Narain Swadeshi Weaving Mills vs The Commissioner Of Excessprofits Tax

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

Court: supreme-court

Case Number: Civil Appeal No. 145 of 1953

Decision Date: 23 October 1954

Coram: DAS J.

In the case titled Narain Swadeshi Weaving Mills versus The Commissioner of Excess-Profits Tax, the judgment was delivered on 23 October 1954 by a bench of the Supreme Court of India. The petitioner was Narain Swadeshi Weaving Mills and the respondent was the Commissioner of Excess-Profits Tax. The matter concerned the interpretation of the Excess Profits Tax Act of 1940, specifically sections 2(5), 5 and 10-A. The issue before the Court was to determine the condition precedent required for the applicability of section 10-A, namely whether the assessee was carrying on a “business” within the meaning of the Act during the charge-able accounting period.

Section 2(5) of the Act defines what is included in the word “business”. The Court observed that a universal definition of business that would fit every possible situation cannot be laid down. Rather, business is characterised by a continuous activity that is real, substantial and organised with a definite purpose. The Court noted that even a single, isolated transaction may display the clear hallmarks of trade or an adventure in the nature of trade, and such a transaction is also captured by the term “business” in section 2(5). Consequently, the determination of whether a particular source of income constitutes business must be made by examining the facts and circumstances of each case in accordance with ordinary conceptions of business.

The factual background revealed that since 1935 the assessee firm had been engaged in the manufacture of ribbons and laces. To conduct this manufacture the firm owned buildings, leasehold rights, plant and machinery. On 7 April 1940 a public limited company was incorporated with the specific object of acquiring and taking over those buildings, leasehold rights, plant and machinery from the assessee firm. The newly formed company purchased the leasehold rights in the lands and buildings where the plant and machinery were installed. Following this acquisition the assessee firm ceased to manufacture ribbons and laces and was left possessing plant, machinery and other assets that it no longer required. Those assets ceased to be commercial assets in the hands of the firm because the land and buildings had been sold, removing the firm’s power to use the plant and machinery.

In the circumstances that arose, the company entered into a lease with the assessee firm for the plant, machinery and related equipment. The lease was granted at an annual rent of Rs 40,000. The Court held that this lease of plant and machinery could not be characterised as a “business” within the meaning of section 2(5) of the Excess Profits Tax Act, 1940. The Court distinguished the earlier decision of the Commissioner of Excess Profits Tax, Bombay City v. Shri Lakshmi Silk Mills Ltd. (1952 S.C.R. 1) and relied on Inland Revenue Commissioner v. Broadway Car Co., Ltd. (1946 2 A.E.R. 609). It also referred to Commissioner of Income-Tax v. Shaw Wallace & Co. (1932 I.L.R. 59 Cal. 1348) for guidance.

Thus, the appeal, which was Civil Appeal No. 145 of 1953 and was filed by special leave against the judgment and order dated 8 September 1950 of the High Court of Judicature for the State of Punjab at Simla, was decided on the basis that the lease arrangement did not satisfy the statutory requirement of a “business” under the relevant provisions of the Excess Profits Tax Act.

On 8 September 1950 the High Court of Judicature for the State of Punjab at Simla issued a decision in Civil Reference No 3 of 1949. The appellants were represented by counsel, while the respondent was defended by the Attorney-General for India and his team. The judgment was pronounced on 25 October 1954 by Justice Das. This appeal by special leave originated from a consolidated reference made on 19 April 1949 under section 66(1) of the Indian Income-Tax Act read with section 21 of the Excess Profits Tax Act. The reference was ordered by the Income-Tax Appellate Tribunal, Madras Bench, and it concerned four separate assessments of excess-profits tax against the appellant for the accounting periods ending 31 March 1942, 31 March 1943, 31 March 1944 and 31 March 1945. The court then set out the material facts as extracted from the consolidated statement of the case.

Narain Swadeshi Weaving Mills, the appellant, was a partnership firm formed on 6 November 1935 pursuant to a deed of partnership. The partners were Narain Singh and his two sons, Ram Singh and Gurdayal Singh, who held partnership shares of six annas, five annas and five annas respectively. The firm’s business, carried on at Chheharta, Amritsar in the Punjab, involved manufacturing ribbons and laces, and for that purpose it owned buildings, plant and machinery. On 7 April 1940 a public limited company was incorporated under the name Hindustan Embroidery Mills Ltd. The company’s objects included purchasing, acquiring and taking over from the partnership the buildings and leasehold rights, plant and machinery, on the terms set out in a draft agreement, together with the other objects listed in its Memorandum of Association. Of the 41 000 subscribed shares, the partnership was allotted 23 000 shares; of these, 20 000 were allotted without cash payment and the remaining 3 000 were paid in cash. The directors of the company were Narain Singh, his three sons Ram Singh, Gurdayal Singh and Dr Surmukh Singh, and N D Nanda, a brother-in-law of Gurdayal Singh. Dr Surmukh Singh resided in South Africa at all material times. Collectively these four directors held 33 340 shares, including the 23 000 shares allotted to the partnership, making the company a director-controlled entity. Because the company’s funds were insufficient to acquire all the partnership’s assets, it bought only the buildings and leasehold rights, while it took the plant and machinery on lease for an annual rent of Rs 40 000. On 28 July 1940 the company executed a managing agency agreement in favour

The company entered into a managing agency arrangement with a newly formed firm called Uppal & Co. This firm was created on the same day that Ram Singh and Gurdayal Singh, who were two sons of Narain Singh, became partners, each holding an equal share in the partnership. Under the managing agency agreement dated 28 July 1940, Uppal & Co. was required to receive ten per cent of the net profits of the company in addition to a salary and other allowances that were specifically mentioned in the agreement. Subsequently, on 25 January 1941, the company appointed another newly created firm, Ram Singh & Co., to act as its selling agent. This firm was constituted on that same day with three partners: Ram Singh, Gurdayal Singh and Dr Surmukh Singh, the three sons of Narain Singh, each holding an equal one-third share. The partnership terms were formally recorded in writing on 17 March 1941. According to those terms, Ram Singh & Co. was to receive 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 new firms, Narain Singh did not hold any share. To compensate for this loss, the partners of the assessee firm altered the distribution of shares in the assessee firm by an agreement dated 21 April 1941. Under that agreement, Narain Singh was allotted a share of twelve annas, while each of his two sons, Ram Singh and Gurdayal Singh, received two annas each. All three firms – the original assessee firm, Uppal & Co., and Ram Singh & Co. – were subsequently 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 primary purpose behind forming the company and the two associated firms, Uppal & Co. and Ram Singh & Co., was to evade liability under the excess profits tax regime. Accordingly, on 16 November 1944, the Officer issued notices under section 10A of the Excess Profits Tax Act to the company as well as to the three firms. Later, the proceedings against the company were withdrawn, and the Officer proceeded only against the three firms. He held that the three firms were, in substance, a single entity and therefore merged their incomes for the purpose of assessment. On that basis, the Officer assessed the assessee firm for excess profits tax for the four distinct chargeable accounting periods that had been identified. Pursuant to sub-section (3) of section 10A, the assessee firm filed four separate appeals before the Appellate Tribunal. In its order, the Tribunal examined four issues: (1) whether the income of the firms styled “Uppal & Co.” and “Ram Singh & Co.” could be amalgamated with the income of the assessee firm under the provisions of section 10A of the Excess Profits Tax Act; (2) whether the share of income attributable to Dr Surmukh Singh, who was 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; (3) whether the lease money

The Appellate Tribunal considered four specific issues that arose from the assessment under section 10 A of the Excess Profits Tax Act. The issues were (1) whether the income of the firms styled “Uppal & Co.” and “Ram Singh & Co.” could be amalgamated with the income of the assessee firm; (2) whether the share of income of 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; (3) whether the lease money obtained by the assessee firm could be legally treated as business profits liable to excess-profits tax; and (4) whether the assessee firm had been given a proper opportunity under section 10 A. Before the Tribunal, as before the Excess Profits Tax Officer, the assessee firm objected to the application of section 10 A on the ground that it had not carried on any business within the meaning of section 2(5) of the Act during the relevant chargeable accounting periods, and therefore the profits of the two other firms could not be amalgamated with its own income. The Tribunal rejected this contention with respect to issue 3, observing that instead of using its plant and machinery for its own manufacture, the assessee firm let those revenue-yielding assets on an annual rent of Rs 40,000. The Tribunal held that such letting out constituted an adventure in the nature of trade as contemplated by section 2(5) read with rule 4 of Schedule I, and therefore the lease money was properly treated as business profits subject to excess-profits tax.

Regarding issue 1, the Tribunal agreed with the Excess Profits Tax Officer that a definite scheme had been adopted by the three firms—the assessee firm, Uppal & Co., and Ram Singh & Co.—to create separate charges and avoid excess-profits tax. The scheme involved four steps: formation of the company, appointment of Uppal & Co. as managing agents instead of the assessee firm, creation of Ram Singh & Co. to act as the selling agency, and adjustment of the partners’ shares in the assessee firm so that Narain Singh’s share was equalised with the shares received by his sons in the various firms. The Tribunal concluded that, although the steps need not have been fictitious, they were transactions that attracted the operation of section 10 A. The Tribunal also decided against the assessee firm on issues 2 and 4, holding that the share of income of Dr Surmukh Singh could be included under section 10 A and that the assessee firm had been afforded the appropriate opportunity. Consequently, all four appeals were dismissed. Following the dismissal, 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 the present proceeding the assessee filed an application under the Excess Profits Tax Act seeking the High Court’s intervention on a series of issues that arose from the order of the Appellate Tribunal. The application asked that the following five questions be referred to the High Court for determination: first, whether, given the facts and circumstances of the case, the application of section 10 A for the purpose of amalgamating the income of the firms “Uppal & Co.” and “Ram Singh & Co.” with the income of the appellant firms was correct and legally valid; second, whether, considering the facts that had been admitted on record, the share of income attributable 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 10 A; third, whether, in light of the facts, circumstances and observations recorded, 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 subject to excess profits tax; fourth, whether the type of notice that had been served on the appellant, under the facts and circumstances of the case, amounted to a proper opportunity under section 10 A of the Excess Profits Tax Act, and if it did not, what the legal effect of the denial of such an opportunity would be; and fifth, whether the proceedings under section 1O A were void from the beginning because the required prior sanction from the Inspecting Assistant Commissioner of Excess Profits Tax had not been obtained, the absence of any mention of such sanction in the order and the failure to prove its existence before the Appellate Tribunal at the time of hearing despite an explicit requirement by the Court. The Appellate Tribunal refused to refer questions four and five, which had been raised by the assessee, and no grievance on that refusal was made before this Court. The Tribunal, however, did refer the first three questions after restating them in a re-framed form as follows: (i) whether any evidence before the Tribunal supported the conclusion that the principal purpose of the transactions was to avoid excess profits tax; (ii) whether, on the basis of the facts admitted or proved, the share of income of Dr Surmukh Singh in the firm Ram Singh & Co. could be lawfully included together with the shares of income of Ram Singh and Gurdayal Singh; and (iii) whether, given the facts and circumstances of the case, the leasing of machinery and related items by the assessee firm to the company constituted a business within the meaning of section 2(5) of the Excess Profits Tax Act. Counsel appearing for the assessee submitted to the High Court that the third of the referred questions should be considered and decided first. The High Court, however, held that a decision on the first question was a necessary preliminary step before the third question could be addressed, and accordingly proceeded to consider the matters in that order.

The High Court first turned to the initial question and, after referring to several facts that the Appellate Tribunal had found and labelled as steps, treated those facts as circumstantial evidence. The Court concluded that it could not be said that there was an absence of evidence justifying 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 concern, and on that basis it proceeded to address the third question. After referring to section 2(5) of the Excess Profits Tax Act and to certain judicial decisions, the Court articulated its reasoning as follows: the argument advanced by Mr. Pathak would have been persuasive only if the sole activity of the assessee firm consisted of receiving hire of machinery from a company in which the firm had an interest; however, that was not the factual situation. The Court found that, pursuant to the first question, the assessee firm, the managing-agents firm and the selling-agents firm were in fact a single entity, whose partners held the majority of shares in the company. The agreement for payment of Rs. 40,000 as rent of machinery, therefore, was an agreement between the assessee firm and a company that the assessee firm controlled. The business of the assessee firm was, and continued to be, the manufacture of ribbons and laces, and the receipt of Rs. 40,000 represented profit from that manufacturing business that was diverted into the hands of the assessee firm. The High Court thus answered the third question in the affirmative, holding against the assessee firm.

The certificate of fitness for appeal to this Court was refused by the High Court, prompting the assessee firm to obtain special leave to file the present appeal. Counsel for the assessee submitted, and the Court concurred, that the High Court’s approach was erroneous because it had taken up discussion of question I first. That question, as framed, proceeded on the assumption that section 10 A applied to the case and merely raised the issue of whether any evidence existed to support the Tribunal’s finding—derived from an enquiry under that section—that the main purpose of the transaction was the avoidance of excess profits tax. The long title and preamble of the Excess Profits Tax Act refer to the imposition of tax on excess profits arising out of certain businesses. Section 4, the charging provision, and section 5, which delineates the Act’s application to particular businesses, clearly postulate the existence of a business that is carried on during the relevant period; only where such a business exists can the question of the applicability of section 10 A arise. Accordingly, the Court observed that both the Appellate Tribunal and the High Court should have considered question III first, because the determination of that question would decide whether section 10 A could even be invoked.

The Court observed that Section 10A could become relevant only when the assessee was actually carrying on a business whose profits were liable to the excess profits tax. Consequently, if such a business existed during the relevant period, only then could the question of Section 10A’s applicability arise; if no such business as contemplated by the Act existed, the Act did not apply and Section 10A could not operate at all. The Court further explained that before the Excess Profits Tax Officer could commence an enquiry to determine whether a transaction was effected for the purpose of avoiding or reducing excess profits tax liability, and before he could make any adjustments he deemed appropriate, it was necessary to establish that the assessee, in the chargeable accounting period, was carrying on a business of the kind described in Section 5 of the Act. Logically, therefore, the Appellate Tribunal and the High Court should have first addressed Question 3, because the answer to that question would determine whether Section 10A applied. If the answer had been in favour of the assessee firm, the further legal issue raised in Question 1 would not have arisen. The Court held that the High Court’s approach was thus logically misconceived on the facts of this case. Turning to the factual findings of the Appellate Tribunal, the Court noted that, apart from its findings under Section 10A, the Tribunal concluded that after the formation of the company the assessee firm was left with no business at all. The company had purchased the lease-hold rights in the lands and buildings where the plant, machinery and other equipment were installed, and the firm consequently ceased to manufacture any ribbons or laces. The firm retained the plant, machinery, which it no longer required and which ceased to be a commercial asset in its possession because it no longer engaged in manufacturing. Moreover, the assessee firm lacked any right to use the plant, machinery, or the premises where they were situated. In those circumstances, the firm let out the plant and machinery to the company, and thereafter the company, not the assessee, carried on the business of manufacturing ribbons and laces, hiring the equipment from the assessee firm. It was the company that appointed the managing agents and the selling agents, and, ex-facto, those transactions did not belong to the assessee firm. Thus, the assessee firm was left only with some property that had once been a commercial asset but had ceased to be so, and it let out that property for rent. The Court identified the remaining question as whether such letting out, under those circumstances, amounted to the carrying on of a business, as defined in Section 2(5) of the Excess Profits Tax Act.

The Act defines “business” for the purposes of the Excess Profits Tax to include, among other things, any trade, any commerce, any manufacture, or any adventure that is of the nature of trade, commerce or manufacture. The initial portion of this definition is identical to the definition of business that appears in section 2(4) of the Indian Income-Tax Act. Determining whether a particular activity falls within the meaning of trade, commerce, manufacture or an adventure in the nature of those activities is invariably a difficult question. The Judicial Committee, in the case of Commissioner of Income-tax v. Shaw Wallace & Co., observed that although the language of the definition is deliberately wide, the underlying concept in each term is the idea of a continuous exercise of an activity. In other words, the term “business” suggests a real, substantial, systematic or organised course of conduct that is pursued with a definite purpose. On the other hand, the Committee also recognised that even a single, isolated transaction may, on the strength of clear trade indicia, be regarded as an adventure in the nature of trade and therefore fall within the definition of business. Consequently, the question of whether a particular source of income is to be treated as business must be resolved by applying ordinary notions of what constitutes a business.

The present Court distinguished the present matter from the decision in Commissioner of Excess Profits Tax, Bombay City v. Shri Lakshmi Silk Mills Ltd., a case that is clearly different on its facts. In that case the respondent company had been formed expressly to manufacture silk cloth and, as part of that enterprise, it had installed a plant for dyeing silk yarn. During the relevant chargeable accounting period the company was unable to use the plant because the war had made silk yarn unavailable, and the plant remained idle for a period of time. In August 1943 the company let the plant to another firm on a monthly rent. The issue that arose was whether the rental income earned by the respondent during the chargeable period should be characterised as income from business and therefore be liable to excess profits tax. It is important to note that, despite the temporary idleness of the dyeing plant, the respondent continued its principal business of manufacturing silk cloth. Only the specific activity of dyeing silk yarn had to be suspended because of the wartime shortage. The Court held that the assets used for that suspended activity did not cease to be commercial assets of the business, since they were merely placed in a different temporary use or let out to a third party. Accordingly, any income derived from those assets was to be treated as profit of the business, irrespective of the manner in which the assets were exploited. The Court further observed that no single general principle could be laid down that would govern all such situations; each case must be examined on its own facts and circumstances.

In the present matter the assessee’s enterprise had ceased all manufacturing activity. The firm no longer produced any ribbons or laces and consequently had no further trading or commercial operations. Moreover, it could not continue to use its plant, machinery and other equipment because the land and the buildings on which those assets were situated had been sold to another company. Under those circumstances the assessee elected to lease the plant, machinery and related assets for an annual rent of Rs 40,000. The factual situation closely mirrors the circumstances described in Inland Revenue Commissioners v. Broadway Car Co., Ltd. (1) [1946] 2 A.E.R. 609, where wartime conditions reduced the company’s business to a very small scale. The court in that case observed that the company dealt with part of its property that had become redundant and sub-let the assets purely to generate income, a transaction wholly separate from the ordinary business activities of the enterprise. The ratio articulated in that judgment was considered by this Court to be applicable to the facts of the present case, apart from the findings recorded under section 10A. Applying the ordinary principles of common sense to the present facts, it is impossible to conclude that the letting out of the plant, machinery and related assets constituted a business operation when the firm’s regular business had terminated.

It is noteworthy that sub-sections (3) and (4) of section 12 of the Indian Income-Tax Act expressly recognise that income derived from letting out plant, machinery and similar assets may fall under the head “other sources” rather than under the head “business” dealt with in section 10 of that Act. Accordingly, in the circumstances of this case the lease income cannot be said to fall within the definition of “business” contained in section 2(5) of the Excess Profits Tax Act. Consequently, the Court found it unnecessary to express an opinion on the meaning or implication of the proviso to that definition or on rule 4(4) of Schedule I to the Act. In the Court’s opinion, on the facts and circumstances of the case, question No. 3 should have been answered in the negative. Because the third question was answered in favour of the assessee, the issue of the applicability of section 10A of the Excess Profits Tax Act could not arise; the assessee had no business during the relevant period to which that provision could apply. Therefore the revenue could not invoke section 10A, and the question of whether there was evidence to support the Tribunal’s finding under that section could not arise. Instead, a further question of law would emerge from the order of the Appellate Tribunal as a consequence of the answer to question No. 3.

In this case, the Court examined whether, given the facts and circumstances, the application of section 1O A for the purpose of amalgamating the income of the firms Uppal & Co. and Ram Singh & Co. with the income of the assessee firm was correct and valid in law, and that issue formed precisely the first question that the assessee firm had raised by its application. The Court held that the High Court should not only have answered question number three in the negative, but also, as a necessary corollary to that negative answer, should have raised the further question of law set out in question I of the assessee’s petition. In other words, after answering question three negatively, the High Court ought to have reframed the referred question I by restoring question one as suggested by the assessee in its petition, and then should have answered the restored question in the negative, thereby deciding in favour of the assessee. For the reasons stated, the Court allowed this appeal and ordered that question I be reframed by reinstating the first question proposed by the assessee, namely: “Whether, under the facts and circumstances of the case, the application of section 1O A 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 the reframed question in the negative. By necessary implication, question two was also answered in the negative and in favour of the assessee, and question three was likewise answered in the negative. Consequently, the appellant was awarded costs of the appeal, and the appeal was allowed.