Ajit K. Sengupta, J.
1. The assessee was a firm of chartered accountants and the assessee had undergone a change of constitution when some erstwhile partners retired from the firm and, in terms of the deed of retirement, certain specific items of outstanding fees were to be paid to the retiring partners after these had been collected by the present assessee. The Income-tax Officer, however, assessed these outstanding fees as the income of the present assessee on 'receipt basis' as the assessee's accounting system was cash.
2. In appeal by the assessee, the Appellate Assistant Commissioner of Income-tax held that the amount of Rs. 1,37,518 as has been added by the Income-tax Officer, cannot be the income of the present assessee as the said income was never received or else was receivable by the present assessee. He further held that the said amount of Rs. 1,37,518 as such cannot constitute income in the hands of the present assessee. The addition was, accordingly, deleted and the assessee got relief.
3. On second appeal by the Department, the Tribunal upheld the decision of the Appellate Assistant Commissioner holding that the assessee-firm is a distinct and separate entity vis-a-vis the firm on whose behalf the amount of Rs. 1,37,518 has been collected and, accordingly, on these facts, it cannot be said that the said amount can be treated as the income of the asses-see-firm as it existed during the accounting period relevant to the assessment year under appeal.
4. On these facts, the following question of law has been referred to this court at the instance of the Commissioner under Section 256(1) of the Income-tax Act, 1961 :
'Whether, on the facts and in the circumstances of the case, the Tribunal was justified in holding that the amount of Rs. 1,37,518 should not be included in the assessee's income for the relevant previous year?'
5. At the hearing, Mr. Moitra, learned advocate for the Commissioner, has contended that the assessee-firm received the amount in question and thereafter, distributed the same to the erstwhile partner. Accordingly, it must be treated as the income of the assessee-firm. He has also submitted that the assessee-firm maintains accounts on cash basis. Accordingly, whatever cash is received has to be accounted for in the account of the firm.
6. Mr. N.K. Poddar, learned advocate for the assessee, has submitted that, in view of the agreement between one of the partners of the present firm and the erstwhile partner, the amount received had to be paid to the erstwhile partner. The collection was made by the assessee-firm on behalf of the erstwhile partner. The assessee-firm has no right to retain any part of the amount which is earmarked for the erstwhile partner.
7. We have considered the rival contentions. The undisputed facts are that the total fees for the prior period realised during the accounting year came to Rs. 2,35,201 against which a sum of Rs. 62,428 has been claimed as payments to other firms for audit work done on behalf of the assessee-firm against the earnings of the above income. Thus the net amount of receipts on account of prior periods works out to Rs. 1,72,773 against which only a sum of Rs. 35,255 as mentioned above has been taken into account by the assessee in arriving at the disclosed income. In other words, a sum of Rs. 1,37,518 was not included in the income of the firm. The firms of Messrs. G. Basu and Co. (Calcutta) and Messrs. Tarmaster and Co. (Delhi) carrying on professional practice as chartered accountants had faced certain troubles on account of disputes and differences arising among the partners as a result of which the matter was referred to arbitration for settlement. Pursuant to an award of arbitration and in consequence of the deed of retirement dated March 30, 1970, the erstwhile partners, B. Mitra, N.C. Kundu and S.C. Basu retired from the firm with effect from December 9, 1969. In terms of the deed of retirement, the three retiring partners were to be paid certain amounts as their share of the firm's assets including goodwill and outstanding fees in full satisfaction of their right and interest in the firm.
8. As per the terms in the retiring deed, certain specific items of outstanding fees were directly assigned to the retiring partners and the balance amount as found payable to them were collected by the assessee-firm and paid over a certain period by instalments commencing on July 1, 1970. It was stipulated in para 3(b) of the agreement portion in the said deed of retirement that the outstanding fees falling to the shares of the retiring partners as and when collected would not form part of the receipts of the firm but shall be held by the continuing partners in trust for the retiring partners until payment was made in full to them. In the context of those facts, it is necessary to set out the relevant clause of the deed of retirement dated March 14, 1970 which, inter alia, provides as follows :
'Bimalanda Mitra, Nemai Chand Kundu and Sunilendra Chandra Basu (hereinafter referred to as the 'retiring partners') have retired from the partnership business of Messrs. G. Basu and Co. and Messrs. Tarmaster and Co. from close of business on the 8th October, 1969.
9. The firms of Messrs. G. Basu and Co, and Messrs. Tarmaster and Co. will be carried on by Arun Kumar Basu and Anil Kumar (hereinafter referred to as the 'continuing partners').
10. Arun Kumar Basu shall pay the following sums to the retiring partners in full satisfaction of all their claims for their rights, share of outstanding fees, goodwill, assets and other dues :
Rs.Bimalanda Mitra62,842Nemai Chand Kundu44,656Sunilendra Chandra Basu42,437
11. The above sums of Rs. 62,842, Rs. 44,656 and Rs. 42,437 as reduced by the outstanding fees assigned as per Clause 6 hereinbelow shall be paid as follows : Rs. 4,600 each to Bimalanda Mitra, Nemai Chand Kundu, Sunilen-dra Chandra Basu on the execution of a deed of retirement and the balance thereafter due to the respective retiring partners, namely, Rs. 58,242, Rs. 40,056 and 37,837 shall be paid in twelve equal quarterly instalments commencing from July 1, 1970, no interest being chargeable on such instalments and the outstanding fees as and when collected to the extent of the above sums will not form part of the receipts of the firm but shall be held by the continuing partners in trust for the retiring partners until payment in full to the retiring partners.
12. The payment of Rs. 58,242, Rs. 32,215 and Rs. 14,963 due to Bimalanda Mitra, Nemai Chand Kundu and Sunilendra Chandra Basu, respectively, falling due on the respective future dates as set out in the preceding paragraph shall be guaranteed by an insurance company of repute to the said recipients thereof individually within one month from the date hereof and this agreement is conditional upon such guarantee being given.'
13. It may be mentioned that the amount payable to the retiring partners as computed in the said agreement was considered by the Income-tax Officer. Apart from the aforesaid amount, other payments in terms of the deed payable to the retiring partners were also allowed. It may be mentioned that, under the said deed of retirement, the liability to pay the retiring partners was on the said A. K. Basu. As it appears in the deed of retirement, certain specific items of outstanding fees were directly assigned to the retiring partners and the balance amount as found payable to them were collected by the assessee-firm and paid over a certain period by instalments commencing on July 1, 1970. It was stipulated in para 3(b) of the deed of retirement that the outstanding fees falling to the shares of the retiring partners as and when collected would not form part of the receipts of the firm but shall be held by the continuing partners in trust for the retiring partners until payment was made in full to them.
14. These facts would clearly demonstrate that the outstanding fees relating to the retiring partners will be held in trust on account of the retiring partners and they are payable to the retiring partners. It cannot constitute the income of the assessee-firm. The question is not one of artificial stipulation in the deed of retirement with regard to the receipt of the outstanding fees, as contended by the Income-tax Officer. The question is whether there was any legal obligation on the part of the assessee-firm to the retiring partners. Under the agreement, when there has been division of assets and income of the firm earlier constituted, the assessee-firm cannot carry on the profession without fulfilling its obligation. The agreement is binding on the parties.
15. It is not a case of distribution or diversion of income after the income is received by the assessee. It is a case where the amount does not reach the hands of the assessee as its income. Every receipt is not income. It will depend on the nature and character of the receipt. It is true that no assessee can, by agreement, change the nature and character of the receipt. If the receipt is impressed with the character of income, whether it is distributed before or after the receipt is of no consequence. Similarly, where there is an obligation to pay and it has to be diverted by overriding title, it cannot be treated as income. These principles have been laid down by the Supreme Court in CIT v. Sitaldas Tirathdas : 41ITR367(SC) :
'In our opinion, the true test is whether the amount sought to be deducted, in truth, never reached the assessee as his income. Obligations, no doubt, there are in every case, but it is the nature of the obligation which is the decisive fact. There is a difference between an amount which a person is obliged to apply out of his income and an amount which by the nature of the obligation cannot be said to be a part of the income of the assessee. Where by the obligation income is diverted before it reaches the assessee, it is deductible ; but where the income is required to be applied to discharge an obligation after such income reaches the assessee, the same consequence, in law, does not follow. It is the first kind of payment which can truly be excused and not the second. The second payment is merely an obligation to pay another a portion of one's own income which has been received and is since applied. The first is a case in which the income never reaches the assessee, who even if he were to collect it, does so, not as part of his income but for and on behalf of the person to whom it is payable.'
16. The present case, in our view, is not one of application of a portion of income by the assessee to discharge its obligation. It is a case in which under the overriding charge or obligation, the assessee became only the collector of income for the erstwhile partners. The outstanding dues collected by the present firm did not belong to the firm at all. It belonged to the erstwhile partners.
17. Reliance has been placed on the decision of this court in CIT v. A. Tosh and Sons (P.) Ltd. : 166ITR867(Cal) . In that case the assessee carried on busines's in the purchase and sale of tea. In its said business, the assessee exported tea to foreign countries. At the material time, the assessee entered into agreements with foreign Governments and foreign Government authorities in the USSR, Poland, the United Arab Republic and Iraq for export of tea. Under the said agreement, the foreign buyers were liable to pay all taxes, duties and levies, Central and State. It was also provided that if and when an excise rebate was received by the assessee from the customs on export, the same would be remitted to the foreign buyers after obtaining approval from the Reserve Bank of India. The Income-tax Officer reopened the assessment on the ground that the income arising from the receipt of rebate on excise duty and duty drawback and interest on deposits of such rebate and drawback had escaped assessment for the said year. The matter went to the Tribunal and the Tribunal held that there was a diversion of benefit in respect of the said rebate and drawback even from the inception and there was an overriding title in favour of the foreign buyers. A contention was raised on behalf of the Revenue before this court that there was no diversion of the amount of excise rebate and drawback at source nor was there any overriding title of the foreign buyers in respect of the amounts and the assessee alone was entitled to the said amounts. Repelling the said contention, the Division Bench held as follows (at page 881) :
'On a consideration of the facts as found, the provisions of the relevant agreements between the assessee and its foreign buyers, the respective submissions of the parties and the decisions cited, it appears to us that, under the agreements it was made clear that the assessee would be entitled to receive the excise duty rebate and customs duty drawback only on account of the foreign buyers and not on his own account. Under the said agreements the assessee was also under an obligation to remit the said amounts received to the foreign buyers after obtaining the permission from the Reserve Bank of India. It follows that the said amount never reached the hands of the assessee as its own receipt or income. The assessee received the same on behalf of its foreign buyers and the foreign buyers were entitled to the same and to hold the assessee accountable for the same. Even if the permission of the Reserve Bank was not received for remittance of the said amount outside India, it was open to the foreign buyers to receive the said money in India and spend the same in India.
There is no reason why the principles laid down in the decisions cited on behalf of the assessee should not apply to the facts of the case. If such principles are applied, it would follow that the said amounts received on account of excise duty rebate and customs duty drawback were never the real income of the assessee.'
18. A similar question came up for consideration before the Madras High Court in V.N.V. Devarajulu Chetty and Co. v. CIT : 18ITR357(Mad) . In that case, it was found that, in September, 1940, five persons entered into a partnership. In October, 1942, two of them retired but the business was continued by the remaining three. At the time of retirement of the two partners, there was a forward contract of 336 bales of cloth subsisting and the profit and loss from this forward contract were not taken into consideration by the partners at that time. On September 29, 1943, two arbitrators were appointed to arrive at the proportionate profit of 317 bales which were dealt with by the firm by then and later on, on March 16, 1944, the arbitrators decided the proportionate profit on the balance of 19 bales. As a result of the arbitrators' award, during the year of account, Rs. 18,911-12-0 was paid to the partners who had left the firm in October, 1942. The accounting year of the applicants was from April 1, 1943, to March 31, 1944.
19. The claim of the applicants (appellants) before the Tribunal was that the partnership continued with regard to 336 bales and, therefore, Section 26(1) of the Income-tax Act was applicable. In other words, it submitted that though the partners had retired in 1942, it must be taken that with regard to this forward contract, they continued to be partners and the profits should be apportioned between them as they were entitled to receive the profits in the 'previous year'. It may be stated that the partnership deed executed by the new firm did not mention anything about the old partners continuing with regard to the 336 bales. During the whole of the relevant accounting year, the firm consisted of three partners only and the application of the firm for registration showed that the profits were shared only between three partners.
20. The Tribunal held that the mere fact that some moneys were paid to the old partners by the new firm as a result of certain arbitration could not affect the taxation of the firm ; as soon as the income was earned, tax was attracted and the Bench disallowed the claim of the applicants (appellants).
21. There, Viswanatha Sastri J., speaking for the court, observed as follows (at page 368) :
'The two old partners had each a three annas' share in the old firm. They had certain valuable rights in respect of the forward contracts for the purchase of piece-goods as the market was rising owing to war conditions. Their rights in respect of these contracts were isolated and reserved at the time of the dissolution on 31st October, 1932, when all other matters were settled. The goods arrived and were taken delivery of and sold by the new firm at a considerable profit. Under Section 37 of the Partnership Act, the retiring partners had a right to a share of those profits which were made by the new firm with the assets of the old firm. Consequently, that part of the profits payable to the old partners by the new firm under an obligation imposed by law was not in truth the income, profits and gains of the new firm.'
22. The Division Bench also considered the matter from another angle and observed thus (at page 368) :
'The matter may also be looked at in this way. The arbitrators decided that the sum of Rs. 18,911-12-0 should be paid to the retiring partners by the new firm in respect of the rights of the former under these forward contracts and in consideration of the new firm handling and disposing of the entire 334 bales as part of their stock-in-trade. This sum was paid out of the profits made by the new firm and was paid because the new firm had made profits out of the sale of the 334 bales delivered under the contracts entered into by the old firm. This sum was really part of the price paid by the new firm to acquire full exclusive title to the goods from the old partners and it must be remembered that the goods so acquired were the stock-in-trade of the new firm which sold the goods and thereby made a large profit. If instead of taking cash the two old partners who had themselves started their own piece-goods business had taken delivery each of 3/16ths share of the goods delivered under the forward contracts and sold the goods on their own account, they would well have been within their rights and made a profit directly. In such an event, the new firm could only have sold 10/16ths of the total number of bales and their profits would have been proportionately less. Instead, the new firm acquired the entire quantity of the goods by paying the retiring partners the sum of Rs. 18,911 which according to the award of the arbitrators represented the percentage of the profits payable to the old partners for their having parted with the goods or their right in the goods in favour of the new firm. The sum though paid as representing the old partners' share of the profits was really the price paid by the new firm for the acquisition of an exclusive right to the goods which formed the stock-in-trade and is, therefore, a revenue expenditure laid out solely and exclusively for the business of the new firm.'
23. Reliance has also been placed on the decision of IRC v. Hogarth  23 TC 491. In that case, 'in 1934, one of the partners of the firm of which the respondent was a member became seriously ill and was unable to attend to the business. In the absence of a provision for retirement in the partnership deed, an agreement was concluded in January, 1937, under which the partner retired as at 31st December, 1936, and 'in full settlement of his whole share ... in the capital, assets and profits of the business he was to be paid, inter alia, 'a sum equal to one-fourteenth part of the net profits of the business for the three years ending 31st December, 1937, 1938 and 1939, under deduction of income-tax.
24. The retiring partner died on 12th February, 1937. Certain payments were made to his representatives under the agreement, including an item, paid in May, 1938, of 2,389 representing, after deduction of income-tax, 1/14th of the net profits of the business for the year to 31st December 1937.
25. The respondent claimed his share of the gross sum corresponding to this net payment as a deduction in the computation of his income for surtax purposes for 1938-39. It was contended on behalf of the Revenue that under the head of the agreement providing for the payment in question one sum only was payable and that this sum was a capital sum in respect of which no deduction was due.'
26. In that case, the court held that the payment was an admissible deduction for purposes of surtax, as claimed by the respondent.
27. The court observed as follows (p. 503 of 23 TC):
'I accordingly reach with your Lordship the view that on a sound construction of this agreement Mr. Henderson became entitled year by year after the execution of the agreement to claim from the firm over a period of three years a share of the profits which kept exact step with the share which would have fallen to him had he not consented to retire. It is further in favour of the view that this was an income payment in annual form and was not a payment of capital, that it is expressly stipulated in the agreement that the sum payable to Mr. Henderson shall be a sum under deduction of income-tax. It is of course quite possible to make a capital payment measured by reference to the profits of a firm; but if the payment is indeed to be a capital payment, it seems wholly inept to measure it by profits which have been taxed rather than by gross profits. I accordingly find in this stipulation for payment of income-tax a strong argument in favour of the respondent's contention. It has been observed that on such a question we should have regard to the substance of the transaction ; and again it has been observed that a capital sum may be payable by instalments, and that accordingly a recurring series of payments in contrast to a single payment is not conclusive of the question of whether the sum payable be capital or income. At the same time I think that although a capital payment may be made by instalments this is likely to be exceptional, and that a series of recurring payments is per se a strong indication that the right which has passed is an income and not a capital right. But if one turns to the substance of this transaction, a similar conclusion is suggested by the object and purpose of the agreement itself. This is a case of a partner being called on to retire for reasons of health and being in dispute with his partners as to whether he is subject to be called on so to retire. Under the agreement of co-partnery, if those who call on him to retire are right, he loses as at the date of retiring all interest in the profits of the firm. II, on the other hand, he is right in maintaining his position as a partner of the firm, he continues with an indefinite right over an unmeasured term of future years to enjoy year by year his share in the profits of the firm. It is an immediate determination of his right to profits on the one hand ; and continuance without definite term of his share of profits on the other. What is in issue is his right to an income and a claim against capital. The partners could have settled the matter by arbitration. They preferred to settle it by compromise, and the agreement of 14th January, 1937, is an agreement to compromise any conflicting claims. In form it provides, inter alia, for three instalments of a share of the profits calculated on the share which would have been enjoyed by Mr. Henderson as a continuing partner. On the interpretation that your Lordship has arrived at--and at which I also arrive--these instalments were to be paid year by year. This seems to me much more like a continuing income right calculated upon the income right of the past, although limited for a period of years, than like a single capital payment measured by similar income instalments over the first three years following on his retiral. For these reasons I agree with your Lordship in holding that the decision of the Special Commissioners was right, and for the reasons your Lordship has given I do not find myself in any way perplexed by the decisions or the observations in the two cases which were cited.'
28. The principles are thus well-settled. An obligation to apply the income in a particular way before it is received by the assessee or before it has accrued or arisen to the assessee results in diversion of the income: It is necessary to decide, in the context and setting of the facts of a case, as to whether the disbursement in question amounts to diversion of income or not. The test is to find out whether the amount sought to be deducted did or did not reach the assessee as his own income. Obligations there are in every case, but it is the nature of the obligation which is the decisive test. In the instant case, there is a legal obligation in terms of the deed of retirement to pay in a particular manner to the erstwhile partners in respect of realisation of fees after their retirement. This is an instance of the source being subject to an obligation. The mere collection of income where obligation is attached to the source of such income cannot be taxed as it can never be income, far less a real income.
29. For the reasons aforesaid, we answer the question in this reference in the affirmative and in favour of the assessee.
30. There will be no order as to costs.
J.N. Hore, J.
31. I agree.