Commissioner of Income Tax, Bombay vs Bipinchandra Maganlal and Co.

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

Court: Supreme Court of India

Case Number: Civil Appeal No. 761 of 1957

Decision Date: 17 November 1960

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

The case was titled Commissioner of Income‑Tax, Bombay versus Bipinchandra Maganlal and Co., and the judgment was delivered on 17 November 1960. The matter was heard before a bench of the Supreme Court of India consisting of Justice J. C. Shah, Justice S. K. Das and Justice M. Hidayatullah. The petitioner was the Commissioner of Income‑Tax for Bombay City, while the respondent was Bipinchandra Maganlal and Co. Ltd., a company registered in Bombay. The judgment was recorded under the citation 1961 AIR 1040 and also reported in 1961 SCR (2) 493. Subsequent citations referenced the decision in later reports, including R 1965 SC 1977 (11) RF, 1966 SC 870 (11) R, 1973 SC 1034 (21) F, 1977 SC 560 (7) R, and 1978 SC 1099 (4,7). The statutory framework concerned the Indian Income‑Tax Act of 1922, specifically sections 10(2)(VII) second proviso and 66(1), dealing with the determination of profit and assessable income, as well as the concept of “smallness of profit.” The headnote summarized that the respondent company had bought machinery for Rs 89,000 and sold it for the same amount, yet the books reflected a written‑down value of Rs 73,392 for that year. The Income‑Tax Officer added the difference of Rs 15,608 to the company’s profit in computing assessable income and, under section 23A, treated the undistributed portion of that income as deemed dividend. The officer’s order was affirmed by the Appellate Tribunal, and the question was referred by the Tribunal to the Bombay High Court under section 66(1) for determination of whether the Rs 15,608 should be counted as “profit” for assessing the reasonableness of a larger dividend.

The High Court answered the question in the negative, holding that the amount should not be included in the definition of profit for that purpose. By special leave, the matter reached the Supreme Court, which affirmed the High Court’s view. The Court explained that, by the fiction created in section 10(2)(VII) second proviso read together with section 2(6C), amounts that are not income for the purpose of assessing taxable income become taxable income, but they do not become commercial profit. Consequently, such amounts are not relevant when assessing whether, in view of the smallness of profits, a larger dividend would be unreasonable. The Court clarified that “smallness of profit” must not be equated with “smallness of assessable income” and should instead be determined according to commercial principles. The Court referred to earlier decisions, including Sir Kasturchand Ltd. v. Commissioner of Income‑Tax, Bombay City (1949) XVII ITR 493; Ezra Proprietary Estates Ltd. v. Commissioner of Income‑Tax, West Bengal (1950) XVIII ITR 762; and Commissioner of Income‑Tax, Bombay City v. F. L. Smith & Co. (Bombay) Ltd. (1959) XXXV ITR 183, to support this reasoning. The final judgment affirmed the appellate tribunal’s order and upheld that the Rs 15,608 should not be treated as profit for the purpose of evaluating dividend reasonableness.

The appeal, numbered 48/X of 1954, was argued by counsel Hardayal Hardy and D. Gupta for the appellant, while counsel N. A. Palkhivala and I. N. Shroff represented the respondent; judgment was delivered on 17 November 1960 by Justice Shah. The Court noted that the Income Tax Appellate Tribunal, Bombay Bench “A”, had, under section 66(1) of the Indian Income Tax Act, 1922, referred a specific question to the High Court: whether the amount of Rs 15,608 should be treated as part of the assessee company’s profit for the purpose of deciding if paying a dividend larger than the one declared would be unreasonable. The High Court had answered this question in the negative, and the present appeal was filed against that order by way of special leave under article 136 of the Constitution. The company involved, M/s Bipinchandra Maganlal & Co., Ltd., was incorporated under the Indian Companies Act and, under section 23A explanation, did not have the public substantially interested. At the relevant time its paid‑up capital amounted to Rs 20,800, comprising twenty shares of Rs 50 fully paid and nineteen‑eighty shares of Rs 50 each with Rs 10 paid per share. In December 1945 the company purchased machinery for Rs 89,000 and later sold the same machinery in March 1947 for the original purchase price. In the company’s accounts for the year 1946‑47 (1 April 1946 to 31 March 1947) the written‑down value of the machinery was recorded as Rs 73,392, while the disclosed trading profit for that year was Rs 33,245. At the general meeting held on 21 October 1947 the company declared a dividend of Rs 12,000 for that accounting year. When assessing tax for the assessment year 1947‑48, the Income Tax Officer calculated the company’s assessable income for 1946‑47 as Rs 48,761, adding to the reported profit the amount of Rs 15,608, which represented the excess of the sale proceeds over the written‑down value of the machinery. Pursuant to section 23A of the Act, the Officer issued an order deeming Rs 15,429 – the undistributed portion of the assessable income after deducting tax payable – to have been distributed as dividend among the shareholders as of the date of the general meeting, and each shareholder’s proportionate share was to be included in his total income. The company’s challenges to this order before the Appellate Assistant Commissioner and the Income Tax Appellate Tribunal were unsuccessful; consequently, the Tribunal, at the company’s request, referred the same question to the High Court under section 66(1). The Court then reproduced the wording of section 23A(1) of the Act as it existed at the relevant time, insofar as it was material, for further consideration.

Section 23A required the Income Tax Officer to make a written order, with prior approval of the Inspecting Assistant Commissioner, deeming that any portion of a company’s assessable income which remained undistributed after the end of the sixth month following the accounting year would be treated as if it had been paid out as dividend to the shareholders at the date of the general meeting. The statute imposed this duty only when the Officer was satisfied that, for the relevant previous year, the total amount of profits and gains that the company actually distributed as dividends by the end of the sixth month after the accounts were laid before the company in a general meeting was less than sixty per cent of the assessable income for that year after deducting the income‑tax and super‑tax payable on that income. The Officer was further required, unless he was convinced that it would be unreasonable to require a dividend or a larger dividend than was actually declared, to consider two additional circumstances: first, whether the company had suffered losses in earlier years, and second, whether the profit made in the year in question was so small that paying a larger dividend would be unreasonable. If, after evaluating these factors, the Officer concluded that a larger dividend would be unreasonable, he could not make the deemed‑distribution order.

The Court explained that, under section 23A, the Income Tax Officer must issue an order deeming the undistributed portion of assessable income to be dividend only when two conditions are satisfied. The first condition is that the company has failed to distribute at least sixty per cent of its assessable income, reduced by the income‑tax and super‑tax that is payable. The second condition is that the Officer must be satisfied that requiring the company to pay a dividend, or a larger dividend than the one actually declared, would not be unreasonable taking into account either (a) losses incurred by the company in earlier years or (b) the smallness of the profit earned in the year under consideration.

In the case at bar, the total assessable income for the year of account was Rs 48,761 and the tax payable on that amount was Rs 21,332. After deducting the tax, the assessable income reduced for the purpose of the sixty‑per‑cent test was Rs 27,249. Sixty per cent of that reduced amount amounted to Rs 16,349, which was Rs 4,458 more than the dividend that had actually been declared by the company. Accordingly, the first condition prescribed by section 23A was clearly met, and the jurisdiction of the Income Tax Officer to act under the provision was indisputably triggered.

Nevertheless, the Officer still had to be satisfied that, because the profit was small, requiring the company to pay a larger dividend would be unreasonable. No evidence was presented to show that the company had suffered losses in earlier years, so the only factor to consider was the smallness of the profit. The Officer did not expressly address this issue. Instead, he based his decision on the rejection of the company’s contention that the excess of the sale price of machinery over its written‑down value could not be taken into account when applying section 23A. Implicitly, the Officer assumed that if that excess were taken into account, the payment of a larger dividend would not be unreasonable. The Tribunal accepted this assumption and proceeded on the footing that the Officer’s view was correct.

Counsel for the Revenue argued that the phrase “smallness of profit” should be understood simply as the smallness of assessable income, and that, regardless of this interpretation, the amount received from the sale of the machinery in the relevant accounting year that exceeded its written‑down value must be taken into account when deciding whether the “smallness of profit” condition was satisfied. At the time of the dispute, section 2(6C) of the Act defined “income” to include, among other things, any sum that was deemed to be profit under the second proviso to clause (vii) of sub‑section (2) of section 10. According to section 10, when computing the profits or gains of a taxpayer under the head “Profits and gains of business, profession or vocation,” the amount by which the written‑down value of any building, machinery or plant that has been sold, discarded, demolished or destroyed exceeds the actual sale price or scrap value is allowed as a deduction. However, this deduction is subject to an exception set out in the second proviso to clause (vii) of sub‑section (2) of section 10, which provides that if the sale price exceeds the written‑down value, the portion of the excess that does not exceed the difference between the original cost and the written‑down value is to be treated as profit of the previous year in which the sale occurred. Applying this rule to the Company, the difference between the written‑down value of the machinery in the accounting year and the actual sale price—bearing in mind that the sale price did not exceed the original cost—had to be deemed profit for that accounting year, and consequently it had to be included in the assessable income for the year of assessment. The Revenue counsel emphasized that this inclusion is a statutory fiction: in substance the receipt represents a return of capital, but the statute treats it as income for tax purposes. Because the statute makes the gap between sale price and written‑down value taxable, its nature is not transformed into ordinary business profit; it remains a component of the capital originally invested, despite the fiction created by the second proviso of section 10(2)(vii). The rationale for this fictional treatment, according to the counsel, is to enable the Revenue to recover, in the year of sale, the depreciation allowances that had previously reduced taxable income, since the asset ultimately fetched a price higher than its written‑down value, i.e., higher than the original cost less accumulated depreciation.

The Court explained that the rule allowing recoupment against wear and tear is based on the presumption that depreciation has actually been taken, even though in many cases the depreciation has not materialised in fact. The rationale behind the rule, however, does not change the true nature of the receipt that arises when an asset is sold. The Court further observed that it is the total depreciation that has been accumulated over several years which the law treats as the income of the year in which the asset is disposed of. Consequently, the gap between the written‑down value of the asset and the amount realised on its sale, although it is not profit derived from the ordinary business activities of the assessee, is nonetheless treated as profit for that year. This treatment is intended to enable the tax authorities to recover the allowances that were granted in earlier years when the depreciation was allowed.

The Court then turned to the question of dividend distribution. It noted that a company ordinarily pays dividends out of its real commercial profits, not out of the figure called assessable income. There is no precise correlation between assessable income, which is computed for tax purposes, and the actual commercial profits of a business. The computation of assessable income is governed by a series of artificial rules that incorporate various fictional receipts, deductions and allowances. When assessing whether a larger dividend would be unreasonable, the source of the dividend – that is, the actual profits – must be considered rather than the amount of assessable income. The legislation, specifically section 23A, does not require the court to take into account the “smallness of the assessable income” when deciding whether an order deeming undistributed profits as distributed is appropriate. Instead, the test of reasonableness must be based on the profit earned in the relevant year. The Court pointed out that even if a company’s assessable income appears large, its true commercial profit may be so small that forcing a larger dividend would compel the company to draw on its reserves or on its capital, which the law forbids. For example, companies that earn income from property may be taxed under section 9 of the Act on the basis of the bona‑fide annual value of the property, while the actual cash receipts may be far lower than that valuation. If the test of reasonableness were measured by assessable income rather than by commercial profit, such companies might frequently be forced to sell their income‑producing assets. The Legislature deliberately used the term “smallness of profit” and not “smallness of assessable income,” and there is nothing in the context of the statute that permits equating “profit” with “assessable income.” Accordingly, “smallness of profit” under section 23A must be assessed in light of commercial principles, not on the basis of total receipts, whether actual or fictional. The Court observed that this interpretation has been adopted uniformly by the High Courts in India, without any dissenting opinion, see Sir.

In the present case, the Court referred to three earlier decisions: Kasturchand Ltd. v. Commissioner of Income Tax, Bombay City (1940) XVII I.T.R. 493; Ezra Proprietary Estates Ltd. v. Commissioner of Income Tax, West Bengal (1950) XVIII I.T.R. 762; and Commissioner of Income Tax, Bombay City v. F. L. Smith & Co., (Bombay) Ltd. (1959) XXXV I.T.R. 183. Those authorities were cited to illustrate the principle that, under the legal fiction created by section 10(2)(vii) second proviso read together with section 2(6C), an amount that is in reality not income may be treated as taxable income solely for the purpose of computing assessable income. However, that treatment does not convert the amount into commercial profit. Because the amount does not become commercial profit, it cannot be considered when the court examines whether, given the smallness of the company's profits, declaring a larger dividend would be unreasonable.

The Court then applied this reasoning to the specific fact that the High Court had held that the sum of Rs. 15,608 should not be taken into account for the purpose of deciding whether the modest profit of the company made a larger dividend unreasonable. The Supreme Court agreed with that holding, concluding that the amount of Rs. 15,608 was irrelevant to the test of unreasonable dividend in light of the small profit. Accordingly, the Court found that the appeal was untenable, ordered it dismissed, and awarded costs to the respondent. The final order dismissed the appeal with costs.