Indore Malwa United Mills Ltd. vs State of Madhya Bharat and Others

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

Court: Supreme Court of India

Case Number: Civil Appeal No. 1013 of 1963

Decision Date: 1 October 1964

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

In this matter the Supreme Court of India rendered judgment on 1 October 1964 involving Indore Malwa United Mills Ltd., a textile manufacturing company, as the petitioner and the State of Madhya Bharat together with other respondents. The judgment was delivered by a bench comprising Justices J C Shah, S M Sikri and K Subbarao. The case was reported in the 1965 All India Reporter at page 1272 and in the 1965 Supreme Court Reports (first series) at page 559. The dispute concerned the application of the Indore Industrial Tax Rules of 1927, section 3, which corresponded to the provisions of the Indian Income‑tax Act of 1922, section 10(2), regarding the deductibility of trade losses. The petitioner’s memorandum of association authorised it to borrow money for business purposes and to invest such funds, including loans to others. Its board of directors passed a resolution allowing the surplus of the company to be placed in a current account with its managing agents on an interest basis. The managing agents subsequently borrowed large sums from external parties, recorded those borrowings in the company’s books, and invested the amounts with themselves in a current account. Prior to the annual general meeting, the agents would return the money to the company’s accounts to demonstrate repayment of debts, after which they would again withdraw substantial sums for personal use. In 1933 the managing agents’ own company entered liquidation, leaving a considerable debt owed to the petitioner. By 1941 the debt was determined to be unrecoverable, and the petitioner claimed it as a bad debt and a trading loss for the purpose of computing taxable income under the Indore Industrial Tax Rules, whose provisions mirrored those of the Indian Income‑tax Act, 1922. The assessing authority rejected the claim, an order which was affirmed by the Appellate Authority, and the Madhya Pradesh High Court also held that the losses were outside the scope of the company’s business. Consequently the petitioner appealed to the Supreme Court.

The appellant argued that the employment of the managing agents was incidental to the conduct of its business, and that because the agents possessed authority to borrow funds on behalf of the company and to invest surplus amounts in loans to themselves, any loss arising from such investments should likewise be considered incidental to the business and therefore deductible in computing trading profit. The Supreme Court held that the appeal must be allowed. It observed that the managing agents had borrowed money from outsiders and invested it with themselves in accordance with the company’s resolution, and that the borrowed money had become part of the company’s funds, creating legal obligations enforceable by the company’s creditors and by the company against the agents. The borrowing and the investment were entered in the company’s accounts following commercial practice, and the amounts invested with the agents were recorded as debts that became bad debts when they proved unrecoverable. The Court concluded that the loss resulting from these bad debts was incidental to the petitioner’s business and thus deductible in calculating the company’s profits for the assessment year in question.

The Court observed that, because the creditors of the managing agents could have sued the company to recover the sums advanced, the company itself could also have sued the managing agents to recover the amounts it had invested with them. Both the act of borrowing by the company and the subsequent investment of those funds with the managing agents gave rise to enforceable legal obligations. The company recorded these transactions in its books in a manner consistent with ordinary commercial practice. The sums placed with the managing agents were shown in the accounts as debts owed to the company, and when those debts later proved unrecoverable they were re‑classified as bad debts. In the factual context, the loss that resulted from those bad debts was closely connected to the ordinary course of the appellant’s business and, therefore, was allowed as a deductible loss in computing the company’s profit for the assessment year under consideration.

The judgment also cited earlier authorities, namely Badridas Daga v. Commissioner of Income‑tax, [1959] S.C.R. 690 and Commissioner of Income‑tax, U.P. v. M/s. Nainital Bank Ltd., [1965] 1 S.C.R. 340, to support the principle that such losses are deductible when they are incidental to the business. The matter was heard in civil appellate jurisdiction as Civil Appeal No. 1013 of 1963, arising from a November 9, 1960 decision of the Madhya Pradesh High Court in Civil Miscellaneous Appeal No. 40 of 1955. Counsel for the appellant and respondents presented their arguments, and the judgment was delivered by Justice Subba Rao.

The appeal, taken on certificate, sought to overturn the High Court’s order and examined whether an amount of Rs 42,63,090‑14‑7 could be treated as a trading loss for the purpose of determining the appellant‑company’s profits under Section 3 of the Indore Industrial Tax Rules, 1927. The Court set out the essential facts. The appellant, Indore Malwa United Mills Ltd., was a public limited company incorporated and registered under the Indore Companies Act, 1914. From its inception the company had engaged in the manufacture of cloth. Its memorandum of association authorised the company, for the conduct of its textile business, to raise or borrow money as required and to invest its surplus funds, including making loans to third parties.

In order to facilitate its operations, the company originally appointed M/s Karimbhai Ibrahim & Co. Ltd. as its managing agents. On 8 June 1926 the board of directors passed a resolution directing that the company’s surplus fund be invested with the agents on a current‑account basis at an interest rate of six per cent. Subsequently, on 28 November 1929, the company entered into a formal agency agreement with M/s Karimbhai Ibrahim & Sons Ltd., appointing this firm as the new managing agents in place of the earlier appointment. The board reaffirmed the original 1926 resolution on 19 July 1932. Under the authority granted by the agency agreement and the reiterated resolution, Karimbhai Ibrahim & Sons Ltd. borrowed substantial sums from external lenders, recorded those borrowings in the appellant‑company’s books, and then invested the same amounts with themselves “in current account with the company” as contemplated by the resolution.

The managing agents deposited the borrowed sums into the company's accounts and then employed those funds for their own purposes. In the period preceding each Annual General Body Meeting they would introduce large amounts into the company's books and present them as repayments of debts, thereby creating the appearance that the company's liabilities had been settled. After the General Body gave its approval, the agents would again withdraw substantial sums for their personal use. The General Body was aware of these loans and, in fact, gave its approval to the transactions. In 1933 the managing‑agent company entered liquidation. For the assessment year 1941 the appellant‑company filed its income return and, among other items, claimed a deduction of Rs 49,13,316 under the head of bad debt and trading loss that had been written off in its profit and loss account. The appeal concerns only this item, and therefore no other particulars of the assessment need be noted. The Assessing Authority allowed a deduction of only Rs 6,41,913‑2‑0 as bad debt and disallowed the balance due from Karimbhai Ibrahim & Sons Ltd. on the ground that the borrowings had not been made for the purpose of the company's business. On appeal, the Appellate Authority adopted the same view. The High Court, on further appeal, affirmed the Appellate Authority’s finding, holding that the losses incurred by the company were indeed outside the business of the company, even though the losses might have arisen from fraudulent conduct by the managing agents. Consequently, the present appeal was filed.

Counsel for the appellant contended that the employment of the managing agents was incidental to the conduct of the appellant’s business, and that because the agents possessed authority to borrow funds on behalf of the appellant‑company and to invest the surplus in loans to themselves, the loss resulting from such investments was likewise incidental to the business and therefore deductible in arriving at the appellant‑company’s trading profits. Counsel for the respondents advanced two separate contentions. The first contention was that the assessment in question had been made under the Indore Industrial Tax Rules, 1927, which imposed tax only on profits or gains arising from any cotton‑mill industry, and that profits or losses relating to the company's money‑lending activities could not logically be subject to tax or allowance for deduction under those rules. The second contention was that the debt owed by the managing agents did not constitute a trading debt because the agents had borrowed money that was not necessary for the appellant‑company’s business and had lent the same amount to themselves; consequently, the loss was incurred outside the business of the company. The first issue raised by counsel for the respondents was based on the distinction between the Indore Industrial Tax Rules and the corresponding provisions of the Indian Income‑Tax Act, with the argument that the Rules were concerned exclusively with the cotton‑mill industry and that tax was payable only on profits derived from that industry.

In this matter the Court observed that the tax imposed under the Indore Industrial Tax Rules was confined to the specific industry mentioned, whereas the Income‑tax Act imposed tax on the overall income generated by the assessee’s business. A review of the entire record of proceedings at every stage revealed that no party had ever raised the argument that the two tax regimes applied to different bases of income. Even if one assumes, for the sake of argument, that such a contention were correct and had been properly raised, the assessee could then have attempted to demonstrate, by presenting appropriate evidence, that the sum borrowed by the Managing Agents originated from the amounts that had themselves been borrowed for the purpose of the designated industry. The Court held that it could not entertain a question that is essentially a mixed question of fact and law when that question is being presented for the first time before this Court. Accordingly, the Court expressly declined to express any opinion on the merits of that unraised contention. Instead, the Court proceeded on the premise that, for the purpose of allowing the deduction of trading losses in the computation of trading profits, there is no substantive distinction between the provisions of the Income‑tax Act and those contained in the relevant Indore Industrial Tax Rules. Consequently, the sole issue for determination was whether the loss asserted in the present case qualified as a trading loss that could be deducted in computing the company’s profits.

The Court then referred to the legal principle articulated by this Court in Badridas Daga v. Commissioner of Income‑tax (1959) S.C.R. 690. After examining the authorities applicable to the question, that decision formulated the test that governs deductions where no specific provision exists in Section 10(2). The Court quoted the test as follows: “The result is that when a claim is made for a deduction for which there is no specific provision in S. 10(2), whether it is admissible or not will depend on whether, having regard to accepted commercial practice and trading principles, it can be said to arise out of the carrying on the business and to be incidental to it. If that is established, then the deduction must be allowed, provided of course there is no prohibition against it, express or implied, in the Act.” Applying this test, the Court noted a prior case in which an agent employed by the appellant, while exercising powers conferred upon him, accessed the company’s bank accounts, withdrew money and applied the proceeds to settle his personal obligations. The Court in that earlier decision held that the misappropriated amount, being irrecoverable, was an allowable deduction under the Income‑tax Act. The Court distinguished that earlier scenario from the present facts by observing that, in the earlier case, the agent had misappropriated the funds, whereas in the present case the Managing Agents, exercising the authority granted by the appellant, borrowed the money but failed to return it. The Court reasoned that if the embezzlement of money entrusted to an agent is considered incidental to the business, then money that is lawfully utilized by an agent should, by the same logic, also be regarded as incidental to the business. The Court further referred to a recent judgment in The Commissioner of Income‑tax, U.P. v. M/s. Nainital Bank Ltd., wherein this Court held that an amount lost to

In the earlier decision, the Court held that money lost to dacoity represented a loss incidental to the banking business, because large sums are ordinarily kept on the premises of a bank and the risk of such loss is part of banking operations. By analogy, the fact that the Managing Agents introduced amounts into the company’s till that exceeded the immediate needs of the business does not remove the character of those borrowings or the subsequent lending of money to themselves as incidental to the authorised business activities. The point of contention therefore was not whether the Managing Agents committed fraud against the company, but whether the amounts they borrowed constituted the company’s own funds. Had the creditors instituted a suit against the company, the company could not have defended the action on the ground that the Managing Agents lacked authority to borrow because the sums exceeded the business requirements at that time; such a defence would have been unavailable. Once the borrowing took place, the money became the company’s money. Moreover, there was no allegation of fraud, since the profit and loss account and the balance‑sheet presented annually at the General Body Meeting disclosed the total sum borrowed through the Managing Agents, and the General Body approved those amounts. The only irregularity, if any, lay in the practice of the Managing Agents of entering the entire amount they had borrowed into the company’s accounts so as to reassure shareholders that nothing was amiss. Under the memorandum of association and the specific resolution, the company, through the Managing Agents, possessed the express power to invest its funds by granting loans. Had there been no default, the Managing Agents would have repaid the full amount; if they failed to do so, the company retained the right to recover the sum from them. Consequently, both the borrowing undertaken by the Managing Agents on the company’s behalf from third parties and the subsequent lending of those funds to themselves gave rise to legal obligations that were created in the ordinary course of business. The loan appeared as a debit entry in the company’s books in accordance with accepted commercial practice, and its recovery would be recorded as a credit entry; both entries were appropriate for determining the company’s profit and loss. Should the debt prove unrecoverable, it would be classified as a bad debt. Accordingly, we find no difficulty in holding that the unrecoverable debt constituted a trading loss deductible in computing the appellant‑company’s profit for the assessment year, as it was a loss incidental to the appellant’s business and sanctioned by commercial practice and trading principles.

The Court observed that the loss which had become irrecoverable arose directly from the appellant’s ordinary business activities and that such a loss was fully sanctioned by established commercial practice and the principles governing trading operations. In reaching this conclusion, the Court emphasized that losses incurred in the normal course of trade are recognised as deductible trading losses and that the loss in question fell squarely within that category. Accordingly, the Court held that the judgment of the High Court was erroneous because it had characterised the amount as a loss incurred by the appellant dehors its business, that is, outside the scope of its commercial operations. The Court therefore set aside the High Court’s finding and concluded that the appellant was entitled to treat the loss as a legitimate trading loss in computing its taxable profit. As a result of this finding, the Court allowed the appeal filed by the appellant. In addition, the Court directed that the appellant should be awarded costs of these proceedings as well as costs that were incurred in the earlier proceedings before the High Court. The order therefore confirmed that the appellant would recover the costs incurred at both judicial levels and affirmed that the appeal was allowed.