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PETITIONER: BRITISH INDIA CORPORATION

       Vs.

RESPONDENT: COMMISSIONER OF INCOME-TAX, U.P., LUCKNOW

DATE OF JUDGMENT03/10/1972

BENCH: REDDY, P. JAGANMOHAN BENCH: REDDY, P. JAGANMOHAN HEGDE, K.S. DUA, I.D.

CITATION:  1973 AIR  416            1973 SCR  (2) 524  1973 SCC  (3) 285

ACT: Excess   Profits   Tax   Act   1940,   Schedule   I,    r.12 (1)--Determination   by  officer  whether   expenditure   is reasonable and necessary--Tests for.

HEADNOTE: Rule  12  (1) of Schedule I to the Excess Profits  Tax  Act, 1940,  is  designed  to prevent the  dissipation  of  excess profits  by inflating expenditure which has no  relation  to the  requirements of the business.  The test is whether  the expenditure is unreasonable and unnecessary having regard to the  requirements  of  the business, and,  in  the  case  of directors’  fees  or  other payments for  services,  to  the actual  services rendered.  All relevant  facts,  especially commercial expediency or commercial practice, must be  taken into  consideration  by the Excess Profits  Tax  Officer  in considering  whether  the  expenditure  is  reasonable   and necessary; that is, he could not apply the rule to increases that  can  be justified on ordinary  commercial  principles, because, an increase in profits may in certain cases be  due to increase in the activity of the management or increase in the establishment justifying a corresponding increase in the expenditure.  But when huge profits are earned,, not due  to any  activity  of managers but due to  national  emergencies such  as  war situations, the government is  entitled  to  a certain share of the excess profits computed under the  Act. Any  commission  paid on the excess profits  for  which  the managers or employees made no sort of contribution would  ex facie be unreasonable and unnecessary and the Excess Profits Tax   Officer   would  be  justified  in   disallowing   the proportion,  which, according to him, was ’unreasonable  and unnecessary  having  regard  to  the  requirements  of   the business. [530A-D; 531G-H; 532A] In  the  present  case, the assessee  is  a  public  limited company having several branches and subsidiary companies  It has  a  Board of Directors which looks after  its  business. The managers who look after the branches ,of the company are also  members of the Board.  The assessee  was  remunerating its directors by way of commission based on a certain  fixed percentage  of  its net audited profits.   The  phrase  ’net audited  profits"  was clarified to mean  the  amount  after

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depreciation  had  been  allowed  for,  but  prior  to   any allocation  or appropriation of profits including  provision for taxation.  The Excess Profits Tax Act came into force on April 5, 1940, and on 27th July, 1940, the phrase "including provision  for  tax’  in  the  clarification,  was   further clarified  that  it  was  intended to  cover  all  forms  of taxation  including  excess  profits  tax  and  other   like impositions.  Therefore, no, deduction of excess profits tax was  to  be  made prior to  the  calculation  of  managerial commissions.   For the chargeable accounting years 1945  and 1946 the Excess Profits Tax Officer found that the  assessee had  made large profits and held that if the commission  was to  be  paid on the ,net audited profits  the  whole  excess profits  would  be  taken into account for  the  payment  of commission; that a portion of the commission attributable to excess  profits,  in  the  peculiar  circumstances  of   war conditions.  was  not  reasonable and  necessary  with.  the meaning of r. 12 (1), and that any payment, in excess of the agreed  proportion  of the net profit’s after  deduction  of excess  profits  tax,  was not  justified.   He,  therefore, disallowed  a  percentage of the said excess  profits  which would  be payable to the State on account of excess  profits tax liability. [526A-H;, 527A.C] 525 On  the question whether the disallowed we for each  of  the years was rightly made, the Tribunal and the High Court held against the assessee. Dismissing the appeal to this Court, HELD : The Excess Profits Tax Officer and the Tribunal  have given  valid reasons for not allowing the entire  commission claimed  on  the  basis  of  the  audited  accounts  without deducting the excess profits tax., [531G] Ahmedabad  Manufacturing & Calico Printing Co. v.  Commr  of E.P.T., 38 I.T.R. 675 followed. British  India  Corporation  Ltd. v. Commr.  of  E.P.T.,  33 I.T.R. 826 and Shyamlal Pragnarain v. C.I.T., 27 I.T.R.  404 referred to

JUDGMENT: CIVIL APPELLATE JURISDICTION : Civil Appeal Nos. 1987 to 1988 of 1.969. Appeals  by  certificate from the judgment and  order  dated October  22, 1965 of the Allahabad High Court in  Income-tax Reference No. 154 of 1957. S.  T.  Desai,  Alok Kumar Verma and B.  P.  Singh  for  the appellant B.  Sen, J. Ramamurthy, B.D. Sharma and R. N.  Sachthey  for the  respondent. The Judgment of the Court was delivered by JAGANMOHAN  REDDY,  J.   These appeals  are  by  certificate against  the  Judgment  of the Allahabad  High  Court  in  a reference  under S. 21 of the Excess Profits Tax  Act,  1940 (hereinafter  called  the ’Act’) read with s. 66(2)  of  the Indian Income-tax Act, 1922.  The questions referred were in respect  of  the  two chargeable  accounting  periods  being January 1, 1945 to December 31, 1945 and January 1, 1946  to March 31, 1946 and are given below               1.    Whether  on the facts and  circumstances               of this case the amount of Rs. 5,39,057/-  was               rightly  disallowed  under rule 12(1)  of  the               Schedule to the Excess Profits Tax Act?               2.    Whether  on the facts and  circumstances               of this case the amount of Rs. 1,28,743/-  was

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             rightly  disallowed  under  rule  12  (1)   of               Schedule I to the Excess Profits Tax Act? Both these questions were answered in the affirmative. The  facts  and  circumstances of the case  on  which  these answers  were given are :-The assessee is a  public  limited company   (hereinafter  called  the  ’Corporation’)   having several  branches and subsidiary companies.  It has a  Board of  Directors which looks after its business.  The  branches of the Company are looked after by mangers who ,ire  members of the Board of Directors.  It 526 appears  that for a long time and even before the  Act  came into  force  the  corporation  has  been  remunerating   its directors   including  the  Managing  Director  and   branch managers  by  way  of commission based on  a  certain  fixed percentage of its net audited profits.  This commission  was in addition to the directors’ fees and/or stipulated monthly salary.   In  the  case of a branch manager  the  amount  of commission  to be paid was calculated on the profits of  the branch of which he was in charge.  In the case of others the profits  made by the Corporation as a whole were taken  into consideration.   The commission to be paid was either  fixed at   the  time  of  appointment  or  by  resolution   passed subsequently.   In so far as the two  chargeable  accounting periods are concerned, the position in regard to the payment of  the commission has been set out in the statement of  the case  but  this  is not relevant for the  purpose  of  these appeals  except to note. as we have earlier mentioned,  that the  commission was to be calculated with reference  to  the net  audited  profits  which  phrase  was  clarified  by   a resolution of the Corporation dated February 24, 1940.  That resolution is as follows :-               "Commission.               In order to regularise previous Resolutions on               the  subject  of  Managerial  Commission,  the               Board  resolved  that commission on  profits               would be payable to the Managing Director  and               the  Branch Managers entitled thereto, on  net               audited  profits, only after depreciation  had               been  allowed for but prior to any  allocation               or  appropriation  of such  profits  including               provision for taxation."               Though it is not mentioned in the statement of               the  case  we can take judicial notice  of  it               that   the   Excess  Profits  Tax   Bill   was               introduced in the Central Legislative Assembly               on  January 27, 1940 and after it was  passed,               received the assent of the Governor-General on               April  5, 1940.  On July 27, 1940  the  phrase               ’including provision for taxation’ was further               clarified by the following resolution :-               "The Board, therefore, resolved that the words               ’including   provision  for   taxation’   were               intended  to  and did specifically  cover  all               forms of taxation including the Excess Profits               Tax and other like impositions and, therefore,               no  deduction of excess profits tax and  other               like  impositions  from  the  audited  profits               should  be  made prior to the  calculation  of               Managerial   commissions.   The   Board   also               resolved that this ruling, which could only be               regarded  as fair and reasonable  should  have               effect retrospectively to the commission  paid               in respect of the year 1939."               527

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             In respect of the chargeable accounting period               ending  December 31, 1945 the  Excess  Profits               Tax  Officer had observed in his  order  dated               December 15, 1947 as follows :-               "For  reasons stated in the order dated  30-3-               1945 and Rule 12 Schedule I for the chargeable               accounting  period  up to 31-12-1943,  1  hold               that, having regard to the requirements of the               business  and the actual services rendered  by               the persons concerned, the commission  allowed               to  the management and directors is  both  un-               reasonable  and unnecessary.  Any  payment  in               excess  of  the agreed proportion of  the  net               profits after deduction of Excess Profits  Tax               is not justified." The  Excess  Profits Tax Officer accordingly held  that  Rs. 11,47,143 for the first chargeable accounting period and Rs. 11,06,693 for the second chargeable accounting period  could not be allowed and was further of the view that a portion of it  was  not reasonable and necessary having regard  to  the requirements  of  the  business  and  the  actual   services rendered by the persons concerned.  It was pointed out that the  commission of the nature under consideration was  being paid by the Corporation even before the Act came into  force and  that such commission was being allowed in its  entirely for  purposes  of  computing profits, under  s.  10  of  the Income-tax  Act, 1922 in the two  corresponding  assessments made under s. 10 of the Income-tax Act.  Though this was  so under  the Income-tax Act the Excess Profits Tax Officer  on the  facts of the case and having regard to rule 12  of  the Schedule to the Act took the view that since the  commission in  the respective chargeable accounting periods  were  paid out  of  the  profits which could not  be  retained  by  the Corporation, a portion of the commission attributable to the Excess Profits Tax Act earned in the peculiar  circumstances of  a national calamity was not "reasonable  and  necessary" within the meaning of the said rule.  It was found that  for the  first chargeable accounting period the  Excess  profits payable  were  approximately  Rs.  64,36,000/-  but  if  the commission was to be paid on the net audited profits of  Rs. 1.37  crores,  the whole excess profits which could  not  be retained  by the Corporation for its own use would be  taken into  account for the payment of the commission as  such  be determined the portion to be disallowed was at 8.4 % of  the said  excess profits which will be payable to the  State  on account  of the Exces Profits Tax liability.  On this  basis the  amount worked out was Rs. 5,39,057.  Applying the  same method for the following accounting chargeable, period ended March 3 1. 1946 he determined the amount as Rs.  1,28,743/-. These two amounts were disallowed in the assessments for the respective  chargeable accounting periods.  In  arriving  at these  amounts  the Excess Profits Tax Officer  ignored  the terms  of appointment and the resolutions and  drew  support from the orders passed by the 528 Tribunal  in  respect of the two prior assessments  for  the accounting periods ended December 31, 1943 and December  31, 1946,  against which orders of the Tribunal a reference  had earlier  been  made  to  the  Allahabad  High  Court.   This reference  was  then pending before it when  the  subsequent assessments  were being dealt with.  In the appeals  against assessments  made for the accounting periods in the  instant case,  it was admitted on behalf of the  Corporation  before the Tribunal that there was no new material other than  what was  on record in the, Excess Profits Tax  assessment  files

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and the Tribunal files relating to the chargeable accounting periods  for  the  years 1943 and 1944.   These  files  were produced  before  the  Tribunal  in  the  appeals  for   the assessments  in  question.  The Tribunal  however  dismissed those appeals following its earlier decision relating to the chargeable  accounting periods for 1943 and  1944.   Against that  order  the  High Court on a reference  under  the  Act considered  a  similar question, viz.  whether  the  amounts claimed  by  the  Corporation  in respect  of  each  of  the assessment  year was rightly disallowed under rule 12(1)  of tile First Schedule to the Act. In  the earlier reference for the assessment in  respect  of the  assessment  years  1943  and  1944,  a  Bench  of   the Allahabad  High Court in British India CorPoration  Ltd.  v. Commr.  of E.P.T.(1) consisting of Bhargava, J. (as he  was) and  Mehrotra, J. were of the View that the findings of  the Excess  Profits Tax Officer that the payments were both  not necessary  and not reasonable amounted to holding  that  the previous practice and agreements save no indication that the commission  had  to  be paid without  deducting  the  excess profits tax from the net profits and that the payments  made were  beyond the terms of the agreement.  According to  that court  this  was  not the basis on  which  the  question  of reasonableness  and  necessity  of the payments  had  to  be decided.   But  what the officer and the Tribunal  ought  to have  decided is the question whether or not these  payments were necessary and justified, having regard to the  ordinary commercial  practice and commercial expediency ,and  taking into  account the services rendered by the persons  to  whom the  _payments  were made.  Bhargava, J. who  delivered  the judgement  of the Bench in arriving at the  conclusion  that the disallowance of the amounts was act justified followed a Full Bench judgement of that Court in Shyamlal Pragnarain v. C.I.T.(2). In that Full Bench it was observed that what  the Excess  Profits Tax Officer had to bear in mind is that  the amount  could  be disallowed in whole or in part if  it  was found  that it was not reasonable and it was  not  necessary having  regard to the requirements of the business  and  the actual  services rendered by the managers.  The question  as to the terms of the contract, it said "may have been a (1) 33 I.T.R. 826. (2) 27 I.T.R. 404. 529 matter  of  importance  as  between  the  employer  and  the employee  but not for the purposes of the  determination  of the question of reasonableness or necessity either under the Income-tax  Act or the Excess Profits Tax Act" which had  to be  judged in the light of the requirements of business  and to  the exigencies of the business keeping in view  ordinary commercial practice and commercial expediency. When  the Tribunal decided the appeal which is  the  subject matter of this reference, the decision of the High Court, as we  said earlier, had not been rendered and consequently  it did not have the benefit of that decision the High Court  in the judgment under appeal however observed :-               "The  Full Bench did not discuss  whether  for               disallowing a deduction both  unreasonableness               and  want of necessity are required or  either               is  enough and presumed Presumably  from  the,               fact  that both reasonableness  and  necessity               are  required  for allowing it that  both  are               required.   As the question was not  expressly               raised  before  and decided  by  Bhargava  and               Mehrotra,  JJ. in one case and the Full  Bench               in  the  other case, the assumption  on  which

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             they proceeded would not bind us."               In  our  view,  these  observations  are   not               justified  because  in both  those  cases  the               aspects  referred  to were certainly  kept  in               view in determining the questions before them.               It  appears  that the Revenue did  not  appeal               against the decision of Bhargava and Mehrotra,               JJ.  in the case above referred.   The  Excess               Profits  Tax Officer had made the  assessments               basing  them  on  the  reasons  given  in  the               earlier  orders  relating  to  the  chargeable               accounting  years  1943 and  1944  which  were               referred to in the statement of the case.   We               also  find that the High Court in its  earlier               judgment  was not justified in  thinking  that               the Excess Profits Tax Officer had not applied               the requirements of rule 12 of the Schedule to               the Act.               Rule 12(1) of Schedule I which is relevant  is               as follows               "(1)   In   computing  the  profits   of   any               chargeable  accounting  period  no   deduction               shall  be  allowed in respect of  expenses  in               excess of the amount which the Excess  profits               Tax Officer considers reasonable and necessary               having  regard  to  the  requirements  of  the               business  and, in the case of directors’  fees               or other payments for services, to the  actual               services rendered by the person concerned;               Provided that no disallowance under this  rule               shall  be  made  by  the  Excess  Profits  Tax               Officer  unless  he  has  obtained  the  prior               authority   of  the  Commissioner  of   Excess               Profits Tax." 530 This  rule  is de-signed to prevent the dissipation  of  the excess  profits  by  inflating  expenditure  which  has   no relation to the requirements of the business.  The, test is, whether  the  expenditure is  unreasonable  and  unnecessary having regard to the requirements of the business and in the case  of directors’ fees or other payments for  services  to the  actual  services  rendered.   There  is  of  course  no reference   in  this  rule  to  commercial   expediency   or commercial practice in considering whether an expenditure is unreasonable   and   unnecessary  having   regard   to   the requirements  of the business.  But that is another  way  of saying  that  all  relevant  factors  must  be  taken   into consideration  by  the Excess Profits Tax  Officer  in  con- sidering   whether  that  expenditure  is   reasonable   and necessary.   What  it means is that the Excess  Profits  Tax Officer  could  not apply the rule to increase that  can  be justified  on  ordinary  commercial  principles  because  an increase in profits may in certain cases be due to  increase in  the  activity  of  the management  or  increase  in  the establishment  justifying  a corresponding increase  in  the expenditure.   The  Full Bench decision in  Shyamlal’s  case came   up   consideration  by  this   Court   in   Ahmedabad Manufacturing & Calico Printing Co. v. Commr. of  E.P.T.(1). That  was  also  a case where the question  was  whether  in determining  the profits on which the percentage had  to  be determined for payment of bonus to five of its employees and the  contribution to be made to the provident funds of  5  3 employees, deduction, of depreciation, income-tax and super- tax in respect of first category and deduction of income-tax or  excess  profits tax in respect of  the  second  category

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could  be made before arriving at the profits.   The  Excess Profits Tax Officer came to the conclusion that the payments were  unnecessarily large and unreasonable having regard  to the requirements of the business and without taking up  each individual  case he held, applying rule 12 that it was:  not necessary  for the assessee company for the purpose  of  its business to calculate the bonus or the contribution on  that basis of net profits before the deduction of excess  profits tax.   He accordingly disallowed the excess of  the  payment calculated without deduction of that tax.  In upholding  the disallowance  this  Court held that there  was  material  on which  the  Excess  Profits Tax Officer could  arrive  at  a finding  and  on  which  the  Tribunal  could  confirm  that finding.  In that case also the Excess Profits Tax  Officer, in   the  assessment  order  relating  to   the   chargeable accounting  year  ending December 31, 1943  gave  sufficient reasons for  disallowing the amounts  which  reasons  were incorporated   by   reference  in  the   assessment   orders pertaining   to  the  disallowance  of  the  claim  in   the chargeable  accounting  years in question.  In  the  earlier order the reasons given were as follows :               "The rates of commission were fixed long prior               to the commencement of the present war and  no               deduction               531               was admittedly made for the Excess Profits Tax               liability  in computing the net profit of  the               corporation  for  the purpose  of  calculating               commission    payable   to    directors    and               management.   As a result of  war  conditions               the  profits of the Corporation have  gone  up               tremendously  from about Rs. 10 lakhs  in  the               prewar period to about Rs. 2 crores during the               relevant chargeable accounting period and  the               commission  to management on the basis of  net               profits  has  risen in  the  same  proportion.               Since   the  Excess  Profits  Tax,  which   is               intended  to prevent the owner of  a  business               from  making a large fortune out of what is  a               national  danger, is not deducted out  of  net               profits   in   calculating   commission,   ’an               employee  stands to benefit from the  national               emergency   to  a  greater  extent   than   an               employer’;  (Walchand & Co. Ltd. v.  The  Hin-               dustan Construction Co. Ltd. (12 I.T.R.  104).               it  therefore,  appears  both  unnecessary.and               unreasonable  to  pay  more  than  the  agreed               proportion  of the profits after deduction  of               Excess  Profits Tax.  In the circumstances,  I               hold  that  the  increased  expenditure  under               commission  although of a nature  which  under               the provisions of s. 10 of the Income-tax Act,               is  in  itself  an  allowable  deduction,   is               ’unreasonable and unnecessary having regard to               the  requirements  of  the  business  and  the               actual   services  rendered  by  the   persons               concerned."               After giving these reasons he went on to say               "Having  held that the aforesaid  payments  of               commission  are unjustifiable and  exceptional               the question arises as to what the  reasonable               amount,  having regard to the requirements  of               the business and the actual services  rendered               by the persons should be.  As mentioned above,               any payment in excess of the agreed proportion

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             of  the net profits after deduction of  Excess               Profits Tax is unreasonable and unnecessary." The Excess Profits Tax Officer accordingly computed what was the reasonable amount of commission which should be allowed. We can find very little justification in the criticism  that no reasons have been given by the Excess Profits Tax Officer or  the  Tribunal  for not allowing  the  entire  commission claimed  on  the  basis  of  the  audited  accounts  without deducting  the taxes paid including the excess profits  tax. It  is obvious that when huge profits are earned not due  to any  activity of the managers but due to war situation,  the Government  is  entitled to a certain share  of  the  excess profits computed under the Act.  Any commission paid on  the excess  profits for which the managers or employees made  no sort of contribution would ex facie be unreasonable and  un- necessary  and the Excess Profits Tax Officer was  perfectly justified 532 in disallowing certain proportion which according to him was unreasonable   and   unnecessary  having   regard   to   the requirements  of  the business.  In this view,  the  answers rendered  by  the High Court cannot be disturbed  and  these appeals are accordingly dismissed with costs. V.P.S. Appeals dismissed. 533