Commissioner of Income-Tax, Bombay vs M/S. Abdullabhai Abdulkadar

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

Court: Supreme Court of India

Case Number: Civil Appeal No. 312 of 1959

Decision Date: 06 December 1960

Coram: J.L. Kapur, M. Hidayatullah, J.C. Shah

On 6 December 1960 the Supreme Court of India delivered its judgment in the case titled Commissioner of Income‑Tax, Bombay versus M S Abdullabhai Abdulkadar. The opinion was authored by Justice J L Kapur and was heard by a bench consisting of Justices J L Kapur, M Hidayatullah and J C Shah. The petitioner in the proceeding was the Commissioner of Income‑Tax for Bombay and the respondent was the firm M S Abdullabhai Abdulkadar. The judgment is reported in the 1961 volume of the All India Reporter at page 701 and also appears in the 1961 Supplement to the Supreme Court Reporter at page 949. The case is cited in later reports as R 1964 SC 1722 (9) and R 1966 SC 1250 (5). The matters addressed relate to a commission agent’s liability to pay tax on behalf of a non‑resident principal, the test for a deductible business loss, and the application of sections 10(1), 10(2)(xi), 42(1) and 43 of the Indian Income‑Tax Act of 1922 (Eleventh Amendment).

The respondent was a registered firm engaged in the business of commission agents and, for income‑tax purposes, was treated as the agent of a non‑resident principal who conducted business outside India. Under section 42(1) of the Income‑Tax Act the firm was deemed to be the assessee and was required to pay a tax amount of Rs 3,78,49‑r on behalf of the non‑resident principal. After adjusting for sums that remained with the respondent firm, the account of the non‑resident principal showed a debit balance of Rs 3,20,162. The respondent classified this balance as a bad debt and claimed a deduction for the loss. The Assessing Officer and the Appellate Assistant Commissioner rejected the claim, but the Income‑Tax Appellate Tribunal held that the loss was an allowable deduction because it arose from the respondent’s business dealings with the non‑resident principal. The Bombay High Court, treating the amount as a business loss incurred by the respondent, affirmed the Tribunal’s decision. On appeal, the Commissioner of Income‑Tax argued that the respondent was not entitled to the deduction. The Supreme Court held that the liability imposed under section 42(2) did not arise directly from the respondent’s own business activities nor was it incidental to them. The Court reasoned that the loss was not a commercial loss incurred in the respondent’s own business but rather stemmed from the business of another person, and consequently it was not a permissible deduction under section 10(1) or section 10(2)(xi) of the Act. The Court referred to the authority of Gresham Life Assurance Society v Styles (1892) 3 T C 185 (House of Lords). It followed the precedent set in Commissioner of Income‑Tax v Sir S M Chitnavis (1932) L R 59 I A 290, discussed Badridas Daga v Commissioner of Income‑Tax [1959] S C R 690, Curtis v I and G Oldfield Ltd (1925) 9 T C 319, and noted that Lord’s Dairy Farm Ltd v Commissioner of Income‑Tax, Bombay [1955] 27 I T R 700, Calcutta Co Ltd v Commissioner of Income‑Tax [1959] 37 I T R 1 and C I R v Hagart and Burn Murdoch [1929] A C 386 were not applicable. The judgment concerned Civil Appeal No 312 of 1959, which was an appeal from the Bombay High Court order dated 23 August 1956 in Income‑Tax Reference No 21 of 1956. The counsel for the appellant was Hardyal Hardy and D Gupta, while A V represented the respondent.

Viswanatha Sastri and I N Shroff appeared for the respondent. The judgment was delivered on 6 December 1960 by Justice Kapur. The matter before the Supreme Court was an appeal by special leave filed by the Commissioner of Income‑Tax. The appeal challenged the judgment and order of the Bombay High Court, which had answered a question in favour of the assessee, the respondent firm. The original question referred by the Income‑Tax Appellate Tribunal concerned whether, given the facts and circumstances of the case, the sum of Rs 3,20,162 could be allowed as a deduction under Section 10(2)(xi) or Section 10(2)(xv) of the Income‑Tax Act. The High Court altered the wording of the question to ask simply whether the amount of Rs 3,20,162 was an allowable deduction, and it answered this modified question affirmatively, thereby ruling against the appellant, the Commissioner.

The respondent was a registered firm that acted as commission agents. It functioned as the agent of a non‑resident principal, Haji Mohamed Syed Ali Barbari of Port Sudan, who is hereinafter referred to as the non‑resident principal. The firm’s business involved exporting cloth and kariana—miscellaneous goods—to destinations such as Aden, Saudi Arabia and Sudan. In return, the non‑resident principal supplied cotton to the respondent and to other merchants for sale in India. During the assessment years 1942‑43, 1943‑44, 1944‑45 and 1945‑46, the respondent was treated as the agent of the non‑resident principal under Section 43 of the Income‑Tax Act, for the purposes of both income‑tax and Excess Profits Tax. Under Section 42(1) of the Act, the respondent was required to pay a total of Rs 3,78,491. After accounting for the amounts that remained in the respondent’s possession, the account of the principal showed a debit balance of Rs 3,20,162.

For the assessment year 1953‑54, the respondent treated this debit balance as a bad debt and claimed it as a deductible loss to be set off against its profits. The Income‑Tax Officer regarded the claim as falling under Section 10(2)(xv) of the Act and disallowed the deduction. Subsequently, the Appellate Assistant Commissioner examined the claim under Section 10(2)(xi) of the Act and also disallowed it. The respondent then appealed to the Income‑Tax Appellate Tribunal. The Tribunal held that the amount represented a bad debt arising from the respondent’s business activities with the non‑resident principal and therefore constituted an allowable deduction. The Commissioner of Income‑Tax then preferred a reference to the High Court. The High Court, after modifying the original question, again answered affirmatively, finding that the law imposed upon the respondent an obligation to discharge the liability and that the liability was incidental to the respondent’s business. Consequently, the High Court concluded that the amount was a deductible loss; even if the amount were not strictly a debt, the court held that the assessee could still claim it as a loss incurred in the course of its business.

The Court observed that the loss claimed by the respondent could be characterised as a business or trading loss because, in computing the true profit of the respondent’s business, that loss needed to be deducted. Accordingly, the High Court applied section 10(1) of the Income‑Tax Act to the amount sought by the respondent. The Court noted that the admissibility of the disputed amount hinged on the nature of the liability imposed upon the respondent firm.

According to the respondent’s counsel, the firm was engaged in foreign trade, maintaining dealings with a foreign merchant and conducting both imports and exports. The counsel argued that the relationship between the respondent firm and the non‑resident principal was so intimate that it warranted the application of section 42(1) of the Act, which contemplates the establishment of an agency. The liability to pay, the counsel said, arose under section 42(2), which provides that when a person who is not resident or not ordinarily resident in the taxable territories carries on business with a resident person, and the Income‑Tax Officer observes that, because of the close connection between the parties, the business arrangement yields either no profit or profits below the ordinary expectation, the profits so derived—or deemed to be so derived—shall be chargeable to income‑tax in the name of the resident person, who shall be deemed, for all purposes of the Act, to be the assessee for that income‑tax.

Relying on this provision, the counsel contended that the respondent’s business, being foreign trade, was inter‑connected with the business of the non‑resident principal and therefore attracted liability under section 42(2). Consequently, the loss incurred should be considered incidental to and arising out of the respondent’s business.

The Court quoted Lord Halsbury, L.C., stating, “The thing to be taxed is the amount of profits and gains. The word ‘profits’ I think is to be understood in its natural and proper sense—in a sense which no commercial man would misunderstand” (Gresham Life Assurance Society v. Styles). The Court further observed that even if a deduction is not expressly listed in sub‑section (2) of section 10, it may still be a legitimate item for determining taxable profits.

Referring to the Privy Council decision in Commissioner of Income‑Tax v. Sir S. M. Chitnavis, the Court noted that the Act does not expressly authorise the deduction of bad debts of a business; nevertheless, such a deduction is necessarily permissible because income‑tax is levied on the profits and gains of a year, and the assessment of those profits and gains must necessarily take account of all losses incurred. Otherwise, the true profits and gains could not be ascertained. (1892) 3 T.C. 185, 188.

The Court observed that for a loss to be deductible under the statute, the loss must arise in the business of the assessee and it cannot be a payment that relates to the business of another person but is, under the provisions of the Act, treated as a liability of the assessee. The loss will be allowed only when it “springs directly from and is incidental” to the assessee’s own business. Consequently, the determination of deductibility depends primarily on whether the loss claimed qualifies as a business loss of the required character.

Applying this principle, the Court held that the amount which had become payable by the respondent firm could not be described as its business loss. To qualify as a deductible loss, the loss must be of a commercial nature, must arise directly from the business, and must truly be incidental to the business itself. It is not enough that the loss merely falls on the trader in some other capacity or that it is simply connected with his business.

The respondent’s counsel relied upon a decision of this Court in Badridas Daga v. The Commissioner of Income‑Tax. In that case an agent employed by the assessee for the purpose of carrying on the assessee’s business was authorized to operate a bank account on the assessee’s behalf. Acting under that authority, the agent withdrew money from the bank and used the funds for his personal purposes. The assessee was able to recover only part of the misappropriated amount; the balance was written off as an irrecoverable debt. The Court held that the loss could not be allowed under sections 10(2)(xi) or 10(2)(xv) of the Act, but it was allowable under section 10(1) as a loss incidental to the carrying on of the business.

From that judgment, counsel cited the observation of Justice Venkatarama Ayyar at page 695: “The result is that when a claim is made for a deduction for which there is no specific provision in s. 10(2), whether it is admissible or not will depend on whether, having regard to accepted commercial practice and trading principles, it can be said to arise out of the carrying on of the business and to be incidental to it.” The Court noted that this passage must be read in the context of the Badridas Daga case, reported in [1959] S.C.R. 690, where the employment of agents was held to be incidental to the carrying on of the business, and it was logically concluded that losses incidental to such employment were likewise incidental to the business.

Further, at page 696 the judgment emphasized: “It should be stressed that the loss for which a deduction may be made under s. 10(1) must be one that springs directly from the carrying on of the business and is incidental to it, and not any loss sustained by the assessee, even if it has some connection with his business.” The Court also indicated that reference could be made to an English decision in Curtis v. J. & G. Oldfield Ltd., which dealt with a similar issue of whether an embezzlement loss qualified as a trading loss.

In the decision of J. & G. Oldfield Ltd., the court considered a situation where the managing director of a wine and spirit merchant company misappropriated company funds. The company sought to treat the misappropriated amount as a bad debt and to claim a deduction for it. The court held that the loss could not be characterised as a trading loss and consequently was not an admissible deduction. The Crown argued that the sum did not constitute an ordinary trading debt and therefore could not be regarded as a bad debt; it further contended that the loss was not connected with, nor did it arise out of, the trade. Justice Rowlatt, speaking at page 330, explained that a “bad debt” under the rule refers to a debt that would have appeared on the balance‑sheet as a trading debt in the relevant trade and that has become uncollectible. He clarified that the term does not encompass any uncollectible debt that, if it had been sound, would not have contributed to profit.

The matter before this Court involved a liability imposed on the respondent firm because the firm was treated as an agent within the meaning of section 42(1) of the Act, and the liability arose by operation of the deeming provision in subsection (2) of section 42. The Court examined whether, in the present circumstances, the liability could be described as a business debt that springs directly from the carrying on of the respondent’s business or, in the words of Justice Venkatarama Ayyar, “incidental to it or a trading debt in the business of the respondent firm.” The Court concluded that this condition had not been satisfied. The loss incurred by the respondent did not arise in its own business; rather, it stemmed from the business activities of another person. Accordingly, the loss could not be allowed as a deduction under section 10(1) of the Act, because it is not a loss that must be deducted from the profits and gains of the respondent’s own business.

Counsel for the respondent relied on the case of Lord’s Dairy Farm Ltd. v. Commissioner of Income‑Tax, Bombay, wherein an embezzlement by an employee was held to be a trading loss because it arose from the necessity of employing cashiers. However, that decision also required that a claim for deduction of a bad debt must be a debt recognised at law. The Court found that the precedent was not applicable to the present facts and offered little assistance in resolving the issue. Counsel also cited Calcutta Co., Ltd. v. Commissioner of Income‑Tax, where it was held that the expression “profits and gains” must be interpreted in its commercial sense.

It was observed that profits and gains could not be computed until the expenditure necessary to earn those profits and gains was first deducted. When section 10(2) contains no specific provision regarding a particular claim, the allowability of that claim depends on accepted commercial practice and trading principles. Accordingly, a deduction will be permissible only if it can be said to arise out of, and to be incidental to, the carrying on of the business. This principle is without doubt correct, but it does not resolve the matter any further.

The respondent further contended that the expense fell within section 10(2)(xi) of the Act, arguing that it was incurred in respect of the business. This argument was found to have even less substance than the claim for deduction under section 10(1). Under clause (xi) a debt is allowable only when it is, in fact, a debt and when it arises out of, and is incidental to, the trade. Except in the case of money‑lending, trade debts can be described only when they are due from customers for goods supplied, or when they are loans to constituents or transactions of a similar kind, as noted in the authorities (1) [1955] 27 I.T.R. 700 and (2) [1959] 37 I.T.R. In every situation the test to be applied is whether the debt was due as an incident to the business; if it is not of that character, it will be treated as a capital loss. For example, a loan advanced by a firm of solicitors to a company whose formation they advised was not deductible when it became irrecoverable, because such a loss does not form part of the solicitors’ profession, as stated in C. I. R. v. Hagart & Burn Murdoch (1).

In the Court’s opinion, the High Court erred in answering the question in favour of the respondent. Consequently, the appeal was allowed, the judgment and order of the High Court were set aside, and the question was answered against the respondent. The appellant was awarded costs in both the Supreme Court and the High Court. The appeal was therefore allowed.