Messrs. Godrej and Company, Bombay vs Commissioner Of Income-Tax, Bombay

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

Court: Supreme Court of India

Case Number: Civil Appeal No. 183 of 1956

Decision Date: 4 August 1959

Coram: DAS C.J., Natwarlal H. Bhagwati, M. Hidayatullah

In this case the Court observed that an agreement dated 8 December 1933 appointed the appellant firm, Messrs Godrej & Company, Bombay, as the managing agent of a limited company for a period of thirty years commencing on 9 November 1933, and that clause 2 of that agreement stipulated the manner of remuneration for the managing agent. Some shareholders and directors later regarded the scale of remuneration as unusually excessive and, after negotiations, the appellant and the company executed a supplementary agreement on 24 March 1948. Under that supplementary agreement the company agreed to pay a sum of Rs 7,50,000 as compensation for releasing the company from the onerous remuneration term contained in the original agreement, and the managing agent, in return, consented to receive from September 1 1946 onward, for the remainder of the agency term, ten per cent of the net annual profits of the company as defined in section 87C, sub-section (3) of the Indian Companies Act, 1938. The compensation of Rs 7,50,000 was actually paid by the company to the appellant in 1947. For the assessment year 1948-49 the Income-Tax Officer treated that sum as a revenue receipt in the hands of the appellant and levied tax accordingly. The appellant contended that the payment was made by the company in full discharge of a contingent liability to pay the higher remuneration and therefore constituted a capital expenditure incurred by the company and a capital receipt received by the appellant, which should not be taxable. The tax authorities argued that, although described as compensation, the true object of the payment was to reduce the remuneration; that it was a lump-sum consideration for varying the terms of employment and thus a revenue receipt; and that there was no interruption of service, so the payment was made in the normal course of the managing agency’s business and therefore represented ordinary revenue. The Court held that the sum of Rs 7,50,000 was paid by the company to secure immunity from the liability to pay the higher remuneration for the balance of the managing agency term and consequently was a capital expenditure; for the appellant it was received as compensation for the deterioration of the agency’s right to higher remuneration and therefore constituted a capital receipt. Citation: 1959 AIR 1352; 1960 SCR (1) 527. Act: Income-tax—Capital or revenue receipt—Remuneration of the managing agent—Variation of terms of agreement—Compensation for reduction of the scale of remuneration for the subsequent period of agency—Capital expenditure.

The Court held that the sum paid was made to secure the continuation of the managing agency’s duties for the remainder of the term, and consequently it qualified as a capital expenditure. In relation to the appellant, the Court explained that the amount was received as compensation for the loss or injury suffered by the managing agency due to the relinquishment of its right to obtain a higher remuneration, and therefore it constituted a capital receipt. The Court referred to the authorities Commissioner of Income-tax v. Vazir Sultan and Sons [1959] 36 I.T.R. 175; Hunter v. Dewhuyst (1932) 16 Tax Cas. 605; and Glenboig Union Fiyeclay Co. Ltd. v. The Commissioners of Inland Revenue (1922) 12 Tax Cas. 427 as relied upon, and also considered the cases Assam Bengal Cement Co. Ltd. v. Commissioner of Income-tax [1955] I S.C.R. 972; The Commissioner of Income-tax and Excess Profits Tax v. The South India Pictures Ltd. [1956] S.C.R. 223; The Commissioner of Income-tax v. Jairam Valji [1959] S.C.R. (Suppl.) 110; and The Commissioner of Income-tax v. Shaw Wallace and Co. (1932) L.R. 59 I.A. 206.

The judgment was delivered in the Civil Appellate Jurisdiction in Civil Appeal No. 183 of 1956, arising from the judgment and order dated 11 September 1953 of the Bombay High Court in Income-tax Reference No. 23 of 1953. Counsel for the appellants included A. V. Viswanatha Sastri, S. N. Andley and J. B. Dadachanji, while counsel for the respondent comprised M. C. Setalvad, Attorney-General for India, K. N. Rajagopal Sastri and D. Gupta. The judgment was pronounced on 4 August 1959 by Chief Justice Das. The appeal challenged the High Court’s decision, which had answered a reference made by the Income-tax Appellate Tribunal under section 66(1) of the Income-tax Act in the affirmative and ordered the appellant to pay the respondent’s costs. The appellant, a registered firm referred to as “the assessee firm,” had been appointed as managing agent of Godrej Soaps Limited (the “managed company”) since October 1928 under an original agreement dated 28 October 1928, later replaced by a new agreement dated 8 December 1933, termed the “Principal Agreement.” Under that Principal Agreement, the assessee firm was designated Managing Agent for a term of thirty years commencing 9 November 1933. Clause 2 of the agreement stipulated that the company would, during the life of the agreement, pay the firm a remuneration comprising (a) an annual commission of twenty per cent on the net profits of the company after deducting interest on loans, advances and debentures, working expenses, repairs, outgoings and depreciation, without any deduction for income-tax, super-tax or capital-account expenditure, and (b) additional sums as specified in sub-clauses (b) and (c) of the clause.

Clause (b) stipulated that if, after allowing for interest on any loans, advances and debentures, as well as for working expenses, depreciation, repairs and outgoings, the net profits of the Company, reduced by the commission set out in sub-clause (a), exceeded the amount of one lakh rupees in any given year, then the portion of the excess that lay above one lakh rupees could be paid to the Managing Agent, but only up to a maximum of twenty-four thousand rupees. Clause (c) further provided that where, after making the same deductions for interest, working expenses, depreciation, repairs, outgoings and the commission of sub-clause (a), the net profits of the Company in any year exceeded one lakh rupees and twenty-four thousand rupees, the surplus above that threshold would be divided equally: one half of such excess would be paid to the Managing Agent and the other half to the shareholders. Some of the shareholders and directors of the managed company considered the scale of remuneration granted to the assessee firm under clause (2) of the Principal Agreement to be extraordinarily excessive and atypical, and therefore thought that the terms should be altered. Consequently, negotiations were opened with the aim of reducing the remuneration; after a series of discussions, the assessee firm and the managed company reached a consensus on certain modifications. Those agreed changes were formally recorded in a special resolution that was passed at an extraordinary general meeting of the managed company held on 22 October 1946. The resolution stated, in its first part, that the managing agents, in exchange for the Company’s payment of seven lakh fifty thousand rupees as compensation for releasing the Company from the onerous remuneration clause contained in the existing managing agency agreement, would accept as their remuneration for the balance of the agency term a rate of ten percent of the net annual profits of the Company, where such net profits were defined in section 87C, subsection (3) of the Indian Companies Act, in place of the higher remuneration to which they were previously entitled under the existing agreement; the resolution further confirmed and approved this arrangement. The second part of the resolution directed that the Company and the managing agents shall execute the necessary documentation to modify the terms of the original managing agency agreement in accordance with the agreed arrangement, that the document should be prepared by the Company’s solicitors, approved by the managing agents, and that the directors were authorized to give effect to it with or without further modifications as they deemed appropriate. The modifications agreed upon were subsequently incorporated into a Supplementary Agreement executed between the assessee firm and the managed company on 24 March 1948. That Supplementary Agreement began by reciting the appointment of the assessee firm as Managing Agent under the terms of the Principal Agreement and by recounting the agreement reached between the parties and the resolution previously mentioned, and then declared, in its first clause, that the remuneration of the Managing Agents, effective from the first day of September 1946, would be ten percent of the net annual profits of the Company as defined in the referenced statutory provision, thereby replacing the higher remuneration previously provided for in clause (2) of the Principal Agreement.

According to the supplementary agreement, the remuneration payable to the Managing Agents from the first day of September 1946 was fixed at ten per cent of the net annual profits of the Company, as defined in section 87C, subsection (3) of the Indian Companies Act, 1913, and this amount was to replace the higher remuneration that had been stipulated in clause (2) of the Principal Agreement. The agreement further provided that, subject to the variations contained therein and any other modifications necessary to make the Principal Agreement consistent with these new terms, the Principal Agreement would continue to be in full force and effect and would be interpreted and enforced as if the new terms had been inserted therein by substitution.

The managed company paid a sum of Rs 7,50,000 to the assessee firm during the calendar year 1947, which corresponded to the accounting year for assessment year 1948-49. During the assessment proceedings for that year, the departmental representative argued three points: first, that although the payment was described as compensation, its true purpose was to reduce the remuneration payable; second, that because the payment was a lump-sum consideration for a variation of the terms of employment, it should be characterised as a revenue receipt rather than a capital receipt; and third, that there was no interruption in service and the payment was made in the ordinary course of the continuing managing-agency relationship, thereby constituting a revenue receipt of the assessee’s managing-agency business. In contrast, the assessee firm contended that the Rs 7,50,000 represented a payment made by the managed company solely to discharge a contingent liability for the higher remuneration and to relieve itself of an onerous contingent obligation, and therefore it was a capital expenditure for the managed company and a capital receipt for the assessee firm, which should not be subject to tax.

The Income-Tax Officer treated the amount as a revenue receipt in the hands of the assessee firm and imposed tax accordingly. On appeal, the Appellate Assistant Commissioner affirmed this treatment, and the decision was subsequently upheld by the Tribunal in an order dated 23 July 1952. The assessee firm then invoked section 66(1) of the Act, prompting the Tribunal to refer a question of law to the High Court: whether, given the facts and circumstances, the sum of Rs 7,50,000 should be classified as a revenue receipt liable to tax. The High Court heard the reference and, in its judgment delivered on 11 September 1953, answered the question affirmatively, directing the assessee firm to bear the costs of the reference, while also granting the assessee firm certain additional relief.

The appeal reached this Court because the High Court had issued a certificate of fitness for appeal, and the parties therefore brought the matter before the Supreme Court. The Court referred to its earlier decision in Commissioner of Income-tax and Excess Profits Tax, Madras v. The South India Pictures Ltd. (1), noting that the Court had observed that “it is not always easy to decide whether a particular payment received by a person is his income or whether it is to be regarded as his capital receipt.” The judgment further cited the well-known observation of eminent judges that the word “income” has the broadest possible meaning and that it is difficult, perhaps even impossible, to define it by any precise general formula. While the distinction between an income and a capital receipt is generally recognised, the Court acknowledged that certain transactions lie on the borderline and that the correct classification must be determined on the basis of the particular facts of each case. The Court stressed that no infallible criterion or test can be laid down; rather, decided cases are useful only to the extent that they indicate the considerations which may be relevant in approaching the problem. The character of a payment, the Court explained, may vary according to the surrounding circumstances. For example, an amount received as consideration for the sale of a plot of land is ordinarily a capital receipt, but where the recipient’s business is precisely to buy and sell lands, the same amount may be treated as income (1) [1956] S.C.R. 223, 228. Consequently, the problem must be approached by keeping in view the specific facts and circumstances in which the receipt arose, and the Court warned that the classification cannot be made by a mechanical application of a universal rule.

Turning to the facts of the present case, the Court observed that by paying the sum of Rs 7,50,000 the managed company secured a release from its obligation to pay a higher remuneration to the assessee firm for the balance of the managing-agency period covered by the Principal Agreement. Prima facie, this release from liability for a period of more than seventeen years represented an advantage obtained by the managed company for the benefit of its business. The Court noted that the immunity thus obtained could be regarded as the acquisition of an asset of enduring value, acquired through a capital outlay that would, according to the test laid down by Viscount Cave, L.C., in Atherton v. British Insulated and Helsby Cables Limited (1) and reiterated in Assam Bengal Cement Co. Ltd. v. Commissioner of Income-tax (2), constitute a capital expenditure. If the payment of Rs 7,50,000 was indeed a capital expenditure incurred by the managed company, learned counsel for the assessee firm submitted that the receipt should be classified as a capital receipt in the hands of the assessee firm, because the intrinsic characteristics of capital sums and revenue items are essentially the same for receipts as for expenditure (see Simon’s Income-tax, II Edn., Vol. 1, para. 44, p. 31). However, the Court also pointed out, as the learned author highlighted in that paragraph, that this proposition cannot be applied inflexibly, for there is always the possibility that a particular sum may change its character depending on the circumstances of the payer or the recipient.

The Court observed that the character of a payment could change depending on the circumstances of the payer or the recipient. Accordingly, the learned Attorney-General appearing for the respondent argued that the appeal did not require a determination of whether, from the managed company’s standpoint, the sum represented a capital expenditure. Instead, the issue for determination was whether the same sum constituted a capital receipt in the hands of the assessee firm. The argument was supported by reference to earlier authorities, namely (1) (1925) 10 Tax Cas. 155 and (2) [1955] 1 S.C.R. 972. The resolution adopted by the managed company and the recitals contained in the Supplementary Agreement described the sum as a payment “as compensation for releasing the company from the onerous term as to remuneration contained” in the Principal Agreement. Both the High Court and the learned Attorney-General acknowledged that the wording employed in the document was not conclusive and that the question had to be decided by considering all the surrounding circumstances. Nevertheless, they agreed that the language could not be disregarded entirely and had to be weighed together with other relevant factors. The sum of Rs 7,50,000 was, in the Court’s view, unquestionably not paid as compensation for the termination or cancellation of an ordinary business contract that formed part of the assessee’s stock-in-trade, and therefore it could not be treated as ordinary income. This contrasted with amounts received by the assessee in the cases of The Commissioner of Income-tax and Excess Profits Tax v. The South India Pictures Ltd. (1) and The Commissioner of Income-tax, Nagpur v. Rai Bahadur Jairam Valji (2), which had been held to be taxable income. The Court also held that the amount could not be characterized as compensation for the cancellation or cessation of the managing agency of the assessee firm, because the managing agency had continued to operate. Consequently, the decision of the Judicial Committee of the Privy Council in The Commissioner of Income-tax v. Shaw Wallace and Co. (1) could not be applied. Counsel for the respondent further submitted that to treat the payment as a capital receipt it was unnecessary for the entire managing agency to be acquired. If the payment represented the price for sterilising even a part of a capital asset that formed the framework or the whole structure of the assessee’s profit-making apparatus, the amount should be regarded as a capital receipt. In support of this proposition, counsel cited Lord Wrenbury’s observation in Glenboig Union Fireclay Co. Ltd. v. The Commissioners of Inland Revenue (4) that “what is true of the whole must be equally true of part,” a principle that had been adopted by this Court in The Commissioner of Income-tax, Hyderabad-Deccan v. Messrs. Vazir Sultan and Sons (1) [(1956) S.C.R. 223, 228]. The learned Attorney-General, however, maintained that the present case was not governed by the decisions in Shaw Wallace’s case (2) or Messrs. Vazir Sultan and Sons’ case (1) because there was no acquisition of the entire managing-agency business nor any sterilisation of any part of the capital asset, and the business structure remained intact.

The Court explained that the authorities cited in the Shaw Wallace case and in the earlier Vazir Sultan and Sons case could not be applied to the present dispute. In the instant matter there was no purchase of the whole managing-agency business, nor was any portion of the capital asset sterilised; consequently the business structure, that is, the profit-making apparatus consisting of the managing agency, remained unchanged. The Court observed that no part of the business structure had been destroyed or sterilised. It further noted that the sum under consideration had been paid because the assessee agreed to continue acting as the managing agent while accepting a reduced remuneration. Accordingly, the payment bore the same character as ordinary remuneration and therefore should be treated as a revenue receipt. The Court rejected this argument. It held that if the reasoning were accepted, the decision in the Vazir Sultan and Sons case would have been reached differently, since in that case the agency also continued to operate, albeit with its territorial jurisdiction reduced to its original extent and limited to the State of Hyderabad. To describe such an arrangement merely as a variation in the terms of remuneration would, in the Court’s view, be a superficial assessment that ignores the impact of the variation on what is described as the profit-making apparatus. The Court explained that a managing agency that receives remuneration calculated at twenty per cent of profits is not equivalent to one that receives ten per cent of profits. There is a clear and enduring deterioration in the character and quality of the managing agency when its remuneration is cut, and this deterioration affects the profit-making apparatus. Because the reduced remuneration was provided separately, the Court concluded that the payment of Rs 7,50,000 must be regarded as compensation for the injury to or deterioration of the managing agency, in the same way that the amounts awarded in the Glenboig case and in the Vazir Sultan case were treated. The Court further observed that this principle is closely aligned with the majority decision of the English House of Lords in Hunter v Dewhurst. While later English decisions such as Prendergast v Cameron and Wales Tilley distinguished Hunter v Dewhurst on the basis that they dealt with the wording of rule 1 of Schedule E to the English Act, those cases involved a simple continuation of personal service on reduced remuneration and did not concern the acquisition, wholly or in part, of any managing agency viewed as a profit-making apparatus. Consequently, the effect of the agreements giving rise to the payment on the profit-making apparatus was not a matter for consideration in those later cases. On the construction of the agreements in the present case, the Court therefore found that the payment could not be characterized merely as remuneration.

It was held that the sum paid was not merely remuneration advanced to bridge the gap between a higher rate of remuneration and a reduced rate, and therefore it could not be treated as a revenue receipt. The Court observed that the issue of whether a payment constitutes compensation for the acquisition, wholly or partly, of any managing agency, or for injury to or deterioration of such agency as a profit-making apparatus, was already covered by the decisions previously cited. Applying the principles laid down in those earlier rulings, the Court found that the amount of Rs 7,50,000 was not paid to compensate the difference between the higher and lower remuneration. Instead, the payment was made as compensation for releasing the company from the onerous remuneration terms that had been imposed. In other words, for the managed company, the payment represented an expense incurred to obtain immunity from the obligation to pay higher remuneration to the assessee firm for the remainder of the managing agency’s term, and thus it was a capital expenditure. Conversely, for the assessee firm, the receipt was compensation for the injury or deterioration to the managing agency caused by the surrender of its right to a higher remuneration, and consequently it was a capital receipt. The Court referred to the following authorities in support of this view: (1) Civil Appeal No. 346 of 1957, decided on March 20 1959; [1959] 36 I.T.R. 175; (2) (1932) 16 Tax Cas. 605; (3) (1940) 23 Tax Cas. 122; and (4) (1943) 25 Tax Cas. 136, all of which fall within the decisions of this Court previously mentioned. After considering the foregoing discussion, the Court concluded that the answer to the question referred to should be negative. Accordingly, the appeal was allowed, the High Court’s answer to the question was set aside, and the question was answered in the negative. The appellant was ordered to be awarded the costs incurred in the reference before the High Court as well as the costs incurred in this Court, and the appeal was granted.