The Commissioner Of Income-Taxbombay vs E.D.Sheppard

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

Court: Supreme Court of India

Case Number: Civil Appeal No. 527 of 1961

Decision Date: 12 December, 1962

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

In this matter the Supreme Court of India delivered its judgment on 12 December 1962. The case was titled The Commissioner of Income‑Tax, Bombay versus E D Sheppard. The opinion was authored by Justice S K Das and the judgment was pronounced by a bench consisting of Justices S K Das, J L Kapur, A K Sarkar, and Raghubar Dayal. The petitioner was the Commissioner of Income‑Tax for Bombay and the respondent was E D Sheppard. The decision is reported in the 1963 volume of the All India Reporter at page 1343 and also in the 1964 Supreme Court Reports (First Series) at page 163. The case has been cited in subsequent decisions, for example in the 1963 Supreme Court Reports (Third Division) at page 1583 and in the 1973 Supreme Court Reports (Third Division) at page 2733. The dispute concerned the application of the Indian Income‑Tax Act of 1922, specifically section 7(1) and its second explanation, to a situation where a partnership terminated an employee’s services by notice, transferred its assets to newly formed companies, and granted shares of the new companies to the former employee as alleged compensation for loss of employment.

The factual background recorded by the Court indicates that in 1930 the respondent, acting as an assessee, was employed as an officer‑assistant by a partnership on a three‑year contract. That contract permitted the firm to end the engagement by providing the employee with one calendar month’s notice, provided the employee’s work remained satisfactory. The employee, like other assistants in the firm, anticipated eventually becoming a partner. He continued his service, and the partnership repeatedly renewed his contract over the ensuing years. In 1947 the firm decided to reorganise its business and consequently established two limited companies: Killick Industries Ltd., a public limited company, and Killick Nixon and Company, a private limited company, which were intended to assume the business previously conducted by the partnership. On 29 December 1947 the respondent received a notice from the partnership indicating that, owing to the proposed reorganisation, his employment would cease on 31 January 1948. The new entity, Killick Industries Ltd., agreed to employ the respondent, and he commenced work with that company on 1 February 1948. The partnership transferred its assets to the newly formed companies and, in exchange, received shares in those companies. All members of the covenanted staff, including the respondent, were allotted shares of Killick Industries Ltd. without any monetary payment. The respondent was allotted 1,700 shares having a face value of Rs 2,21,000. The respondent contended that the shares were granted by the partnership to its staff as compensation for the loss of employment that resulted from the premature termination of their services. The Income‑Tax Officer, on the other hand, argued that the value of the shares – Rs 2,21,000 – should be taxed as income, classifying the allotment as consideration for past services rendered. The Appellate Tribunal, after examining the evidence, held that the payment constituted solely compensation for loss of employment and, consequently, was exempt from tax under Explanation 2 to section 7(1) of the Indian Income‑Tax Act, 1922. It was contended for the

In this case the Commissioner of Income‑tax argued that, under the Explanation to section 7(1) of the Indian Income‑tax Act, 1922, the term “compensation” referred only to amounts that were payable or enforceable at law as compensation, and therefore any sum received by an assessee from his present or former employer should be treated as profit received in lieu of salary. On that basis the Commissioner maintained that the payment of Rs 2,21,000 made to the assessee could not be characterized as compensation solely for loss of employment and therefore was taxable. The dissenting judge, Raghubar Dayal, J., disagreed with this narrow construction. He held that the expression “compensation for loss of employment” in Explanation 2 to section 7(1) embraced any payment, whether made under a legal liability or voluntarily, that was intended to compensate the employee or to act as a solatium for the loss of employment suffered, and was not limited to amounts that were legally enforceable. Consequently, the payment of Rs 2,21,000, which the Tribunal had found to be made exclusively as compensation for loss of employment, was exempt from tax because the Explanation expressly excluded such payments from being treated as profit in lieu of salary. In arriving at this conclusion the Court relied on several authorities, namely Chibbet v. Joseph Robinson & Sons (1924) 9 Tax Cas. 49, Commissioner of Income‑tax v. Shaw Wallace and Company, 32 L.R. 59 I.A. 206, W. A. Guff v. Commissioner of Income‑tax, Bombay City, [1937] 31 I.T.R. 826, Commissioner of Income‑tax, Hyderabad v. Vazir Sultan and Sons, [1959] Supp. 2 S.C.R. 375 and Mahesh Anantrai Pattani v. The Commissioner of Income‑tax, Bombay Nora, Ahmedabad, [1961] 2 S.C.R. 742. The majority judges, Das, Kapur and Sarkar, JJ., observed that no distinction could be drawn between compensation for loss of employment and compensation for loss of future prospects arising from that employment; if the object of the payment was unrelated to the employer‑employee relationship, it would not fall within the phrase “profit received in lieu of salary” in Explanation 2. Judge Raghubar Dayal, however, articulated two specific points. First, he stated that any sum paid by an employer or former employer to an employee at the termination of services would qualify as a “payment made solely as compensation for loss of employment” only when it was made in consideration of a legal right or contractual entitlement to such compensation. Since the assessee’s services were terminated by giving one month’s notice in accordance with the service contract and he had no legal claim to compensation, the payment of Rs 2,21,000 could not be said to be made as compensation for loss of employment. Second, he noted that the payment was made by the firm to the employee a day before termination of his services; therefore the sum fell within the first part of Explanation 2 to section 7(1) and amounted to “profits in lieu of service.” The judgment concluded with the observation that the case arose on appeal from the High Court of Bombay dated 6 July 1959 in Income Tax Reference No. 64 of 1958, and it was recorded as Civil Appeal No. 527 of 1961.

The case was identified as Tax Reference No. 64 of 1958. Counsel K. N. Rajagopal Sastri and R. N. Sachthey appeared for the appellant, while counsel N. A. Palkhivala, J. B. Dadachanji, O. C. Mathur and Ravinder Narian represented the respondent. The judgment was dated 12 December 1962. The Court noted that several judgments were to be delivered, and that the opinion of Justices S. K. Das, L. Kapur and A. K. Sarkar was to be read as a single judgment delivered by Justice S. K. Das, whereas Justice Raghubar Dayal delivered a separate opinion. Justice S. K. Das began by stating that the proceeding before the Court was an appeal against a certificate of fitness that had been granted by the High Court of Bombay pursuant to section 66‑A(2) of the Indian Income‑Tax Act, 1922. He observed that the material facts were confined to a limited scope. The appellant in the appeal was the Commissioner of Income‑Tax for Bombay, and the respondent was the assessee, identified as E. D. Sheppard. The business under consideration was Killick Nixon & Company, a partnership that conducted a substantial enterprise in India, owning a number of mills and managing agencies of several limited companies. The partnership habitually employed officer‑assistants, the majority of whom were Europeans, on fixed three‑year contracts. When the services of such assistants were judged satisfactory, the partnership customarily extended the contracts after each triennial period, usually with a salary increase, and the assistants could anticipate eventual admission as partners, provided their performance remained satisfactory.

The respondent, Mr. Sheppard, was one of those assistants and had entered the partnership in 1930. Although the original employment contract specific to Mr. Sheppard was not produced, the Court noted that a specimen copy of an initial agreement with another assistant, W. J. Heygate, was on record, and it was uncontested that the terms applicable to Mr. Sheppard were identical to those in the Heygate agreement. Clause 10 of that agreement expressly allowed the firm, irrespective of any other provision, to terminate the contract without assigning a reason, provided the firm gave the assistant one calendar month’s prior notice of its intention to do so. Mr. Sheppard remained in the firm’s employ, and his service contract was successively renewed. The final renewal occurred on 1 November 1947, mirroring the terms of a renewed contract presented in the record for J. G. Milne. This last renewal covered the period from 1 November 1947 to 31 October 1950, stipulating a monthly salary of Rs. 1,200 and a commission equal to 21 percent of the partnership’s net profits. The Appellate Tribunal had previously assessed that, had the partnership continued operating, the respondent would have earned roughly Rs. 50,000 per year from the commission. In the latter part of 1947, the partnership resolved to reorganise its business structure, leading to the formation of two limited companies: a public limited company named Killick Industries Ltd. and a private limited company called Killick Nixon and Company, the latter intended to assume the business previously carried out by the partnership.

In this case, the private limited company Killick Nixon and Company was created to assume the business that the partnership had previously carried on, and this restructuring required the termination of the firm’s employees. The assessee received a notice from the firm dated 29 December 1947 stating that, because of the proposed changes, his employment would end on 31 January 1948. At the time of the notice the assessee was about thirty‑eight years old. The firm employed sixteen officers on contract terms; all of them were Europeans except for one. Each of the sixteen contracts expired on a different date according to the original date of appointment. For the assessee, the new public limited company Killick Industries Ltd. agreed to engage him on fresh terms. Under those terms his monthly salary was increased, but the commission that had previously been payable was withdrawn, leaving him in roughly the same financial position as before. He therefore entered the employment of Killick Industries Ltd. on the new terms on 1 February 1948. Killick Nixon and Company transferred its assets to the newly formed companies and, in exchange, received shares in those companies. A large number of shares of Killick Industries Ltd. were then offered to the Indian market; although the shares had a face value of one hundred rupees, they were quoted at one hundred and thirty rupees per share. Some of the shares were retained by the partners of Killick Nixon and Company. All members of the covenanted staff of the partnership, who were officers, were allotted shares of Killick Industries Ltd. without any payment. The assessee was allotted one thousand seven hundred shares having a total face value of two hundred twenty‑one thousand rupees. The assessee contended that these shares were provided by the partnership to the staff as compensation for the loss of employment resulting from the premature termination of their services. The Income‑Tax Officer, however, sought to levy tax on the value of two hundred twenty‑one thousand rupees, treating the shares as consideration for past services rendered. To support his claim, the assessee produced a letter that he said was written by D.R.C. Hartley on 1 October 1952 on behalf of the firm, informing him that the firm had caused the allotment of one thousand seven hundred shares in Killick Industries Ltd. as “compensation for loss of employment.” The order of the Income‑Tax Officer, which brought the amount of two hundred twenty‑one thousand rupees within the charge of tax, was affirmed by the Appellate Assistant Commissioner. Before the Income‑Tax Appellate Tribunal, the assessee submitted an affidavit dated 22 February 1954, sworn by five of the six partners who had constituted the firm in January 1948 (the sixth partner had since died). The affidavit affirmed the contents of a memorandum that had been submitted to the Income‑Tax Officer by Messrs Crawford Bayley & Co. on the assessee’s behalf.

In the affidavit, paragraph 8 set out that the partners of the firm had resolved to discontinue the partnership and, before doing so, on 27 December 1947 had written to each assistant who was then employed by the firm, informing them that their services would be terminated effective 31 January 1948 and that a further notice would follow concerning “the question of compensation for loss of employment.” The affidavit further recorded that the partners’ purpose in causing certain share allotments to the assistants was to compensate them for the loss of employment and that the allotments were “in no sense a reward for past services.” It was also stated that all the assistants accepted the share allotments as compensation for the loss of employment as contemplated in the 27 December 1947 notice, that no assistant thereafter made any claim against the firm, and that, subsequently, the partnership issued a confirmatory letter to the assistants “for purposes of record.” When the matter came before the Income‑Tax Appellate Tribunal, the two members of the Tribunal expressed divergent views regarding the true character of the payment received by the assessee. The accountant member held that the assessee had not suffered any loss because, from 1 February 1948—the day after his termination by the partnership—he was employed by Killick Industries Ltd., receiving remuneration that was virtually the same as his previous earnings. Moreover, the accountant member argued that the payment could not be said to be made “solely for loss of employment,” since part of the amount was intended to compensate for the loss of expectations and future prospects that the assessee had in the partnership. He further observed that the assessee’s employment was terminable on one month’s notice and that the unexpired portion of his contract would not have amounted to Rs 2,21,000; consequently, the payment could not be treated as compensation for loss of employment but, at best, as a payment made under the contract and not for the loss of the contract. In contrast, the judicial member disagreed, stating that the assessee’s services were determined by the firm, which was ultimately dissolved, and that the share allotment was made to the assessee “at or in connection with the termination of his employment and solely as compensation for loss of employment.” The judicial member found no material in the record to support the view that the payment was in lieu of past services. Because the two members could not agree on the issue, the matter was referred to the President of the Tribunal. The President concurred with the judicial member, concluding that the payment was made to the assessee solely for loss of employment and that it was irrelevant that the assessee obtained another, equally advantageous, employment with a different employer on the very next day after his termination from the partnership.

The President examined the material presented by the assessee, which consisted of an affidavit submitted by the partners, and concluded that the department’s allegation of concealment was unfounded; consequently, both the judicial member and the President accepted the affidavit as reliable evidence supporting the assessee’s claim. Thereafter, the appellant requested that the Tribunal refer a specific question of law to the High Court. The question presented for referral was whether, considering the facts and circumstances of the case, the amount of Rs 2,21,000—representing the value of the shares allotted to the assessee without any payment—should be treated as income of the assessee and therefore fall within the charge of section 7 of the Income‑tax Act. Acting under section 66 of the Income‑tax Act, 1922, the Tribunal made the reference, and the matter was heard before Judges Shah and Desai of the Bombay High Court. The High Court turned to Explanation 2 to section 7(1) of the Income‑tax Act as it existed at the relevant time and held that when an agreement between an employee and his employer specifies a sum to compensate for the loss anticipated from termination of employment, the fact that the employee subsequently obtains another position and consequently does not suffer an actual loss does not, for tax purposes, alter the character of the payment. The Court further observed that, because the Tribunal had already accepted the assessee’s evidence in support of his claim, that evidence could not be re‑examined by the High Court in a reference made under section 66, which is limited strictly to questions of law arising from the Tribunal’s order. Accordingly, the sole issue for determination was whether the compensation received by the assessee should be characterised as an income receipt or as a capital receipt in his hands. While considering Explanation 2 to subsection (1) of section 7, an argument was advanced before the Court that the payment to the assessee was not made solely for loss of employment but also included compensation for the loss of future prospects. The Court responded that the employee’s expectations and prospects were intrinsically linked to his employment, making it difficult to separate compensation for loss of employment from compensation for loss of future prospects within the same employment relationship. The Court then stated that, although Explanation 2 provides that any sum due to or received from an employer or former employer is to be treated as profit received in lieu of salary for the purposes of subsection (1) of section 7, the payment must arise because of the relationship between employee and employer; if the purpose of the payment is unrelated to that relationship, it does not fall within the expression “profit received in lieu of salary.”

The Court observed that if a payment does not arise from the relationship between the employer and the employee, it cannot be described as “profit received in lieu of salary” within Explanation 2 to Section 7(1). Consequently, the Court assumed that a portion of the compensation paid to the assessee was not solely for the loss of employment but also reflected the loss of future prospects, specifically the assessee’s expectation of becoming a partner in the firm. The Court held that such a component of the payment does not fall within the meaning of “profit received in lieu of salary” under Section 7(1) or its accompanying Explanation. Because the payment is neither salary nor profit in lieu of salary, there is no other head of income, profit, or gain under which it can be taxed. Ultimately, the Court stated that the issue before it is whether the payment should be treated as a capital receipt or a revenue receipt in the hands of the assessee; if it is not a revenue receipt, it cannot be subject to tax. The Court indicated that it would next address the arguments presented on behalf of the appellant, but first it needed to note that Section 7 of the Income‑Tax Act, 1922, was completely rewritten by the Finance Act of 1955, and the present consideration concerns the provision as it existed before that amendment.

The Court then reproduced the relevant wording of Section 7(1) and Explanation 2 as they stood at the relevant time. Section 7(1) provides that tax is payable by an assessee under the head “Salaries” on any salary, wages, annuity, pension, gratuity, fees, commissions, perquisites, or profits in lieu of, or in addition to, any salary or wages that are due to the assessee, whether actually paid or not, and whether paid by or on behalf of the Government, a local authority, a company, any other public body or association, or any private employer. It further states that advances of any kind that are chargeable to this head shall be deemed salary on the date the advance is received. Explanation 2 adds that a payment due to or received by an assessee from an employer, former employer, or a provident or other fund constitutes, to the extent it does not consist of the assessee’s contributions or interest thereon, a profit received in lieu of salary for the purposes of the subsection, unless the payment is made solely as compensation for loss of employment and not as remuneration for past services. After setting out this statutory framework, the Court noted that counsel for the department had raised two principal submissions, the first of which concerned the interpretation of the term “compensation” in Explanation 2.

The Department argued that the term “compensation” in Explanation 2 should be understood as the amount that is legally payable or enforceable as compensation, meaning the monetary equivalent of the injury suffered as a result of the damage caused. Accordingly, the Department submitted that the assessee in the present case did not suffer any injury that would make the partnership legally liable to pay damages. The Department further explained that “compensation for loss of employment” signifies the monetary value of the earnings that the assessee would have obtained under the existing contract, without including any loss of future prospects, and that any such loss must be mitigated in accordance with established legal principles. On that basis, the Department contended that the sum of Rs 2,21,000 paid to the assessee could not be characterized as compensation solely for loss of employment within the meaning of Explanation 2. The Department’s second submission was that, under Explanation 2, any amount received by an assessee from his present or former employer—except for payments from a provident or other fund mentioned in the Explanation—shall be treated as profit received in lieu of salary for the purposes of subsection (1) of section 7, unless the payment is made exclusively as compensation for loss of employment. It submitted that Explanation 2 creates, in effect, an artificial definition of “profits in lieu of salary,” and that if the payment is not compensation in the sense of a sum legally enforceable at law, then no further inquiry is required as to whether the payment is connected with employment or unrelated, nor whether it should be classified as capital or revenue in the assessee’s hands. The Department further maintained that the High Court erred on both of these points and therefore its answer to the reference question was incorrect. The Court observed that both of the Department’s contentions lacked merit and were not supported by precedent, including decisions of this Court. Turning to the first contention, the Court cited Romer, L.J., in Henry v. Arthur Foster, stating that compensation for loss of office or employment is a well‑known concept that denotes a payment to an office‑holder for being deprived of profits to which he would have been entitled, but for an act of deprivation by his employer or a third party such as the Legislature. The Court noted that when the deprivation is caused by the Legislature, there can be no legal liability or enforceability to pay damages, and that the emphasis lies on the act of deprivation, which may or may not give rise to liability at law. The Court then referred to Chibbett v. Joseph Robinson & Sons, where the assessees, employed as ship managers and paid a percentage of the company’s annual profits, received a sum of £ 50,000 in bonds as compensation for loss of office after the company entered liquidation, and that the question before the lower court concerned the character of that sum.

In this case the Court examined the question of whether the amount of fifty thousand pounds that the assessors had been paid should be treated as a capital receipt or as income. The learned judge, citing Sir Richard Henn Collins, explained that the proper analysis must not begin with the position of the person making the payment and whether that person was legally compelled to pay. Rather, the inquiry must start from the standpoint of the recipient to determine whether the payment was made in respect of services rendered in an office, or in respect of trade, or for some other consideration. The judge emphasized that this perspective of the recipient inevitably leads back to an examination of the payer’s situation, not in terms of compellability or liability, but in order to understand the purpose for which the payment was made. It was noted that the judge made no distinction between office and trade when deciding whether a receipt should be classified as capital or income in the hands of the assessors.

The Court then outlined the statutory classifications applicable at the time. Income derived from employment was taxed as “salaries” under section 7, while profits of a business were taxed under section 10. Income arising from an office that did not involve employment—for example, that of a managing or selling agent whose activities amount to carrying on a business—was also taxed under section 10 as business profits. In other situations, such as the remuneration of an ordinary director of a company, the income was taxed under section 12 as income from other sources. Consequently, the question of whether compensation received for loss of employment, loss of office, or cessation of a business should be taxed under any of those three sections required, before the amendments of 1955, an application of the general principle of income‑tax law that seeks to tax income. In essence, the issue reduced to determining whether the receipt was income or capital in the hands of the assessors.

The Court referred to the earlier decision of the Privy Council in Commissioner of Income‑tax v. Shaw, Wallace and Company, where it was held that a sum received as compensation for the loss or cessation of oil‑distributing agencies did not constitute income, profit or gain within the meaning of the Indian Income‑tax Act. The Privy Council judgment did not suggest that the compensation was a liability enforceable at law. The Court pointed out, as noted in that judgment (1) (1932) L.R. 59 I.A. 206, that the object of the Indian Income‑tax Act was to tax “income,” a term that was not expressly defined but which implied a periodic monetary return arising from definite sources with some degree of regularity. This observation underscored the Court’s approach to the present question of classification.

In explaining the object of the Income‑Tax Act, the Court observed that the statute sought to tax “income,” a term it did not expressly define, but which was understood to mean a periodic monetary return received with some regularity or expected regularity from definite sources. The Court therefore stated the ratio of the earlier decision: “But when once it is admitted that they were sums received, not for carrying on this business, but as some sort of solatium for its compulsory cessation, the answer seems fairly plain.” A similar issue arose before the Bombay High Court in the case of W. Guff v. Commissioner of Income Tax, Bombay City. In that case the assessee had joined a company on 27 May 1946 as an executive responsible for a newly created department, under an agreement that allowed termination of his services on giving six months’ notice. On 23 March 1948 the company informed him that the department could no longer function; nevertheless the assessee continued to work until 10 November 1948 in order to wind up the department. On 30 November 1948 the company paid the assessee a sum of Rs 12,000 as compensation equivalent to six months’ salary for the termination of his employment caused by the closure of the department. The dispute centred on whether the Rs 12,000 received constituted a capital receipt or a revenue receipt taxable as salary under section 7 of the Income‑Tax Act. The employer argued that because there was no legal liability to pay the compensation, any payment made would not fall within the expression “compensation” used in Explanation 2; they cited a finding of the Tribunal that a proper notice, as given, meant the employee was not entitled to compensation after the six‑month period elapsed. The High Court rejected this argument. Chief Justice Chagla, delivering the judgment, referred to the earlier authorities Shaw, Wallace and Company v. Commissioner of Income‑Tax (1) and Chibbett v. Joseph Robinson & Sons (2), and held that the expression “compensation for loss of employment” in Explanation 2 to section 7 covered any payment, whether made under a legal liability or voluntarily, intended to compensate or act as a solatium for the loss of employment suffered by the employee.

Subsequently, the Supreme Court considered a related question in Commissioner of Income‑Tax, Hyderabad v. Vazir Sultan and Sons (3). In that matter the assessee, a registered firm, had been appointed the sole selling agent and sole distributor for the Hyderabad State for cigarettes manufactured by a certain company, and it was allowed a discount on the gross selling price. In 1939 the parties modified their arrangement so that the assessee received a discount not only on goods sold within the Hyderabad State but also on goods sold outside that State. In 1950 the parties reverted to the original arrangement, restricting the sole agency to the Hyderabad State, and the assessee was paid a sum of Rs 2,19,343 as compensation for the loss of the agency outside the Hyderabad State. The issue before the Court was whether this amount was a revenue receipt assessable to income tax or a capital receipt outside the scope of taxation. One of the principal arguments presented to the Court was that there was no enforceable agreement between the assessee and the company that could give rise to a legal claim for damages or compensation should the agreement be terminated, because the agency agreement was terminable at the will of the company, leaving the assessee without any legal remedy.

In 1950 the assessee and the company returned to the earlier arrangement that limited the assessee’s exclusive agency to the Hyderabad State, and the company paid the assessee the sum of Rs 2,19,343 as compensation for the loss of the agency that had previously extended to territories outside the Hyderabad State. The principal issue before the Court was whether this amount constituted a revenue receipt that should be taxed under the income‑tax law, or whether it was a capital receipt that fell outside the scope of taxable income. One of the arguments advanced before the Court, and pressed with considerable vigor, was that there existed no enforceable contract between the assessee and the company that could serve as the basis for a legal claim for damages or compensation in the event that the company terminated the arrangement or cancelled the agency. The Court noted that the agency agreement was terminable at the sole discretion of the company, and that, should the company elect to terminate, the assessee would have no legal remedy. Consequently, the argument asserted that the absence of a legally enforceable agreement meant that no claim for compensation could arise. The Court rejected this contention and observed that, in situations of this kind, the decisive factor is the character of the receipt in the hands of the assessee, irrespective of the motive or intention of the paying party. The Court endorsed the observations of Rowlatt, J., in Chibbett v. Joseph Robinson and Sons (1), and also approved the ruling in W A Guff v. Commissioner of Income‑tax (2), emphasizing that it is irrelevant whether the payment was made because the employer was legally liable to pay compensation or whether it was made as an ex gratia gesture. In light of these authorities, the Court overruled the first contention raised on behalf of the appellant that the term “compensation” in Explanation 2 to section 7(1) should be interpreted to refer only to compensation that is payable or enforceable at law. Turning to the second contention, the Court explained that, before the amendments introduced by the Finance Act, 1955, Explanation 2 to section 7(1) expressly distinguished between a payment made solely as compensation for loss of employment, which was not assessable, and a payment made as remuneration for past services, which was taxable as income. The underlying principle was that compensation arising from wrongful termination of a service agreement, loss of office, loss of employment, or cessation of business constituted a capital receipt, even if the payment was wholly voluntary and the recipient possessed no legal right to any compensation. In such circumstances, the compensation was deemed to be a capital receipt because it related to the source of income (1) (1924) 9 Tax Cas. 48; (2) [1957] 31 I.T.R. 826.

The department’s counsel argued that Explanation 2 to section 7(1) treated every receipt by a taxpayer from his present or former employer as a profit in lieu of salary, except where the payment derived from a provident fund or a similar fund expressly mentioned in the explanation. According to that submission, the explanation created an artificial definition that automatically classified any such receipt as income, without any need to examine whether the receipt related to the employment relationship or whether it should be characterised as capital or income. The department’s counsel further conceded, however, that a payment made solely as compensation for loss of employment fell outside that artificial definition. The Court regarded the counsel’s proposition, which was presented in very broad terms, as untenable. The Court noted that the contention that every payment from an employer is automatically income, irrespective of its nature, could not be accepted. The Court therefore rejected the department’s sweeping interpretation and emphasized that the true character of the receipt must be examined, particularly when the receipt is intended as compensation for the loss of employment.

The Court then referred to the earlier authority in Mahesh Anantrai Pattani v. The Commissioner of Income‑Tax, Bombay North, Ahmedabad, a decision that considered section 7(1) and Explanation 2 as they existed before the 1955 amendments. In that case, M. A. Pattani, who had served as Dewan of the State of Bhavnagar, received a monthly pension of Rs 2,000 by order of the Maharajah dated 15 January 1948. After the State of Bhavnagar merged into the United States of Saurashtra on 1 March 1948, the Maharajah ceased to be the ruler. Subsequently, on 31 May 1950, the Maharajah directed his banker in Bombay to pay Pattani a sum of Rs 5,00,000, stating that the payment was made in consideration of Pattani’s loyal and meritorious services to the State. The question was whether the Rs 5,00,000 was taxable under section 7(1) read with Explanation 2. The Court held that the sum was not paid as compensation for services already rendered but was a gift expressing the Maharajah’s affection and regard for the assessee. Consequently, the Court concluded that the receipt was a capital receipt and not assessable as income under the statutory provision. The decision demonstrated that the Court did not accept the department’s view that every payment from an employer must be treated as income. Applying that reasoning to the present appeal, the Court observed that once it is established that the payment in dispute was made solely as compensation for loss of employment, Explanation 2 expressly excludes such a receipt from being treated as a profit in lieu of salary, thereby concluding the appeal.

The Tribunal, after reviewing the evidence before it, concluded that the sum in question had been paid solely as compensation for loss of employment. The High Court correctly observed that no distinction could be drawn between compensation for loss of employment and compensation for loss of prospects that were rooted in that employment, and it further pointed out that when the purpose of a payment is unrelated to the employer‑employee relationship, the payment does not fall within the expression “profit received in lieu of salary” as defined in Explanation 2. The Court found that the High Court had not erred in addressing the point referred to it, and, for the reasons already set out, the Court held that the appeal lacked any substantive ground. Accordingly, the appeal was dismissed with costs. In a separate note, Justice RaghuBar Dayal expressed that, although he had read the majority judgment of Justice S. K. Das, he could not agree with the view that the amount of Rs 2,21,000‑/‑ was paid solely as compensation for loss of employment and therefore did not constitute “profit in lieu of salary.” Counsel for the appellant, identified only as the representative of the appellant, conceded that the disputed sum received by the assessee‑respondent would not be liable to income‑tax unless it could be characterised as profit received in lieu of salary under Explanation 2 to section 7(1) of the Income‑Tax Act as it stood before the 1955 amendment. Section 7 deals with tax on income under the head “salaries,” and the relevant portion of Explanation 2 reads: “A payment due to or received by an assessee from an employer or former employer...... is...... a profit received in lieu of salary for the purposes of this sub‑section, unless the payment is made solely as compensation for loss of employment and not by way of remuneration for past services.” The counsel for the appellant argued that the sum of Rs 2,21,000‑/‑ was received from the employer Killick Nixon & Co. on 30 January, a day before the termination of his services by that company, and that it would be deemed profit received in lieu of salary unless it could be shown that the payment was made solely as compensation for loss of employment and not as remuneration for past services. He submitted that the term “compensation” refers to the monetary equivalent of damage suffered by wrongful termination of service, usually calculated as the loss of earnings under the terminated contract less any expected reimbursement from subsequent employment. Counsel for the assessee, identified as the representative of the assessee, urged that the parties’ intention is the primary factor in determining the nature of the amount paid by the employer to the employee at termination, and that for the purpose of the Income‑Tax provision, compensation need not be identical to the damages that a court of law might award for personal injury. He further contended that the word “compensation” has a well‑established meaning for the Act, as articulated by Justice Romer in the cases of Henry (H.M. Inspector of Taxes) v. Arthur Foster and Henry (H.M. Inspector of Taxes) v. Joseph Foster. It was not disputed that, by virtue of the contract, the assessee’s services could be terminated by giving one calendar month’s notice, and that such termination would not be wrongful, thereby precluding any entitlement to compensation under the contract terms.

In this case, counsel argued that the amount paid by the employer to the employee at the termination of service must be viewed as compensation for loss of employment, and that, for the purposes of the Income‑Tax Act, such compensation need not be equal to the amount of damages that a court of law would award for an injury to the claimant. The argument further relied on the proposition that the term “compensation” has acquired a settled meaning in the context of the Act, citing the definition offered by Lord Justice Romer in the cases Henry (H.M. Inspector of Taxes) v. Arthur Foster and Henry (H.M. Inspector of Taxes) v. Joseph Foster (1931) 16 Tax. Cas. 605, 634. It was not contested that the contract between the employee and the firm allowed termination of the employee’s services by giving one calendar month’s notice, and that such termination would therefore not be wrongful under the contractual terms. Consequently, the employee could not have a right to claim compensation because the termination would have been carried out according to the agreed contract.

The employee, however, expected that his contract would be renewed at the end of its term, as had occurred with his previous contracts, and he also anticipated that he might eventually become a partner in the firm, a progression that other assistants had previously achieved. The firm consequently proposed to allocate shares to the employee, representing payment for the loss of employment, and the employee accepted those shares as compensation. The argument emphasized that the intention of the parties as to what the sum represented was irrelevant to determining the true nature of the payment, although the parties’ intention could be taken into account as a factor in reaching the proper conclusion.

The essential question before the Court was whether, in substance, the sum received by the employee fell within the expression “compensation for loss of employment.” If the sum qualified as such compensation, it would not be taxable under section 7 of the Act because it would not be deemed “profit in lieu of salary.” Conversely, if the sum did not meet that description, it would be treated as “profit in lieu of salary” and would be taxable under section 7 and the other applicable provisions of the Act. Accordingly, the Court needed to determine both whether the payment constituted compensation at all and, if so, whether it specifically represented compensation for loss of employment.

Counsel for the appellant referred to several authorities supporting the view that compensation could be awarded only when the recipient was legally entitled to it, and that the amount of compensation should not differ significantly from the damages that might be awarded for an injury to the claimant’s rights. The respondent contended that, for the purposes of the Income‑Tax Act, it was unnecessary that the recipient be legally entitled to the payment under civil law, and that the principles used to calculate damages in civil suits should not be applied to determine compensation for loss of office. The Court noted that this contention could be assumed correct without deciding it, but recognized that accepting it alone would not resolve the issue. The term “compensation” inherently implies a payment intended to offset a loss suffered by the recipient; if no loss occurs, no compensation arises. Therefore, if an employee’s contract does not entitle him to any relief upon termination performed in accordance with the contract, there can be no basis for claiming compensation for loss of employment, nor for the employer to pay such compensation.

The Court observed that, for a payment to be characterised as compensation, it is not essential that the recipient possess a legal right to receive that amount under the law, and the rules used to assess damages in civil actions need not be applied to the assessment of compensation for loss of office. The Court noted that it could, without passing a definitive ruling, assume that the respondent’s submission on this point was correct, but it added that such an assumption alone would not resolve the issue before it. The Court explained that the term “compensation” inherently implies a payment intended to replace a loss suffered by the person who receives it; consequently, if no loss has been incurred, there can be no occasion for compensation to arise. From this principle, the Court inferred that where an employee’s contract expressly provides that, upon termination of service in accordance with the contractual terms, the employee is not entitled to any further relief, there can be no basis for the employee to claim compensation for loss of employment, nor can any payment made to the employee in such circumstances be described as compensation for loss of employment. The respondent contended that a sum paid to an employee at the time of termination need not constitute compensation that the employee has a legal claim to receive. The respondent further argued that any voluntary payment made at that time, whether described as a gift or a solatium, would nevertheless constitute compensation for loss of employment. In support of this position, the respondent relied upon the judgment of Romer L.J. in Henry (HM Inspector of Taxes) v Arthur Foster, where the learned judge stated that the phrase “compensation for loss of office” is a well‑known expression meaning a payment to the holder of an office as compensation for being deprived of profits that, between the holder and the employer, he would have earned but for an act of deprivation by the employer or some third party such as the Legislature. The Court pointed out that the word “deprived” suggests that the office‑holder is denied profits because of an unjustified act by the employer, and that “deprived” carries a connotation of coercion, as noted in the Law Lexicon of British India by P. Ramanatha Aiyar. Likewise, the term “entitled” signifies that the employee possesses a legal claim to the profits from which he is deprived and, consequently, is entitled to compensation for that deprivation. The Court held that neither “deprived” nor “entitled” appropriately applies to a situation where an employee’s tenure is terminated by the employer exercising a contractual right, and where the termination does not give the employee any statutory or contractual right to relief. The Court further referred to Romer L.J.’s comments in the same case, observing that his explanation of the meaning of “compensation for loss of office” aligns with the Court’s own view. Romer L.J. had further explained, at page 634 of the report, that in the case before him the payments in question were to be made on the occasion of death, resignation or cessation of office, and that such circumstances did not give rise to a loss of salary or profit for which compensation could be claimed.

In the judgment, it was observed that under the terms of a man's contract of employment, his office and the salary that accompanied it were destined to terminate upon certain events that were not excepted by the article. The Court explained that it was impossible to say that the employee suffered a loss of salary or profits when he died, resigned, or otherwise ceased to hold office, because his contractual rights to those emoluments ended at that moment. Consequently, the expression “compensation for loss of office” was described as wholly misleading in such a situation. The Court further stated that when a contract expressly provides that the employee has no further claim to salary or profits after termination, any sum paid thereafter cannot be characterized as compensation for loss of office. According to Romer, L.J., the phrase “compensation for loss of office” could apply only where the holder of the office was legally entitled to receive payment because he was, against his will, deprived of profits to which he was contractually entitled. If the employee was not entitled to any profits upon cessation, any payment made could not be described as compensation for loss of office.

The respondent relied on several authorities to argue that the amount received by the assessee fell within the expression “compensation for loss of office,” which the respondent treated as synonymous with “compensation for loss of employment.” The Court first considered the case reported as Commissioner of Income‑Tax v. Shaw, Wallace & Co. (1932) L.R. 59 I.A. 206, which examined whether a sum paid to a firm as compensation for the termination of certain agency arrangements was assessable under sections 10 and 12 of the Income‑Tax Act. Section 10 dealt with income, profits and gains from business, while section 12 covered income from other sources that might otherwise be included in total income. The tribunal held that the sum was not taxable as business income because, under section 10, tax is payable on profits or gains derived from a business actually carried on, and the payment in question was not received for the conduct of a business but as a solatium for its compulsory cessation. The Court noted that this reasoning did not assist in determining whether the present sum constituted “compensation for loss of employment,” as the earlier case had not examined whether the payment was compensation at all, given that there was no dispute on that point. The Court therefore indicated that the cited cases dealing with payments on cessation of agencies were of no assistance in resolving the issue before it.

The Court noted that earlier decisions dealing with the cessation of agency contracts were of no assistance in determining the issue before it, although the respondent had placed considerable reliance upon those decisions. The Court then referred to Anglo‑French Exploration Co. Ltd. v. Clayson (H.M. Inspector of Taxes) (1), a case concerning the assessment of income‑tax under Schedule D of the English Income‑Tax Act. In that case the question was whether the sum that was sought to be assessed should be treated as annual profits arising from or accruing to any trade carried on within the United Kingdom. The amount in question had been paid to the assessee because the assessee had resigned as an agent of another company. Lord Evershed, M.R., observed at page 557 that the real issue was not whether the sum could in some sense be described as a “capital” payment, but whether, within the meaning of Schedule D, it represented a profit or gain arising from the trade of the recipient. The Court applied the same line of enquiry to the present matter, observing that the question was not whether the sum of Rs 2,21,000 could be characterised as a capital receipt in any sense, but whether that sum could be characterised as a payment to the assessee as compensation for the loss of his employment with Killick Nixon & Co. The Court then considered the decision in Commissioner of Income‑Tax, Hyderabad Deccan v. Messrs Vazir Sultan & Sons (1). In that case the assessee had received a certain amount as compensation for the termination of his agency over a specific area, although the agency continued in other areas. The earlier Court had held that the amount sought to be taxed was a capital receipt in the hands of the assessee and therefore not income from business chargeable under section 10 of the Income‑Tax Act. The present Court clarified that it was not concerned with deciding whether the amount of Rs 2,21,000 was a capital receipt or a revenue receipt in the hands of the respondent. In view of Explanation 2, the Court held that the sum would be treated as a revenue receipt, being deemed “profit in lieu of salary”, because it was a payment made by the employer to the employee where the payment was not made as compensation for loss of employment. With reference to the question of whether the sum was a capital or revenue receipt, the Court recalled that in the Vazir Sultan case (1) it was submitted that there was no enforceable agreement between the assessee and the company that could give rise to a legal claim for damages or compensation by the assessee if the agreement were terminated or cancelled by the company. The agency agreement was terminable at the will of the company, and if the company chose to terminate it the assessee had no remedy at law. Bhagwati, J., speaking at page 392, warned that in all such cases one must remember the underlying principle that the nature of the receipt in the hands of the assessee must be examined irrespective of the motive or intention of the other party.

The Court explained that analysis must focus on the nature of the receipt in the hands of the assessee, without regard to the motive of the other party. For purposes of Explanation 2 to subsection (1) of section 7, the perspective is that of the employer who makes the payment, not that of the employee who receives it. The payment excluded from the first part of the Explanation is defined as “the payment made solely as compensation for loss of employment”. The exception therefore applies to the character of the employer’s obligation, not to the character of the amount received by the employee. The employer must make such a payment only when he is compelled or liable to pay compensation, and therefore the Court’s observations do not contradict the earlier explanation of the word “compensation”. The Court noted that there are other decisions dealing with payments made to employees at the termination of their services. The Court stated that English decisions are of relevance because in those cases the payments were taxed under Schedule E of the Income‑tax Act, which dealt with income of persons holding an office or employment. Those English cases held that the payments did not arise by reason of the office that had ended and were characterized as testimonials, solatium or gifts, and therefore were not taxable. However, Explanation 2 to subsection (1) of section 7 of the Indian Income‑tax Act provides for taxation of such sums on a different basis, and consequently the English rulings under Schedule E cannot be used to decide whether a sum constitutes compensation for loss of employment under Indian law. The Court referred to Covan v. Seymour, where payments made to a company secretary by shareholders out of profits were held not to accrue to him in respect of an office or employment of profit, and therefore those payments were deemed not chargeable under Schedule E. Nevertheless, the Court quoted the judgment at page 378, stating that it is well settled that a voluntary payment, if it accrues by reason of an office or employment, is a profit under this Section. The Court further observed that a voluntary payment or a gift can be a profit if it accrues by reason of the office. In that case the amount was held to be a testimonial for past services rendered while the office was still held. The payment was made after the office had terminated and was not intended as compensation for those services. The Court identified the factors leading to that conclusion as the timing of the payment after termination and the nature of the payment.

In the case of Chibbett v. Joseph Robinson & Sons (2) the assessees, who were a firm of ship‑managers, had been taxed under Schedule D of the English Income‑Tax Act. The firm had performed its managerial duties for a particular steam‑ship company. When that company entered liquidation, the liquidator transferred to the assessees a sum of £50,000 consisting of 5 percent National War Bonds, describing the transfer as compensation for the loss of the office the assessees had previously held. After the liquidation, the undertaking of the former company—including two ships and its remaining assets—was transferred to a newly formed company that bore the same name and was owned by the same shareholders. The assessees were then appointed as the first managers of this new entity, and their remuneration was fixed on terms that were substantially similar to those that had applied previously. The court examined whether the £50,000 payment should be treated as a profit liable to income‑tax or excess‑profits‑tax duty. It concluded that the nature of the payment did not constitute a taxable profit. Rowlatt, J. expressed this view at page 61, stating: “But at any rate it does seem to me that compensation for loss of an employment which need not continue, but which was likely to continue, is not an annual profit within the scope of the Income‑tax at all.” These observations were made in reference to the provisions relating to income‑tax that were applicable in the jurisdiction.

The reasoning in Chibbett was later considered in Henry (H. M. Inspector of Taxes) v. Arthur Foster Etc. (1). In that matter, the sum paid to a man named Dewhurst was examined in the context of an article of association that regulated his remuneration as a director of a company. Lord Macmillan, speaking at page 653, cautioned that the earlier observations were “too widely expressed,” adding that remuneration for services may, in part, take the form of a payment at the end of the employment, and that a payment does not cease to be remuneration merely because it becomes payable after the services have ended. Returning to the facts of Chibbett’s case, Rowlatt, J. reiterated at page 61 that the original company had unequivocally ceased to exist, and that the liquidator’s grant of the £50,000 was made “out of their abundant prosperity, once for all, not because of anything they were doing, but really very much, I think, as the Master of the Rolls puts it, as a testimonial for what they had done in the past in their office which had now terminated.” He further explained that, while the receipt could be described as a trade receipt—since the individuals would not have obtained it had they not been managers—it was not a personal gift. The payment was made because of the assessees’ former status, and it represented a solatium for the termination of the old arrangement rather than a conventional profit arising from ongoing employment.

The Court observed that the lump‑sum payment could be described either as compensation for the loss of office or as a testimonial for the work the assessee had performed in the past, work that had now come to an end. The principal issue for determination was whether the disputed amount fell within the definition of profits under Schedule D. The Court noted that it was not essential to ascertain the exact character of the sum, provided it was not classified as profits. Accordingly, the alternative view expressed by Rowlatt, J. was acknowledged, namely that the payment might represent compensation for loss of office or a testimonial for past services rendered by the assessee. The Court further held that this precedent did not aid the respondent’s argument that the sum of Rs 2,21,000 constituted compensation for loss of employment.

The Court then referred to Duff (H. M. Inspector‑of Taxes) v. Barlow, in which the Managing Director of a company received a payment of £4,000 for the loss of his right to future remuneration that he was entitled to under a prior agreement, while he continued to hold the position of Managing Director. That case was held to show that the £4,000 was not remuneration under the contract of employment, nor payment for services rendered or to be rendered, but was instead compensation for surrendering a right to remuneration. The Court found that Duff did not offer any guidance for the matter presently before it. In a similar vein, the Court cited Hose v. Warwirk (H. M. Inspector of Taxes), where a sum paid to the assessee was held to be compensation for the relinquishment of rights arising from an earlier service agreement and personal connection with the payer. In both of these authorities, the payment was made for the loss of a benefit to which the recipient was legally entitled under an existing agreement. Because the respondent in the present case had no entitlement to any emoluments after his service terminated upon one‑month’s notice pursuant to the original contract, those decisions were deemed inapplicable.

The Court noted that several decisions of this Court and the High Courts had been examined, but only one Supreme Court decision directly concerned an assessment under Explanation 2 to sub‑section (1) of section 7 of the Act. That decision was Mahesh Anantrai Pattani v. The Commissioner of Income‑tax, Bombay North, Ahmedabad. In that case, the assessee had served as Dewan of the State of Bhavnagar and, upon retirement, was granted a monthly pension of Rs 2,000. After the State merged into the United States of Saurashtra on 1 March 1950 and the Maharajah ceased to be the ruler, the Maharajah ordered, on 31 May 1950, a payment of Rs 5,00,000 to the former Dewan.

In the case of Mahesh Anantrai Pattani, the Maharajah wrote a letter dated March 10, 1953, in which he declared that the sum of five hundred thousand rupees was given as a gift in token of his affection and regard for the assessee and his family. Earlier, in a letter dated December 27, 1950, the Maharajah had described the same amount as a gift in consideration of the assessee, the former Dewan of the State, having rendered meritorious and loyal services. The Supreme Court, by a majority, concluded that the Income‑tax Appellate Tribunal ought to have given effect to the later letter of March 10, 1953, because that document indicated that the payment was made as a personal gift for the assessee’s personal qualities and as a token of personal esteem, and it was not made in appreciation of services rendered as Dewan of Bhavnagar State. The Court therefore accepted the assessee’s argument that the payment did not fall within Explanation 2 to sub‑section (1) of section 7 of the Act, since the payment was neither made by the Maharajah for services rendered to him nor could it be related to the office of Dewan that the assessee had previously occupied, having already received compensation for his services to the Maharajah personally and to the State. Justice Kapur, speaking at page 749, observed that the December 1950 document contains no reference to any services rendered to the Maharaja, and that the Tribunal had not examined why the Maharaja would use his personal funds to make such a large gift for something that was not done for the Maharaja specifically, especially when the services to the State and to the Maharaja and his family had already been well compensated. He noted that this observation supported the appellant’s contention that the amount was paid merely as a gift reflecting the Maharaja’s affection and regard for the assessee. Again, at page 752, Justice Kapur remarked that while it was clear that the gift was voluntary, it was difficult to see how the amount could be related to the office held by the recipient. He pointed out that, according to the respondent’s own case, the payment was made about two years after the assessee had ceased to be an employee of the Maharaja or the State, and that immediately after the assessee’s retirement as Dewan of Bhavnagar State, the Maharaja had granted him a generous monthly pension of two thousand rupees from public funds for his services to the State as Dewan and for services rendered to the Maharaja and his family. Consequently, the Court held that Explanation 2 to sub‑section (1) of section 7 of the Act was not applicable to the sum of five hundred thousand rupees, because that sum was not paid by the State, the former employer, out of public funds for services rendered, but was paid by the Maharaja personally from his own funds to the assessee.

In this case the Court observed that the payment was made as a token of affection and regard to the employee and his family and was not made in reference to any services rendered. The Court further noted that the facts differed from those in Pattani’s Case (1). It was emphasized that it could not be said, and the respondent did not contend, that the amount of Rs. 2,21000/‑ was given as a personal gift because of the assessee’s personal qualities or as a token of personal esteem. The Court pointed out that a similar payment had been made to all the employees of the company, that the payment was clearly connected with past services, and that it was made a day before the employee’s services were terminated. Consequently, the Court held that Pattani’s Case did not support the respondent’s position. The Court then reviewed the jurisprudence of several High Courts on the question of whether a sum is taxable under Explanation 2 to sub‑section (1) of section 7 of the Act. In the majority of those decisions, the sum was considered compensation for loss of employment, and the recipient was deemed entitled to such compensation under law. The Court cited the authorities P. D. Kholsa, In re (1); H. S. Captain v. Commissioner of Income‑Tax (2); and Agrawala v. Commissioner of Income‑Tax (3), all reported respectively in [1961] 2 S.C.R. 742 and the relevant Income‑Tax Reports. The Court noted that only in one case was the recipient not entitled, and that decision had been based on a broader interpretation of the term “compensation for loss of employment,” a view the Court rejected. The Court also considered the decision in W. A. Guff v. Commissioner of Income‑Tax, which the respondent relied upon. In that case the assessee had joined the company as an executive under an agreement that allowed termination on six months’ notice. After receiving notice on 23 March 1948 that the department would be closed, the assessee continued to serve until 10 November 1948 to wind up the department. On 13 November 1948 the company paid him Rs. 12,000/‑, equivalent to six months’ salary, as compensation for the termination of his employment caused by the closure. The Court held that the March notice constituted the contractual termination required, and that the payment was not for past services but was a solatium for the loss of employment, therefore a capital receipt exempt from tax. Chief Justice Chagla, quoting at page 831, stated that to succeed, the assessee must demonstrate that the payment was made solely as compensation for loss of employment. The Court explained that the expression “compensation for loss of employment” gives rise to two possible interpretations. One view, cited in [1945] 13 I.T.R. 436; [1959] 36 I.T.R. 84; [1960] 38 I.T.R. 67; and [1957] 31 I.T.R. 826, regards compensation as an amount that the employer is legally obliged to pay to the employee, implying that only payments arising from a legal liability fall within the Explanation.

The Court observed that an employer is legally obliged to pay an employee only when the employee’s loss is such that the law would require the employer to compensate that loss. In other words, if there is no legal liability on the part of the employer to make compensation, any sum paid by the employer would fall outside the meaning of the term used in Explanation 2 of sub‑section (1) of section 7. The Court then framed a further question for consideration: whether the expression in Explanation 2 should be interpreted narrowly, limiting it to situations where a legal liability exists, or whether it should be understood more broadly to include a solatium for the deprivation of employment by the employer. Put differently, the inquiry was whether the Legislature intended merely to address the factual loss of employment and any amount paid for that loss, irrespective of whether the payment arose from a legal liability.

Proceeding to its own view, the Court expressed that, apart from the cited authorities, the broader interpretation appears preferable. The reasoning was that when an employee loses his employment—the source of his income—any payment made by the employer to offset that loss should not be treated as taxable income. Such a payment, by its very nature, functions as compensation or a solatium for the loss of the very source that generated taxable earnings, and therefore it should not be included in the employee’s assessable income.

The Court clarified that the term ‘solatium’ is not synonymous with ‘compensation.’ The phrase ‘compensation for loss of employment’ is distinct from a ‘profit in lieu of salary’ as contemplated in Explanation 2, and it is also distinct from a ‘gift’ or any other form of payment that is separate from compensation. To support this perspective, the Court referred to the earlier decision of Commissioner of Income‑Tax v. Shaw, Wallace & Co., acknowledging that it had already examined that case and concluded that it does not inform the construction of Explanation 2 to sub‑section (1) of section 7.

The Court noted that the Privy Council in that case held that the sums received were not derived from the conduct of a business and therefore were not taxable. Although the Privy Council described those receipts as a form of solatium for the compulsory cessation of agencies, it did not elaborate on the precise nature of that solatium. The Court opined that the forced termination of employment is not the same as the forced termination of an agency for the purpose of deciding whether a voluntary payment made at the end of employment or at the end of an agency should be taxed. The two situations are governed by different provisions of the Act, and the character of the payment must be examined according to Explanation 2 of sub‑section (1) of section 7 in one context and according to the relevant provisions applicable in the other context.

In this case, the Court referred to section ten of the statute and indicated that, in the earlier judgment known as Guff’s Case, Chief Justice Chagla, together with Justice Chibbett and the observations of Lord Justice Romer in the matter of Henry (H.M. Inspector of Taxes) v. Arthur Foster, had been considered. The Court already examined the remarks made by Lord Justice Romer concerning the character of the disputed payment, and it had also reviewed the principles set out in Chibbett’s Case. Consequently, the Court felt no further discussion of those authorities was required. The Court therefore expressed the view that any amount paid by an employer or a former employer to an employee at the time the employee’s services end will constitute a “payment made solely as compensation for loss of employment” only when the payment is made in response to a claim that the employee is legally entitled to such compensation, either under statutory law or under the terms of the employment contract. If the employee has no entitlement to claim such compensation, the amount paid cannot be characterized as compensation for loss of employment. The Court emphasized that it does not matter whether the employer makes the payment or the employee receives it as compensation; the true nature of the sum must be determined according to the principle just described.

The Court then turned to the facts of the present matter. It observed that the assessee’s employment was terminated by the firm giving him one month’s notice, as stipulated in his service contract, and that the assessee possessed no contractual or legal right to any compensation upon termination. Accordingly, the payment of Rs 2,21,000 made by the employer to the assessee could not be described as compensation for loss of employment. The Court therefore considered whether the payment fell within the first part of Explanation two to subsection one of section seven, which defines “profits in lieu of salary.” The Court noted that the sum was received by the assessee a day before his services ended, and that it was paid by the firm in its capacity as employer to the individual in his capacity as employee. Because these circumstances matched the description in the first part of the Explanation, the Court held that the amount must be treated as “profit in lieu of salary” for purposes of subsection one of section seven. Consequently, the assessee was liable to pay tax on the amount under the head “salaries” as provided by section seven of the Act. The Court further observed that it was unnecessary to decide whether the sum was a capital receipt or a revenue receipt, since, by being classified as “profit in lieu of salary,” it is automatically deemed a revenue receipt and therefore “income” under the Act. The respondent had argued that the wording of the first part of the Explanation should be given a narrow construction, limiting it to payments made strictly because of the employer‑employee relationship. The Court, however, rejected that narrow view and affirmed that the payment of Rs 2,21,000 was indeed made because of the existing employment relationship, and therefore fell squarely within the scope of “profit in lieu of salary.”

In this case, the Court observed that a payment can be characterised as “profit in lieu of salary” only when it arises from the relationship between an employer and his employee. The Court noted that the argument advanced by the respondent sought to limit the meaning of the first part of the Explanation so that it would apply only to payments made for reasons unrelated to the employer‑employee relationship. Accordingly, the respondent contended that because the sum of Rs. 2,21,000/- was not linked to the relation between the firm and the assessee, it could not be treated as “profit in lieu of salary”. The Court rejected that restricted construction. Even assuming a narrow interpretation of the Explanation, the Court held that the sum of Rs. 2,21,000/- fell within its scope because it was paid to the assessee owing to the employer‑employee relationship. The payment was made in connection with the assessee’s service to the firm and was the consequence of the termination of his employment under the terms of his contract. The Court emphasized that the amount was not provided for any extraneous consideration, personal affection, esteem, or any special personal qualities of the assessee, nor was it a payment made because of any personal relationship between the firm’s partners and the assessee. Rather, the Court found that the amount was paid in recognition of the assessee’s past service, which the employer appreciated. On this basis, the Court concluded that the sum of Rs. 2,21,000/- received by the respondent, who was an employee of Killick Nixon & Co., on the occasion of the termination of his services after the requisite one‑month notice, did not constitute compensation for loss of employment. Consequently, the amount amounted to “profit in lieu of salary” within Explanation 2 to subsection (1) of section 7 of the Act and was therefore subject to income‑tax. The Court therefore held that the High Court had erred in holding otherwise. The appeal was allowed with costs, and the answer to the reference point was that the sum was taxable as “profit in lieu of salary” under subsection (1) of section 7 of the Act. By the Court: In view of the majority judgment the appeal is dismissed with costs. Appeal dismissed.