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Judgment
Rajagopalan, J.—u/s 66 (1) of the Income Tax Act, the Appellate Tribunal referred the following question to this Court: ""Whether the sum
of Rs. 40,000 paid to Mr. J. H. Philips on his retirement from the service of the company was not an admissible deduction u/s 10 (2) (xv), Income
Tax Act, 1922?
The facts were never in dispute. The assessee which was a private limited company, was incorporated in 1928 to carry on business in the
manufacture of leather. Gordon Woodroffe & Co. Ltd., was the parent company, and after the incorporation of the asses see-company Gordon
Woodroffe Co. Ltd., were the managing agents. Mr. Philips was employed in the parent company from 1922 to 1935, and thereafter he was
employed in the assessee-company. He was manager of the assessee-company and also one of its directors from 1940.
Mr. Philips decided to retire from service with effect from 4-4-1949. He resigned his directorship. At the meeting of the Board of Directors dated
24-3-1949 it was resolved ""to accept Mr. Philips''s resignation with regret and to place on record the keen appreciation of the Board of his long
and valuable services to the company. It was further resolved to convey to Mr. Philips the best wishes of the directors and the staff in his
retirement from India....It was also resolved to recommend at the forthcoming extraordinary general meeting that Mr. J. H. Philips be paid a
gratuity of Rs. 50,000, and to recommend further that the parent company should be asked to contribute a portion of this sum.
These recommendations were accepted. Rs. 60,000 was paid as a gratuity to Mr. Philips, of which, however, the assessee-company paid only Rs.
40,000. The balance was paid by the parent company. This payment of Rs. 40,000 was claimed by the assessee as an allowable deduction in the
assessment year 1950-51. The claim was disallowed by the department and the Tribunal agreed with them.
The Tribunal held as recorded in para. 8 of the statement of the case, that the amount was not expended wholly and exclusively for the purpose
of the business and that it was also capital in nature.
It is easier to dispose of the question, whether the payment of Rs. 40,000 constituted an expenditure of a capital nature. Every lump sum
payment is not necessarily a payment incurred by way of capital expenditure. The test most frequently applied is that laid down by Lord Cave in
British Insulated and Helsby Cables Ltd. v. Atherton, 1928 AC 205: 10 Tax Gas 155 (A):
But when an expenditure is made not only once and for all, but with a view to bring into existence in asset or advantage for the enduring benefit of
trade, I think that there is very good reason (in the absence of special circumstances leading to an opposite conclusion) for treating such an
expenditure as properly attributable not to revenue but to capital."" Judged by that test, it should he obvious that the expenditure in question was not
of a capital nature.
The payment of Rs. 40,000 did not bring into existence any asset for the enduring benefit of the business the assessee carried on. Nor did it secure
to it an advantage for the enduring benefit of its business. It was a payment to an employee who retired from the service of the assessee-company
in grateful recognition of his past services, which the assessee-company justly assessed as valuable services. It should he noted that the good faith
attendant on the transaction was never in doubt.
That it was not an expenditure of a capital nature does not solve the question we have to answer; the claim has still to satisfy the other
requirements of Section 10 (2) (xv) of the Act; Was it laid out or expended wholly or exclusively for the assessee''s business still remains to be
answered.
The two cases on which text book writers both in England and in India have based their comments, with reference to such lump sum payments
of gratuity to retiring servants, are Smith v. Incorporated Council of Law Reporting, (1914) 6 TC 477: 1914 3 KB 674 (B) and Hancock v.
General Reversionary and Investment Co. Ltd., (1919) 7 Tax Gas 858 (C).
In (1914) 6 Tax Cas 477: 1914 3 KB 674 (B), the Incorporated Council paid a sum of �1,500 as gratuity on the retirement of one of its
reporters. The question, was, whether this �1.500 should be included in the profits of the assessee (The Incorporated Council) assessable to
Income Tax. The Commissioners decided that it was not. That decision was confirmed by Scrutton, J., when the Crown appealed. The learned
Judge pointed out that the Commissioners had found as a fact that �1,500 was money wholly and exclusively laid out or expended for the
purpose of the trading and proceeded to determine the question, was there evidence upon which they could find that.
The learned Judge observed ""What they find is that though the reporters have no legal right to payment on retirement, it has been the habit of the
respondents to give a gratuitous pension or to make a gratuity of a lump sum on retirement to a reporter after long service. One cannot help using
one''s ordinary knowledge of human nature to know that in some cases the expectation of gratuities may materially affect the amount of salary.
......when I find that the Commissioners have found that it is the habit of these employers to give their reporters gratuitous pensions or gratuities of
lump sums, I cannot help seeing that there is evidence upon which the Commissioners, judging facts, may find that those payments were made in
the way of their trade, because they at any rate may affect the amount of ordinary salary which they pay to their reporters.''
In (1919) 7 Tax Gas 358 (C), the assessee-company sought to charge as a trading expenditure a lump sum which it had paid for the purchase,
for the benefit of -a former actuary and secretary of the company of an annuity equal in amount to the pension, which had been awarded to him by
a resolution of the company. Lush, J., held that the lump sum paid to purchase, the annuity was an expenditure incurred in the business not in the
nature of capital expenditure, and was an admissible expense in computing the company''s profits assessable to Income Tax. Lush, J., observed at
p. 371,
.....I think that it necessarily follows....... that �4.994 should be treated, as the pension was treated, as an ordinary business expenditure, and
that the deduction should be allowed. It is the pension in another form; it is actuarially equivalent in value and it is identical in character. It was paid
to meet a continuing demand which was itself an ordinary business expense. It seems to be as impossible to hold that the fact that a lump sum was
paid instead of a recurring series of annual payments alters the character of the expenditure, as it would be to hold that, if any employer were under
a voluntary arrangement with his servant to pay the servant a year''s salary in advance instead of paying each year''s salary as it fell due, he would
be making a capital outlay.
There is no scope for extending to the claim of the assessee in this case the principle laid down in (1919) 7 Tax Cas 358 (C). - It was not, as if
Mr. Philips was paid a lump sum gratuity in lien of any annual pension to which he would otherwise have been entitled.
In our opinion, the principle laid down in (1914) 6 Tax Cas 477 (B), either cannot be extended to the assessee''s claim. The Tribunal
recorded, ""........there is nothing to indicate that Mr. J. H. Philips had accepted a lower salary in the hope of getting a gratuity. He could not have
had any such hope as there was no such practice in the assessee-company.....
It should be remembered it was found in (1914) 6 Tax Cas 477 (B), that it was the habit of the Incorporated Council of Law Reporting to give a
gratuitous pension or to make a gratuity of a lump sum on retirement to a reported after long service. No precedent for the payment"" of such a
gratuity was proved by the assessee-company before the Tribunal. During the course of arguments before us, we efferent an opportunity to learned
counsel for the assessee to produce evidence, if any, of similar payments having been made in the past either by the assessee-company or by its
parent company.
Had any such evidence'' been forthcoming, we would have considered the desirability of allowing the assessee to place that material before the
Tribunal and to call for a further statement of the case, But no real evidence of similar payments in the past was forthcoming. Of course, a
precedent for such a payment would only be one of the relevant factors to be taken into consideration with its proper probative value. We should
not be understood to lay down that in the absence of precedents a claim u/s 10 (2) (xv) of the Act must necessarily be disallowed. Every company
has to make a beginning, and a first payment of its kind does not cease to be deductible if it satisfies the requirements of Section 10 (2) (xv).
What was the nature of the payment made to Mr. Philips is the question for consideration. It was obviously paid to him in grateful and possibly
just recognition of the valuable services he had rendered to the company. But those services had already been rendered. The payment was
certainly not to secure the services of Mr. Philips in the future. The assessee did not establish that the payment was designed in the interests of the
future business of the company, either to act as an incentive to the employees still in service, or to act as an incentive to the employees to be
recruited in future.
As the Tribunal has in effect found, expectancy of a gratuity on retirement did not play any part either when Mr. Philips joined the service of the
company, or when any other employee entered its services. Apparently the company has now a scheme of a contributory provident, fund which, of
course, is quite distinct from the expectancy of a gratuity on retirement.
Thus the position is that the normal service conditions of the assessee-company did not provide for any expectancy of any gratuity on retirement
either in the past or probably in the future. It is with reference to these facts that we have to decide the question, whether the payment of Rs.
40,000 to Mr. Philips satisfies the test, whether it was wholly or exclusively expended for the business of the company. Gratitude for past services
expressed in a monetary form by itself, and with nothing more, may not satisfy that test.
In the Principles of Income Taxation by Hannau and Farris worth, at p. 478, the learned authors stated;
Arrangements for the retirement of employees are a necessary part of the operations of a business. Consequently financial provision by the
employer for such a happening is more or less directly associated with the earning of the profits. An employee is likely to give better service when
he can reasonably expect to receive a gratuity or pension upon the termination of a long period of employment.
The expectation, though it may rest only upon the fact that similar provision has been made for former employees, is calculated to promote better
relations between employer and employee with beneficial results to the business concerned. For these reasons it is now generally recognised that
the payments made by an employer to his retired employees are a proper charge in arriving at the taxable profits of his business. Such payments
are in an entirely different category from a lump sum set aside to establish a pension fund similar to that to Atherton v. British Insulated and Helsley
Cables Ltd., (1925) 10 Tax Gas 155 (D). But even payments of the former class may be made in circumstances so exceptional that their
admissibility as deductions is liable to be challenged by the revenue, authorities.
Learned counsel for the department invited our attention to a passage from Gunn''s Commonwealth Income Tax Law and Practice, 4th Edn.
Section 51 of the Australian Act provided ""losses and outgoings to the extent, to which they are incurred in gaining or producing the assessable
income or are necessarily incurred in carrying on a business for the purpose of gaining or producing such income shall be allowable deductions
except to the extent to which they are losses or outgoings of capital.......
Though not in pari materia with Section 10 (2) (xv) of the Income Tax Act one of the tests imposed by Section 51 is the expenditure should be
necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income.
In para. 1195 at p. 421 the learned Authors stated:
A payment to an employee on his retrenchment or retirement is deductible u/s 51 only where it can be established that the payment was in the
future interests of the tax-payers'' business. The position is otherwise under the specific provisions of Section 78 (1) (c) where an allowance is
granted for payments in consideration of the past services of employees.
Section 78 (1) (c) provided for a deduction of ""pensions, gratuities, or retiring allowance to persons who are or have been employees or
dependants of the employees to the extent to which in the opinion of the Commissioners those sums are paid in good faith in consideration of the
past services of the employees in any business operations which were carried by the tax-payer"".
There is no analogous provision In the Indian Income Tax Act. With reference to a claim u/s 51 of the Australian Act, somewhat analogous to
Section 10 (2) (xv) of the Indian Act, the learned Authors extracted a passage in an Australian decision:
It has never been held that a pension or other allowance paid by a tax-payer in business to a retiring or deceased director or employee or his
dependants solely in respect of past services of the director or employee is an allowable deduction under Income Tax provisions dealing with the
allowance of business outgoings generally.
Whenever such a payment has been held to be deductible the decision has been based on the fact that it was made in the future interests of the
business..... There must be a connexion between the purpose of the payment and the further pursuit of gain. There must be some facts which justify
the inference that the outgoing was incurred to conduce to that end.
These principles, in ""our opinion, could well be invoked in applying the provisions of Section 10 (2) (xv) of the Income Tax Act.
17.Two other cases were referred to, though they did not themselves deal with payments of gratuities to a retiring servant.
In B. W. Noble Ltd, v. Mitchell, (1926) 11 Tax Gas 372 (E), the Directors were appointed for life, subject to dismissal forthwith for neglect
or misconduct towards the company. A director so dismissed was only entitled to receive his salary then due. He could also be required to sell his
shares to the other directors at par.
He would also have to surrender for cancellation certain notes issued by the company entitling him to participate in the surplus profits. The market-
value of the shares was considerably above its face value, because the shares paid a dividend of 677 per cent.
Circumstances arose in 1920 and 1921, in which the company might have been justified in dismissing one of the directors. But to avoid publicity
injurious to the company''s reputation it entered into a negotiated settlement with the director, under which he retired from the company and the
company paid him �19,200. The company''s claim to deduct this payment was allowed.
Rowlatt, J., held, ""....... Although the largeness of the figures and the peculiar nature of the circumstances perplex one... ...this is not more than
payment to get rid of a servant in the course of the business and in the year in which the trouble comes. J do not think it is a capital expense; and I
have held that it is an expense incurred in the conduct of the business.
Lord Hanworth, M. R., agreed that the payment should be treated as a revenue item, and not as a capital item. He observed at p. 420:
It seems to attain more closely to (1919) 7 Tax Cas 358 (C) and (1914) 6 Tax Cas 477 (B), than to other cases...... It is a payment made in the
course of business, dealing with a particular difficulty which arose in the course of the year, and was made in order not to secure an actual asset to
the company but to enable them to continue, as they had in the past, to carry on the same type and high quality of business unfettered and
unimperilled by the presence of one who, if the public had known about it, might have caused difficulty to their business and whom it was
necessary to deal with and settle with at once.
The principle laid down in (1926) 11 Tax Cas 872 (E) was followed by the High Court of Australia in W. Nervill and Go. Ltd. v. Federal
Commissioner of Taxation, 36 CLR 290 (F). There again it was an unwanted director that the company got rid of, and, it secured the cancellation
of the agreement in his favour by a payment �2,500. The High Court held that this sum of �2500 was a ""loss or outgoing incurred in gaining or
producing assessable in come"", to satisfy the requirements of the statutory provisions in Australia.
Latham, C. J., observed at p. 801, ""No expenditure, strictly and narrowly considered, m itself actually gains or produces income. It is an outgoing,
not an incoming. Its character can be determined only in relation to the object which the person making the expenditure has in view. If the actual
object is the conduct of the business on a profitable basis with that due regard to economy which is essential in any well-conducted business, then
the expenditure (if not a capital expenditure) is ""ah expenditure, incurred in gaining or producing the assessable, income. If it is not a capital
expenditure it should be Deducted in ascertaining the taxable income of the tax-payer.
Though, as we said, Nevill''s case (F) did not deal with the payment of a gratuity voluntarily made by the employer to a retiring employee,, the
general observations of Latham, C. J., which we have extracted above, explain the view point from which to judge whether an expenditure was
laid out by the assessee wholly or exclusively for the purpose of his business.
Before we revert to the requirements of Section 10 (2) (xv) of the Act, we have to refer to two features of the order of the Tribunal. The
Tribunal pointed out that Mr. Philips was in receipt of a salary and a 2-1/2 per cent, commission in addition to his salary and recorded ""In these
circumstances it is idle to contend that the payment made on resignation of the employee was in return for long and faithful services rendered.
We are really unable to appreciate the scope-of these observations or discover what the basis for them was. As we said, that the company acted
in good faith was never really in dispute. The genuineness of the payment was not in dispute. That Mr. Philips rendered valuable services to the
asses-see-company and that the company was conscious of that and was justly grateful to him, for that were not matters in dispute either.
As the learned counsel for the assessee pointed out, the Tribunal failed to understand the scope of the payment; it failed to view it from the view
point of commercial expediency. The Tribunal then referred to the fact that the expenditure was not debited to the profit and loss account, but was
debited to the appropriation account, thereby strongly indicating that it was an extraordinary payment or a payment made m the nature of capital
expenditure.
Every extraordinary payment is not necessarily an expenditure of a capital nature. Entry in the accounts by itself may not conclude the question,
what was the nature of the payment. Neither of the two features to which we have referred above, which were taken into consideration by the
Tribunal in disallowing the assessee''s claim, was really relevant. But that does not in any way affect our decision in this case on the question,
whether the claim of the assessee falls within the scope of Section 10 (2) (xv) of the Act.
We have already pointed out that to bring a claim within the scope of Section 10 (2) (xv) it is not enough to show that It was not in the nature
of a capital expenditure. The further test of Section 10 (2) (xv) has to be satisfied; was the amount laid out or expended wholly and exclusively for
the purpose of the business of the assessee company.
In this case the sum of Rs. 40,000 was paid as gratuity on retirement for the valuable services rendered by the employee, Mr. Philips. There was
no evidence to show that at any time before the payment was resolved Mr. Philips expected to receive it or even that the company contemplated
its payment. No doubt the payment was for past services rendered. But it was not remuneration that the company was bound to pay for those
services.
The payment of gratuity was voluntary. Even a voluntary payment could satisfy the requirements of Section 10 (2) (xv). In this case, there was no
evidence to show that it was in the future interests of the business of the assessee that the expenditure was incurred. In the case of a payment of a
gratuity to a retiring employee recognition of his past services, with nothing more, cannot, in our opinion, satisfy the requirements of Section 10 (2)
(xv), even if those requirements are judged from the view point of commercial expediency, as it always should be when a claim arises u/s 10 (2)
(xv) .
Was the expenditure incurred in the future interests of the business of the assessee? Was there any connection between the purpose of the payment
and the further conduct of the business of the assessee? These are the tests to be satisfied before it Could be said that in paying the gratuity, money
was laid out or expended wholly and exclusively for the purpose of the business of the company. These tests the assessee did not satisfy in this
case.
Mr. Subbaraya Aiyar, learned counsel for the assessee, pointed out that the company accepted it as a legitimate payment. But obviously that is
not enough to sustain a claim u/s 10 (2) (xv). As we said, the good faith attendant on the transaction was never in dispute.
The action of the company in rewarding a trusted employee after long years of faithful services by making him a substantial payment may be
laudable, but the question is, is it a claim that could be allowed u/s 10 (2) (xv) of the Act That question, in the circumstances of this case, has to be
answered in the negative.
We answer the question in the negative and against the assessee. The assessee will pay the costs of this reference. Counsel''s fee Rs. 250.