Appeal No 1554 of 1970
Appeal
by Special Leave from the Judgment  Order dated the 19th August 1968 of the Madras High Court in Tax Case No 18 of 1 965
G B Pai A G Manessea D C Mathur and K K John for appellant
B B Ahuja and section P Nayar for the respondent
807 The Judgment of the Court was delivered by GUPTA J
This is an appeal by special leave from a judgment of the Madras High Court in a reference under section 661 of the Income Tax Act 1922
The appellant Nonsuch Estate Limited is a public limited company incorporated in the year 1924 under the Companies Act 1913
The appellant referred to hereinafter as the Company derives its income from tea grown in its estate for which it is assessed to income tax
Ms Harrisons and Crosfield Limited have been the managing agents of the Company from the beginning
The following question relating to the assessment year 1959 60 was referred to the High Court  Whether on the facts and in the circumstances of the case the sum of Rs 97188 representing the Managing Agency remuneration for the period 1 4 1956 to 30 6 1957 was deductible in the computation of the income of previous year ending on 30th June 1958 relevant for the assessment year 1959 60
 The relevant facts leading to the reference are these
The managing agents of the Company were entitled to commission at the rate of 11 per cent on all sales of tea and other produces of the Company and a further sum of Rs 12000 per annum for secratarial work
There was however no written
agreement embodying the terms
After the came into force on April 1 1956 it was decided that there should be a fresh managing agency agreement between the Company and its managing agents in conformity with the provisions of the said Act
A fresh agreement drawn up and submitted by the managing agents was approved by the Company
The new agreement proposed the reappointment of Ms Harrisons  Crosfield Limited as the managing agents of the Company for a period of 10 years on a remuneration of 5 per cent commission on the net profits of the Company computed in the manner laid down in sections 349 to 351 of the subject to a minimum remuneration of Rs 12000 per annum
The revised terms were to take effect from April 1 1956
As required by sec
326 of the  the new agreement was sent to the Central Government for approval by a communication dated august 3 1957 enclosing a formal application for the purpose in Form 25 On September 2 1957 by a letter addressed to the Company the Government conveyed its approval to the appointment of Ms Harrisons  Crosfields Ltd as the Managing agents  for a period of 10 years with effect from 1st April 1956 on a remuneration of 5 per cent commission on the net profits of the Company computed in the manner as laid down in Sections 349 to 351 of the subject to a minimum remuneration of Rs 12000 Rupees twelve thousand only per annum payable to the Managing Agents in the event of absence or inadequacy of profits in any financial year
 On receipt of the approval the Company by a resolution adopted at an extraordinary general meeting of its shareholders held on October 4 1957 reappointed Ms Harrisons  Crosfield Limited on the terms stated above
In terms of the new agreement the existing agency agreement between the parties stood cancelled with the expiry of March 31 1956
808 The Company follows the mercantile system of accounting
For the period April 1 1956 to June 30 1956 the Company credited a sum of Rs 9320 to the account of the managing agents as their remuneration in accordance with the terms of the proposed new agreement
This was disclosed in the published accounts of the Company for the year July 1 1955 to June 30 1956 relevant to the assessment year 1957 58
For the purpose of assessment of income tax however the Company added back the said sum of Rs 9320 to its taxable income
In the next accounting year ending on June 30 1957 relevant to the assessment year 1958 59 the same process was followed with regard to the remuneration payable to the managing agents
For the assessment year 1959 60 for which the previous year was July 1 1957 to June 30 1958 a total sum of Rs 97188 was shown as managing agents  remuneration payable during that year
This amount was made up as under Amount lm15  Proportionate remuneration for 3 months at 5 per cent on the net profits for the period ending on 30 6 1956 paid during the year ending on 30 6 1958 9320 Remuneration at 5 per cent on the net profit of the year ending on 30th June 1957 paid during the year ending on 30 6 1958 71368 Managing Agents expenses for the year ending 30th June 1957 recouped during the year ending on 30th June 195813200 Proportionate Managing Agent s expenses for the year ending on 30th June 1956 recouped during the year ending on 30 6 19583300 97188
Though this sum did not pertain to the previous year relevant to the assessment year 1959 60 the Company claimed it as deductible expenditure for that year on the ground that the sum became payable only during that year when the Government accorded its approval to the new agreement
The Income tax Officer rejected this claim on the view that the approval of the Central Government was necessary only for actual payment and the assessee should have ascertained the liability for each year and claimed it on the mercantile basis which was the system adopted by the assessee company
 The Appellate Assistant Commissioner and the Tribunal also took the same view
The High Court answered the question referred to it against the assessee on the following reasoning   
There was undoubtedly an understanding between the managing agency and the assessee as to the new terms of remuneration which actually were given effect to by making debit entries in the remuneration account then and there
It is true that at the time the debit entries were made approval of the Central Government had not come
But when it came actually later it gave legal effect to the debit 809 entries not from the date of the approval but from April 1 1956
That being the case the refusal of the deduction in our opinion was right
 In our judgment the High Court was in error in answering the question referred to it against the assessee
It appears that the Income tax authorities the Tribunal and the
High Court all laid special emphasis on the fact that the Company followed the mercantile system of accounting
The distinction between the two methods of accounting one on the cash basis and the other on the mercantile basis is well known
In Commissioner of Income tax Madras vs A Gajapathy Naidu1 this Court explained the difference between the two methods quoting with approval an extract from a Judgment of the Allahabad High Court in Commissioner of Income tax vs Singari Bai2
In Gajapathy Naidu s1 case this Court said  It is commonplace that there are two principal methods of accounting for the income profits and gains of a business one is the cash basis and the other the mercantile basis
The latter system of accountancy brings into credit what is due immediately it becomes legally due and before it is actually received and it brings into debit expenditure the amount for which a legal liability has been incurred before it is actually disbursed However even an assessee following the mercantile system of accounting is not entitled to claim a deduction until liability for the sum for which deduction is claimed has accrued
The reasons given by the High Court overlook the plain terms of sec
326 of the 
326 so far it is material for the question involved in this case is in these terms  Sec
3261 In respect of any company  a  b unless the approval of the Central Government has been obtained for such appointment or re appointment
2 The Central Government shall not accord its approval under sub section 1 in any case unless it is satisfied a that it is not against the public interest to allow the company to have a managing agent b that the managing agent proposed is in the opinion a fit and proper person to be appoi nted or re appointed as such and that the conditions of the managing agency agreement proposed are fair and reasonable and c that the managing agent proposed has fulfilled any conditions which the Central Government requires him to fulfil
 1 2 810 Section 326 prohibits the appointment or re appointment of a managing agent unless the Central Government approved such appointment or re appointment
The Central Government would not accord its approval unless the requirements specified in clauses a b and c of sub section 2 of the section have been fulfilled
Therefore it cannot be assumed that the Central Government will approve every proposed appointment or reappointment of a managing agent
Thus in the instant case it is only when the Central Government conveyed its approval to the appointment of Ms Harrisons and Crosfield Limited as managing agents by its letter dated September 2 1957 that the appointment became effective and the Company s liability to pay the remuneration of the managing agents accrued
The position here is not that the liability had arisen earlier and its quantification only depended on the approval of the Central Government
It is true that the liability became effective from April 1 1956 a date anterior to the relevant previous year but that is because the Central Government chose to give its approval retrospective operation
The liability in these circumstances cannot be said to have arisen from any date prior to September 2 1957 when the approval was given as sec
326 contains an absolute prohibition against the appointment or re appointment of a managing agent before the approval of the Central Government was obtained
In our opinion the position is quite clear from the terms of sec
326 and we do not consider it necessary to refer to the authorities cited by the learned counsel for either side
The appeal is accordingly allowed the answer given by the High Court to the question referred to it is discharged and the question is answered in the affirmative and in favour of the assessee
The appellantwill be entitled to its costs in this Court and in the High Court
PER Appeal allowed


Summary:
The assessee who followed the mercantile system of accounting debited in its account books certain sums of money as remuneration of the managing agents for the assessment years 1957 58 to 1959 60
For the purpose of income tax the company added back the sum to its taxable income and claimed the whole sum as a deductible expenditure in the assessment year 1959 60 on the ground that the sum became payable only during that year when the Government accorded its approval to the new managing agency agreement
The income tax Officer rejected the claim holding that the approval of the Central Government was necessary only for actual payment and the assessee should have ascertained the liability for each year and claimed it since he followed the mercantile system of accounting
This view was upheld by the Appellate Assistant Commissioner and the Income tax Appellate Tribunal
The High Court held that although at the time the debit entries were made in the account books of the assessee approval of the Central Government had not been received when it came later it gave legal effect to the debit entries with retrospective effect from April 1 1956 and that the refusal of deduction by the Income tax Officer was right
Allowing the appeal to this Court HELD  The High Court was in error in answering the question against the assessee
Even an assessee following the mercantile system of accounting is not entitled to claim a deduction until liability for the sum for which deduction is claimed has accrued
The High Court overlooked the plain terms of s326 of the under which it could not be assumed that the Central Government would approve every proposed appointment or re appointment of managing agent
809A D 810A In the instant case it is only when the Central Government conveyed its approval to the appointment of managing agents by its letter dated September 2 1957 that the appointment became effective and the Company s liability to pay the remuneration of the managing agents accrued
The liability became effective from April 1 1956 because the Central Government chose to give its approval retrospective operation
The liability could not be said to had risen from any date prior to September 2 1957 when the approval was given
Section 326 of the contains an absolute prohibition against the appointment or re appointment of a managing agent before the approval of Central Government was obtained
810B C