The Commissioner Of Income-Tax, Delhi vs The Delhi Flour Mills Co., Ltd., Delhi

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

Court: Supreme Court of India

Case Number: Civil Appeal No. 211 of 1955

Decision Date: 3 October 1958

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

The case was styled The Commissioner of Income‑Tax, Delhi versus The Delhi Flour Mills Co., Ltd., Delhi, and the judgment was delivered on 3 October 1958 by a bench of the Supreme Court of India. The bench comprised Justice A.K. Sarkar, Justice P.B. Gajendragadkar together with Justice A.Iyyar and Justice T.L. Venkatarama. The petitioner was the Commissioner of Income‑Tax, Delhi and the respondent was The Delhi Flour Mills Co., Ltd., Delhi. The official citation of the decision is reported in 1959 AIR 185 and in the 1959 Supplement to the Supreme Court Reports at page 28. The case is also referenced in the citation index as RF 1961 SC 692 (12). The matter concerned the provisions of the Excess Profits Tax Act and centered on the interpretation of an agreement between the assessee company and its managing agents regarding the computation of “net profits” for the purpose of assessing a commission payable to the agents.

The agreement, entered into in 1936, stipulated that the managing agents were to receive a fixed remuneration of Rs 750 per month, or such principal sum as the directors might from time to time deem reasonable, in addition to a commission equal to ten per cent of the annual net profits of the company. The agreement defined “net profits” as the amount arrived at after allowing for working expenses, interest on loans and due depreciation, expressly stating that no amount should be set aside for reserves or other special funds. The essential question before the Court was whether, in calculating the “net profits” upon which the ten per cent commission was to be based, the excess profits tax payable by the company should be deducted. The Commissioner of Income‑Tax argued that the tax should be allowed as a deduction, whereas the company contended that the commission should be calculated on profits before any deduction of the excess profits tax.

The Court held that the term “net profits” in the managing‑agency agreement meant the profits that were to be divided between the company and the managing agents. In arriving at that divisible profit, the Court ruled that deduction must be made not only of the items expressly mentioned in the agreement—working expenses, interest on loans and due depreciation—but also of the excess profits tax payable by the company. Accordingly, the tax was to be subtracted before the ten per cent commission was calculated. In reaching this conclusion the Court considered the earlier decisions of James Finlay & Co., Ltd. v. Finlay Mills Ltd. (1942 47 Bombay Law Reporter 774) and Walchand & Co., Ltd. v. Hindusthan Construction Co., Ltd. (1943 45 Bombay Law Reporter 951). It distinguished the cases of Ashton Gas Company v. Attorney‑General ([1906] A.C. 10) and Re G.B. Ollivant & Co. Ltd.’s Agreement ([1942] 2 All E.R. 528), clarifying that those authorities were not applicable to the present factual matrix.

The matter arose on civil appeal No. 211 of 1955, which was an appeal from the judgment and order dated 30 December 1952 of the Punjab High Court in Civil Reference Case No. 18 of 1952. Counsel for the appellant were H.J. Umrigar and R.H. Dhebar, while counsel for the respondents was Hardayal Hardy. The appeal was heard on 3 October 1958, and the judgment was delivered by Justice Sarkar. In his opinion, Justice Sarkar explained that the managing‑agency agreement, by expressly excluding any provision for reserves or special funds, intended that the profit figure on which the commission was to be calculated should be the amount remaining after all permissible deductions, which logically included the excess profits tax imposed under the statute. This interpretation gave effect to the commercial intention of the parties to share the net earnings of the business after meeting all statutory obligations, including the excess profits tax.

The Court observed that the central issue was whether the commission payable to the managing agents under the 1936 agreement was to be calculated as ten per cent of the assessee’s profits before deduction of the excess profits tax or after such deduction. The dispute arose during the assessment of excess profits tax payable by the assessee. The Excess Profits Tax Officer had held that the commission should be measured on the profits that remained after the excess profits tax had been deducted. This view was affirmed by the Appellate Assistant Commissioner when the assessee appealed that decision. Subsequently, on a further appeal to the Appellate Tribunal, the Tribunal reversed the earlier position and held that the commission must be computed on the profits without any deduction of the tax. The revenue authorities then obtained an order from the Tribunal directing that the question be referred to the High Court for determination. The question presented to the High Court was whether, on a true construction of the Managing Agency Agreement between the assessee company and its managing agents, the excess profits tax payable should be deducted from the company’s profits for the purpose of arriving at the annual net profits on which a percentage was to be paid to the agents as commission. The High Court answered this question negatively. The present appeal was filed by the revenue authorities against the High Court’s judgment. The Court noted that the matter involved a construction of the managing agency agreement and that there was no dispute that any remuneration payable to the managing agents under the agreement constituted a proper business expense of the assessee and therefore had to be deducted in ascertaining the assessee’s profits, which formed the basis for assessing excess profits tax. The only disputed point concerned the component of the remuneration that was the variable commission, not the fixed minimum remuneration of Rs 750 per month, which the Court agreed was uncontroversial and was to be calculated on the profits. The dispute centred on whether the agreement meant that the profits on which the ten per cent commission was to be calculated were the profits before the excess profits tax deduction or after it. The Court examined the agreement’s wording, which provided that “the net profits will be arrived at after allowing the working expenses, interest on loans and due depreciation but without setting aside anything to reserves or special funds.” The Court observed that the items expressly excluded from deduction were clear, and the remaining question was whether excess profits tax could also be deducted. It further noted that the agreement expressly made working expenses, interest on loans and depreciation deductible in determining the net profits.

If the only deductions permissible were those expressly listed, then excess profits tax could not be deducted because it fit none of the specified categories. Nevertheless, the Court was of the view that the agreement was not meant to enumerate every possible deduction. It was undisputed that expenses such as overhead costs, litigation costs and other proper business expenditures were allowable in computing net profits. Such expenses would not fall within the term “working expenses,” a phrase that is ordinarily understood to mean expenses chargeable to the trading account that are incurred directly in generating the income shown there. Had the expression “working expenses” been intended to encompass all revenue expenditures, there would have been no necessity to refer separately to interest on loans and depreciation, since those items would have been subsumed under the broader category of revenue expenses. Consequently, the Court inclined itself to the conclusion that, apart from the items expressly mentioned, there existed additional deductions that must be taken before arriving at net profits. Determining what these further items might be required an inquiry into what the parties intended when they employed the words “net profits.” The parties’ intention could be best ascertained by examining the purpose underlying the agreement.

The parties were in a master‑servant relationship and were fixing the servant’s remuneration. They agreed that, irrespective of whether any profit was earned, the servant would receive a fixed sum each month. In addition, they stipulated that the servant would receive a certain share of the net profits. Because net profits would vary from year to year, the parties understood that the servant’s variable remuneration would rise or fall in line with the fluctuations in profit. The rationale for this arrangement was plainly that the servant’s pay should correspond to the benefit his work generated for the master; a larger benefit justified a larger remuneration and a smaller benefit a smaller pay. It is hard to conceive that the parties intended to compensate the servant for profit that resulted solely from the servant’s effort without any advantage to the master. This interpretation is reinforced by the fact that, besides the variable share of profits, the servant also enjoyed a guaranteed minimum remuneration. Thus, the agreement was fundamentally a profit‑sharing arrangement, whereby a portion of the profit was destined for the servant and the remainder for the master. If this is the correct construction of the agreement, then the net profits contemplated by the parties are those profits that can be divided between master and servant.

The Court observed that, if the agreement was understood in the manner it had been described, the term “net profits” necessarily referred to profits that could be apportioned between the master and the servant in the proportions set out in the contract. In other words, the parties intended that the profits to be shared were the portion of the company’s earnings that were divisible between the two parties. To determine those divisible profits, the Court explained, the excess‑profits tax imposed by the State had to be deducted, because the amount taken by the State was not available to either the master or the servant and therefore could not be part of the shared pool. The argument that the contract could not be read in this way because it would require the insertion of the word “divisible,” which was absent from the document, was rejected. The Court held that no new word was being added; rather, the existing language was being clarified. The phrase “net profits” was interpreted as meaning the divisible profits, and the Court emphasized that this was simply a restatement of the parties’ intention in different terms. Moreover, the Court accepted that the excess‑profits tax formed a component of the overall profits, but it was not part of the “net profits” contemplated by the parties, since it had to be subtracted to arrive at the divisible profit figure that the parties had in mind. Consequently, the Court concluded that, on proper construction of the agreement, “net profits” meant the divisible profits after deduction of the excess‑profits tax payable by the assessee. Having reached this conclusion, the Court then turned to the authorities cited by counsel, which included In re Condran, Condran v. Stark, Patent Castings Syndicate Ltd. v. Etherington, Vulcan Motor and Engineering Co. v. Hampson, Re G. B. Ollivant & Co. Ltd.’s Agreement, James Finlay & Co. Ltd. v. Finlay Mills Ltd., and Walchand & Co. Ltd. v. Hindusthan Construction Co. Ltd. The Court noted that each of these cases turned on the construction of the specific agreements involved and therefore offered little assistance for construing the present agreement, which had to be interpreted according to its own words and the circumstances of its making. The Court also referenced the House of Lords decision in Re G. B. Ollivant & Co. Ltd.’s Agreement, indicating that the ensuing discussion would proceed without reliance on those authorities.

In the appeal reported at (1942) 2 All E.R. 528, which the majority of the House of Lords affirmed, Lord Greene, MR, cautioned that authorities were of no assistance in questions of this kind. Referring to the earlier English cases, he observed on page 532 that the courts had interpreted the phrase “net profits” in Etherington’s case, the phrase “profits earned by the company” in Vulcan’s case, and the phrase “net profits” in Condran’s case as meaning the divisible profits of the company in the first two cases and the divisible profits of the partnership in the third. He added that those courts had also decided a point he regarded as beyond question, namely that excess‑profits duty must be deducted when ascertaining divisible profits. Lord Greene then stated that, apart from this observation, those authorities offered no assistance. He explained that the first part of those decisions, which dealt with the meaning of “profits” or “net profits” in the respective agreements, could not help because the language used in those agreements was entirely different from the language in the present case. He further noted that the second part of the decisions, which held that excess‑profits duty must be deducted in computing divisible profits, was a principle for which he thought no authority was required. He listed the relevant authorities as (1) [1917] 1 Ch. 639; (3) [1921] 3 K.B. 597; (5) (1942) 47 Bom. L.R. 774; (2) [1919] 2 Ch. 254; (4) [1942] 2 All E.R. 528; and (6) (1943) 45 Bom. L.R. 951, and reiterated that these did not aid the present construction.

The Court further observed that, like the earlier English cases, the decision in Re O. B. Ollivant & Co. Ltd.’s Agreement (1) was based on the specific language of that agreement and therefore did not provide much assistance here. The Indian authorities previously mentioned were also decided by examining the particular agreements to which they related. In the James Finlay & Co. Ltd. case (2), the agreement required that “net profits” be calculated before setting aside any sum “for payment of income‑tax, super‑tax or any other tax on income”. The Court held that the phrase “any other tax on income” included excess‑profits tax, which could not be deducted. Beaumont, C.J., observed that, since income‑tax was held to be payable out of profits and not a liability to be deducted in ascertaining profits, it was difficult to explain why the same principle should not apply to excess‑profits duty. He also noted that a distinction between the two taxes had been drawn in the English cases referred to earlier, but he did not consider it necessary to examine whether every ground for that distinction was sound, because in the case before him excess‑profits tax had been expressly dealt with. The Court then turned to the Walchand & Co. Ltd. case, remarking that the agreement in that case was very much…

In the present case the agreement under consideration required that the managing agents receive ten per cent of the company’s annual net profits. The agreement further stipulated that, in computing those net profits, certain deductions were to be allowed, including ordinary working expenses, while other deductions were expressly excluded. Notably, the agreement made no reference to excess profits tax, either as a deductible item or otherwise. The learned judge who sit on the bench that decided the earlier case, Beaumont C. J., characterized the instrument as a profit‑sharing agreement and held that the calculation of net profits must be performed after deducting excess profits tax. The Court does not cite the three earlier decisions—(1) [1942] 2 All E.R. 528, (2) (1942) 47 Bom. L.R. 774, and (3) (1943) 45 Bom. L.R. 951—as authorities that support its present view. Rather, it observes that the High Court erred in assuming that the Walchand & Co. Ltd. case (1) preceded the James Finlay & Co. Ltd. case (2) and that Beaumont C. J. had apparently revised his earlier position. This assumption is corrected by noting that the James Finlay case was decided long before the Walchand case, and there is no inconsistency between the two decisions. In Walchand & Co. Ltd. (1), Beaumont C. J. explained why he distinguished income‑tax from excess profits tax, concluding that the distinction drawn in the English authorities was not substantial. The Court declines to pass judgment on whether Beaumont C. J.’s reasoning was correct.

Appearing on behalf of the assessee, counsel reiterated the long‑standing contention that, since income‑tax is not deductible in the computation of a company’s net profits, excess profits tax should likewise be excluded, both being taxes imposed on profits. To support this argument, counsel referred to the decision in Ashton Gas Company v. Attorney‑General (3), where the House of Lords interpreted a statutory provision limiting the amount of profit that could be distributed to shareholders. Lord Halsbury L. C., at page 12, observed that income‑tax is a charge on profit and that the profit must be ascertained before any tax can be deducted, stating that “you have no right to deduct the income‑tax before you ascertain what the profit is.” The Court notes that the reasoning in the Ashton Gas case does not preclude the conclusion that excess profits tax must be excluded when determining the net profits for the purpose of the profit‑sharing agreement. Consequently, the Court finds no authority in Ashton Gas that prevents it from holding that excess profits tax should not be deducted in ascertaining the divisible profits under the present agreement.

In the sources cited, namely 45 Bom. L.R. 951, 47 Bom. L.R. 774 (2) (1942) and the decision reported at [1906] A.C. 10, 12 (3), the court held that, when the net profits required by the present agreement are being determined, the amount of excess‑profits tax must be excluded. The earlier case did not involve any profit‑sharing arrangement and it did not address the question of which expenses may be deducted in order to calculate the divisible profits under a profit‑sharing contract. The present matter, however, does require a decision on that precise issue. Consequently, the Court considered that the Ashton Gas Co. ruling (1) does not provide assistance for answering the question that arises in this case. Moreover, the Court decided that it was unnecessary to resolve, as previously indicated, whether any distinction exists between income‑tax and excess‑profits tax. The Court was not concerned with the proposition that income‑tax might be deducted before the net profits required by the agreement are ascertained; it proceeded on the assumption that such a deduction could not be made. Established authority and common‑sense reasoning, already referenced, confirm that, in arriving at the divisible profits, excess‑profits tax must be deducted. Having interpreted the agreement to mean that “net profits” are synonymous with “divisible profits,” the Court concluded that the divisible profit figure can be reached only after deducting excess‑profits tax. The Court then turned to the minority opinions expressed in the House of Lords decision in Re G. B. Ollivant & Co. Ltd.’s Agreement (2), on which the High Court had largely relied. Viscount Simon, L.C., dissented because he held that the term “profits” in the agreement before the House did not refer to the divisible profits. The Court is not concerned with the detailed reasoning that hinged on the wording of that agreement. After deciding that “profits” did not mean divisible profits, Viscount Simon examined whether excess‑profits tax could be deducted in computing net profits and, following the reasoning of the Ashton Gas Co. case (1), asserted that neither income‑tax nor excess‑profits tax could be deducted because both are components of profit. He further argued that the Court of Appeal erred in allowing excess‑profits tax to be charged to the profit‑and‑loss account, and therefore he held that the net profit normally shown in that account must be determined without deducting excess‑profits tax. The Court does not adopt this portion of the Lord Chancellor’s opinion, which was premised on the view that the profits were not the divisible profits, a point that is irrelevant to the present analysis. The other dissenting judge, Lord Macmillan, essentially echoed Viscount Simon’s view, and the Court finds it unnecessary to address his separate opinion. Nonetheless, the dissenting judges do not influence the determination that, for the agreement in question, excess‑profits tax must be deducted to arrive at the divisible profits.

In this case the Court observed that the House of Lords had previously held that where the profits under consideration are the divisible profits, excess profits tax could not be deducted before those profits were ascertained. Applying that principle to the agreement before the Court, it was concluded that no assistance could be drawn from the dissenting opinions. The Court also noted that another decision, N. M. Rayaloo Iyer and Sons v. The Commissioner of Income‑tax, Madras, had been brought to its attention. That decision likewise sought to follow the reasoning set out in the minority judgments in Re G. B. Ollivant and Co. Ltd.’s Agreement and relied upon the authority of the judgment then under appeal; consequently the Court found it unnecessary to refer to that case further. The appellant’s counsel argued that even if the net profits mentioned in the agreement were not the divisible profits and even if income‑tax could not be deducted to determine those profits, excess profits tax was a proper deduction. The argument advanced that excess profits tax differed in nature from income‑tax because, first, under section 12 of the Excess Profits Tax Act, 1940, excess profits tax was deductible as an expense for income‑tax assessment; second, where the employer is a company, as in the present case, the income‑tax paid is refundable to shareholders whereas excess profits tax is not; third, excess profits tax constitutes a debt of the business and therefore an outgoing; and fourth, it is akin to a licence fee whose payment alone enables the business to continue. The Court considered these points unnecessary to examine because, in its view, the net profits in the present case were the divisible profits, and irrespective of whether excess profits tax could be distinguished from income‑tax on any of the stated grounds, it was properly deductible. The Court also referred to an argument raised by the assessee based on section 87‑C of the Indian Companies Act, 1913, as amended in 1936, which provides that the remuneration of the managing agents of a company shall be a fixed percentage of its net annual profits and that, in calculating those net profits, no deduction for any tax or duty on income is to be made. The assessee contended that this statutory provision reflected a universal commercial practice and therefore excess profits tax could not be deducted in construing the present agreement. The Court found this contention entirely unfounded, noting that the provision had been applied only to managing‑agency agreements entered into after the amendment became effective, whereas the agreement in question was executed before that date. Finally, the Court pointed out that nothing turned on the fact that, at the date the agreement under consideration was made, the Excess Profits Tax Act had

The Court observed that the Excess Profits Tax Act had not yet been enacted at the time the agreement was executed, and it is likely that the parties could not have contemplated its provisions. The Court held that when the term “net profits” is understood to mean “divisible profits”, every item that must be excluded in order to compute the divisible profits must be deducted, irrespective of whether the parties had foreseen that item at the time they entered into the contract. The Court illustrated this principle by suggesting a hypothetical scenario: after the parties had signed the agreement, the Government might impose a licence fee that is essential for the continuation of the business, and such a fee would not have been within the parties’ contemplation when the contract was formed. Nevertheless, the Court stated that the licence fee must be deducted in order to arrive at the correct amount of divisible profits. Accordingly, the Court concluded that the question presented to it should be answered affirmatively. Thus, the legal principle that deductions must be made to determine divisible profits operates independently of the parties’ subjective expectations at the time of contracting. Consequently, the Court allowed the appeal, ordering that costs be awarded both in this Court and in the High Court. The appeal was therefore permitted.