Badridas Daga vs The Commissioner Of Income-Tax

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

Court: supreme-court

Case Number: Civil Appeal No. 149 of 1956

Decision Date: 25 April, 1958

Coram: P.B. Gajendragadkar, A.K. Sarkar, Venkatarama Aiiyr

In this case the petitioner, Badridas Daga, challenged an order made by the Commissioner of Income‑Tax. The judgment was delivered on 25 April 1958 by a bench consisting of Justice P.B. Gajendragadkar, Justice A.K. Sarkar and Justice T.L. Venkatarama Ai. The appeal was cited as Civil Appeal No 149 of 1956 and was taken on special leave from a decree of the Nagpur High Court dated 22 December 1954 in Miscellaneous Civil Case No 36 of 1954. The matter concerned the application of the Indian Income‑Tax Act, 1922, specifically sections 10(1), 10(2)(xi) and 10(2)(xv). The petitioner had employed an agent to manage his business and had given the agent extensive powers, including the authority to operate the firm’s bank accounts. While exercising that authority the agent withdrew a large sum of money from the bank and used it to settle his own personal debts. The petitioner was able to recover only a part of the misappropriated amount; the balance was written off at the close of the accounting year as irrecoverable. The central question was whether the amount that remained unrecovered could be deducted from the petitioner’s taxable income. The Court held that the loss could not be claimed as a bad debt under section 10(2)(xi) nor as a business expenditure under section 10(2)(xv). However, the Court determined that the loss was deductible under section 10(1) as a loss incidental to the carrying on of the business. The Court explained that when an agent or employee who is authorized to deal with bank accounts misappropriates money, the loss is attributable to the character of the authorized agent and is therefore incidental to the business, even though the money was not withdrawn for business purposes. The Court relied on earlier authorities, namely Curtis v. J. & G. Oldfield (1925) 9 Tax Cas. 319, Rama‑Swami Chettiar v. Commissioner of Income‑Tax, Madras (1930) I.L.R. 53 Mad. 904, Venkatachalapathy Iyer v. Commissioner of Income‑Tax (1951) 20 I.T.R. 363, Lord’s Dairy Farm Ltd. v. Commissioner of Income‑Tax (1955) 27 I.T.R. 700 and Motipur Sugar Factory Ltd. v. Commissioner of Income‑Tax (1955) 28 I.T.R. 128. Counsel for the appellant were described as representing the petitioner, while counsel for the respondent represented the Commissioner of Income‑Tax.

The judgment was delivered by Justice Venkatarama Aiyar. The case was an appeal against a judgment of the High Court of Nagpur that arose from a reference made under section 66(1) of the Indian Income‑Tax Act, 1922, hereinafter referred to as the Act. The appellant was the sole proprietor of a firm named Bansilal Abirchand Kasturchand, which carried on business as money‑lenders, as dealers in shares and bullion, and as commission agents in Bombay, Calcutta and other places. He was a resident of Bikaner and managed the various branches of the business through agents appointed at each location. During the period in question the agent employed at Bombay was a person named Chandratan, who possessed a power‑of‑attorney dated 13 May 1944 that gave him extensive management powers, including authority to operate the firm’s bank accounts. Between 15 November 1944 and 23 November 1944 the agent withdrew from the firm’s bank account sums totalling Rs 2,30,636‑4‑0 and applied the money to discharge personal debts that he had incurred in speculative transactions. On 25 November 1944 the firm’s cashier transmitted a telegram to the appellant informing him of the true state of affairs. In response the appellant travelled to Bombay on 3 December 1944, and on the following day cancelled the power‑of‑attorney that had been granted to the agent. By a notice dated 6 December 1944 the appellant demanded that the agent repay the amounts that had been withdrawn. The agent replied on 8 December 1944, admitted to the misappropriation and pleaded for mercy. On 16 January 1945 the appellant instituted a suit in the High Court of Bombay seeking recovery of Rs 2,30,636‑4‑0; the suit was decreed on 20 February 1945. From Chandratan a sum of Rs 28,000 was recovered and applied against the decree, and the remaining balance of Rs 2,02,442‑13‑9 was written off at the close of the accounting year as irrecoverable. Before the income‑tax authorities the dispute centred on whether the amount of Rs 2,02,442‑13‑9 could be allowed as a deduction. The Tribunal held that the sum represented a loss suffered by the appellant because of the agent’s misappropriation, but relying on the authority of Curtis v. J. & G. Oldfield, Limited (1925) 9 Tax Cas. 319, it concluded that the loss was not a trading loss and therefore could not be permitted as a deduction. On the appellant’s application the Tribunal referred a question of law to the Nagpur High Court: whether the sum of Rs 2,02,442‑13‑9, being part of the amount embezzled by the assessee’s munim, was allowable as a deduction under the Indian Income‑Tax Act either under section 10(1), under the general principles for determining profit and loss of the assessee, or under section 10(2)(xv). The learned judges of the Nagpur High Court answered the question against the appellant, holding that the case was governed by the decision in Curtis v. J. & G. Oldfield, Limited and that the deduction could not be allowed. An application under section 66(A)(2) for a certificate was also dismissed, and subsequently the appellant obtained leave to appeal to this Court under article 136.

The appeal reached the Court because the appellant sought to allow a deduction for sums that were misappropriated by his agent. The central issue was whether monies embezzled by an agent or employee could be treated as a deductible expense in computing the profits of a business under section 10 of the Income‑Tax Act. The courts of India had considered this question on many occasions, but the decisions had not been uniform. Before examining the case law, the Court found it necessary to set out the legal principles applicable to the determination of the issue. Three arguments were advanced in support of allowing the deduction. First, the loss caused by the embezzlement was characterized as a bad debt that could be deducted under section 10(2)(xi). Second, it was described as a business expense that fell within section 10(2)(xv). Third, it was claimed to be a trading loss that should be taken into account under section 10(1). Regarding the first argument, the Court observed that authorities consistently rejected the view that a deduction could be taken under section 10(2)(xi), and it agreed with that position. A debt, the Court explained, arises from an express or implied contract between parties. When an agent fraudulently misappropriates money belonging to his principal, the agent does not owe the money under any contractual arrangement. Although the agent is legally liable to make restitution, that liability does not stem from a contract, express or implied. The Court further noted that the manner in which the embezzled amounts appear in the business’s books—recorded as debits, any recoveries shown as credits, and the balance ultimately written off—are merely accounting entries. Such entries do not create a contractual liability, and therefore the deduction under section 10(2)(xi) was unavailable.

The Court then turned to the second argument. It held that a claim for deduction could not be sustained under section 10(2)(xv) because monies withdrawn by an employee without authority and in fraud of the proprietor could not be described as “an expenditure laid out or expended wholly and exclusively” for the purpose of the business. Consequently, the controversy narrowed to the question of whether amounts lost through an employee’s embezzlement qualified as a trading loss that could be deducted under section 10(1). The Court observed that while section 10(1) imposes a charge on the profits or gains of a trade, it does not prescribe the method of computing those profits. Section 10(2) lists various items that are admissible as deductions, but it is well settled that the list is not exhaustive of all allowances that may be made in ascertaining taxable profits under section 10(1). The Court referenced the decision in Income‑Tax Commissioner v. Chitnavis, where the issue was whether a bad debt could be deducted under section 10(1) in the absence of a specific provision in the Act. In that case, the Court had affirmed that losses incurred in the ordinary course of business, even if not expressly enumerated in section 10(2), could be deducted when calculating profits for tax purposes.

The Court turned to the question of whether a loss that is not mentioned in section 10(2)(xi) of the Income‑Tax Act could nevertheless be allowed as a deduction. In doing so, it relied on the earlier decision of Lord Russell, who had answered the same question in the affirmative. Lord Russell stated that, although the statute does not expressly authorise the deduction of bad debts incurred in the course of business, the deduction is nonetheless necessarily permissible. He explained that the items which are chargeable to income‑tax in respect of a business are the profits and gains of a year, and that, in arriving at the amount of those profits and gains, every loss that has been incurred must be taken into account; otherwise the true profit and gain would not be arrived at. The Court noted that it is now well settled that profits and gains subject to tax under section 10(1) are to be understood in accordance with ordinary commercial principles. Accordingly, the Court quoted Lord Halsbury’s observation in Gresham Life Assurance Society v Styles, that the word “profits” is to be understood “in its natural and proper sense‑in a sense which no commercial man would misunderstand.” The Court also recalled the observations of Lord Macmillan in Pondicherry Railway Co. v Income‑Tax Commissioner, wherein he warned that English authorities must be employed with caution in Indian tax cases because of legislative differences, but affirmed that the principle laid down by Lord Chancellor Halsbury in the Gresham case remains of general application and is not affected by the particularities of the English tax system. The effect of these authorities is that when a claim for a deduction is made for a loss for which there is no express provision in section 10(2), the admissibility of the deduction depends on whether, having regard to accepted commercial practice and trading principles, the loss can be said to arise out of the carrying on of the business and to be incidental to it. If that connection is established and there is no express or implied prohibition in the Act, the deduction must be allowed. Applying this principle to the present issue of loss caused by an employee’s embezzlement, the Court held that the decisive inquiry is whether the loss arises out of the carrying on of the business and is incidental to it. Viewing the matter as a businessman would, the Court found it difficult to argue otherwise. A profitable business necessarily operates through agents, cashiers, clerks and other staff, whose salaries and remuneration are admissible under section 10(2)(xv) as expenses incurred for the purpose of the business. If the employment of such agents is incidental to the operation of the business, then, logically, losses that are incidental to that employment must also be incidental to the business. The Court recognised that human nature makes it impossible to rule out the possibility that an employee might abuse his position and misappropriate funds, and therefore such losses must be treated as arising out of and incidental to the carrying on of the business.

The Court explained that when an employee misappropriates the funds of his employer, the loss that results must be regarded as arising out of the carrying on of the business and as incidental to it. The Court relied on earlier decisions, notably the authorities recorded in (1)(1931) L.R. 58 I.A. 239, 252 and (2)(1892) A.C. 309, 315; 3 Tax Cas. 185, 188, to support this view. According to ordinary commercial principles of trading, such a loss is treated in the same way as any other expense that is incurred in the ordinary course of business. However, the Court emphasized that a deduction under section 10(1) is permissible only for a loss that springs directly from the carrying on of the business and is incidental to it; it is not available for every loss that the assessee may suffer, even if the loss has some connection with the business. To illustrate the distinction, the Court gave a hypothetical case where a thief breaks into the premises of a money‑lender overnight and steals the funds kept there. Although the theft reduces the capital available for lending and therefore constitutes a business loss in a broad sense, the loss is not incurred in the ordinary running of the business but is rather the type of loss to which any owner of property is exposed, regardless of whether he is engaged in business. Consequently, the loss in such a scenario would be treated as a loss falling on the assessee as a property owner, not as a loss incurred by a person carrying on a business. The Court stressed that this fine but material distinction determines whether a deduction under section 10(1) may be allowed.

Having set out the guiding principles, the Court proceeded to examine the relevant authorities. In Jagarnath Therani v. Commissioner of Income‑Tax (1), the assessee, who was engaged in business, entrusted a sum of Rs 25,000 to his gumastha for payment to a creditor, and the gumastha embezzled the amount. The question referred for the High Court’s opinion was whether the embezzled sum could be deducted in computing profits. The learned judges answered affirmatively. They observed that, according to the practice prevailing in England, losses caused by the embezzlement of employees were allowed as deductions. They cited statements of law from Sanders’ Income‑tax and Super‑tax, Murray and Carter’s Guide to Income‑tax Practice, and a passage from Snellings’ Dictionary of Income‑tax and Super‑Tax Practice, which read: “If a loss by embezzlement can be said to be necessarily incurred in carrying on the trade it is allowable as a deduction from profits. In an ordinary case it springs directly from the necessity of deputing certain duties to an employee, and should therefore be allowed.” Accordingly, the deduction was permitted as a loss incidental to the conduct of the business. In Ramaswami Chettiar v. Commissioner of Income‑Tax, Madras (1), the assessee operated banking businesses in several locations in India and Burma. On 21 October 1926, thieves broke into the strong‑room at the Moulmiengyum premises and stole cash and currency notes worth Rs 9,335. The issue before the Court was whether this amount could be allowed as a deduction. The majority of the judges held that it could not. The learned Chief Justice explained that a loss suffered after profits have been collected and are being transported or stored in a safe place is not incidental to the business. He added that when the collection of profits or payment of debts is entrusted to a gumastha or servant who then absconds with the money, the loss is incidental to the business and a deduction is permissible. This articulation underscored the Court’s nuanced approach to distinguishing losses that qualify for deduction under section 10(1) from those that do not.

In the case concerning the loss of Rs 9,335 that occurred on 21 October 1926, the Court examined whether that loss could be deducted from the assessee’s income. The majority of the judges held that the amount could not be allowed as a deduction. The learned Chief Justice expressed the principle that if a person receives a sum of money that is his profit, places it in his own possession, and is subsequently robbed on his way home, it is difficult to argue that such a loss is incidental to the conduct of his business. The difficulty becomes greater when the profit has already been secured in a strong‑room or another place that the owner considers safe. The Chief Justice further explained that when the collection of profits or the receipt of debts is entrusted to a gumastha or servant and that person absconds with the money or otherwise mishandles it, the loss is indeed incidental to the business and should be deductible. This is because the assessee must employ servants for the purpose of collecting sums due to him, and there is a risk that a dishonest servant may appropriate the funds for personal use. However, the Chief Justice could not distinguish the present situation from that of a professional or trader who, after collecting his profits, is robbed by a stranger unrelated to his business. In the present case, none of the thieves were servants of the assessee at the time of the theft, although one of them had formerly served as the assessee’s cook.

These observations reinforce the right of an assessee to claim a deduction for losses caused by embezzlement committed by an employee, while also delineating the scope of that right. In Bansidhar Onkarmal v. Commissioner of Income‑tax, a theft of money by an accountant took place after office hours, and the Court, following the earlier decision in Ramaswami Chettiar v. Commissioner of Income‑tax (1), held that the loss could not be allowed as a deduction under section 10(1) of the Act because it was not incidental to the carrying on of the trade. The leading judgment, delivered by Narasimham J., observed that the result might have been different had the theft been committed by the accountant during office hours. In the subsequent case of Venkatachalapathy Iyer v. Commissioner of Income‑tax (3), the assessee was a firm of merchants dealing in yarn. Their accountant, Rajarathnam Iyer, was responsible for receiving cash on sales, making disbursements and maintaining accounts. Although he recorded all transactions in the cash book, at the end of each day he deliberately under‑stated receipts and overstated disbursements, thereby misappropriating the difference. The Court examined whether the amounts thus embezzled could be deducted, reviewing the authorities previously discussed.

Satyanarayana Rao and Raghava Rao JJ held that the loss suffered by the assessee was incidental to the carrying on of the business and therefore should be allowed as a deduction. The appellant argued that this judgment was decisive in his favour and that it bound the court to allow the deduction. However, the learned judges of the lower court were of the view that, on the facts of the present case, the decision in Satyanarayana Rao was distinguishable. They further concluded that the present matter fell within the principles laid down in Curtis v. J. and G. Oldfield, Limited (4). Consequently, the court felt it necessary to examine the Curtis decision closely, because the precise legal position emerging from that case has been the subject of considerable controversy in Indian jurisprudence. In the Curtis case, the managing director of a company, who exercised exclusive control over the company’s affairs, repeatedly withdrew large sums of money and applied them to his personal use, exploiting his position as managing director. This conduct continued for several years prior to the director’s death, as reported in (1) [1949] 17 I.T.R. 247, (3) [1951] 20 I.T.R. 363, (2) (1930) I.L.R. 53 Mad. 904, 906, 907 and (4) (1925) 9 Tax Cas. 319, and was only discovered after his death when the fraud was uncovered and the over‑drawn amounts were written off as irrecoverable.

The central question in Curtis was whether the amounts fraudulently taken by the managing director could be allowed as a tax deduction. Rowlatt J answered this question in the negative, holding that the deduction could not be permitted. It is important to note, however, that the learned judge did not declare that every amount embezzled by an employee in the course of business would be disallowed. On the contrary, he observed, “I quite think, with Mr. Latter, that if you have a business...... in the course of which you have to employ subordinates, and owing to the negligence or the dishonesty of the subordinates some of the receipts of the business do not find their way into the till, or some of the bills are not collected at all, or something of that sort, that may be an expense connected with and arising out of the trade in the most complete sense of the word.” He further explained, “I do not see that there is any evidence at all that there was a loss in the trade in that respect. It simply means that the assets of the Company—moneys which the Company had got and which had got home to the Company—got into the control of the Managing Director of the Company, and he took them out. It seems to me that what has happened is that he has made away with, receipts of the Company de hors the trade altogether in virtue of his position as Managing Director in the office and being in a position to do exactly what he likes.” From this discussion, the judge concluded that the embezzlement by the managing director was not connected with the carrying on of the trade but was outside it, and on that basis the deduction must be disallowed. The learned judges of the lower court, however, interpreted these observations differently, leading to the present appeal.

The Court below seemed to interpret the earlier observations as establishing a general legal rule that embezzlements occurring before the assessee received the amounts were incidental to the trade and thus allowable as deductions, whereas embezzlements occurring after receipt were not connected with the trade and therefore disallowed. The present Court did not adopt that interpretation. It held that the determination must be made on the facts of each individual case, assessing whether the particular embezzlement for which a deduction was claimed took place in the course of the business. The observations of the learned Judge that, in his case, the embezzlement was not part of the business were limited to that factual situation and could not be used as a blanket rule for other cases. The Court then referred to the earlier case of Curtis v. J. & G. Oldfield Limited, where the company was engaged in the wine‑and‑spirit trade. In that context it was conceivable to say that once the sale price had been realised and the proceeds deposited in a bank, the trading activity had effectively ended and subsequent banking operations were not incidental to the trade. However, the present matter involved a banking enterprise, an activity characterised by making advances, collecting repayments and extending fresh advances. Such a business requires not only the deposit of monies in banks but also the regular withdrawal of funds. Consequently, continual operations on the bank account were integral to the conduct of the banking business. The notion that money, once placed in a bank, had “got home” and that any later withdrawal was outside the business was deemed wholly inappropriate for a banking operation. It would be an unrealistic view to assert that the business of money‑lending ceased at the moment of deposit. The Court also noted that in Curtis v. J. & G. Oldfield Limited, although the assessee was a company, all shares were held by members of the Oldfield family, the company lacked an auditor, kept no minutes book and had virtually no balance sheets. One family member, Mr. J. E. Oldfield, exercised wide managerial powers and owned a large proportion of the shares, making the company effectively a private concern. His withdrawals were more akin to a partner overdrawing his own account than an agent stealing the employer’s funds, and it could properly be held that such overdrawing bore no relation to the trading activities of the firm, whose profits are

It would be a mistake to treat the observations of Rowlatt J. as establishing a general rule that, as a matter of law, no business activity can involve money after it has been collected, and therefore embezzlement could never be incidental to the carrying on of a business, regardless of the nature of that business. Moreover, the Court held that it does not matter whether the employee who misappropriates funds is in a subordinate position or is an agent with extensive management powers; the admissibility of a deduction for the loss is the same in either case. After the decision that is now being appealed, the Bombay High Court examined the same question in Lord’s Dairy Farm Ltd. v. Commissioner of Income‑Tax (1). On review of earlier authorities, including the decision in Curtis v. J. & G. Oldfield, Limited (2), the judges Chagla C.J. and Tendolkar J. concluded that a loss caused to a business by the defalcation of an employee is a trading loss and may be deducted under section 10(1). In Motipur Sugar Factory Ltd. v. Commissioner of Income‑Tax (3), an employee who had been entrusted with company funds for distributing them among sugarcane growers under statutory rules was robbed on the way. The Court, through Ramaswami and Sahai JJ., held that the loss was incidental to the conduct of the trade and therefore had to be allowed. The present Court agrees with the decisions in Venkatachalapathy Iyer v. Commissioner of Income‑Tax (4), Lord’s Dairy Farm Ltd. v. Commissioner of Income‑Tax (1) and Motipur Sugar Factory Ltd. v. Commissioner of Income‑Tax (3).

The respondent contended that there was no evidence, let alone proof, that Chandratan withdrew funds from the bank with the purpose of making any advance, and therefore the withdrawal could not be regarded as being for the conduct of the trade. The Court found that such proof was not required. Once it is shown that Chandratan was in charge of the business, that he possessed the authority to operate the bank accounts, and that he withdrew the monies in the purported exercise of that authority, his conduct is attributable to his role as an agent, and any loss resulting from his misappropriation is a loss incidental to the carrying on of the business. It was also argued that the power‑of‑attorney dated 13 May 1944, which appointed Chandratan as an agent, related not only to the appellant’s business but also to his private affairs, and that there was no proof that the embezzlement concerned the appellant’s business assets rather than his personal funds. No such question was raised before the Income‑Tax authorities, and their finding assumes the misappropriated monies were business funds.

In its assessment, the Court concluded that the monies taken by the agent were indeed funds belonging to the business and not private assets of the appellant. The Court further expressed that it was not persuaded by the argument that the power of attorney, when properly interpreted, gave the agent authority to manage the appellant’s personal affairs in addition to the business matters. Consequently, the Court held that the loss suffered by the appellant as a result of the misappropriation by the agent was a loss that arose incidentally from the conduct of the business. Accordingly, the Court determined that such loss could be allowed as a deduction when computing the appellant’s taxable profits under section ten one of the Income‑Tax Act. Based on this reasoning, the Court decided to overturn the decision of the lower tribunal and to answer the reference in the appellant’s favour. The Court further ordered that the appellant should be awarded costs incurred in pursuing the appeal as well as costs associated with the reference made to the lower court. In sum, the appeal was allowed and the appellate court set aside the earlier order, granting the relief claimed by the appellant.