Full Judgment Text
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PETITIONER:
BHARAT BEEDI WORKS (PRIVATE) LIMITED AND ANR.ETC. ETC.
Vs.
RESPONDENT:
COMMISSIONER OF INCOME-TAX
DATE OF JUDGMENT07/05/1993
BENCH:
JEEVAN REDDY, B.P. (J)
BENCH:
JEEVAN REDDY, B.P. (J)
VENKATACHALA N. (J)
CITATION:
1993 AIR 1751 1993 SCR (3) 606
1993 SCC (3) 252 JT 1993 (3) 526
1993 SCALE (2)896
ACT:
Income-Tax Act 1961--S.40 (c)--Partners in firm also
directors in a company--Whether royalty payments by company
to firm falls within s. 40 (c)--Held, Payments are
consideration for a valuable right parted by firm/
partners/directors of the assessee--Company a favour of
assessee--Where agreement whereunder payments made not mere
device or screen, it cannot be treated as payments made to
directors qua directors--S.40(A) (2).
HEADNOTE:
A partnership firm consisting of three partners was engaged
inter alia in the business of manufacturing and sale of
beedies under the brand name "Mangalore Prakash Beedies".
On May 20,1972 a private limited company called prakash
beedies Ltd. the assessee-appellant was incorporated. One
of its objects was to take over the business of the
aforesaid firms which it did under an agreement dated 15
July 1972 whereby the firms sold its rights and assets to
the company. For the use of the trade name, a royalty at
10p. for every 1000 beedies was to be paid by the company to
the firm. This payment was made ever year by the assesse on
account of royalty. The three partners of the firms were
also directors of the company.
The relevant assessment years were 1974-75 and 1975-76. The
facts in the other appeals are similar.
The assessee claimed deduction of the amount paid by it as
royalty. The ITO allowed the deductions as claimed. The
CIT in stio motu proceedings disallow the aforesaid
deductions. On appeal, the tribunal restored the order of
the ITO.
On reference, the High Court answered in fan,our of the
revenue as the three directors of the assessee company were
also partners in the firm. It held that in law, a firm is
merely a collection or association of individuals for
carrying on a business. Merely because the firm is an
assessable entity, under the Income Tax Act, it does not
follow that it is a juristic or legal entity. It must
therefore be held that the payments to the firm were in
reality made to the
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directors, thus attracting S. 40 (c).
Before this Court, it was contended for the assessee that
payment to a firm is not ipso fact payment to the partners,
directly or indirectly. In any event, the payments were
made to the three persons not in their capacity of directors
(qua directors). but in consideration of a valuable right
parted by them in favour of the assessee-company. S. 40(c)
was never intended to take in such payments. They relied on
the budget speech of the Finance Minister and argued that
the principle of interpretation noscitor a sociis must be
applied to the words "remuneration, benefit or amenity".
The genuineness or validity of the agreement, the factum of
payments as royalty, and that the brand name carries
significant business value was not disputed. The question
before this Court was whether the royalty payments fail
within S. 40(c).
Allowing the appeal, this Court,
HELD : 1. Even assuming that the payments to firm were
payments to partners, the said payments did not fall within
S. 40(c). The payment,-. were made In consideration of a
valuable right parted by the firm/partners/ directors of the
assessee-company in favour of the assessee. So long as the
agreement whereunder the said payments were made is not held
to be a mere device or a mere screen, the said payments
cannot be treated as payments made to the directors (qua
directors). (613-H, 614-A)
The payments were made by way of consideration for allowing
the to use a valuable right belonging to them viz. the brand
name. Such a payment may be liable to be scrutinised under
sub-section. (2) of section 40 (A), but it certainly did not
fall within the four corners of section 40(c). (614-A)
T.T. (Pvt.) Ltd. v. ITO Bangalore 121 ITR 551, approved.
CIT Patiale v. Avon Cycles (p) Ltd. 126 IT R 448 and India
Jute Co. Ltd. v. CIT 178 ITR 649, referred to.
2. The power vested in the ITO is to determine whether any
expenditure of allowance is excessive or unreasonable having
regard to the legitimate business needs of the company and
the benefit derived by the assessee or
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accruing therefrom. Any payment to a relative of a director
or other persons mentioned in clause (c) will necessarily be
examined applying the above test and if it is found that
they are unwarranted, unreasonable or excessive, they will
be disallowed. Such a situation does not arise herein.
(615-C)
CIT, Bombay v. M/s. Indian Engineering and Commercial
Corporation (p) Ltd. [1983] distinguished. JT 683.
JUDGMENT:
CIVIL APPELLATE JURISDICTION: Civil Appeal No. 1452 of 1987.
From the Judgment and Order dated 10.7.1986 of the Kamataka
High Court in I.T.R.C. No. 198 of 1987.
WITH
C.A. Nos. 4462/89, 1822, 1902, 1465/87, 675, 658, 4461/89,
6093/90, 6204/ 90, 6092. and 6092 A of 1990.
H. Salve, P.H. Parekh, Ms. Meenakshi Grover, R. Nariman, Ms.
R. Gill and Ms. Simi Kr. for the Appellants.
B.B. Ahuja, Ranbir Chandra and Ms. A. Subhasini for the
Respondent.
The Judgment of the Court was delivered by
B.P. JEEVAN REDDY J. These appeals are preferred against the
judgment of the Karnataka High Court answering the question
referred to it, at the instance of the revenue, in favour of
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the revenue and against the assessee. The question referred
under section 256 of the Income Tax Act, 196 1, read as
follows: "Whether on the facts and in the circumstances of
the case, the Tribunal was right in holding that the sum of
Rs. 1, 79, 742 could not be disallowed under section 40 (c)
of the Income Tax Act, 1961." (The above question related to
Assessment Year 1974-75. The question referred for A.Y.
1975-76 was identical except in the matter of amount).
Since the facts in all the appeals are identical it would be
sufficient to notice the facts in C.A. Nos. 6092 and
6092A/90 (Prakash Beedies (P) Lid. v. Commr. of Income Tax.
Karnataka, Bangalore).
Prior to 15.7.1992, a partnership firm called K.M. Anand
Prabhu & Sons, Mangalore, consisting of three partners K.M.
Vishnudas Prabhu, K.M. Ramdas Prabhu and K.M. Shankar Prabhu
was engaged inter alia in the business of manufacturing and
sale of beedies under the brand name ’Mangalore Prakash
Beedies’. On May 20, 1972 a Private limited company called
Prakash Beedies
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Limited (the assessee-appellant herein), was incorporated
with its registered off-ice at Manoalore. One of its
objects was to take over business of the aforesaid firm.
Under an agreement dated July 15, 1972 between the firm and
the company, the firm sold its rights and assets to the
company on the terms and conditions set out therein. Clause
4(a) of the agreement, which alone is material for the
purposes of these appeals reads:
"(a) For the use of the trade name the Company
shall pay royalty to the Vendor at the rate of
10ps. for every thousand beedies sold by the
Company by using the trade name of the Vendor.
The royalty shall be worked out at the end of
each quarter ending on March, June, September
and December, on the sales made during each
quarter. The royalty fixed hereby shall not
be varied for a period of one year and may be
reviewed and/or revised thereafter wards from
time to time".
The assessee was making payments to the firm every year on
account of royalty in terms of said clause.
The three partners aforesaid of the firm were also the
directors of the assessee- company.
For the assessment years 1974-75 and 1975-76, the assessee
claimed deduction of the amount paid by it to the firm on
account of royalty in terms of clause 4(a) of the agreement.
The amounts paid during the accounting years relevant to the
said assessment years were Rs. 3, 16, 526 and Rs. 3, 95, 742
respectively. The I.T.O. allowed the deductions as claimed.
In exercise of the powers conferred on him by Section 263,
the Commissioner of Income Tax initiated (suo moto)
proceedings for revising the said assessments in so far as
the aforesaid deductions were concerned. After hearing the
assessee, he passed orders on September 16, 1976 whereunder
he disallowed payments to the firm over and above the
ceiling prescribed in Section 40(c). The assessee preferred
appeals to the Tribunal against the orders of the I.T.O, The
appeals were allowed and the orders of the I.T.O. restored.
On reference, the High Court answered to question in the
negative i.e., in favour of the revenue and against the
assessee, on the following reasoning : the three directors
of the assessee company were also the partners in the firm
to which royalty payments were made. In law, a firm has no
separate legal existence; it is not a juristic person or a
distinct legal entity. It is merely a collection or
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association of the individuals for carrying
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on a business. Merely because the firm is an assessable
entity under the Income Tax Act it does not follow that it
is a juristic or legal entity. It must, therefore, be held
that the payments made to the firm are in reality payments
made to the directors. Such payments clearly attract and
fall within the mischief of Section 40(c). The Commissioner
was right in saying so and the opinion of the Tribunal to
the contrary is unsustainable in law.
In these appeals, S/Shri Harish N.Salve and Rohinton Nariman
assailed the correctness of the view taken by the High
Court. They submitted firstly that the payments were made
not to the directors of the assessee but to a firm which was
a separate entity. A payment to a firm is not ipso facto a
payment to the partners, directly or indirectly. In a firm
there may be other partners besides the directors of the
assessee-company. It may also happen that the firm has no
income to distribute because of the losses incurred by it
which are set-off against the income so received. The High
Court was in error in holding that payment to a firm is a
payment to the partners. Assuming that a partnership firm
is not a separate juristic entity distinct from its
partners, even so the payments were made to the said three
persons not in their capacity as directors (qua directors)
but in consideration of a valuable right parted by them in
favour of the assessee-company. Such payments do not and
cannot fall within the mischief of Section4O(c). Section
40(c) was never intended to take in such payments. A
company may take on lease the house of its directors for its
legitimate business purposes and pay rent which is
reasonable having regard to the market conditions, or it may
pay even less than the market rate of rent. Whether the
rent paid by the company to its director in such a case
falls within Section 40(c), ask the counsel. Another
illustration given by the counsel is where a director
supplies raw material to the assessee-company for a price
which is the appropriate market price. Would such payment
also fall under section 40(c), they ask. The Budget speech
of the Finance Minister in the Parliament, while introducing
the said provision, is relied upon in support of their
contention. It is also argued that the words "remuneration,
benefit or amenity" occurring in Section 40(c) must be read
having regard to the context in which they occur applying
the principle NOSCITORA SPCOOS (recognition of associated
words). If so read, the payments in question can never fall
within the ambit of the said words.
Shri Ahuja, the learned counsel for the Revenue justified
the reasoning and approach of the High Court having regard
to the clear language employed in clause (c).
The genuineness or validity of the agreement between the
assessee-company and the firm is not disputed. The factum
of payments made on account of royalty in terms of clause
4(a) of the said agreement is also not disputed. It is also
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not disputed that in the beedi trade, brand name carries
significant business value. It is necessary to keep this
factual context in mind while examining the question at
issue. Section 40(c) read as follows during the relevant
assessment years
"40. Notwithstanding anything to the contrary
in sections 30 to 39, the following amounts
shall not be deducted in computing the income
charge able under the head" profits and gains
of business or profession",
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(a)........
(b).........
(c) in the case of any company-
(i) any expenditure which results directly or
indirectly in the provision of any
remuneration of benefit or amenity to director
or to a person who has a substantial interest
in the company or to a relative of the
director or of such person, as the case may
be,
(ii) any expenditure or allowance in respect
of any assets of the company used by any
person referred to in sub-clause (i) either
wholly or partly for his own purposes of
benefit,
if in the opinion of the Income-tax Officer
any such expenditure or allowance as is
mentioned in sub-clause (i) and (ii) is
excessive or unreasonable having regard to the
legitimate business needs of the company and
the benefit derived by or accruing to it
therefrom, so, however, that the deduction in
respect of the aggregate of such expenditure
and allowance in respect of any one person
referred to in sub-clause (i) shall, in no
case, exceed-
(A) where such expenditure or allowance
relates to a period exceeding eleven months
comprised in the previous year, the amount of
seventy-two thousand rupees;
(B) where such expenditure of allowance
relates to a period not exceeding eleven
months comprised in the previous year, an
amount calculated at the rate of six thousand
rupees for each month or part thereof
comprised in that period:
612
Provided that in case where such person is
also and employee of the company for any
period comprised in the previous year,
expenditure of the nature referred to in
clauses (i), (ii), (iii) and (iv) of the
second proviso to clause (a) of sub-section
(5) of section 40A shall not be taken into
account for the purposes of sub-clause (A) or
subclause (B), as the case may be;
(iii)
Explanation.-The provisions of this clause
shall apply notwithstanding that any amount
not to be allowed under this clause is
included in the total income of any person
referred to in sub-clause (i);"
The Budget speech of the Finance Minister, in so far as it
mentions the reasons for introduction of clause (c) of
Section 40, reads as follows:
"I am firmly of the view that the fiscal
instrument must be deployed to discourage
payment of high salaries and remunerations
which go ill with the norms of egalitarian
society. I accordingly propose to impose a
calling on the remuneration of company
employees which would be deductible in the
computation of taxable profits. The ceiling
is being set at Rs. 5,000 per month. Together
with the existing ceiling of Rs. 1,000 per
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month in the case of perquisites, the
allowable overall ceiling on remuneration and
perquisites, for purposes of taxation, will be
at Rs. 6,000 per month.................."
The object behind the provision undoubtedly was to
discourage and disallow "payment of high salaries and
remunerations which go ill with the norms of egalitarian
society". The provision was, of course, not confined to the
directors.’ It took in relatives of directors, persons
having substantial interest in the company and their
relatives. The clause vested in the I.T.O. the power to
determine whether any such expenditure or allowances as is
mentioned in the said clause was excessive or unreasonable
having regard to the legitimate business needs of the
company and the benefit derived by or accruing to it
therefrom. In addition to it, a ceiling was also prescribed
beyond which such expenditure or allowance could not go in
any event.
At this juncture, it would be appropriate to notice the
provision contained in sub-section (2) of Sec 40A. Clause,
A provides that where the assessee incurs any expenditure in
respect of which payment has been made or is to be made to
any
613
person referred to in clause (b) of the sub-section, and the
Income-tax Officer is of the opinion that such expenditure
is excessive or unreasonable having regard to the fair
market value of the goods, services or facilities for which
the payment is made or the legitimate needs of the business
or profession of the assessee or the benefit derived by or
accruing to him therefrom, so much of the expenditure as is
so considered by him to be excessive or unreasonable shall
not be allowed as a deduction. Clause (b) mentions the
categories of persons to whom the provision in clause (a)
applies. It includes directors of the company and their
relatives among others. Clause b) also takes in any payment
to any company, firm, association of persons or Hindu
undivided family of which a director, partner or member, as
the case may be, has substantial, interest in the business
or profession of the assessee. In short, the net is cast
very wide to ensure that excessive or unreasonable payments
are not made to the persons in control of the affairs of the
assessee in the name of paying for the goods, services and
facilities rendered, supplied or extended by them, as the
case may be.
That the payments made by the assessee-company to the firm
on account of royalty in terms of clause (4) (a) of the
agreement fall within the meaning of the expression
’expenditure’ in sub-clause (i) of clause (c) is not
disputed. The observations in CIT, Bombay. v. M/s. Indian
Engineering and Commercial Corporation Private Uinited
(Civil Appeal Nos. 1583 and 1584 (NT) of 1977 decided on
13.4.1993 by us-reported in (1993) 2 J.T. 683 do not say
otherwise. That case arose under Section 40(A) (5). The
payments in question were made to the directors by way of
commission on sales. The question was whether the said
payments fell within sub-clause (ii) of clause (a) of sub-
section (5) of section 40(A). It was held that they did
not. While holding so it was observed that it is difficult
to say that payment of certain cash amount by way of
commission on sales, directly to an employee, can be said to
fall within the words ’where the assessee incurs any
expenditure which results directly or indirectly’." The said
observations were made in response to the Revenue’s argument
that the said payment constituted ’perquisites’ within the
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meaning of sub-clause (ii) of clause (a) of Section 40(A)
(5). The observations are clearly confined to the said sub-
clause and have no relevance to any other provision in the
Act. The observations cannot be read dissociated from their
context. Coming back to the provisions of Section 4O(c) and
the facts of the case before us the only question is whether
the royalty payments to the firm fell within clause (c). We
assume for the purpose of this argument that in this case,
payments to firm were payments to partners. Even so, we
think that the said payments did not fall within clause (C).
The payments were made in consideration of a valuable right
parted by the partners/ directors of the assessee company in
favour of the assessee. SO long a,, the agreement
whereunder the said payments were made is not held to be a
mere
614
device or a mere screen, the said payments cannot be treated
as payments made to the directors as directors (qua
directors). The payments were made by way of consideration
for allowing the assessee to use a valuable right belonging
to them viz., the brand name. Such a payment may be liable
to be scrutinised under subsection (2) of Section 40(A), but
it certainly did not fall within the four corners of Section
40(c).
In T. T Ltd. v. LTO., Bangalore 121 I.T.R. 55 1, a Bench
of Karnataka High Court comprising D.M. Chandrashekhar, CJ.
and E.S. Venkataramiah,J. has taken a view which accords
with the one taken by us. Speaking for the Bench, E.S.
Venkataramiah, J. (as he then was) observed:
"A close reading of the above provision shows
that s. 40(c) refers to an expenditure in-
curred by making periodical payments to person
mentioned in that clause apparently for any
personal service that may be rendered by him.
It cannot have any reference to payments made
by the assessee for all kinds of "services or
facilities" referred to in s. 4OA(2) (a). It
is argued that the proviso thereto suggests
that any expenditure incurred for any kind of
service which is referred to in the main part
of s. 40A (2) (a) and the expenditure referred
to in s. 40(c) belong to the same category.
This contention is not correct. The
expression "services" in s. 40A (2) (a) is an
expression of wider import............... If
the remuneration, benefit or amenity referred
to in s. 40(c) is treated as the same as what
is paid in return for "the goods, services or
facilities" then irrespective of the fair
market value of the goods, services and
facilities provided by a person who may be a
director or a person who has a substantial
interest in the company or a relative of the
director or of such person, as the case may
be, only a maximum of Rs. 72,000 can be
allowed to be deducted in computing the income
of the company in any one year. We do not
think that Parliament ever intended that such
a result should follow. The goods, services
and facilities referred to in s. 40A (2) (a)
are those which have a market value and which
are commercial in character. Many of the
services and facilities referred to above are
those which are nowadays provided by
independent organisations.’
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The said decision has been followed by the Punjab and
Haryana High Court in Commissioner of Income Tax, Patiala v.
Avon Cycles (P) Ltd. 126 I.T.R. 448, The Calcutta High Court
has also taken a similar view in India Jute Co. Ltd v.
615
Commr of Income-Tax 178 ITR 649.
Mr. Ahuja, learned counsel for the Revenue submitted that
the argument of the assessee that only the payments made to
directors as directors fall within clause (c) and not the
other payments, becomes inapt when the payments are made to
the relative,,, of the directors or to persons holding
substantial interest in the assessee company or their
relatives. The ceilinG prescribed in clause (c) cannot also
be applied to such persons-says the counsel. The answer
perhaps lies in the clause itself-in the power vested in the
I.T.O. to determine whether any expenditure or allowance is
excessive or unreasonable having regard to the legitimate
business needs of the company and the benefit derived by the
assessee or accruing therefrom. Any payment to a relative
of a director or other persons mentioned in clause (c) will
necessarily be examined applying the above test and if it is
found that they are unwarranted, unreasonable or excessive,
they will be disallowed. Since such a situation does not
arise herein, we need not pursue the argument further.
For the above reasons, we are of the opinion that the
judgment under appeal cannot be sustained. It must he held
that the payments in question did not fall within section
40(c). Accordingly, the appeals are allowed, the judgment
of the High Court is set aside and the question referred to
the High Court is answered in the affirmative, i.e., in
favour of the assessee and against the revenue. No costs.
U.J. R. Appeal allowed.
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