JAGADISAN J. - The question that has been referred to us under section 66 of the Indian Income-tax Act is : 'Whether the sum of Rs. 65,802, being part of the amount due from the Alwaye Textiles Ltd., as per decree of court and not realised is properly a trade debt allowable as a bad debt in the computation of the income for the assessment year 1952-53 ?'
Somasundaram Mills Ltd., which will hereinafter be referred to as the assessee, is a private limited company incorporated under the Indian Companies Act. The company is carrying on business in spinning and weaving cotton yarn at Coimbatore. The assessee is also a partner in three registered firms of partnership, Messrs. Krishna Ginning Factory, Messrs. Somavilas Ginning Factory and Messrs. Sundaravilas Ginning Factory, holding 7/8, 8/12 and 1/12 shares in each of the three concerns respectively. In this reference, we are not concerned with any question relating to the share income of the assessee in these partnership firms. We are only concerned with the business activities of the assessee in regard to its own business as textile manufacturers. Between the years 1943 to 1945, the assessee sold goods (stock-in-trade) and certain items and pieces of machinery to Messrs. Alwaye Textile Ltd. During the same period the assessee had also made cash advances to Messrs. Alwaye Textile Ltd. As a result of these transactions Alwaye Textile Ltd. became indebted to the assessee in a total sum of Rs. 3,55,323; the particulars of this total indebtedness are as follows :
Value of goods supplied
Sale price of machinery sold
Loans and cash advances
Alwaye Textiles Ltd. defaulted to pay and the assessee filed a suit against it and obtained a decree for a sum of about Rs. 4,79,228. Even thereafter the decree remained undischarged and the assessee assigned and transferred the decree to Messrs. S. Kathayee & Co. receiving a sum of Rs. 1,50,000. It appears that the assessee received some further amounts also towards this decree. It is now common ground that the assessee was able to recover in all a sum of Rs. 1,61,771 towards the amounts due to it from Alwaye Textiles Ltd. We must mention at this stage, before continuing the narration, that in accordance with the assessees books of account the written down value of the machinery sold as on January 1, 1944, was Rs. 38,981. They were sold for Rs. 1,20,000 resulting in a profit to the assessee to the extent of Rs. 81,019 (Rs. 1,20,000 minus Rs. 38,981). This amount less Rs. 5,080 assessed under section 10 (2) was treated as capital gain or accretion by the department and was not assessed to tax. Section 12B, which came upon the statute book for the first time by the Income-tax and Excess Profits Tax (Amendment) Act, 1947, rendered capital gains as a subject of taxation only in respect of any profits or gains arising from the sale, exchange or transfer of a capital asset effected after March, 31, 1946, and before April 1, 1948. The present section 12B was introduced by the Finance Act of 1956, and now tax is payable by an assessee under the head 'capital gains' in respect of any profits or gains arising from sale, exchange or relinquishment of capital asset effected after March 31, 1946. It is clear that the sale of machinery by the assessee to Alwaye Textile Ltd. did not result in income, profits or gains chargeable to tax, nor 'capital gain' within the meaning of section 12B which as stated came into force only from 1947. The assessee having waited sufficiently long hoping to realise the decree in full and finding ultimately that the decree amount was irrecoverable wrote off the sum of Rs. 1,93,552 as bad debt on December 31, 1951. The accounting year of the assessee is the calendar year and the assessee wrote of the debt as bad in the year of account ending with December 31, 1951. The relevant assessment year for the previous calendar year 1951 is 1951-52 is 1952-53. It is in the assessment of its income in respect of the assessment year 1952-53 that the claim was made by the assessee to deduct this amount of Rs. 1,93,552 as a bad debt written off. The property of the writing-off is not called in question by the department as the amount really become irrecoverable from Alwaye Textile Ltd.
Before the Income-tax Officer it was conceded by the assessee, very properly, that loans and cash advances made to Alwaye Textile Ltd. were not incidental to the manufacturing business and could not be treated as trade debts liable to be written off. The assessee however claimed deduction under section 10 (2) (xi) of the Act in respect of a proportionate part of the sum of Rs. 1,03,552 attributable to the value of goods supplied and machinery sold. The Income-tax Officer upheld the assessees claim only in so far as it related to the value of the stock-in-trade sold, namely, Rs. 19,388. He apportioned the receipt, Rs. 1,61,771, between 'trade' and 'non-trade debt' and worked out the figure of Rs. 8,987 as deemed to have been received towards Rs. 19,388. The excess of Rs. 19,388 over Rs. 8,987, namely, Rs. 10,401, was allowed to be written off as bad debt.
In the appeal to the Appellate Assistant Commissioner by the assessee it was contended that the price of machinery sold taken as Rs. 1,20,000 not having been recovered in full, the unrecovered part thereof should also be treated as bed debt. The value of goods (stock-in-trade) and machineries sold was taken as Rs. 1,40,000 by rounding off the total of Rs. 19,388 plus Rs. 1,20,000. Out of the realisation of Rs. 1,61,771 the proportion referable to Rs. 1,40,000 was calculated as Rs. 63,797. The irrecoverable part of Rs. 1,40,000 was therefore Rs. 1,40,000 minus Rs. 63,797, that is, Rs. 76,203. This was held to be a bad debt by the Appellate Assistant Commissioner. The Income-tax Officer had already allowed Rs. 10,401. The Appellate Assistant Commissioner allowed a further amount of Rs. 65,802 to make up the total bad debt of Rs. 76,203. In the opinion of the Appellate Assistant Commissioner the sale of the machineries was a transaction in the normal course of the assessees business of manufacture and sale of yarn and textiles and that the amount due from Alwaye Textile Ltd. by such sale was a trade debt falling within the ambit of section 10 (2) (xi).
The department filed an appeal against the decision of the Appellate Assistant Commissioner to the Tribunal which however affirmed that decision on a reasoning of its own different from that of the Appellate Assistant Commissioner. The view of the Tribunal is that the liability of the debtor, Alwaye Textiles Ltd., was under a decree of court on the date of the writing off, and that was sufficient to constitute it as a trade debt susceptible of being brought under section 10 (2) (xi), and that it was not necessary to look into the origin of that decree debt. Whether this view is sound or not we shall consider later in this judgment. The Tribunal further observed that the assessee having received the machinery back from Alwaye Textiles Ltd., and having discarded it as outmoded and useless could claim the deduction asked for. The Tribunal of course does not state under what provision of section 10 this can be permitted. If the Tribunal thought that the return of the machinery by the debtor to the assessee would stamp the character of the debt as a trade debt it has certainly gone wrong and this decision is manifestly erroneous. Notwithstanding the expression of this opinion by the Tribunal holding that in some way the assessee is entitled to have the allowance claimed, the question still remains whether the matter is one which is within section 10 (2) (xi). On the application of the department under section 66 (1) of the Act the question set out already has been referred to this court.
The short question that arises for decision is whether the assessee is entitled to claim the deduction under section 10 (2) (xi). That provision reads as follows :
'Such profits or gains shall be computed after making the following allowances, namely :- ..... (xi) when the assessees accounts in respect of any part of his business, profession or vocation are not kept on the cash basis, such sum, in respect of bad and doubtful debts, due to the assessee in respect of that part of his business, profession or vocation, and in the case of an assessee carrying on a banking or money-lending business, such sum in respect of loans made in the ordinary course of such business as the Income-tax Officer may estimate to be irrecoverable but not exceeding the amount actually written off as irrecoverable in the books of the assessee :
Provided that if the amount ultimately recoverable on any such debt or loan is greater than the difference between the whole debt or loan and the amount so allowed, the excess shall be deemed to be a profit of the year in which it is recovered, and if less, the deficiency shall be deemed to be a business expenses of that year.'
The assessee is not carrying on business in banking or money-lending. The second part of the section relating to the assessees, who are bankers or money-lenders, is not applicable to the present assessee, and, therefore, its proper construction need not be considered. The assessees accounts are not on the cash basis, being on mercantile basis, and one of the conditions laid down in the first part of the section is satisfied. The controversy between the revenue and the assessee is whether the debt, which has become indisputably bad, is in respect of the business. The revenue contends that it is not in respect of the assessees business which consists only of spinning and weaving activities and which does not comprise of any trade in the buying and selling of machineries. In other words, the contention of the revenue is that the words 'in respect of' should not be construed as referring to any transaction leading to a bad debt provided that it is in some way associated or related to the business but should be construed as 'incidental' to the trade. According to the department an obvious capital loss like loss of value of capital asset cannot be brought within section 10 (2) (xi). The point of view urged by the assessee is that in whatever manner the debt may arise, if it is not de hors the business, but is connected with the business irrespective of the nature of the degree of such connection, it should be held to be in respect of the business, and that any other interpretation would be restrictive of the generality of the words used. The assessees further submission is that any enquiry whether the loss resulting from the bad debt is of a revenue or capital nature would not be germane to a consideration of the applicability of section 10 (2) (xi).
Before dealing with the rival contentions set out above, we shall examine the soundness of the view-point of the Tribunal. The formula devised by the Tribunal to resolve problems under section 10 (2) (xi) is attractively simple. It is this : if the assessee had a debt to recover and this is merged into a decree of court, and that decree becomes futile, wholly or partly, a bad debt arises in whole or in part, as the case may be, provided that the debt was due to the assessee in his capacity as a trader or businessman; the origin and nature of the debt and its character whether capital or revenue need not be investigated or ascertained. This view of the Tribunal is clearly untenable, and in fairness to the learned counsel for the assessee, we must observe that we did not understand him to support it. This view is in the teeth of the section. If the assessee, who is not a banker or money-lender, and whose stock-in-trade is not money, lends money taken out of the business, for a purpose not connected with the business, surely such a debt cannot be claimed to be within the section if bad and irrecoverable only on the ground that a decree has been obtained by the assessee. This certainly is an extreme illustration, but we are giving it to emphasise the fallacy underlying the Tribunals view.
The allowances provided for under section 10 (2) in the computation of assessable profits or gains of a business, profession or vocation are generally of revenue nature. Depreciation allowance in respect of buildings, machinery, plant or furniture is of an exceptional kind and that is perhaps the solitary instance where a capital loss is charged against the revenue receipt. It is true that while an expenditure in the nature of capital expenditure is specifically excepted under section 10 (2) (xi) no such express provision is found in the words of section 10 (2) (xi). The scheme of the Act regarding deduction of allowances in the computation of profits seems to rest on the basis that what may be called the cost of earning the income should not be taxed including it in the profits as such inclusion would really mean the taxation of gross receipts and not profits in the sense in which the expression is understood in the commercial world. The observation of Lord Halsbury in Gresham Life Assurance Society v. Styles that the term should be understood in the ordinary commercial sense or in a sense in which no commercial man would misunderstand has not only become classical, but has been treated and affirmed as a well settled rule of income-tax law.
Now looking at the provisions of section 10 (2) (xi), and examining it closely, it seems to us that a capital loss cannot be claimed to be written off under the guise of a bad trade debt. The condition enunciated in the first part of the section, that the assessee must have maintained the accounts not on the cash basis to make him eligible for deduction of a bad debt, is indeed significant. Where an assessee keeps his accounts on the mercantile system, he is obliged to pay tax on accrual basis in regard to his income. What is legally due to the assessee is brought in as credit though not actually received and what is incurred as a legal liability is debited as expenditure without having been actually disbursed. It is the profit earned but not received or the loss sustained but not paid that comes in for computation and assessment under this system. In the cash system of accountancy, what is reckoned is the actual receipt and disbursement. The profit or loss is the difference between such receipts and expenses. The assumption underlying the principle of allowing a bad debt as a revenue charge is that it would have figured as a revenue credit before the year of write-off and would have suffered tax and that therefore it is only just and proper that it should be treated as a revenue loss when it becomes irrecoverable.
In regard to bankers and money-lenders the system of accounting does not matter, whether it be the cash basis or the mercantile basis, as money is their stock-in-trade. A loss of stock-in-trade is certainly a revenue loss, and that should go in deduction in the computation of the assessment to tax. It is quite clear that a trade debt which is sought to be written off should be of such a nature that it could be brought on the credit side of the profit and loss account, and if so brought would swell the profits of the assessee. An assessee cannot call that a trade debt which at the inception when it was good was not treated and dealt with as income receipt.
Now the question is whether the assessee can be said to have failed to realise a trading receipt by reason of its failure to recover the decree amount fully from Alwaye Textiles Ltd. What the assessee sold to the Alwaye Textiles Ltd. was certainly a capital asset. The assessee treated the excess of sale price over the written down value of the machineries as capital gain not chargeable to tax. It is enough to point out that the assessee did not treat it as income, profits or gains. The mere fact that the assessee was obliged to sue Alwaye Textiles Ltd. for recovery of the money due on a sale of capital asset cannot in the least alter the character of the asset. If the Alwaye Textiles Ltd. had paid the full sale price, the receipt in the hands of the assessee would have been of a capital nature. This is beyond question. The course of transactions between the assessee and Alwaye Textiles Ltd. in regard to the sale of the items of machinery led only to the conversion of the machineries into a decree debt, and not to convert a capital asset into a revenue receipt. Before the sale the capital asset was in the shape of machineries and after the sale it became transmuted into an outstanding due to the assessee.
There is no evidence in the case that the items of machinery were sold by the assessee in the usual course of business operations substituting good and efficient machineries in the place of bad and unworkable machineries. Learned counsel for the assessee at one stage of his arguments submitted that the sale was part of the business operations of the assessee and sought to support it by the fact that the assessee got back the machineries from Alwaye Textiles Ltd. in 1952 and they were lying as mere scrap in its custody. Even assuming that the machineries became useless in 1952, that cannot evidence the necessity for sale of the items in or about 1943. We must observe that there is a singular lack of evidence in the present case as to why the assessee parted with the machineries to Alwaye Textiles Ltd. and as to how and why it got back the machineries in 1952. Apart from the fact that the machineries belonged to the assessee and were sold away in 1943 to Alwaye Textiles Ltd., there is nothing to show that the sale transaction was incidental to the assessees manufacturing business or that it was in respect of such business.
The words 'in respect of' mean 'in the matter of'. It is true that while the first part of section 10 (2) (xi) uses the expression 'in respect of', the second part of it uses the expression 'in the course of'. A decision of the Bombay High Court in Commissioner of Income-tax v. Abdullabhai Abdulkadar has been cited. In that case the assessee was a firm which was carrying on business as commission agents of a non-resident principal. Under section 42 (1) of the Income-tax Act an agent of a non-resident can be assessed to tax in respect of the income of such non-resident. The department made such an assessment and recovered the tax of about Rs. 3 lakhs from the resident commission agent. The assessee was unable to recoup this amount from the non-resident and in the year of account concerned in that case wrote it off as bad debt or trading loss. The question was whether the debt was a trade debt within the meaning of section 10 (2) (xi) of the Act. In construing the provisions of section 10 (2) (xi), Chagla C.J. observed thus at page 78 :
'Now, in the first place, the Legislature has not used the expression in section 10 (2) (xi) in the course of business. It has used the expression with a wider connotation and the expression is in respect of the business. Therefore, what the Legislature required was that there must be a connection between the debt and the business, and it is difficult to understand how in this particular case it could possibly be urged that there is no connection between the business of the assessee and the debt which has become a bad debt...... It is perfectly true that, even giving to the expression in respect of the widest connotation, the debt must be incidental to the business.'
The actual decision in the Bombay case has been reversed by the Supreme Court in Commissioner of Income-tax v. Abdullabhai Abdulkadar.
With respect we agree with the learned Chief Justice that the particular debt should be incidental to the business before it can fall within the ambit of section 10 (2) (xi). But if the learned Chief Justice meant to lay down that it would be sufficient if there is some connection between the debt that it would be sufficient if there is some connection between the debt and the business, however weak and slender the connecting link may be, with respect, we cannot agree. In this regard we are supported by the decision of the Supreme Court in the above case. A debt can be incidental to a business only if it arises out of a transaction, which was necessary in furtherance of the business and was within the range of the business activities. Everything associated or connected with the business cannot be said to be incidental thereto. Not merely should there be a close proximity of the debt to the business as such, but it should also be an integral and essential part of the carrying on of the business.
Learned counsel for the assessee relied upon the decision of the Patna High Court in Sitalpore Sugar Works Ltd. v. Commissioner of Income-tax. In our opinion that decision does not lend any support to the assessee in the present case. The facts in that case were that the assessee which was a manufacturing company carrying on the business of sugar manufacture sold a machinery to another company called Lakshmiji Sugar Mills Ltd. The sale was necessitated by the fact that there was no prospect of obtaining adequate sugarcane in the area in which the assessee was carrying on business on account of the introduction by the Government of the zoning system. The terms of the sale effected by the assessee were that the purchaser should pay half the amount, namely, Rs. 2,57,500, by March 31, 1939, and that the other half should be paid in equal installments on March 31, 1940, and March 31, 1941. These installments carried interest at the rate of 5 per cent. The purchaser executed a mortgage bond in respect of the installment payments undertaken by him. The purchaser paid promptly the sum of Rs. 2,57,500 before March 31, 1939. The purchaser also paid interest for the installment amount between the years 1939 to 1942. The interest received by the assessee from the purchaser was assessed to income-tax. In 1941 due to the default of the purchaser in fulfilling the terms of the bargain, the assessee had to file a suit on the mortgage. The parties entered into a compromise and the purchaser paid in all Rs. 2,66,000 in full satisfaction of the claim due on the mortgage bond. The total amount claimed by the assessee was Rs. 2,99,353 and the result of the compromise was that the assessee had to remit a sum of Rs. 33,343. It is clear from this narration of the facts that the assessee realised the principal amount due under the mortgage but what was ultimately forgone was only a part of the interest due. This is made clear by the terms of the question referred to for the opinion of the High Court which was in these terms :
'Whether the department having previously taxed the interest income of Rs. 41,843-12-0 during the years 1938-39 to 1941-42 on mercantile basis as business income the amount of Rs. 33,343 realised short subsequently as interest can be allowed as a deduction ?' The Patna High Court held that the transaction was a proper trading transaction in the course of the normal business of the assessee, that the loss resulting to the assessee from the shortfall was eligible to be treated as a bad debt under section 10 (2) (xi). We respectfully agree with the principle of the decision. It is obvious that the interest forgone by the assessee had attracted tax in its hands as the mercantile system of accountancy had been adopted. The loss consequent on the non-realisation of the interest amount was certainly in the nature of a revenue loss. The finding of the court was that on the facts and circumstances of that case the sale of the machinery constituted a trading activity. We do not think that that decision can at all apply to the present case.
In our opinion, the question referred to us should be answered against the assessee and in favour of the department.
Mr. R. Venkataraman, learned counsel for the assessee, submitted that the assessee had raised an alternative contention before the Appellate Assistant Commissioner and the Income-tax Appellate Tribunal, which however was not considered in view of the finding that the claim for deduction was permissible under section 10 (2) (xi) of the Act. This alternative contention was that the machinery sold having come back to the assessee itself, the written down value of Rs. 38,981 as also the profit limited to depreciation allowance of Rs. 5,180 together making up Rs. 44,061 should be allowed as a loss in the computation of the income. We are not expressing any opinion on this aspect of the matter. It will be open to the Tribunal to consider this question and give relief to the assessee if the claim is well founded.
The reference is answered against the assessee, and the department will be entitled to its costs. Counsels fee Rs. 250.
Reference answered against the assessee.