http://JUDIS.NIC.IN SUPREME COURT OF INDIA Page 1 of 8  

PETITIONER: BHARAT BEEDI WORKS (PRIVATE) LIMITED AND ANR.ETC.  ETC.

       Vs.

RESPONDENT: COMMISSIONER OF INCOME-TAX

DATE OF JUDGMENT07/05/1993

BENCH: JEEVAN REDDY, B.P. (J) BENCH: JEEVAN REDDY, B.P. (J) VENKATACHALA N. (J)

CITATION:  1993 AIR 1751            1993 SCR  (3) 606  1993 SCC  (3) 252        JT 1993 (3)   526  1993 SCALE  (2)896

ACT: Income-Tax   Act  1961--S.40  (c)--Partners  in  firm   also directors in a company--Whether royalty payments by  company to  firm  falls  within  s.  40  (c)--Held,   Payments   are consideration   for  a  valuable  right  parted   by   firm/ partners/directors  of  the assessee--Company  a  favour  of assessee--Where agreement whereunder payments made not  mere device  or screen, it cannot be treated as payments made  to directors qua directors--S.40(A) (2).

HEADNOTE: A partnership firm consisting of three partners was  engaged inter  alia  in the business of manufacturing  and  sale  of beedies  under the brand name "Mangalore  Prakash  Beedies". On  May  20,1972 a private limited  company  called  prakash beedies  Ltd. the assessee-appellant was incorporated.   One of  its  objects  was  to take  over  the  business  of  the aforesaid  firms  which it did under an agreement  dated  15 July  1972 whereby the firms sold its rights and  assets  to the  company.  For the use of the trade name, a  royalty  at 10p. for every 1000 beedies was to be paid by the company to the firm.  This payment was made ever year by the assesse on account  of royalty.  The three partners of the  firms  were also directors of the company. The relevant assessment years were 1974-75 and 1975-76.  The facts in the other appeals are similar. The  assessee claimed deduction of the amount paid by it  as royalty.   The ITO allowed the deductions as  claimed.   The CIT   in  stio  motu  proceedings  disallow  the   aforesaid deductions.   On appeal, the tribunal restored the order  of the ITO. On  reference,  the High Court answered in  fan,our  of  the revenue as the three directors of the assessee company  were also  partners in the firm.  It held that in law, a firm  is merely  a  collection  or  association  of  individuals  for carrying  on  a  business.  Merely because the  firm  is  an assessable  entity,  under the Income Tax Act, it  does  not follow  that  it  is a juristic or legal  entity.   It  must therefore  be  held that the payments to the  firm  were  in reality made to the  607

http://JUDIS.NIC.IN SUPREME COURT OF INDIA Page 2 of 8  

directors, thus attracting S. 40 (c). Before  this Court, it was contended for the  assessee  that payment to a firm is not ipso fact payment to the  partners, directly  or  indirectly.  In any event, the  payments  were made to the three persons not in their capacity of directors (qua  directors). but in consideration of a  valuable  right parted by them in favour of the assessee-company.  S.  40(c) was never intended to take in such payments.  They relied on the  budget speech of the Finance Minister and  argued  that the  principle of interpretation noscitor a sociis  must  be applied to the words "remuneration, benefit or amenity". The genuineness or validity of the agreement, the factum  of payments  as  royalty,  and  that  the  brand  name  carries significant  business value was not disputed.  The  question before  this  Court was whether the  royalty  payments  fail within S. 40(c). Allowing the appeal, this Court, HELD  :  1.  Even assuming that the payments  to  firm  were payments to partners, the said payments did not fall  within S.  40(c).  The payment,-. were made In consideration  of  a valuable right parted by the firm/partners/ directors of the assessee-company in favour of the assessee.  So long as  the agreement whereunder the said payments were made is not held to  be  a mere device or a mere screen,  the  said  payments cannot  be  treated as payments made to the  directors  (qua directors). (613-H, 614-A) The payments were made by way of consideration for  allowing the to use a valuable right belonging to them viz. the brand name.  Such a payment may be liable to be scrutinised  under sub-section. (2) of section 40 (A), but it certainly did not fall within the four corners of section 40(c). (614-A) T.T. (Pvt.) Ltd. v. ITO Bangalore 121 ITR 551, approved. CIT  Patiale v. Avon Cycles (p) Ltd. 126 IT R 448 and  India Jute Co.  Ltd. v. CIT 178 ITR 649, referred to. 2.  The power vested in the ITO is to determine whether  any expenditure of allowance is excessive or unreasonable having regard  to the legitimate business needs of the company  and the benefit derived by the assessee or 608 accruing therefrom.  Any payment to a relative of a director or other persons mentioned in clause (c) will necessarily be examined  applying  the above test and if it is  found  that they  are unwarranted, unreasonable or excessive, they  will be  disallowed.   Such a situation does  not  arise  herein. (615-C) CIT,  Bombay  v.  M/s.  Indian  Engineering  and  Commercial Corporation (p) Ltd. [1983] distinguished.  JT 683.

JUDGMENT: CIVIL APPELLATE JURISDICTION: Civil Appeal No. 1452 of 1987. From the Judgment and Order dated 10.7.1986 of the  Kamataka High Court in I.T.R.C. No. 198 of 1987.                             WITH C.A.  Nos. 4462/89, 1822, 1902, 1465/87, 675, 658,  4461/89, 6093/90, 6204/ 90, 6092. and 6092 A of 1990. H. Salve, P.H. Parekh, Ms. Meenakshi Grover, R. Nariman, Ms. R. Gill and Ms. Simi Kr. for the Appellants. B.B.  Ahuja,  Ranbir Chandra and Ms. A.  Subhasini  for  the Respondent. The Judgment of the Court was delivered by B.P. JEEVAN REDDY J. These appeals are preferred against the judgment of the Karnataka High Court answering the  question referred to it, at the instance of the revenue, in favour of

http://JUDIS.NIC.IN SUPREME COURT OF INDIA Page 3 of 8  

the revenue and against the assessee.  The question referred under  section  256 of the Income Tax Act, 196  1,  read  as follows:  "Whether on the facts and in the circumstances  of the case, the Tribunal was right in holding that the sum  of Rs. 1, 79, 742 could not be disallowed under section 40  (c) of the Income Tax Act, 1961." (The above question related to Assessment  Year  1974-75.  The question referred  for  A.Y. 1975-76  was  identical  except in the  matter  of  amount). Since the facts in all the appeals are identical it would be sufficient  to  notice  the  facts in  C.A.  Nos.  6092  and 6092A/90 (Prakash Beedies (P) Lid. v. Commr. of Income  Tax. Karnataka, Bangalore). Prior  to  15.7.1992, a partnership firm called  K.M.  Anand Prabhu & Sons, Mangalore, consisting of three partners  K.M. Vishnudas Prabhu, K.M. Ramdas Prabhu and K.M. Shankar Prabhu was engaged inter alia in the business of manufacturing  and sale  of  beedies under the brand  name  ’Mangalore  Prakash Beedies’.  On May 20, 1972 a Private limited company  called Prakash Beedies 609 Limited  (the assessee-appellant herein),  was  incorporated with  its  registered  off-ice at  Manoalore.   One  of  its objects  was  to take over business of the  aforesaid  firm. Under an agreement dated July 15, 1972 between the firm  and the  company,  the firm sold its rights and  assets  to  the company on the terms and conditions set out therein.  Clause 4(a)  of  the  agreement, which alone is  material  for  the purposes of these appeals reads:               "(a) For the use of the trade name the Company               shall pay royalty to the Vendor at the rate of               10ps.  for every thousand beedies sold by  the               Company by using the trade name of the Vendor.               The royalty shall be worked out at the end  of               each quarter ending on March, June,  September               and  December, on the sales made  during  each               quarter.   The royalty fixed hereby shall  not               be varied for a period of one year and may  be               reviewed and/or revised thereafter wards  from               time to time". The  assessee was making payments to the firm every year  on account of royalty in terms of said clause. The  three  partners  aforesaid of the firm  were  also  the directors of the assessee- company. For  the assessment years 1974-75 and 1975-76, the  assessee claimed  deduction of the amount paid by it to the  firm  on account of royalty in terms of clause 4(a) of the agreement. The amounts paid during the accounting years relevant to the said assessment years were Rs. 3, 16, 526 and Rs. 3, 95, 742 respectively.  The I.T.O. allowed the deductions as claimed. In  exercise of the powers conferred on him by Section  263, the   Commissioner  of  Income  Tax  initiated  (suo   moto) proceedings  for revising the said assessments in so far  as the aforesaid deductions were concerned.  After hearing  the assessee, he passed orders on September 16, 1976  whereunder he  disallowed  payments  to the firm  over  and  above  the ceiling prescribed in Section 40(c).  The assessee preferred appeals to the Tribunal against the orders of the I.T.O, The appeals were allowed and the orders of the I.T.O.  restored. On  reference,  the High Court answered to question  in  the negative  i.e.,  in favour of the revenue  and  against  the assessee,  on the following reasoning : the three  directors of  the assessee company were also the partners in the  firm to which royalty payments were made.  In law, a firm has  no separate  legal existence; it is not a juristic person or  a distinct  legal  entity.   It  is  merely  a  collection  or

http://JUDIS.NIC.IN SUPREME COURT OF INDIA Page 4 of 8  

association of the individuals for carrying 610 on  a  business.  Merely because the firm is  an  assessable entity  under the Income Tax Act it does not follow that  it is a juristic or legal entity.  It must, therefore, be  held that  the payments made to the firm are in reality  payments made  to the directors.  Such payments clearly  attract  and fall within the mischief of Section 40(c).  The Commissioner was  right in saying so and the opinion of the  Tribunal  to the contrary is unsustainable in law. In these appeals, S/Shri Harish N.Salve and Rohinton Nariman assailed  the  correctness  of the view taken  by  the  High Court.   They submitted firstly that the payments were  made not to the directors of the assessee but to a firm which was a separate entity.  A payment to a firm is not ipso facto  a payment to the partners, directly or indirectly.  In a  firm there  may  be other partners besides the directors  of  the assessee-company.   It may also happen that the firm has  no income  to distribute because of the losses incurred  by  it which are set-off against the income so received.  The  High Court  was in error in holding that payment to a firm  is  a payment  to the partners.  Assuming that a partnership  firm is  not  a  separate  juristic  entity  distinct  from   its partners,  even so the payments were made to the said  three persons  not in their capacity as directors (qua  directors) but  in consideration of a valuable right parted by them  in favour  of the assessee-company.  Such payments do  not  and cannot  fall within the mischief of  Section4O(c).   Section 40(c)  was  never  intended to take  in  such  payments.   A company may take on lease the house of its directors for its legitimate   business  purposes  and  pay  rent   which   is reasonable having regard to the market conditions, or it may pay  even  less than the market rate of rent.   Whether  the rent  paid  by the company to its director in  such  a  case falls  within  Section  40(c),  ask  the  counsel.   Another illustration  given  by  the counsel  is  where  a  director supplies  raw material to the assessee-company for  a  price which  is the appropriate market price.  Would such  payment also fall under section 40(c), they ask.  The Budget  speech of the Finance Minister in the Parliament, while introducing the  said  provision,  is relied upon in  support  of  their contention.  It is also argued that the words "remuneration, benefit or amenity" occurring in Section 40(c) must be  read having  regard to the context in which they  occur  applying the  principle NOSCITORA SPCOOS (recognition  of  associated words).  If so read, the payments in question can never fall within the ambit of the said words. Shri  Ahuja, the learned counsel for the  Revenue  justified the  reasoning and approach of the High Court having  regard to the clear language employed in clause (c). The  genuineness  or validity of the agreement  between  the assessee-company  and the firm is not disputed.  The  factum of  payments made on account of royalty in terms  of  clause 4(a) of the said agreement is also not disputed.  It is also 611 not  disputed  that in the beedi trade, brand  name  carries significant  business value.  It is necessary to  keep  this factual  context  in mind while examining  the  question  at issue.   Section 40(c) read as follows during  the  relevant assessment years               "40.  Notwithstanding anything to the contrary               in  sections 30 to 39, the  following  amounts               shall not be deducted in computing the  income               charge able under the head" profits and  gains               of business or profession",

http://JUDIS.NIC.IN SUPREME COURT OF INDIA Page 5 of 8  

             (a)........               (b).........               (c) in the case of any company-               (i) any expenditure which results directly  or               indirectly    in   the   provision   of    any               remuneration of benefit or amenity to director               or to a person who has a substantial  interest               in  the  company  or  to  a  relative  of  the               director  or of such person, as the  case  may               be,               (ii)  any expenditure or allowance in  respect               of  any  assets  of the company  used  by  any               person  referred to in sub-clause  (i)  either               wholly  or  partly  for his  own  purposes  of               benefit,               if  in the opinion of the  Income-tax  Officer               any  such  expenditure  or  allowance  as   is               mentioned  in  sub-clause  (i)  and  (ii)   is               excessive or unreasonable having regard to the               legitimate  business needs of the company  and               the  benefit  derived  by or  accruing  to  it               therefrom, so, however, that the deduction  in               respect  of the aggregate of such  expenditure               and  allowance  in respect of any  one  person               referred  to  in sub-clause (i) shall,  in  no               case, exceed-               (A)   where  such  expenditure  or   allowance               relates  to a period exceeding  eleven  months               comprised in the previous year, the amount  of               seventy-two thousand rupees;               (B)   where  such  expenditure  of   allowance               relates  to  a  period  not  exceeding  eleven               months  comprised  in the  previous  year,  an               amount calculated at the rate of six  thousand               rupees   for  each  month  or   part   thereof                             comprised in that period: 612               Provided  that  in case where such  person  is               also  and  employee  of the  company  for  any               period   comprised  in  the   previous   year,               expenditure  of  the  nature  referred  to  in               clauses  (i),  (ii),  (iii) and  (iv)  of  the               second  proviso to clause (a)  of  sub-section               (5)  of  section 40A shall not be  taken  into               account for the purposes of sub-clause (A)  or               subclause (B), as the case may be;               (iii) *      *      *        *               Explanation.-The  provisions  of  this  clause               shall  apply notwithstanding that  any  amount               not  to  be  allowed  under  this  clause   is               included  in  the total income of  any  person               referred to in sub-clause (i);" The  Budget speech of the Finance Minister, in so far as  it mentions  the  reasons  for introduction of  clause  (c)  of Section 40, reads as follows:               "I  am  firmly  of the view  that  the  fiscal               instrument  must  be  deployed  to  discourage               payment  of  high salaries  and  remunerations               which  go  ill with the norms  of  egalitarian               society.   I accordingly propose to  impose  a               calling   on  the  remuneration   of   company               employees  which  would be deductible  in  the               computation  of taxable profits.  The  ceiling               is being set at Rs. 5,000 per month.  Together               with  the  existing ceiling of Rs.  1,000  per

http://JUDIS.NIC.IN SUPREME COURT OF INDIA Page 6 of 8  

             month   in  the  case  of   perquisites,   the               allowable overall ceiling on remuneration  and               perquisites, for purposes of taxation, will be               at Rs. 6,000 per month.................." The   object  behind  the  provision  undoubtedly   was   to discourage  and  disallow  "payment  of  high  salaries  and remunerations  which  go ill with the norms  of  egalitarian society".  The provision was, of course, not confined to the directors.’  It  took  in relatives  of  directors,  persons having  substantial  interest  in  the  company  and   their relatives.   The  clause vested in the I.T.O. the  power  to determine  whether any such expenditure or allowances as  is mentioned  in the said clause was excessive or  unreasonable having  regard  to  the legitimate  business  needs  of  the company  and  the  benefit  derived by  or  accruing  to  it therefrom.  In addition to it, a ceiling was also prescribed beyond  which such expenditure or allowance could not go  in any event. At  this  juncture, it would be appropriate  to  notice  the provision contained in sub-section (2) of Sec 40A.   Clause, A provides that where the assessee incurs any expenditure in respect  of which payment has been made or is to be made  to any 613 person referred to in clause (b) of the sub-section, and the Income-tax  Officer is of the opinion that such  expenditure is  excessive  or  unreasonable having regard  to  the  fair market value of the goods, services or facilities for  which the payment is made or the legitimate needs of the  business or  profession of the assessee or the benefit derived by  or accruing to him therefrom, so much of the expenditure as  is so  considered by him to be excessive or unreasonable  shall not  be  allowed as a deduction.  Clause  (b)  mentions  the categories  of persons to whom the provision in  clause  (a) applies.   It  includes directors of the company  and  their relatives among others.  Clause b) also takes in any payment to  any  company,  firm, association  of  persons  or  Hindu undivided family of which a director, partner or member,  as the  case may be, has substantial, interest in the  business or  profession of the assessee.  In short, the net  is  cast very wide to ensure that excessive or unreasonable  payments are not made to the persons in control of the affairs of the assessee  in the name of paying for the goods, services  and facilities  rendered, supplied or extended by them,  as  the case may be. That  the payments made by the assessee-company to the  firm on  account  of royalty in terms of clause (4)  (a)  of  the agreement   fall  within  the  meaning  of  the   expression ’expenditure’  in  sub-clause  (i)  of  clause  (c)  is  not disputed.  The observations in CIT, Bombay. v. M/s.   Indian Engineering  and  Commercial  Corporation  Private   Uinited (Civil  Appeal  Nos. 1583 and 1584 (NT) of 1977  decided  on 13.4.1993  by  us-reported in (1993) 2 J.T. 683 do  not  say otherwise.   That case arose under Section 40(A)  (5).   The payments  in question were made to the directors by  way  of commission  on  sales.  The question was  whether  the  said payments  fell within sub-clause (ii) of clause (a) of  sub- section  (5)  of section 40(A).  It was held that  they  did not.  While holding so it was observed that it is  difficult to  say  that  payment  of certain cash  amount  by  way  of commission on sales, directly to an employee, can be said to fall  within  the  words  ’where  the  assessee  incurs  any expenditure which results directly or indirectly’." The said observations were made in response to the Revenue’s argument that  the said payment constituted ’perquisites’ within  the

http://JUDIS.NIC.IN SUPREME COURT OF INDIA Page 7 of 8  

meaning  of sub-clause (ii) of clause (a) of  Section  40(A) (5).  The observations are clearly confined to the said sub- clause  and have no relevance to any other provision in  the Act.  The observations cannot be read dissociated from their context.  Coming back to the provisions of Section 4O(c) and the facts of the case before us the only question is whether the royalty payments to the firm fell within clause (c).  We assume  for the purpose of this argument that in this  case, payments  to  firm were payments to partners.  Even  so,  we think that the said payments did not fall within clause (C). The payments were made in consideration of a valuable  right parted by the partners/ directors of the assessee company in favour   of  the  assessee.   SO  long  a,,  the   agreement whereunder  the said payments were made is not held to be  a mere 614 device or a mere screen, the said payments cannot be treated as  payments  made  to  the  directors  as  directors   (qua directors).  The payments were made by way of  consideration for allowing the assessee to use a valuable right  belonging to them viz., the brand name.  Such a payment may be  liable to be scrutinised under subsection (2) of Section 40(A), but it certainly did not fall within the four corners of Section 40(c). In T. T   Ltd.  v. LTO., Bangalore 121 I.T.R. 55 1, a  Bench of Karnataka High Court comprising D.M. Chandrashekhar,  CJ. and  E.S.  Venkataramiah,J. has taken a view  which  accords with  the  one taken by us.  Speaking for  the  Bench,  E.S. Venkataramiah, J. (as he then was) observed:               "A close reading of the above provision  shows               that  s.  40(c) refers to an  expenditure  in-               curred by making periodical payments to person               mentioned  in that clause apparently  for  any               personal service that may be rendered by  him.               It cannot have any reference to payments  made               by the assessee for all kinds of "services  or               facilities" referred to in s. 4OA(2) (a).   It               is  argued that the proviso  thereto  suggests               that any expenditure incurred for any kind  of               service which is referred to in the main  part               of s. 40A (2) (a) and the expenditure referred               to  in s. 40(c) belong to the  same  category.               This   contention   is   not   correct.    The               expression "services" in s. 40A (2) (a) is  an               expression  of wider import...............  If               the remuneration, benefit or amenity  referred               to in s. 40(c) is treated as the same as  what               is paid in return for "the goods, services  or               facilities"  then  irrespective  of  the  fair               market  value  of  the  goods,  services   and               facilities  provided by a person who may be  a               director  or  a person who has  a  substantial               interest  in the company or a relative of  the               director  or of such person, as the  case  may               be,  only  a  maximum of  Rs.  72,000  can  be               allowed to be deducted in computing the income               of  the  company in any one year.  We  do  not               think that Parliament ever intended that  such               a  result should follow.  The goods,  services               and  facilities referred to in s. 40A (2)  (a)               are those which have a market value and  which               are  commercial  in character.   Many  of  the               services and facilities referred to above  are               those   which   are   nowadays   provided   by               independent organisations.’

http://JUDIS.NIC.IN SUPREME COURT OF INDIA Page 8 of 8  

The  said  decision  has been followed  by  the  Punjab  and Haryana High Court in Commissioner of Income Tax, Patiala v. Avon Cycles (P) Ltd. 126 I.T.R. 448, The Calcutta High Court has also taken a similar view in India Jute Co. Ltd v. 615 Commr of Income-Tax 178 ITR 649. Mr.  Ahuja, learned counsel  for the Revenue submitted  that the argument of the assessee that only the payments made  to directors  as directors fall within clause (c) and  not  the other payments, becomes inapt when the payments are made  to the  relative,,,  of  the directors or  to  persons  holding substantial  interest  in  the  assessee  company  or  their relatives.  The ceilinG prescribed in clause (c) cannot also be  applied  to such persons-says the counsel.   The  answer perhaps lies in the clause itself-in the power vested in the I.T.O. to determine whether any expenditure or allowance  is excessive  or unreasonable having regard to  the  legitimate business needs of the company and the benefit derived by the assessee  or accruing therefrom.  Any payment to a  relative of a director or other persons mentioned in clause (c)  will necessarily be examined applying the above test and if it is found that they are unwarranted, unreasonable or  excessive, they  will be disallowed.  Since such a situation  does  not arise herein, we need not pursue the argument further. For  the  above  reasons, we are of  the  opinion  that  the judgment under appeal cannot be sustained.  It must he  held that  the payments in question did not fall  within  section 40(c).   Accordingly, the appeals are allowed, the  judgment of the High Court is set aside and the question referred  to the  High  Court is answered in the  affirmative,  i.e.,  in favour of the assessee and against the revenue.  No costs. U.J. R.             Appeal allowed. 616