Madan Gopal Bagla vs The Commissioner Of Income-Tax,West

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

Court: Supreme Court of India

Case Number: Civil Appeal No. 6 of 1954

Decision Date: 8 May, 1956

Coram: Natwarlal H. Bhagwati, DAS, SUDHI RANJAN (CJ), AIYYAR, T.L. VENKATARAMA

In the matter titled Madan Gopal Bagla versus the Commissioner of Income-Tax, West Bengal, the Supreme Court of India delivered its judgment on the eighth of May, 1956. The judgment was authored by Justice Natwarlal H. Bhagwati, who sat on a bench that also included Justice Sudhi Ranjan Das as Chief Justice and Justice T. L. Aiyy ar. The petition was filed by Madan Gopal Bagla as the petitioner and the respondent was the Commissioner of Income-Tax for West Bengal. The report of the decision appears in the 1956 volume of the All India Reporter at page 571 and in the Supreme Court Reports at page 551. The dispute concerned the application of section ten, sub-section two, clause xi of the Indian Income-Tax Act of 1922 to a loss incurred by a timber merchant who had stood as surety for a third party. The timber merchant, the appellant, obtained a loan from the Bank of India on joint security with a third person identified as M. On the same day M obtained a separate loan from the Imperial Bank of India, also on joint security with the appellant. M subsequently failed in his business, and the Imperial Bank of India realized the loan amount from the appellant. After receiving some dividends from the receivers of M’s estate, the appellant wrote off the remaining balance as a bad debt in the assessment year under consideration and claimed it as an allowable deduction under the cited provision, arguing that the loss arose in the ordinary course of securing finances for his timber business, a practice he claimed to be customary for persons carrying on such business. The Court observed that it had not been established that the appellant habitually acted as surety for other persons for the purpose of securing loans for their benefit. Consequently, the Court held that the debt could not be characterised as a debt incurred in the course of the appellant’s own business, because the appellant was not engaged in the business of standing surety for others. Moreover, the Court concluded that any loss sustained by paying a debt borrowed for another’s benefit would be treated as a capital loss rather than a business loss, and therefore it was not an allowable deduction under the specified clause of the Income-Tax Act. The Court distinguished the earlier decision of Commissioner of Income-Tax, Madras v. S. A. S. Bamaswamy Chettiar and approved the decision of Commissioner of Income-Tax, Madras v. S. B. Subramanya Pillai.

The appeal arose under civil appellate jurisdiction as Civil Appeal number six of 1954, challenging the judgment and order dated the sixth of June, 1951, rendered by the Calcutta High Court in Income-tax Reference number one of 1951. The appellant was represented by counsel appearing for the petitioner, while the respondent was represented by counsel appearing for the respondent. The judgment was pronounced on the eighth of May, 1956, and delivered by Justice Bhagwati. The matter involved a certificate under section sixty-six-A, sub-section two of the Indian Income-Tax Act, 1922, which permitted the appeal from the High Court’s reference decision made under section sixty-six, sub-section one of the same Act.

The High Court responded to the reference by answering in the negative. The appellant, who was engaged in the timber trade, obtained a loan of one lakh rupees from the Bank of India on 5 February 1930, and the loan was secured jointly by the appellant and a man named Mamraj Rambhagat. On that very same day, Mamraj Rambhagat also secured a loan of one lakh rupees from the Imperial Bank of India, Bombay, and that loan was jointly secured by him and the appellant. The appellant subsequently repaid his own loan of one lakh rupees to the Bank of India, but Mamraj Rambhagat failed to satisfy his obligation to the Imperial Bank of India, Bombay. Consequently, the Imperial Bank of India recovered the sum of one lakh rupees from the appellant, together with interest amounting to six hundred twenty-six rupees, on 24 March 1930. Mamraj Rambhagat’s business subsequently collapsed and his estate was placed under the control of receivers on 25 April 1930. In response, the appellant opened a ledger account in the name of Mamraj Rambhagat and recorded a debit of one lakh rupees and six hundred twenty-six rupees against that account. Over the following years the appellant received dividend payments from the receivers: thirty-one thousand four hundred forty-six rupees on 30 October 1930, nine thousand four hundred thirty-four rupees on 25 April 1934, and four thousand seven hundred sixteen rupees on 17 May 1938. The total of these receipts amounted to forty-five thousand five hundred ninety-six rupees, leaving an unpaid balance of fifty-five thousand thirty rupees. The appellant wrote off this unpaid balance as a bad debt in the assessment year 1941-42 (the accounting year being 1997 Ramnavmi) and claimed it as an allowable deduction under section 10 of the Income-Tax Act. The Income-Tax Officer rejected the deduction, holding that the loss was a capital loss, and the Appellate Assistant Commissioner concurred with that view. Before the Appellate Assistant Commissioner, counsel for the appellant argued that in Bombay it was a usual commercial custom for persons carrying on business to secure loans on joint security from banks. It was submitted that banks preferred such joint-security arrangements and that traders benefited because the interest rates were lower when a loan was jointly secured. It was further pleaded that the appellant frequently borrowed on joint security and that several old promissory notes executed jointly were produced as evidence. The appellant’s counsel cited the decision in Commissioner of Income-Tax, Madras v. S. A. S. Ramaswamy Chettiar, where it was held that among the Nattukottai Chettiars it was customary to stand surety for one another when borrowing from banks in order to lend at higher rates, and that a loss incurred under such a guarantee agreement was allowable as a deduction. The Appellate Assistant Commissioner, however, distinguished that case on factual grounds and held that although the appellant had stood surety for Mamraj Rambhagat in the course of obtaining finance for his timber business, the loss represented a sum borrowed by another person, that sum was capital in nature, and therefore the loss suffered by the appellant could not be treated as an allowable deduction.

In the present dispute, the loss that arose because Mamraj Rambhagat failed to repay the loan was characterised by the lower authority as a capital loss. The appellant challenged that finding before the Income Tax Appellate Tribunal. The Tribunal observed that the order of the Appellate Assistant Commissioner contained no statement on whether a customary practice of standing surety existed, and that the Commissioner had not required the appellant to prove such a custom. On that basis, the Tribunal concluded that the Department had accepted the existence of the custom. The Tribunal further held that there was no material distinction between a money-lending activity and the appellant’s timber-trading business, both of which were financed by borrowing on joint security. Accordingly, the Tribunal followed the reasoning in Commissioner of Income-tax, Madras v. S. A. S. Ramaswamy Chettiar, 1 [1946] 14 I.T.R. 236, and held that a loss incurred while standing surety could be allowed as a deduction, thereby upholding the appellant’s claim. The respondent then invoked section 66(1) of the Income-Tax Act and asked the High Court to consider whether, on the facts found, the sum of Rs 55,030 could be treated as a bad debt deductible under section 10(2)(xi) of the Act. The High Court, after hearing the reference, held that the Tribunal had proceeded on an erroneous factual assumption. It noted that the loan obtained from the Imperial Bank of India by Mamraj Rambhagat, although secured jointly by the appellant, was never applied to the appellant’s timber business. Consequently, no portion of the debt could be regarded as incurred in the course of the appellant’s trade, and therefore no deduction was permissible. The High Court further ruled that the Tribunal was wrong in law because section 10(2)(xi) permits deduction only of a trading or business debt arising from the taxpayer’s own trade or business. Since the appellant’s ordinary business was timber trading and not the business of standing surety for others, the loss was a capital loss, not a business loss. In reviewing the precedent relied upon by the Tribunal, the High Court referred to Commissioner of Income-tax, Madras v. S. R. Subramanya Pillai, 1 [1950] 18 I.T.R. 85, and held that the earlier decision was limited to the specific facts of a money-lending business of the Nattukottai Chettiars and could not be extended to other trades. Accordingly, the High Court answered the reference question in the negative. The present appeal therefore turns on the single issue of whether the loss of Rs 55,030 suffered by the appellant in this transaction should be characterised as a capital loss or as a trading loss.

The Court observed that the loss claimed by the appellant was a bad debt that arose in connection with a transaction in which the appellant acted as surety for another businessman, Mamraj Rambhagat, but that the money borrowed on the joint security of the appellant and Mamraj from the Imperial Bank of India, Bombay never entered the appellant’s timber enterprise. All of the borrowed funds were used by Mamraj in his own separate business and were not required to finance the appellant’s timber operations. Consequently, the debt recorded by the appellant in his ledger under Mamraj’s name was not a liability of the timber business; it was merely a personal obligation of Mamraj that the appellant had undertaken as a surety. The Court noted that if the appellant had borrowed money for his timber business, such borrowing would have represented his capital, and any loss incurred would consequently have been a capital loss. The appellant, however, attempted to treat the loss as a trading loss by relying on a customary practice in Bombay whereby businessmen obtained loans on joint security. According to the appellant’s argument, when a businessman A wished to obtain financing for his own venture, he could persuade another businessman B to join as a surety, on the condition that A, in turn, stood as surety for B’s separate loan from the bank. This reciprocal surety arrangement was presented as consideration for B’s participation and, the appellant argued, rendered the act of joining B as surety an essential component of financing A’s own business. The appellant contended that, despite none of B’s borrowed funds flowing into A’s business, A’s engagement as surety for B was an incident of A’s trade and that any loss suffered by A in connection with this arrangement should therefore be characterised as a trading loss arising in the course of his business. The Court therefore needed to examine the precise nature and scope of the custom the Department claimed to have accepted, namely that persons conducting business in Bombay commonly borrowed money on joint security from banks.

In the matter before the appellate authority, it was explained that businessmen in Bombay customarily obtained loans from banks at lower rates of interest by arranging for another businessman to stand as surety for the loan. A person could secure a loan for himself at a higher rate if he did not have a surety, but he could obtain a reduced rate by having a third party approved by the bank act as guarantor. The explanation, however, made clear that this commercial practice did not automatically require a system of mutual accommodation in which each participant had to act as surety for the other’s loans. A businessman such as A might approach B, C or D to act as his surety in order to obtain a lower-interest loan, but the custom did not compel A to reciprocally stand as surety for the loans that B, C or D obtained for their own enterprises. Unless evidence showed that such reciprocal suretyship was a regular feature of the practice, merely showing that A had procured B, C or D as guarantors would be insufficient to prove the custom that the appellant sought to rely upon. The appellant’s earlier pronotes, which had been presented to the Appellate Assistant Commissioner, failed to demonstrate the full extent of the alleged custom; they stopped short of establishing that a reciprocal arrangement existed between the parties. Consequently, the transaction in which the appellant acted as surety for Mamraj Rambhagat’s loan could not be characterized as an activity carried out in the ordinary course of the appellant’s timber business. While obtaining finance is undeniably an essential step in the operation of any business, that principle could not be extended to the specific act of the appellant standing surety for a loan that was entirely intended to finance Mamraj Rambhagat’s own venture and not the appellant’s timber operations. Counsel for the appellant highlighted the Appellate Assistant Commissioner’s finding that “it was in the course of securing finance for the business of timber that he stood surety with Mamraj Rambhagat.” This observation merely recorded a factual statement and did not substantiate the existence of the broader custom the appellant relied upon. Moreover, the pronotes submitted by the appellant related only to instances where other individuals had acted as surety for his loans; they did not show that the appellant had, in turn, acted as surety for those individuals’ separate borrowing transactions. Without such reciprocal evidence, the single occurrence of the appellant’s surety for Mamraj Rambhagat could not, on its own, establish the custom claimed, and the scope of that custom could not be enlarged beyond what the facts on record before the Appellate Assistant Commissioner warranted.

The Court observed that the solitary instance in which the appellant stood as surety for Mamraj Rambhagat could not, by itself, establish the custom that the appellant attempted to invoke, and it found no justification for expanding the alleged custom beyond the factual limitations set out in the order of the Appellate Assistant Commissioner. The Court noted that the custom among the Nattukottai Chettiars, as proved in Commissioner of Income-tax, Madras v. S. A. S. Ramaswamy Chettiar (supra), required members of that community to stand as surety for one another when they borrowed from banks for the purpose of re-lending the monies at higher rates of interest. Moreover, the Court explained that such joint suretyship formed an essential element of the money-lender’s trade, because the capital required for lending could be obtained only through borrowing on the collective security of the Chettiars, who mutually guaranteed each other’s overdrafts. In the absence of this type of collective surety, a solitary Nattukottai Chettiar would be unable to procure any funds that could be invested in his money-lending business. Accordingly, the Court reproduced the passage from page 238 of the cited judgment, which it described as highly relevant: “It is their custom to borrow from banks for the purpose of lending out the sums so obtained at higher rates of interest. The banks require such overdrafts to be guaranteed by other Chettiars. The Chettiars stand surety for one another in these borrowings. If a Chettiar refused to accommodate another moneylender in this way, he would not be able to obtain a guarantor for his own essential borrowings. The assessee in this case borrowed money on the guarantee of others and in turn stood surety for other Chettiars.” The Court stressed that the present case lacked both the mutuality and the indispensable business ingredient that characterized the custom identified in the earlier decision, and therefore the custom could not be extended to the appellant’s arrangement. The Court further observed that the decision in Commissioner of Income-tax, Madras v. S. A. S. Ramaswamy Chettiar had been expressly distinguished by the Madras High Court in Commissioner of Income-tax, Madras V. S. B. Subramanya Pillai (supra), which held that the precedent was confined to its own factual matrix and could not be applied to businesses other than the Nattukottai Chettiar money-lending trade. In the Subramanya Pillai case, the assessee was a bookseller who, together with another individual identified as L, jointly borrowed Rs 16,200, of which the assessee utilized Rs 10,450 for his own commercial needs while L retained the balance. The joint borrowing arose from the business requirements of both parties and from the insistence of money lenders who demanded joint security. When L’s business failed, the assessee was compelled to repay the entire joint liability to the creditors and also incurred an additional expense of Rs 658 in an unsuccessful attempt to recover L’s share of the loan. The Court concluded that the factual circumstances and the nature of the commercial activity in that case were materially different from those before it, reinforcing the view that the custom articulated in the earlier Nattukottai Chettiar decision did not apply to the appellant’s situation.

In the earlier case the assessee had tried unsuccessfully to recover the amount due from the co-borrower, L. The assessee then asserted that he was entitled to deduct two amounts from his business profit computation: the sum of Rs 658 that he had spent in the failed recovery effort, and the sum of Rs 520,495 that he had paid to the creditors on behalf of L’s share of the joint loan. The tribunal held that the assessee could not deduct either of these sums when calculating his business profit, whether under section 10(2)(xi), section 10(2)(xv), or as a loss incurred in the ordinary course of business. The Court observed that the precedent provides a proper analogy for the present matter and leads to the correct conclusion regarding the appellant’s claim. The Court then quoted the leading passage from the judgment of the learned Chief Justice that was under appeal, noting that it encapsulated the entire position: “The debt must therefore be one which can properly be called a trading debt and a debt of the trade, the profits of which are being computed. Judged by that test, it is difficult to see how the debt in the present case can be said to be a debt in respect of the business of the assessee. The assessee is not a person carrying on a business of standing surety for other persons. Nor is he a money-lender. He is simply a timber-merchant. There seems to have been some evidence before the Appellate Assistant Commissioner that he had from time to time obtained finances for his business by procuring loans on the joint security of himself and some other person. But it is not established, nor does it seem to have been alleged, that he in his turn was in the habit of standing surety for other persons along with them for the purpose of securing loans for their use and benefit. Even if such had been the case, any loss suffered by reason of having to pay a debt borrowed for the benefit of another would have been a capital loss to him and not a business loss at all.” Applying that reasoning, the Court concluded that the appeal could not succeed, ordered that the appeal be dismissed with costs, and affirmed that the appeal stood dismissed.