Commissioner of Income Tax vs Sri Rangavilas Ginning and Oil Mills

Thanikkachalam, J,

At the instance of the Department, the Tribunal referred the following question for the opinion of this Court u/s 256(1) of the income tax Act, 1961 : "Whether, on the facts and in the circumstances of the case, the Appellate Tribunal was right in holding that registration cannot be refused to the firm even though the assessee had transferred a portion of the net profits to a dissolution account and distributed only the balance amongst the partners ?"

The assessee is a firm of three partners which came into existence on 1-7-1978. The partners of the firm and their shares are :

G.R. Govindarajulu30 per cent

G.R. Devarajan35 per cent

G. Rangaswamy35 per cent

Prior to the formation of this firm, there existed a firm under the same trade name and its assets and liabilities were taken over by G.R. Govindarajulu and the present firm came into existence as a result of Govindarajulu taking in the other two persons as partners. The firm closed its accounts on 31-12-1978. On 17-11-1978, the firm filed an application in Form No. 11 seeking registration of the firm.

The ITO in his order dated 31-3-1982 passed u/s 185(1)(B) of the Act refused to grant registration to the firm for this year and the firm was treated as an unregistered firm. The assessee preferred an appeal to the Commissioner (Appeals), who held that the genuineness of the partnership had not been doubted by the ITO and, hence, there was no warrant for the ITO to deny registration of the firm.

The Department preferred an appeal to the Tribunal and contended that in appropriating a portion of the properties towards the personal liability of the partners, that too in a ratio different from the profit- sharing ratio, the assessee had violated the very provisions of the Act. The Department placed reliance on the decision of the Allahabad High Court in Setha Ram Dhanvir Singh Vs. Commissioner of Income Tax, However, the Tribunal placed reliance on the decision of the Supreme Court in the case of Khanjan Lal Sewak Ram Vs. Commissioner of Income Tax, U.P., and held that the distribution of profits may vary from the shares as stipulated in the instrument of partnership but registration cannot be refused only for that reason. It, therefore, dismissed the appeal.

Before us, the learned standing counsel appearing for the Department submitted that the total profit earned by the firm was Rs. 2,11,590 and out of the said sum of Rs. 1,95,000 relates to personal liability of the partners which was adjusted in the total profit earned in the assessment year under consideration. According to the learned standing counsel, this amount of Rs. 1,95,000 was not divided in accordance with the profit- sharing ratio as stated in the partnership deed. Therefore, inasmuch as a portion of the profit was shared in different ratio against the deed, the assessee is not entitled to the registration.

It was further submitted that the firm is not entitled to adjust the personal liability of the partners out of the profits earned by the firm. Therefore, according to the learned standing counsel, the Tribunal was not correct in holding that the firm is entitled to registration in spite of the fact that a portion of the profit was not divided in accordance with the profit-sharing ratio as stated in the deed.

However, the learned counsel for the assessee submitted that when the new firm came into existence, it took over the assets and liabilities of the old firm. While adjusting the profits among the partners the firm set apart a sum of Rs. 2,11,590 towards the liabilities of the partners relating to the erstwhile firm. It was further submitted that the ITO has got to see only the genuineness of the firm and the constitution as per the deed of partnership and he cannot probe into how the profits were arrived at by the firm which has got to be done only at the stage of assessment of the firm. The Department has not doubted the genuineness of the firm. It is not correct to say that Rs. 2,11,590 was divided between the partners as against the profit-sharing ratio as stated in the partnership deed. Setting apart a portion of the profits towards the liability of the partners would not in any way be an impediment for the ITO to refuse registration.

We have heard both the learned standing counsel appearing for the Department as well as the learned counsel for the assessee. In the assessment year 1979-80, the assessee claimed registration of the firm by filing Form No. 11 on the basis of the partnership deed executed on 3-11-1978. The partners were G.R. Govindarajulu, G.R. Devarajan and G. Rangaswamy. The deed stated that the first partner had taken over the assets and liabilities of Sri Rangavilas Ginning & Oil Mills, Coimbatore in the course of the distribution of assets and liabilities of the firm as per the terms and conditions stipulated in the deed of dissolution of that partnership with effect from 1-7-1978. The new partnership came into existence from 1-7-1978. Each of the partners contributed in terms of clause 9 capital of Rs. 2 lakhs. It was also provided that the parties may withdraw amounts which they thought necessary and such withdrawals would be debited to the personal accounts of the partners. According to clause 17, the profits or losses were to be shared by the partners as under:

G.R. Govindarajulu 30 per cent

G. Devarajan 35 per cent

G. Rangaswamy 35 per cent

The assessee-firm closed its accounts on 31-12-1978 and the calendar year was the relevant accounting period for the assessment year 1979-80. The application for registration was dated 3-11-1978.

It remains to be seen that the accounts of the erstwhile firm were closed and the assets and liabilities were brought into the books of the new firm and a dissolution adjustment account was created with the debit balance. The deficit in the dissolution adjustment account was brought into the balance sheet of the assessee-firm, and this was the personal loss of all the three partners who were partners in the erstwhile firm. The net profit according to the profit and loss account of the assessee-firm was Rs. 2,11,590. This was transferred to a profit and loss appropriation account and therefrom a sum of Rs. 1,95,000 was transferred to the dissolution adjustment account and the balance of Rs. 16,590 only was apportioned among the three partners, as per the profit-sharing ratio as mentioned in the partnership deed. According to the Department, a sum of Rs. 1,95,000 was divided among the partners. According to the assessee, the ITO had no right to scrutinise the deed of dissolution of the earlier firm nor the conclusion derived therefrom had any bearing on the genuineness of the firm and its constitution. It was further contended that profits were allocated as per the partnership deed, but even assuming that they had not been allocated so, the ITO had no power to refuse registration. But, according to the Department, it bad the right to seek every clarification that was necessary to decide whether the firm was genuine or not and since the profits were distributed according to the shares of the partners, it was held that the assessee was not entitled to registration. However, the Commissioner while disposing of the appeal was of the view that the ITO was not justified in refusing registration to the firm. u/s 185 before granting registration, the ITO can go into the question of genuineness of the firm and its constitution as specified in the instrument of partnership and it is only after he is satisfied that he will grant registration.

The point for consideration is whether the assessee-firm is genuine and whether the firm allocated the profits as per the profit-sharing ratio as stated in the instrument of partnership.

While submitting the return of income, the assessee set out the net profit as per the profit and loss account and after making certain adjustments for partnership inadmissible, etc., arrived at the net profit. It was allocated in the ratio as specified in the instrument of partnership. The total income came to Rs. 2,31,100 which was shown in the return filed on 31-10-1979. A sum of Rs. 2,11,590 was transferred to a profit and loss appropriation account and therefrom Rs. 1,95,000 was transferred to dissolution adjustment account and the balance of Rs. 16,590 only was apportioned between the three partners as per the ratio stated in the partnership deed. There is no evidence on record to show that a sum of Rs. 1,95,000 was apportioned among the partners equally as stated by the Department. A sum of Rs. 1,95,000 was set apart towards the partnership''s liability arising on account of the dissolution of the firm. Therefore, according to the assessee, the net profit available was divided as per the profit-sharing ratio. The Department thought that the adjustment of a portion of the profits against the deficit in dissolution adjustment account was in contravention of the terms of the partnership deed. This conclusion was arrived at by the Department because the Department presumed that a sum of Rs. 1,95,000 was divided among the three partners equally as against the profit-sharing ratio as stated in the partnership deed. But there is no material for drawing such an inference.

In Setha Ram Dhanvir Singh''s case (supra), the Allahabad High Court held that the expression ''genuine firm'' denotes that the firm is really in existence and that the partners were collectively carrying on the business. Genuineness was also inter-related to the specified constitution of the firm. ''Constitution of the firm'' refers to the identity of the partners and their share in profit or loss of the firm''s business. If it is found that the partners have any instrument of partnership indicating their share, but, in fact, they have, while dividing the profits or loss adopted some other shares voluntarily and unknowingly, it will be a case where the firm, though in existence, is not a genuine firm within the specified constitution.

According to the assessee, in the present case, the firm was a genuine firm and the constitution was as specified in the deed of partnership and further that the certificate given in Form No. 11 filed was also a correct certificate. It was also stated that a portion of the income earned by the firm was set apart for liability of the partners incurred on account of the dissolution of the erstwhile firm and that would not amount to dividing a portion of the profits not in accordance with the profit-sharing ratio in terms of the partnership deed. Hence, registration cannot be refused.

According to the above-cited Allahabad High Court''s decision, the partners have not voluntarily and unknowingly divided the profits as against the profit-sharing ratio as stated in the partnership deed. According to the assessee, that was not the case here. In the present case, since the assets and liabilities of the erstwhile dissolved firm were brought into the books of the new firm, the assessee is bound to adjust the personal liabilities of the partners out of the income earned by the new firm. It is only after such adjustment that the net profit was so arrived at which was divided among the partners as per the profit-sharing ratio in the partnership deed. Therefore, there is no question of voluntarily and unknowingly dividing a portion of the profit earned by the firm in accordance with the profit-sharing ratio as stated in the partnership deed.

In Commissioner of Income Tax, Madhya Pradesh, Nagpur and Bhandara Vs. D''costa Brothers, the Bombay High Court while considering the provisions of section 26A of the Indian income tax Act, 1922 and rules 2, 3 Form, SCH. B,4 of the Indian income tax Rules, 1922 held as under :

"The determination of profits by a firm in a manner different from the provisions of the Indian income tax Act or even not strictly in accordance with the express terms of the deed of partnership would not entitle the income tax Officer to reject the application for registration of the deed of partnership u/s 26A of the Indian income tax Act, 1922, on the ground that the application for registration has not been properly made within the meaning of rule 4. In what manner the profits are to be determined and what deductions are to be allowed in the determination of the profits of the firm is a matter entirely for the partners inter se to decide. The requirements of the law are that there must be an instrument of partnership under which the partnership is constituted; that it must specify the individual shares of the partners; that the application has to be in the prescribed form and must be signed by all major partners; and that if the application is made after the expiry of the relevant previous year, it must show the manner in which the profits of the business as determined by the partners have been distributed or would be distributed and that must be in accordance with the shares specified in the deed of partnership. Any error in the computation of profits by the partners does not give a right to the income tax Officer to reject an application for registration on the ground that the application for registration has not been properly made."

However, the learned standing counsel for the Department relied on a decision of the Supreme Court in Khanjan Lal Sewak Ram''s case (supra) in order to show that when a portion of the profit was not divided in accordance with the profit-sharing ratio of the partnership deed, the firm is not entitled to registration. According to the facts arising in the above decision, the firm had earned profits in the black market and though it had distributed its book profits among the partners according to the instrument of partnership, it had not distributed its profits earned by it in the black market among the partners according to the instrument of the partnership deed. Inasmuch as a portion of the profits earned by the firm was not divided among the partners as per profit-sharing ratio of the partnership deed, the Supreme Court held that the assessee-firm is not entitled to registration. But, according to the facts arising in the instant case, a portion of the profits was set apart for discharging the liabilities of the partners which arose on account of the dissolution of the erstwhile firm. Hence, a portion of the profit was transferred to the partnership dissolution adjustment account. Further, it also remains to be seen that the assets and liabilities taken over while the erstwhile firm was dissolved, were brought into the accounts of the newly-constituted firm. In such circumstances, it cannot be said that a portion of the profit was not divided in accordance with the profit-sharing ratio under the partnership deed. Reliance was also placed on the decision of the Allahabad High Court in Commissioner of Income Tax Vs. Hari Ram Khanna, . According to the facts arising in that case, a firm consisted of Hari Ram Khanna and his two sons. Under the partnership deed, Hari Ram Khanna was entitled to 6 annas share in the profits of the firm and his sons were entitled to 5 annas share each. On the question whether the firm was entitled to registration, the Tribunal found the following facts : The application for registration had been made in the proper form and within time. The firm had complied with all the requisite formalities including a declaration that the profits of the firm would be distributed in accordance with the shares specified in the partnership deed. There was a minor deviation subsequently in the division of shares and it was because of the inadvertent fault of the accountant. The deviation was that Hari Ram was credited with 5-1/3 annas instead of 6 annas and two annas were credited with 5-1/3 annas instead of 5 annas each. On an overall consideration of all the facts the Tribunal came to the conclusion that it cannot be said that the firm was not genuine. On reference the Allahabad High Court held that the Tribunal was correct in holding that in spite of the minor deviation in the crediting of the shares of partners the firm was genuine and that the firm was entitled to registration. In Sampath Iyengar''s Law of income tax, 8th edition at page 4813 under the caption ''Genuineness and validity matter'', it was stated as under :

"The concept of a firm being valid in law is distinguished from the factual genuineness and for the purpose of granting registration both the aspects are relevant; the presence of one without the other will be insufficient. Even if a firm brought into existence by executing an instrument of partnership deed is shown to possess the legal attributes, it would be open to the taxing authority to refuse registration if it is satisfied that no genuine firm has been constituted."

In the present case, the distribution of profits had not taken place when the application for registration was made. What happened was that the assessee subsequently, when the accounts were transferred to a dissolution account, distributed a portion of the profits. While filing the return of income, the assessee started with the profit as per the profit and loss account, i.e., prior to the transfer of the dissolution account which was made only to the profit and loss appropriation account and in the statement accompanying the return the profit-sharing allocation of the entire profits of the year was shown strictly in conformity with the shares as specified in the instrument of partnership. Therefore, in the present case, it cannot be said that unknowingly and voluntarily the assessee-firm had distributed a portion of the profits not in accordance with the profit- sharing ratio as stated in the partnership deed. Therefore, in the present case, when the assessee asked for registration of the firm, it distributed the available profits as per the profit-sharing ratio as found in the partnership deed after making certain adjustments in the accounts with regard to the liabilities incurred by the partners while dissolving the erstwhile firm. The Tribunal pointed out that u/s 271(4) of the Act, if any authority in accordance with any proceedings under this Act is satisfied that the profits of a registered firm have been distributed otherwise than in accordance with the shares of the partners as shown in the instrument of partnership on the basis of which the firm has been registered under this Act and that any partner has thereby returned his income below its real amount, that he may direct, such partner, shall in addition to the tax, if any, payable by him, pay by way of penalty a sum not exceeding 1 1 / 2 times the amount of tax which has been evaded if the income returned by such partner has been accepted as correct income and no refund or other adjustment shall be claimable by any other partner by reason of such direction. Therefore, according to the facts arising in the present case, it cannot be said that the assessee has deliberately distributed a portion of the profit not in accordance with the profit-sharing ratio as stated in the partnership deed. Therefore, in the present case since a portion of the profit was transferred to a dissolution settlement account and incurred on account of the dissolution of the earlier firm, the registration cannot be refused, especially in view of the decision of the Bombay High Court in D ''CostaBros. case (supra) Accordingly, we are of the opinion that there is no infirmity in the order passed by the Tribunal in confirming the order passed by the first appellate authority in granting registration to the assessee-firm. In that view of the matter, we answer the question referred to us in the affirmative and against the Department. No costs.