The petitioner, Narayanaswami Iyer, was employed as the manager of Swami and Co., a proprietary concern owned by his wife. His remuneration under the agreement dated 16th October, 1948, between himself and his employer, was Rs. 750 a month or half per cent. of the annual turnover, whichever was higher. A fresh agreement was entered into between the petitioner and his employer on July 1, 1949, which revised the scale of remuneration. The petitioner was to get thereafter one per cent. of the annual turnover, if it exceeded Rs. 24 lakhs, subject to the minimum of Rs. 750 a month. For the period between July 1, 1949, and June 30, 1950, the petitioner was paid a sum of Rs. 33,146, as remuneration under the revised agreement, as the turnover amounted to Rs. 33,14,620. Swami and Co. claimed this payment as an admissible item of deduction in the assessment proceedings for 1951-52. The Tribunal ultimately held that only a deduction of Rs. 16,573 was admissible in computing the taxable profits of the employer, Swami and Co. The petitioner was, however, assessed on the actual receipt of Rs. 33,146, which was apportioned between his years of account, which ended with 31st March each year in the assessment proceedings for the assessment years 1950-51 and 1951-52.
The petitioner claimed that under the terms of the Notification No. 878-F dated February 21, 1922, as it was subsequently amended, the petitioner was entitled to exclude from his assessable income the amount that was disallowed in the assessment proceedings of his employer, Swami and Co. that is, the difference between Rs. 33,146 that was paid to the assessee, and Rs. 16,573 which alone was allowed as a deduction by the Tribunal. That claim was rejected by the Income-tax Officer by his order dated August 25, 1955. The petitioner invoked the revisional jurisdiction of the Commissioner under section 33A(2) of the Income-tax Act. The petitioners request was rejected by the Commissioner by his order dated June 21, 1956.
The petitioner applied to this court under article 226 of the Constitution for the issue of a writ of certiorari to set aside the order of the Department culminating with the order of the Commissioner dated June 21, 1956.
The relevant portion of Notification No. 878-F on which the petitioner based his claim for relief ran :
'The following classes of income shall be exempt from the tax payable under the said Act....
(1) Sums received by an assessee on account of salary, bonus, commission or other remuneration for services rendered... to a person for purposes of his business, where such sums have been paid out of, or determined with reference to, the profits of such business, and by reason of such mode of payment or determination, have not been allowed as a deduction but have been included in the profits of the business on which income-tax has been assessed and charged under the head business...'
The agreement between the petitioner and his employer did not provide for a determination of the petitioners remuneration with reference to the profits of the business of the employer. It should be remembered the agreement specifically provided for the determination of the remuneration payable to the petitioner-employee on the basis of the gross turnover of the business.
To satisfy the requirements of the notification conferring the right of exemption, what the petitioner had to prove was (1) that the received Rs. 33,146 as remuneration for services rendered to Swami and Co., for purposes of the business of Swami and Co., (2) that that sum was paid out of the profits of the business of Swami and Co., and (3) by reason of such mode of payment Rs. 33,146 minus Rs. 16,573 was not allowed as a deduction but was included in the profits of Swami and Co., on which income-tax was assessed and charged under the head of business in the case of Swami and Co. As pointed out by the Supreme Court in Commissioner of Income-tax v. M. K. Kirtikar : 36ITR360(SC) .) these conditions are cumulative, and all of them have to be fulfilled before the petitioner can claim the benefit of the exemption.
The first of the conditions was satisfied, and there was no dispute about that. The petitioner received Rs. 33,146 as his remuneration for services rendered by him to his employer for purposes of her business. The next question is whether the second test has been satisfied, whether this sum of Rs. 33,146 was paid out of the profits of the business carried on by the petitioners employer. Before answering that question shall deal with the third of the tests to be satisfied by the petitioner that by reason of such mode of payment the sum which the petitioner seeks to exclude from his assessable income was not allowed as a deduction but was included in the profits of the business on which income-tax was charged under the head 'business' so far as the employer was concerned.
That the petitioners employer was assessed to income-tax on the claim disallowed, that is, on the difference between Rs. 33,146 and Rs. 16,573 was never in dispute. But what is the ground on which the claim of the employer, Swami and Co., was disallowed is the question for determination.
In the appeal preferred by Swami and Co., the Tribunal stated :
'It is clear that the whole arrangement is a very artificial one. The business though ostensibly in the name of the wife (she) is more or less a mere name-lender. At best, it is an arrangement in the nature of a partnership between the husband and the wife, where the wife has brought the necessary finance and the husband does the entire work.'
That, however, was not the ground on which the claim of the assessee, Swami and Co., was disallowed, because the Tribunal proceeded :
'Be that as it may, as the Department has not challenged the impugned payment on these lines, and has accepted the fact of relationship of a master and servant between the husband and the wife, the consideration must be confined to the question posed above.'
The question posed was, whether the Department could go behind the agreement of July 1, 1949, and if so, whether the remuneration of Rs. 33,146 was reasonable and could be said to have been laid out wholly and exclusively for the purpose of the business. That question the Tribunal answered :
'We, therefore, hold that the second agreement was not wholly actuated by business consideration and the relationship of the parties had a distinct bearing thereon. The absurdity of the second agreement is also demonstrated by the fact that by giving effect to it, Swami (petitioner) got a larger share of the net profits than the assessee (Swami and Co.). In all the circumstances of this case, the reasonable remuneration to be allowed in the year of account will be that calculated at 0.5 per cent. of the turnover, viz., Rs. 16,573....'
Thus the disallowance of the rest of the claim of Swami and Co. was on the ground, that the requirements of section 10(2)(xv) of the Act had not been satisfied, and that the disallowed amount had not been an expenditure incurred by Swami and Co. wholly and exclusively for the business the proprietrix carried on.
Both the Income-tax Officer and the Commissioner took the view, that as the disallowance in the assessment proceedings of the employer, Swami and Co., was not on the ground that it was in effect a case of division of profits but on the ground that the requirements of section 10(2)(xv) had not been satisfied, the claim of the assessee did not fall within the scope of the notification. In other words, the finding of the Income-tax Officer and the Commissioner in effect was that the third of the tests was not satisfied and that it was not by reason of such mode of payment the amount in question was not allowed as a deduction in the assessment proceedings of the employer, Swami and Co.
In our opinion that finding would appear to be correct. If any significance is to be attached to the use of the expression 'such' in the phrase 'by reason of such mode of payment', it should relate to the second of the conditions to be satisfied, that the sums were paid out of the profits of the business, in this case the profits of the business of Swami and Co. It was certainly not on the ground that the payment was out of the profits of Swami and Co. that the claim was disallowed. In other words, it was not on the ground that the agreement provided for an allocation of a share of the profits to the petitioner after it had accrued to his employer that the employers claim was disallowed. Factually, no doubt, the emlopyer had profits during the period in question, which more than covered the amount paid to the employee. But it should be obvious that under the terms of the agreement, whether there was any profit or not during the period in question, the petitioner was entitled to be paid his remuneration calculated on the basis of the turnover during the period. We are mentioning this only to emphasis that the view taken by the Department was correct, that the mode of payment described in the agreement had nothing to do with the profits and that it was not on the ground of that mode of payment that the claim of Swami and Co. for deduction of the entire amount was negative in the assessment proceedings of Swami and Co.
In Commissioner of Income-tax v. M. K. Kirtikar the Supreme Court observed at page 364 :
'The second condition, which appears not to have been noticed by the High Court, is that the sum paid out of profits or determined with reference to the profits of the business had not been allowed as a deduction by reason of such mode of payment or determination. In this case, learned counsel for the Department urges, the amount was disallowed not because it had been paid out of profits or had been determined with reference to the profits of the business, but because he held it to be excessive and unnecessary and not a permissible deduction under section 10(2)(xv) of the said Act. There is good deal to be said for this view. But here, again, the matter does not appear to have been raised either before the income-tax authorities or the High Court and we cannot, therefore, base our decision on this ground.'
This point was left open without any express decision by their Lordships of the Supreme Court. We have already explained the scope of the expression 'such mode of payment', which accords with one of the contentions pressed for acceptance in Commissioner of Income-tax v. M. K. Kirtikar.
In Commissioner of Income-tax v. Mulraj Karsondas at 566.) Shah, J., said :
'Undoubtedly, exemption from payment of tax under the notification is claimable in respect of sums paid out of or determined with reference to the commercial profits, but in computing even the commercial profits, the salaries paid to the employees must be taken into account. It is only after the expenses incurred for earning the profits are deducted that the commercial profits of a business can be ascertained, and if, for ascertaining the commercial profits, they salary paid to the employee is deducted, the salary will not be a sum paid out of or determined with reference to the profits of the business. In Jacquess case the court came to the conclusion that the amount paid to the assessee was not liable to be taxed in his hands; but in that case the amount sought to be taxed was received by the employee as bonus and not as salary. Payment by the employer of a sum of money to his employee as bonus is in its very nature gratuitous. It is made as a payment ex gratia having regard to the profits earned by him in his business and the services rendered by the employee, and in its very nature bonus is a payment out of the profits or determined with reference to the profits and is related directly to profits and is not deducted before ascertainment of the profits. R. R. Jacquess case is clearly distinguishable from the facts of the present case. In the present case, if the salary paid to the assessee is to be deducted from the gross earnings of the company before ascertaining the commercial profits, the payment to the assessee is not out of or determined with reference to the profits of the business. Again, the disallowance is not by reason of the mode of payment or determination of the salary out of the profits of the business; it is disallowed because it is not an expenditure laid out or expended wholly or exclusively for the purpose of the business.'
Thus with reference to the claim of Mulraj Karsondas, the learned judges were of the opinion that neither the second nor the third of the three cumulative tests we have enumerated above was satisfied. With reference to the scope of the third of the tests, that the disallowance must have been correlated to the mode of payment to the person claiming the exemption granted by the notification we are in respectful agreement with the view of Shah, J.
In the view we have taken that the third of the requirements was not satisfied in this case, it is not really necessary for us to examine whether the second test was satisfied, that is, whether what was paid to the petitioner was paid out of the profits of the business of Swami and Co., even construing the term 'profits' in the commercial sense.
We have held in effect that the Income-tax Officer and the Commissioner correctly construed the order of the Tribunal in deciding what was the ground on which the claim of Swami and Co. was disallowed. Even if that was incorrect, it would have been only an erroneous decision. But even independent of that as the disallowance of the claim of Swami and Co. was on a ground other than that for which alone the notification in question provided, the authorities were right in negativing the petitioners claim.
The rule nisi is discharged and the petition is dismissed with costs. Counsels fee Rs. 250.