Commissioner of Income Tax, Bombay vs Khatau Makanji Spinning and Weaving Co. Ltd.

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

Court: Supreme Court of India

Case Number: Civil Appeal No. 303 of 1958

Decision Date: 4 May 1960

Coram: M. Hidayatullah, S. K. Das, J. L. Kapur

The case before the Supreme Court of India was titled The Commissioner of Income‑Tax, Bombay versus The Khatau Makanji Spinning and Weaving Co. Ltd., Bombay, and the judgment was delivered on 4 May 1960. The petition was filed by the Commissioner of Income‑Tax for Bombay City, and the respondent was the Khatau Makanji Spinning and Weaving Company Limited, situated in Bombay. The judgment was authored by Justice M. Hidayatullah, and the bench on which the matter was heard comprised Justices M. Hidayatullah, S. K. Das and J. L. Kapur. The official citation for the decision is 1960 AIR 1022, and the judgment is also referenced in the citator as D 1961 SC 699 (8) and D 1981 SC 1562 (17). The statutes and provisions that were relevant to the dispute included the Indian Income‑Tax Act, 1922 (II of 1922), specifically Section 3, as well as the Indian Finance Act, 1953 (XIV of 1953). The headnote of the report summarized the factual and procedural background of the case.

According to the headnote, the Income‑Tax Officer had found that during the assessment year 1953‑54 the respondent company had declared excess dividends amounting to Rs 1,87,691. The officer consequently levied additional income‑tax on that amount at a rate of five annas in the rupee, after reducing the income‑tax that had been borne by the profits of the preceding year at a rate of four annas per rupee, and also imposing a surcharge of five per cent less a rebate of one anna in the rupee as provided by the Finance Act, 1953. The Income‑Tax Tribunal held that the excess dividends were deemed to have been paid out of undistributed profits of the earlier year ending 30 June 1951, on which a rebate of one anna in the rupee had been granted in the assessment year 1952‑53. The Tribunal further observed that the additional income‑tax constituted a tax on income, and that the Finance Act could stipulate that the tax be payable on the income of any year preceding the previous year. The Tribunal, however, referred three questions to the High Court, which the High Court consolidated into a single question: whether additional income‑tax had been legally charged under Clause (ii) of the proviso to paragraph B of Part 1 of the First Schedule to the Indian Finance Act, 1951, as applied to the assessment year 1953‑54 by the Indian Finance Act, 1953, read with Section 3 of the Indian Income‑Tax Act. The High Court answered that Section 3 of the Indian Income‑Tax Act placed the liability to tax on the total income of the previous year or on what could be deemed to be income, and that the Finance Act merely provided the rate applicable to that income and a method of computing total income. The High Court held that the Finance Act’s provision that additional income‑tax should be paid upon accumulated profits of previous years exceeded the purpose for which the Finance Act was enacted each year, and that the Finance Act could not operate independently without the support of Section 3 of the Indian Income‑Tax Act. On appeal by the Commissioner of Income‑Tax, the Court affirmed that the High Court was correct in its negative answer to the question it had framed, noting that the Finance Act stipulated that the tax should be levied on the “total income” as defined and determined under the Indian Income‑Tax Act.

The Court observed that the additional income‑tax could not be correctly imposed on the total income because the amount that was taxed was neither part of the total income of the preceding year nor could it be deemed to be so. This appeal arose from the judgment and order dated 3 August 1956 of the Bombay High Court in an income‑tax reference numbered 10 of 1956. Counsel for the appellant were K. N. Rajagopal Sastri and D. Gupta, while counsel for the respondents included N. A. Palkhivala, S. N. Andley, J. B. Dadachanji and Rameshwar Nath. The judgment was delivered on 4 May 1960 by Justice Hidayatullah. The appellant was the Commissioner of Income‑tax for Bombay City and the respondent was Khatau Makanji Spinning and Weaving Co. Ltd., a company whose financial year ended on 30 June each year. At the close of the 1951 accounting year the company carried forward profits of Rs 30,680 and appears to have taken a rebate by declaring dividends below the limit fixed by the Finance Act. For the 1952 accounting year the company’s book profits were Rs 28,67,235 before allowances for depreciation and tax; after such allowances and other adjustments the amount available for distribution was Rs 5,02,915. The Income‑tax Officer, however, determined the total income for that year to be Rs 5,26,681. During the 1952 year the company declared dividends of Rs 4,78,950 and carried forward a balance of Rs 23,965. The matter before this Court concerned the assessment year 1953‑54, to which the Finance Act of 1953 applied, the 1953 Act incorporating the provisions of the Finance Act of 1951 with certain modifications, and henceforth referred to simply as the Finance Act. The Income‑tax Officer concluded that the company had declared excess dividends amounting to Rs 1,87,691. He calculated an additional income‑tax on that excess at a rate of five annas in the rupee after deducting income‑tax already paid on the profits of the previous year at four annas per rupee, and after applying a surcharge of five percent reduced by a rebate of one anna per rupee as permitted by the Finance Act. The resulting additional tax liability was Rs 21,115‑4‑0. The company's appeals under the Income‑tax Act were dismissed. The Tribunal held that the excess dividends should be treated as having been paid out of undistributed profits of the earlier year ending 30 June 1951, which amounted to Rs 6,60,720, on which a rebate of one anna per rupee was given in the assessment year 1952‑53.

In the assessment year 1952‑53 a rebate of one anna in the rupee was granted. The Tribunal observed that the additional income‑tax imposed on the excess dividend was likewise a tax on income, and that the Finance Act could stipulate that such tax be payable on the income of any year preceding the year previous to the assessment. The Tribunal therefore referred four questions to the High Court; the first question was abandoned before the High Court considered it. The remaining questions were as follows: (ii) assuming a negative answer to question 1, whether the provisions in dispute exceed the scope of the Indian Income‑tax Act; (iii) whether additional income‑tax may be levied, assessed and recovered under the provisions of the Indian Income‑tax Act; and (iv) whether, in any event, the additional income‑tax has been lawfully imposed under the Indian Finance Act 1953 read with the Indian Income‑tax Act.

The High Court consolidated the three remaining questions into a single query: whether the additional income‑tax has been lawfully charged under clause (ii) of the proviso to paragraph B of Part 1 of the First Schedule to the Indian Finance Act 1951, as applied to the assessment year 1953‑54 by the Indian Finance Act 1953, read in conjunction with Section 3 of the Indian Income‑tax Act. The High Court answered this question in the negative. In its reasoning, the Court held that Section 3 of the Indian Income‑tax Act defines the liability to tax and places the tax on the total income of the preceding year. The method for computing that total income is set out in the Finance Act, which merely supplies the rate applicable to the computed income.

According to the High Court, the Finance Act’s provision that additional income‑tax should be paid on accumulated profits of earlier years exceeds the purpose for which the Central Act is enacted each year and cannot operate in isolation without the support of Section 3 of the Income‑tax Act. The Court declared that the Finance Act had “misfired” because it did not employ legislative measures that would conform to the object of the Finance Act. The learned Chief Justice, delivering the judgment of the High Court, noted that the legislature had several alternatives to achieve the intended objective but had not adopted any of them. He explained that the legislature could have pursued one of three methods: (a) treat the excess dividend declared by the company as a notional income and include it in the total income of the preceding year; (b) provide for rectification of the assessment of the year in which those profits were taxed at a lower rate, a measure that Parliament had actually incorporated in the Finance Act; and (c) finally, impose a penalty on a company that violated Parliament’s directive not to pay dividend beyond a prescribed ceiling.

In the Court’s view, a third possible method for Parliament was to impose a penalty on any company that disobeyed the parliamentary rule prohibiting the payment of dividends above a prescribed ceiling. The Court then examined the scope of Section 3 of the Income‑Tax Act and held that Section 3 is plain in stating that the tax which may be levied must be a tax on income, and that Parliament’s power under the Act is equally clear: Parliament may fix the rate at which income‑tax is to be charged on the total income of the preceding year of the assessee. The Court expressed the opinion that the provision introduced by the Finance Act of 1956 extends beyond the limits laid down in Section 3. Consequently, if Parliament has indeed acted beyond those limits, the Finance Act cannot create an effective charge on the total income of the preceding year of the assessee with respect to the additional tax on excess dividend that the Act purports to impose.

The Court pointed out that, before the High Court, it had been conceded that for the provisions of the Finance Act to be operative they must fall within the ambit of Section 3 of the Income‑Tax Act. It was argued, however, that it was not necessary to rely solely on Section 3; the argument also considered whether the Finance Act itself could empower Parliament to levy a new tax independently, should it wish to do so. Other submissions sought to modify the language of the Finance Act so that the tax could be sustained without reference to Section 3 of the Income‑Tax Act. The Court rejected that line of reasoning, referring to its earlier decision in Civil Appeal No 427 of 1957, and explained that such modifications would amount to a complete rewriting of the relevant paragraph of the Finance Act, a step that is within the exclusive competence of the legislature and not of the judiciary.

The Court further observed that the words of the Finance Act must be given their natural meaning and construed as they stand. It agreed with the learned Chief Justice that the Income‑Tax Act imposes tax only on income, or on something that the Act deems to be income, and that the tax is to be collected at a specified rate on the total income, a rate that is provided for in an annual Central Act. The Court noted that the Finance Act follows the same pattern, laying down the rate at which tax is to be collected. While the Finance Act places the tax on the total income, it contains two provisos that modify the rate in certain circumstances. At this point the Court read the relevant provision from Part 1 of the First Schedule, which states: “In the case of every company—Rate. Surcharge. On the whole of Four annas One‑twentieth of total income in the rupee, the rate specified in the preceding column.”

Provided that a company, with respect to its profits liable to tax under the Income‑tax Act for the year ending on the 31st day of March 1953, had made the prescribed arrangements for the declaration and payment of dividends within the territory of India, excluding the State of Jammu and Kashmir, and that it had deducted super‑tax from those dividends in accordance with the provisions of subsection (3D) or (3E) of section 18 of the Act, the Finance Act stipulated two separate consequences. First, where the total income of the company, after being reduced by seven annas in the rupee and by any amount that was exempt from income‑tax, exceeded the amount of any dividends (including dividends payable at a fixed rate) declared in respect of the whole or part of the previous year for the assessment year ending on 31 March 1953, and where no order had been made under sub‑section (1) of section 23A of the Income‑tax Act, a rebate was to be allowed at the rate of one anna per rupee on the amount of such excess. Second, where the amount of dividends referred to in the first clause exceeded the total income after the same reduction of seven annas and any exemption, an additional income‑tax was to be charged on the total income. This additional tax was to equal the difference, if any, between the aggregate amount of income‑tax actually borne by the excess dividend (hereinafter referred to as the “excess dividend”) and the amount that would be calculated at the rate of five annas per rupee on that excess dividend. For the purpose of determining the aggregate amount of income‑tax actually borne by the excess dividend, the Finance Act specified that the excess dividend would be deemed to be drawn out of the whole or such portion of the undistributed profits of one or more years immediately preceding the previous year as would be just sufficient to cover the amount of the excess dividend, and that such portion of the undistributed profits had not previously been taken into account to cover an excess dividend of an earlier year. Furthermore, each portion of the excess dividend deemed to arise from the undistributed profits of a particular year was to be treated as having borne tax in the following manner: if an order had been made under sub‑section (1) of section 23A of the Income‑tax Act in respect of the undistributed profits of that year, the tax rate of five annas in the rupee would apply; for any other year, the tax rate applicable to the total income of the company for that year, reduced by any rebate that might have been allowed on the undistributed profits, would apply. By the first proviso, therefore, a rebate of one anna per rupee was granted to a company that paid dividends at a rate of less than nine annas in the rupee out of its profits. By the second proviso, that rebate ceased to apply, and an additional income‑tax became payable on dividends that exceeded the stipulated limit.

In this case, the Court explained that the additional tax had to be paid on dividends that exceeded the prescribed limit and were paid in the relevant year. The explanation attached to the statute provided that “the excess dividend shall be deemed to be out of the whole or such portion of the undistributed profits of one or more years immediately preceding the previous year as would be just sufficient to cover the amount of the excess dividend and as have not likewise been taken into account to cover an excess dividend of a preceding year.” The Court observed that this fictional device merely treated the dividend as if it came from profits of years other than the previous year that was under assessment. The Court then pointed out that the Finance Act did not go on to treat those profits as part of the “total income” for the purpose of applying the rate prescribed in the proviso. Unless the Finance Act had expressly stated that, after applying the fiction, the profits of the earlier year or years should be deemed to form part of the total income of the previous year under assessment, the statutory purpose could not be achieved. The Court reiterated that income‑tax is levied on the income of the previous year and cannot be imposed on something that is not income of that year, even if it is treated fictionally as such. The Court noted that the Finance Act could have, as the learned Chief Justice had suggested, included those back‑year profits within the total income of the assessed previous year, but it did not. The Court also observed that the Finance Act might have employed another fictional device that could have satisfied the requirement, but it failed to do so. Even accepting that the dividends were deemed to arise from earlier‑year profits, those amounts did not become income of the relevant previous year, and without an express provision making them part of total income, the purpose of the legislation was not fulfilled. Moreover, the Finance Act continued to state that tax was to be levied on the total income as defined and computed under the Income‑tax Act. Consequently, the Court concluded that it was impossible to say that the additional income‑tax had been correctly imposed on total income, because the amount actually taxed was never part of the total income of the previous year. For these reasons, the Court held that the High Court was correct in answering the framed question in the negative. Accordingly, the appeal was dismissed with costs.