Patel Engineering Co. Ltd. vs Commissioner of Income Tax

A short but interesting point arises for determination in this reference in which the following question is referred to us by the Appellate Tribunal, Bombay Bench "C": Whether, on the facts and in the circumstances of the case, the percentage of allowance of entertainment expenditure as laid down in section 37(2) of the income tax Act, 1961, is to be applied to the profits and gains of the assessee''s own business or to the entire business income of the assessee inclusive of share income from joint ventures/partnerships.

In order to appreciate the arguments urged at the bar on behalf of the assessee and the revenue respectively, a few facts may be stated. The assessee is a limited company and we are concerned with the assessment years 1963-64 and 1964-65. In the former year, the assessee had claimed entertainment expenditure of Rs. 35,958. According to the ITO, the amount in excess of Rs. 15,557 was required to be disallowed and the same was accordingly disallowed. The amount disallowed came to Rs. 20,401. For the next year, the assessee had claimed entertainment expenditure in the amount of Rs. 30,000. The ITO only allowed the same in the amount of Rs. 7,431. We are concerned in this reference with the two disallowances.

It may be pointed out that the aggrieved assessee carried the matter in appeal to the AAC. One of the items of which complaint was made in the said appeal was as regards the disallowance of the entertainment expenditure. The AAC noted in his order that no reason for the disallowance had been given by the ITO in his order. The ITO had remained present before the AAC and he was presumably asked orally to indicate the basis of the disallowance and this is what the AAC has noted in this order for the above assessment years:

The ITO noticed that the appellant claimed entertainment expenses at Rs. 35,958 and he allowed Rs. 15,557 only out of the total claim. The ITO has not given any reason for disallowance. Apparently there seems to be no dispute that the expenses were incurred wholly and exclusively for the purpose of business of the company. The ITO who was present stated he had disallowed a part of the entertainment allowance u/s 37(2).

On behalf of the assessee, it was contended before the AAC that the ITO had failed to interpret correctly section 37(2) of the Income- tax Act (hereinafter referred to as "the Act") and that if the section was correctly interpreted, the expenses would be within the allowable limit.

In his order the AAC proceeded to indicate the various heads of income earned by the assessee. The question considered by the AAC then was whether the statutory percentage of the allowable expenditure on entertainment was required to be calculated on the total income of the assessee. It was conceded that if the entire income was to be taken into account then the total expenditure claimed on entertainment was certainly below the limit prescribed u/s 37(2). According to the AAC, the statutory provisions made it clear that the income as reflected in the profit and loss account of the appellant-company only should be taken into consideration for measuring the allowable percentage and the income earned by the assessee from joint ventures/partnerships ought not to betaken into account. The AAC noted that the assessee had received shares in joint venture/partnership business, principally from three sources, and if these large amounts are excluded then the disallowance made by the ITO would be justified.

The assessee carried the matter to the Appellate Tribunal. The Tribunal found itself in complete agreement with the reasoning of the AAC. In its view, the words "the business" occurring in section 37(2) must be interpreted as the assessee''s own business. This meant, according to the Tribunal that the income as reflected in the profit and loss account of the assessee-company should only be considered in measuring the statutory percentage. If the other view which was canvassed by the assessee were to prevail then, according to the Tribunal serious anomalies would result. The adoption of the other view would, in the opinion of the Tribunal, defeat the very object of the section in putting a ceiling on the entertainment expenditure as envisaged in the section.

Now, the total income of the assessee for the two years under consideration is set out in the statement of case and the same is as follows:

Assessment year

1963-64

1964-65

Rs.

Rs.

Income from own business

15,36,081

2,92,572

Share income from joint ventures partnerships

45,77,299

48,58,506

Dividends, interest on securities and capital gains

38,992

47,303

Total income

61,52,372

51,98,381

It seems to be the obvious position that the assessee''s income from dividends, interest on securities and capital gains for the two years under consideration, viz., Rs. 38,992 and Rs. 47,303, will be required to be excluded. This has not been disputed by Mr. Dastur. The question, however, which is required to be seriously considered is whether the limit prescribed by section 37 is to be calculated on the profits and gains of the wholly owned business of the assessee-company, viz., Rs. 15,36,081 and Rs. 2,92,572, respectively or whether the share of the income received by the assessee-company from the joint ventures/partnerships, which income comes to substantial amounts in the two years under consideration, is also to be considered.

It is necessary in our opinion to set out in the first place the provisions of section 37. It reads as under:

General. -(1) Any expenditure (not being expenditure of the nature described in sections 30 to 36 and section 80VV and not being in the nature of capital expenditure or personal expenses of the assessee), laid out or expended wholly and exclusively for the purposes of the business or profession shall be allowed in computing the income chargeable under the head ''Profits and gains of business or profession''.

(2) Notwithstanding anything contained in subsection (1), no expenditure in the nature of entertainment expenditure shall be allowed in the case of a company, which exceeds the aggregate amount computed as hereunder:-

(i) on the first Rs. 10,00,000 of the profits and gains of the business (computed before making any allowance u/s 33 or section 33A or in respect of entertainment expenditure)

at the rate of 1 percent or Rs. 5,000 whichever is higher;

(ii) on the next Rs. 40,00,000 of the profits and gains of the business (computed in the manner aforesaid)

at the rate of 1/2 percent;

(iii) on the next Rs. 1,20,00,000 of the profits and gains of the business (computed in the manner aforesaid)

at the rate of 1/4 percent;

(iv) on the balance of the profits and gains of the business (computed in the manner aforesaid)

nil. "

The short question is whether the Tribunal is right in its view that profits and gains of the business must necessarily mean the profits and gains of a business wholly owned by the assessee and exclude necessarily the income of the assessee from joint ventures/partnerships.

Before considering the question, it may be pointed out that we are proceeding to answer the question referred to us on the footing that there is no dispute that the entertainment expenses were incurred wholly and exclusively for the purposes of the business of the company. This has been made clear by the AAC in his order dealing with the disallowance of the entertainment expenditure. Thus, the ITO seems to have conceded and, hence, accepted that there were expenses covered by section 37(1). We thus left in this reference with the limited question of considering how the limit of entertainment expenditure prescribed by section 37(2) is to be calculated in the instant case.

The Tribunal in its order confirming the view of the AAC has laid stress in the first place on the expression "the business" which we have in clauses (i), (ii), (iii) and (iv) prescribing the percentage for calculating the limits of allowable entertainment expenditure. It is further to be borne in mind that the same phrase "the business" also occurs in section 37(1) where we have a provision for allowance of expenditure "laid out or expended wholly and exclusively for the purpose of the business or profession".

Now section 14 of the Act deals with heads of income and head "D" deals with profits and gains of business or profession. It is true that the article "the" is not to be found in the said section. Profits and gains of business or profession are further explained by section 28 of the Act where it is provided, inter alia, that profits and gains of business or profession will include the profits and gains of any business or profession which was carried on by the assessee at any time during the previous year. What is the significance to be attached to the departure from the phraseology employed in section 28 where business was prefixed with the word "any" and the substitution of the said word by the word "the" in section 37? Will this change warrant the view taken by the Tribunal that the business would mean the wholly owned business of the assessee-company and not its other business income?

It has to be borne in mind that section 37(2) is a special provision for companies and that special provision is in the nature of prescribing a limit on allowable entertainment expenditure. In other words, such expenditure would be allowed for any other assessee and would be required to be allowed even for a limited company, were it not for the limit prescribed. Two consequences must follow once this position is realised. In the first place, the statutory provision must be strictly construed, i.e., liberally as far as assessee is concerned and strictly as far as the department is concerned. In the second place, if two interpretations are possible to be given to the same, then, since it is a provision prescribing a limit or imposing a ceiling on allowable expenditure occurring under a taxing statute, that interpretation is required to be given which is more beneficial to the assessee.

It would appear that the very provisions has not come up for consideration before any High Court or the Supreme Court. However, in Commissioner of Income Tax, Bihar Vs. Ramniklal Kothari, , it has been observed by the Supreme Court that share in the profits of a partnership received by a partner is "profits and gains of business" carried on by him. It has been observed further that "it is a matter of no moment that the total profits of the partnership were computed in the manner provided by section 10 of the Act and allowances admissible to the partner ship in the computation of the profits and gains were taken into account". The Supreme Court made it clear that the income of the partnership carrying on business is computed initially as business income. Thereafter, the share of the partner in the taxable profits of the registered firms liable to be included in his total income and is still received as income from business carried on by him (emphasis supplied). In other words, according to the Supreme Court, the business carried on by a firm is business carried on by the partners and profits of the firm are profits earned by all the partners in carrying on the business.

Once the correct position is understood, it is required to be held that there is no warrant for reading the words "the business" as implying or meaning "the assessee''s own business" and not the share of profits in the partnership business carried by the assessee along with some other partner, even though the said partnership is a registered firm and thus a separate taxable entity. It is not permissible to give this interpretation to the statutory provision by considering what the object of the section was and whether the same would be defeated or frustrated by the interpretation to be put. The words used are "the business". It would appear from a perusal of the returns and the orders that the assessee earned an income of Rs. 15,36,081 from the construction business which was wholly owned by it (for the assessment year 1963-64) and for the very same year it earned Rs. 45,77,299 as its share of income from joint ventures/partnerships from similar construction work. The latter business, how ever, was not wholly owned by the assessee but were either joint ventures or partnerships. According to the Supreme Court as per its observations in Ramniklal Kothar''s case (supra), both these are businesses of the assessee and hence both the income must be regarded as its business income. The words occurring in section 37(2)(ii), viz., "on the first Rs. 10,00,000 of the profits and gains of business" cannot be read to include one out of two heads of business income and in the instant case bearing in mind that the nature of activity is more or less identical, though at different place, the limit will have to be calculated aggregating the two heads of business income for both the years under consideration.

In this connection we may refer to the observations of the Supreme Court in COMMISSIONER OF Income Tax, ANDHRA PRADESH Vs. A. DHARMA REDDY (DECD.). (BY HIS LEGAL REPRESENTATIVE)., where the emphasis appears to be on the nature of the business and not on the organisational set up in which the same is carried on. It has been observed by the Supreme Court in that decision that the assessee before it must be regarded as carrying on the business of taking contracts in respect of or dealing in bidi leaves irrespective of whether he did the same individually (hence wholly owned) or in partnership with someone else. If these observations in A. Dharma Reddy''s case (supra) are also considered and applied they would seem to suggest that the assessee was carrying on construction business although in different set up and the limit prescribed by section 37(2) would be required to be calculated having reference to all income from that business irrespective of whether a part of that income arose to the assessee from ventures carried on jointly or in partnership with others and part from venture wholly carried on by the assessee.

We make it clear that we have proceeded to consider the question referred to us on the footing that it is expressly conceded by the ITO that this amount is laid out or expended wholly or exclusively for the purpose of the business of the assessee. It is on that footing which is reflected in the order of the AAC that we have considered the computation of the limit prescribed u/s 37(2). On that footing, the question referred to us is answered as follows:

In case of this assessee and for the two years under consideration the percentage of allowance of entertainment expenditure as laid down in section 37(2) is to be applied to the entire business income of the assessee inclusive of share income from joint venture/partnership. It is made clear that the dividends, interest on securities and capital gains will be required to be excluded. The Commissioner to pay the costs of the reference to the assessee.