Bombay Steam Navigation Co. (1953) Private Ltd. vs Commissioner of Income-Tax, Bombay

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

Court: Supreme Court of India

Case Number: Civil Appeals Nos. 1023-1024 of 1963

Decision Date: 21 October 1964

Coram: J.C. Shah, S.M. Sikri

In the matter titled Bombay Steam Navigation Co. (1953) Private Ltd. versus Commissioner of Income‑Tax, Bombay, the Supreme Court of India delivered its judgment on 21 October 1964. The judgment was authored by Justice J.C. Shah, who was joined by Justice S.M. Sikri, and it also recorded the observations of Justice Subba Rao. The case was reported in the 1965 volume of the All India Reporter at page 1201 and in the 1965 Supplementary Cause Reports at page 770, with subsequent citations appearing in later law reports. The appeal concerned Civil Appeals Nos. 1023‑1024 of 1963, arising from the judgment and order of the Bombay High Court dated 9 August 1962 in Income‑Tax Reference No. 3 of 1961. The parties before the Court were the petitioner, Bombay Steam Navigation Co. (1953) Private Ltd., and the respondent, the Commissioner of Income‑Tax, Bombay.

The issue before the Court concerned the deductibility of interest paid on the unpaid portion of a purchase price for assets acquired by the petitioner for its business. Under the Income‑Tax Act, 1922 (Act 11 of 1922), section 10(2)(iii) permits a deduction only for interest paid on capital actually borrowed for the purpose of the business, profession, or vocation. The petitioner had been incorporated with the objective of taking over certain passenger and ferry services on the Konkan Coast. It purchased the necessary assets from the Scindia Steam Navigation Company, paying part of the consideration by issuing its own fully paid shares and leaving the remaining balance unpaid. The purchase agreement stipulated that interest at six per cent per annum would be payable to the Scindia Company on any unpaid balance until the whole amount was settled. The Income‑Tax authorities disallowed the deduction of this interest in computing the petitioner’s profits and gains, a decision that was affirmed by the High Court. The Supreme Court held that the interest paid by the petitioner was a permissible deduction, but not under section 10(2)(iii); rather, it fell under section 10(2)(xv). The Court explained that a mere agreement to pay the balance of consideration does not create a loan, and although a loan creates a debt, not every debt constitutes a loan. Consequently, the unpaid balance did not represent capital borrowed, and the interest could not be deducted under section 10(2)(iii). The Court approved the earlier decisions in Metro Theatre Bombay Ltd. v. C.I.T. (1946) 14 I.T.R. 638 and V. Ramaswami Ayyangar and another v. C.I.T., Madras (1950) 18 I.T.R. 150, while distinguishing C.I.T., Madras v. S. Ramsay Ungar (1947) 15 I.T.R. 87. Justice Subba Rao reserved his opinion on the application of clause (iii) of sub‑section (2) of section 10 of the Indian Income‑Tax Act, 1922 to the claim for interest deduction.

The Bombay High Court rendered its judgment on August 9 1962 in Income‑tax Reference No 3 of 1961. Counsel for the appellant in both appeals comprised A V Viswanatha Sastri, T A Ramachandran, J B Dadachanji, O C Mathur and Ravinder Narain. Counsel for the respondent in both appeals included C K Daphtary, Attorney‑General, K N Rajagopala Sastri, R H Dehbar and R N Sachthey. The judgment of Justices J C Shah and S M Sikri was delivered by Justice Shah. Justice Subba Rao expressed agreement with the conclusion but stated that he would not articulate a view on the construction of clause (iii) of sub‑section (2) of section 10 of the Indian Income‑tax Act, 1922.

Bombay Steam Navigation Company Ltd., which operated passenger and ferry services along the Konkan coast and in the Bombay harbour, was amalgamated with effect from 30 June 1952 into the Scindia Steam Navigation Company Ltd., thereafter referred to as “the Scindias”. The High Court of Bombay sanctioned the scheme of amalgamation and authorized the Scindias to establish a joint‑stock company whose purpose was to assume the services previously provided by Bombay Steam Navigation Company Ltd. Pursuant to that authority, Bombay Steam Navigation Co. (1953) Private Ltd., hereinafter called “the assessee Company”, was incorporated on 10 August 1953. On 12 August 1953 the assessee Company entered into a contract with the Scindias for the purchase of certain steamers, launches, boats, barges, buildings, furniture, fixtures and vehicles, the consideration for which was provisionally estimated at Rs 80 lakhs. The agreement stipulated that the purchase price would be satisfied by allotting to the Scindias 29,900 fully paid‑up shares of Rs 100 each in the share capital of the assessee Company, and that the remaining balance would be treated by the assessee Company as a loan granted by the Scindias. Clause 3(b) of the agreement provided that interest at a simple rate of six per cent per annum would be payable on the unpaid balance of the purchase price. The clause read: “The balance shall be treated by the Transferee Company as a loan granted by the Transferor Company secured by a Promissory Note duly executed by the Transferee Company in favour of the Transferor Company and until it is repaid in full it shall carry interest of 6 % per annum (simple) and shall be further secured by hypothecation of all movable properties of the Transferee Company in favour of the Transferor Company.” (L2Sup.165‑6). Upon final valuation of the transferred assets, it was determined that the assessee Company was liable to pay Rs 81,55,000 to the Scindias. By a supplemental agreement dated 16 September 1953, the original clause 3(b) was rectified with retrospective effect from 12 August 1953, and replaced by the following provision: “The balance shall be paid by the Transferee Company to the Transferor Company on completion of the transfer referred to in Clause 2 above and until…”

The amendment provided that until the balance was repaid in full, the amount then unpaid would bear simple interest at six per cent per annum. The unpaid amount would also be secured by hypothecation of all movable property of the Transferee Company in favour of the Transferor Company. In the assessments for the fiscal years 1955‑56 and 1956‑57, the Income‑Tax Officer of Companies Circle II in Bombay refused to allow the assessee Company to deduct amounts it had paid as interest. The amounts in question had been paid to the Scindias. Specifically, the officer disallowed a payment of Rs 2,74,610 made in the financial year ending 30 June 1954 and a further payment of Rs 2,86,823 made in the year ending 30 June 1955. The officer’s order was subsequently upheld by the Appellate Assistant Commissioner and later affirmed by the Appellate Tribunal. The High Court of Bombay, acting on a reference from the Income‑Tax Appellate Tribunal, answered in the negative the question whether, on the facts and circumstances. The sums of Rs 2,74,610 and Rs 2,96,823 representing interest could be permitted as a deduction under any of sections 10(2)(iii), 10(2)(xv) or 10(1) of the Income‑Tax Act. After obtaining a certificate of fitness under section 66A(2) of the Act, the assessee Company filed an appeal before this Court. The company contended that the interest payments were incurred in the ordinary course of its business and therefore should be allowed as deductions. Consequently, the company’s taxable profit for each year was increased by the amount of the disallowed interest.

In the computation of its profits and gains, the assessee Company asserted that the two interest payments could be taken as permissible allowances under section 10(2)(iii) or alternatively under section 10(2)(xv). The Company further argued that, even when profits were determined under the general rule of section 10(1), the interest amounts were necessarily deductible because they related to capital borrowed for business purposes. Section 10, in its opening clause, declares that tax is payable by an assessee under the head ‘Profits and gains of business, profession or vocation’. The tax applies to the profit or gain of any such activity carried on by the assessee in the relevant year. Consequently, tax liability arises only with respect to profits earned in a year in which the business is actually carried on; if no business is conducted in that year, no tax falls under section 10(1). Clause (iii) of subsection (2) of section 10 provides that profits or gains shall be computed after making the allowance for interest paid on capital borrowed for the purposes of the business, profession or vocation. The proviso and the explanatory note attached to this provision were not relied upon in the present appeals. The phrase ‘such profits or gains’ in subsection (2) is to be understood, on plain language, as referring to the profits or gains of a business that is carried on during the relevant accounting year. In determining the taxable profit from the receipts of the business, both revenue and certain capital allowances, such as depreciation and interest on borrowed capital, may be deducted.

In the computation of profits or gains derived from a business carried on during the accounting year, the law permitted the allowances enumerated in clauses (i) through (xv); some of these allowances were of a revenue nature while others were of a capital nature. The gross profit or gain necessarily represented revenue receipts. Nevertheless, when determining taxable profit from those receipts, the statute allowed not only deductions for revenue expenses but also certain deductions for capital expenditures, such as depreciation, amounts paid to scientific research associations, expenditures of a capital character on scientific research, and other capital outlays. Clause (iii) of subsection (2) specifically authorised an allowance for interest paid on capital that had been borrowed for the purpose of the business, profession, or vocation. The term “capital” in that clause, within its context, was understood to refer to money and not to any other type of asset, because interest becomes payable on a loan of money and not on assets acquired under a contract. Although interest paid did not have to be characterised as a revenue outflow, it could be claimed as an allowable deduction under clause (iii) only if it was paid on money that had actually been borrowed; interest paid on amounts that had not been borrowed could not be allowed. In the present matter, the assessable company had, in fact, not borrowed any capital. To summarise the relevant facts, the company had purchased the assets it required for its business from the Scindias and had paid a portion of the purchase price by issuing shares valued at Rs. 29,99,000, leaving a balance of Rs. 51,56,000 unpaid. Clause 3(b) of the original contract stated that this outstanding balance was to be treated as a loan from the Scindias to the company, but a later amendment gave the covenant a retrospective effect and recharacterised the amount as the remaining purchase price still owing. Counsel for the company contended that the company was indebted to the Scindias for Rs. 51,56,000, a debt that was secured by a promissory note and a charge on the company’s assets. According to that counsel, the substance of the arrangement was that the Scindias had effectively advanced a loan to their subsidiary—the company—to enable it to acquire the necessary assets, even though the formal documentation did not label the transaction as a loan. Because a contractual liability to repay a debt had therefore arisen, the counsel argued that the court should treat the transaction as involving a borrowing of the agreed sum. The counsel further submitted that if the company had borrowed the same amount from an unrelated party and had paid the full consideration to the Scindias, the interest paid to that unrelated lender would unquestionably be an allowable deduction in computing the company’s taxable profit, and there was no justification for applying a different principle when, in substance, the Scindias had supplied the funds required for the purchase. It was also submitted that the transaction with the vendor could be seen as a composite arrangement consisting of (i) a borrowing of Rs. 51,56,000 from the Scindias and (ii) a payment of the entire purchase price for the assets acquired from the Scindias, and that this view should be adopted in determining the true nature of the transaction.

In this case the Court observed that there was no justification for applying a different principle simply because the Scindias, in substance, had supplied the funds needed for the assessee Company to acquire the assets. It was contended that the transaction with the vendor could be characterized as a composite transaction, first as a borrowing of Rs 51,56,000 from the Scindias and second as a payment of the full consideration for the purchase of the assets from the Scindias. The Court held that this characterization was not a permissible method for determining the true nature of the transaction. The parties had agreed that the assessee Company would take over assets valued at Rs 31,55,000 from the Scindias. Of this amount the assessee Company had actually paid Rs 29,99,000, leaving the remaining balance unpaid. Because the Scindias consented to a deferred payment of that part of the consideration, they were to receive interest on the unpaid portion. The Court explained that an agreement to pay the outstanding balance of the purchase price does not, in reality, create a loan. While a loan of money inevitably creates a debt, not every debt originates from a loan; a debt may arise from many different sources, and a loan is only one of those sources. Moreover, a creditor who is entitled to receive a debt cannot automatically be treated as a lender. The Court noted that if the required consideration had been borrowed from an unrelated party, the interest paid on that borrowing for business purposes would have been allowed as a deduction, but that circumstance was entirely irrelevant to the issue of whether clause (iii) of sub‑section (2) applied in the present case. The Legislature, under clause (iii), permitted a deduction for interest paid on capital that had been borrowed for business purposes; if interest is paid on capital that has not been borrowed, clause (iii) does not apply. The Court referred to the decision in Metro Theatre Bombay Ltd. v. Commissioner of Income‑Tax(1), where the Bombay High Court held that the simple purchase of a capital asset on long‑term credit with a provision for interest on the reduced balance did not constitute borrowing of capital within the meaning of section 10(2)(iii). In that case the assessee had agreed to obtain a long‑term lease of property and to pay the stipulated consideration in half‑yearly instalments over several years, with interest at five per cent on the outstanding balance. The interest paid on that balance was disallowed as a permissible deduction in computing total assessable income. The Court distinguished that situation by noting that the liability to pay interest in Metro Theatre arose from an agreement to obtain a future lease, whereas the liability in the present matter arose from an agreement to pay the unpaid balance of a completed sale transaction. However, the Court found that this distinction was not substantive, because in both cases the amounts paid were interest, and in neither case was the interest paid on capital that had been borrowed. The Court then referred to the decision in V. Ramaswami Ayyangar and Anr v. Commissioner of Income‑Tax, Madras(2), where the assessee

In this case, the petitioner who was engaged in a money‑lending business contended that, for the purpose of computing his business income, the interest paid on death duty owed to the Government of Ceylon on property inherited from a deceased person could be deducted under section 10(2)(iii). The Court rejected that contention. It observed that although the amount of death duty that remained unpaid was subsequently employed in the business, such amount could not be characterised as a loan from the Government of Ceylon. The Court explained that section 10(2)(iii) is intended to cover situations where a lender advances money to a borrower and the borrower agrees to repay the principal together with interest; when a loan thus obtained is used for the borrower’s business, the interest on that loan is a deductible expense. (1) (1946) 14 I.T.R. 638. (2) (1950) 18 I.T.R. 150. By contrast, an amount that becomes payable under a statute does not constitute borrowed capital, because the concept of “capital borrowed” requires the existence of a borrower‑lender relationship, which was absent here. The Court further noted that the principle articulated in Commissioner of Income‑Tax, Madras v. S. Ramsay Unger (1), which had been heavily relied upon by the counsel for the appellant, could not be applied, since in that earlier case the Court had found, on the facts, that the liability to pay interest arose out of a genuine borrowing of capital and consequently the entire interest recorded in the books was allowable as interest on borrowed capital. Accordingly, the Court agreed with the High Court that the claim for a deduction of interest under section 10(2)(iii) could not be allowed. Nevertheless, the Court held that the interest actually paid by the assessee company was deductible under section 10(2)(xv), which permits “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 of the assessee laid out or expended wholly and exclusively for the purpose of such business, profession or vocation” as an allowable deduction in computing the profits or gains of the business for the relevant accounting year. The Court recognised that interest is indeed an expenditure, but it does not fall within the specific allowance described in clause (iii) and none of the other clauses (i) to (xiv) apply to interest on the unpaid balance of the consideration for the sale of assets. The expenditure in question arose after the business had commenced, it was not incurred for any private or domestic purpose, and it was incurred in the capacity of a person carrying on a business. The remaining issue, therefore, was whether such expenditure should be regarded as capital in nature. The Court observed that formulating a definitive test for distinguishing capital from revenue expenditure is generally difficult, and the determination must depend on the particular facts and circumstances of each case.

In determining whether an outlay is of a capital or revenue nature, the Court must examine the specific facts and circumstances of each case, taking into account the character of the business, its ordinary course, and the purpose for which the expenditure was incurred. The assessee company contended that the interest it paid should be treated as revenue expenditure for its business because, as it argued, failure to pay the interest accruing to the Scindias would enable them to enforce their lien and consequently bring the company’s business to an end; moreover, the company maintained that the outlay was necessary for business expediency and was incurred directly or indirectly to facilitate the continuation of its operations. The Court observed that, although the Scindias would indeed have a right to enforce their lien against the assets of the assessee’s business if the principal or interest were not paid, this circumstance alone does not justify classifying the interest payment within section 10(2)(xv). Even where a liability bears no connection to the business, a creditor may be able to seize the business’s assets, and such seizure could halt business activities; nevertheless, expenditure incurred to satisfy a liability unrelated to the business, even if undertaken to avoid a danger to the conduct of the business, cannot be characterised as revenue expenditure. Likewise, the presence of some relationship between a liability and the business does not automatically render the expenditure falling under section 10(2)(xv). The Court held that the character of any particular expenditure must be assessed by considering all the surrounding facts and applying the principles of commercial trading. The inquiry must be placed in the broader context of business necessity or expediency. Where the outlay is so closely linked to the carrying on or conduct of the business that it forms an integral part of the profit‑earning process, and where it is not incurred for the acquisition of a permanent asset whose possession is a condition of the business, the expenditure may be treated as revenue expenditure. In the recent decision of State of Madras v. G. J. Coelho (1), the Court examined the permissibility of a deduction under section 5(e) of the Madras Plantations Agricultural Income‑Tax Act, 1955. Section 5(e) is worded in a manner comparable to section 10(2)(xv) of the Income‑Tax Act. Section 5 allows deductions of various items of expenditure in the computation of agricultural income, and clause (e) provides for the deduction of any expenditure incurred in the previous year (not being in the nature of capital expenditure or personal expenses of the assessee) laid out or expended wholly and exclusively for the

In the case under discussion, the assessee had purchased an estate that comprised tea, coffee and rubber plantations situated in the Nilgiris mountains for a total consideration of Rs 3,10,000, as reported in the 1964 decision cited at 53 I.T.R. 186. To finance this purchase, the assessee borrowed Rs 2,90,000 on the basis of an interest‑bearing loan and thereafter claimed a deduction for the interest actually paid, seeking to set off that amount against the income generated by the plantations for the assessment year 1955‑56. The deduction was sought under clauses (e) and (k) of section 5 of the relevant statute. The claim made under clause (k) was rejected because the interest was not payable on the sums that had been borrowed and actually expended on the plantations during the previous year; consequently, the only remaining issue for determination was whether the interest allowance fell within the permissible scope of clause (e) of section 5. The Court held that the interest payment could not be characterised as capital expenditure for the year of account. Instead, the Court observed that even when interest is incurred on capital borrowed for the purpose of acquiring assets that are required for the conduct of a business, such interest must be treated as revenue expenditure in ordinary commercial practice and should not be labelled as capital expenditure. In applying section 5(e), the Court remarked, “The assessee had bought the plantation for the purpose of operating it as a plantation, that is, for the cultivation of tea, coffee and rubber. When the entire transaction—including the purchase and the subsequent operation of the plantation—is viewed as an integrated whole, the interest paid on the borrowed sum is so closely connected with the plantation that the expenditure may be said to be laid out or expended wholly and exclusively for the purpose of the plantation. It is relevant to note that the statute aims to tax agricultural income, not merely agricultural receipts, and therefore from the agricultural receipts all expenses that, in ordinary commercial accounting, would be debited against those receipts must be deducted. No distinction is drawn between interest paid on capital borrowed to acquire a plantation and interest paid on capital borrowed for the purpose of existing plantations; both are incurred for the purposes of the plantation.” From this observation the Court derived a test, namely that any expenditure arising out of a transaction that is so closely related to the business that it may be regarded as an integral part of the conduct of that business can be treated as revenue expenditure that is laid out wholly and exclusively for the business’s purposes. Applying this principle, the Court noted that the assessee company had unquestionably obtained the required assets by pledging its credit. The company had been formed expressly to take over the business previously acquired by the Scindia family, and in order to continue that business the assets necessary for its operation had to be secured. To obtain those assets, the company bound itself to a liability of Rs 51,56,000 and consented to pay the stipulated rate of interest on that sum. The acquisition of the assets was therefore closely linked to the commencement and the ongoing carrying on of the business.

In this case, the Court observed that interest paid on the amount that remained outstanding should, in the ordinary course of business, be regarded as expenditure incurred for the purpose of the business that was being carried on in the relevant year of account. The Court further noted that there was no dispute that if interest was paid for the purpose of the business, it was laid out or expended wholly and exclusively for that purpose. The revenue counsel, Mr. Rajagopala Sastri, argued that because profits that arise after a business has been closed are not taxable under section 10(1), any expenditure whose source is a liability incurred before the actual commencement of business could not be treated as a permissible outgoing under section 10(2)(xv). The Court found it unnecessary to examine the correctness of that argument because it had no factual basis. The Court pointed out that the assessee company was formed on 10 August 1953, entered into the relevant agreement on 12 August 1953, and that interest on the loan was actually paid in the accounting years ending 30 June 1954 and 30 June 1955. Consequently, the liability for interest did not arise before the date on which the business of the assessee company commenced. Section 10(2) requires that, when computing the taxable profits or gains of a business that is carried on in the year of account, allowances described in clauses (i) to (xv) may be made, but such allowances are not permissible if no business was carried on in that year. The Court observed that the interest for which the allowance was claimed was paid at a time when the business was indeed being carried on, and that the source of the liability to pay that interest was also incurred within the period in which the business was carried on. Accordingly, the Court held that the allowance claimed was a permissible deduction under section 10(2)(xv). The Court indicated that, in the present circumstances, it was not required to consider whether, for the purpose of computing income under section 10(1), interest paid could be regarded as a necessary outgoing for the business of the assessee company. The appeals were therefore allowed, with costs awarded in this Court and a single hearing fee ordered. Appeals were allowed.