The Commissioner Of Excess Profits Tax... vs The Ruby General Insurance Co. Ltd

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

Court: Supreme Court of India

Case Number: Civil Appeal No. 12 of 1955

Decision Date: 24 April 1957

Coram: Natwarlal H. Bhagwati, J.L. Kapur, Venkatarama Aiyar

The case was titled The Commissioner Of Excess Profits Tax versus The Ruby General Insurance Co. Ltd and was decided on 24 April 1957 by the Supreme Court of India. The bench that heard the appeal consisted of Justice Natwarlal H. Bhagwati and Justice J. L. Kapur. This was a civil appeal numbered 12 of 1955, arising from the judgment and decree dated 10 September 1953 rendered by the Calcutta High Court in the original proceedings identified as I. T. Reference No. 8 of 1947. Counsel for the appellant included the Solicitor‑General for India and two additional advocates, while the respondents were represented by a team of four lawyers.

The judgment was delivered by Justice Venkatramaiyar, who noted that the appeal presented an important question of whether reserves shown by an insurance company for unexpired risks on pending policies could be deducted under rule 2 of Schedule II of the Excess Profits Tax Act (XV of 1940), hereinafter referred to as the Act. The pertinent provision stated that “The debts to be deducted under this sub‑rule shall include any such sums in respect of accruing liabilities as are allowable as a deduction in computing profits for the purposes of excess profits tax; and the said sums shall be deducted notwithstanding that they have not become payable.” For the provision to operate, two conditions must be satisfied: first, the sums must be allowable as a deduction in computing profits for the purposes of the Act, and second, they must relate to accruing liabilities. Rule 1 of Schedule I provides that “The profits of a business … during any chargeable accounting period … shall, subject to the provisions of this Schedule, be computed on the principles on which the profits of a business are computed for the purposes of income‑tax under section 10 of the Indian Income‑Tax Act, 1922.” Section 10(7) of the Indian Income‑Tax Act further declares that “Notwithstanding anything to the contrary contained in sections 8, 9, 10, 12 or 18, the profits and gains of any business of insurance and the tax payable thereon shall be computed in accordance with the rules contained in the Schedule to this Act.” Rule 6 of that Schedule adds that “The profits and gains of any business of insurance other than life insurance shall be taken to be the balance of the profits disclosed by the annual accounts, copies of which are required under the Insurance Act, 1938, to be furnished to the Controller of Insurance after adjusting such balance so as to exclude from it any expenditure other than expenditure which may under the provisions of section 10 of this Act be allowed for in computing the profits and gains of a business.” The Court observed that the situation was analogous to one in which, if goods are purchased, their value cannot be treated as profit without deducting the liability to pay for them, citing authorities such as [1912] A.C. 443; 6 T.C. 59 and a 1908 decision.

The judgment cited the authority found in volume five of the Tax Cases, page 308, which discussed profit calculation without subtracting the value of the liability that the buyer must later pay. Lord Alverstone articulated the reasoning that supported his conclusion, and Lord Atkinson likewise based his decision on the same principle, offering a similar observation. The Court also noted that one of the authorities relied upon by the Crown was the decision in Scottish Union and National Insurance Company v. Smiles, where the Lord President examined the treatment of the reserve for unexpired risk in fire policies for profit computation. In that decision, the Lord President explained that, over an assessment period or on an average of three years, deducting fire losses occurring in the same period together with ordinary expenses could fairly be regarded as the company’s profits and gains, without needing to consider or provide any allowance for the balance of annual risks that remained unexpired at the close of the company’s financial year. Referring to this case and another decision, Lord Haldane remarked that, when carefully examined in the light of the true principle, those authorities were not reliable for a proposition that would run counter to commercial practice and common sense. Relying on the observations just quoted, the learned Solicitor‑General advanced the argument that the obligation undertaken by an insurance company when it issues a policy should, for tax purposes, be treated as a present liability (a liability in praesenti) when computing the company’s profits.

Mr K. P. Khaitan, the learned counsel for the respondent, challenged the correctness of that contentions. He argued that, irrespective of English law, a contract of insurance under the Indian Contract Act is merely a contingent contract, meaning that until the insured event occurs there is no enforceable liability, and consequently the unexpired risks in policies that are still pending cannot be treated as present liabilities. He further contended that the history of rule 2 of Schedule II to the Act demonstrated that the rule originally referred only to borrowed money and debts, and that it was only by section 10 of the Excess Profits Tax (Amendment) Act, XLII of 1940, that accruing liabilities were brought within its scope. When that inclusion occurred, it was not as a category independent of borrowed money and debts; rather it was enacted through a provision that specified that the debts deductible under the rule included sums relating to accruing liabilities. On that basis, counsel for the respondent submitted that, even if the phrase “accruing liabilities” were interpreted broadly, it could not be extended to cover liabilities that do not have the character of debts. Accordingly, a liability arising from an insurance contract where the risk has not materialised cannot be regarded as a debt and therefore does not fall within the definition of an accruing liability under the rule. In support of this position, he relied on the authorities previously mentioned.

The Court referred to the authorities of Webb v. Stenton and Israelson v. Dawson, both of which concerned the operation of rule 0. 45 R 2 of the English Rules of Practice. In the case of Webb v. Stenton the issue was whether a sum that was due to the judgment‑debtor under a trust deed but had not yet become payable could be seized by the trustees as a debt that was either owing or accruing. Lindley L.J., delivering the opinion, held that such a sum could not be attached and explained that a debt, whether legal or equitable, must be a sum of money presently payable or one that will become payable in the future because of an existing obligation, describing it as “debitum in praesenti, solvendum in futuro”. He further clarified that an accruing debt is a debt not yet actually payable, but one that is represented by an existing obligation.

In Israelson v. Dawson, the Court again examined rule 0. 45 R 2 and determined that an amount which became payable under an insurance policy after the specified accident had occurred could not be treated as a debt subject to attachment before the arbitrator had fixed the compensation in accordance with the policy conditions. On the basis of these two decisions, the respondent argued that, until the risk described in an insurance policy actually materialises and the corresponding compensation is ascertained, the liability remains merely contingent and does not qualify as a debt within rule 2 of Schedule II to the Act.

Addressing this contention, the learned Solicitor‑General replied that the cited authorities were not applicable because they were decided under a different statute. He pointed out that the decision in Sun Insurance Office v. Clark, reported in 1883 11 Q.B.D. 518, 527, dealt with assessment for taxation purposes and was directly relevant to the present dispute. According to that decision, sums reserved for unexpired risks constitute amounts in respect of accruing liabilities for tax valuation. The Solicitor‑General argued that the core question was whether the claim should be treated as an essential charge against the trade receipts of the year. In distinguishing Sun Insurance Office v. Clark, Lord Oaksey observed that, although the decision and the observations in Southern Railway of Peru Ltd. v. Owen supported the appellant’s view that unexpired risks should be regarded as present liabilities for income‑tax computation, the fact remained that rule 6 of the Schedule to the Indian Income‑tax Act had adopted the principle laid down in Sun Insurance Office v. Clark, which did not automatically extend to the definition of accruing liability under rule 2 of Schedule II to the Excess Profits Tax Act.

In considering the decision in Office v. Clark (1), the Court noted that the remaining issue was whether the unexpired risk that exists in an outstanding insurance policy should be classified as an accruing liability within rule 2 of Schedule II to the Act. The appellant argued, citing the authorities (1) [1912] A.C. 443: 6 T.C. 59 and (2) [1956] 2 All E.R. 728, that if such liability is regarded as a present liability for the purpose of assessing taxable profits under the income‑tax legislation, then the same treatment ought logically to apply for the excess profits tax and the amount should consequently be deducted under rule 2 of Schedule II to the Act. The appellant further submitted that this reasoning would be appropriate only if the scheme and framework of the Excess Profits Tax Act were identical to those of the Income‑Tax Act. The Court, however, observed that the Excess Profits Tax Act differs in material respects from the Income‑Tax Act, and therefore the principles that govern profit assessment under section 10 of the Income‑Tax Act cannot be automatically applied to the calculation of capital employed under rules 1 and 2 of Schedule II to the Excess Profits Tax Act. The Court explained that the purpose of the Excess Profits Tax Act is to levy tax on the portion of a business’s profits that exceeds a predetermined level. That level is established by first selecting a standard period, then determining the capital actually invested and the profits earned by the business during that year, and finally computing the standard profits in relation to those two figures. Afterward, the capital that is really employed in the business during the chargeable accounting period is ascertained. If the capital employed in the chargeable period equals the capital employed in the standard period, no further adjustment is required; if it is greater, the standard profits are increased proportionally, and if it is lower, the standard profits are reduced proportionately. Thus, the Act is designed to tax only those profits that rise above a level that moves up or down according to changes in the capital employed. The Court emphasized that this feature distinguishes the Excess Profits Tax Act from other tax statutes, and it identified the determination of the capital actually employed in the business as one of the most important and demanding tasks in ascertaining taxable profits under the Act. Rule 1 of Schedule II to the Act enumerates three categories of property that must be included in the computation of capital. The Court observed that this rule does not rely on any technical or conventional definition of “capital”; instead, it adopts a factual approach that includes anything used in the business, whether tangible or intangible. The objective of the provision is plainly to give an advantage to the assessee by allowing him to retain, at least in part, the profits derived from the investment of additional capital. Rule 2 then provides for certain deductions to be made from the capital so calculated. The Court noted that, apart from the “accruing liabilities” which are at the heart of the present controversy, the other two items mentioned in rule 2 are borrowed money and debts.

The Court observed that the two remaining items listed in the rule were borrowed money and debts, and explained why these items were excluded from the definition of capital in rule 1. It held that money borrowed and debts incurred for the purpose of the business would necessarily have been put to use in the business, and therefore they would be counted as part of the capital employed as defined in rule 1.

The Court then explained that the purpose of the statute was to provide relief to a taxpayer who introduced additional capital of his own into the business. Consequently, the relief had to be limited to capital contributed by the taxpayer himself. The Court warned that if borrowed capital were allowed to qualify, the intended benefit could be abused and the purpose of the legislation would be defeated by wide‑scale use of borrowed money. For that reason, the Court said that borrowed money and debt must be deducted from the amount that is treated as capital under rule 1.

The Court turned to the phrase “accruing liabilities” and asked what this expression meant. It said that to answer the question it was necessary to consider the scope and purpose of rules 1 and 2 of Schedule II and to view the phrase in its surrounding context. The Court recalled that the object of the Act was to tax profits that exceeded a line referred to as “standard profits,” a line that moved according to the amount of capital employed. The scheme of rule 1 was therefore factual: it treated every tangible or intangible asset that was thrown into the business and that helped generate profit as capital, while rule 2 excluded from that capital the portion that arose from borrowing.

From this foundation the Court concluded that a deduction under rule 2 could relate only to something that qualified as capital under rule 1, and that such capital had to be a genuine profit‑earning asset, whether tangible or not. Borrowed money that was to be deducted under rule 2 was money borrowed for the business purpose and which had increased the capital measured under rule 1. The same reasoning applied to debts. The Court added that accruing liabilities that were to be deducted under rule 2 had to be of the same nature as the borrowed money and debts with which they were associated, following the principle of noscitur a sociis. In other words, those liabilities must have been used in the business and must have formed part of the effective trading assets during the chargeable accounting period.

Finally, the Court stated that the correct approach did not require asking whether the liability technically amounted to a debt. If the liability could be used in the business and actually was used, it would fall within rule 2 even if it was not strictly a debt. Nor was it necessary to decide whether the liability had been treated as a liability for income‑tax assessment purposes. The Court emphasized that the issue must be examined in the context of assessing business income under section 10 of the Income‑Tax Act.

The judgment explained that a deduction is permissible only for a liability that has been incurred solely and exclusively for the purpose of the business; where such liability has not yet matured, its value must be ascertained in accordance with accounting rules and then deducted. When a deduction is sought under rule 2, the enquiry must be whether the obligation can be treated as an asset employed in the business and whether it could conceivably contribute to the profit of the enterprise. If that connection is not established, the obligation cannot be treated as capital under rule 1, nor can it be deducted as an accruing liability under rule 2. The judgment further stressed that deductions under section 10 of the Income‑Tax Act and deductions under rule 2 of Schedule 11 operate on completely different principles and pursue different objectives. Under section 10, the assessee claims a deduction, and if the claim is allowed it reduces the taxable profit. Conversely, under rule 2 the revenue department makes the claim; if the claim is allowed it increases the assessee’s liability by reducing the amount of capital that would otherwise fall under rule 1. The judgment observed that the principle laid down in Sun Insurance Office v Clark (1912) A.C. 443; 6 T.C. 59 would be unsuitable for determining capital employed in business for the purposes of the Excess Profits Tax Act. The question arose whether the reserve for unexpired risks could be classified as an “accruing liability” within rule 2. The Sun case had allowed a deduction on two bases: first, that the reserve represented unearned income, and second, that it was a liability in the nature of an unpaid price of property that formed part of the trading assets. The present case required a strained analogy to apply that reasoning, and the judgment asked whether such a liability could be regarded as falling within the scope of rule 2, and whether, like borrowed money or debt, it formed part of the genuine trading assets of the business. The answer was clearly negative. The reserve liability could not be shown to have contributed to the operation of the business or to the generation of profit; it was merely a contingent amount with no practical effect on the concern during the chargeable accounting period. Consequently, it could not be treated as an “accruing liability” under rule 2 of Schedule 11. The judgment then referred to the decision in Northern Aluminium Co. Ltd. v Inland Revenue Commissioners (1), which addressed a similar issue concerning the character of a conditional liability in the context of the English Excess Profits Tax Act.

In the case under discussion, the Court examined whether a conditional liability arising from a contract could be treated as an “accruing liability” within the meaning of the relevant provision of the English Excess Profits Tax Act. The factual background involved an agreement dated 16 December 1939 between the Ministry of Aircraft Production and a company that manufactured aluminium products for government aircraft manufacturers. That agreement stipulated that the company should reduce the prices it charged its customers for the period from 1 July 1939 to 30 June 1940, and that any excess amount paid by customers over the reduced price should be remitted by the company to the Ministry. Additionally, the agreement required that negotiations commence no later than 30 June 1940 to determine the rates applicable to periods after that date. In reality, however, the parties did not conclude a final agreement until 12 October 1942, at which time the company’s prices were fixed for the years 1941, 1942 and 1943. Pursuant to the October 1942 agreement, the company repaid to the Ministry in 1943 a sum of £2,743,469, representing the difference between the amounts actually received from customers and the amounts fixed by the agreement. That repayment was allowed as a deduction when the company’s business income was assessed for income‑tax purposes. The legal dispute therefore turned on whether the same sum could also be deducted for the purpose of assessing the excess profits tax as an “accruing liability” of the company for the chargeable accounting year that ran from 1 January to 31 December 1941. The Court of Appeal held that, during the 1941 accounting period, there was no operative agreement between the parties; consequently, no liability had arisen in that year. The Court also considered an alternative argument that the original 16 December 1939 agreement might be viewed as a conditional arrangement affecting periods after 30 June 1940. Even under that view, the Court concluded that the obligation created could not be regarded as an accruing liability within the rule at issue. Lord Greene, Master of the Rolls, explained his reasoning: a purely conditional liability, which may or may not materialise, does not fall within the statutory language because it does not affect the company’s capital position, just as a conditional receipt does not. A receipt that depends on the occurrence of some future event cannot be used to generate profits, and the capital provisions are concerned only with the possibility of earning profits on actual capital. Accordingly, even if one were to formulate a hypothetical conditional contract, it would not give rise to an accruing liability for excess‑profits tax purposes.

The Court observed that, even if those words were given their plain meaning, the effect would not be to create an accruing liability within the meaning of the relevant section. The decision of the lower court was taken on appeal to the House of Lords and was affirmed, as indicated by the reference to Inland Revenue Commissioners v. Northern Aluminium Co. Ltd. (1). That authority establishes that a conditional liability arising from a concluded contract was not an accruing liability for the purposes of the Excess Profits Tax Act, because it had no impact on the actual capital position of the company, and the fact that the liability could be allowed for income‑tax purposes did not alter its character under the Excess Profits Tax Act. The Solicitor‑General attempted to distinguish that decision on the ground that it did not involve an insurance business, while it was contended that Sun Insurance Office v. Clark (2) directly addressed the issue now before the Court, namely whether reserves for unexpired risks under pending policies constitute liabilities that may be deducted. The Court found no material difference in the construction of rule 2 of Schedule II to the Act between a liability arising under an insurance policy and a liability arising under any other contract. The Court noted the citations (1) [1947] 1 All E.R. 608 and (2) [1912] A.C. 443; 6 T.C. 59. Accordingly, the Court held that the principles set out in Northern Aluminium Co., Ltd. v. Inland Revenue Commissioners (1) and Inland Revenue Commissioners v. Northern Aluminium Co., Ltd. (2) apply to the present case, and that a contingent liability relating to unexpired risk does not qualify as an “accruing liability” within rule 2 of Schedule II to the Act. Consequently, the Court affirmed the correctness of the decision that was appealed from and ordered that the appeal be dismissed with costs. The appeal was dismissed.