdrawn that agency and are doing the business themselves. It seems difficult to accept the view that the appointment of an agent, or the withdrawal of an agency, in the very business belonging to the principals, creates or destroys a business of a separate nature or an asset which is to be added to the capital account... where, as in this case, the expenditure is to bring back into the hands of the company a necessary ingredient of their existing business - important, but still ancillary and necessary to the business which they carry on-the expenditure ought to be debited to the circulating capital rather than to the fixed capital, which is employed in and sunk in the permanent - even if wasting - assets of the business.'
Lawrence, L. J., said at page 271 :
'... in the present case the expenditure brought no... permanent advantage into existence as the company might, at any time, revert to its former method of conducting its business, and place the management of its business in Persia again in the hands of an agent. The change in the method of carrying on the companys business in Persia has, in fact, resulted in a more economical and efficient working of the companys trade, and in that sense has proved to be advantageous to the companys business, but it cannot be said that the expenditure in bringing about such a change has created an advantage for the enduring benefit of the companys trade.'
In Scammell and Nephew Ltd. v. Rowles Sir Wilfrid Greene, M. R., observed at pages 497-498 :
'.... we find this company finding itself in a situation of trading relationship with another company, which it wishes to get rid of because it is inconvenient to it... The termination of trading relationship in order to avoid losses occurring in the future through that relationship, whether pecuniary losses or commercial inconveniences, is just as much for the purposes of the trade as the making or the carrying into effect of a trading agreement.'
The learned Master of the Rolls continued at page 499 :
'In the present case, if the trading relation was one that was disadvantageous to the company, and, in order to get rid of it, the company had to enter into an agreement... and if in order to secure that that agreement should be effective, it was necessary to make a payment... it seems to me, a payment that was made of or and was directly connected with the procuring by the company of the advantage of terminating that trading relation and, as such, was wholly and exclusively laid out for the purposes of the companys trade.'
Having reached the conclusion, that the payment in question constituted an item of revenue expenditure and not a capital expenditure, the next question is whether the other requirements of section 10 (2) (xv) have been satisfied, that is, whether the expenditure was incurred wholly and exclusively for the business of the assessee. The viewpoint is that of business expediency, what a normally prudent businessman could be expected to do in good faith. It should be remembered that the good faith of none of the parties to the transaction was ever in doubt. All of them acted in the best interest of the company. The shareholders approved of the proposals made by the directors. Judged by the test of business expediency, it seems clear to us that the amount was expended wholly and exclusively for the business of the assessee company. What we have stated earlier should suffice to answer this question also in favour of the assessee.
In paragraph 30 of its further statement of the case the Tribunal recorded :
'....it is not unreasonable to infer that the directors in making the proposals for termination were fully conscious of Smiths independent intention to retire from India whether with or without compensation.'
What the Tribunal appears to have overlooked is that there was no indication that on quitting India Smith intended to throw away the valuable rights he could claim under the managing agency agreement. He could assign those rights; he could appoint some one to carry on the managing agency on behalf of Smith Ltd. Quitting India did not mean quitting business. We are unable to find on what basis the Tribunal came to the conclusion, that Smith contemplated complete retirement from business and without compensation. The Smith benefited by the transaction is not proof that the sole object of the company was that he should benefit. An employee obviously benefits by the salary that is paid to him for his services. But the expenditure cannot be disallowed on that ground. We have found that the arrangement which involved the payment of Rs. 1,25,000 was entered into to enable the assessee company to continue its business freed of the managing agency, freed of the liability to pay the managing agents a monthly remuneration and 25 per cent. of the net profits every year. The quantum of payment was wholly reasonable from a businessmans point of view. It represented what the directors then thought was but three years commission but actually it cost them less. In our opinion the only conclusion possible on the material on record is that this amount of Rs. 1,25,000 was expended by the assessee company in the relevant year of account wholly and exclusively for its business. The requirements of section 10 (2) (xv) of the Act were satisfied.
Our answer to the question is that the payment is deductible under the provisions of section 10 (2) (xv) of the Act. The assessee will be entitled to the costs of this reference. Counsels fee Rs. 250.
Reference answered accordingly.