The Commissioner of Income-Tax, Bombay vs Chandulal Keshavlal and Co., Petlad

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

Court: Supreme Court of India

Case Number: Civil Appeal No. 167 of 1958

Decision Date: 17 February 1960

Coram: P.B. Gajendragadkar, A.K. Sarkar, Kapur J.

In this case the Supreme Court of India delivered its judgment on 17 February 1960. The bench was composed of P.B. Gajendragadkar and A.K. Sarkar. The petitioner was the Commissioner of Income‑Tax, Bombay and the respondent was Chandulal Keshavlal & Co., a firm of agents based in Petlad. The respondent acted as the managing agent of a certain company. For the accounting year referred to as “950” the respondent’s total commission from the managed company amounted to Rs 3,09,114. During that year the directors of the managed company orally requested that the respondent accept only Rs 1,00,000 as commission and that the balance be relinquished. The respondent complied with this request and gave up Rs 2,09,114 of the commission.

The Income‑Tax Officer, together with the Appellate Assistant Commissioner, held that the entire sum of Rs 3,09,114 had accrued to the respondent and therefore the whole amount was taxable. On appeal before the Appellate Tribunal, the Tribunal concluded that the portion relinquished—Rs 2,09,114—could be allowed as a deduction under Section 10(2)(XV) of the Income‑Tax Act. In reaching that conclusion the Tribunal recorded several factual observations: (i) the financial condition of the managed company was unsatisfactory; (ii) the respondent had previously, in similar situations, remitted part or all of its commission when the managed company’s profits were low; (iii) if the full commission of Rs 3,09,114 had been retained, the managed company’s profit for the year would have been Rs 3,63,078, which would have been the lowest profit recorded since 1940; (iv) the relinquishment was not a bounty paid by the respondent to the managed company; (v) the respondent’s business was closely linked with that of the managed company, and improving the latter’s financial position would enable the respondent to earn a larger commission in the future; and (vi) the respondent accepted the reduced commission of Rs 1,00,000 at the request of the managed company.

The Commissioner of Income‑Tax argued that Section 10(2)(XV) should apply only when an expenditure is incurred directly for the respondent’s own business, and not where the benefit to the respondent is indirect, arising solely from the advantage conferred on the managed company. The Supreme Court held that the Tribunal’s finding—that the amount claimed as a deduction under Section 10(2)(XV) was incurred wholly and exclusively for the purpose of the respondent’s business—was a question of fact. Because the Tribunal’s finding was supported by evidence, the Court declined to interfere. The Court further stated that in determining whether an outlay is a deductible expense, the considerations of commercial expediency and the ordinary principles of trade must be borne in mind; the fact that the payment also benefited a third party does not, by itself, preclude deduction, provided the expense was incurred for the respondent’s own trade or business.

When an expenditure was incurred for the purpose of the assessee’s trade or business, the fact that the payment also benefited a third party was irrelevant. The court considered another criterion, namely whether the transaction had been properly entered into as part of the assessee’s legitimate commercial undertaking, with the aim of facilitating the continuation of its business. However, the court cautioned that if an expense was made solely to promote the business of another party, or if it represented a distribution of profits, a gratuitous payment, or any purpose that was improper, oblique, or outside the normal course of business, such expense could not be allowed as a deduction. In reaching this conclusion, the court referred to several authorities, including Tata Sons Ltd v. The Commissioner of Income‑tax, Bombay (1950) I.T.R. 460, Union Cold Storage Company Ltd v. Jones 8 T.C. 725, Odhams Press Ltd v. Cook 23 T.C. 233, Usher’s Wiltslire Brewery Ltd v. Bruce 6 T.C. 399, Easterr Investments Ltd v. The Commissioner of Income‑tax, West Bengal [1951] S.C.R. 594, and Atherton v. British Insulated & Helsby Cables Ltd 10 T.C. 156. The judgment was rendered in a civil appellate jurisdiction, specifically Civil Appeal No. 167 of 1958, which had been granted special leave to be heard after the High Court of Bombay’s order dated 15 February 1955 in Income‑tax Reference No. 29 of 1953. The appellant before the Supreme Court was the Commissioner of Income‑tax, and the respondent was a partnership firm that, under an agreement dated 23 September 1935, had been appointed the Managing Agent of Keshav Mills Ltd., Petlad. For convenience, the judgment referred to the partnership as the Managing Agent and to Keshav Mills Ltd. as the Managed Company. Clause 4 of that agency agreement stipulated that the Managing Agent was entitled to a commission of four per cent on the sale proceeds of cloth, yarn or any other goods manufactured and sold by the company, and fifteen per cent on the amounts of bills for charges such as ginning, pressing, dyeing, bleaching, labour and other work performed in the factory. The commission was exclusive of other charges like ad‑valorem, interest, discount or brokerage. The commission earned was to be credited to the Managing Agent’s account every six months, and it was to accrue interest at a rate of six per cent per annum on the credited amount. The agreement contained additional conditions, but those were not material to the issues before the court. The total commission accrued for the accounting year 1950 amounted to Rs. 3,09,114. During that year, at the oral request of the Board of Directors of the Managed Company, the Managing Agent agreed to accept only Rs. 1,00,000 as its commission, and this sum was recorded in the company’s books at the end of 1950.

During the accounting year, the Board of Directors of the Managed Company orally requested that the Managing Agent accept a reduced commission of one lakh rupees, and the Managing Agent agreed to this arrangement. Consequently, the sum of one lakh rupees was credited to the Managing Agent’s account in the company’s books at the close of the year 1950. The Income‑Tax Officer, together with the Appellate Assistant Commissioner, held that the commission which had accrued to the Managing Agent amounted to three lakh nine thousand one hundred fourteen rupees and that the entire amount was taxable. The Managing Agent appealed this assessment before the Income‑Tax Appellate Tribunal. By an order dated 26 February 1953, the Tribunal affirmed that the commission which had accrued was indeed three lakh nine thousand one hundred fourteen rupees, but it accepted only one lakh rupees as taxable income. The balance of two lakh nine thousand one hundred fourteen rupees was treated as an allowable expenditure under section 10(2)(xv) of the Act and was therefore permitted as a deduction. In reaching this conclusion, the Tribunal observed that the Managing Agent had, on previous occasions and in the interest of the Managed Company, voluntarily waived a portion of its commission. The Tribunal stated that such a foregone commission, when relinquished for the benefit of the Managed Company, would qualify as an expenditure under section 10(2)(xv) and consequently would be allowable. Dissatisfied with this order, the Managing Agent (the appellant) proceeded to seek the opinion of the Bombay High Court on two points: first, whether the sum of two lakh nine thousand one hundred fourteen rupees was assessable as income in the hands of the assessee; and second, if it were assessable, whether that sum could be deducted under section 10(2)(xv) of the Act. The High Court’s judgment indicated a tendency to decide the questions in favour of the appellant, but at the appellant’s request the Tribunal was directed to furnish a supplementary statement. No new evidence was presented before the Tribunal, although particular attention was given to a letter dated 18 September 1951, written by the Managing Agent to the Income‑Tax Officer. In that letter the Managing Agent asserted that the only commission that had accrued to it was one lakh rupees and that no portion had been foregone or relinquished. The letter explained that the one‑lakh‑rupee commission arose because of a variation in the terms of the Managing Agency Agreement. The correspondence also referred to the Balance Sheet of the Managed Company as of 31 December 1950, which showed a paid‑up capital of thirty lakh rupees and a depreciation fund of fourteen lakh rupees, totaling forty‑four lakh rupees. Against this capital the Block Account recorded a debit exceeding forty‑eight lakh rupees, the purpose of which, as explained, was to strengthen the financial position of the Managed Company; in this context the Chairman of the Board of Directors had requested, and the Managing Agent had agreed, that the commission be limited to one lakh rupees.

The Court recorded that the Managed Company was in a weak financial condition, and that, in order to improve that condition, the Chairman of the Board of Directors asked the Managing Agent to accept a commission of one lakh rupees. The Managing Agent consented to this reduced commission. Subsequently, the Income‑Tax Appellate Tribunal filed a supplementary Statement of Case on 3 May 1954. In that statement the Tribunal asserted four principal conclusions. First, it declared that there was no hidden or improper motive in the Managing Agent’s decision to accept one hundred thousand rupees instead of the usual three lakh rupees and that the reduction of the commission was made in good faith. Second, it observed that the Department had never suggested, even faintly, that the Managing Agent’s forfeiture of part of the commission was driven by any dishonest intention. Third, it held that the amount forgone by the Managing Agent constituted an expenditure incurred wholly and exclusively for the purpose of the Managing Agent’s own business. Fourth, it affirmed that, at the time the appeal was decided, the Tribunal had no doubt that the commission was relinquished for legitimate business considerations and that the forfeiture was made for reasons of commercial expediency.

Paragraph four of the supplementary Statement was particularly noteworthy. It explained that the Tribunal had assumed that what benefitted the Managed Company would also benefit the Managing Agent, because the interests of the two entities were closely linked. It further stated that if the Managed Company were placed on a more sound financial footing, not only would its shareholders gain, but the Managing Agent would also stand to receive a larger commission in the future. The Court then outlined the fundamental facts emerging from the Statement of Case and from the documents produced by the Managing Agent. These facts were: (i) the Managed Company’s balance sheet revealed an unsatisfactory financial position; (ii) historically, the Managing Agent had, whenever the Managed Company’s profits were inadequate, remitted part or the whole of its commission; (iii) for the accounting year in question, the Managed Company reported a profit of five lakh seventy‑two thousand one hundred ninety‑two rupees after paying the Managing Agent a commission of one lakh rupees; had the entire accrued commission been deducted, the profit would have fallen to three lakh sixty‑three thousand seventy‑eight rupees, which would represent the lowest profit since 1940 and the highest commission amount; (iv) the reduction of commission was not a gratuitous gift from the Managing Agent to the Managed Company; (v) the Managing Agent’s business was so intertwined with that of the Managed Company that improving the latter’s financial health would inevitably lead to a larger future commission for the former; and (vi) the Managing Agent had accepted the reduced commission of one lakh rupees at the request of the Chairman of the Board of Directors of the Managed Company. These matters formed the material basis on which the Tribunal rendered its finding in the supplementary Statement that the amount given up by the assessee was an expenditure incurred for the purpose of the assessee’s business.

The Court observed that the amount advanced by the assessee was characterised as an expenditure incurred for the purpose of the assessee’s business. Relying on this characterisation, the High Court, in its judgment dated 15 February 1955, held that the finding of the Appellate Tribunal constituted a finding of fact. The High Court quoted its own reasoning, stating: “Now this is a finding of fact and unless it can be suggested that there was no evidence to support the finding of fact we are concluded by this finding of fact.” On the basis of that conclusion, the High Court answered the issue raised under section 10(2)(xv) of the Income‑Tax Act in favour of the Managing Agent. The appellant, dissatisfied with that judgment and order, appealed to this Court by way of special leave. The appellant contended that there was no evidence to support the Tribunal’s finding that the sum of approximately two lakh rupees, which the Managing Agent had foregone, was wholly and exclusively laid out for the purpose of the Managing Agent’s own business. Emphasis was placed on the Tribunal’s order dated 26 February 1953, which observed that, historically, the commission had been surrendered by the Managing Agent in the interest of the Managed Company, and that a commission or portion thereof foregone in the interest of the Managed Company could not be treated as an allowable expenditure under section 10(2)(xv). The appellant further argued that there was no evidence establishing that the amount was expended for the benefit of the Managing Agent. Even assuming that the foregone amount indirectly aided the Managing Agent because it benefited the Managed Company, the appellant maintained that section 10(2)(xv) would not be triggered. In other words, the inquiry should focus on the direct effect on the Managing Agent rather than on remote or indirect consequences that may arise from any benefit to the Managed Company. The central question, according to the appellant, was whether the benefit accrued to the assessee—that is, the Managing Agent—or to some other party. In support of these submissions, the learned Solicitor General referred to the decision in Tata Sons Ltd. v. The Commissioner of Income‑Tax, Bombay, wherein the assessee acted as Managing Agent of another company and was entitled to receive commission on the net profits of the Managed Company. During the relevant year, the assessee voluntarily contributed a sum of money towards a bonus paid by the Managed Company to some of its officers and claimed that contribution as a deductible expenditure under section 10(2)(xv).

In this case the Court explained that the purpose of the payment, when examined according to ordinary commercial principles, was to improve the efficiency of the Managed Company and consequently to raise the profits of the Managed Company together with the commission earned by the Managing Agent. The Court therefore found a significant connection between the Managed Company and the Managing Agent. It further held that the determination of whether money was entirely expended or laid out for the purpose of the assessee’s trade must be made on the basis of ordinary commercial trading principles. Accordingly, money that was wholly and exclusively laid out for the trade of the assessee could be treated as a deduction, whereas expenditures on machinery and plant that were not employed for those purposes could not be allowed as deductions.

The Court noted that in the earlier case the agreement secured for the assessee company not only the right to receive a specified sum but also gave the American company an incentive to direct business to the assessee so that its profits would reach the stipulated amount. The Court, however, decided that for a deduction to be permissible, the expenditure must benefit the trade that immediate concerns the assessee company. It added that if the expenditure satisfied this condition, the deduction would be prima facie proper even though it might also benefit a third party, and the question should be examined from the standpoint of the assessee company. The learned Solicitor General referred to a passage at page 741 of the judgment, which observed that the Commissioners found a reflex result of the agreement that benefited the appellant company, but that result was not a direct consequence. The Commissioners further stated that the arrangements concerning stores, machinery and plant were not of an ordinary nature and did not expand the appellant’s market, and that the machinery and plant in question were primarily used for the trade of the National Company. Based on those findings, the Court concluded that the present facts distinguished this case entirely from the precedent set in Usher’s case.

The Court reiterated the test articulated after reference to Usher’s Wiltshire Brewery Ltd. v. Bruce, namely that a deduction may be allowed when the payment or expenditure is incurred for the purpose of the trade of the entity filing the return, irrespective of any benefit that may flow to a third party. Another authority cited was Eastern Investments Ltd. v. The Commissioner of Income‑tax, West Bengal, where a private limited company with a share capital of rupees 250 lacs, of which rupees 50 lacs were held by a particular shareholder, was involved in a transaction that was later examined for its commercial nature and its impact on the assessee’s business.

In the matter before the Court, the petitioner company owned shares that were divided between a person identified as A and the remaining shares held by A’s nominees. The company required additional funds, and with A’s consent the board resolved to reduce its share capital by fifty lakh rupees. To effect this reduction, the company reacquired shares worth fifty lakh rupees and, in exchange, issued debentures to A whose face value was fifty lakh rupees and which carried an interest rate of five percent. The Income‑Tax Appellate Tribunal, followed by the High Court, held that the interest payable on those debentures could not be allowed as a deduction under section twelve two of the Income‑Tax Act. Upon appeal, this Court examined the nature of the transaction from the perspective of the assessee company. After reviewing all the surrounding facts, the Court concluded that the transaction had been entered into voluntarily and was intended, albeit indirectly, to facilitate the continuation of the company’s business. Consequently, the Court characterized the arrangement as one of commercial expediency. An argument was raised that the debentures were held by a shareholder, but the Court rejected that line of reasoning, observing that the ownership of the debentures—whether by a shareholder or by an external party—made no difference to the tax consequences. The Court thereby articulated a test: where no fraud or hidden motive is present, and where a transaction is entered into in the ordinary course of the assessee’s business and is commercially sensible, the expenditure may be treated as a deductible allowance. The Court further held that any benefit flowing to the assessee as a result of the transaction was sufficient, even if a third party also derived a benefit.

At page five hundred ninety‑nine, Justice Bose remarked that, in the absence of any suggestion of fraud, the purpose of the provision should be given effect without regard to the identity of the beneficiary. He noted that most commercial transactions are undertaken for the mutual benefit of the parties involved, or at the very least each side expects to obtain something for itself. The relevant test, according to the Court, was not to inquire whether the other party gained, nor to assess whether the transaction was a prudent one that ultimately resulted in gain to the appellant; rather, the critical enquiry was whether the transaction had been properly entered into as a part of the appellant’s legitimate commercial undertaking, and whether it indirectly facilitated the carrying on of its business. The Court further referred to the decision in Odhams Press Ltd. v. Cook, where the assessee company had purchased all the shares of a subsidiary and had printed and published a periodical on behalf of that subsidiary. During the accounting year the subsidiary incurred a loss, and the parent company wrote off that loss against amounts due from the subsidiary, claiming a deduction as an expense incurred for its trade. The Special Commissioners held that the loss was not written off wholly or exclusively for the purpose of the parent’s trade or business, and therefore the claimed deduction was inadmissible. The Court underscored that the determination of whether such a deduction was allowable was a question of fact.

In the discussion, the Court noted that there was evidence sufficient to support the conclusion reached by the Commissioner. Viscount Caldecote, speaking as a Lord of the Court of Appeal, explained that the trade or business of one company, even when it closely influences the trade or business of another company, remains distinct from the other company’s trade. Accordingly, when the assessor computes the profits and gains of the assessee, the relevant consideration is the trade of the assessee itself. Viscount Maugham, referring to page 110 of the record, observed that the issue essentially answered itself. He pointed out that two relationships between the appellant company and Coming Fashions Ltd. had already been identified. The allowance of £2 927 5s 8d to Coming Fashions Ltd. could have been laid out or expended for the purpose of Coming Fashions’ trade, or to some extent for both companies’ purposes, and he held that these facts alone were enough to demonstrate that there was evidence supporting the Commissioner’s finding that the sum written off was not wholly and exclusively for the purpose of the appellant’s trade or business.

The Court explained that, apart from the mere holding of shares, the connection between the assessee company and its subsidiary consisted of the assessee’s printing services for the subsidiary. The transaction resulted in the subsidiary’s loss being debited to the assessee’s accounts, yet there was no direct link between the assessee’s profits and the amount claimed as a deduction. The essential point, according to the Court, was that the amount was not wholly and exclusively written off for the benefit of the assessee’s own business. Viscount Maugham further questioned whether any real ground existed, based on the evidence, to contend that one reason for writing off the sum was to enable Coming Fashions Ltd. to continue its business as a compiler and vendor of the publication “Every Woman’s.”

The Court then turned to the statutory provision under section 10(2)(xv) of the Income‑Tax Act, emphasizing that each case requires a factual determination of whether the amount claimed as a deductible allowance was laid out wholly and exclusively for the purpose of the assessee’s business. If the Income‑Tax Appellate Tribunal, after examining the evidence, arrives at a conclusion that is justified by the factual material, that conclusion must be accepted and the deduction allowed. The Court stressed that the Tribunal’s decision on such factual questions must be upheld wherever the evidence could plausibly support it.

Finally, the Court observed another principle emerging from the earlier authorities: an expense incurred solely to foster the business of another entity, or an expense made as a distribution of profits, or an expense that is wholly gratuitous or pursued for an improper or indirect purpose outside the normal course of business, is not deductible. In determining whether a payment qualifies as a deductible expenditure, the Court said, it is necessary to consider questions of commercial expediency and the ordinary principles of trading. An expenditure may be permitted even if it indirectly benefits a third party, provided it is incurred for the purpose of the assessee’s own trade. The Court reiterated that the decisive factor remains whether the outlay was made wholly and exclusively for the assessee’s trade or business.

The Court explained that the test for deductibility includes the principles of ordinary commercial trading. It held that if a payment or expenditure is incurred for the purpose of the assessee’s trade, it is irrelevant that the payment may inure to the benefit of a third party, as stated in Usher's Wiltshire Brewery Ltd. v. Bruce. Another test, according to Eastern Investments Ltd. v. The Commissioner of Income‑tax, West Bengal, is whether the transaction is entered into as part of the assessee’s legitimate commercial undertaking in order to facilitate the carrying on of its business, and it is immaterial that a third party also benefits. Nevertheless, the Court emphasized that in every case the question of fact is whether the expenditure was laid out wholly and exclusively for the purpose of the trade or business of the assessee. In the present case the Tribunal found that the amount was laid out for the purpose of the assessee’s business and that there is evidence to support this finding. Counsel referred to Atherton v. British Insulated & Helsby Cables Ltd., where Viscount Cave L.C. at page 191 observed that a sum of money expended voluntarily, on the ground of commercial expediency and indirectly to facilitate the business, may still be expended wholly and exclusively for the purpose of the trade. He quoted the earlier cases of Usher's Wiltshire Brewery v. Bruce and Smith v. Incorporated Council of Law Reporting, stating that such expenditure, though not of necessity, can be deductible when incurred for commercial expediency. Viscount Cave noted that the Commissioners’ findings in the present case bring the payment within that description, because the payment was made for the sound commercial purpose of retaining existing and future staff and increasing staff efficiency.

The Crown contended that the sum of £31,784 was not wholly and exclusively laid out for trade purposes, but the Commissioners concluded that the deduction was admissible, thereby rejecting the Crown’s contention. Viscount Cave expressed that there was ample material to support the Commissioners’ findings and that the prohibition did not apply. Consequently, in cases such as this, to justify a deduction the sum must be incurred for reasons of commercial expediency; it may be voluntary, but so long as it benefits the assessee, the deduction is claimable. The Income‑tax Appellate Tribunal found in favour of the Managing Agent that the amount was expended for commercial expediency, not as a bounty, but to strengthen the Managed Company, and that a stronger financial position of the Managed Company would benefit the Managing Agent.

In the factual scenario presented, the strengthening of the Managed Company inevitably resulted in a corresponding benefit accruing to the Managing Agent. The Tribunal identified this relationship as a factual finding that the Managed Company’s improved financial position would directly enhance the Managing Agent’s interests. Relying upon that factual finding, the Income‑tax Appellate Tribunal correctly determined that the expenditure in question satisfied the criteria for a deductible expense under section 10(2)(xv) of the Income‑Tax Act. The Supreme Court affirmed that the High Court’s judgment, which had accepted the Tribunal’s conclusion, was well‑founded. Consequently, the Court ordered that the appeal be dismissed and that the appellant bear the costs of the proceedings. The appeal was therefore dismissed with costs awarded to the respondent.