M/S. Haji Aziz And Abdul Shakoor Bros vs The Commissioner Of Income-Tax, Bombay

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

Court: supreme-court

Case Number: Civil Appeal No.110 of 1957

Decision Date: 24 November 1960

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

M/S Haji Aziz and Abdul Shakoor Brothers filed a petition against the Commissioner of Income‑Tax, Bombay City. The matter was heard by a Bench of the Supreme Court of India consisting of Justice J L Kapur, Justice M Hidayatullah and Justice J C Shah. The judgment was delivered on 24 November 1960. The case is reported in the 1961 volume of the All India Reporter at page 663 and also appears in the 1961 Supplement to the Supreme Court Reports at page 651. Several citator references are associated with the decision, including reports in the Research Foundations and the Supreme Court reports of later years. The statutory provisions that were examined include section 167(8) of the Sea Customs Act of 1878, section 183 of the same Act, and section 10(2)(XV) of the Indian Income‑Tax Act of 1922.

The firm, which was engaged in the business of importing dates from foreign sources, imported part of its consignment by steamship and the remainder by a country craft. At the relevant period the Government had issued a notification prohibiting the import of dates by steamers. Consequently the consignments that arrived by steamship were seized by the customs authorities under section 167, item 8, of the Sea Customs Act. The Act, however, permitted the importer to pay a monetary penalty in lieu of confiscation. The appellant elected to pay a sum of Rs 82,250 under the authority of section 183 and, upon payment of that amount, the seized dates were released to the firm.

After the release of the dates the appellant presented the amount paid as penalty before the Income‑Tax authorities and sought to deduct the sum as an allowable business expense under section 10(2)(XV) of the Income‑Tax Act. The tax authorities rejected the claim, holding that the payment could not be treated as a deduction. The appellant argued that the confiscation order targeted the stock‑in‑trade rather than the firm itself and that the penalty was incurred solely for the purpose of recovering that stock, thereby qualifying it as a legitimate business expenditure.

The Court held that the penalty paid for violating a statutory prohibition could not be characterized as an expenditure laid out wholly and exclusively for the purpose of the business. Accordingly, the amount was not deductible under section 10(2)(XV). The Court explained that deductions are permitted only for expenses that are incurred to enable a person to carry on a trade and to earn profit from that trade. It is insufficient that an outlay arises in the course of business or is connected with business profits; the expense must be incurred with the specific purpose of earning those profits. An expense is deductible only when it represents a commercial loss in the ordinary course of trade. A penalty imposed for a breach of law, even if paid during the course of business, is a public‑policy measure and cannot be treated as a commercial expense for the purposes of taxation.

The appeal was filed under special leave against the judgment and order of the former Bombay High Court in Income Tax Reference No. 57/X of 1954, dated 25 February 1955. The appellant was the firm that imported dates, while the respondent was the Commissioner of Income‑Tax. Counsel for the appellant and counsel for the respondent were instructed. The case was listed on 24 November 1960, and the judgment was delivered by Justice Kapur. The matter concerned the assessment year 1949‑50, with the accounting year ending on 25 July 1948. The appellant engaged in the business of importing dates from abroad and selling them within India. During the relevant accounting year the firm imported dates from Iraq. At that time two government notifications, dated 12 December 1946 and 4 June 1947, prohibited the import of dates by steamers, although import by country craft remained permissible. Consequently, the firm received its ordered consignment partly by steamer and partly by country craft. The portion that arrived by steamer, valued at five lakh rupees, was seized by the Customs Authorities under section 167, item 8 of the Sea Customs Act. Under section 183 of the same Act the appellant was offered the option of paying a fine of one lakh sixty‑three thousand nine hundred fifty rupees; on appeal that amount was reduced to eighty‑two thousand two hundred fifty rupees, which the appellant paid, and the dates were subsequently released.

After selling the released dates the firm earned profits and sought to deduct the amount of eighty‑two thousand two hundred fifty rupees, which it had paid as a penalty, in accordance with ordinary principles of commercial accounting. The Income‑Tax Officer rejected the deduction, and the decision was confirmed by the Appellate Assistant Commissioner. The appellant then appealed to the Income‑Tax Appellate Tribunal, where a majority of two judges to one held that the penalty payment was allowable as a deduction. The respondent asked the Tribunal to refer the question to the High Court for clarification, specifically whether, on the facts and circumstances of the case, the payment of eighty‑two thousand two hundred fifty rupees qualified as an allowable expenditure under section 10(2)(xv) of the Indian Income‑Tax Act. The Bombay High Court answered that the amount could not be characterised as a payment made for salvaging the goods; rather, it was a penalty imposed as a consequence of an illegal act committed by the appellant, and therefore it was not an allowable expense under the cited provision. The appellant firm thereby sought special leave to appeal this judgment to this Court.

The Court noted that any contract of hire purchase that might be contemplated could not be applied broadly, because such a contract contains both the element of bailment and the element of sale. At common law the term “hire‑purchase” is used with a specific meaning that distinguishes it from other arrangements.

In this discussion the term hire‑purchase was explained as applying correctly only to contracts that gave the hirer an option to purchase the goods, although the term was often employed to refer to agreements that were in fact instalment purchase arrangements in which ownership did not pass until all instalments were paid. The Court emphasized that the distinction between these two kinds of hire‑purchase contracts was of great importance. Under an instalment purchase contract, the hirer bore a binding obligation to buy the goods, and consequently the hirer could transfer a good title to any purchaser or pledgee who dealt with him in good faith and without notice of the true owner's rights. By contrast, where the contract merely conferred an option to purchase, the hirer was not bound to complete the purchase, and any purchaser or pledgee could acquire no better title than the hirer himself possessed, unless a sale in market overt applied; such a contract was not an agreement to buy within the meaning of the Factors Act of 1889 or the Sale of Goods Act of 1893. The observations quoted above were founded principally on two leading authorities that had become the classic statements of law on the subject. The first was Lee v. Butler, in which Lord Esher, Master of the Rolls, described the transaction as a “Hire and Purchase Agreement.” The second was Helby v. Matthews, in which the House of Lords distinguished the earlier case by holding that the latter involved a binding contract to buy rather than merely an option to buy, and that no obligation to purchase existed. Both decisions were rendered under the provisions of the Factors Act of 1889, section nine. The forms of agreement illustrated by those two cases would now fall within the definition of “hire‑purchase” provided in section twenty‑one of the Hire Purchase Act of 1938. That section defined a hire‑purchase agreement as an arrangement for the bailment of goods whereby the bailee may purchase the goods or where ownership of the goods may pass to the bailee, and where, by virtue of two or more agreements that individually did not constitute a hire‑purchase agreement, there is a bailment of goods and either the bailee may purchase the goods or ownership may pass to the bailee, the collection of agreements would be treated as a single agreement for the purposes of the Act at the time the last agreement was made. Nevertheless, the petitioners contended that in the present case there was no binding agreement to purchase the goods and that title remained with the owner absolutely, not merely as security for the payment of price. They relied on the third term of the agreement, which provided that when the hirer duly performed and observed the terms of the agreement, particularly with respect to the payment of the monthly instalments, the hiring would terminate and, at the hirer's option, the vehicle would become his absolute property; until such payments were completed, the vehicle would continue to be the property of the owners.

According to the agreement, the hirer was required to pay monthly instalments. The agreement provided that once the hirer had duly performed the terms and paid all instalments, the hiring relationship would terminate and, at the hirer’s option, the vehicle would become the hirer’s absolute property. Until the required payments were completed, the vehicle would remain the property of the owners. The hirer also retained the option of purchasing the vehicle at any time, subject to the conditions set out in the contract. In addition, the statute empowered a magistrate to enforce the payment of any penalty or increased rate of duty that remained unrecovered, treating the amount as if it were a fine imposed directly by the magistrate. The relevant statutory sections set out the punishments for violations of the import‑export prohibitions contained in sections 18 and 19, and they authorised the customs authorities to offer an option of payment in lieu of confiscation, specifying the manner in which such penalties were to be imposed. Consequently, when the appellants incurred liability, they did so as a penalty for an infraction of the law, and under section 167(8) the amount paid was characterised as a penalty.

In support of this position, counsel for the appellant referred to the decision in Maqbool Hussain et al. v. The State of Bombay, quoting the judgment of Bhagwati, J., who explained that confiscation is a penalty that the customs authorities may impose, but it operates as a proceeding in rem rather than a proceeding in personam, the object being to confiscate goods dealt with contrary to law, and that the owner may be offered the alternative of paying a fine in lieu of confiscation. Similar observations were made by S. K. Das, J., in Shewpujanrai Indrasanrai Ltd. v. The Collector of Customs & Ors., where the distinction between an action in rem and a proceeding in personam was stressed, and confiscation was described as a proceeding in rem with penalties enforced against the goods themselves. The Court’s approach in the other authorities cited by the appellant—namely Leo Roy, Frey v. The Superintendent, District Jail, Amritsar, and Thomas Dana v. The State of Punjab—echoed the same principle. In the Dana case, Subba Rao, J. observed that when the authority makes an order of confiscation it is a proceeding in rem and the penalty is enforced against the goods, whereas a penalty imposed directly against a person constitutes a proceeding against that person, who is then punished for the offence.

In the Court’s discussion, it explained that when an order of confiscation is made the proceeding is directed against the thing itself and not against the individual who possessed it, so that the individual is not prosecuted and no personal penalty is imposed. The Court therefore clarified that a confiscation proceeding does not amount to a prosecution of the person concerned, nor does it involve the imposition of a penalty on that person. In the case of Maqbool Hussain, the primary question before the Court was whether, after a proceeding under the Sea Customs Act, the accused could subsequently be prosecuted and rely on the defence of double jeopardy; the Court held that such a subsequent prosecution was not permissible. In the case of Shewpujanrai, the contention raised before the Court was that once proceedings had been initiated under the Foreign Exchange Regulation Act, the Customs Authorities were not authorised to take any further action under the Sea Customs Act; that contention was examined in light of the earlier decision. The two other authorities cited by counsel were said to be similar to the Maqbool Hussain decision. The matter now before the Court was of a different nature, because the issue was whether the penalty that the appellant firm had paid could be allowed as a deduction under section ten point two point xv of the Income‑Tax Act, which defines an allowable deduction as any expenditure, other than capital expense or personal expense of the assessee, that is laid out or expended wholly and exclusively for the purpose of the business, profession or vocation. The words “for the purpose of such business” had been interpreted in Inland Revenue v Anglo Brewing Co Ltd to mean “for the purpose of keeping the trade going and of making it pay”. The essential requirement for a deduction, therefore, was that the expenditure must have been laid out or expended wholly and exclusively for that business purpose.

To aid its analysis, the Court referred to several English decisions. In Commissioners of Inland Revenue v Warnes & Co, the assessee, who was engaged in the oil‑exporting business, was sued for a penalty under the Sea Customs Consolidation Act after the Attorney‑General exhibited information showing breach of orders and proclamations. The matter was resolved by consent when the assessee agreed to pay a reduced penalty of two thousand pounds, and all imputation of moral culpability was withdrawn. The statutory provision under which the information was lodged and the penalty was paid was similar to the provisions of the Indian Sea Customs Act. The Court held that the penalty could not be allowed as a deduction because, to fall within a provision analogous to section ten point two point xv of the Indian Act, the loss must be something that is within commercial contemplation and of the nature of a commercial loss. Rowlatt, J., relying on Lord Loreburn’s observation in Strong & Co v Woodifield, stated that a penal liability of this kind could not be regarded as a loss connected with or arising out of a trade. This reasoning was subsequently affirmed in Commissioners of Inland Revenue v Alexander Von Glehn & Co Ltd, where a similar consent‑settlement involved a penalty of three thousand pounds that the Special Commissioners held could not be treated as a deductible expense.

In the case under consideration, the Court observed that a loss which is connected with or arises out of a trade must, at the very least, be something that can be contemplated as a commercial loss. The Court clarified that this description was not intended to be exhaustive, but it insisted that it could not be said that a fine—such as the penalty imposed in the present matter—constituted a “loss connected with or arising out of” the trade within the meaning of the rule. This principle had been endorsed in the decision of Commissioners of Inland Revenue v. Alexander Von Glehn & Co. Ltd., where, under similar circumstances, the assessee had paid a penalty of £3,000 by consent and then claimed the penalty together with the associated costs as deductions in computing profit. The Special Commissioners had held that the penalty and costs were incurred in the course of the assessee’s trade and were therefore admissible deductions. However, on a reference, Rowlatt, J. classified the amount as a non‑deductible item, a finding that was later affirmed on appeal by the Court of Appeal. Lord Sterndale, M. R., expressed the view that it was irrelevant whether the proceedings were technically criminal; the money was paid as a penalty and the terminology used in the information, whether “forfeiture” or otherwise, did not alter its character. The assessee argued that no moral culpability had been attached to them and contended that the nature of the expense—whether arising from a legal infraction or being a penalty for an illegal act—was immaterial. Lord Sterndale, citing paragraph 565, remarked that the business could have been conducted without any infraction, and that the penalty, imposed because of an infraction, was not comparable to an expense laid out for the purpose of the trade as discussed in Strong & Co. v. Woodifield. Warrington L.J., at paragraph 569, described the sum as one that the persons conducting the trade were forced to pay because their conduct rendered them liable to the penalty. He concluded that such a payment was not a commercial loss, and that when the Act referred to a loss connected with or arising out of a trade, it meant a commercial loss that was truly incidental to the trade. The earlier case of Strong & Co. v. Woodifield involved a brewing company that owned a licensed house and operated it as an inn; the company incurred a liability for damages arising from a chimney collapse, and that sum was held not to be allowable as a deduction in computing profits.

In explaining the law on allowable deductions, the Court observed that a sum could be deducted from profits only when it was money that had been wholly and exclusively laid out or expended for the purpose of the trade. Lord Loreburn, speaking for the Court, emphasized that only losses which were truly incidental to the trade itself could be deducted, and that expenses incurred in a character other than that of a trader were excluded. Lord Davey further clarified that a disbursement must be made for the purpose of earning profits; it was insufficient for the expense merely to arise in the course of trade, to be connected with trade, or to be funded from trade profits.

The Court then turned to the principle illustrated in the judgment of Lord Sterndale in the Von Glehn case. He explained that when a company, during the course of its trading activities, committed a breach of law and was consequently fined, the fine represented a personal penalty imposed on the company rather than a commercial loss arising from the trade. He acknowledged the difficulty of articulating the distinction in precise language but maintained that a clear difference existed between a loss incurred in the ordinary course of business and a penalty imposed for a statutory violation. Accordingly, the Court affirmed the earlier decisions of Rowlatt, J., in the present matter and in Inland Revenue Commissioners v Warnes & Co., holding that the appeal should be dismissed with costs.

In the case of Spofforth and Prince v Glider, the assessee was a firm of chartered accountants that sought to deduct legal costs incurred in connection with the successful defence of one of its partners in a Police Court, as well as expenses for legal advice relating to other proceedings. The firm argued that all of the costs were wholly and exclusively laid out for the purpose of its profession and therefore should be allowable deductions. The Special Commissioner rejected the claim, a decision that was upheld by the Court. Applying the test articulated by Lord Davey in Strong & Co. v Woodifield, the Court held that, except for the expenses incurred in obtaining legal advice, the other legal costs could not be admitted as deductions because they were not wholly and exclusively incurred for the purpose of earning professional profits.

In this case the Court examined whether the entire sum of costs incurred in the legal proceedings could be described as “wholly and exclusively” laid out or expended for the appellant’s profession and therefore permitted as a deduction. The Special Commissioner had ruled against the assessee on that issue and the Court upheld that finding. Applying the test laid down by Lord Davey in Strong & Co. v. Woodifield (1), the Court held that, except for the expenses incurred in obtaining legal advice, the remaining costs were not admissible. The Court then turned to the authority in Farrie v. Hall (2), where a sugar broker, identified as F, was sued for libel. The High Court found that F had acted maliciously, rejected his defence of privilege and awarded damages against him. F attempted to claim those damages as an allowable deduction, arguing that the payment was an expenditure laid out wholly and exclusively for the purposes of his trade or, alternatively, a loss arising out of the trade. Relying on the earlier authorities, the Court disallowed the deduction, observing that the damages represented a penalty incurred in the character of a calumniator of a rival sugar broker and were only remotely connected with his business as a sugar broker. Consequently the expenditure was not laid out exclusively and wholly for the purpose of his trade. The Court also cited the observations of Danckwerts, J., in Newson v. Robertson (3), which explained that when a taxpayer incurs an expense that serves more than one purpose – both a commercial purpose of earning trade profits and an extraneous purpose – the expense cannot be claimed because it is not wholly and exclusively laid out for the trade. The illustration involved a barrister who claimed travelling expenses between his house and his chambers; the claim was disallowed because the traveller’s purpose was mixed and not wholly and exclusively for his profession.

Turning to Indian authorities, the Court discussed Mask & Co. v. Commissioner of Income‑tax, Madras (1). In that case the assessee, having breached a contract, sold crackers at a lower price and was subsequently ordered to pay damages for breach of contract, which he then sought to treat as an allowable deduction. The Court held that, because the assessee had disregarded the contractual undertaking and acted dishonestly, the payment did not qualify as an allowable expenditure. Sir Lionel Leach, C. J., after referring to Warne’s case (2) and Von Glehn’s case (3), concluded that the amount did not fall within section 10(2)(xii). The Madras High Court decision in Senthikumara Nadar & Sons v. Commissioner of Income‑tax, Madras (4) was also cited; it held that the payment of a penalty for an infringement of the law fell outside the permissible deductions under section 10(2)(xv). In that case the assessee was required to pay liquidated damages that were akin to a penalty for an act contrary to public policy.

The Court observed that the damages in question were essentially a penalty imposed for conduct that contravened public policy, specifically the policy embodied in the Coffee Market Expansion Act, 1942, the enforcement of which was left to the Coffee Board. During the arguments, reference was also made to the decision in Commissioner of Income‑tax v. Hirjee. In that case the assessee had been prosecuted under the Hoarding and Profiteering Ordinance, was ultimately acquitted, and thereafter sought to deduct the amount he had spent on his defence under section 10(2)(xv) of the Act. The Court held that drawing a distinction between legal expenses incurred in a successful defence and those incurred in an unsuccessful defence was not appropriate; the test for deductibility under section 10(2)(xv) depended on the nature and purpose of the legal proceedings in relation to the business whose profits were being computed, and the deductibility was not affected by the ultimate outcome of the proceedings. A review of the cited authorities—namely the cases reported in [1943] 11 I.T.R. 454, [1910] 2 K.B. 444, [1920] 2 K.B. 553, [1957] 32 I.T.R. 138 and [1953] S.C.R. 714—demonstrated that only expenses made for the purpose of carrying on the business, that is, expenses intended to enable a person to conduct the business and earn profit, could be allowed as deductions. It was emphasised that it is insufficient for a disbursement merely to arise out of, be concerned with, or be paid out of the profits of the business; the expenditure must be incurred for the purpose of earning those profits. As reiterated in Von Glehn’s case, an expenditure is deductible only when it constitutes a commercial loss in the course of trade, and a penalty imposed for a breach of law during the course of trade does not satisfy this requirement. Consequently, if an assessee pays a sum because, in conducting his business, he has acted in a manner that renders him liable to a penalty, that sum cannot be claimed as a deductible expense. Such a payment must be a commercial loss in its very nature to be allowable. Penalties incurred by an assessee in proceedings initiated against him for an infraction of the law cannot be characterised as commercial losses incurred in the ordinary course of business, because an infraction of law is not a normal incident of trade. Only those disbursements that are truly incidental to the business itself may be deducted; expenses that fall upon the assessee in a capacity other than that of a trader are excluded. Therefore, when a penalty is imposed for contravention of a specific statutory provision, it cannot be regarded as a commercial loss falling on the assessee as a trader. The test remains that expenses which enable a person to carry on trade and make a profit are permitted, whereas expenses that are merely connected with the business are not. It was argued that unless the penalty is of a nature which

In this case, the Court observed that the argument that a penalty is personal to the assessee or that it is imposed only on imported goods does not create a valid ground for allowing a deduction. The Court explained that a disbursement can be deducted only when it falls within section 10(2)(xv) of the Income‑tax Act and when it satisfies the test articulated in the earlier authorities, namely that the expense must be incurred wholly and exclusively for the purpose of the business. The Court considered whether a penalty paid for a statutory infraction, even where no personal liability in the sense of a criminal fine exists, could be characterised as wholly and exclusively laid for the business, citing the decision reported in (1) (1920) 2 K.B. 553. The Court concluded that no expense that is incurred as a penalty for violating the law can be described as an amount wholly and exclusively laid for the purpose of the business. The Court further rejected the distinction drawn between a personal liability and the liability presently before it, holding that any act constituting a breach of law and attracting a penalty cannot, on public‑policy grounds, be treated as a commercial expense or as a disbursement incurred for earning business profits. Accordingly, the Court affirmed the view of the High Court that the amount claimed by the appellant was not deductible. On that basis, the Court dismissed the appeal, ordered the appellant to bear costs, and entered a final order of dismissal.