UHARA T BEEDI WORKS (PRIVATE) LIMITED AND ANR. n c ETC.ETC. v. COMMISSIONER OF INCOME-TAX MAY 7, 1993 [B.P . .JEEVAN REDDY AND N. VENKATACHALA,JJ.J Income-Tax Act 1961-S.40 (c)-Parmers in firm also directors in a company-\Vhether royalty payme111s by company to jinn falls within s. 40 (c)-Held, pay111e111s are consideration for a valuable right parted by firm! par111ersldirectors of the assessee-Company in favour of assessee-\l'here agreemem wherewuler pay111e111s made not mere device or screen, it cannu1 be trea1ed as payments made 10 directors qua direc/ors-S. -10 (A) (2). A partnership firm consisting of three partners was engaged inter alia in the business of manufacturing and sale of becdics under the brand name "Mangalorc Prakash Bccdics". On May 20, 1972 a private limited compan~· called' prakash Bccdics Ltd. '-the asscssce-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.July1972 whereby the firms sold its rights and assets to the company. For the use of' the trade name,a royalty at l Op. for every 1000 becdies was to be paid by the company to the firm. This payment ~·as made every year by the as.,.cssce 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 arc similar. The assesscc claimed deduction of the amount paid by it as royalty. The ITO allowed the deductions as claimed. The CIT in mo motu proceedings disallow the aforesaid deductions. On appeal, the Tribunal rest9rcd the order of the ITO.
On reference, the High Court answered in favour of the revenue as the three directors of'thc assessce-company were also partners in the firm. It held that in law, a firm is mcrcl)' a collection or association of' individuals for carrying on a business. Merely beL-ausc the firm is an assessable entity under the Income Tax Act, it docs not follow that it is a juristic or legal entity. It must therefore he held that t-he payments to the firm were in reality made to the -….
BI-IARA T BEED! WORKS v. COMMISSIONER OF INCOME-TAX [REDDY,J.] 607 directors, thus attracting S. 40 (c). Before this Court, it was contended for the assessee.Jbat payment to a firm is not ipso fact pa~·ment to the partners, directly or indirectly. In any event, the payments were made ~ the three persons not in .their capacity of directors (qua directors). but in consideration of a valuable right parted by them in fal·our of the assessee-company. S. 40(c) was neveri~tended 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 pa~·ments 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 : J. Even assuming that the payments to firm were payments to partnerst the t;aid payments did. not fall within S. 40(c). The payments were made in con..,ideration 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.a!> payments made ffJ the directors (qua directors). (613-H, 614-A)
·fhe payments were made by way of consideration for allowing the assE:Ssce 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) o.f section 40 (A), but it certainly did not fall within the four corners of section 40(c). (614-M
T.T. (Pvt.) Ltd. v. / T 0 Bangalore 121 ITR 551, approved. CIT Patiale·v. Avon Cycles (p) Ltd. 126 ITR 448 and Indialttte C~. 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 der.ived by the assessee or (1993 I 3 S.C.R.
accruing therefrom. Any pa~·ment to.a relative ofa director or other persons mentioned in clause (c) will necessarily be examined applying the above test and if it is found that the~· are unwarranted, unreasonable or excessive, they will be disallowed. Such a situation does not arise herein. (61S-C) CIT. Bombay v. Mis. Indian Engineering and Commercial Corporation (p) Lld. (1993] 2 distinguished. JT 683.
c CIVIL APPELLATE JURISDICTION : Civil Appeal No. 1452 of 1987. From the Judgment and Order dated 10.7. 1986 of the Karnataka High Court in l.T.R.C. No. 198of1987. WITH C.A. Nos. 4462/89, 1822, 1902, 1465/87, 675, 658,4461189. 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. JEEV AN REDDY J. These appeals are preferred against the judg- ment of the Karnataka High Court answering the question referred to it, at the instance of the revenue, in favour of the revenue and against the assessee. The question referred under section 256 of the Income Tax Act, 1961, 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. l, 79, 742 could not be disallowed under section 40 ( c) of the Income Tax Act, 1961." (The above qµestion related to Assessment Year 1974-75. The question referred for A. Y. 1975-76 was identical except in 1hematter 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) Lld. v. Commr. of Income Tax. Karnataka, Bangalore).
Prior to 15.7.1992, a partnership firm called K.M. Anand Prabhu & Sons, Mang al ore, 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 BHARAT BEEDI WORKS v. COMMISSIONER OF INCOME-TAX [REDDY ,J.) 609 Limited' (the assessee-appellant herein), was incorporated with its registered office at Man galore. 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 fitms 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 al the rate of !Ops. 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 aod December, on the sales made during eacb 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 E 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 l.T.O. allowed the deductions as claimed. In exercise of the powers conferred on him by Section 263, the Commis- sioner of Income Tax initiated (suo 111010) 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 l.T.O, The appeals were allowed and the orders of the I. T. 0. 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 association of the individuals for carrying H A ·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.
c 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 thatthe firmhas 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 mischiefofSection40(c). Section 40( c) wamiever 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 illu.stration 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 ofassociated 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-com- pany 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 BHARAT BEEDI WORKS v. COMMISSIONER OF INCOME-TAX
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 chargeable under the head "profits and gains of business or profession",
(a)········ (b) …….. . (c) in the case of any company- (i) any expenditure which results directly or indirectly in tne 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 c
of the director or of such person, as the case may be, (ii) any expend~~ure or allo\l1ance 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 allow~nce 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 exceed- . ing 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 comprist:U in the previous.year, an aml)Unt c:l.lculated at the rate of six thousand rupees for each month or part thereof comprised in that period :
c {199313 S.C.R. ~ Provided that in case where such person is also and employee of the company for any period comprised in the previous year, expendi- ture 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 accou~t for the purposes of sub-clause (A) or sub- clause (B), as the case may be;·
(iii) Explanation.-The provisions of this clause shall apply notwith- standing that any amount not to be allowed under this clause is included in the total income of any person refeged 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 woujcl be cieductible 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 month in the case of perquisites, the allowable overall ceiling on remuneration and perquisite·s. for purposes of taxation, will be at Rs. 6,000 per month ………. , ….. ·· The object behind the provision undoubtedly was to discourage and disaUow "payment of high salaries and remunerations which go ill with the norms of egalitarian society". The provision was, ofcourse, not confined to the directors.• It took in relatives of directors, persons having substantial interest in the company and theirrelatives. The clause vested in the l.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 G 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 BHARATBEEDI WORKS v. COMMISSIONER OF INCOME-TAX [REDDY.I.] 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 asSt!ssee or the benefit derived by or accruing to him therefrom. so much of the expenditure as is so considered by him to be exc.essive 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 th~irrelatives 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 1n 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 tlJe case may be.
c That the payments made by the assessee-company to the firm on account of royalty in terms of clause (4) (a) of the ~greement fall within the meaning of the expression 'expenditure' in sub-clause (i) of clause (c) is not disputed. The observations in C./. T., Bombay v. Mis. Indian Engineering and Commercial Corporation Private Limited (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 payrnents 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 expenqiture 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 meaning of sub-clause (ii) of clause (a) of Section 40(A) (5). The observations are clearly confin~cl to uie said' sub- clause and have no relevance to any other provision in the Act Th~ tj~seniations cannot be read dissociated from their context. Coming back to the. provisions of Section 40( c) and the facts of the c.ase before us, the' only questiorih•Whe.ther the royalty payments to the firm fell within clause (c)~ We assumefor\he:puri}ose of _-11
this argumentthat in this case. payments to firm were paymems·to'partners. Even so, we think that the said paymen'tS did not faJl witbtnc~au~e<{c), l'he'{?ayments were made in· consideration ·Of a valua!)le rightparted·•t).fthe q~artners/ .. directors of tn~ assessee-company hi:favour ofthe .. ~essee~ So. loo!!.,,as. tne agreement whereunder tbe said payipents were lnll.de iS'tmt:ueld~tl :vi a mere u [1.993) 3 S.C.R.
A · 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 a<;sessee to use a valual)le 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).
c In TT. (Pvt.) Ltd. v. I. T.O., Bangalore 121I.T.R.551, a BenchofKarnataka 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 thats. 40(c) refers to an expenditure incurred by making periodical payments to person men~ioned 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 fpr all kinds of .. services or facilities" referred to ins. 40A(2) (a). Jt is ar~ued that the proviso thereto suggests that any expenditure ~ncurred for any kind of service which is referred to in the main part of s. 4UA (2) (a) and the expenditure referred to in s. 40(c) belong to the same category. This contention is not correct. The expression "services" ins. 40A (2) (a) is an expression of wider import ………….. .If the remuneration, benefit or amenity referred to in s. 40( c) is treatecl "'" the same as what is paid in return for "the goods, services or lu.;litties" 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 interestinthecompanyorarelativeofthedirectororofsuchperson, 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. 401\ (2) (a) are those which have a market value and which are conunercial in character. Many of the services and facilities referred to above are those which are nowadays provided by independent organisations.·
The said decision has been followed by the Punjab and Haryana High Court in Commissioner of Income Tax, Patia/a v. Avon Cycles (P) Ltd. 126 I.T.R. 448. The Calcutta High Court has also taken a similar view in India Jure Co. Ltd. v. HHARAT BEED! WORKS v. Cm.1!\1ISSIONER OF INCOME-TAX [REDDY.J.] Comm r. (.!{Income-Tax 178 ITR 649.
Mr. Ahuja, iearned counsel for the Revenue submitted that the argument of the asses see 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 relatives 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 po,ver \"CStcd 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 ~nd the benefit derived by the assessee or accruing therefrom. Any payment ti) a relative of a director or other persons mentioned in clause tc.) will necessarily be examined applying the above test and if it is found c that they are unwarranted, unreasonable or excessive, they will he 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 he sustained. It must be held that the payments in question did not fall within section 40(c). Accordingly, the appeals arc 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.R.
Appeal allowed.