A. V. Thomas and Co., Ltd., Alleppey vs. The Commissioner of Income‑Tax (Bangalore) Kerala

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

Court: supreme-court

Case Number: Civil Appeal No. 214 of 1962

Decision Date: 25 October 1962

Coram: J.L. Kapur, S.K. Das, A.K. Sarkar, M. Hidayatullah, Raghubar Dayal

In the matter titled A. V. Thomas & Co., Ltd., Alleppey versus The Commissioner of Income‑Tax (Bangalore), the Supreme Court delivered its judgment on 25 October 1962. The judgment was authored by Justice J. L. Kapur, and the bench was composed of Justices J. L. Kapur, S. K. Das, A. K. Sarkar, M. Hidayatullah, and Raghubar Dayal. The citation for the decision appears in the 1964 All India Reporter at page 569 and in the Supplement to the Supreme Court Reports, 1963, at page 608. The case concerned the interpretation of sections 10(2)(xi) and 10(2)(xv) of the Indian Income‑Tax Act, 1922 (Eleventh of 1922), dealing respectively with deductions for bad debts and for expenditures not of a capital nature that are wholly and exclusively incurred for the purpose of business. The petitioner, A. V. Thomas & Co., Ltd., was a company incorporated in 1935 whose memorandum of association expressly empowered it to promote and establish other companies and to provide financial assistance to such enterprises. The director of the petitioner, Mr. A. V. Thomas, also served as director of another firm, Southern Agencies Ltd. In 1948 Southern Agencies Ltd. commenced the promotion of a new entity to be called Rodier Textile Mills Ltd., intending to acquire an existing textile mill known by the same name. The petitioner advanced a sum of a little over six lakh rupees to the promoter for the purchase of six thousand shares in the newly formed company. However, the public showed no interest in the venture, the project failed, no application for shares was made on behalf of the petitioner, and consequently no shares were acquired. Southern Agencies Ltd. returned only two lakh rupees on 7 December 1951, which the petitioner accepted as full satisfaction. The remaining balance of Rs 4,05,071‑8‑6 was written off in the petitioner’s books on 31 December 1951, the closing date of its financial year.

For the assessment year 1952‑53 the petitioner claimed a deduction of the written‑off amount, either as a bad debt under section 10(2)(xi) or, alternatively, as an expenditure not of a capital nature under section 10(2)(xv). The Court held that the amount advanced for the purchase of shares constituted a capital investment and therefore could not be treated as an allowable expenditure under section 10(2)(xv). The Court observed that it was not within the ordinary business of the petitioner to buy agencies and subsequently sell them, and furthermore the amount had been expended in 1948, not in the financial year ending 31 December 1951. Consequently, the deduction was disallowed. The Court further ruled that the loss could not be classified as a bad debt under section 10(2)(xi). It explained that a debt that qualifies as a bad debt is one which, if recovered, would increase the taxpayer’s profits; by contrast, the sum in question represented money advanced for a purchase that never materialised, and the intended purchase was never completed. The Court therefore concluded that the claim for deduction was untenable, referencing the principle articulated in Curtis v. J. & … to support its reasoning.

The Court recorded that the earlier authorities cited by the parties included G. Old Field Ltd. (1925) 9 Tax Cas. 319; Arunachalam Chettiar v. Commissioner of Income‑Tax (1936) L.R. 63 I.A. 233; Badridas Daga v. Commissioner of Income‑Tax, [1959] S.C.R. 690; and Commissioner of Income‑Tax v. Abdullabhi Abdulakadar, [1961] 2 S.C.R. 949. The matter came before the Supreme Court in civil appellate jurisdiction as Civil Appeal No. 214 of 1962, an appeal against the judgment dated 8 July 1960 of the Kerala High Court, Emakulam, rendered in Income‑tax Referred Case No. 10 of 1957. Counsel for the appellant and counsel for the respondent were instructed, and the appeal was heard on 25 October 1962. The judgment was delivered by Justice Hidayatullah. The appellant, A.V. Thomas & Co., Ltd., Alleppey, had claimed a deduction of Rs 4,05,072‑8‑6 for the assessment year 1952‑53 on the ground that the amount represented a bad debt written off in its books on 31 December 1951. The assessing authority had disallowed the claim. After the procedural steps taken, the High Court of Kerala examined the question whether, based on the facts and circumstances, the Tribunal was correct in holding that the amount claimed by the assessee could not be allowed under section 10(2)(xi) or section 10(2)(xv) of the Income‑Tax Act. The High Court certified the case as suitable for appeal, and the present appeal was filed by the assessee company, with the Commissioner of Income‑Tax (Bangalore), Kerala, as respondent.

The Court noted that the assessee company had been incorporated in 1935 and its Memorandum of Association authorised it to engage in a variety of businesses. Specifically, clauses 1, 5, 18 and 23 permitted the company “to be interested in, to promote, and to undertake the formation and establishment of other companies”, to make investments and to provide financial or other assistance to any company. At the relevant time, the board consisted of three directors: A.V. Thomas, S. Sankaranarayana Iyer and J. Thomas. Another private limited company, Southern Agencies Limited, Pondicherry, had as its directors A.V. Thomas, S.S. Natarajan and C.S. Ramakrishna Karayalar. In Pondicherry there existed the Rodier Textile Mill, owned by Anglo‑French Textiles Limited. The assessee asserted that Southern Agencies Ltd. had, in 1948, undertaken the promotion of a new limited company to be called Rodier Textile Mills Ltd., Pondicherry, with the purpose of acquiring and developing the Rodier Textile Mill. To finance this venture, the assessee company provided Southern Agencies Ltd. with funds totalling Rs 6,05,071‑8‑6. The transfer of these funds was not made directly by the assessee but was effected, at its direction, through India Coffee and Tea Distributors Ltd., Madras. The assessee further explained that an entry in its own books dated 31 December 1948 recorded the amount as an advance for the purchase of 6,000 shares of Rs 100 each in Rodier Textile Mills Ltd., although the primary intention was to assist and finance Southern Agencies Ltd. in accordance with the powers conferred by its Memorandum.

The company’s principal aim in providing the sum of Rs 6,05,071‑8‑6 was to support and finance Southern Agencies Ltd. in accordance with the memorandum of the company. The intention was to enable the purchase of shares, each having a face value of Rs 100, in the yet‑to‑be‑formed Rodier Textile Mills Ltd. The subscription window for the new company was opened from 5 January to 20 January 1949, but the company itself did not submit any application for shares, and consequently it did not acquire any shares. Public interest in the venture was negligible, and the entire project eventually stalled. On 1 September 1950 the company formally approved the action taken by Mr A. V. Thomas in making the advance, and on 18 September 1950 the Board passed a resolution directing that Rs 6,00,000 of the amount be recorded as an advance for the purchase of shares in Rodier Textile Mills Ltd. (still in formation) and that the remaining Rs 5,072‑8‑5 be shown as sundry advances due from the promoters of the new company.

Southern Agencies Ltd. failed to return the whole advance. It repaid Rs 2,00,000 on 7 December 1951, which the company treated as full satisfaction of that portion. Although the advance was still regarded as recoverable and sound as of 12 June 1951, the balance was written off on 31 December 1951, the closing date of the company’s financial year. The written‑off balance was claimed in the assessment year 1952‑53 either as a bad debt that had actually become unrecoverable or, alternatively, as an expense that was not of a capital nature and was incurred wholly and exclusively for the purposes of the company’s business. The Income‑Tax Officer at Alleppey held that the debt had been written off when it was neither bad nor doubtful, deeming the claim premature and therefore disallowing the deduction.

The company appealed this decision to the Appellate Assistant Commissioner, who affirmed the Income‑Tax Officer’s order but for a different reason. He concluded that the advance had been made for the purpose of acquiring shares in the newly forming company, which amounted to the acquisition of a capital asset—either control of the new company or the expectation of obtaining goodwill that would likely result in agency rights for the company. Accordingly, any loss, if it existed, was of a capital character, and the issue of whether the bad‑debt claim was premature did not arise for consideration. The Commissioner further held that the deduction could not be claimed under section 10(2)(xv) of the Income‑Tax Act.

Subsequently, the company appealed to the Tribunal. The Tribunal upheld the Appellate Assistant Commissioner’s order, this time relying on a third ground. It accepted that one of the company’s objectives was the promotion and financing of other enterprises for profit, but it found that the advance of Rs 6,00,000 was not made in the ordinary course of the company’s business. Instead, the Tribunal characterized the transaction as being driven solely by personal motives, a conclusion that it drew from the lack of any prior business relationship with Southern Agencies Ltd., the absence of any expectation of financial benefit, and the absence of evidence that the company would receive any agency rights. Consequently, the Tribunal determined that the deduction could not be allowed because the advance originated from personal rather than business considerations.

The Tribunal observed that the advance of six lakh rupees was not made by the assessee company in the ordinary course of its trade. Rather, the Tribunal described the transaction as being driven solely by personal motives. In reaching this conclusion the Tribunal noted that the money was advanced to Southern Agencies Ltd., a firm that was not promoted by the assessee company, that there was no prior business relationship between the two entities, and that the assessee company had no expectation of any financial benefit from the advance. The Tribunal further held that Rodier Textile Mills Ltd., located in Pondicherry, was not being financed or promoted by the assessee company, and that the assessee’s claim that it would obtain some agency rights was unsupported by any evidence. The Tribunal expressed the opinion that the advance was likely the result of the substantially common ownership of the assessee company and Southern Agencies Ltd. by two individuals, namely A. V. Thomas and S. S. Natarajan. Consequently, the Tribunal ruled that the deduction sought could not be allowed because the amount was given out of personal motives and not as part of the assessee’s business activities. The assessee company applied for a reference of the matter, but the Tribunal refused to grant a case. In its application, the assessee framed three specific questions: (i) whether, on the facts and circumstances, the sum of Rs 4,05,072‑85 could be claimed as a bad debt written off under Section 10(2)(xi) of the Act; (ii) whether, on the facts and circumstances, the sum could be allowed as a permissible deduction under Section 10(2)(xv) of the Act; and (iii) whether, on the facts and circumstances, the assessee was entitled to claim the deduction of that sum as a proper debit and charge it to its profit and loss account. These questions indicate that the assessee sought the deduction in three different ways: as a loss incurred in the course of business under Section 10(1), as a bad debt written off under Section 10(2)(xi), and as an expenditure wholly and exclusively for business purposes under Section 10(2)(xv) of the Income‑Tax Act. The assessee then approached the High Court, which directed a reference on a single question that was quoted earlier. That single question demonstrates that the High Court did not frame the reference under Section 10(1). The Tribunal had examined the matter from a business‑activity perspective and concluded that the advance was not a normal business transaction but was instead motivated by personal considerations. The High Court apparently did not accept that the issue could be dealt with under Section 10(1) and instead formulated the reference under clauses (xi) and (xv) of Section 10(2).

The Court observed that the reference made by the High Court dealt only with the two clauses specified in the question. The assessee company had attempted before this Court to rely on section 10(1) of the Act and to treat the deduction as an ordinary loss arising in the course of its business. That argument was rejected because, in the view of the Court, the matter that the High Court examined did not encompass a claim under section 10(1). The Court further noted that the assessee company could have asked the High Court, at an appropriate stage, to formulate a question on the ground that there was no material before the Tribunal to support its conclusion that the transaction was not a business transaction but an advance made for personal motives.

The Court stated that it had been contended before it that the High Court, in ordering a reference on a single question, had indicated that the question would address three issues. The first two issues were expressly mentioned in the question, while the third issue, described as implicit, concerned whether the Tribunal was competent to decide a case that the Department had not previously established. The Court clarified that this implicit issue was not equivalent to a finding that the Tribunal lacked any material on which it could base a conclusion that the advance was not made in the ordinary course of business by the assessee company. The High Court, in its order calling for a statement of the case, observed that there had been no dispute at any earlier stage that the advance was not in the ordinary course of business. However, the Court held that the conclusion reached by the High Court in the order made under section 66(2) could not have any relevance or binding effect. The Court further expressed that the High Court was in error in arriving at its own finding, and it was therefore not surprising that the Tribunal protested against that finding.

The Court explained that it would have been open to the High Court to frame a question asking whether any material existed to support the Tribunal’s finding and to invite the Tribunal to state its case on that basis. Because the High Court did not do so, the question as framed required the assessee company to prove its case either under section 10(2)(xi) or under section 10(2)(xv). Accordingly, the present Court will consider the matter from those two perspectives. Clause (xi) and clause (xv) of section 10(2) read as follows:

“(2) Such profits or gains shall be computed after making the following allowances, namely … a (xi) when the assessee’s accounts in respect of any part of his business, profession or vocation are not kept on the cash basis, such sum, in respect of bad and doubtful debts, due to the assessee in respect of that part of his business, profession or vocation, and in the case of an assessee carrying on a banking or money‑lending business, such sum in respect of loans made in the ordinary course of such business as the Income‑tax Officer may estimate to be irrecoverable but not exceeding the amount actually written off as irrecoverable in the books of the assessee: (Proviso omitted). (xv) any expenditure (not being an allowance of the nature described in any of the clauses (i) to (xiv) inclusive, and not being in the nature of capital expenditure or personal expenses) laid out or expended wholly and exclusively for the purpose of such business, profession or vocation.”

The Court explained that section 10(2)(xv) of the Income‑Tax Act permits a deduction for any expenditure, which is not an allowance described in clauses (i) to (xiv), is not capital expenditure, and is not a personal expense, provided that the expenditure is laid out or expended wholly and exclusively for the purpose of the assessee’s business, profession or vocation. In support of its case, the assessee company asserted that there was no dispute that the money in question represented an advance made in the ordinary course of business, and therefore it should be treated either as a trading loss, as a bad debt, or as an expenditure allowable under section 10(2)(xv). The company relied heavily on certain ledger entries of Rodier Textile Mills Ltd. that appeared in its own books, and these entries were identified in the record as Annexures A.1 to A.3. The High Court also examined these accounts and interpreted them as indicating an attempt by the assessee to acquire a capital asset. The ledger entries commenced in 1948 and concluded on 31 December 1951, and the pages were headed “Personal Ledger.” In December 1948, the ledger showed sundry amounts totalling Rs 6,05,071‑8‑5 recorded as “paid to you by Indian Coffee and Tea Distributors Ltd., Madras, towards purchase of shares.” On 1 January 1949 the ledger opened with a debit balance of the same amount, but the identity of the “you” to whom the payment was made was not disclosed. Subsequently a number of reversing entries were entered for certain amounts, and on 31 December 1949 the balance was shown as follows: an advance for sundry expenses due from the promoters of a new company, transferred amounting to Rs 5,071‑8‑5, and a balance of Rs 6,00,000‑0‑0. The accounts for the year 1950 opened on 1 January with a balance of Rs 6,00,000‑0‑0 and were closed with an entry showing an amount paid to Southern Agencies Ltd. of Rs 6,00,000‑0‑0, which then appeared as the opening balance on 1 January 1951. On 7 December 1951 a payment of Rs 2,00,000 was recorded and Rs 4,00,000 was transferred for writing off. On 31 December 1951, Rs 4,00,000 was written off together with Rs 5,072‑8‑5; the latter included a sum of Rs 1 for hire of carriage, which was also written off after the entry had been reversed. From these entries it is clear that the original amount was shown as an advance for the purchase of shares of Rodier Textile Mills Ltd. If the purpose was indeed to acquire shares, the outlay cannot be characterised as revenue expenditure. The High Court correctly observed that the business of the assessee was not to purchase agencies and sell them. Rather, the shares were being acquired so that the assessee might later engage in the lucrative business of selling agencies and similar interests belonging to Rodier Textile Mills Ltd. Finally, the Chairman of the assessee, in a speech dated 15 December 1952, stated: “You are aware that an advance was made to the Southern Agencies (Pondicherry) Ltd. to acquire for us shares in Rodier Textile Mills.”

In this case, the company’s chairman explained that once the promotion and operation of Rodier Textile Mills Ltd. became a fait accompli, the appellant would benefit substantially by obtaining the agency for handling Rodier’s goods. This statement demonstrated that the appellant’s intention was to acquire a capital asset for its own use. Because the purpose was to obtain a capital asset, the expenditure fell outside the scope of section 10(2)(xv) of the Income‑Tax Act, which does not permit a deduction for capital‑nature outlays. The chairman’s declaration therefore rendered the argument for a deduction under section 10(2)(xv) untenable. Moreover, the amount in question had not been spent in the financial year ending 31 December 1951; rather, the expenditure had occurred in 1948. Consequently, the issue had to be examined under section 10(2)(xi). At this stage, the memorandum of association of the appellant was examined, which listed among its objects the promotion of other companies, and it showed that the sum had been paid to Southern Agencies Ltd. for the purpose of promoting Rodier Textile Mills Ltd. While the memorandum explicitly included the promotion and financing of other companies as objects, a memorandum alone does not determine the true character of a transaction; the actual nature must be inferred from the surrounding circumstances. The accounting records of the appellant contained conflicting versions that contradicted the claim that the payment was made to promote Rodier Textile Mills Ltd. Although the funds were available on 31 December 1948 and the subscription list for Rodier’s shares remained open from 5 January to 20 January 1949, the appellant made no application for any share on its own behalf. The entries in the books up to the end of 1949 recorded the amount as being set aside for the purchase of shares. Only later did the records show the sum as an advance to Southern Agencies Ltd., and this notation appeared only at the end of 1950, when it was entered as “Amount paid to Southern Agencies Ltd.” The appellant advanced three contentions in support of treating the amount as a bad and doubtful debt that had been written off. First, it argued that the High Court erred in requiring the appellant to prove that it had previously bought and sold agencies before it could claim a deduction under section 10(2)(xi). Second, it maintained that the appellant’s object was to acquire shares, but because it did not actually apply for any shares, the transaction with Southern Agencies should be regarded as an ordinary‑course advance. Third, it contended that since Southern Agencies failed to return the money, the appellant was entitled to write off the amount as a bad and doubtful debt. The Court noted that a question under section 10(2)(xi) could arise only where a bad or doubtful debt existed.

In order for a liability to be treated as a bad or doubtful debt, it must first qualify as a debt. The meaning of “debt” in this context was explained by Rowlatt, J., in the case of Curtis v. 1 & G Oldfield Ltd., at page 330, where he stated that a bad debt is a debt that would have appeared on the balance sheet as a trading debt in the relevant trade and that is now bad. He emphasized that the term does not refer to any liability that, when it was a good debt, would not have increased profits. Consequently, a debt is an outstanding amount that, if recovered, would have enlarged the profits. It is not merely money given to someone for the purchase of an item that the recipient fails to return when no purchase has actually taken place. The statute therefore regards a debt as something more substantial than a simple advance; it must be connected with, or arise out of, the business. To be allowed as a deduction for a bad or doubtful debt, the liability must first be established as a genuine debt. The same observations of Rowlatt, J., were later applied by the Privy Council in Arunachalam Chettiar v. Commissioner of Income‑Tax, at page 245, where the Lords rejected the suggestion that, upon the dissolution of a partnership, a partner’s share of losses from several previous years could be aggregated and set off against the income of another partner for a particular year. They held that no principle for writing off a bad debt could support such a course, whether in the year after dissolution or in any later year when a partner’s insolvency became apparent, because a “bad debt”, if it were good, would not have increased the taxable profits of the other partner.

Subsequently, this Court endorsed Rowlatt, J.’s dictum in Commissioner of Income‑Tax v. Abdullabhai Abdulkadar, at page 550, and also referred to the remarks of Venkatarama Ayyar, J., in Badridas Daga v. Commissioner of Income‑Tax, where the learned judge observed that a business debt “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.” Section 10(2)(xi) contains two sub‑clauses: one applies to an assessee engaged in the business of a banker or money‑lender, and the other to all other businesses. Because the present case did not involve a loan made by a banker or money‑lender, the liability in question had to be a proper debt that, if it were good, would have increased taxable profits. Applying these criteria, it became clear that an advance paid by the assessee company to another party for the purchase of shares could not be characterised as a debt that arose out of the assessee’s trading activities.

In the case at bar, the Court observed that the payment made by the assessee company could not be characterised as an expense incidental to its ordinary trading activities. Rather, the payment represented a price paid in advance for shares that Southern Agencies were entitled to allot in Rodell Textile Mills Ltd. Consequently, the transaction could not be described as a debt. The Court further noted that the entries in the assessee’s books of account demonstrated that the company had altered those entries in order to transform the advance into a recorded debt, thereby enabling the company to write off the amount and to claim the benefit of section 10(2)(xi). The Court referred to the authorities (1) [1961] 2 S.C.R. 949, 954 and (2) [1959] S.C.R. 690 in support of this view. After considering the nature of the transaction, the Court held that section 10(2)(xi) was inapplicable to the facts of this case. Accordingly, the appeal was dismissed. The Court ordered that the assessee company should bear the costs of the respondent, and the dismissal of the appeal was affirmed.