Sirhind Steel Pvt. Ltd. vs Commissioner of Income Tax

M.S. Shah

In this reference at the instance of the revenue, the following question has been referred for the opinion of this Court in respect of assessment year 1982-83:-

"Whether, on the facts and circumstances of the case, the provisions of section 40A(2) were applicable?"

The facts giving rise to this Reference, briefly stated, are as under:-

2.1 The assessee is a private limited company engaged in the business of re-rolling steel into C.T.D.. bars as also the conversion work of P.W.D. on job basis. Its directors R.R. Malhotra, A.R. Malhotra and Ravinder Malhotra, were carrying on business in partnership in the name and style of M/s. Malhotra Steel Corporation. On 16-10-1978, the assessee-company became a partner in that firm. Thereafter the firm was dissolved with effect from 30-6-1980 and the business was taken over by the assessee-company. A dissolution deed was drawn on 1-8-1980. Clause 6 of the deed of dissolution stated that the company was not in a position to make full payment of the balance standing to the credit of the above mentioned three persons in their capital account and hence they agreed to retain amounts of Rs.2 lacs each in each of their respective sarafi account for ten years (aggregate amount of retained capital Rs.6 lacs). In consideration thereof, the company agreed to pay to each of them for a period of 10 years 5% of the net profit of the company (aggregate 15% net profit) or 15% per annum on the amounts credited to the sarafi account of each of them, whichever is higher.

2.2 The accounting year in question ended on 30-6-1981 relevant to assessment year 1982-83. The assessment was framed on 14-3-1983 determining the total income of the assessee at Rs.43,01,922/-. The assessee company''s claim for deduction of Rs.7.93 lacs paid to the former partners as return on their retained capital of Rs.6 lacs was allowed on the basis of Clause 6 in the dissolution deed for payment of 5% of the gross profits payable to each of the three former partners.

2.3 On 31-1-1985, the Commissioner of Income Tax(CIT) issued a show cause notice u/s 263 of the Act. The assessee-company submitted its reply dated 22-2-1985. After considering the same, the CIT passed order dated 12-3-1985 holding that the order dated 14-3-1983 passed by the I.T.O. was erroneous and prejudicial to the interest of the revenue, inasmuch as the payment of Rs.2,57,729/- each to the three Directors of the company had been wrongly allowed by the I.T.O. while computing the total income. The CIT directed the I.T.O. to revise the assessed income by adding the amount in question as the same was not allowable as a deduction. Alternatively, the CIT was of the view that the provisions of section 40A(2) as also section 40A(8) were applicable to the aforesaid payment, as the payment was excessive and unreasonable.

2.4 The assessee-company carried the matter in appeal before the Tribunal against the aforesaid order of the CIT u/s 263. The Tribunal dismissed the appeal holding that the CIT had rightly invoked his powers and assumed jurisdiction u/s 263. The Tribunal was of the view that provisions of section 40A(2) would be squarely applicable in view of the close connection between the payer and the payee, as the outgoing partners were also the present Directors of the assessee-company, a closely held private limited company. While observing that it was for the assessee-company to decide whether to retain the amount of Rs.6 lacs being the capital of the three partners (who are now Directors of the company) with the assessee-company as a deposit, the Tribunal held that the payment of Rs.7.93 lacs made by the assessee-company to the three former partners of the firm (who are now the Directors of the assessee-company) as profit/interest for retaining the refundable deposit of Rs.6 lacs for the year under consideration and also a recurring liability to share 15% profits/pay 15% interest (whichever is higher) for another period of nine years was excessive and unreasonable and 50% of such payment was disallowed by the Tribunal for the assessment year in question i.e. 1982-83. Hence, this reference at the instance of the assessee.

At the hearing of this reference, Mr. R.K. Patel learned counsel for the assessee urged the following contentions :

3.1. NO ADDITION/DISALLOWANCE IS SUSTAINABLE

1) Once Tribunal disapproved the method of revision on alternatives by the Commissioner u/s. 263, no addition/disallowance can be sustained on any other estimate basis.

2) Tribunal has concluded that amounts payable to ex-partners were in the interest of business and tax authority can not interfere with the decision of businessmen.

3) There is a factual finding of Tribunal that transaction is not doubted and there is no attempt to evade tax.

4) There is finding that there are huge liabilities and liabilities of outsiders are being given preference so far as discharging of business liability is concerned.

5) Sharing of profits on the facts and circumstances of the case is not prohibited by law.

3.2. NON APPLICABILITY OF SECTION 40A(2)

1) Department has not proved pre requisite conditions required for the existence of excessive/unreasonableness of payments as compared to fair market value of services to outsiders.

2) Ex-partners are taxed in higher slabs of rates of tax and the only basis for retaining 50% disallowance by Tribunal is that they may not be taxed in future in higher bracket of tax rate.

3) Reliance is placed on Circular No.6P of 1968 dtd.6th July, 1968 (Chaturvedi and Pithisaria - Vol.II Page 2431 at Para 74 on Page 2432), for the purpose of contending that the powers under sec. 40A(2) can not be invoked when there is no tax evasion.

3.3 The learned counsel for the assessee has placed strong reliance on the decisions of this Court in Marghabhai Kishabhai 108 ITR 54 Guj, and in Voltemp Transformer 129 ITR 105 Gujarat.

On the other hand Mr.Akil Kureshi, learned counsel for the Revenue has made the following submissions :

4.1 The power under sec. 40A(2) can be invoked whenever the tax authority is of the opinion that the expenditure or payment is excessive or unreasonable having regard to the relevant considerations mentioned in the provision, so much of the payment as is considered by the tax authority to be excessive or unreasonable shall not be allowed as a deduction. The facts are glaring. For retaining an amount of Rs.6 lacs of the former partners (the present Directors of the assessee -company), the assessee-company pays return of Rs.7.93 lacs for one year with similar liability to pay profits at the rate of 15% of the gross profits for the next five years or interest at the rate of 15% per annum whichever is higher for the next nine years. This fact is too glaring to be ignored.

4.2 Malhotra Steel Corporation (i.e. a dissolved firm) was doing lucrative business and earning good profits. Hence, at the time of dissolution, the parties knew that the firm was making substantial profits and that 15% of the amount of gross profit of the firm is going to be a sizeable amount.

4.3 The three outgoing partners of the dissolved firm are Directors in the assessee- company (which is a closely held Private Limited Company which took over the business of the dissolved firm). Hence, this was a case of the payer and payee being the same persons for all practical purposes. Whatever assets in the partnership firm which they gave up in dissolution, they got them as share holders and directors of the closely held private limited company.

4.4 The fact that the outgoing partners ( present Directors of the assessee-company) paid individual tax on the amounts of Rs.7.93 lacs received from the assessee company as return on their capital can not wipe out the fact that even if the said outgoing partners had been paid by the assessee company interest at 30% p.a., only that part of the amount (i.e. Rs. 1,80,000/-)would have been deductible from the income of the assessee company and on the balance amount of Rs.6,13,000/- the assessee-company would have had to pay income tax at the corporate rate plus the outgoing partners (who are present Directors of the assessee-company) would also have to pay income tax on dividend from the assessee company at the individual rates (they were in the high bracket). Hence, by the arrangement in question, the Directors of the company decided to pay this huge amount as return on their own capital i.e. their capital in their capacity as the outgoing partners of the dissolved firm.

4.5 In any view of the matter, the finding that the payment made by the assessee-company to the outgoing partners (the present Directors of the assessee-company) was excessive and unreasonable to the extent of 50%, is a finding of fact which has been given by the Tribunal after taking into consideration all the relevant facts and circumstances and that the finding of the Tribunal is not outside the bracket nor is it such that no reasonable person could have arrived at. In short, the finding of the Tribunal can never be said to be perverse. Hence, this court may not go behind the finding of fact given by the Tribunal.

Before dealing with rival submissions, it is necessary to refer to the provisions of section 40A(2) of the Act, which reads as under:-

40 A (2)(a) "Where the assessee incurs any expenditure in respect of which payment has been made or is to be made to any person referred to in clause (b) of this subsection, and the Income Tax Officer is of opinion that such expenditure is excessive or unreasonable having regard to the fair market value of the goods, services or facilities for which the payment is made or the legitimate needs of the business or profession of the assessee or the benefit derived by or accruing to him therefrom, so much of the expenditure as is so considered by him to be excessive or unreasonable shall not be allowed as a deduction: Provided that the provisions of this sub-section shall not apply in the case of an assessee being a company in respect of any expenditure to which subclause (i) of clause (c) of section 40 applies.

It is clear that the Legislature has laid down the relevant considerations for enabling, and empowering, the ITO to decide whether the payment in question made by the assessee is excessive or unreasonable so as to warrant disallowance.

u/s 263 of the Act, the Commissioner came to the conclusion that the decision of the ITO to allow the entire amount of Rs.7.93 lacs as payment which was not at all excessive or unreasonable was prejudicial to the interest of the revenue. The Commissioner disallowed the entire payment. In appeal the Appellate Tribunal held that having regard to the facts and circumstances of the case, the payment was excessive and unreasonable only to the extent of 50%. Hence, 50% payment was allowed as deductible business expenditure and the remaining 50% was disallowed. Having heard the learned counsel for the parties, the Court is of the view that there is considerable substance in the submissions made by the learned counsel for the revenue that the finding given by the Tribunal that the payment made by the assessee-company to the three outgoing partners (the present Directors of the assessee-company) is excessive or unreasonable to the extent of 50% is a finding of fact which does not warrant any interference by this Court.

6-A. We also find considerable substance in the submission made by Mr. Kureshi for the revenue that the question arising out of section 40A(2) - whether a particular expenditure is excessive and unreasonable or not, is essentially a question of fact and does not involve any issue of law. In taking this view, we are fortified by the decision of the Apex Court in Upper India Publishing House (P) Ltd. Vs. Commissioner of Income Tax, Lucknow, , decision of the Delhi High Court in Commissioner of Income Tax Vs. Northern India Iron and Steel Co. Ltd., , and decision of the Punjab & Haryana High Court in Narain Motors Vs. Commissioner of Income Tax, .

As regards the contention urged by the learned counsel for the assessee that once the Tribunal disapproved the method of revision on alternatives by the Commissioner under sec. 263, no addition/disallowance can be sustained on any other estimate basis, the contention is misconceived. It is open to the authority to arrive at a conclusion that the order of the assessing authority is prejudicial to the interest of the revenue by examining the matter from more than one possible angle and then to support its conclusion with more than one reason. If the authority examines all the possible arguments coming from the assessee and finds no substance in them, it is open to revisional authority to hold that, looking at from whatever angle, the assessment calls for revision in respect of a particular item the payment of which was allowed by the assessing officer and which has caused serious prejudice to the revenue.

As regards the second contention, the learned counsel for the assessee has obviously misread the order of the Tribunal. All that the Tribunal observed was that the decision of the assessee-company to retain the amount of Rs.6 lacs (which was the capital of the outgoing partners in the dissolved firm) was the decision of a businessman looking to the business exigencies and the Commissioner could not have disallowed the entire payment of Rs.7.93 lacs to the outgoing partners (the present Directors of the assess) only on the ground that the amount of Rs.6 lacs ought not to have been retained by the assessee-company but ought to have been paid off if necessary by borrowing from outside sources. Thus after coming to the conclusion that it was not for the Department to decide whether the assessee-company was justified in retaining the amount of Rs.6 lacs, there was no contradiction in examining whether the return given by the assessee-company to the outgoing partners (the present Directors) on the retained capital was excessive or unreasonable having regard to the relevant factors. Hence, the second contention does not carry the assessee''s case any further.

Coming to the third contention, it is required to be noted that the power available to the tax authority u/s 40A(2) is not available only in the case of sham or bogus transactions but it is available even in case of bonafide transactions if the expenditure or payment is found to be excessive or unreasonable having regard to the relevant factors and it is only excess/unreasonable payment, which is to be disallowed. Hence, it is not possible to accept the assessee''s contention that once the transaction is not found to be malafide or "device" the power u/s 40A(2) cannot be exercised. It was open to the Tribunal, as an appellate authority, to inquire into the question whether the Commissioner''s finding that the payment was excessive or unreasonable was proper or not.

10.1 At this stage, it would not be out of place to note the submission made by the learned counsel for the revenue that even if the assessee company had paid interest on the retained capital of Rs.6 lacs at 30% (the bank rate at the relevant time did not exceed 24%), on the balance amount of Rs.6.13 lacs (Rs.7.93 lacs minus Rs.1.80 lacs), the assessee-company would have been required to pay Income Tax at the corporate rate and the three Directors of the assessee-company (outgoing partners) would also have been required to pay income tax on the income which they would have got by way of dividend from the assessee-company at the highest individual rates and, therefore, there is no justification for proceeding on the basis that there was no attempt to evade or avoid income tax. The learned counsel for the assessee would, of course, counter the said suggestion by submitting that the revenue had not led any evidence to show what would have been the income tax payable by the present Directors of the assessee company (three outgoing partners) on the dividend which they would have received out of the amount in question (Rs.7.93 lacs minus interest at 30% or whatever may be the rate of interest).

10.2 We need not go into this dispute nor was it necessary for the Tribunal to calculate with mathematical precision or arithmetical accuracy the aggregate of the amount of tax which would have been payable by the assessee company on the excess payment and by the three directors of the assessee company (outgoing partners) on the amount of dividend which they would have received if the disputed amount was not paid to them by way of return on retained capital. The Tribunal has allowed 50% of payment i.e. 50% of Rs. 7.93 lacs as a reasonable return on retained capital of Rs. 6 lacs, after taking into consideration all the relevant facts including the fact that the outgoing partners (who are the Directors of the assessee-company at the time of dissolution and thereafter) had given up a lucrative business whose goodwill at the time of dissolution could be evaluated at a huge figure and they also gave up large bundle of rights as stated in the dissolution deed which included licences, quota, tenancy rights etc.. In other words, when the assessee-company paid Rs. 7.93 lacs as return on the retained capital of Rs.6 lacs, the assessee-company has been allowed deduction to the extent of Rs.3.91 lacs which would come to almost 65% return on the retained capital of Rs. 6 lacs in the very first year. When such a large junk of payment (65%) from the assessee-company to the outgoing partners (the present Directors of the assessee-company)by way of return on their capital retained by the assessee-company is allowed by the Tribunal, in spite of the fact that whatever goodwill, licenses, tenancy rights etc. which were enjoyed by the firm before dissolution were taken over by the closely held private limited company (assessee company) of which the outgoing partners became directors, we do not think that any detailed inquiry was required to be held by the Tribunal about the possible taxes which the assessee company would have been required to pay on excess payment and the Directors would have been required to pay on the dividend which they would have received instead of the return on their capital (i.e. Rs.7.93 lacs minus 30% interest on Rs.6 lacs). This Court is, therefore, of the view that even though sharing of profits by the outgoing partners in lieu of return on their retained capital is not prohibited by law, the Tribunal did not err in holding that the return of Rs.7.93 lacs on the retained capital of Rs.6 lacs was excessive and unreasonable to the extent of 50%.

10.3 The Tribunal has also referred to the following payments made by the assessee-company to the outgoing partners (the present Directors of the assessee-company) for four years including the present assessment year.

Asstt. Year Amount

1982-83 7,73,187

1983-84 5,78,561

1984-85 5,35,512

1985-86 90,000

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19,77,160

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It is after the order dated 12-3-1985 of the CIT under sec. 263 that the assessee-company paid off all its liabilities to the outgoing partners (the present Directors) by returning the capital amount of Rs.6 lacs which goes to show that the assessee-company had made the arrangement to reduce its tax liabilities and not out of any commercial considerations.

In view of the above conclusion, this Court is of the view that the relevance of circular No.6-P dated 6th July, 1968 is of no consequence because this Court is not in a position to express a view that the assessee-company had not resorted to the arrangement in question to reduce its tax liabilities or to evade the payment of tax. This Court is not in a position to say that the arrangement made by the assessee-company was bonafide. Even otherwise, the view taken by the Tribunal that it does not approve of any method which would cast a burden on the exchequer for a period of ten years cannot be said to be perverse. This Court is of the view that the Tribunal was justified in holding that the provisions of section 40A(2) were squarely applicable to the facts of the case and the disallowance to the extent of 50% under the said provision does not warrant any interference by this Court.

11-A. In VED PRAKASH M. PATEL Vs. COMMISSIONER OF Income Tax., , the Madhya Pradesh High Court also had an occasion to consider a similar case where the beneficiaries of the royalty under an agreement in question were being paid the royalty in sum equal to the amount of the investment. The High Court upheld the finding of the Tribunal that the payment of royalty was excessive after noting that had the beneficiaries of the royalty under the agreement not been the members of the assessee''s own family and were outsiders, such an agreement whereunder a sum equal to the amount of the investment was to be paid as royalty would not have been entered into by any prudent businessman.

As regards the decision cited by the learned counsel for the assessee in MARGHABHAI KISHABHAI PATEL and CO. Vs. COMMISSIONER OF Income Tax, GUJARAT., , in that case this Court had no occasion to consider the provisions of sec. 40A(2) of the Act because that case related to assessment years 1962-63 to 1965-66 whereas the provisions of section 40A were inserted by the Finance Act, 1968 w.e.f. 1-4-1968. Moreover, in the aforesaid case, the commodity in question was tobacco and the assessee had contended that it had paid higher price for better quality of tobacco. This Court was, therefore, of the view that since qualities of tobacco differ very widely and also there may be fluctuations in the market from time to time, striking an average of the price of all tobacco purchased during the entire season irrespective of qualities and of fluctuations in the market rate was a very unscientific method followed by the Department in arriving at its conclusion and the Department had no right to depart from the prices shown in the books of account unless it found the transaction not to be a bonafide one or to be a sham one or unless it found that the prices paid were not what was shown in the books of account. As already stated above, the Court had no occasion to consider the provisions of section 40A(2) of the Act and the commodity in question was one which was susceptible to fluctuations in terms of price as well as in terms of quality. Whatever may be the fluctuations in the rate of interest on monies being borrowed from the market, it could never be 130% p.a. which was the rate of return paid by the assessee company to its directors on their capital as former partners. When the Tribunal has disallowed only 50% of that amount as excessive or unreasonable (i.e. 65%), the decision in Marghabhai''s case (supra) can not come to the assessee''s rescue.

As regards the decision of this Court in Voltamp Transformers P. Ltd. vs. CIT (1981) 129 ITR 105, it is true that in that case the Court did have an occasion to consider the provisions of section 40A(2) of the Act but in that case the facts were entirely different. The assessee therein was carrying on the business of manufacture and sale of electric transformers. The assessee-company had agreed to pay commission to sole selling agency which was a partnership firm wherein the partners were wives of the Directors of the assessee-company. The agreed rate of commission was at the rate of 3% (three per cent) in case of sales made to Government or semi-Government institutions and 5% (five per cent) in the case of sales to a private party. The commission was to be calculated on the invoice value of the goods sold by the company. Sales tax, general sales tax, excise duty or any other taxes, freight, transport charges, etc. were not to be included in the net invoice value for the purpose of calculating the commission. In the year in question, i.e. the year ending June 30, 1968 relevant to the assessment year 1969-70, the assessee-company paid a total amount on commission of Rs.80,977/- (eighty one thousand only) to the partnership firm in question. The question was - whether this amount of commission could be allowed. The I.T.O. disallowed the entire commission amount on the ground that there was no commercial expediency for paying commission. It was in this set of facts that this Court held that the finding given by the Tribunal that the partnership firm business was not really carried on by its partners and that the partnership firm did not appear to be genuine was not warranted as the partnership firm was already formed since 1965 and it had been doing considerable business in the line of electric materials. This Court also held that so far as the questions of commercial expediency and business needs of an organisation are concerned, it is not the view-point of a revenue officer which should count but it should be the view-point of an ordinary businessman dealing with a situation like the one faced by the particular assessee in question.

In the facts of the aforesaid case, therefore, this Court came to the conclusion that the payment of 5% commission was a fair market value for the services rendered by the sole selling agency.

In the facts of the instant case, the Tribunal did hold that the decision of the assessee-company whether to retain an amount of Rs.6 lacs - the capital of the outgoing partners (the present Directors of the assessee-company) or to pay it off was the decision of the assessee-company as a businessman and that such decision was not to be interfered with but the Tribunal was justified in considering the question whether the return paid by the assessee company to the outgoing partners (the present Directors of the assessee-company) was excessive or unreasonable or not. This is a question of fact which the Tribunal has considered with due regard to all the relevant facts and circumstances and the criteria laid down in Section 40A(2) and thereafter the Tribunal has rightly held that payment of Rs.7.93 lacs as return on the retained capital of Rs.6 lacs for one year and liability to pay 15% profits for the next nine years with liability of the assessee-company to refund full amount of Rs.6 lacs after ten years was certainly excessive and unreasonable. This Court finds no reason to interfere with the view taken by the Tribunal. If at all there was any error committed by the Tribunal it was in favour of the assessee company by making disallowance to the extent of 50% only. However, we need not examine it any further as no question has been referred to us at the instance of the revenue.

This Court is, therefore, of the view that the Tribunal was right in applying the provisions of section 40A(2) of the Act to the facts of the instant case. Our answer to the question is accordingly in the affirmative i.e. in favour of the revenue and against the assessee.

The Reference accordingly stands disposed of with no order as to costs.