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PETITIONER: COMMISSIONER OF INCOME-TAX, KERALA

       Vs.

RESPONDENT: GEMINI CASHEW SALES CORPORATION, QUILON

DATE OF JUDGMENT: 20/04/1967

BENCH: SHAH, J.C. BENCH: SHAH, J.C. SIKRI, S.M. RAMASWAMI, V.

CITATION:  1967 AIR 1559            1967 SCR  (3) 727

ACT: Income-Tax  Act, 1922, s. 10(1) and  10(2)  (xv)-Partnership dissolved  on death of one partner-Whether liability to  pay retrenchment  compensation  under s. 25FF  on  transfer   of business  to  surviving partner a permissible  deduction  as liability of a revenue nature.

HEADNOTE: A partnership of two partners was dissolved on the death  of one  of them on August 24, 1957 and the business  was  taken over  by  the  surviving partner on his  own  account.   The services of the employees were not interrupted and there was no alteration in their terms of employment.  In  proceedings for assessment to income-tax for the assessment year 1958-59 it  was  urged on behalf of the firm that an amount  of  Rs. 1,41,506 taken into account under the head "gratuity payable to workers of the business" in settling the accounts of  the firm  till August 24, 1957 was a permissible outgoing.   The Income-tax  Officer  rejected the claim  and  the  Appellate Assistant  Commissioner confirmed his order.   However,  the Tribunal,  in  appeal, held that on the dissolution  of  the firm,   the   workmen  became   entitled   to   retrenchment compensation  under s. 25FF of the Industrial Disputes  Act, 1947  and the firm was therefore entitled to the  deduction. The High Court, upon a reference, confirmed this view. On appeal to this Court, HELD  : The amount claimed by the assessee as a  permissible allowance  in  his  profit and loss  account  could  not  be regarded  as  properly admissible either under s.  10(1)  or under s. 10(2)(xv) of the Income-Tax Act, 1922. [735 B] Under   the  proviso  to  s.  25FF  the   liability.to   pay retrenchment compensation arose for the first time after the closure of the business and not before.  It arose not in the carrying on of the business, but on account of the  transfer of  the  business.  It was not therefore a  liability  of  a revenue  nature  and could not be treated as  a  permissible deduction under s. 10(1). [733 H] Alex  A.  Apcar  (Jr.) & Company v. M. V.  Gan  and  Others, A.I.R, 1960 Cal. 14, referred to. Anakpalia Cooperative Agricultural and Industrial Society v. Its, Workmen & Others, [1962] 2 LL.J. 621, Calcutta  Company

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Ltd. v. Commissioner of Income-tax, West Bengal, 37 I.T.R. 1 and Owen (H.  M. Inspector of Taxes) v. Southern Railway  of Peru Ltd., 36 T.C. 602, distinguished. Where  accounts are maintained on the mercantile system,  if liability  to make a payment has arisen during the time  the business  is  carried  on. and the expenditure  is  for  the purpose  of carrying on the business, it may  be  deductible under  Section 10(2)(xv) but where the liability  is  during the  whole  of the period that the business  is  carried  on wholly contingent and does not raise any definite obligation during that time it cannot fall L9Sup.CI/67-3 728 within  the  expression "expenditure laid  out  or  expended wholly or exclusively" for the purpose of the business. [734 D-E) Commissioner  of  Income-tax,  Madras v.  Indian  Metal  and Metallurgical Corporation, 51 I.T.R. 240 and Standard  Mills Company  Ltd.  v.  Commissioner of  Wealth-tax,  Bombay,  63 I.T.R. 470, relied on.

JUDGMENT: CIVIL APPELLATE JURISDICTION: Civil Appeal No. 702 of 1966. Appeal  by special Leave from the judgment and  order  dated July  30,  1964  of  the Kerala  High  Court  in  Income-tax Referred Case No. 20 of 1963. S.   T.  Desai,  S.  K. Aiyar and R. N.  Sachthey,  for  the appellant. T.   V.  Viswanath Iyer, S. K. Dholakia, and O.  C.  Mathur, for the respondent. The Judgment of the Court was delivered by Shah,  J.  Two persons-Walter and  Ramasubramony-carried  on business in cashewnuts as partners in the name and style  of Messrs.   Gemini Cashew Sales Corporation.  The  partnership was  dissolved on the death of Ramasubramony on  August  24, 1957,  and  the  business was taken over  and  continued  by Walter  on his own account.  The services of  the  employees were  not  interrupted and there was no  alteration  in  the terms of employment of the employees of the establishment. In proceedings for assessment of tax it was urged on  behalf of  the  firm  that an amount of  Rs.  1,41,506  taken  into account  under the head "Gratuity payable to workers of  the business"  in settling the accounts of the firm till  August 24,  1957,  was  a  permissible  outgoing.   The  Income-tax Officer  rejected  the  claim and  the  Appellate  Assistant Commissioner confirmed that order.  The Income-tax Appellate Tribunal  held  that by the transfer of the  undertaking  to Walter,  there was no interruption in the employment of  the workmen of the establishment, that the terms and  conditions of  service  applicable to the workmen were not  altered  to their  detriment,  that Walter had not expressly  agreed  to take  over the liability for compensation payable  under  S. 25FF  of the Industrial Disputes Act, 1947, and since  there was  dissolution of the partnership on August 24,  1957  and the undertaking was transferred, the workmen became entitled to  retrenchment compensation, which the firm was liable  to pay.   The  Tribunal  accordingly held  that  the  firm  was entitled   to  deduct  the  sum  of  Rs.  1,41,506  in   the computation of income in the assessment year. 1958-59. In recording their opinion on the following question submit- ted by the Tribunal,                             729               "Whether   the  allowance  of   Rs.   1,41,506

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             constitutes  an allowable expenditure  in  the               assessment of the firm for the year 1958-59", the High Court of Kerala observed that in the  determination of  the  taxable profits of the firm till  its  dissolution, considerations  about  the  liability  to  pay  retrenchment compensation  devolving upon Walter as the assignee  of  the business  valuable consideration were irrelevant, and  since it  was maintaining accounts on mercantile system, the  firm could  claim as a Permissible outgoing the amount for  which liability was incurred though no actual payment was made  to the  workmen.  The Commissioner of Income-tax  appeals  with special leave, against the order of the High Court recording an answer in the affirmative. The,  subject-matter of the claim was  retrenchment  compen- sation payable to workmen of the establishment under s. 25FF of the Industrial Disputes Act, 1947, Section 25F of the In- dustrial Disputes Act, 1947, provides :               "No  workman employed in any industry who  has               been  in continuous service for not less  than               one year under an employer shall be retrenched               by that employer until-               (a)   the  workman has been given one  month’s               notice  in writing indicating the reasons  for               retrenchment  and  the period  of  notice  has               expired, or the workman has been paid in  lieu               of  such notice, wages for the period  of  the               notice:               Provided  that no such notice shall be  neces-               sary if the retrenchment is under an agreement               which specifies a date for the termination  of               service;               (b)   the  workman has been paid, at the  time               of  retrenchment, compensation which shall  be               equivalent  to fifteen days’ average  pay  for               every  completed year of service or  any  part               thereof in excess of six months; and               (c)   notice  in  the  prescribed  manner   is               served on the appropriate Government." Section  25FF, as substituted by Act 18 of 1957 with  effect from November 28, 1956, provides :               "Where  the  ownership  or  management  of  an               undertaking   is   transferred,   whether   by               agreement  or  by operation of law,  from  the               employer in relation to that undertaking to  a               new employer, every workman who               73 0               has  been in continuous service for  not  less               than one year in that undertaking  immediately               before  such  transfer shall  be  entitled  to               notice and compensation in accordance with the               provisions  of Section 25F, as if the  workman               had been retrenched : Provided  that  nothing  in this section shall  apply  to  a workman  in  any  case  where there has  been  a  change  of employers by reason of the transfer, if-               (a)   the service of the workman has not  been               interrupted by such transfer;               (b)   the  terms  and  conditions  of  service               applicable to the workman after such  transfer               are  not  in any way less  favourable  to  the               workman   than   those   applicable   to   him               immediately before the transfer; and               (c)   the new employer is, under the terms  of               such transfer or otherwise, legally liable  to               pay  to  the  workman, in  the  event  of  his

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             retrenchment,  compensation on the basis  that               his  service has been continuous and  has  not               been interrupted by the transfer." Under S. 25FF the right of the workmen to retrenchment  com- pensation  arises  on transfer of ownerships  or  management from  the employer in relation to the undertaking to  a  new employer.   But in the conditions set out in the proviso  no such right accrues.  It is common ground that the first  and the second conditions in the proviso are satisfied.  Counsel for  the Commissioner contended that the third condition  of the proviso was also satisfied, and no right to retrenchment compensation arose in favour of the workmen under s. 25FF of the  Industrial Disputes Act.  Counsel for the  Commissioner contended  that the liability of the partners in a  firm  to pay retrenchment compensation being joint and several,  when the undertaking carried on by a firm is continued by one  of the partners after its dissolution, and the services of  the workmen  are not terminated and the terms and conditions  of the  service  are  not made  less  favourable,  the  partner continuing the business may appropriately be held liable  to pay to the workmen retrenchment compensation on the  footing that  the  service  of  the  workmen  had  been  continuous. Counsel relied upon the view expressed by the Calcutta  High Court  in  Alex A. Apcar (Jr.) & Company v. M.  N.  Gan  and Others(1)  in  which  it  was  observed  that  a  change  of partnership  by  inclusion or retirement of  partner,  which legally  changes  the  constitution of the  firm,  does  not result (1)  A.I.R. 1960 Cal. 14                             731 in, a "change of business or employer within the meaning  of ss. 25F and 25FF". Counsel  for  the assessee relied upon a  judgment  of  this Court in Anakapalia Co-operative Agricultural and Industrial Society  v.  Its  Workmen  & Others(1)  in  support  of  the contention  that on a bona fide transfer of  an  undertaking the  workmen  employed in the undertaking  are  entitled  to retrenchment   compensation  under  s.  25FF   against   the transferor.  That however was a case in which the transferee had declined to re-employ the workmen of the transferor  and the first condition of the proviso was not fulfilled.   That case can have no application to the present case. In  the  view we take, that the allowance claimed is  not  a proper  outgoing, or allowance in computing the  profits  of the assessee, we do not express any opinion on the  question whether the workmen of   the undertaking became entitled  to retrenchment compensation on  the     transfer    of     the undertaking to Walter. Liability  to pay retrenchment compensation arises under  s. 25FF when there is a transfer of the ownership or management of   an  undertaking  :  it arises on the  transfer  of  the undertaking  and  not  before.   Transfer  of  ownership  or management of an undertaking in law operates, except in  the conditions  Set out in the proviso, as retrenchment  of  the workmen.   But until there is a transfer of the  undertaking resulting in determination of employment the workmen do  not become  entitled to retrenchment compensation.  So  long  as the  ownership of the business continues with the  employer, the  right  of  the workmen to  claim  compensation  remains contingent.  A workman may, before the transfer of ownership of  the business, himself terminate the employment:  he  may die  or he may become superannuated: in none of these  cases the  owner  of the business is under any obligation  to  pay retrenchment compensation to the workman.  The obligation to pay  compensation  becomes  definite  only  when  there,  is

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retrenchment  by  the  employer, or when  the  ownership  or management  of  the  undertaking is,  except  in  the  cases contemplated by the proviso, transferred to a new  employer, and  not  till  then.   The  right  therefore  arises   from determination  of  employment,  or  from  transfer  of   the undertaking  : it has no existence before these events  take place. The judgment of this Court in Calcutta Company Ltd v. Com- missioner  of Income-tax, West Bengal (2) on which  reliance was placed by counsel for the assessee has no bearing on the present  case,  for in that case, expenditure which  it  was estimated  had to be incurred to discharge an  existing  and definite  obligation  enforceable against  the  assessee  in praesenti was held a permissible (1) [962] 2 L.L.J. 621. (2) 37 I.T.R. 1. 732 deduction  in the computation of income.  The Calcutta  Com- pany  Ltd  had  sold plots of  land  for  building  purposes undertaking to develop them within six months by laying  out roads,  providing drainage and installing lights,  etc.   In the  accounts  of the Company maintained  according  to  the mercantile  system, the Company had credited the  full  sale price of the. plots agreed to be paid by the purchasers, but not  actually received, and against the price it debited  an estimated  sum  as expenditure for the  development  it  had undertaken  to carry out, even though no part of the  amount was  actually spent.  By the terms of sale, the Company  had undertaken an unconditional obligation which was enforceable against  it  :  the liability was not  contingent  upon  the happening of a future event.  It was held by this Court that the outgoing debited was properly admissible. The decision of the House of Lords in Owen (H.  M. Inspector of  Taxes)  v.  Southern Railway of Peru  Ltd.(1)  on  which counsel for the assessee relied also does not assist the the assessee.  In that case under the Peruvian law the  Southern Railway of Peru Ltd. was bound to pay its employees in  Peru prescribed  compensation payments upon termination of  their services,  subject  to  the fulfilment by  the  employee  of certain  conditions.  The amount to be paid depended on  the length  of service and rate of pay at the end of the  period of service.  The Company set apart from the gross profits of each year sums prospectively payable under the Peruvian  law as  compensation  on  the  termination  of  employment.   In proceedings for assessment to tax of the Company made  under Case 1 of Sch.  D of the Income Tax Act, 1918 (8 & 9 Geo. 5, Ch. 40), it was contended on behalf of the Company that upon proper  principles  of commercial  accountancy  compensation calculated to have accrued due to each employee from year to year  as deferred remuneration was properly allowable  as  a deduction.   The Special Commissioners upheld the  claim  of the  Company on the (,round that it was a matter of  correct accountancy  practice to make provision in the accounts  for the sums in question.  The matter reached the House of Lords in  appeal from an order on a reference under s. 64  of  the Income-Tax Act, 1952.  The House held that where a number of similar contingent obligations arise from trading, there  is no  rule of law which prevents the deduction of a  provision for  them in ascertaining annual profits, if a  sufficiently accurate estimate can be made.  But a majority of the  House held  that the "provision claimed by the Company  throughout the proceedings was not permissible by reason of the absence of discount and other factors".  Lord MacDermott observed at p. 635 : ".....as a general proposition it is, I think, right to  say

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that in computing his taxable profits for a (1)  36 T.C. 602.                             733               particular  year  a  trader  who  is  under  a               definite  obligation to pay his employees  for               their  services  in  that  year  an  immediate               payment  and  also a future  payment  in  some               subsequent year, may properly deduct not  only               the immediate payment but the present value of               the future payment provided such present value               can  be  satisfactorily determined  or  fairly               estimated.  Apart from special  circumstances,               such a procedure, if practicable, is justified               because it brings the true costs of trading in               the particular year into account for that year               and  thus  promotes the ascertainment  of  the               "annual  profits or gains arising or  accruing               fro in" the trade." Lord  MacDermott was of the view that the provision made  by the  Company  led to anomalies, and was  not  admissible  as made,  and  the  case  should be  remitted  to  the  Special Commissioners  whether  it  is  practicable  to  arrive   at satisfactory deductions.  Lord Radcliffe with whom the  Lord Chancellor and Lord Tucker agreed was of the view that there is  no  rule  of law which forbids  the  introduction  of  a provision  for  future payments in or payments out,  if  the right  to receive them or the liability to make them, is  in legal terms contingent at the closing of the relevant year. The  question which arises in the present case is not  about the  admissibility  of a provision made by a trader  by  the adoption of it reasonably satisfactory method estimating the present value of an obligation which may arise in future  to pay  a  sum of money to his employees.   The  question  that falls to be determined is whether the liability which arises on  transfer  of  the,  business is  to  be  regarded  as  a permissible outgoing in the account of the business which is transferred.    Broadly   stated,  the  present   value   on commercial valuation of money to become due in future, under a  definite  obligation, will be a permissible  outgoing  or deduction in computing the taxable profits of a trader, even if  in certain conditions the obligation may cease to  exist because  of  forfeiture of the right.  Where,  however,  the obligation  of the trader is purely contingent, no  question of  estimating  its  present value may arise, for  to  be  a permissible outgoing or allowance, there must in the year of account  be  a  present  obligation  capable  of  commercial valuation. As already observed, the liability to pay retrenchment  com- pensation arose for the first time after the closure of  the business and not before.      It  arose not in the  carrying on of the business, but on account of  the transfer  of  the business.  During the entire period that the business    was continuing,  there  was  no liability  to  pay  retrenchment compensation.  The liability which arose on transfer of  the business was not of a revenue nature.  Profits of a business involve comparison between the state of the business at 734 two  specific  dates.  Normally the liability  which  occurs after the last date, unless its source is in a  pre-existing definite  obligation,  cannot be regarded as a part  of  the outgoing  of the. business debit-able in the profit  &  loss account.   A  deduction which is proper  and  necessary  for ascertaining  the  balance  of  profits  and  gains  of  the business  is  undoubtedly properly allowable,  but  where  a liability to make a payment arises not in the course of the

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business,  not for the purpose of carrying on the  business, but springs from the transfer of the business, it is not, in our judgment, a properly debatable item in its profit & loss account  as  a revenue outgoing.  The claim of the  firm  to treat  it as an item in the determination of the profits  of the  firm  under  s. 10(1) of the  Income-tax  Act  can.not, therefore,. be sustained. Under  s.  10(2) (xv) of the Indian Income-tax  Act  in  the computation of taxable profits (omitting parts of the clause not  material) "any expenditure laid out or expended  wholly and exclusively for the purpose of such business, profession or vocation", i.e. business, profession or vocation  carried on by the assessee, is a permissible allowance.  But to be a permissible  allowance  the  expenditure  must  be  for  the purpose  of  carrying on the business.  Where  accounts  are maintained  on  the the mercantile system, if  liability  to make the payment has arisen during the time the business  is carried on, it May appropriately be regarded as expenditure. But  where the liability is, during the whole of the  period that the business is carried on, wholly contingent and  does not  raise any definite obligation during the time that  the business is carried on, it cannot fall within the expression "expenditure  laid not or expended wholly  and  exclusively" for the purpose of the business. Two cases illustrative of the principle may be noticed.   It was held by the Madras High Court in Commissioner of Income- tax, Madras v. Indian Metal and Metallurgical Corporation(1) that  a provision made in the annual accounts maintained  by an  employer setting apart by way of a reserve to  meet  the liability, if any, to which the employer may become  subject in the event of retrenching workmen because of the necessity of  retrenchment  of the services of the staff,  was  not  a liability in praesenti in the year of account, but was  only a contingent liability which may arise on the happening of a particular contingency and was not allowable as a ,deduction in  assessment of tax.  This- Court in dealing with  a  case under the Wealth Tax Act in Standard Mills Company Ltd.   V. ,Commissioner of Wealth-tax, Bombay(1) held that a liability under  the award of the Industrial Court to pay gratuity  to its  ,employees at certain rates on death while in  service, or  on  voluntary retirement or  resignation  after  fifteen years’ continuous (1) 51 I.T.R. 240. (2) 63 I.T.R. 470. 735 service,   or  on  termination  of  service  after   certain specified periods, but not if the employee was dismissed for dishonesty  or misconduct, was a mere  contingent  liability which  arose  only when the employment of the  employee  was determined by death, incapacity, retirement or resignation : the liability did not exist its praesenti. The amount of Rs. 1,41,506/- claimed as a permissible allow- ance by the assessee in its profit & loss account cannot, in our  judgment,  be regarded as  properly  admissible  either under  s.  10 (1) or s. 10 (2) (xv) of the  Income-tax  Act. The  answer  to  the question must,  therefore,  be  in  the negative. The appeal is allowed and the order passed by the High Court is  set  aside.  The Commissioner will be  entitled  to  his costs in this Court. R.K.P.S.                                              Appeal allowed. 736

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