Navnitlal C. Javeri vs K. K. Sen

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

Court: Supreme Court of India

Case Number: Civil Appeal No. 45 of 1964

Decision Date: 28 October 1964

Coram: P.B. Gajendragadkar, K.N. Wanchoo, M. Hidayatullah, Raghubar Dayal, J.R. Mudholkar

In the matter titled Navnitlal C. Javeri versus K. K. Sen, the Supreme Court of India delivered its judgment on 28 October 1964. The opinion was authored by Chief Justice P. B. Gajendragadkar and was joined by Justices K. N. Wanchoo, M. Hidayatullah, Raghubar Dayal and J. R. Mudholkar. The case arose from an appeal filed by the petitioner, Navnitlal C. Javeri, against the order of the Appellate Assistant Commissioner of Income‑Tax, the respondent being K. K. Sen. The citation of the decision appears in the 1965 volume of the All India Reporter at page 1375 and in the 1965 Supreme Court Reports (Second) at page 909, together with numerous subsequent references in later law reports. The constitutional provisions under consideration were Article VIII of the Constitution of India, List I, Entry 82, concerning the definition of “income”, and Sections 2(6A)(e) and 12(1B) of the Income‑Tax Act of 1922, the validity of which was challenged on the ground of legislative competence.

The factual backdrop involved the petitioner, who was a shareholder in a private limited company whose ordinary business did not involve money‑lending. The petitioner obtained a loan of more than four lakh rupees from the company. The Income‑Tax Officer computed the petitioner’s taxable income at approximately three lakh rupees, invoking Section 12(1B) read with Section 2(6A)(e) of the Income‑Tax Act. The computation included an amount exceeding two lakh rupees, which represented the accumulated profits of the company. The petitioner argued that his share of those accumulated profits, if they were distributed as dividend, would be proportionate to his shareholding, and therefore the balance of the accumulated profits should not be treated as his personal income. He further contended that Parliament lacked the competence to enact the two contested sections that treated the loan amount as income. The petitioner raised a writ petition in the High Court challenging the constitutional validity of the provisions, but the High Court dismissed the petition. Accordingly, the petitioner appealed the decision to the Supreme Court.

The Court, speaking through Chief Justice Gajendragadkar and Justices Wanchoo, Hidayatullah and Mudholkar, held that the questioned sections were within the legislative competence of Parliament. The Court explained that Section 12(1B) applies to companies in which at least seventy‑five percent of the voting power is held by persons other than the public, indicating that such companies are effectively controlled by a cohesive group of allied persons sharing a common interest. This controlling group possesses the authority to decide whether the company’s profits are to be distributed as dividends. The Court observed that when the controlling group deliberately refrains from distributing accumulated profits as dividends and instead advances the same amounts to a shareholder in the form of a loan, the purpose is to evade tax on those profits. Accordingly, Section 12(1B) deems the shareholder to have received the loan amount as if it were a dividend, rendering it taxable in his hands.

In this case, the Court observed that if a shareholder receives a loan that is treated as a dividend, he would be liable to pay tax on that income. The term “income” appearing in Entry 82 of List I of the Seventh Schedule to the Constitution must be given a broad construction that varies according to the particular facts of each case. Considering that the Legislature knew of schemes designed to avoid tax, the Court held that the Legislature was competent to create a legal fiction. Such a fiction would allow an apparent loan to be regarded as the receipt of a dividend. The Court cited authorities at [919 A‑H. 920 H; 921 C‑D]. The Court further stated that the lack of a provision allowing the income‑tax officer to examine each loan to determine whether it was genuine or a tax‑avoidance device is problematic. However, this deficiency does not make the section exceed the Legislature’s competence. The Court referenced this point at [921 D‑E]. If the Legislature believed that in most cases advances or loans were used as tax‑avoidance devices, it could enact a legal fiction. Under that fiction, tax would be recovered from the shareholder on the ground that he had received a dividend. The Court cited this reasoning at [921 G‑H]. Regarding Section 12(lB), the Court found that the provision does not impose an unreasonable restriction on the appellant’s fundamental rights protected by Article 19(1)(f) and (g) of the Constitution. This conclusion was recorded at [922 A]. The provision does not interfere with the appellant’s right to borrow money, and the Court saw no element of unfairness because the other shareholders deliberately consented to make the loan or advance, and the recipient shareholder deliberately accepted it with the intention of helping the company evade tax while enjoying the use of the money subject to interest.

The company earned interest, the shareholder enjoyed the funds, and tax liability was avoided. The Court also noted that previous transactions had been excluded from the operation of the sections by a circular issued by the Central Board of Revenue. This observation was recorded at [922 B‑F]. In dissent, Justice Raghubar Dayal held that Sections 2(6A)(e) and 12(lB) of the Income‑tax Act, 1922, as they stood in 1955, were void. He recorded this at [923 B]. He argued that the Legislature cannot label any payment made by a company to a shareholder as “dividend.” Furthermore, the Legislature may not then treat that payment as “income” under Item 82 of List I of Schedule VII. He emphasized that the definition of dividend must bear a rational relationship to the concept of dividend as profit distribution among shareholders. According to him, a dividend represents the proportional share that a particular shareholder is entitled to receive from the company’s profits earmarked for dividend distribution. Any ad‑hoc payment to a shareholder in the form of an advance or loan that is unrelated to his share in the accumulated profits cannot logically be classified as a dividend. He recorded this conclusion at [926].

The Court observed that the provisions under challenge imposed unreasonable restrictions on the fundamental right to hold property guaranteed by Article 19(1)(f) of the Constitution. It held that if any statute declares that certain profits of a company, although not actually distributed as dividend, shall be treated as being used for the payment of dividends, then it must necessarily be presumed that each shareholder is deemed to have received a proportionate share of those profits. The Court found it unreasonable to allow a statute to deem that a particular shareholder received an amount exceeding his proportional share as dividend. Likewise, the Court considered it unreasonable to treat a loan or advance made by a company to a shareholder as if the entire amount were dividend when the shareholder’s proportional share of the company’s profits would be considerably less. The Court referred to the authorities Navinchandra Mafatlal v. Commissioner of Income-tax, Bombay City, [1955] 1 S.C.R. 829; Sardar Baldev Singh v. Commissioner of Income-tax, Delhi and Agra [1961] 1 S.C.R. 482; and Balaji v. Income-tax Officer, Special Investigation Circle, [1962] 2 S.C.R. 983 in support of this reasoning. The judgment concerned Civil Appeal No. 45 of 1964, which was an appeal from the Bombay High Court’s order dated July 30, 1962, in Special Civil Application No. 69 of 1962. Counsel for the appellant included G.S. Pathak, M.M. Gharekhan and I.N. Shroff, while counsel for the respondent comprised C.K. Daphtary, the Attorney-General, R. Ganapathy Iyer, Gopal Singh and R.N. Sachthey. The opinion of the Court was delivered by Chief Justice Gajendragadkar, with Justice Raghubar Dayal delivering a dissenting opinion. The appeal originated from a writ petition filed by the appellant, Navnit Lal C. Javeri, who contested the validity of section 12(1B) read with section 2(6A)(e) of the Indian Income-tax Act, 1922 as it stood in 1955. The High Court had rejected the appellant’s claim of invalidity, and the appellant obtained a certificate of appeal to bring the matter before this Court. The appellant owned eleven of the eight hundred forty‑five shares of the private limited company Malegaon Electricity Co. (Private) Ltd., each share having a face value of Rs. 100, and the company’s business was to supply electricity to the residents of Malegaon. In 1955, the appellant borrowed a sum exceeding Rs. 4 lakhs from the company. Subsequently, the Income‑Tax Officer, exercising power under section 22(2) of the Act, issued a notice requiring the appellant to file his return for the assessment year 1956‑57. The officer computed the appellant’s income at Rs. 3,58,460, a figure that incorporated Rs. 2,83,126 representing the company’s accumulated profits. The officer held that, pursuant to section 2(6A)(e), this amount must be treated as dividend received by the appellant and therefore included in his total income.

In this case, the Income‑Tax Officer held that the sum of Rs 2,83,126, which represented the accumulated profits of the company, must be deemed a dividend under subsection (e) of section 2(6A). Consequently, the officer treated that amount as income from other sources within the meaning of section 12(1B) of the Act. The appellant challenged this assessment by filing an appeal before the Appellate Assistant Commissioner; that appeal was dismissed. Thereafter, the appellant filed a second appeal before the Income Tax Appellate Tribunal. While the appeal before the Tribunal was pending, the appellant instituted proceedings in the High Court under articles 226 and 227 of the Constitution, contending that the statutory provision relied upon by the department to levy the assessment was beyond the powers of the legislature. The sole issue for determination in the writ proceedings was whether section 12(1B) read together with subsection (e) of section 2(6A) was constitutionally valid. To address this issue, it was necessary to examine the relevant provisions of the Act. Section 2(6C) defines “income” as including dividend. Section 2(6A) provides an inclusive definition of “dividend”. Subsection (e) of section 2(6A) stipulates that “dividend” includes any payment by a company, which is not a company in which the public are substantially interested within the meaning of section 23A, of any sum—whether representing a part of the assets of the company or otherwise—by way of advance or loan to a shareholder, or any payment by such a company on behalf of or for the individual benefit of a shareholder, to the extent that the company possesses accumulated profits; however, dividend does not include (i) any advance or loan made to a shareholder by a company in the ordinary course of its business where the lending of money constitutes a substantial part of the business, and (ii) any dividend paid by a company which is set off by the company against the whole or any part of any sum previously paid by it and treated as a dividend within the meaning of sub‑clause (e), to the extent of such set‑off. Thus, the inclusive definition of “dividend” embraces the payments referred to in clause (e) and treats them as dividend for the purposes of the statute. Section 12(1) provides that tax shall be payable by an assessee under the head “Income from other sources” in respect of income, profits and gains of every kind which may be included in his total income if they are not included under any of the preceding heads. Section 12(lB) further provides that any payment by a company to a shareholder by way of advance or loan which would have been treated as a dividend within the meaning of clause (e) of subsection (6A) of section 2 in any previous year relevant to any assessment year prior to the assessment year ending on the thirty‑first day of March, 1956, had that clause been in force in that year, shall be treated as a dividend received by him in the previous year relevant to the assessment year ending on the thirty‑first day of March, 1956, if such loan or advance remained outstanding on the first day of such previous year.

The Court observed that the provision relating to the assessment year ending on the thirty‑first day of March 1956 applied only if the loan or advance remained outstanding on the first day of the preceding year. Both of the relevant provisions, namely section 2(6A)(e) and section 12(lB), had been introduced into the Income Tax Act by the Finance Act 15 of 1955, which became effective on the first day of April 1955. The Court explained that, taken together, these two provisions caused three categories of payments made to a shareholder of a company, to which the provisions were applicable, to be treated as taxable dividend to the extent of the accumulated profits of the company. The three categories were identified as follows: first, payments made to the shareholder in the form of an advance or a loan; second, payments made on behalf of the shareholder; and third, payments made for the personal benefit of the shareholder. The Court then set out five conditions that had to be fulfilled before section 12(lB) could be invoked against a shareholder. The first condition required that the company concerned be one in which the public were not substantially interested, as defined by section 23A as it stood in the year in which the loan was advanced. The second condition stipulated that the borrower must have been a shareholder at the date of advancement, regardless of the size of his shareholding. The third condition limited the deeming of the loan as dividend to the extent that the company possessed accumulated profit at the date of the loan, a limitation expressly prescribed by the relevant section. The fourth condition demanded that the loan not have been advanced in the ordinary course of the company’s business; consequently, the provision did not apply where the company itself was engaged in the business of money‑lending. The final condition required that the loan remained outstanding at the commencement of the shareholder’s previous year in relation to the assessment year 1955‑56. In addressing the question of the constitutionality of the impugned provisions, the Court emphasized that these conditions were essential to understand the scope of the provisions. The Court also noted another material circumstance: when the amendments were introduced in Parliament, the Honourable Minister for Revenue and Civil Expenditure gave an assurance that outstanding loans and advances that would otherwise be taxable as dividends in the assessment year 1955‑56 would not be taxed provided that they could be shown to have been genuinely repaid to the respective companies before thirty‑first June 1955. The Court recorded that the Government recognized that, without such a safeguard, the operation of section 12(1B) would have caused extreme hardship, because it would have swept in the total of all outstanding loans of previous years and could have imposed an unreasonably high tax liability on the shareholders concerned.

The Court noted that to implement the assurance given by the Minister in Parliament, the Central Board of Revenue issued circular No. 20(XXI-6)/55 on 10 May 1955. The Court observed that such a circular, issued under the authority of section 5(8) of the Act, was binding on all officers and persons responsible for administering the Act. The circular informed officers that some companies might have extended loans to their shareholders as part of genuine loan transactions, and that the purpose was not to disturb those genuine transactions or to bring them within the scope of the new provision. Consequently, officers were directed to notify every company that if the loans were repaid before 30 June 1955 in a genuine manner, those repayments would not be considered when calculating the tax liability of the shareholders who had received the loans. In other words, the Court explained that past transactions that would normally have fallen within the strict provisions of section 12(lB) as introduced in 1955 were effectively exempted from those provisions, provided that the companies and their shareholders were clearly advised that genuine refunds of earlier loans would not be taken into account under section 12(lB). Accordingly, section 12(1B) would ordinarily apply to loans made by companies to their shareholders, with full notice of the prescribed provisions.

The Court then turned to the submissions of counsel for the appellant, who contended that the impugned provision was constitutionally invalid because it exceeded Parliament’s legislative competence. The counsel argued that Entry 82 in List I of the Seventh Schedule, which authorises taxes on income other than agricultural income, could not support the impugned provision, since a loan advanced by a company to its shareholder does not, in any legitimate sense, constitute that shareholder’s income, and that treating such a dividend as income was an artificial construction unsupported by the entry. The counsel further maintained that the provision infringed article 19(1)(f) and (g) of the Constitution and could not be justified under clauses (5) or (6) of the same article. The Court recognized that if a provision lies beyond Parliament’s legislative powers, it would be invalid, and that tax legislation must also satisfy the scrutiny of fundamental rights guaranteed by the Constitution. Therefore, any invasion of the appellant’s fundamental rights that is not constitutionally justified would render the provision invalid. In addressing this issue, the Court indicated that it was necessary to analyse the precise meaning of the term “income” as used in the relevant entry, noting that further discussion of that definition was required.

The Court observed that the entries contained in the constitutional Lists must not be understood in a narrow or restricted manner. As Chief Justice Gwyer explained in United Provinces v. Atiqa Begum, each general word in a constitutional entry should be construed to cover all ancillary or subsidiary matters that can fairly and reasonably be said to fall within its scope. The purpose of the entries in the List is to grant legislative authority to the respective legislatures over the areas or fields described by those entries, and therefore the rule of construction requires that the words be given their widest possible meaning. However, this principle of wide construction does not empower Parliament to treat as “income” any item that, in a rational sense, cannot be regarded as a citizen’s income. An item that is taxed must be capable of being considered the income of a citizen. In assessing whether a particular item in a citizen’s possession may be treated as his income, it would be inappropriate to apply mechanically the tests traditionally set out in the Income‑Tax Act.

In the case of Navinchandra Mafatlal v. Commissioner of Income‑Tax, Bombay City, the Court examined whether capital gains could be classified as income within the meaning of item 54 of List I of the Seventh Schedule to the Government of India Act, 1935. Section 12‑B of the Indian Income‑Tax Act, 1922—inserted by Act XXII of 1947—imposed tax on “capital gains”. The validity of that provision was challenged on the ground that capital gains were not income within entry 54. The Court rejected this plea, holding that words in a constitutional enactment that confers legislative powers must be interpreted as liberally and broadly as possible. Justice Das, speaking for the Court, stated that the word “income” in the entry should be given its ordinary, natural and grammatical meaning, namely, something that comes in. On that basis the Court found no difficulty in concluding that income includes capital gains. The argument that the traditional sense of income, as reflected in earlier authorities such as [1941] F.C.R. 110 and [1955] 1 S.C.R. 829, would exclude capital gains was advanced by counsel for the appellant. The learned judge warned that if the meaning of “income” were held to be rigidly fixed by earlier judicial interpretation of the Income‑Tax Act, then any future enlargement of the scope of that Act, whether by amendment or otherwise, would be impermissible. He further emphasized that reaching such an extravagant and astounding conclusion would be untenable.

The Court observed that a conclusion which would rigidly restrict the meaning of “income” could scarcely be contemplated or countenanced. Accordingly, the Court held that the term “income” appearing in entry 54, which corresponds to the present entry 82 in List I of the Seventh Schedule of the Constitution, was to be given a liberal construction, so that capital gains were to be treated as included within its ambit. The Court also noted that this liberal approach had been expressly affirmed by the learned Chief Justice Gwyer in the case In re: The Central Provinces and Berar Sales of Motor Spirit and Lubricants Taxation Act, 1938 (No 14 of 1938) (1). The Chief Justice had remarked, “I conceive that a broad and liberal spirit should inspire those whose duty it is to interpret it (the Constitution); but I do not imply by this that they are free to stretch or pervert the language of the enactment in the interests of any legal or constitutional theory, or even for the purpose of supplying omissions or of correcting supposed errors.” The next authority considered by the Court concerned section 23A of the Income‑Tax Act. In the matter of Sardar Baldev Singh v. Commissioner of Income‑tax, Delhi & Ajmer (1), the validity of that provision was challenged. Section 23A(1) provides, inter alia, that subject to the provisions of sub‑sections (3) and (4), if the Income‑tax Officer is satisfied that, for any previous year, the profits and gains distributed as dividends by a company within the twelve months immediately following the expiry of that year are less than sixty per cent of the total income of the company for that year—after reduction by the amounts specified in clauses (a), (b) and (c) of the sub‑section—then, unless the Officer is convinced that, because of losses incurred in earlier years or because of the small size of the profits in the previous year, the payment of a dividend or a larger dividend would be unreasonable, the Officer shall make a written order directing the company, apart from the sum determined as payable by it on the basis of the assessment under section 23, to be liable to pay super‑tax at the rate prescribed by the sub‑section. The Court explained that the object of this provision was to prevent avoidance of super‑tax by shareholders of a company in which the public did not have a substantial interest. It was well established that the rates of super‑tax applicable to companies were considerably lower than those applicable to individual assessees. The legislature had therefore presumed that individuals might attempt to evade the higher super‑tax rate by transferring the sources of their income to a private limited company in return for shares; the profits of such a company could then be allowed to accumulate without the declaration of dividends, and eventually be distributed in a capital form by various devices. Section 23A was enacted to defeat such schemes, and its main effect was to bring the accumulated profits within the reach of taxation.

Section 23A of the Income‑Tax Act effectively limits a company from retaining more than forty percent of its net profits for the purpose of creating reserves or financing capital expenditure. The provision must be understood in the context of Section 2(6A), which has incorporated the accumulated profits of such companies within the definition of “dividend.” Consequently, Section 23A seeks to bring those accumulated profits within the scope of taxation. In the case of Sardar Baldev Singh (1), it was contended that a company and its shareholders are distinct legal entities, and therefore the section was ultra‑vires because it allegedly attempted to tax shareholders on income that technically belonged to the company in which they held shares. The argument asserted that taxation was permissible only when accumulated profits were actually distributed to shareholders as dividends; taxing shareholders on undistributed accumulated profits would, in the appellant’s view, amount to an invalid levy on income that never passed to them. The Court rejected this submission, holding that the clear purpose of Section 23A was to prevent tax evasion. The Court explained that Entry 54 of the Federal Legislative List should be interpreted not merely as authorising the imposition of a tax but also as empowering the legislature to enact measures that forestall avoidance of that tax; otherwise, clever schemes could render the power to tax a person’s income ineffective. The provision was designed to address situations where shareholders deliberately refrain from distributing accumulated profits as dividends. Accordingly, Section 23A deems such accumulated profits to have been distributed to the shareholders and imposes tax on them on that basis. The Court acknowledged that this approach might cause hardship to some honest taxpayers, but it emphatically stated that considerations of hardship are irrelevant when assessing the constitutional competence of the legislature. The decision in Sardar Baldev Singh (1) therefore established that income which, in a technical sense, belongs to the company can be treated as income of the shareholders in proportion to their shareholdings, and tax can be levied on that income without violating the Constitution. The Court also referred to another decision, Balaji v. Income‑tax Officer, Special Investigation Circle (2), in which a partnership consisting of a husband, his wife, and their three minor sons was examined. In that case, the Income‑tax Officer had included the share of income attributable to the wife and the minor sons in the assessment of the husband under Section 16(3)(a)(i) & (ii), raising similar questions about taxing the income of other persons.

In this case, the Court observed that the provision under discussion had been challenged on the basis that it attempted to tax a person for income that actually belonged to his wife and his minor sons. The Court rejected that contention and explained that the entries in the Legislative Lists, such as those in the Federal List, should be understood not as grants of power but as categories of subject matter within which legislation may be made, and that the fullest possible meaning must be given to those categories. Applying that approach, the Court concluded that Entry 54 of the Federal Legislative List legitimately encompassed legislation like section 16(3)(a)(i) and (ii), because the purpose of those provisions was to prevent tax evasion. The judgment further recorded that the validity of the same section had also been attacked on the ground that it violated Articles 14 and 19(1)(f) and (g) of the Constitution; that challenge was likewise dismissed. One of the reasons the Court gave for rejecting the constitutional plea was that any additional tax paid on the income of the wife or the minor children would ultimately be borne by those individuals when the accounts between them were finally settled. Considering that reasoning, together with the view that the method of taxation authorized by the impugned section, although stringent, was necessary to thwart attempts to evade tax, the Court held the section to be constitutionally valid. In light of those earlier decisions, the Court turned to the argument raised by Mr Pathak that section 12(1B) of the Act was ultra vires, referencing the reports of Sardar Baldev Singh (1961) 1 S.C.R. 482 and Balaji v. Income‑Tax Officer (1962) 2 S.C.R. 983. To address that argument, the Court recalled the factual backdrop: the companies to which section 12(1B) applies are those in which at least seventy‑five percent of the voting power is held by persons other than the general public, meaning that such companies are effectively controlled by a cohesive group of persons sharing a common interest. In companies of that character, the controlling group may exercise its discretion over the management of the company, its affairs and its profits, subject only to the limitations imposed by the Companies Act. The group also decides whether the profits earned by the company will be distributed as dividends, and the decision to declare a dividend rests entirely within its discretion. The legislature, having observed that although profits were readily available within these companies, the persons in control often chose not to distribute those profits as dividends to shareholders. Instead, they employed the device of advancing the accumulated profits to one of the shareholders in the form of a loan or advance, a practice that was plainly intended to circumvent the tax on accumulated profits provided for under section 23A. The Court noted that an advance or loan made in this manner fell squarely within the mischief that the impugned legislation sought to address.

The Court explained that the impugned provision dealt with an advance or loan made by a company that ordinarily did not engage in money‑lending, and that such an advance was given with full knowledge of the provisions contained in the impugned section. The Court observed that the purpose of retaining accumulated profits without distributing them was clearly to obtain the advantage of the lower rate of super‑tax prescribed for companies. This avoidance scheme was countered by section 23A, which provided that when profits were deemed to be distributed, tax would be imposed on the shareholders on the basis that the accumulated profits were deemed to have been distributed among them. In the same vein, section 12(1B) provided that if a controlled company employed the device of granting a loan or advance to one of its shareholders, that shareholder would be deemed to have received the amount out of the accumulated profits and would therefore be liable to pay tax as if the loan had been received in the form of a dividend. The Court held that it was evident that, when a controlled company adopted such a device, the controlling group of shareholders deliberately chose to make the loan or advance. The arrangement was intended to evade the operation of section 23A. Although the loan might bear interest and the interest could be received by the company, the principal objective underlying the loan was to avoid tax liability. The loan could eventually be repaid to the company, and upon repayment it might or might not be treated as part of the accumulated profits. The Court described this as a well‑planned device that section 12(1B) sought to capture for taxation purposes. The Court noted that similar devices were reportedly adopted by private companies in many jurisdictions. Referring to the authority of Simon, the Court reproduced the following description: “Generally speaking, surtax is charged only on individuals, not on companies or other bodies corporate. Various devices have been adopted from time to time to enable the individual to avoid surtax on his real total income or on a portion of it, and one method involved the formation of what is popularly called a ‘one‑man company’. The individual transferred his assets, in exchange for shares, to a limited company specially registered for the purpose, which thereafter received the income from the assets concerned. The individual’s total income for tax purposes was then limited to the amount of the dividends distributed to him as practically the only shareholder, which distribution was in his own control. The balance of the income, which was not so distributed, remained with the company to form, in effect, a fund of savings accumulated from income which had not immediately attracted surtax. Should the individual wish to avail himself of the use of any part of these savings he could effect this by borrowing from the company, any interest payable by him going to swell the savings fund; and at any time the individual could acquire the whole balance of the fund in the character of capital by putting the company into liquidation.” The Court concluded that the device described by Simon illustrated the same principle that the legislature sought to curb through sections 23A and 12(1B).

In this matter the Court observed that the description of a “one‑man company” could just as appropriately apply to a private company whose business is directed by a tightly‑knit group of persons sharing the same interest. The issue before the Court was whether, by classifying a loan received by a shareholder as a dividend paid by the company, the impugned provision had gone beyond the legislative authority granted under Entry 82 of List I. The Court noted that the term “income” in the relevant context must be given a broad meaning, but that the precise breadth was not a question for abstract speculation; rather, the enquiry must be resolved on the facts of each individual case. The Court emphasized that there must be a rational link between the item being taxed and the concept of income when that concept is construed liberally. If the legislature is aware that privately‑controlled companies frequently use advances or loans to shareholders as a device for avoiding tax, it is within its power to intervene and to create a legal fiction whereby an amount that appears and is labeled as a loan is, for tax purposes, treated as a dividend. The Court reiterated its earlier explanation of how a small number of shareholders who dominate a private company may employ this device. Given the legislature’s knowledge of such schemes, the Court held that it was competent for the legislature to devise a fiction that treats the ostensible loan as a dividend receipt. Consequently, the Court found it difficult to sustain the contention that, by adopting this fiction, the legislature had exceeded the scope of its authority under Entry 82 of List I. Counsel for the respondent argued, however, that the legislation should have compelled the Income‑Tax Officer to assess, on a case‑by‑case basis, whether a loan was genuine or a device, and that the absence of such a requirement, coupled with the uniform presumption created by the provision, demonstrated that Parliament had acted beyond its competence. To support this view, counsel referred to section 108(1) of the Commonwealth Income‑Tax Act, which permits taxation of an amount advanced to a shareholder if the Commissioner believes it represents a distribution of income; such a provision, he suggested, would have rendered the impugned section valid. The omission of a clause to exclude genuine loans or advances, and the failure to distinguish between ordinary loans and those employed as tax‑avoidance devices, were presented as evidence that Parliament had acted blindly and thereby exceeded its legislative power. The Court declined to accept this argument.

In this case, the Court observed that if the legislature is of the view that most advances or loans to shareholders are in fact devices to avoid tax, it is within its authority to create a legal fiction. Under such a fiction the law may treat those advances or loans as if the shareholder had received a dividend, thereby allowing the tax authorities to recover tax from the shareholder on that basis. The Court therefore expressed satisfaction with the High Court’s conclusion that the impugned provision does not exceed the legislative competence of Parliament. Accordingly, the statutory provision was deemed to be a valid exercise of legislative power rather than an ultra vires act.

The Court then turned to the argument raised by counsel that the provision infringes the appellant’s fundamental rights guaranteed under Article 19(1)(f) and Article 19(1)(g), and that the provision is not saved by clauses (5) and (6) of that article. The Court noted that Article 19(1)(f) protects a citizen’s right to acquire, hold and dispose of property, while Article 19(1)(g) protects the right to practice any profession, occupation, trade or business. It held that the impugned provision does not violate either of these rights. The right of a shareholder to borrow money from his own company is not a fundamental right, and the provision merely declares that a loan taken by a shareholder from a company covered by the provision will be treated as a deemed dividend. This treatment does not hinder the appellant’s ability to obtain loans from other sources, nor does it convert the company into a money‑lending business. Consequently, the restriction imposed by the provision is not unreasonable. The Court also emphasized that a circular issued earlier excluded past transactions from the operation of the provision, thereby removing any element of unfairness. The legislation assumes that the shareholders involved have deliberately agreed to make the loan or advance, and that the borrowing shareholder intends to assist the company in evading tax while enjoying the use of the funds and paying interest to the company. In this context, the Court found no unfairness to either the taxed shareholder or the other shareholders who advance the loan. Accordingly, the Court concluded that the provision does not contravene the fundamental rights under Article 19(1)(f) or Article 19(1)(g) and rejected the counsel’s claim that the provision is invalid on that ground.

In this matter, the Court observed that there was clearly no basis for alleging that the questioned provision violated Article 14 of the Constitution, and moreover, the petitioner had not raised such a contention before the Court. The petitioner, however, correctly directed the Court’s attention to a decision of the Madras High Court in K. M. S. Lakshmana Aiyar v. Additional Income‑tax Officer, Special Circle, Madras, where a challenge to the validity of the same provision on the ground of contravention of Article 14 had been rejected. Consequently, the Court noted that the appeal was unsuccessful and ordered its dismissal with costs.

Judge Raghubar Dayal expressed a contrary view, holding that the appeal ought to be allowed because sections 12(1B) and 2(6A)(e) of the Indian Income‑tax Act, 1922, as they existed in 1955, were void. He explained that both provisions had been enacted by Parliament pursuant to Entry 82 of List I in the Seventh Schedule of the Constitution, which authorises “taxes on income other than agricultural income.” The Judge emphasized that, irrespective of how broadly the term “income” might be interpreted in that entry, the item being taxed must genuinely qualify as income, there must be a rational link between the taxed item and the concept of income, and Parliament could not arbitrarily designate a non‑income item as taxable income. He further affirmed that Parliament retained the authority to legislate against the evasion of income‑tax. In the earlier case of Navinchandra Mafatlal v. The Commissioner of Income‑tax, Bombay City, the Court had examined the meaning of “income” as used in Entry 54 of List I of the Seventh Schedule of the Government of India Act, 1935, which is identical to Entry 82 of the Constitution, to decide whether a tax imposed on capital gains under the head “capital gains” was beyond the powers of the Central Legislature. Section 12‑B, introduced into the Income‑tax Act by the Indian Income‑tax and Excess Profits Tax (Amendment) Act, 1947, provided for tax on capital gains arising from certain transactions. The Court observed that, according to dictionary definitions, “income” signifies “a thing that comes in,” and noted that in jurisdictions such as the United States and Australia the term is applied broadly to include capital gains. Citing authorities from those countries, the Court held that the natural meaning of “income” encompasses any profit or gain actually received. It further referred to the United States case of Stratton’s Independence v. Howhert, decided on 1 December 1913, which defined income as “gain derived from capital, from labour, or from both combined.” The Court was then required to interpret the word “income” as used in Section 38 of the

The Court referred to the Corporation Excise Tax Act of 5 August 1909, which imposed an excise tax “equivalent to one per centum upon the entire net income … received by it from all sources during the year.” The Court then discussed the United States case Eisner v. Macomber, which it had earlier cited in Mafatlal’s case. In that American decision the Court was required to interpret the word “income” as it appeared in the Sixteenth Amendment to the Constitution of the United States, which provides: “The Congress shall have power to lay and collect taxes on incomes, from whatever source derived, without apportionment among the several States, and without regard to any census or enumeration.” The Court observed, at page 206 of the opinion, that Congress could not settle the meaning of the term by a statutory definition because it could not by legislation alter the Constitution, which alone supplies the authority for taxation and within whose limits that authority must be exercised. For the present purpose, the Court explained, it was necessary only to obtain a clear definition of “income” as the term is used in ordinary language, so that its meaning in the amendment could be ascertained. Having also reached a correct view of the character of a stock dividend, the Court said the issue would then be easy to resolve. After consulting dictionaries commonly employed, the Court found little to add to the concise definition that had been adopted in two earlier cases decided under the Corporation Tax Act of 5 August 1909. The definition stated that “income may be defined as the gain derived from capital, from labour, or from both combined,” provided that the definition is understood to include profit obtained through the sale or conversion of capital assets. The Court noted that this definition had been applied in the Doyle case and that, brief as it may be, it identifies the characteristic and distinguishing attribute of income that is essential for a correct solution of the controversy before the Court.

The Court further observed that the definition of “income” articulated in Eisner v. Macomber had been adopted in two additional decisions that were referenced in Mafatlal’s case. Those decisions are Merchants’ Loan and Trust Co. v. Smietanka and United States v. Stewart, both of which addressed the taxation of gains arising from the sale of capital assets. The Court also mentioned the Australian case Resch v. The Federal Commissioner of Taxation, which examined whether provisions of provincial income‑tax legislation could treat distributions made during the winding‑up of a company in the same manner as distributions made by a company that continued as a going concern. The Court held that the provincial provision was valid because Parliament possessed the power to bring to tax in an income‑tax statute all profits and gains accruing to a taxpayer, without distinguishing whether the profit or gain should be characterized as a receipt on capital account or on income or revenue account. In all of these authorities, the word “income” was interpreted in its natural sense, and the Court emphasized that the definition given in Eisner’s case is considerably narrower and more limited in content than the broad meaning now being advocated.

In this case the Court observed that the earlier decision in Mafatlal’s case did not give a very broad meaning to the term “income”. The Court explained that “income” was not to be understood as anything that merely comes into a person’s possession, and therefore a loan received by a shareholder could not automatically be classified as income. A loan taken by a shareholder from the company was not, by itself, within the ordinary definition of income because it did not represent earnings from labour, capital, or profits derived from the sale of capital assets. The borrower was required to repay the loan. However, the Court noted that if a shareholder were in reality paid a share of the profits under the disguise of a nominal loan, that amount could be treated as income for tax purposes under an appropriate statute. The Court then turned to the specific facts of the present matter. The appellant owned eleven of the total eight hundred forty‑five shares in a private limited company, each share having a face value of one hundred rupees. In the year 1955 the appellant obtained a loan from the company amounting to more than four hundred thousand rupees. At that time the company had accumulated profits of two lakh eighty‑three thousand one hundred twenty‑six rupees, and under sections 2(6A)(e) and 12(1B) of the Income Tax Act that whole sum had been added to the appellant’s total income for the assessment year ending 31 March 1956. The Court calculated that the appellant’s proportionate share of the accumulated profits, if distributed as a dividend, would be eleven divided by eight hundred forty‑five of the total, which amounted to three thousand six hundred eighty‑six rupees. The remaining balance of two lakh seventy‑nine thousand four hundred forty rupees would then be the dividend payable to the other shareholders. The appellant contested that the balance of two lakh seventy‑nine thousand four hundred forty rupees was not his income and argued that Parliament was not competent to enact sections 2(6A)(e) and 12(1B) which treated that balance as his income from dividend. The Court proceeded to set out the operation of the impugned provisions. Section 2(6A)(e) defined “dividend” to include, in the situation described, any payment by a company of any sum by way of an advance or a loan to a shareholder, or any payment made by the company on behalf of or for the personal benefit of a shareholder, to the extent that the company possessed accumulated profits in either case. Section 12(1B) provided that any such payment made to a shareholder as an advance or loan, if it remained outstanding on the first day of the preceding year, would be deemed to be a dividend received by the shareholder in that preceding year, which was the year relevant to the assessment ending 31 March 1956. The appellant’s argument was that while Parliament could enact legislation to prevent tax evasion, it could not impose tax on amounts that did not constitute “income”. He maintained that the portion of the loan exceeding his proportional share of the accumulated profits was not income from dividend, and therefore Parliament could not validly treat that excess as a dividend and consequently as his “income”.

In this case, the Court observed that the appellant contended that the amount in excess of his proportionate share of Rs 2,83,126 had not actually been distributed as profits by the company, and therefore could not be regarded as his income from dividend; he further argued that because the sum had not been distributed as a dividend, he could not have evaded payment of income‑tax on it, and consequently Parliament could not enact a provision treating such excess amount as a dividend paid to him and thus as his “income”. The Court noted that this contention possessed merit. It explained that the essential character of a dividend is that it must represent the proportionate amount a particular shareholder is entitled to receive, based on the number of shares he holds, out of the profits of the company that have been set aside for payment of dividend to shareholders. The Court held that an ad‑hoc payment of money to a shareholder in the form of an advance or loan, which is unrelated to his share in the accumulated profits, could not logically be encompassed within the expression “dividend”. Accordingly, the Court opined that it was not within the legislature’s power to describe any payment of money by a company to a shareholder by the word “dividend” and then provide that such payment, labelled dividend, would fall within the expression “income” for the purposes of any law made under Entry 82 of List 1 of the Seventh Schedule to the Constitution. The definition of “dividend” must maintain a rational connection with the concept of dividend in the context of a company’s profits and their distribution among shareholders after the profits have been earned; the Court found that clauses (a) to (d) of Section 2(6A) satisfied such a connection. The Court further observed that it was conceivable, and not disputed by the appellant, that persons might attempt to evade income‑tax by having companies accumulate profits, refrain from paying dividends, and later distribute the amount to shareholders as advances or loans; such shareholders could then pass on the ratable share to the remaining shareholders, enabling them to escape payment of the higher “super‑tax” because the amounts received could not be treated as “dividends” and therefore would not be added to their “income”. At the same time, the Court noted that the respondent did not dispute that genuine cases could arise where shareholders legitimately borrowed from a company that possessed surplus funds. The Court mentioned that, after the enactment of Section 2(6A)(e), the Central Board of Revenue issued a circular directing its officers to inform all companies that if loans advanced by them were repaid before 30 June 1955 in a genuine manner, such loans would not be taken into account in determining the tax liability of the shareholders to whom they had been advanced, because it was likely that some companies might have extended loans to their shareholders as a result of bona‑fide loan transactions, and the intention was not to affect those genuine transactions nor to bring them within the mischief contemplated by the statute.

The Court explained that the new provision, contained in section 2(6A)(e), covered every advance or loan made by a company to its shareholders, irrespective of whether the advance was made in good faith or for the purpose of avoiding super‑tax. Under the provision, the shareholder who borrowed the money became liable to tax on any part of the loan that exceeded his proportionate share in the company’s accumulated profits, the tax liability extending up to the total amount of the loan. The Court noted that other jurisdictions had also taken notice of schemes designed to evade income‑tax by similar means, and that the legislatures of those countries had enacted provisions to defeat such devices. As an illustration, the Court referred to section 108 of the Income Tax and Social Services Contribution Assessment Act 1936‑53 of the Commonwealth of Australia, which dealt with loans to shareholders. The Australian provision differed materially in that it deemed only the portion of an advance that the Commissioner regarded as a distribution of income to be a dividend; the whole amount of the advance was not treated as a dividend received by the shareholder‑borrower.

The Court observed that the imposition of a tax constituted a restriction on an assessee’s right to hold property, and that any such restriction could be justified only if it was reasonable and served the public interest. Under the impugned provisions, a shareholder who obtained a loan or advance from a company possessing accumulated profits was treated, to the extent of those profits, as having received a dividend. The Court reiterated that profits earmarked for dividend distribution must be allocated proportionately among all shareholders. Consequently, if a statute deemed certain undistributed profits to be used for the payment of dividends, each shareholder must be considered to have received a proportionate share of those profits as a dividend. It would therefore be unreasonable for the law to treat a particular shareholder as having received an amount exceeding his proportionate share, while the other shareholders were presumed to have received only their proper shares. A reasonable statute might assess each shareholder on the dividend amount deemed to have been distributed to him, but it would be unreasonable to deem a single shareholder to have received the entire loan amount as a dividend when his rightful share of the accumulated profits was far smaller. For this reason, the Court regarded the provisions of sections 2(6A)(e) as imposing an unreasonable restriction on the fundamental right to hold property guaranteed by Article 19(1)(f). The Court then indicated that it would rely on certain precedents to support its analysis.

In this passage the Court listed authorities that support the view that statutes enacted to prevent avoidance of income tax are valid, and therefore provisions aimed at preventing avoidance of the super‑tax should also be upheld. The cases cited are Mafatlal’s case(1), Sardar Baldev Singh v. Commissioner of Income‑tax, Delhi & Ajmer (2) and Balaji v. Income‑tax Officer, Special Investigation Circle (a). Mafatlal’s case(1) concerned the legality of a tax on capital gains imposed under Section 12B of the Act. The tax was levied on the gain realised by the assessee from a disposition of capital assets, and the gain was to be calculated after allowing certain deductions, including the actual cost incurred by the assessee in acquiring the capital assets; the tax therefore did not apply to the whole amount received from the transaction. This decision is therefore an authority for the simple proposition that the word “income” appearing in Entry 82, List 1, Seventh Schedule to the Constitution has a broad meaning and should not be confined to the narrower interpretation that courts had previously given to the term in the Act. In the statutory scheme, “income” has been understood to mean generally what a person regularly earns from existing sources. The Court further observed that profits earned from the transfer of a capital asset can rationally be treated as income, because they represent the excess of the amount received over the cost incurred by the transferor‑assessee in acquiring the asset. Baldev Singh’s case(2) dealt with the validity of Section 23A of the Act, which empowered the Income‑tax Officer to issue a written order declaring that the undistributed portion of the ostensible income of a company, calculated as profit, shall be deemed to have been distributed as dividends among the shareholders as of the date of the relevant general meeting, and that each shareholder’s proportionate share shall be included in his total income for assessment purposes. The Officer could make such an order only when satisfied that the profits and gains actually distributed as dividends by the company up to the end of the sixth month after the close of its accounts for the preceding year were less than sixty per cent of the company’s assessable income, and that a larger dividend would not be unreasonable in view of earlier losses and the small amount of profit earned. It is clear that the Officer’s order could not deem the undistributed profits to be the dividend paid to any particular shareholder; rather, the deeming applied to all shareholders collectively. The validity of this provision was not contested. What was contested was whether the proportionate share of Baldev Singh, the assessee, in such undistributed profits could be added to his total income for the year concerned. The Court held that, because of the deeming provision, the proportionate share of the dividend was to be treated as income of the assessee and that failure to tax it would amount to an escape from assessment under Section 34 of the Act. The Court noted that this case is distinguishable on several grounds, one of which is that the Income‑tax Officer is required to make the order only when he is convinced that a larger dividend could justifiably have been distributed, a circumstance that necessarily leads to the inference that a lower dividend had been paid.

In this case the Court observed that the provision under discussion was not challenged on the ground of its validity. The issue that was raised concerned whether the proportionate share of the assessee, Baldev Singh, in the undistributed profits could be added to his total income for the year in which it was so added. The Court held that because the statute deemed the undistributed profits to be distributed as dividends among all shareholders, each shareholder’s proportionate share was to be treated as income of that shareholder. Consequently, when such deemed dividend was not taxed, it was considered to have escaped assessment under section 34 of the Act. The Court distinguished the present case on several important points. First, the Income‑tax Officer is empowered to make an order only when he is satisfied that a larger dividend could have been justifiably distributed, which necessarily leads to the inference that a lower dividend was paid in order to avoid the payment of super‑tax by shareholders who were liable to that tax. Second, the Officer’s authority to issue the order is limited to situations where dividends distributed amount to less than sixty per cent of the company’s assessable income, indicating that the company may legitimately retain up to forty per cent of its assessable income for genuine reasons. This suggests that the accumulation of profits, for which no action has been taken under section 23A, can be justified, and that the mere fact that a company could advance money to a shareholder for his needs does not, by itself, imply that the advance was made to evade super‑tax. Third, the Court noted that no individual shareholder is made liable to tax for an amount of undistributed profit that exceeds his own proportionate share in those profits, so the shareholder is not prejudiced. His income is increased only by an amount that he could have legitimately obtained from the company if the persons controlling the company had acted reasonably and retained the necessary profits for the company’s purposes. The Court also addressed an objection raised in Baldev Singh’s case that section 23A was unconstitutional because it purported to tax shareholders on the income of the company in which they held shares, without granting them a right to realise from the company the dividend that the order deemed to have been paid to them. The Court upheld the constitutional validity of the section, holding that it was enacted to prevent tax evasion in view of the conditions of its applicability. In the circumstances of the cases covered by section 23A, there was a

The Court observed that there was a reasonable link between the sum that was treated as a distributed dividend and any possible scheme to avoid payment of the additional tax. It further held that the taxpayer could not have been disadvantaged if the individuals who controlled the company's management had acted reasonably or had actually paid that sum out of profits after the order issued by the Income‑tax Officer. The judgment referred to the precedent reported in 1961 1 S.C.R. 482. In the matter of Balaji, the Court examined the constitutionality of section 16(3)(a), clauses (i) and (ii). Those clauses stipulate that, when calculating a person's total income for assessment, the income of the person’s wife or minor child that arises directly or indirectly from the wife's membership in a partnership in which the husband is a partner, or from the minor’s participation in a partnership in which the individual is a partner, must be included. The Court found those provisions to be valid. It left open the question of whether one person could be taxed on another’s income and framed the issue for decision as whether section 16(3)(a), clauses (i) and (ii), were enacted by the Legislature to prevent tax evasion. The Court answered affirmatively, explaining that a husband or father could nominally include his wife or minor child as a partner so that the overall tax burden would be reduced, thereby allowing the assessee to capture the entire business income while avoiding tax that would otherwise be payable. At page 999, the Court explained that the provisions applied only to a limited group of close family members who are normally under the protection of the assessee and who act as his dependents. It noted that the persons named by the provision – namely the wife and minor children – could not ordinarily be expected to run a business independently with their own capital while the husband or father was alive and providing protection. Consequently, the Court clarified that the justification for upholding section 16(3)(a), clauses (i) and (ii), was that the husband or father was in reality the person managing the firm, while the wife or child were merely nominal partners, making the partnership a facade. In that context, there was no possibility that the provisions would prejudice the husband or father by adding to his income amounts that were not truly his. The Court emphasized that this reasoning could not be extended to the present case or to other cases that fall within the scope of the challenged sections. Addressing the contention that the provisions of section 16(3)(a), clauses (i) and (ii), violated Article 14 of the Constitution, the Court quoted its earlier observation at page 991, stating that the purpose of the legislation was to prevent tax evasion and that individuals would not normally employ a similar device unless they intended to circumvent tax obligations.

The Court observed that entering (1) [1962) 2 S.C.R. 983. Supp. 1/65‑ into partnership with persons other than those named in the relevant sub‑section would create a danger that a third party could later assert his own rights. Accordingly, the Legislature, for the purpose of classification, chose only that category of persons who in reality are employed as a façade to facilitate tax fraud. “Such a risk is always involved in a company making payments as advances or loans to a shareholder when it possesses accumulated profits, as the other shareholders run the risk of not receiving their proportional share of profits which they would have obtained if those profits had been truly distributed as dividends.” The Court explained that this consideration again leads to the conclusion that the likelihood of an advance or loan being genuine depends less on the existence of accumulated profits and more on the number of shareholders in the company and on the proportion of shares held by the borrower compared with the total shares held by all shareholders. The Court noted that when the borrower’s shareholdings constitute a smaller proportion of the total, the probability that the advance or loan is genuine increases, because in such a situation the risk to the remaining shareholders of losing their share of profits deemed to be distributed as dividends is greater. On this basis, the Court held that the impugned provisions, namely sections 2(6A)(e) and 12(1B) of the Act, are void. Consequently, the Court allowed the appeal and recorded that the appeal was allowed.