Case: Bharat Beedi Works Private Limited and Anothers Vs. Commissioner of Income Tax

2. Prior to July 15, 1972, a partnership firm called K. M. Anand Prabhu & Sons, Mangalore, 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 beedis under the brand name Mangalore Prakash Beedies. On May 20, 1972 a private limited company called Prakash Beedis Limited (the assessee appellant herein), was incorporated with its registered office at mangalore. One of its objects was to take over the business of the aforesaid firm. Under an agreement dated July 15, 1972 between the firm and the company, the firm 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 appealsFor the use of the trade name the company shall pay royalty to the Vendor at the rate of 10 ps. for every thousand beedis 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 and December, on the sales made during each quarter. The royalty fixed hereby shall not be varied for a period of one year and may be reviewed and/or revised thereafterwards from time to time."The assessee was making payments to the firm every year on account of royalty in terms of the said clause4. The three partners aforesaid of the firm were also the directors of the assessee-company5. 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 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 ITO allowed the deductions as claimed6. In exercise of the powers conferred on him by section 263, the Commissioner of Income Tax initiated (suo motu) proceedings for revising the said assessments insofar 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 ITO (sic CIT). The appeals were allowed and the orders of the ITO restored. On reference, the High court answered the 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 on a business. Merely because the firm is 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

Reasoning:
11. The object behind the provision undoubtedly was to discourage and disallow "payment of high salaries and remunerations which go ill with the norms of egalitarian society". The provision was, of course, not confined to the directors. It took in relatives of directors, persons having substantial interest in the company and their relatives. The clause vested in the ITO 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 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 event12. At this juncture, it would be appropriate to notice the provision contained in sub-section (2) of Section 40-A. Clause (a) of sub-section (2) provides that where the assessee incurs any expenditure in respect of which payment has been made or is to be made to any 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 assessee or the benefit derived by or accruing to him therefrom, so much of the expenditure as is so considered by him to be excessive or unreasonable shall not be allowed as deduction. Clause (b) mentions the categories of persons to whom the provision in Clause (a) applies. It includes directors of the company and their relatives among others. Clause (b) also takes in any payment to any company, fire, association of persons or Hindu undivided family of which a director, partner of member, as the case may be, has a substantial interest in 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 the case may be13. That the payments made by the assessee-company to the firm on account of royalty in terms of clause (4) (a) of the agreement fall within the meaning of the expression expenditure in sub-clause (i) of clause (c) is not disputed. The observations in CIT v. Indian Engineering and Commercial Corpn. (P) Ltd. ( 1993 (3) SCC 246 : 1993 (2) JT 683) do not say otherwise. That case arose under section 40-A(5). The payments 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 a certain cash amount by way of commission on sales, directly to an employee, can be said to fall within the Revenues 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 confined to the said sub-clause and have no relevance to any other provision in the Act. The observations cannot be read dissociated from their context. Coming back to the provisions of Section 40(c) and the facts of the case before us, the only question is whether the royalty payments to the firm fell within clause (c). We assume for the purpose of this argument that in this case, payments to firm were payments to partners. Even so, we think that the said payments did not fall within clause (c). The payments were made in consideration 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 as payments made to the directors as directors (qua directors).The payments were made by way of consideration for allowing the assessee 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) of section 40-A, but it certainly did not fall within the four corners of Section 40(c)14. In T. T. (P) Ltd. v. ITO ( 1980 (121) ITR 551 (Kant)) a bench of Karnataka High Court comprising D. M. Chandrashekhar, C.J. 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)close reading of the above provision shows that Section 40(c) refers to an expenditure incurred by making periodical payments to a person mentioned 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 for all kinds of services or facilities referred to in Section 40-a(2)(a). It is argued that the proviso thereto suggests that any expenditure incurred for any kind of service which is referred to in the main part of section 40-A(2)(a) and the expenditure referred to in Section 40(c) belong to the same category. This contention is not correct. The expression services in section 40-A(2)(a) is an expression of wider importIf the remuneration, benefit or amenity referred to in Section 40(c) is treated as the same as what is paid in return for the goods, services or facilities 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 interest in the company or a relative of the director or of such person, 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 Section 40-A(2)(a) are those which have a market value and which are commercial 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 CIT v. Avon Cycles (P) Ltd. ( 1980 (126) ITR 448 : 1980 TaxLR 148 (P&H HC)) The Calcutta High Court has also taken a similar view in India Jute Co. Ltd. v. CIT ( 1989 (178) ITR 649 answer perhaps lies in the clause itself-in the power vested in the ITO to determine whether any expenditure or allowance is excessive or unreasonable having regard to the legitimate business needs of the company and the benefit derived by the assessee or accruing therefrom. Any payment to a relative of a director or other persons mentioned in clause(c) will necessarily be examined applying the above test and if it is found that they are unwarranted, unreasonable or excessive, they will be disallowed. Since such a situation does not arise herein, we need not pursue the argument further