Anglo-French Textile Co. Ltd vs Commissioner of Income Tax, Madras

Rewritten Version Notice: This is a rewritten version of the original judgment.

Court: Supreme Court of India

Case Number: Civil Appeal No. 12 of 1952

Decision Date: 22 December 1952

Coram: Mehr Chand Mahajan, Vivian Bose, Natwarlal H. Bhagwati

In this case the Supreme Court of India considered the appeal filed by Anglo-French Textile Co. Ltd. against the Commissioner of Income-Tax, Madras. The appeal was heard on 22 December 1952 and the judgment was delivered by Justice Mahajan. The bench was composed of Justices Mehr Chand Mahajan, Vivian Bose and Natwarlal H. Bhagwati. The petitioners were identified as Anglo-French Textile Co. Ltd. while the respondents were the Commissioner of Income-Tax, Madras. The official citation of the decision is reported as 1953 AIR 105 and 1953 S.C.R. 454, with additional citator references including C 1954 S.C. 198, R 1958 S.C. 269, R 1958 S.C. 861, and R 1965 S.C. 1526. The judgment concerned the provisions of the Indian Income-Tax Act (XI of 1922), specifically sections 42(1) and 42(3) dealing with non-resident purchase of materials in India through an established agency and the concept of an “operation” in India for the purpose of assessing profits attributable to such purchases. The headnote explained that while a few isolated purchases of raw materials in India by a manufacturer located abroad may not constitute an “operation” under section 42(3), systematic and habitual purchases made through a competent agency in India do constitute an “operation”. Consequently the portion of profits attributable to those purchases can be assessed to income-tax under sections 42(1) and 42(3). The Court relied upon earlier decisions including Bangalore Woollen, Cotton & Silk Mills Co. Ltd. v. Commissioner of Income-Tax, Madras (1950), Commissioner of Income-Tax, Bombay v. Ahmedbhai Umarbhai & Co. (1950), Commissioners of Taxation v. Kirk (1900), Rogers Pyatt Shellac Co. v. Secretary of State for India (1925) and Webb Sons & Co. v. Commissioner of Income-Tax, East Punjab (1950). The Court observed that an isolated transaction lacking a continuing business relationship does not attract section 42, whereas a continuous relationship between the Indian intermediary who assists in making the profit and the foreign party who receives the profit establishes a business connection.

The appeal arose from Civil Appeal No. 12 of 1952 and was filed against the judgment and order dated 18 January 1950 of the High Court of Judicature at Madras, which had been rendered by Judges Satyanarayana Rao and Viswanatha Sastri on a reference made by the Income-Tax Appellate Tribunal under section 66(1) of the Indian Income-Tax Act. Counsel for the appellant was a senior advocate assisted by a junior, while the respondent was represented by the Attorney-General for India, the Solicitor-General for India, and their junior counsel. The Supreme Court judgment was pronounced by Justice Mahajan, who delivered the opinion after reviewing the procedural history, the factual background of the appellant’s foreign corporation purchasing cotton in British India through an established agent, and the legal question of whether such activity created a taxable “operation” and a business connection under the relevant tax provisions. The Court’s decision clarified the scope of sections 42(1) and 42(3) concerning non-resident enterprises engaging in systematic procurement of raw materials in India via an agency.

The Tribunal had exercised its jurisdiction under section 66(1) of the Indian Income-tax Act, and consequently the High Court was called upon to answer two questions that had been referred to it, both of which were answered in the affirmative. The appellant in this matter was a public limited company that had been incorporated in the United Kingdom and that owned a spinning and weaving mill situated at Pondicherry, which at the time formed part of French India. The company’s financial year corresponded with the calendar year. In the year 1939 the company did not sell any yarn or cloth that it had manufactured in British India, although it had made such sales in the preceding year. All of the cotton that was required for the operation of the mill was purchased in British India from a firm identified as Messrs. Best & Co., Ltd. An agreement dated 11 July 1939 between the appellant and Messrs Best & Co., Ltd., whose office was in Madras, appointed that firm as the appellant’s agents for the purpose of conducting its business in India. Under the terms of that agreement the agents were granted full authority to act on behalf of the appellant in matters relating to the purchase of stock, to the signing of bills of exchange, other negotiable instruments and receipts, and to the settlement, compounding or compromise of any claim made by or against the appellant. The agents were also empowered to borrow money on the appellant’s behalf and to make advances. In addition, they were expected to obtain the most favourable commissions, brokerages, rebates, discounts and other allowances that could be secured in connection with the appellant’s business. The agreement required the agents to keep proper accounts for the appellant and to remit to the appellant any sums that were due. For their services the agents received a fixed salary of Rs 6,500 per month together with a commission calculated as a percentage of the profits earned. During the relevant assessment year all purchases of cotton needed for the Pondicherry mill were undertaken by these agents in British India and no purchases were made through any other channel. The agents exercised their judgment and skill, selecting the quality, quantity and price of cotton that they, in their experience, considered most advantageous for the company’s interests. Prior to the assessment year 1939-40 the appellant had been assessed to income-tax in British India on the basis of profits computed on a turnover basis that arose from sales in British India of the goods it manufactured. In the assessment year 1939-40 the appellant declared that it had discontinued its business in British India effective from 1 April 1939 and accordingly claimed relief under section 25(3), relief that was granted. However, during further enquiry the Income-tax Officer discovered that, although the appellant was no longer selling its products in British India and therefore not earning profit from such sales, it continued to maintain an active business connection in British India because of the manner in which the purchase of goods and materials for the mill was conducted. On that basis the Income-tax Officer held that the purchase of cotton in British India constituted a business connection within British India and that the profits attributable to those purchases were liable to tax.

In this matter, the Income-Tax Officer held that the purchases of cotton made in British India created a business connection within that territory, and consequently the profits attributable to those purchases were liable to tax under sections 42(1) and 42(3) of the Act. The officer calculated the net income of the company to be Rs 2,81,176 and then apportioned ten per cent of that amount, on the basis of section 42(3), as the profits and gains reasonably attributable to the portion of the business that was carried out in British India. The appellant challenged this assessment by filing an appeal with the Appellate Assistant Commissioner, who affirmed the Income-Tax Officer’s order. The appellant subsequently appealed to the Tribunal, but the Tribunal also dismissed the appeal. At the Tribunal’s instance, a set of questions was formulated for determination by the High Court under section 66(1) of the Act. The questions were as follows: first, whether, in the circumstances of the case, the assessee-company possessed any business connection in British India within the meaning of sections 42(1) and 42(3); and second, whether any profits could reasonably be attributed to the purchase of the entire cotton manufactured in British India by the secretaries and agents of the assessee-company, again within the meaning of those sections. The High Court answered both questions affirmatively and, in the view of this Court, did so correctly. The counsel for the appellant reiterated before this Court the same arguments that had been presented before the High Court, contending that, on the facts, there was no basis for a finding that any profits or gains accrued to the assessee either directly or indirectly from any business connection in India. The counsel maintained that a mere purchase of raw materials or goods in British India did not give rise to profits, emphasizing that profits on the sale of goods arose only at the place where the sales were effected. Since, in the year of account 1939-40, no sales were effected in British India, the counsel argued that no profits accrued or could be deemed to have accrued in that territory. To support this position, the counsel relied on several earlier decisions, including Board of Revenue v. Madras Export Co., Jiwan Das v. Commissioner of Income-Tax, Lahore, Rahim v. Commissioner of Income-Tax, and Commissioner of Income-Tax v. Little’s Oriental Balm Ltd. Most of those authorities were decided under the 1922 Act before the insertion of section 42(3) by the 1939 amendment. In contrast, a number of authorities cited to this Court have adopted the view that even the purchase of raw materials may constitute an operation connected with a business, and if such purchase is carried out in British India, the profits attributable to that operation may be taxable under section 42 of the Indian Income-Tax Act.

The Court explained that section 42 of the Indian Income-tax Act governs the taxation of profits that arise from operations carried out in British India. It cited the decision in Rogers Pyatt Shellac Co. v. Secretary of State for India as a leading authority on this point. That case had been decided under section 33 of the Indian Income-tax Act, 1918, and the judgment demonstrated that the principle applied there was later incorporated into section 42(3) of the Income-tax Act, 1922. The question referred to the High Court in Rogers Pyatt concerned whether a company that purchased shellac and mica in India for resale in the United States could be liable to income-tax and super-tax under either the Income-tax Act VII of 1918, the Act XI of 1922, or the Super-tax Act VIII of 1917. The High Court answered affirmatively, holding that the purchases constituted an operation within the meaning of the statutory provisions and thus gave rise to assessable profit. The same line of reasoning was subsequently adopted by the Rangoon High Court in Commissioner of Income-tax-Burma v. Steel Bros. Co. (1). The Court further noted recent decisions rendered under section 42 of the 1922 Act, specifically Motor Union Insurance Co. Ltd. v. Commissioner of Income-tax, Bombay (2) and Webb Sons & Co. v. Commissioner of Income-tax, East Punjab (3). In the Webb case the assessee, a United States corporation, manufactured carpets in America and purchased wool in British India through an Indian agent solely as raw material for use in carpet production. The Court held that such purchase was an operation covered by section 42(3), and that profits attributable to that purchase could be deemed to arise in British India and therefore were taxable under the same provision.

The Court recounted the precise questions that had been posed to the High Court in the Webb case: first, whether the mere purchase of raw material qualified as an operation within the meaning of section 42(3); and second, whether any profit could arise from the mere purchase of raw material. Both questions were answered in the affirmative. The Court observed that “it is clear that the purchase of raw material by a firm of manufacturers is one of the processes or operations which contributes to an appreciable degree to the ultimate profit which is realized on the sale of manufactured articles.” The Court highlighted that judicial opinion is not uniform on the proposition that purchase alone does not generate profit, citing authorities such as (1) (1926) I.L.R. 3 Rang. 614 and (2) A.I.R. 1945 Bom. 285, as well as (3) [1950] 18 I.T.R. 33. Finally, the Court turned to the contention advanced by counsel for the appellant, whose entire argument rested on the premise that profit can arise only from the act of sale and not from purchase. The Court indicated that this submission required careful consideration in light of the foregoing authorities.

The argument that profits arise only from the act of sale could no longer be sustained, and it had to be rejected in view of the decision of the Supreme Court in Commissioner of Income-tax, Bombay v. Ahmedbhai Umarbhai & Co. (1). That decision involved a proceeding under the Excess Profits Tax Act, XV of 1940. In the Ahmedbhai case the appellant was a firm resident in British India that engaged in the manufacture and sale of groundnut oil. The firm owned several oil mills in British India and also owned a mill at Raichur in the Hyderabad State where oil was produced. The oil produced at Raichur was sold partly within Hyderabad State and partly in Bombay. The Supreme Court held that the profit attributable to the manufacturing activity at the Raichur mill accrued or arose in Raichur even though the oil was sold in Bombay and the sale price was received there. Consequently, the portion of profit derived from the Bombay sales that could be linked to the manufacturing in Raichur was exempt from excess profits tax under the proviso to section 5 of the Act. The Court also referred to the House of Lords decision in In re Commissioners of Taxation v. Kirk (2). In that case the Lords considered income partly derived from the extraction of ore in the New South Wales Colony and the subsequent conversion of the crude ore into a merchantable product within the same colony, even though the finished product was sold exclusively outside the colony. The Lords held that such income was assessable under the New South Wales Land and Income Tax Assessment Act of 1895, section 15, sub-sections 3 and 4. Lord Davey, delivering the Privy Council judgment, observed that there are four essential processes in earning such income: (i) extraction of the ore from the soil; (ii) conversion of the crude ore into a merchantable product, which is a manufacturing process; (iii) sale of the merchantable product; and (iv) receipt of the money arising from the sale. All four stages are necessary, culminating in money, and income is the money received less the expenses incurred at each stage. The first process clearly falls within sub-section 3, and the second, even if not described as “trade” in sub-section 1, is included in the words “any other source whatsoever” in sub-section 4. Accordingly, the Lords concluded that the income was earned, accrued, and arose in New South Wales.

Applying the same line of reasoning to the present matter, it can be said that the appellant’s profits accrue or arise from three distinct business processes or operations. The first process is the purchase of raw material, the second is its conversion by manufacturing into a merchantable product, and the third is the sale of that product. These three stages must be considered when apportioning the profit between the respective operations. (1)

The Court observed that the appellant’s profit originated from three separate business processes. First, the appellant purchased cotton in British India. Second, the cotton was converted by manufacturing in Pondicherry into yarn or cloth. Third, the finished yarn or cloth was sold as a merchantable product. The Court held that the total profit must be divided among these three distinct operations. The same line of reasoning had been adopted earlier by the Madras High Court in the case of Bangalore Woollen, Cotton & Silk Mills Co. Ltd. v. Commissioner of Income-tax, Madras (1). In that case the High Court ruled that the purchase of raw materials by the managing agents in British India constituted an “operation” within the meaning of section 42(3) and that a portion of the profits could justifiably be attributed to those purchases made in British India. After carefully reviewing the authorities on the subject and taking into account the insertion of section 42(3) in the Act of 1922 by the amending Act of 1939, the Court concluded that, in the present state of the law, there is virtually no room to sustain the position urged by the learned counsel for the appellant. Accordingly, the Court agreed with the High Court’s decision to reject the appellant’s contention and to uphold the earlier ruling.

While affirming the High Court’s view, the Court wished to point out, citing [1950] 18 I.T.R. 423, that not every activity of a manufacturer falls within the expression “operation” to which the provisions of section 42(3) apply. Such provisions are only effective when, according to generally accepted business notions and usages, the activity in question is regarded as a well-defined business operation. Activities that are casual, isolated, or not clearly delineated do not ordinarily come within the ambit of this rule. The Court stressed that the apportionment of profits among different business operations must be based on sufficient and cogent reasons, and that its observations were confined to the facts and circumstances of the present case. The Court noted that where only a few transactions of raw-material purchase are known to have taken place in British India, those isolated acts could not be described as “operations” within the meaning of the statute. In contrast, the present case involved systematic and habitual purchase of raw materials through an established agency that possessed special skill and competence in selecting the goods and determining the time and place of purchase. The Court considered this activity to fall well within the meaning of “operation” as used in section 42(3) of the Act, and it was not an isolated transaction. Consequently, the first contention raised by the assessee was negatived. The learned counsel’s argument that there was no business connection of the assessee in British India was found to be unconvincing and not worthy of serious consideration. The Court observed that an isolated transaction between a non-resident and a resident in British India, without any continuing course of dealings that could be described as a business connection, would not attract the provisions of section 42(3).

In the present case the Court observed that a mere business connection does not by itself bring section 42 into operation, but that when the relationship between a person located in British India who assists in generating profits and a person situated outside British India who actually receives or realizes those profits is continuous, such a relationship does constitute a business connection within the meaning of the provision. The Court then described the facts, noting that a regular agency had been set up in British India for the purpose of purchasing all of the raw materials required for manufacturing abroad, and that the agency had been selected because of the agent’s skill, reputation and experience in that line of trade. The Court further explained that the terms of the agency, as set out earlier in the judgment, clearly showed that Messrs. Best & Co. Ltd. were engaged in activities that were essentially comparable to those of a managing agency in India for the foreign company, and that the foreign company therefore possessed a definite connection with that agency. Accordingly, the Court rejected the contention raised by the learned counsel on behalf of the appellant and held that the argument did not survive scrutiny. For the reasons already discussed, the Court affirmed the view adopted by the High Court, dismissed the appeal and ordered that the costs of the proceedings be awarded to the respondent. The appeal was consequently dismissed. The appellant was represented by an agent identified as P. H. Mukherji, while the respondent was represented by an agent identified as G. H. Rajadhyaksha.