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PETITIONER: M/S. MADDI VENKATARAMAN & CO. (P) LTD.

       Vs.

RESPONDENT: THE COMMISSIONER OF INCOME TAX

DATE OF JUDGMENT:       02/12/1997

BENCH: SUHAS C. SEN, S. SAGHIR AHMAD

ACT:

HEADNOTE:

JUDGMENT:                THE 2ND DAY OF DECEMBER, 1997 Present:                Hon’ble Mr.Justice Suhas C.Sen                Hon’ble Mr.Justice S.Saghir Ahmad Ramesh P.Bhatt,  Sr.Adv. M.N.Shroff, Ms. Ragini Singh, Advs. with him for the appellant Ranvir Chandra, C.V.Rao, S.R.Tardol, Nagpal, and B.K.Prasad, Advs. for the Respondent                       J U D G M E N T      The following Judgment of the Court was delivered: SEN, J.      The Tribunal  referred the following question of law to the Andhra  Pradesh High  Court under Section 256 (1) of the Income Tax Act, 1961.      "1. Whether on the facts and in the      circumstances of the case, a sum of      Rs 2.95,000/-  has to be taken into      account in  computing the income of      the assessee  from  business  under      the provisions of Section 28 of the      Income Tax Act, 1961?      If the answer to the above question      is in the negative-      Whether on  the facts  and  in  the      circumstances  of   the  case,  the      claim of  Rs 2,95,000/-  is covered      by  sub-rule   (J)  of  Rule  6-DD,      framed under Section 40-A(3) of the      Income Tax Act, 1961?"      2.   "Whether on  the facts  and in      the circumstances  of the case, the      sum of the Rs. 19.695/- incurred as      quest-expenses  is   allowable   as      deduction?"      The  assessee,   to  start   with,  was  a  partnership consisting  mostly  of  family  members,  in  1965,  it  was converted into  a public company to carry on the business of export of tobacco. The first directors appointed at the time of incorporation  were to  hold office during their lifetime or until they resigned voluntarily.

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    On the  basis of the information received, a search was conducted by  the Enforcement Directorate in the  assessee’s business premises.  A number  of latters and other documents were seized  which disclosed  that the assessee had indulged in transactions  in violation  of the  provisions of Foreign Exchange (Regulation)  Act (for  short ‘FERA’). It was found that  the  assesee  had  remitted  to  a  private  party  in Singapore  in  violation  of  law.  Proceedings  were  taken against the  assessee for  infringement of Sections 4(2) and 5(1)(e) of FERA and ultimately a penalty of Rs. 35,000/- was imposed under  Section 23  (1)(a) read  with Section 23-c of the Act.  The assessee  in its  income tax   return  for the assessment year  1970-71 claimed deduction of Rs. 2.95,000/- as business  expenditure/loss. According  to the assessee in course of  carrying on  of its business by the year 1966. It had  accumulated   329.2  tonnes  of  sub-standard  quality, tobacco which it could not export over the last three years. Since the  accumulated stock  of tobacco was of sub-standard quality, it  could not  be sold  at the floor price fixed by the Government  of India  for such tobacco. According to the assessee, it had no alternative but to sell the tobacco at a discount of  20% to  a Singapore  party. On  paper, the full sale price  was paid  by the  Singapore party but in reality 20% of  the price paid by the party was remitted back to him through one  Shamsuddin.  In  pursuance  of  this  agreement tobacco was  sold and  the full  floor price was received by the assessee  from the  Singapore party. The assessee paid a sum  of  Rs.  2.88,000/-  to  Shamsuddin  who  remitted  the equivalent amount  in Singapore  currency to  the  Singapore party.  Thus,   according  to   the  assessee,   it  had  no alternative but to enter into such a ******** with a view to dispose of  the sold  unsold stock  of inferior  quality  of tobacco. In  these facts  of the case. It was claimed by the assessee  that   the  amount   of  Rs.  2,88,000/-  paid  to Shamsuddin ought  to be  deducted as business expenditure or treated as business loss.      The Income  Tax Officer  however, disallowed the claim. According to him. Payment was not genuine and it contravened the provisions  of Section  40-A(3) of  FERA. It was further held that  the payment  did  not  fall  within  any  of  the exceptions   to   Rule   6-DD.   The   appellant   Assistant Commissioner affirmed  the order  of the Income Tax Officer. On further appeal, the Tribunal made the following findings. (a)  A sum of Rs. 2,95.000 was paid by this assessee company to Shamsuddin  which consisted  of an  amount payable to him for his  services and  also a  sum of  Rs. 2,88,000/-  to be remitted  to   the  Singapore  party.  The  amount  paid  to Singapore party  was difference of 20% of the floor price of tobacco fixed by the Government. (b)  The  assessee  was  knowingly  a  party  to  the  above transaction and  it violated  the provisions  of  FERA.  The Tribunal also  took the view that the assessee’s income from export to  the Singapore  party in  reality was not the full price shown  to have  been received from the Singapore party i.e., 8.86,702.89.  The figure had to be reduced by a sum of Rs. 2,95.000/-  because this  was the  sum which  was really received by  the assessee.  It was  of the  view that it was unnecessary to  go into  the question whether the sum of Rs. 2,95,000/- was  to be created as a deduction and if so under which Section  and further  whether it attracted Section 40- A(3) of the Act. (c)  The Tribunal held that even otherwise, the said payment did not attract Section 40-A(3) since it was covered by sub- rule  (j)   Rule  6-DD  inasmuch  as  the  said  payment  to Shamsuddin  was   made  in   cash  due  to  exceptional  and

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unavoidable circumstances.      In the  Department’s contentions  that the payment made to Shamsuddin  was illegal  and  could  not  be  taken  into account for  any purpose  were  unsustainable  in  law.  The income tax law did not distinguish between legal and illegal income or between legal and illegal expenditure.      The High Court was of the view that the Tribunal was in error in  coming to the conclusions that it had reached. The High Court pointed out that expenses tainted with illegality could not  be allowed  as business expenditure under Section 37 or as business loss or on any other basis. The High court was of  the further  view that  the assessee  could  not  be allowed to  achieve the  same result by invoking Section 28. The High  Court also  expressed the view that the assessee’s contentions that  its real income from export of tobacco was not Rs.  6.86,702.89 paise which was paid to it but its real income was  that amount  minus Rs.  2,95.000/- which  he had subsequently repatriated in Singapore dollars. It was only a facade to  realise the  true price  of the transaction which was 80%  of the  floor price.  Therefore, the  invoice which showed the  floor price  was not  the true reflection of the real transaction  between the  two parties.  The High  Court rejected this  contention by holding that the very agreement to receive  80% of  the floor  price which  was the  invoice value of the tobacco was illegal. The High Court pointed out that in  law, there  could not have an agreement to agree to take anything  less than  the invoice  price. The  agreement that tobacco  was of the sub-standard quality was no answer. An exporter was not supposed to export sub-standard tobacco.      The High  Court was  of the  view that  the sum  of Rs. 2,88,000/- had  not been  repatriated in  a straight forward manner but  has been  sent to  Singapore through  an illegal channel. It  is not  a case of money being diverted under an overriding  legal  obligation.  The  High  Court  ultimately concluded that  the agreement  being illegal and contrary to law, cannot be recognised by a court of law nor can entering into such  transaction be  a normal incidence of carrying on business. The High court further held that argument based on real price  was of no substance. If a contractor received an amount of  Rs. lakhs  under a contract entered into with the Government he  cannot claim  that in reality, the amount was Rs. 9  lakhs because at the time to awarding the contract he had an  understanding with the authority to pay a sum of Rs. one lakh by way of bribe.      The High  Court referred to a large number of decisions where it has been held that payments tainted with illegality cannot be  claimed as  deduction under  the income  Tax Act. However, if  an assessee  is penalised  under  one  Act,  he cannot claim  that amount  to be  set off against his income under another  Act because  that  will  be  frustrating  the entire object of imposition of penalty.      One exception to this rule which has been recognised by the Courts  is where  the entire business of the assessee is illegal and  that income  is sought to e taxed by the Income Tax Officer  then the  expenditure incurred  in the  illegal activities will also have to be allowed as deduction. But if the business is otherwise lawful and the assessee resorts to unlawful means  to augment  his profits  or reduce his loss, then the  expenditure incurred for these unlawful activities cannot be  allowed to  be deducted. Even if the assessee had to pay  fine or penalty because of an inadvertent infraction of law which did not involve any moral obliquity, the result will be  the same. Even in such cases, deduction will not be permitted of  the amounts  paid as penalty of fine or of the value of the goods confiscated by the statutory authority as

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expenditure wholly and exclusively incurred for the purposes of carrying  on the  trade. It has been consistently held by the English  Courts that  fines  or  penalties  payable  for violation of  law cannot be permitted as deduction under the Income Tax  Act. That  will be  against public  policy. Even though the  need for  making  such  payments  arose  out  of trading  operation   the  payment   were  not   wholly   and exclusively for  the purpose  of the trade. One can carry on his trade  without violating  the law.  In fact,  Section 37 presumes that the trade will be carried on lawfully.      The English  Courts have consistently held that penalty or fine  or money paid to compound and offence under another statute cannot  be allowed  as a  deduction under the Income Tax  Act.   For  the   application  of   these   principles, consideration of moral obliquity was quite immaterial.      In the  case of the Commissioners of Inland Revenue vs. E.C.Warnes 12  Tax Cases  227, the  Company  had  to  pay  a penalty under  the provisions of the Customs (Consolidation) Act, 1876  in respect  of a consignment of oil shipped by it to  Norway.  The  action  was  settled  by  consent  on  the agreement of  the company  to pay a mitigated penalty of Rs. 2,000 and  on all  imputations as  to  the  Company’s  morel culpability being  withdrawn. It was declared that there was no  intention   from  the   beginning  to  the  end  of  the transaction that  the Company  had by  connivance or consent been taking part in trading with the enemy but had only been culpable  of   carelessness.  In   defending   the   penalty proceedings, the  Company had incurred legal costs amounting to   560 18s  10d. These  two amounts incurred on payment of the penalty  and also  legal cost  have been  taken for  the computation of  Excess Profits  Duty purposes,  On behalf of the company.  if was  contended that  both the  penalty  and costs should  be  allowed  as  losses  arising  out  of  and incidental to trade. It was pointed out that the penalty and the costs  were solely  connected with  and arose out of the trace carried  on by them and as such were detectable in the same manner  that bad debts are deductible in computation of profits. Lastly, it was argued that profits must be taken in their commercial sense. In that sense this was loss which an ordinary prudent  commercial man  would and could only write off against  the profits  of the business. The Commissioners who heard the appeal held in favour of the company. When the matter came  before the  High Court  Rowlatt, J.  recognised that the  provision of  law  under  which  the  penalty  was imposed is  "one of very great and startling stringency; but of course the liability it creates can only be regarded as a liability of penal character" and held.      "It  seems   to  me  that  a  penal      liability of  this kind  cannot  be      regarded as  a loss  connected with      arising out  of a  trace.  I  think      that  a   loss  connected  with  or      arising out  of trade  must, at any      race, amount  to something  in  the      nature   of   a   loss   which   is      contemplable and in the nature of a      commercial loss.....but  I  do  not      think it  is possible  to say  that      when a fine, which is what it comes      to  has   been  inflicted   upon  a      trading body.  It can  be said that      is  "a   loss  connected   with  or      arising out  of" the  trade  within      the meaning of this Rule."      This decision of Rowlatt, J. was cited with approval by

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the court  of Appeal  in the  case of  The Commissioners  of Inland Revenue  vs. Alexander  Von Glehn  & Co., Ltd, 12 Tax Cases 232.  In that  case  Lord  Sterndale  noted  that  the assessee was  a firm  of high  standing. A great part of its trade consisted  in the  exporting of  goods to  Russia  and Scandinavia Some  goods were  exported to  Russia at  a time when the Customs (War Powers) Act, 1915 was in force and the goods of  the assessee  had ultimately  gone  to  the  enemy territory Proceedings  were  taken  for  infraction  of  law because the assessee was not able to prove that he had taken all reasonable steps to secure that the ultimate destination of  the   goods  was   the  destination   mentioned  in  the declaration. The  assessee agreed to pay a fine of  3000 and now the question was whether this amount padi as penalty was admissible as  deduction from  the income  of the assessee’s Company.      Lord Sterndale  held that  the customs proceedings were not technically criminal proceedings; but he stated.      "I do  not think that matters. They      certainly are  proceedings in which      a penalty  is being sued for by the      Attorney-General  as   representing      the Crown, for an infraction of the      law, whether  technically  criminal      for the  purpose of appeal seems to      me  to  be  immaterial.  The  money      which is  paid is  money paid  as a      penalty, and  it does not matter in      the least that the Attorney-General      has  elected  to  take  treble  the      value of  the goods,  nor  does  it      matter that it may be called in the      Information a forfeiture."      Lord Sterdale  stated that  it  was  a  hard  case  and observed :      "It may  be so,  and  it  may  seem      hard, because  it was  agreed  that      there was no moral obliquity to use      the expression which is used in all      these cases,  to be  attributed  to      the Appellants,  But is seems to me      that those  are  matters  which  we      cannot  into   consideration,   and      injustice  to   both  the   learned      Counsel who argued the case for the      Appellants, they  did not est their      case upon  any such  basis as that,      but they  rested it  upon the broad      principle that  it does  not matter      whether the  expense is included it      consequence of an infraction of the      law or  whather it is a penalty for      doing an illegal act. So long as it      is  something   which  reduces  the      amount   which   comes   into   the      trader’s pockets  as the  result of      his trading."      Lord Sterndale has, however, held that the payments for infraction of  law could not called to be for the purpose of the trade. Relying upon the remarks of Lord Davey n the case of Strong  vs. Woodifield  5 Tax Cases 215. It was held that the disbursements  permitted as  deductions must  be for the purpose  of   the  trade.   It  was   not  enough  that  the disbursement was  made in  the course  of or arose out of or was connected  with the trade or was made out of the profits

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of the trade.      Dealing with  the question  that the disbursements were connected with the trade. Lord Sterndale observed:      "Of course,  as Mr. Justice Rowlatt      said, in  a sense  you may say that      it  has  been  connected  with  the      trade. because if the trade has not      been carried  on the  penalty would      not have  been incurred there would      not have  been an  opportunity  for      the breach  of the  law which  took      place but in the sense in which the      words are used in the Act. I do not      think that  this was connected with      or  arising   out  of  such  trade,      manufacture, adventure  or  concern      and still  less do  I think  hat it      was a disbursement under the  First      which  applies  to  the  first  two      cases, that  is to  say. "money and      exclusively laid  out  or  expanded      for   the    purposes    of    such      trade".............It is  perhaps a      little   difficult   to   put   the      distinction   into    very    exact      language, but  there seems to me to      be   a    difference   between    a      commercial loss  in trading  and  a      penalty imposed  upon a person or a      company for  a breach  of  the  law      which they  have committed  in that      trading for  that  reason  I  think      that  both   the  decision  of  Mr.      Justice Rowlatt  in this  case  and      his  former   decision  in   Inland      Revenue Commissioners  v. Warnes 12      T.C. 227,  which he  followed  were      right,  and  I  think  this  appeal      should be dismissed with costs."      Warrington.  L.D.   who  agreed   with  Lord  Sterndale observed as under :      "Now it  cannot be  said  that  the      disbursement in the present case is      made in  any way for the purpose of      the trade  or for  the  purpose  of      earning the  profits of  the trade.      The disbursement is made, as I have      already said  and the  same  remark      applied to  this  Rule  as  to  the      Other because the individual who is      conducting the  trade has  not from      any   moral   obliquity   but   has      unfortunately  been  guilty  of  an      infraction of the law."      In the case of Cattermole (H.M. Inspector of Taxes) vs. Borax &  Chemicals Ltd  31 Tax  Cases 202,  the question was whether fines  imposed in  the United States of America upon the company and upon its managing Directors for infringement of anti  trust legislation  of the  United State  of America should be  allowed as  deductions in computing the amount of Company’s profits.  The fine  was imposed  in  very  unusual circumstances. It  was doubtful  whether the Company and its Managing Director  could have  been  proceeded  against  the American Law  but they  decided to submit voluntarily to the jurisdiction of the California Court. It was done out of the

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supposed business  necessity because the English Company was subsidiary of  An American  Company. If  the English Company and its Managing Director alongwith the American Company did not submit  to the  jurisdiction of the California Court the result would  be that  its supplies  would have been stopped altogether and  it would  have been  unable to  carry on the business  with   the  American   Company.  the  Company  was extremely anxious to settlement. It was argued that it was a matter of  vital importance to the American Company that the English Company and Mr. Hatchley should appear in this suit. The matter  was ultimately  settled. One of the terms of the settlement was  that the English Company would pay a fine of 10,000 U.S.Dollars  and the  Managing Director  would pay  a fine of 6.000 US dollars.      The Commissioners  took the  view that  the amount  was deductible as  business expenditure  because it  was paid to ensure the  supplies. Croom-Johnson, J. held that the amount was not  paid wholly  and exclusively  for the  purposes  of carrying on  the trade.  It may have been one of the reasons but manifestly  it was  not the  only reason.  "One  of  the reasons was  to get as cheaply as possible a settlement with the  American   authorities,  paving  something  by  way  of compromise-agreeing with  one’s adversary  while one is in a way with him. That is really what happened hence."      The Indian  Courts have  also  consistently  held  that payments tainted  with illegality cannot be treated as money spent wholly  and exclusively for the purpose of business. A long line  of decisions  was noted  in  the  judgment  under appeal. It  is not  necessary to  refer to  all of  them. We shall refer to three cases decided by this Court.      In the  case of  Hail Aziz  and Abdul  Shakoor Bros. v. Commissioner of  Income Tax  Bombay City  II. 41  ITR 350  a bench of  three Judges  of this Court held that the expenses which were permitted as deduction were such as were made for the purpose  of carrying on the business. It was enough that the disbursements  are made in the course of or arose out of or were  connected with  the  trade.  No  deduction  can  be allowed if  the expenditure  fell on  the assessee  in  some character other  than that  of a  trader. If a sum has to be paid by  an asseessee because in conducting his business, he had acted  in a manner which had rendered liable for penalty for infraction  of  law,  it  could  not  be  claimed  as  a deduction because it could not be called in commercial sense as incurred  in carrying  on the business. It was emphasised in that judgment by Kapoor, J. that infraction of law is not a normal incidents of business.      The point that the expenditure incurred for the purpose of unlawful  activity  must  be  allowed  to  find  out  the commercial profits  of the  Company was  specifically argued and raiected  in the  case of  The Commissioners  of  Inland Revenue vs.  F.C.Warnes (supra). If a penalty is imposed for contravention of  any statutory  provision it cannot be said that the  commercial loss  had fallen  on the  assessee as a trader. Illegal  activity cannot  be created  as a tradition activity at  all. As  Lord Sterndale  held that  it was  not enough that  the disbursement  was made  in the course of or arose out of or was connected with the trade or was made out of the  profits of the trade. Only if it could be shown that it was spent for the purpose of the trade that the deduction can be permitted unless the entire trade was unlawful.      The case  of Haji  Aziz Abdul  Shakoor Bros. (supra) it important for  another reason.  It was categorically held in this case  that no  distinction can  be made  in this regard between a  personal liability  and a  liability of any other kind. So  long as  the payment has to made for infraction of

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law, it  cannot be  said that  it  was  made  in  course  of carrying out of the trade.      In that  case of  Commissioner of  Income Tax  V.  S.C. Kothari 82  ITR 794.  It was  held that  the loss  which had actually been  incurred in carrying on a legal business must be deducted before the true figure relating to profits which had to be brought to tax could be computed or determined. If a business  was illegal,  neither the profits earned nor the loss incurred  would be  enforceable in law but that did not take the  profits our  of the  taxing stature. Similarly the taint of  illegality of  the business could not detract from the loss  baing taken into account for computing the amounts which had  to be  subjected to tax. The Tax Collector cannot be heard to say that he will bring the gross receipts to tax he could tax the profits of a trade or business. That cannot be done  without taking the loss and the legitimate expenses of the business.      In the  case of Commissioner of Income tax, West Bengal v. H.Hirjee 23 ITR 427, a bench of four Judges of this Court dealt with  a case  of an  assessee who  was carrying on the business as  selling agent  of a  Company, he was prosecuted under Section 13 of the Hoarding and Profiteering Ordinance, 1943 on  a charge of selling the goods at prices higher than a reasonable  price in contravention of the provision of the Section 6  of the  Act. A  part of  the stock  of goods  was seized and  taken away.  The persecution  however, ended  in acquittal. The  assessee claimed deduction of a sum of money spent in  defending  the  case.  The  Income  Tax  Appellant Tribunal found  that the expenditure was incurred solely for the purpose  of maintaining  the assessee’s  name as  a good businessman and  to save  his stock  from being undersold if the  Court   held  that  the  prices  charged  by  him  were unreasonable.  The   High  Court   rejected  the   reference application on  the ground that the decision of the Tribunal was based on finding of fact. On appeal this Court held that the findings of the Tribunal were vitiated by its failure to consider the possibility of criminal proceedings terminating in the  conviction and  imprisonment of the assessee. It was held that  the deductibility  such expenses must depend upon the purpose and nature of legal proceedings and could not be affected by  the final  outcome of  the proceedings.  It was also pointed  out that  the Income  Tax assessment had to be made for every years and could Tax assessment had to be made for year  and could not be held up until the final result of the legal  proceedings which pass through several Courts was announced.      In the  instant case,  the  asseesee  had  indulged  in transactions  in  violation  of  the  provision  of  Foreign Exchange (Regulation)  Act.  The  assessee’s  plea  is  that unless it  entered into  such a  transaction, it  would have been unable  to dispose  of the  unsold  stock  of  inferior quality of  tobacco. Another  words, the assessee would have incurred a loss.  Spur of loss cannot be a justification for contravention of  law. The  assessee was  engaged in tobacco business.  The  asseessee  was  expected  to  carry  on  the business in accordance with law. If the asseesee contravenes the provision  of FERA  to cut  down its  losses or  to make larger profits  while carrying  on the business, it was only to be  expected that  proceedings will  be taken against the asseesee for  violation of the Act. The expenditure incurred for evading  the provisions  of the Act and also the penalty levied for  such evasion  cannot be allowed as deduction. As was laid down by Lord Sterndale in the case of Alexander Von Glehn (supra)  that it  was not enough that the disbursement was made  in the course of trade. It must be for the purpose

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of the trade. The purpose must be a lawful purpose.      Moreover, it will be against public policy to allow the benefit of  deduction under  one statute  of any expenditure incurred in  violation of  the provisions another stature or any penalty  imposed under  another statute.  In the instant case, if  the deductions  claimed  are  allowed,  the  penal provisions of  FERA will  become meaningless. It has also to be borne  in mind  that evasion  of law  cannot be  a  trade pursuit. The expenditure in this case cannot, in any way, be allowed as  wholly in  this case  cannot,  in  any,  way  be allowed as  wholly and  exclusively laid out for the purpose of assessee’s business.      We are in agreement with the view expressed by the High Court in  this case.  The appeal is dismissed. There will be no order as to costs.