K. M. S. Lakshmanier and Sons vs Commissioner of Income Tax and Excess Profits Tax

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

Court: Supreme Court of India

Case Number: Civil Appeal No. 71 of 1952

Decision Date: 23 January 1953

Coram: M. Patanjali Sastri, B.K. Mukherjea, N. Chandrasekhara Aiyar, Vivian Bose, Ghulam Hasan

The case was K. M. S. Lakshmanier and Sons versus the Commissioner of Income Tax and Excess Profits Tax, decided on 23 January 1953 by the Supreme Court of India. The judgment was delivered by Justice M. Patanjali Sastri, who also sat as Chief Justice, together with Justices B. K. Mukherjea, N. Chandrasekhara Aiyar, Vivian Bose and Ghulam Hasan. The official citation of the decision is 1953 AIR 145 and 1953 SCR 1057, and it has been subsequently reported in the law reports R 1959 SC 346 and D 1964 SC 1709. The matter concerned the interpretation of Rule 2-A of the Rules contained in the Second Schedule to the Excess Profits Tax Act of 1940 (XV of 1940). The issue before the Court was whether the security deposits received from customers by the assessee, who acted as the sole selling agents of a yarn manufacturing company and distributed yarn to various constituents under forward contracts, should be treated as “borrowed money” within the meaning of that rule and therefore excluded from the computation of average capital used in the business.

The Court recorded that the assessee kept two separate accounts for each constituent: a “contract deposit account” into which advance payments received from the constituents were initially credited, and a “current yarn account” to which those amounts were transferred when the price of the bales supplied was adjusted at the time of delivery under the contract. On 5 May 1944 the assessee decided to retain the advance amounts in a newly named “Contracts Advance Fixed Deposit Account” and promised to return the full advance after the completion of each contract and the full payment for the bales supplied. The account name was changed to “Security Deposit” on 5 December 1944. Subsequently, on 14 February 1945 the assessee further modified the arrangement by demanding a specified sum from each customer as a security deposit, to be retained for as long as the business relationship under the forward contracts continued, and interest was to be paid on the deposited sum. The Court was asked to determine whether the amounts received before 5 May 1944 were merely advance payments of price and could not be regarded as borrowed money; whether the amounts received between 5 May 1944 and 14 February 1945, given the terms then in force, were in substance trading receipts rather than security deposits, effecting the adjustment of the mutual

In the Court’s analysis it was observed that the practice adopted after 14 February 1945 possessed every essential characteristic of a loan transaction, and consequently the deposits received following that date qualified as “borrowed money” within the meaning of Rule 2-A. The Court explained that the amount of each deposit bore no connection to the price of the goods that were to be delivered under the respective contracts; the customer was required to pay the full price for the goods, while the assessee was permitted to employ the deposited funds for its own business purposes and to pay interest on those funds to the customers. Moreover, the deposits were to be returned only at the termination of the business relationship. The Court further held that the terms “loan” and “deposit” are not mutually exclusive, and that a deposit made with the intention of inducing the depositor to deal with the deposit-holder and to serve as security for the performance of the contract does not preclude the deposit from being essentially a loan. In reaching this conclusion the Court relied upon the decision in Nawab Major Sir Mohagned Akbar Khan v. Attar Singh (L.R. 63 I.A. 279). It distinguished the earlier authorities Inland Revenue Commissioners v. Port of London Authority (L.R. [1923] A.C. 507) and Inland Revenue Commissioners v. Rowntree ([1948] 1 All E.R. 482), and applied the principles articulated in Davies v. The Shell Co. of China (32 Tax Cas. 133). The judgment itself formed part of a civil appellate jurisdiction matter, Civil Appeal No. 71 of 1952, arising from an appeal against the judgment dated 19 January 1950 of the High Court of Judicature at Madras (Satyanarayana Rao and Viswanatha Sastri JJ.) in Case Referred No. 67 of 1947. Counsel for the appellants was G. S. Pathak, assisted by G. R. Jagadisan, while counsel for the respondent was M. C. Setalvad, Attorney-General for India, assisted by G. N. Joshi. The judgment was delivered on 23 January 1953 by Chief Justice Patanjali Sastri. This appeal originated from a reference made by the Income-Tax Appellate Tribunal, Madras Bench, under section 21 of the Excess Profits Tax Act, 1940. The appellants were merchants engaged in the yarn trade in Madura, acting as the exclusive selling agents for yarn produced by the Madura Mills Co., Ltd., and they distributed yarn to various constituents under forward contracts for which they obtained advances from those constituents. During the chargeable accounting period from 13 May 1944 to 12 May 1945 the appellants received from their customers sums amounting to Rs 7,69,569 and asserted before the Excess Profits Tax Officer that this amount should be classified as “borrowed money” within the meaning of Rule 2-A of the Second Schedule to the Act, thereby exempting them from liability for excess profits tax for that period. The Officer rejected the claim and assessed excess profits tax of Rs 25,404, holding that, having regard to the terms of the agreement under which the amounts were received, they could not be regarded as borrowed money.

The Tax Officer had held that, in law, the sums received could not be classified as “borrowed money” within the meaning of Rule 2-A. After the appellants’ appeals to the Appellate Assistant Commissioner and to the Income-Tax Appellate Tribunal were unsuccessful, they sought a reference of the legal question to the High Court at Madras. Accordingly, the Tribunal framed the question: whether the monies deposited by the customers with the assessee as security deposits constituted “borrowed money” under Rule 2-A of the Second Schedule to the Excess Profits Tax Act, 1940, either for the whole chargeable accounting period ending 12 April 1945 or for any part thereof. A Division Bench of the Madras High Court, consisting of Justices Satyanarayana Rao and Viswanatha Sastri, heard the reference and, by their judgment dated 9 June 1950, answered the question against the appellants while granting them leave to appeal to this Court.

The Court observed that, during the war, profits from trade and business rose markedly above pre-war levels, prompting the State to levy a tax on the portion of profits deemed “excess” over normal or “standard” profits. The Act thus imposes a tax on excess profits earned under wartime conditions and contains provisions for situations where the capital employed in the business increases during the chargeable accounting period. In such cases, the standard profit is increased by applying a statutory percentage—ranging from eight to twelve per cent depending on the class of case—to the increase in capital. Consequently, a rise in capital employed raises the standard profit and correspondingly reduces the excess profit liable to tax.

The Court further explained that when the increase in capital results from borrowed money, it is equitable that such borrowed amounts, which contribute to the generation of higher profits, should not be deducted when computing the average capital used in the business. Rule 2-A expressly provides that, in calculating the average capital for both the chargeable accounting period and the comparative standard period, no deduction shall be made for borrowed money. Applying this principle to the present case, the appellants admitted that they received no security deposits during the standard period. If the security deposits received—used wholly in the appellants’ business—were treated as borrowed money and included in the average capital for the chargeable period, the calculated increase in average capital would be substantially larger than presently computed, leading to a considerable reduction of the assessed excess profits.

The Court then examined the true legal nature of the sums that had been described as security deposits. These sums had been received by the appellants from their customers under three distinct arrangements, each of which was set out in circulars that the appellants themselves had issued. The first circular, dated 5 May 1944, explained that the parties were aware that, as long as the existing contracts for bales remained open, the amounts that had been paid as contract advance deposits would be transferred to the credit of the current yarn account at the time the bales were supplied. The circular went on to state that, contrary to the earlier practice, the advance amounts would now be retained under a new heading called “Contracts Advance Fixed Deposit Account”. The circular further directed that the advance amounts would be returned in cash, by bank cheque, or by insured post only after the contract under which the bales had been booked and supplied was fully completed, after deduction of any bank commissions or other expenses that might be incurred on the customer’s account. It also stressed that the value of the bales delivered, or to be delivered, should be paid in full and that the new system would apply to all future contract bookings.

A second circular was issued on 5 December 1944. In this communication the appellants informed their customers that the heading of the “Contracts Advance Fixed Deposit” account had been changed to “Security Deposit” account. The circular noted that the amount that was in credit in the former account had been transferred to the credit of the latter account, and that this change would be effective from 1 November 1944. The third and final circular, dated 14 February 1945, modified the arrangement further. It explained that, instead of continuing to call for amounts from customers as “Security Deposit due to bales for which forward contracts were being entered into and then returning the same to the customers at the time of delivery,” the appellants would now demand a fixed sum as a security deposit and retain that sum for as long as the business relationship under forward contracts continued. The circular specified that, in the particular case of the appellants, a certain amount of rupees had been fixed for the deposit, subject to the customer’s approval, and that an amount of rupees already stood as credit in the deposit. It stated that any balance due to the customer would be returned, and it requested an immediate reply. The circular also indicated that interest at three percent per annum would continue to be permitted on the deposit amounts until further notice. It will be seen that before the 5 May 1944 date, which covered the first seven weeks of the chargeable accounting period, the appellants maintained two separate accounts for each constituent.

In this case the appellants maintained two separate accounts for each of their constituent businesses, namely a contract deposit account and a current yarn account. Money received from customers was first entered into the contract deposit account and then transferred to the current yarn account at the time that the price of the bales supplied was adjusted, that is, when deliveries were made under a contract either in installments or in full. The Court observed that under this arrangement the sums received from customers functioned merely as advance payments of the purchase price; those advances were to be set off against the value of the bales supplied from time to time under the forward contracts and therefore could not be described as borrowed money. This characterization was not contested by the counsel for the appellants. The counsel also acknowledged that the circular dated 5 December 1944, which merely altered the heading of the account in which the monies were credited, did not change the legal position that had existed previously. Consequently, the only period that required examination was the interval between 5 May 1944 and 14 February 1945, which covered the major portion of the chargeable accounting period, together with the amounts received after that date until the end of the same period. The Court found it convenient to begin with the later amounts, reasoning that if the learned judges below were correct in holding those later amounts not to be borrowed money, then, by logical extension, the earlier amounts received during the second part of the period would also not be regarded as borrowed money. The circular dated 14 February 1945, however, signified a clear departure from the practice that had prevailed before 5 May 1944. Under the new arrangement, the amount deposited by a customer no longer bore any relationship to the price fixed for the goods to be delivered under a forward contract, whether in installments or otherwise. Instead, the price was to be paid by the customer in full at the time of each delivery, without any adjustment against the deposit. The deposit was to be retained by the appellants merely as security for the proper performance of the customer’s contracts so long as the forward-contract relationship continued, with the appellants paying interest at three percent in the meantime and, as the Court noted from the course of dealings, using the money for their own business purposes. An adjustment against any liability arising from the customer’s default was to be made only at the termination of the business connection, and the appellants also undertook to repay an equivalent amount at the conclusion of the dealing. The Court concluded that the transaction possessed all the essential elements of a loan contract, and therefore held that the deposits received under this final arrangement constituted borrowed money for the purposes of Rule 2-A. The learned Attorney-General emphasized that the deposits were made to induce the appellants to continue dealing with the customers and that the appellants themselves fixed the amount to be deposited in each case, arguing that these features distinguished the transactions from a true borrowing or lending. The Court rejected this argument, stating that the purpose of the customers in making the deposits did not alter the fundamental character of the transaction. It observed that when A pays money to B who agrees to return an equivalent sum later, no bailment arises; the arrangement is simply a loan owed by B to A, and the label “deposit” does not change this characterization. The Court also quoted the Judicial Committee of the Privy Council in Nawab Major Sir Mohammad Akbar Khan v. Attar Singh, noting that the terms “deposit” and “loan” are not mutually exclusive.

In this case, the Attorney-General argued that the deposits were intended to induce the appellants to deal with the customers and were specifically held as security for the customers’ performance of their forward contracts, and that the appellants themselves fixed the amount to be deposited in each instance. He contended that these features distinguished the transactions from a genuine borrowing or lending, which the expression “borrowed money” in Rule 2-A is meant to denote. The Court could not see how the purpose that the customers had in making the deposits could alter the essential character of the transaction. When A pays money to B and B agrees to return an equivalent sum later, no bailment arises; the relationship is simply a loan owed by B to A. The fact that the transaction is called a “deposit” does not change this analysis. As the Judicial Committee of the Privy Council observed in Nawab Major Sir Mohammad Akbar Khan v. Attar Singh (1), the two terms are not mutually exclusive. A deposit of money is not confined to a bailment of specific currency to be returned in specie; for example, a deposit with a banker may create only a debtor-creditor relationship rather than a trust. The condition that the amount may be adjusted against a claim arising from a possible default of the depositor does not transform the character of the transaction. Nor does the purpose of providing security for the due performance of a collateral contract give the deposit a different nature. It remains a loan whose full repayment is conditioned on the satisfactory fulfilment of the obligations under the collateral contract. The Attorney-General, as did the learned judges of the High Court, relied heavily on English decisions such as Inland Revenue Commissioners v. Port of London Authority (2) and Inland Revenue Commissioners v. Rowntree & Co. Ltd. (3). In the first case, the Court held that the stock issued by the Port of London Authority as consideration for the acquisition of certain dock companies, which carried interest and was redeemable after twenty years, could not be regarded as “borrowed money” under Rule 2 of Part III of Schedule IV of the Finance (No. 2) Act, 1915, because that expression referred to a real borrowing and a real lending. The transaction was characterised as a purchase of assets for stock consideration, even though it bore some resemblance to a borrowing.

In this case the Court observed that the expression “borrow money” must be understood in its plain and ordinary sense, which requires the existence of a genuine borrowing and a genuine lending. The earlier finding that there was “nothing of that kind” in a transaction involving the issue of stock as consideration, where no money passed directly or indirectly between the parties, was considered to offer little assistance in deciding whether the security deposits now under scrutiny involved a real borrowing and a real lending. For the reasons previously set out, the Court was satisfied that the deposits did satisfy that description and therefore constituted borrowed money within the meaning of Rule 2-A. The Court then turned to another authority that was deemed even less helpful. In that precedent, a series of financial arrangements were described in which A drew bills on B, B accepted the bills, and then, acting as A’s agent, discounted them with C, passing the proceeds to A, who promised to provide funds before the bills matured in order to settle them. The Court of Appeal in that case held that the money raised by these steps was not “borrowed money” for the purposes of paragraph 2(1) of Part 11 of the Seventh Schedule to the Finance (No 2) Act, 1939, which required that any borrowed money be deducted for Excess Profits Duty. After citing the Port of London decision to support the view that the term “borrowed money” demands the presence of both a borrower and a lender, the judges sought to identify a lender in the arrangement. They concluded that B could not be the lender because an acceptor of a bill need not actually possess cash to lend, and C could not be the lender because C merely acquired certain rights in the bill under the law merchant without providing any loan. Consequently, the Court found it impossible to discover any lender-borrower relationship either between A and B or between A and C. Applying those principles to the present matter, the Court found that a lender-borrower relationship, with all its essential characteristics, was clearly evident between the depositors and the appellants. Accordingly, the earlier decision did not affect the issue at hand. Finally, the Court noted that a more recent English Court of Appeal decision in Davies v. The Shell Company of China, which had been brought to its attention, was more directly relevant to the questions presented.

The deposits were transferred to the United Kingdom for safety reasons and were kept there in sterling. Later, when the Chinese dollar fell in value against sterling, the sums needed to repay the deposits in Chinese dollars became considerably smaller than the amounts that the company continued to hold as sterling equivalents. This disparity raised the issue of whether the deposits should be characterised as trading receipts or as receipts of a capital nature. In deciding that the deposits were capital receipts and that any profit arising from them was a capital gain, Jenkins L.J., who delivered the leading judgment, observed:

“If the agent’s deposit had in truth been a payment in advance to be applied by the company in discharging the sums from time to time due from the agent in respect of petroleum products transferred to the agent and sold by him, the case might well be difficult and might well fall within the ratio decidendi of Landes Bros. v. Simpson (1) and Imperial Tobacco Co. v. Kelley (1). But that is not the character of the deposits here in question. The intention manifested by the terms of the agreement is that the deposit should be retained by the company, carrying interest for the benefit of the depositor throughout the terms of the agency. It is to be available during the (1) (1951) 32 Tax Cas, I33. (3) (1943) 25 Tax Cas. 292. (2) (1934) 19 Tax Cas. 62. deriod of the agency for making good the agent’s defaults in the event of any default by him; but otherwise it remains, as I see it, simply as a loan owing by the company to the agent and repayable on the termination of the agency; and I do not see how the fact that the purpose for which it is given is to provide a security against any possible default by the agent can invest it with the character of a trading receipt.”

The Attorney-General also relied on certain decisions that held security deposits received from employees to be imbued with a fiduciary character, thereby giving the depositors a priority claim on any assignee in the event of the depositee’s bankruptcy. He conceded, however, that other decisions reached the opposite conclusion and the Court indicated that it was unnecessary to explore that body of cases, because the manner in which such sums are treated under the Insolvency Acts does not directly bear on the issue presently before the Court.

Turning now to the deposits received by the appellants between 5 May 1944 and 14 February 1945, the Court expressed the view that, when the terms of the arrangement then in force are considered, those deposits more closely resemble trading receipts than security deposits. It will be seen that the amounts received were treated as advance payments in relation to each “contract number.” Although the agreement required the customer to pay the full price and stipulated that the deposit would be returned to the customer upon completion of delivery under the contract, the transaction is

The Court observed that the arrangement operated in substance and effect to adjust the parties’ mutual obligations at the time each contract was completed. Accordingly, the Court held that the sums received during the period from 5 May 1944 to 14 February 1945 could not be characterized as borrowed money for the purposes of Rule 2-A. Counsel for the appellant then submitted that the proceedings before both the Excess Profits Tax authorities and the High Court had been based on the premise that, if the amounts received from customers during any part of the chargeable accounting period were treated as borrowed money, those amounts would have to be included in the calculation of average profits for the entire chargeable accounting period, and that no distinction should be drawn between different portions of that period for that purpose. The Court could not accept that submission. While it was accurate to note that no such distinction had been made at any earlier stage, that was because it had been decided that none of the amounts received under any of the arrangements qualified as borrowed money within the meaning of Rule 2-A. However, the Court explained that if it were held that the amounts received under one or more, but not all, of the agreements constituted borrowed money, then the computation of average capital under Rule 2-A would necessarily have to reflect the differing character of the sums received under each agreement, which were operative only for a part of the chargeable accounting period. The Court pointed out that the question referred to it expressly recognised this possibility and allowed for a distinction to be drawn, if required, between separate parts of the chargeable accounting period. Consequently, the Court set aside the order of the lower court and answered the reference in the affirmative with respect to the last segment of the chargeable accounting period, namely the period from 14 February 1945 to 12 April 1945, and answered it in the negative with respect to the remainder of that period. The Court also ordered costs and set aside the prior order. Agent for the appellants: Naunit Lal. Agent for the respondent: O. H. Rajadhyaksha.