Commissioner of Income Tax vs State Farming Corporation of Kerala Ltd.

K.A. Nayar, J.—As directed by this court, the Income Tax Appellate Tribunal, Cochin Bench, referred the following question of law arising out of its common order in Income Tax Appeals Nos. 552 (Coch) of 1978-79 and 126,127 and 128 (Coch) of 1980 :

"Whether, on the facts and in the circumstances of the case, the Tribunal is correct in law in holding that the penalties levied by the assessee-company on the contractors are not receipts of the assessee-company, but are only by way of reduction of expenditure and hence not taxable ?"

The reference is at the instance of the Commissioner of Income Tax, Trivandrum. The assessee-respondent is a State Government undertaking engaged in the cultivation of sugarcane. The sugarcane so cultivated will have to be cut and removed for supply to the sugar factories. The assessee gets these operations transacted through contractors. All the contracts entered into by the assessee-company with the contractors contained a clause to ensure that the work is carried on according to the time schedule. If the harvested sugarcane is not transported expeditiously, the recovery of sugar will be affected Therefore, with a view to avoiding loss, in every contract for transport, it is stipulated that the cut sugarcane should be transported within the time limit. Whenever the transport contractors made delay, a suitable penalty is imposed on them to act as a deterrent. For the assessment years 1974-75, 1975-76, 1976-77 and 1977-78, the Income Tax Officer treated these penalty amounts as income of the assessee and taxed accordingly.

The assessee filed appeals before the Appellate Assistant Commissioner, Trivandrum, for the year 1975-76 and before the Commissioner of Income Tax (Appeals), Ernakulam, for the assessment years 1974-75, 1976-77 and 1977-78. The Appellate Assistant Commissioner held that whenever there is violation of the time schedule, a short payment is made which is accounted in the company''s books as penalty. Actually, there was no receipt but there was only a reduction in expenditure. Therefore, he held that the penalty amount in question was not taxable. The same view was taken by the Commissioner of Income Tax (Appeals) for the other assessment years. The Revenue went up in appeal before the Tribunal. The Tribunal, agreeing with the first appellate authority, held that the penalties levied by the assessee-company on the contractors are not receipts but only reduction in expenditure with no liability to tax. It is in the above circumstances that the question of law hereinbefore formulated was referred to this court for opinion.

We heard counsel. The law regarding liability to be taxed as stated in Commissioner of Income Tax, Bombay City I Vs. Shoorji Vallabhdas and Co., brought to our notice by counsel reads as under :

"income tax is a levy on income. No doubt, the Income Tax Act takes into account two points of time at which the liability to tax is attracted, viz., the accrual of the income or its receipt; but the substance of the matter is the income . . . where income has, in fact, been received and is subsequently given up in such circumstances that it remains the income of the recipient, even though given up, the tax may be payable ; where, however, the income can be said not to have resulted at all, there is obviously neither accrual nor receipt of income ..."

The question, therefore, is whether there was accrual of income in the hands of the assessee. If there was accrual of income it follows that it is liable to be taxed regardless of its destination or disposal or what happens afterwards. The decisions in Commissioner of Income Tax, Bombay City I Vs. Shoorji Vallabhdas and Co., , Commissioner of Income Tax, Bombay North, Kutch and Saurashtra, Ahmedabad Vs. Chimanlal Mangladas and Co., and Commissioner Of Income Tax, Bombay North Vs. Harivallabhadas Kalidas and Co., , lay down that there is no accrual of income if it is surrendered or relinquished by an agreement before it could have accrued. The Appellate Assistant Commissioner as well as the Commissioner of Income Tax (Appeals) held that there was no receipt by way of penalty but only a reduction in expenditure. They have noted the contracts entered into by the company with the contractors and held that there were no receipts of penalty amounts but only a reduction in expenditure. The Tribunal, agreeing with the first appellate authority, held that in relation to the penalties, the assessee-company had not received any amount and so there is no question of the assessee earning income so that it can be brought to tax.

Counsel for the Revenue referred to the decision reported in M. K. BROTHERS PRIVATE LIMITED Vs. COMMISSIONER OF Income Tax, U. P., to show that there is a taxable income accrued by way of penalty. In that case, there was an agreement to relinquish the sole agency in favour of the assessee in consideration of the assessee agreeing to permit the manufacturer to retain a portion of the assessee''s commission to be adjusted towards the sole agent''s dues. It was held that the portion of the commission retained by the manufacturer was income of assessee, as it was the application of the income after accrual. Where income is not applied but diverted by an overriding title from the assessee who would otherwise have received it, it cannot be considered as income of the assessee at all. (See P. C. Mullick v. CIT [1938] 6 ITR 206 , Navnitlal C. Javery Vs. Commissioner of Income Tax, Bombay, and COMMISSIONER OF Income Tax, DELHI AND RAJASTHAN Vs. L. BANSI DHAR., ). But it will be otherwise, if the income accrues and the assessee only applies the income. It is the latter principle that was applied in the decision reported in M. K. BROTHERS PRIVATE LIMITED Vs. COMMISSIONER OF Income Tax, U. P., referred to by counsel for the Revenue. That decision was confirmed by the Supreme Court in M.K. Brothers (P) Ltd. Vs. Commissioner of Income Tax, Kanpur, . In that case, under a contract between the British India Corporation and the assessee, the Corporation became liable to pay and the assessee became entitled to receive commission at a certain rate every year. The disputed amount was part of the commission earned by the assessee for the previous year relating to the assessment year and it was after it had been earned by the assessee that it became liable to be retained by the Corporation for the adjustment of the debt due to the Corporation from S and Co., the sole selling agent. It was, therefore, a case of application of income after it was earned by the assessee and the amount in question was hence assessable as income of the assessee. The other decision referred to by counsel is in COMMISSIONER OF Income Tax, BIHAR and ORISSA Vs. MANAGER OF KATRAS ENCUMBERED ESTATE., That also is a case of application of the income by the assessee in a particular way.

In the case in question, there was no finding that the penalty amount accrued to the assessee from the contract and the assessee had paid the amount in reduction of some other liability or applied the income after accrual in a way mentioned in the agreement. In fact, no amount was received but there was only a short payment as stipulated in the contract. Therefore, the decisions referred to by counsel for the Revenue have no application to the facts of the case. In the circumstances, we agree that the penalties levied by the assessee-company on the contractors are not receipts of the assessee-company taxable under the Income Tax Act.

We, therefore, answer the question referred to us in the affirmative, that is, in favour of the assessee and against the Revenue.

A copy of this judgment under the seal of this court and the signature of the Registrar shall be sent to the Income Tax Appellate Tribunal, Cochin Bench.