Commissioner of Income-Tax, Bombay Circle II vs The National Syndicate, Bombay

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

Court: Supreme Court of India

Case Number: Civil Appeal No. 280 of 1959

Decision Date: 01/11/1960

Coram: M. Hidayatullah, S.K. Das, J.C. Shah

The matter before the Supreme Court was styled Commissioner of Income‑Tax, Bombay Circle II versus The National Syndicate, Bombay, and the judgment was delivered on 1 November 1960. The decision was authored by Justice M. Hidayatullah, with Justices S. K. Das and J. C. Shah forming the Bench. The citation for the case appears as 1961 AIR 398 and 1961 SCR (2) 229, and the decision is also referenced in later reports as D 1965 SC 33 (6) R 1971 SC2274 (7). The statutory provision that formed the core of the dispute was section 10(2)(vii) of the Indian Income‑Tax Act, 1922 (the “Act”), which deals with the computation of income from a business carried on for only part of an accounting year.

The factual matrix disclosed that The National Syndicate, a firm based in Bombay, purchased a tailoring business as a going concern on 11 January 1945 for a total consideration of Rs 89,321. The purchase price included amounts paid for sewing machines and a motor lorry that formed part of the business’s plant and equipment. Soon after acquisition the respondent encountered severe difficulties in maintaining the business and consequently ceased operations in August 1945. From 16 August 1945 until 14 February 1946 the respondent sold the sewing machines and the motor lorry at prices that resulted in a loss. The respondent closed its books on 28 February 1946, recorded the two losses, and wrote them off. For the assessment year 1946‑47 the respondent claimed a deduction under section 10(2)(vii) of the Act on the basis that the business had been carried on for a part of the year.

The Income‑Tax Appellate Tribunal examined the claim and held that the sales of the machines and the lorry were effected in the course of winding up the business after the enterprise had already been stopped. Accordingly, the Tribunal concluded that the deduction sought could not be allowed under section 10(2)(vii). Dissatisfied with that conclusion, the respondent approached the High Court seeking relief under section 66(2) of the Act. The High Court, in turn, framed two questions for consideration: (1) whether the Tribunal was correct in law in holding that the respondent had carried on its business only up to 28 August 1945; and (2) whether, given the facts and circumstances, the Tribunal was justified in disallowing the amounts of Rs 41,998 (the proceeds from the sale of the machines) and Rs 3,700 (the proceeds from the sale of the lorry) as deductions from the respondent’s total income. The High Court answered the first question affirmatively, confirming that the business had indeed been carried on only until the said date, and answered the second question negatively, thereby allowing the deduction sought.

The Commissioner of Income‑Tax challenged the High Court’s findings and obtained special leave to appeal before this Court. In its appeal the Commissioner argued that a deduction of this kind could be permitted only if the sale of the machines and the lorry occurred while the business was still being carried on, and not after the business had effectively ceased. The respondent, on the other hand, contended that section 10(2)(vii) was applicable even where the business continued for only a portion of the accounting year, despite the fact that the sale of the machinery and plant took place after the closure of the business during that same accounting year.

The Court held that, in order to levy tax on the profits or gains of a business for a given accounting year, the profit for that whole year must be calculated by taking into account any losses that arose during the same year, but only when certain conditions are satisfied. First, the business must have been carried on by the assessee during the year. Second, the building, machinery or plant involved must have been used for the purpose of that business. Third, the sale or other disposition of the assets must have occurred within the relevant year of account. Fourth, the loss resulting from the disposition must have been entered in the books of the assessee and subsequently written off. The Court emphasized that the Income‑Tax Act and the specific provision do not prescribe any additional requirement. In particular, the statute does not say that the business must have continued for the entire twelve‑month period, nor does it require that the plant or machinery be employed for the whole accounting period. There is no language in the provision that would exclude a loss incurred when the assessee operated the business for only part of the year and then sold the assets, nor any wording that would compel the assessee to pay tax on a nominal profit while also bearing the loss.

The Court noted that the absence of any express wording means that a loss incurred after a partial operation of the business remains a business loss and is allowable under the section. It distinguished the decisions in Liquidators of Pursa Limited v. Commissioner of Income‑Tax, Bihar, [1954] S.C.R. 767 and Commissioner of Income‑Tax v. Express Newspapers Ltd. (1960) 40 I.T.R. 38, and it referred to Indian Iron & Steel Co., Ltd. v. Commissioner of Income‑Tax, Bengal, (1943) 11 I.T.R. 328 and Commissioner of Income‑Tax v. Shaw Wallace & Co., Ltd., (1932) L.R. 59 I.A. 206 for supportive authority. The judgment was rendered in civil appellate jurisdiction concerning Civil Appeal No. 280 of 1959, filed by special leave from the Bombay High Court order dated 22 August 1956 in Income‑Tax Reference No. 17 of 1956. Counsel for the appellant were B. Ganapathy Iyer and D. Gupta, while counsel for the respondent were Sanat P. Mehta, S. N. Andley, J. B. Dadachanji, Rameshwar Nath and P. L. Vohra. The judgment was delivered on 1 November 1960 by Justice Hidayatullah. The appellant, the Commissioner of Income‑Tax, Bombay Circle II, sought to overturn the High Court’s decision under section 66(2) of the Income‑Tax Act. The respondent, the National Syndicate, Bombay, a partnership of three partners, had purchased a tailoring business as a going concern on 11 January 1945 from Chambal Singh for Rs. 89,321, which included Rs. 72,000 for sewing machines and Rs. 8,000 for a motor lorry. The assessment year covered the period from 11 January 1945 to 28 February 1946. The business produced garments for Government departments and had been profitable during the war years, but after the war ended the business was closed in August 1945, leading to the subsequent sale of the machines and lorry at a loss.

The respondent reported that after acquiring the tailoring business it found it difficult to continue operations and therefore closed the business in August 1945. Between 16 August 1945 and 14 February 1946 the respondent sold sewing machines at a loss of Rs. 41,998. The motor lorry was also sold on 14 February 1946 at a loss of Rs. 3,700. The respondent closed its account books on 28 February 1946, recorded the two losses and wrote them off. For the assessment year 1946‑47 the respondent claimed a deduction of Rs. 45,698 under section 10(2)(vii) of the Indian Income‑tax Act. The Income‑tax Officer disallowed the claimed deduction, holding that the loss was of a capital nature and that, because the business had not been carried on after August 1945, section 10(2)(vii) was not applicable. The Appellate Assistant Commissioner confirmed the assessment order, also holding that the loss represented capital loss since the machines and the motor lorry were sold after the business had been closed. On further appeal, the Appellate Tribunal in Bombay again confirmed the order, reasoning that the sales of the machines and the lorry were made in the course of winding up the assessee’s business after it had stopped, and consequently the deduction could not be claimed under section 10(2)(vii). The respondent requested the Tribunal to refer the questions of law arising from its order, but the Tribunal refused the request. The respondent then moved the High Court, obtained an order under section 66(2) of the Income‑tax Act and raised two questions for reference. The first question asked whether the Tribunal was legally justified in holding that the petitioner had carried on its business only until 28 August 1945. The second question asked whether, on the facts and circumstances of the case, the Income‑tax Appellate Tribunal was legally justified in refusing to allow the sum of Rs. 41,998 on the sale of machines and Rs. 3,700 on the sale of the lorry as a deduction from the applicant’s total income.

The High Court answered the first question affirmatively, holding that there was evidence on which the Tribunal could conclude that the business had in fact been continued only until 28 August 1945. Regarding the second question, the High Court opined that because the business had been carried on for at least part of the accounting year, section 10(2)(vii) was applicable and therefore the allowance should be made under that provision. Consequently, the High Court answered the second question in the negative. The High Court refused to grant a certificate of appeal to this Court, but the Commissioner of Income‑tax applied for and obtained special leave, and the present appeal was consequently filed. Before addressing the question of whether section 10(2)(vii) of the Indian Income‑tax Act is applicable to the facts of this case, the Court noted that during the course of the argument…

In this case, the counsel for the respondent, identified as Mr S. P. Mehta, attempted to reopen the first issue that had been decided by the Tribunal and the High Court. He asserted that no evidence existed upon which either the Tribunal or the High Court could have concluded that the respondent’s business had terminated in August 1945. The Court, however, declined to allow that contention to be raised. The Court explained that the objection could not be entertained at this stage of an appeal filed by the Department, and further observed that sufficient material had been available for the High Court to reach its finding. Since the Court concurred with the High Court on the question of whether section 10(2)(vii) of the Income‑Tax Act applied, the Court considered that examining whether the business had actually ceased on 28 August 1945 or had continued until the end of the account year would not serve any useful purpose. The focus of the appeal, the Court noted, was the interpretation of section 10(2)(vii) and its applicability to the facts presented.

For the purpose of this analysis, the Court assumed that the business did, in fact, close on 28 August 1945, although certain receipts and payments continued for the remainder of the year and the books of account were not finally closed until 28 February 1946. The Commissioner contended that an allowance under the provision could be claimed only when the sale of machinery, plant or other assets occurred while the business was still being carried on, and not after the business had ceased. The respondent, on the other hand, argued that section 10(2)(vii) should apply where the business continued for any part of the account year, even if the sale of the machinery, plant or other assets took place after the business had been closed during that same account year.

The Court reproduced the wording of section 10(2)(vii) as follows: “10(2). Such profits or gains shall be computed after making the following allowances, namely: – (vii) in respect of any such building, machinery or plant which has been sold or discarded or demolished or destroyed, the amount by which the written down value thereof exceeds the amount for which the building, machinery or plant, as the case may be, is actually sold or its scrap value: Provided that such amount is actually written off in the books of the assessee.” The Commissioner emphasized the word “such” in the clause and argued that it referred back to clause (iv), which contains the words “used for the purposes of the business.” Accordingly, the Commissioner submitted that if the business itself terminated before the sale took place, the sale occurred not during the continuance of the business but during the winding‑up of the business, and that a condition precedent for the application of section 10 is that the business must be carried on by the person claiming the benefit.

In the passage under consideration, reference was made to the first sub‑section of section 10, which stipulates that tax shall be payable by an assessee under the head “Profits and gains of business… in respect of the profits or gains of any business, etc., carried on by him.” The Department relied upon a decision of this Court reported in The Liquidators of Pursa Limited v. Commissioner of Income‑tax, Bihar (1). The respondent also relied upon the same ruling and argued that it supported the position it had taken. In addition, the respondent cited a recent decision of the Madras High Court in Commissioner of Income‑tax v. Express Newspapers Ltd. (2). Both of these cases had been decided under the second proviso to clause 10(2)(vii) as it existed before the amendment of 1949. The wording of the second proviso at that time was: “Provided further that where the amount for which any such building, machinery or plant is sold whether during the continuance of the business or after the cessation thereof, exceeds the written down value, so much of the excess as does not exceed the difference between the original cost and the written down value shall be deemed to be profits of the previous year in which the sale took place.” The words that are now underlined had been inserted by section 11 of the Taxation Laws (Extension to Merged States and Amendment) Act, 1949. In the two cited cases, the business had undeniably been closed before the relevant sales occurred, and the Court, applying the proviso as it stood prior to the 1949 amendment, held that the receipts from those sales were not taxable. The present amendment, however, renders those earlier decisions obsolete. Nonetheless, the Department placed reliance on certain observations made in those cases and contended that the same line of reasoning should be applied when there is a loss as when there is a profit. Consequently, the Court set out a brief summary of the earlier authorities. In The Liquidators of Pursa Limited v. Commissioner of Income‑tax, Bihar (1), the assessment year was 1945‑46, which corresponded to the accounting year from 1 October 1943 to 30 September 1944. Pursa Limited was a manufacturer of sugar and sold its business on 9 August 1943, including buildings, machinery and plant but excluding manufactured sugar worth approximately Rs 6,00,000. The sugar was sold up to June 1944; however, during the entire accounting period the machinery, plant and buildings were not used. Pursa Limited entered voluntary liquidation on 20 June 1945. In the sale of the buildings, machinery and plant there was an excess amount described in the second proviso, and the tax authorities sought to tax that excess. The Court rejected that claim on two grounds: (a) if the machinery and plant have not been used at all during the accounting year, no allowance can be claimed under clause (vii) in respect of them and the second proviso does not become operative; and (b) the intention of the company was to discontinue its business and the sale of the machinery and plant was a step in the process of winding up its business. The sale was not an operation in furtherance of the business carried on by the company but rather a realisation of assets as part of the gradual winding up that ultimately led to voluntary liquidation.

The Court observed that the sale of the machinery and plant represented a step in the winding‑up of the Company’s business. It held that the transaction was not undertaken to further the business that the Company had been carrying on, but rather it was a realisation of the Company’s assets as part of a gradual winding‑up that ultimately led to voluntary liquidation. Counsel were divided on what the ratio of the case should be. The Commissioner argued that the controlling ratio was that no sale—whether at a loss or at a profit—could fall within clause (vii) or the second proviso if the sale took place after the business had been closed and during the winding‑up process. By contrast, the respondent maintained that the true ratio was that the machinery and plant had not been used at all during the accounting year. Although the Court gave two reasons for its decision, it indicated that the primary consideration was the second ratio. This is evident from a passage near the end of the judgment, which reads: “Even if the sale of the stock of sugar be regarded as carrying on of business by the Company and not a realisation of its assets with a view to winding up, the machinery or plant not being used during the accounting period at all and in any event not having had any connection with the carrying on of that limited business during the accounting year, section 10(2)(vii) can have no application to the sale of any machinery or plant.” The respondent’s counsel relied on this passage and argued that where the buildings, machinery or plant had been used for any part of the accounting period, the ruling would not apply. He emphasised the double use of the words “at all” in the judgment and suggested that if the machinery or plant had been employed even for a portion of the year, the outcome might have been different.

The Court recognised that it could not predict how the decision would have turned out under altered facts, but it was clear that the present case was distinguishable on several grounds. The second proviso is expressed in language that differs from clause (vii); it introduces a legal fiction whereby profits are taxed in order to recover amounts that were previously allowed as depreciation, even though no actual depreciation had occurred. The Court indicated that it would elaborate on this point later. The Court also noted that the Express Newspapers Ltd. case was distinguishable from the present matter. In that case, the Free Press of India (Madras) Ltd. resolved on 31 August 1946 to transfer its right of printing and publishing its daily newspapers to Express Newspapers Ltd. The machinery and other assets were rented to the new company, which took possession on 1 September 1946. The accounting year for the Free Press ended on 31 December 1946. The Free Press entered voluntary liquidation on 31 October 1946, and on 1 November 1946 its building, machinery and plant were sold to the new company at a price that exceeded the written‑down value.

The Court noted that the machinery was sold for a price that exceeded its written‑down value by a total of Rs 6,08,666. This excess amount consisted of two components: Rs 2,14,090 represented the surplus of the original cost price over the written‑down value, and Rs 3,94,576 represented the surplus of the sale price over the original cost price. The focal issue, among several others, was whether the second proviso to section 10(2)(vii) was applicable to this transaction. In examining this question, the Court referred to the observation of the Madras High Court in the case reported at (1) (1960) 40 I.T.R. 38. The High Court had remarked that “in the present case the sale of the machinery took place during the year of account, and it was used by Free Press Company for at least a part of the year. This would be sufficient to attract liability.” The learned counsel for the assessee argued more persuasively that the sale occurred in the course of winding up the company, and therefore section 10(2)(vii) should not apply. The Court accepted that the second proviso to section 10(2)(vii) was intended to be invoked only where a sale was made in the ordinary course of business carried on by the predecessor. Where the sale was a closing‑down sale, the profit arising therefrom could not be brought within the charge of tax. The Court also cited the Supreme Court decision in Liquidators of Pursa Ltd. v. Commissioner of Income‑Tax (1), which held that when the sale of machinery and plant forms part of a process of winding up a business, and the company’s intention is to discontinue the business, such a sale is not an operation in furtherance of the business but merely a realization of assets during gradual winding up that ends in voluntary liquidation; consequently, the provision of section 10(2)(vii) does not apply.

Applying these principles to the present facts, the Court observed that the creation of the new company was undertaken to assume the business of the old company. The lease of the machinery, the transfer of the right to publish newspapers, and the final sale of the machinery were all components of a single scheme designed to wind up the Free Press Company. Accordingly, the sale of the machinery was undeniably a closing‑down sale, and the profit earned on that sale could not be assessed under section 10(2)(vii). The Court explained that the two cited cases dealt with the second proviso to section 10(2)(vii). While clause (vii) addresses losses, the second proviso deals with profits, but it does not mirror the main clause exactly. The proviso creates a legal fiction that the main clause does not. The purpose of this fiction, the Court said, is to capture situations where loss in business may arise not only from ordinary operational deficits but also from loss, destruction, depreciation, or devaluation of equipment used in the business. The law recognises such loss when it has been calculated, recorded in the books, and written off. Thus, the proviso seeks to tax a notional profit that may arise from the reversal of previously claimed depreciation when an asset is sold for more than its written‑down value, even though the underlying transaction is a closing‑down sale.

The Court observed that a depreciation allowance that had been permitted could be claimed as a deduction against taxable income. In contrast, profit in a business is primarily understood to mean the profit actually earned from the business operations. However, the Court explained that when a depreciation allowance had previously been claimed on a building, machinery or plant, and the subsequent sale of that asset revealed that, contrary to the earlier deduction, the asset had actually appreciated in value, the law treats this appreciation as a profit. This legal fiction therefore transforms an amount that may not strictly be profit of the business in a narrow sense into a profit for the purpose of income‑tax assessment. The Court noted that, earlier, there had been doubt as to whether such appreciation could be treated as profit when the business had been wound up. The legislature has now amended the law to require that this fictional profit be taxed regardless of whether the sale occurred during the continuance of the business or after its cessation. The Court further observed that no similar amendment was made to clause (vii) to exclude losses on buildings, machinery or plant that arise after the business has closed. Consequently, the Court held that the principles governing the proviso cannot be applied to the main clause, because profit and loss arise in business in different ways, and the earlier rulings therefore do not apply to the present facts. The analysis must therefore be confined to the scheme of the Indian Income‑Tax Act and the specific clause under consideration.

The Court then turned to the overall structure of the Income‑Tax Act, citing Lord Porter’s observation in Indian Iron and Steel Co. Ltd. v. Commissioner of Income‑Tax, Bengal, that income tax is assessed and paid in the year succeeding the year in which the income arose. Thus, the income of the preceding year becomes taxable in the following year, which is termed the year of assessment. For assessment purposes, the Act classifies income, profits and gains into six heads under section 6, the fourth head being “Profits and gains of business, profession or vocation.” Sections 7, 8, 9, 10, 12, 12A and 12B prescribe the rules of computation for each head. Profits and gains of business are dealt with in section 10, whose opening provision states that tax shall be payable by an assessee under the head “Profits and gains of business” in respect of the profit or gains of any business carried on by him. In Commissioner of Income‑Tax v. Shaw Wallace and Co., Ltd., the Judicial Committee observed that the words “carried on by him” are an essential element of the source of taxable income, meaning that tax is imposed on profit earned through a process of production. The Court affirmed this interpretation in the present context.

The Court observed that the term “business” was defined in the Income‑tax Act to include any trade, commerce or manufacture, or any adventure or concern of a similar nature, and that the definition implied a fundamental idea of the continuous exercise of an activity. However, the Court noted that the source of income need not be continuously productive; rather, its object must be the production of a definite return, excluding mere windfalls, and that capital ordinarily functions merely as an element in the production process. The Court agreed with this interpretation of the Act and recalled that the same observations had been applied in the Pursa Limited case, which had been cited earlier. Consequently, the Court held that capital may, in the course of production, depreciate, be consumed or be lost, and that the Income‑tax Act, while taxing income, profits or gains, expressly acknowledges such eventualities and provides for appropriate allowances. The Court explained that when the profits or gains of a business for a particular year are to be taxed, the computation must cover the whole year and must take into account any losses incurred during that same year. The Court then identified the conditions enumerated in section 10 that must be satisfied for a loss to be treated as a business loss. The first condition, found in the first sub‑section of section 10, is that the business must have been “carried on by the assessee,” a formulation supported by earlier authorities. The second condition, contained in clause (iv) of the second sub‑section of section 10, requires that the building, machinery or plant be used for the purposes of the business. The third condition is that any sale or similar transaction must occur during the relevant year of account, reflecting the principle that tax is assessed on the profits of the preceding year. The fourth condition, set out in the first proviso, is that the loss must have been entered in the assessee’s books and written off. The Court emphasised that no other conditions are expressly stipulated in the section or elsewhere in the Act. In particular, the Act does not require that the business be carried on for the entire year, nor that the machinery or plant be employed for the whole accounting period. There is no language indicating that a taxpayer who operates only for part of a year and then disposes of the business cannot treat the incurred loss as a business loss, or that such a taxpayer must pay tax on any small profit and also bear the loss. The Court further distinguished the situation of profit referred to in the second proviso, noting that profit and loss arise in different manners and have been treated differently by law, a distinction that the legislature has reflected by amending the proviso but not the principal clause.

The Court observed that the amendment made by the legislature had affected only the proviso and had left the substantive clause unchanged. After reviewing the discussion that had been set out earlier in the judgment, the Court stated that, on the basis of that analysis, it was of the view that the decision rendered by the High Court was correct in every respect, taking into account the particular facts and circumstances that had arisen in the present matter. Accordingly, the Court concluded that there was no ground on which to disturb the High Court’s findings, and it therefore ordered that the present appeal be dismissed. In addition, the Court directed that the costs of the appeal be awarded against the appellant. The final order therefore recorded the dismissal of the appeal together with an order that the appellant bear the costs incurred.