Narain Swadeshi Weaving Mills vs The Commissioner Of Excess Profits Tax on 25 October, 1954

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

Court: Supreme Court of India

Case Number: Not extracted

Decision Date: 25 October, 1954

Coram: Mehr Chand Mahajan, Ghulam Hasan, Das

In this case, the Supreme Court considered an appeal that had been granted special leave to be heard. The appeal originated from a consolidated reference that had been made on 19 April 1949. The reference was filed under section 66(1) of the Indian Income-Tax Act together with section 21 of the Excess Profits Tax Act by the Income-Tax Appellate Tribunal of the Madras Bench. The reference concerned four separate assessments made under the Excess Profits Tax, each assessment relating to a different chargeable accounting period. The periods under consideration were those ending on 31 March 1942, 31 March 1943, 31 March 1944 and 31 March 1945. The appeal therefore sought review of the tax assessments made for each of those four years.

The factual background presented in the consolidated statement of the case was as follows. The appellant, Narain Swadeshi Weaving Mills, was a partnership firm that had been created in the year 1935. The firm was formed pursuant to a deed of partnership dated 6 November 1935, which set out the terms and conditions of the partnership. The partners named in the deed were Narain Singh and two of his sons, namely Ram Singh and Gurdayal Singh. Their respective shares in the partnership were allocated as six annas, five annas and five annas. The business of the partnership was carried on at Chheharta, in the city of Amritsar, Punjab, and consisted of manufacturing ribbons and laces. To carry out this manufacturing activity the firm owned various assets, including buildings, plant, machinery and other necessary equipment.

On 7 April 1940 a public limited liability company was incorporated under the name Hindustan Embroidery Mills Ltd. The memorandum of association of the new company stated that its objects were to purchase, acquire and take over from the appellant firm the buildings, leasehold rights, plant, machinery and related assets, and to conduct the business on the terms and conditions set out in a draft agreement that accompanied the memorandum. The authorised capital of Hindustan Embroidery Mills Ltd. was represented by 41 000 shares. Of these, 23 000 shares were allotted to the appellant firm. Within those allotted shares, 20 000 shares were not paid for in cash, while the remaining 3 000 shares were fully paid in cash. The directors of the company were Narain Singh, his three sons Ram Singh, Gurdayal Singh and Dr Surmukh Singh, and an additional director, N. D. Nanda, who was the brother-in-law of Gurdayal Singh. Dr Surmukh Singh was, at all material times, a resident of South Africa. Collectively, these four directors held a total of 33 340 shares, which included the 23 000 shares allotted to the appellant firm. Because the directors and the appellant firm together controlled the majority of the share capital, the company was effectively a director-controlled company.

The capital that was available to Hindustan Embroidery Mills Ltd. proved to be insufficient for the company to acquire all of the assets of the appellant firm. Consequently, the company purchased only the buildings and the leasehold rights associated with those buildings. The plant, machinery and other equipment were not bought outright; instead, the company entered into a lease arrangement under which it would use the plant and machinery by paying an annual rent of Rs 40 000.

On 28 July 1940 the company entered into a managing-agency agreement with a newly formed firm called Uppal and Co. The firm Uppal and Co. was constituted on the same day, and its partners were Ram Singh and Gurdayal Singh, who were the two sons of Narain Singh. Both partners held equal shares in the managing-agency firm. Under the terms of the managing-agency agreement, Uppal and Co. was entitled to receive a fee equal to ten per cent of the net profits earned by Hindustan Embroidery Mills Ltd., in addition to a salary and other allowances that were specified in the agreement.

Later, on 25 January 1941, Hindustan Embroidery Mills Ltd. appointed another newly created firm, Ram Singh and Co., as its selling agent. The firm Ram Singh and Co. also came into existence on the same day as its appointment, and its partners were Ram Singh, Gurdayal Singh and Dr Surmukh Singh – the three sons of Narain Singh. The partnership agreement for Ram Singh and Co. was recorded in writing on 17 March 1941. According to the terms of that agreement, the selling-agent firm was to receive a commission of three per cent of the net sales of the company and six per cent of the gross income derived from those sales.

It was observed that Narain Singh himself held no share in either of the two newly constituted firms, Uppal and Co. or Ram Singh and Co. To compensate for this loss of direct participation, the partners of the original appellant firm altered the distribution of their partnership shares. This modification was effected by an agreement that the partners entered into on 21 April 1941. Under that agreement, the shares of the partners in Narain Swadeshi Weaving Mills were adjusted, although the specific details of the adjustment were not yet set out in the portion of the record under consideration.

According to the managing agency agreement executed on 28 July 1940, Uppal and Co., a firm that was incorporated on the same day and in which Ram Singh and Gurdayal Singh—two sons of Narain Singh—were partners sharing equal ownership, was to receive a payment equal to ten per cent of the net profits of the company in addition to a salary and other allowances specified in the agreement. On 25 January 1941, the company appointed a selling agent named Ram Singh and Co., which was also created on that day and consisted of Ram Singh, Gurdayal Singh and Dr Surmukh Singh—the three sons of Narain Singh—as partners each holding a one-third interest; the partnership terms were documented in writing on 17 March 1941, and the firm was to be entitled to a commission of three per cent on the net sales of the company and six per cent on the gross income of the company. In both of the newly formed firms Narain Singh did not hold any share; consequently, to compensate for his loss, the partners altered the share allocation in the assessee firm by an agreement dated 21 April 1941, providing Narain Singh with a share of twelve annas and each of his two sons, Ram Singh and Gurdayal Singh, with a share of two annas. All three entities—the original assessee firm, Uppal and Co., and Ram Singh and Co.—were registered as firms under section 26A of the Indian Income-tax Act. Based on the foregoing facts, the Excess Profits Tax Officer concluded that the principal purpose behind the formation of the company and the two firms was to evade liability under the Excess Profits Tax. Accordingly, on 16 November 1944 the officer issued notices pursuant to section 10A of the Excess Profits Tax Act to both the company and the three firms. While the proceedings against the company were later abandoned, the officer continued to pursue the three firms, determining that they were effectively a single concern and therefore combined their incomes for assessment purposes, assessing the assessee firm to excess profits tax for each of the four separate chargeable accounting periods involved. Under subsection (3) of section 10A, the assessee company filed four distinct appeals before the Appellate Tribunal. In its order, the Tribunal examined four specific questions: whether the income of the firms styled “Uppal & Co.” and “Ram Singh & Co.” could be merged with the income of the assessee firm under section 10A; whether the share of income attributable to Dr Surmukh Singh, a partner in the selling agency of Ram Singh & Co., could be included in the excess profits tax assessment of the assessee firm; whether the lease payments received by the assessee firm could be lawfully regarded as business profits subject to excess profits tax; and whether the assessee firm had been afforded a proper opportunity under section 10A to contest the assessment.

In the appeal, the Tribunal considered four distinct questions. The fourth question asked whether the assessee firm had been afforded a proper opportunity under section 10A of the Excess Profits Tax Act. Before the Tribunal, and similarly before the Excess Profits Tax Officer, the assessee firm contested the application of section 10A. Its contention was that during the chargeable accounting periods the firm had not carried on any business as defined in section 2(5) of the Excess Profits Tax Act. Because the firm asserted that it had no business activity within the meaning of that provision, it argued that section 10A could not apply and consequently the profits of Uppal & Co. and Ram Singh & Co. could not be amalgamated with its own income. In other words, the firm maintained that a pre-existing business must be present during the relevant period before section 10A could be invoked in relation to transactions concerning that business.

The Tribunal examined the facts and concluded that the assessee firm had, in fact, used its plant, machinery and other revenue-producing assets for a purpose other than its own manufacture. The firm had let these assets on an annual rent of rupees 40,000. The Tribunal held that this arrangement constituted an adventure in the nature of trade as contemplated by section 2(5) of the Excess Profits Tax Act read with rule 4 of Schedule I to that Act. Accordingly, the Tribunal decided that issue 3 was decided against the assessee firm. It held that the firm was carrying on a business of letting out plant, machinery and similar assets on hire and that the lease monies received could be treated as business profits liable to excess profits tax.

Turning to issue 1, the Tribunal agreed with the view of the Excess Profits Tax Officer that it was beyond doubt that a deliberate scheme had been adopted by the three entities – the assessee firm, Uppal & Co. and Ram Singh & Co. – to create separate charges and thereby avoid excess profits tax. The Tribunal described the scheme as proceeding in four steps. First, the company was formed. Second, Uppal & Co. was appointed as managing agents instead of the assessee firm itself. Third, the firm Ram Singh & Co. was created to take up the selling agency of the company. Fourth, the shares of the partners of the assessee firm were adjusted so as to equalise, as far as possible, the share of Narain Singh with the shares that his sons obtained in the various firms. While the Tribunal noted that these steps need not necessarily be fictitious or artificial, it held that they were translations intended to bring the transactions within the operation of section 10A.

Having examined the scheme, the Tribunal decided that issues 2 and 4 were also decided against the assessee firm. Issue 2 concerned whether the share of income of Dr Surmukh Singh, a partner in the selling agency of Ram Singh & Co., could be included under section 10A in the excess profits tax assessment of the assessee firm. Issue 4 dealt with whether the assessee firm had been given a proper opportunity under section 10A. The Tribunal found against the assessee on both points. Consequently, all four appeals filed by the assessee firm were dismissed by the Tribunal.

Following the dismissal of the appeals, the assessee firm filed four separate applications under section 66(1) of the Income-Tax Act read with section 21 of the Excess Profits Tax Act. In those applications, the firm prayed that the questions arising from the Tribunal’s order – including the correctness of applying section 10A to amalgamate the incomes of Uppal & Co. and Ram Singh & Co. with its own, the inclusion of Dr Surmukh Singh’s share of income, the treatment of lease money as business profit, and the proper opportunity under section 10A – be referred to the High Court for consideration.

The Appellate Tribunal sought the intervention of the High Court by presenting five specific questions for determination. The first question asked whether, considering the particular facts and circumstances of the case, the application of section 10A in order to amalgamate the income of the firms “Uppal & Co.” and “Ram Singh & Co.” with the income of the appellant firms was correct and legally valid. The second question inquired whether, given the facts admitted on the record, the share of income accruing to Dr Surmukh Singh—who was a partner in the selling agency but not a partner in the appellant firm—could be lawfully included together with the shares of income of S Ram Singh and S Gurdial Singh, and whether such inclusion fell within the scope of section 10A. The third question examined whether, based on the established facts, circumstances and observations, the lease money received by the appellant firm could be treated as business profits or as profits from an adventure in trade that would be liable to excess profits tax. The fourth question concerned whether the type of notice that had been served on the appellant, in view of the facts and circumstances, amounted to a proper opportunity under section 10A of the Excess Profits Tax Act, and if it did not, what the legal effect of the denial of such an opportunity would be. The fifth question asked whether the proceedings under section 10A were void from the beginning because the required prior sanction from the Inspecting Assistant Commissioner of Excess Profits Tax had not been obtained, noting that the order of the Tribunal made no mention of such sanction and that it had not been proved at the hearing, despite the Court’s express requirement. The Appellate Tribunal declined to refer the fourth and fifth questions to the High Court, and no grievance on that refusal was raised before this Court. Consequently, the Tribunal reformulated the remaining three questions as follows: first, whether there was any evidence before the Tribunal to support the conclusion that the primary purpose of the transactions was the avoidance of excess profits tax; second, whether, on the facts admitted or proved, the share of income of Dr Surmukh Singh in the firm Ram Singh & Co. could be lawfully included with the shares of Ram Singh and Gurdayal Singh; and third, whether, given the facts and circumstances, the leasing of machinery and related equipment by the assessee firm to the company constituted a business within the meaning of section 2(5) of the Excess Profits Tax Act. Counsel for the assessee submitted that the third question should be addressed first, but the High Court held that a determination of the first question was a necessary preliminary step before considering the third, and therefore proceeded to examine the first question by referring to the facts found by the Tribunal and describing them accordingly.

Having regarded the steps taken by the Tribunal as circumstantial evidence, the High Court concluded that it could not be said that no evidence existed to justify the Tribunal’s finding that the formation of the firms Uppal & Co. and Ram Singh & Co. was primarily intended to avoid or reduce liability to excess profits tax. Consequently, the High Court held that the three entities—the assessee firm, Uppal & Co., and Ram Singh & Co.—were in reality one and the same firm, and on that basis it proceeded to consider the third question. After referring to section 2(5) of the Excess Profits Tax Act and to certain judicial decisions, the High Court articulated its reasoning as follows: “The argument of Mr. Pathak when applied to the present case would have force were it a fact that the sole concern of the assessee firm was the receipt of hire of machinery from a company or firm, in which the assessee firm had no interest. But this is not the state of affairs. On the finding under the first question referred, the assessee firm, the firm of managing agents and the firm of selling agents are really one and the same firm. This firm and its partners held the majority of shares in the company. The agreement for payment of Rs. 40,000 as rent of machinery is an agreement between the assessee firm and the company which the assessee firm controls. The business of the assessee firm was, and in effect still is, the manufacture of ribbons and laces, and the receipt of Rs. 40,000 is a profit from that business diverted into the pockets of the assessee firm.”

The High Court therefore answered the third question affirmatively, finding against the assessee firm. Because the High Court had refused to grant a certificate of fitness for appeal to this Court, the assessee firm subsequently obtained special leave to bring the present appeal. Counsel for the assessee firm argued before this Court, and the Court concurred, that the High Court’s approach was erroneous because it began its analysis with question 1. That question, as framed, assumed the applicability of section 10A and merely asked whether there was any evidence supporting the Tribunal’s finding—arrived at during the enquiry under that section—that the main purpose of the transaction was to avoid excess profits tax. The long title and preamble of the Excess Profits Tax Act demonstrate that the legislation is intended to impose tax on excess profits arising from certain businesses. Section 4, the charging provision, together with section 5, which defines the scope of the Act’s application, clearly require the existence of a business carried on by the assessee, the profits of which are subject to excess profits tax. Thus, if such a business existed during the relevant period, only then could the question of section 10A’s applicability arise; absent such a business, the Act would not apply and section 10A could not be invoked. Consequently, the Tribunal and the High Court should have first addressed question 3, because the determination of whether a qualifying business existed would decide the applicability of section 10A, rendering the further legal question in question 1 moot if the answer to question 3 were in favour of the assessee.

In the Court’s analysis, the tax on excess profits could arise only when the assessee was actually carrying on a business that fell within the definition prescribed by the Act during the relevant period. Consequently, the question of whether section 10A applied could be entertained only if such a business existed in that period; if no such business as contemplated by the Act was present, then the Act itself would not apply and section 10A could not be triggered. Before the Excess Profits Tax Officer could commence an enquiry to determine whether a transaction had been undertaken for the purpose of avoiding or reducing excess-profits tax, and before he could make any adjustments he deemed appropriate, it was necessary to establish that the assessee, during the chargeable accounting period, was carrying on a business of the kind described in section 5 of the Act. For this reason, the Court held that both the Appellate Tribunal and the High Court ought first to have considered the issue identified as question 3, because the answer to that issue determined whether section 10A was applicable. If question 3 were decided in favor of the assessee firm, the further legal question framed as question 1 would become unnecessary. The Court therefore concluded that the High Court’s approach was logically misplaced given the facts of the case. Turning to the factual findings of the Appellate Tribunal apart from its determination under section 10A, the Tribunal observed that after the company was formed, the assessee firm was left without any business. The newly formed company purchased the leasehold rights over the lands and buildings where the plant, machinery and related equipment were installed. As a result, the firm ceased to manufacture any ribbons or laces and was left only with the plant and machinery that it no longer required. Those assets ceased to be commercial assets in the hands of the firm because it no longer possessed a manufacturing business. Moreover, the firm lost the ability to use the plant and machinery since it no longer held any right to the land and buildings on which they stood. In these circumstances the firm rented out the plant, machinery and equipment to the company. Thereafter the company alone conducted the business of manufacturing ribbons and laces, hiring the plant, machinery and equipment from the former firm for that purpose. On its face, it appeared that the company appointed the managing agents and the selling agents. Viewed objectively and without regard to any alleged outcome of an enquiry under section 10 or section 10A, those transactions could not be characterised as transactions of the assessee firm. Consequently, the assessee firm was left only with property that at one time had been a commercial asset but had ceased to be so. The firm subsequently let that property on rent. The pivotal question therefore became whether such letting, under those circumstances, amounted to the carrying on of a business. The Court then turned to the definition of “business” in section 2(5) of the Excess Profits Tax Act, which includes, among other things, any trade, commerce or manufacture or any adventure in the nature of trade, commerce or manufacture.

The Act defined “business” to include any trade, commerce or manufacture, or any adventure in the nature of trade, commerce or manufacture, and the first part of this definition was identical to the definition of business in section 2(4) of the Indian Income-tax Act. Determining whether a particular activity falls within trade, commerce, manufacture or an adventure of that character was described as a difficult question that required careful analysis. On one side, the Judicial Committee, in Commissioner of Income-tax v. Shaw Wallace & Co. ((1932) I.L.R. 59 Cal. 1343), observed that although the wording of the definition was wide, each term fundamentally implied the continuous exercise of an activity. The Court explained that the word “business” signified a real, substantial, systematic or organised course of conduct pursued with a definite purpose. On the other side, the Court recognised that a single, isolated transaction could still be regarded as an adventure in the nature of trade if the transaction displayed clear indicia of trade. Consequently, the question of whether a particular source of income constituted business had to be answered according to ordinary notions of what a business is. The Court then distinguished the present case from the earlier decision in Commissioner of Excess Profits Tax, Bombay City v. Shri Lakshmi Silk Mills Ltd. ([1952] S.C.R. 1). In that case, the respondent company had been created to manufacture silk cloth and had installed a plant for dyeing silk yarn as part of its ordinary business. During the relevant chargeable accounting period, wartime difficulties in obtaining silk yarn rendered the plant idle, and in August 1943 the plant was let out to another company for monthly rent. The issue was whether the rent received during that period was income from business and thus assessable to excess profits tax. The Court noted that the respondent continued its silk-cloth manufacturing business, and only the yarn-dyeing operation was temporarily suspended because of the war. The Court held that the plant remained a commercial asset of the business, even though it was temporarily let out, and therefore the rent constituted profits of the business regardless of how the asset was employed. The Court further stressed that no universal principle could govern all situations and that each matter must be decided on its own facts using common-sense reasoning. In the case presently before the Court, the assessee firm’s business had entirely

In the present matter the assessee firm had completely ceased its manufacturing operations. It no longer produced any ribbons or laces and therefore had no further trading or commercial activity. After the land and the buildings on which the plant and machinery were installed were sold to another company, the assessee firm was unable to use that plant and machinery for its own production. Consequently, the firm chose to let out the plant, machinery and related equipment for an annual rent of forty thousand rupees. These circumstances closely resemble those that were found in the decision of Inland Revenue Commissioners v. Broadway Car Co. Ltd. (1946) 2 A.E.R. 609, where wartime conditions had reduced the company’s business to a very small scale. In that case the court observed that the company dealt with part of its property that had become redundant and sublet it solely to generate income, a transaction that was entirely separate from the ordinary business activities of the company. The ratio decidendi of that case, which was referred to in the judgment of this Court, appears to be applicable to the facts of the present case, apart from the findings that were made under section ten A. Applying the common-sense principle to these facts, it is impossible to hold that the letting out of the plant and machinery constituted a business operation when the normal business activity of the firm had already come to an end.

The Court noted that sub-sections three and four of section twelve of the Indian Income-Tax Act expressly recognise that the letting out of plant, machinery or similar assets may be a source of income falling under the head “other sources” and not necessarily under the head “business” dealt with in section ten of that Act. Accordingly, in the facts and circumstances of this case, the letting out of the plant, machinery and related equipment cannot be said to fall within the definition of “business” contained in section two five of the Excess Profits Tax Act. Because of this, the Court considered it unnecessary to express any opinion on the meaning or implication of the proviso to that definition or on rule four four of Schedule I to the Act. In the Court’s opinion, question number three should therefore have been answered in the negative. Since the legal issue raised in the third question was answered in favour of the assessee firm, the question of the applicability of section ten A of the Excess Profits Tax Act could not arise; the assessee firm had no business during the relevant period to which that Act could apply, and consequently the revenue could not invoke section ten A. Therefore, the question of whether there was evidence to support the Tribunal’s finding under that section could not arise. Instead, the further question of law that truly emerged from the Tribunal’s order, following the answer to question three, was whether, under the facts and circumstances of the case, the application of section ten A with a view to

The Court noted that the primary issue was whether the amalgamation of the incomes of the firms Uppal & Co. and Ram Singh & Co. with the income of the assessee firm was lawful and valid under the statute. The Court held that the High Court ought not only to have answered Question No. 3 in the negative but also to have, as a logical consequence of that answer, raised the further question of law framed in Question No. 1 of the assessee’s petition. In effect, the High Court should, after rejecting Question No. 3, have re-formulated the referred Question No. 1 by restoring it exactly as the assessee had proposed in its petition and then have decided that restored question against the revenue. Accordingly, the Court allowed the appeal and re-framed Question No. 1 to read: “Whether, under the facts and circumstances of the case, the application of section 10A with a view to amalgamating the income of the firms Uppal & Co. and Ram Singh & Co. with the income of the appellant firm was correct and valid in law?” The Court answered this re-framed question in the negative, thereby rejecting the revenue’s position. By necessary implication, Question No. 2 was also answered in the negative and in favour of the assessee. The Court further affirmed that Question No. 3 was to be answered in the negative. Consequently, the appellant was awarded costs of the appeal, and the appeal was allowed.