Commissioner of Income Tax vs Georgepolous

V. Balasubrahmanyan, J.—One Georgepolous was carrying on business in the export of hides and skins. It was his sole proprietary

concern. On 11-12-1964, a firm of four partners, ''the assessee-firm'' purchased this business for Rs. 50,000. Under the terms of purchase, the

assessee-firm was entitled to carry on the business of export from where Georgepolous left off. In other words, the take over by the assessee-firm

was of the concern as a whole including goodwill, trade mark and import and export quota rights as well as trade outstandings and trade debts.

Subsequent to the take over of the business and the carrying on of the business by the partnership concern, some of the foreign buyers, to whom

goods had been earlier supplied by the erstwhile sole proprietor, found that deliveries to them had been under short-measurement. When this came

to the notice of the firm which purchased the undertaking as a going concern, they came forward to settle the claims of the foreign buyers. The

claimants included the USSR trade representative and two firms in the USA. The payments made by the firm towards meeting the claims by these

foreign customers amounted in all to Rs. 1,28,384. This amount was paid by the firm in the account year ended 31-12-1965. In their relevant

assessment to income tax for the year 1966-67, the firm claimed the payment of Rs. 1,28,384 as a business outgoing. The ITO rejected the claim

and added back the amount while making the assessment. This assessment was confirmed in appeal by the AAC. The assessee appealed further to

the Tribunal. The Tribunal held that the amount paid was an item of business expenditure wholly and exclusively incurred by the assessee-firm for

the purpose of their business. The Tribunal further held that the expenditure was not of a capital nature.

Aggrieved by this decision of the Tribunal, the department demanded a case from the Tribunal. The Tribunal complied with this requisition and

made a reference to this Court on the following question of law:

Whether, on the facts and in the circumstances of the case, Rs. 1,28,384, being the aggregate of the amounts paid by the assessee during the

relevant previous year to the trade representative of the USSR in India, Bombay, Fleming & Toffee Ltd., New York, and Allied Kid Co. in

satisfaction of their claim for compensation for short-weight delivery of the skins sold to them by its predecessor in business should be allowed as

expenditure allowable u/s 37 of the income tax Act, 1961, for the assessment year 1966-67?

Mr. Jayaraman, the learned standing counsel for the department, addressed his arguments on two distinct aspects of the question, namely, the

one raising the issue as to whether the amount paid by the assessee- firm to the foreign buyers can be regarded as an outgoing wholly and

exclusively for the purpose of the assessee''s business and the other as to whether the expenditure, even if it were an item of business, outgoing for

the purpose of the assessee''s business, was not an item of capital expenditure.

On the first question, the learned standing counsel referred to a clause in the written agreement of sale, dated 13-12-1964, entered into between

the assessee-firm and the erst while sole proprietor of the business. That clause reads as under:

The purchaser shall pay, satisfy, discharge and fulfil all the debts, liabilities, contracts and engagements of the business of the seller, in relation to or

in connection with the said business and shall indemnify the seller against all proceedings, claims, demands in respect thereof and shall be entitled to

all profits and losses from 14-12-1964.

As earlier mentioned, the date 14-12-1964 marks the day from which the assessee-firm began carrying on the business which was a sole

proprietary concern of its previous owner.

The gist of this clause, however, seems to us to be merely a reiteration of the obvious, namely, that with the sale of the business by its sole

proprietor to the assessee-firm, the business becomes entirely that of the assessee-firm and it is the assessee-firm which thereafter has got to take

both the lean with the fat, as the saying goes.

The learned standing counsel then urged that these payments made by the assessee-firm to the USSR trade representative and the two

American firms were not made in discharge of any liability of the assessee''s own either contractual or otherwise. He pointed out that the claims of

these purchasers arose out of short deliveries effected by Mr. Georgepolous at a time when the business was that individual''s sole proprietary

concern. The learned counsel, accordingly, urged that the liability to answer the claims of these buyers, if at all, would be only that individual''s as

the then proprietor of the business. The point which the learned counsel wished to make was that it was not necessary for the purposes of the

assessee''s business, either under contract or under any other legal obligation, to discharge the claims made by its predecessor''s buyers. Since,

there was no legal necessity for the payment, the money laid out, according to the standing counsel, cannot be allowed as the assessee-firm''s own

expenditure in business.

The argument of the learned counsel is easily met by reference to the statutory requirement for allowance of business expenditure under the

residuary head of allowance laid down by section 37 of the income tax Act, 1961 (''the Act''). Under this head, there is no requirement that an item

of expenditure or out going must be incurred or laid out with a view to earn the profits; nor is there any requirement that the expenditure must be

incurred in order to meet an obligation arising either out of a commercial contract or out of any provision of law or custom. All that the section

requires is that the expenditure must be incurred or laid out wholly and exclusively for the purposes of the assessee''s business. A provision of this

kind has been there almost ever since income tax law came to stay as part of our fiscal system. In the United Kingdom, the profits of trade of a

taxpayer are to be computed in accordance with Schedule D of the United Kingdom income tax Act. One of the rules of Schedule D is to the

same effect as section 37. Even in our earlier Indian income tax Act, 1922 (''the 1922 Act'') section 10(2)(xv) employed the same phraseology

and allowed all expenditure wholly and exclusively incurred or laid out for the purposes of the assessee''s business. It is true that the provision as it

existed before 1939 in the 1922 Act, did use language which was appropriate to the argument now being advanced by the learned standing

counsel, namely, that the expenditure must have been incurred ''in order to earn the profits''. But this phraseology, which characterised the relevant

provision in the 1922 Act before its amendment in 1939, yielded place to the more acceptable test of ''wholly and exclusively for the purposes of

the business''. The requirement that expenditure must earn the income in order to be deductible is, however, still retained in the income tax code in

the matter of computation of taxable income under the head ''Income from other sources''. The test of allowability under this residuary head of

income is that the expenditure must be for the purpose of ''earning or making'' the income. However, this is quite a different requirement from that

laid down by section 37, which does not expect the expenditure to satisfy any condition other than that it should be incurred for the purposes of the

business and wholly and exclusively for these purposes.

In Atherton v. British Insulated & Helsby Cables Ltd. [1925] 10 TC 155 (HL), which is an oft-quoted case in a discussion of this kind,

Viscount Cave reiterated the position that a sum of money expended, not of necessity and with a view to a direct and immediate benefit to the

trade, but voluntarily and on the grounds of commercial expediency, and in order indirectly to facilitate the carrying on of the business, may yet be

expended wholly and exclusively for the purposes of the trade. This dictum of Viscount Cave is now the preferred doctrine as contrasted with the

narrower view of the provision for allowance which was propounded again, in a very oft- quoted passage in lax discussions, namely, that of Lord

Davey in Strong & Co. Ltd. v. Woodifield [1906] 5 TC 215 (HL). In that case, Lord Davey construing the relevant rule in Schedule D observed

that-

It is not enough that the disbursement is made in the course of, or arises out of, or is connected with, the trade or is made out of the profits of the

trade. It must be made for the purpose of earning the profits.

Even in the United Kingdom, this view of the deduction provision is not now much favoured. Indeed, the Royal Commission on the Taxation of

Profits and Income, in its final report, made a pointed criticism of the expression of opinion contained in Lord Davey''s judgment. The

Commissioner observed that Lord Davey''s words amount to a gloss upon the statutory words ''wholly and exclusively for the purposes of the

trade''. In the opinion of the Royal Commission, ''for the purposes of earning the profits'' cannot be a good interpretation of ''for the purposes of

the trade'', since the earning of the profits imposes a limiting condition for the expenditure, and this makes for an unduly narrow construction of the

statutory provision. The Royal Commission, however, recognised that Lord Davey''s words had so often been quoted in judgments and they had

almost come to enjoy the status of a new definition added into the statutory one. They expressed the view that the statutory rule would be better

administered if the gloss of Lord Davey could be entirely forgotten.

In our own country, the two viewpoints about the requirement of business expenditure had been the subject of examination as to their validity.

In the case of Commissioner of Income Tax, Kerala Vs. Malayalam Plantation Ltd., Subba Rao J., as he then was, expressed a preference for the

view reflected in Viscount Cave''s judgment. The learned Judge observed that the expression ''for the purposes of the business'' is wider in scope

than the expression ''for the purpose of earning profits'', and adopted it as the test of expenditure allowed under the statute.

In the present case, it is true that the assessee-firm was not under an obligation, either under the terms of the agreement dated 11-12-1964 or

under any provision of law or of custom, to meet the claims for shortage of those who had purchased the goods from the former sole proprietor of

the business. But it is quite clear that these payments were made by the assessee for the purpose of preserving the custom and improving it, having

regard to the fact that they had taken over the export business as a going concern retaining even the same business name as before. The Tribunal

observed that the assessee-firm felt it necessary to keep up the business reputation, especially, when they had acquired the right to use the same

trade name as was used by the predecessor in the business. We are, therefore, satisfied that although there was no legal obligation on the part of

the assessee-firm to make these payments, the expenditure having been incurred as a matter of business expediency, must be held to have been

incurred wholly and exclusively for the purposes of the trade. The learned standing counsel did not suggest that there could be any purpose other

than a business purpose, for the incurring of this expenditure.

We are also satisfied that the expenditure cannot be regarded as not relating to the assessee''s business merely for the reason that if the claims

had been enforced, they would, in all propriety, be enforced not against the assessee-firm but only as against the former owner of the business,

because they related to that period. That the claims related to the sole proprietary business and not to the assessee-firm and related to an earlier

phase of the concern, is only another way of arguing that the assessee-firm was not bound, as of necessity, to meet these expenses. But, if the

element of commercial expediency was fully present, as the assessee firm''s sole motivation, and this has been pointed out by the Tribunal with

reference to the need to keep up the business reputation and the like, then the fact that the claims related to a period when the business was that of

the sole proprietor, cannot make for the disallowance of the expenditure u/s 37.

The next argument, which the learned standing counsel addressed was that this expenditure was, in any case, capital in nature. In this argument,

the learned counsel made an attempt to establish that in some way, this payment of Rs. 1,28,383.85 made by the assessee to the trade

representative of the USSR and the two firms in the United States really formed part and parcel of the aggregate purchase price agreed to be paid

by the assessee for the acquisition of this business as a going concern. This argument, however, cannot be tenable on the facts found in the case.

For, it was not part of the terms of the agreement of take over of the business that the assessee should meet the claims of the clients of the former

sole owner of the firm. Indeed, as the Tribunal pointed out these claims for short delivery came to the surface only subsequent to the take over of

the business by the assessee-firm. The suggestion is that they might not have been anticipated at all either before or at the time when the business

was transferred as a going concern by the former owner in favour of the assessee-firm. Apart from this consideration, the mere fact that certain

liabilities are taken over by the assessee along with a business which it acquired for consideration, cannot in all cases, lead to the conclusion that

the value of the liabilities must also be regarded as forming an integral part of the purchase price and be regarded as payment under capital

account. In our judgment, the real nature of an outgoing represented by the discharge of the liabilities attached to a business, which an assessee

acquires for consideration would depend upon whether the liabilities themselves could be related to the revenue account or to the capital account,

as the case may be. In the present case, there is no doubt, whatever that the amounts aggregating to Rs. 1,28,383.85 were paid by the assessee to

the trade representative of the USSR and other parties only in respect of the dealings under the trading account, which were earlier entered into by

them with the former owner of the business. They arose in respect of purchases of skins made by them from the sole proprietary concern. Their

only claim was that in effecting the deliveries, there was short supply and under the terms of the contract they were entitled to be paid the value of

the extent of the short supply, as compensation or damages, such compensation, therefore, would partake of the same character as a revenue

outgoing, since they only go to offset the purchase price of the goods already paid by the foreign buyers to that extent. In these circumstances,

when the assessee paid these moneys due to the foreign buyers for the purpose of meeting their claims on short delivery, what the assessee did

was to make payments only under the revenue account and not as part and parcel of the aggregate purchase price for which they had acquired the

entire business as a going concern.

Mr. Jayaraman referred to some decided cases in which an assessee having acquired an existing business had made a payment to the former

owner or to the former owner''s account and claimed the payment as a deductible item of expenditure in the computation of his own subsequent

profit from the acquired business. Where the payment is made straightaway to the vendor, it is part of the price for acquisition of the business and,

hence, capital expenditure. But where the consideration consists in the discharge by the purchaser of a liability of the vendor, the payment would

still partake of the character of capital expenditure, because the discharge of the vendor''s liability is part of the agreed purchase consideration. The

line of cases cited by the standing counsel on this point included- Commissioner of Income Tax, Delhi (Central) Vs. D.L.F. Housing Construction

(P.) Ltd., V.N.V. Devarajulu Chetty and Co. Vs. The Commissioner of Income Tax, of same High Court and the Bombay High Court in Western

Mechanical Industries Pvt. Ltd. Vs. Commissioner of Income Tax, Bombay City-I, . The present case, however, is quite different and

distinguishable from all these cases on a fundamental difference in the fact situation. The payment by the assessee of Rs. 1,28,384 was not to the

former owner of the business. There was not even a mandate from the vendor that the claims for short delivery were to be met by the assessee.

These payments were made by the assessee quite otherwise, and de hors the purchase consideration. They were made in the course of the

assessee-firm''s own business, to secure the firm''s good name and custom. Its nature as a deductible item of expenditure must, in our judgment, be

regarded as much the same as it would have been if the sole proprietor had continued the business, had made those payments himself and had

claimed them as proper trading expenses or losses in his business. The fact that the business had changed hands cannot make for a different

conclusion.

Cooke (H.M. Inspector of Taxes) v. Quick Shoe Repair Service [1949] 30 TC 460 (KB) is an English case. But we regard it as very near to

the present case. Hence, we would adopt its general reasonings. The taxpayer in that case was a partnership firm. It purchased an existing shoe

repair business. Under the agreement of sale, the trade outstandings were to be paid by the vendor. Those debts and outstandings included

amounts payable to those who supplied leather, rent for the business premises, wages to workmen and the like. All of those items would have been

proper outgoings in the revenue account, if they had been paid by the former owner. The taxpayer was not to be bothered by these trade debts.

Actually, however, the vendor whose responsibility it was to clear them, did not pay them off. The result was that the taxpayer as purchaser of the

business had to come forward to clear the debts, if only to ensure the maintenance of supply of raw materials to him, the continuation of the

accommodation of the shop premises and the retention of the services of the employees. Having, accordingly, made the payments, the taxpayer

claimed them as part of his deductible expenses for the income tax purposes.

The question arose whether he was entitled to do so. Croom-Johnson, J., decided the issue in favour of the taxpayer on both the points, one on

the point whether the expenditure was wholly and exclusively for the purpose of the assessee''s trade and the other on the point whether it was an

item of revenue or capital expenditure. On the first point, the learned Judge relied on the dictum of Viscount Cave in British Insulated & Helsby

Cables Ltd.''s case (supra) and held that in the circumstances of the case, even though the taxpayer was under no legal liability to make the

payments, he had done so with a view to preserve his business. The learned Judge was not unalive to the possibility that the taxpayer-firm as

between its own partners, might choose to record these outgoings as being under capital accounts. But all the same he held that in the computation

of the taxpayers trading profits for the purposes of income tax, it would not be incorrect to record the outgoings as falling under the revenue

account, since the payments were made in order to ensure the continuance of supplies of the working force and of the shopping accommodation.

As we earlier indicated, we derive substantial support from this English decision. There is only a minor difference, on facts, between that case

and the one before us. But the difference is quite immaterial for a decision on principle. In the case before Croom-John son, J., the sale agreement

expressly reserved the trade liabilities, as on the date of the transfer, as liabilities to be discharged by the vendor. In the agreement in the present

case, there is no such express term, but as a matter of construction of the terms of the sale, it could not be suggested even in the present case that

the claim by the foreign buyers for short fall in delivery was either contemplated or pro vided for to be met by the assessee-firm. The principle of

the Quick Shoe Repair Service (supra) must, therefore, be applied to the present case without any qualification.

The learned standing counsel cited a decision of the Dashmesh Transport Co. (P.) Ltd. Vs. Commissioner of Income Tax, . From the report of

this judgment, it would appear that there was a purchase by the assessee-company in that case of the assets and liabilities of a transport company

under the terms of which certain liabilities had to be discharged by the purchaser-company. In a short judgment, the High Court came to the

conclusion that the value of the liabilities discharged by the assessee-company formed part of the very consideration for the acquisition of the

business. On this ground, they held that the amount which went in for discharge of the vendor company''s liabilities, was capital expenditure not

entitled to deduction. We do not think this decision affords any guide for taking a decision in the case before us. On the brief statement of facts

contained in that judgment, it would seem that the decision of the Court rested on the finding that the very purchase price for the acquisition of the

business in that case comprised an obligation on the purchaser''s part to discharge the vendor''s liabilities. That position, as we have earlier

explained, is not the case in the reference before us. For all the above reasons, we hold that the Tribunal was justified in holding that the payment

of Rs. 1,28,384 by the assessee was an admissible deduction u/s 37. The question of law referred to us is, accordingly, answered in the assessee''s

favour and against the revenue. The department shall pay the costs of this reference to the assessee. Counsel''s fee Rs. 500.