Case: Commissioner of Income Tax, Kerala Vs. Alagappa Textile (Cochin) Limited

The facts giving rise to the question may briefly be stated as follows: The assessee (M/s Alagappa Textiles (Cochin) Ltd.) is a public limited company carrying on business of manufacture and sale of yarn and has its registered office at Alagappa Nagar in Kerala State. It entered into an Agreement dated November 10, 1955 with Kamala Mills Ltd. Coimbatore for financing and managing the assessee mills at Alagappa Nagar for a period of five years. Clause 8 of the Agreement provided that Kamala Mills Ltd. shall be paid, for the services rendered by it by way of purchases, sales and management, remuneration at the rate of 1% on all purchases made by it for the assessee mills and at half a per cent on all sales of yarn, yarn waste and cotton waste and other products of the mill. Pursuant to the aforesaid term Kamala Mills Ltd. drew remuneration to the tune of Rs. 1, 03, 547/- and Rs. 18, 294/- respectively for the calendar years 1957 and 1958 corresponding to the assessment years 1958-59 and 1959-60. These amounts were assessed to tax i n the hands of Kamala Mills Ltd. The assessee in its assessment proceedings for the said two assessment years claimed deduction in respect of the said two amounts as business expenditure under s. 10(2) (xv) of the Act. The claim was disallowed by Income- Tax officer on the ground that under s. 384 of the new Companies Act, 1956, which had come into force on April 1. 1956, the continuation of a body corporate as manager was prohibited for the period beyond six months from the coming in to force of the Act, that remuneration paid to Kamala Mills Ltd. subsequent to October 1, 1956, was illegal being in violation of s. 384 and, therefore, the deduction claimed in respect of such payment for the calendar years 1957 and 1958 could no t be allowed. In the appeals preferred by the assessee against the decision of the Income Tax officer, it was contended that though the payment of remuneration to a body corporate as Manager after October 1, 1956 was illegal under s. 384, the payments were for services rendered and were fully justified by commercial expediency and as such the same should be allowed under s. 10(2) (xv) of the Act. It was also urged that even if the expenses incurred were in violation of the statute such expenses should be allowed since in computing the profits even of illegal business only the net profit was taxed after allowing all the expenses. The Appellate Assistant Commissioner was not impressed by these arguments; but he disallowed the deduction mainly on the ground that the assessee by its own conduct had disputed its liability to pay any remuneration to Kamala Mills Ltd. after October 1, 1956 and in that behalf he relied on an admitted fact that the assessee had filed a suit against Kamala Mills Ltd. to recover such remuneration which had been paid to it in contravention of s. 384 on the basis that since the payment was illegal Kamala Mills Ltd. was holding such amounts of remuneration in trust for and on behalf of the assessee and in such a situation the deduction could not be allowed. The assessee carried the matter in further appeals to the Tribunal, but the Tribunal confirmed the view of the taxing authorities that under s. 384 ofthe Companies Act, 1956 it was not legal for the assessee to have permitted Kamala Mills Ltd. to continue to work as its Manager after October 1, 1956 and that the payment of remuneration after the said date was illegal and could not be considered as valid expenditure for the purpose of Income Tax Act. fn this behalf the Tribunal relied on two decisions in C.I.T. v. Haji Aziz and Abdul Sakoor Bros. and Raj Woollen Industries v. C.I.T. An argument was raised before the Tribunal that Kamala Mills Ltd. was not only a manager but also a financier and that the remuneration should be treated as having been paid to the financier While observing that it was a new case put forward by the assessee, the Tribunal negatived the contention holding, on construction of the Agreement, that it was by virtue of its position as Manager that Kamala Mills Ltd. was allowed to carry on the financial affairs of the assessee and the remuneration was payable to it as Manager and in no other capacity. The Tribunal also held that the claim for deduction was in respect of a disputed liability inasmuch as the assessee had not merely filed a suit to recover the amount but had in the meantime obtained a decree against Kamala Mills Ltd., and, therefore, the amounts could not be lawfully claimed as permissible deduction.At the instance of the assessee the following question was referred to the High Court for itson the facts and in the circumstances of the case, the Tribunal was justified in law in disallowing the claim of the assessee for deduction of Rs. 1, 03, 547/- and Rs. 18, 294/- from the income of the assessment years 1958-59 and 1959-60 as not an admissible business expenditure under sec. 10(2)(xv) of the Indian Income Tax Act, 1922High Court answered the question in the negative in favour of the assessee and against the Department. The High Court, on construction of the Agreement dated November 10, 1955, took the view that since in the matter of the exercise of its powers and the discharge of its functions thereunder Kamala Mills Ltd. could not be said to be "subject to the superintendence control and direction of the Board of Directors" of the assessee, Kamala Mills Ltd. was not a "manager" of the assessee within the definition given in s. 2(24) ofthe Companies Act, 1956, and, therefore, the illegality under s. 384 was not attracted and as such the remuneration paid by the assessee to Kamala Mills Ltd. for services rendered during the calender years 1957 and 1958 was allowable as a business expenditure under s. 10(2) (xv) of the Act. As regards the decree that had been obtained by the assessee against Kamala Mills Ltd. the High Court observed that the appeal filed by Kamala Mills Ltd. against the said decree was still pending in the High Court and if ultimately the appeal was dismissed and the amounts were recovered back from Kamala Mills Ltd., the assessee could be taxed on those amounts under s. 41(1) of the 1961 Act, but that could not be a valid ground for disallowing the deduction claimed by the assessee. The Revenue has challenged in these appeals the view of the High Court that Kamala Mills Ltd. was not the Manager of the assessee within the meaning of s. 384 read with s. 2(24) ofthe Companies Act, 1956 and the further view that the remuneration paid to Kamala Mills Ltd. during the calendar years 1957 and 1958 was deductible as business expenditure under s. 10(2) (xv) of the Act.

Reasoning: On a perusal of the aforesaid clauses of the Agreeme nt in question two or three things stand out very clearly. It is true that at the commencement of the deed Kamala Mills Ltd. has been described and referred to as the "Managers" of the assessee throughout the document but mere label or nomenclature given to a party in the document will not be decisive. It is also true that the. several powers and functions were entrusted to Kamala Mills Ltd. under cl. 1 of the Agreement to enable it "to manage or run the mill" of the assessee. But simply because powers and functions were given to Kamala Mills Ltd. for the purpose of "managing and running the m ills" of the assessee, it would not follow that Kamala Mills Ltd. was in truth and substance a manager of the assessee within the meaning o f s. 2(24) of the 1956 Act. For this purpose the Agreement will have to be read as a whole and the Court will have to decide that was the true, intention of the parties in entering into such agreement. The two recitals clearly indicate the object with which and the purpose for which the Agreement was entered into. It does appear that the assessee was in financially straightened circumstances and on that account was utterly unable to carry on its business of manufacture and sale of yarn and, therefore, the board of directors were in search of a financier who would make available the necessary finances for the running of the mill as also to take active interest in the business of the assessee and when Kamala Mills Ltd. a greed "to assist the company (assessee) with sufficient finance and manage the mill" belonging to the assessee on terms and conditions that were approved b-y the Board of Directors of the assessee that the Agreement was entered into between the parties; in other words, it is clear that the dominant object with which the Agreement was entered into was that Kamala Mills Ltd. should really act as financier so that the assessee mill could run and since heavy finances were to be procure d by Kamala Mills Ltd. large powers and functions connected with the working of the mill were entrusted to it. This aspect becomes abundantly clear from cl. 16 of the Agreement wherein the parties expressly provided that this Agreement for management was by way of and amounted to an Agency coupled with interest so far as Kamala Mills Ltd. was concerned and, therefore, revocation of the Agreement before the expiry of the five years period was made dependent upon 12 months notice in writing being given by one party to the other and further if such revocation was done by the assessee suitable compensation was made payable to Kamala Millsother words, managerial functions were incidental and had to be entrusted to Kamala Mills because of the financiers role undertaken by it. The large powers and functions entrusted to Kamala Mills Ltd. under the several sub-clauses of cl. 1 of the Agreement do show that management of substantially the whole, if not the whole, of the affairs of the assessee company had been made over to Kamala Mills Ltd. But the crucial question is whether such management was to be done by Kamala Mills Ltd. under "the superintendence, control and direction of the Board of Direct ors" of the assessee and in that behalf cl. 13 of the Agreement which we have quoted above is very eloquent. In terms it provided that so far as the powers conferred and the functions entrusted to Kamala Mills Ltd., were concerned, the Board of Directors shall not exercise or perform the same except by way of general supervision and advice and it was further made clear that the Board of Directors shall not interfere with the discretion of Kamala Mills Ltd. in the exercise o f their functions and powers vested in it by virtue of the Agreement. In other words, the general supervision or advice of the Board of Directors was of such character that the Board had not say whatsoever nor could it interfere with the discretion of Kamala Mills Ltd. in the matter of the exercise of the powers and the discharge of the functions entrusted to Kamala Mills Ltd. under the Agreement. It is thus clear to us that the dominant object of the Agreement was that Kamala Mill s Ltd. should act as financiers of the assessee mill and in the matter of the exercise of its powers and discharge of its functions Kamala Mills Ltd. was never "subject to the superintendence, control or direction" of the Board of directors of the assessee. If this position clearly emerges on true construction of the Agreement in question then it is obvious that Kamala Mills was not acting or working as the "Manager" of the assesses within the meaning of s. 2(24) of the Companies Act , 1956 and as such the illegality of s. 384 of that Act was not attracted. In this view of the matter, the remuneration paid by the assessee to Kamala Mills Ltd.. for the two calendar years 1957 and 1958 relevant to the assessment years 1958-59 and 1959-60 could not be regarded as being in violation of s. 384 ofthe Companies Act, 1956 and as such the expenditure incurred by way of paying such remuneration would be deductible as business expenditure under s. 10 (2) (xv) of the Income Tax Ac t. 1922.In view of our aforesaid conclusion the aspects whether the assessee had disputed its liability to pay such remuneration to Kamala Mills Ltd. Or had filed a suit at the instance of the Company Law Board to recover it back from Kamala Mills Ltd. Or had obtained a decree in that behalf against Kamala Mills Ltd. become irrelevant. However, we would like to place on record the fact that the decree obtained by the assessees against Kamala Mills Ltd. has been reversed or se t aside in appeal by the Kerala High Court-a fact which was brought to our notice by the Advocate-on- Record for the assessee communicated to him by his client in a letter dated 22nd August, 1979. However, even 7 if in further appeal the trial courts decree were restored and the assessee were to recover back the remuneration the assessee can be taxed on the two amounts under s. 41(1) of the 1961 Act.