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PETITIONER:

BHARAT BEEDI WORKS (PRIVATE) LIMITED AND ANR.ETC. ETC.

Vs.

RESPONDENT:

COMMISSIONER OF INCOME-TAX

DATE OF JUDGMENT07/05/1993

BENCH:

JEEVAN REDDY, B.P. (J)

BENCH:

JEEVAN REDDY, B.P. (J)

VENKATACHALA N. (J)

CITATION:

1993 AIR 1751 1993 SCR (3) 606

1993 SCC (3) 252 JT 1993 (3) 526

1993 SCALE (2)896

ACT:

Income-Tax Act 1961--S.40 (c)--Partners in firm also

directors in a company--Whether royalty payments by company

to firm falls within s. 40 (c)--Held, Payments are

consideration for a valuable right parted by firm/

partners/directors of the assessee--Company a favour of

assessee--Where agreement whereunder payments made not mere

device or screen, it cannot be treated as payments made to

directors qua directors--S.40(A) (2).

HEADNOTE:

A partnership firm consisting of three partners 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 Ltd. the assessee-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

July 1972 whereby the firms sold its rights and assets to

the company. For the use of the trade name, a royalty at

10p. for every 1000 beedies was to be paid by the company to

the firm. This payment was made ever year by the assesse 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 are similar.

The assessee claimed deduction of the amount paid by it as

royalty. The ITO allowed the deductions as claimed. The

CIT in stio motu proceedings disallow the aforesaid

deductions. On appeal, the tribunal restored the order of

the ITO.

On reference, the High Court answered in fan,our of the

revenue as the three directors of the assessee company were

also partners in the firm. It held that in law, a firm is

merely a collection or association of individuals for

carrying 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 to the firm were in

reality made to the

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directors, thus attracting S. 40 (c).

Before this Court, it was contended for the assessee that

payment to a firm is not ipso fact payment to the partners,

directly or indirectly. In any event, the payments were

made to the three persons not in their capacity of directors

(qua directors). but in consideration of a valuable right

parted by them in favour of the assessee-company. S. 40(c)

was never intended 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

payments 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 : 1. Even assuming that the payments to firm were

payments to partners, the said payments did not fall within

S. 40(c). The payment,-. 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 (qua

directors). (613-H, 614-A)

The payments were made by way of consideration for allowing

the 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). (614-A)

T.T. (Pvt.) Ltd. v. ITO Bangalore 121 ITR 551, approved.

CIT Patiale v. Avon Cycles (p) Ltd. 126 IT R 448 and India

Jute Co. 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 derived by the assessee or

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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. Such a situation does not arise herein.

(615-C)

CIT, Bombay v. M/s. Indian Engineering and Commercial

Corporation (p) Ltd. [1983] distinguished. JT 683.

JUDGMENT:

CIVIL APPELLATE JURISDICTION: Civil Appeal No. 1452 of 1987.

From the Judgment and Order dated 10.7.1986 of the Kamataka

High Court in I.T.R.C. No. 198 of 1987.

WITH

C.A. Nos. 4462/89, 1822, 1902, 1465/87, 675, 658, 4461/89,

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. JEEVAN REDDY J. These appeals are preferred against the

judgment of the Karnataka High Court answering the question

referred to it, at the instance of the revenue, in favour of

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the revenue and against the assessee. The question referred

under section 256 of the Income Tax Act, 196 1, 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. 1, 79, 742 could not be disallowed under section 40 (c)

of the Income Tax Act, 1961." (The above question related to

Assessment Year 1974-75. The question referred for A.Y.

1975-76 was identical except in the matter 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) Lid. v. Commr. of Income Tax.

Karnataka, Bangalore).

Prior to 15.7.1992, 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 beedies under the brand name 'Mangalore Prakash

Beedies'. On May 20, 1972 a Private limited company called

Prakash Beedies

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Limited (the assessee-appellant herein), was incorporated

with its registered off-ice at Manoalore. 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 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 appeals reads:

"(a) For the use of the trade name the Company

shall pay royalty to the Vendor at the rate of

10ps. 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

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 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 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 I.T.O. allowed the deductions as claimed.

In exercise of the powers conferred on him by Section 263,

the Commissioner of Income Tax initiated (suo moto)

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 I.T.O, The

appeals were allowed and the orders of the I.T.O. 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

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association of the individuals for carrying

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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.

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 that the firm has 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 mischief of Section4O(c). Section

40(c) was never 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

illustration 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 of associated

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-company 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

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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

charge able under the head" profits and gains

of business or profession",

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(a)........

(b).........

(c) in the case of any company-

(i) any expenditure which results directly or

indirectly in the 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 of the

director or of such person, as the case may

be,

(ii) any expenditure or allowance 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 allowance 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 exceeding 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 comprised in the previous year, an

amount calculated at the rate of six thousand

rupees for each month or part thereof

comprised in that period:

612

Provided that in case where such person is

also and employee of the company for any

period comprised in the previous year,

expenditure 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

account for the purposes of sub-clause (A) or

subclause (B), as the case may be;

(iii) * * * *

Explanation.-The provisions of this clause

shall apply notwithstanding that any amount

not to be allowed under this clause is

included in the total income of any person

referred 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 would be deductible 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

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month in the case of perquisites, the

allowable overall ceiling on remuneration and

perquisites, for purposes of taxation, will be

at Rs. 6,000 per month.................."

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 I.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

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

613

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 a 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, firm, association of persons or Hindu

undivided family of which a director, partner or member, as

the case may be, has 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 be.

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, Bombay. v. M/s. Indian

Engineering and Commercial Corporation Private Uinited

(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

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 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

expenditure 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

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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 4O(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 partners/ directors of the assessee company in

favour of the assessee. SO long a,, the agreement

whereunder the said payments were made is not held to be a

mere

614

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 subsection (2) of Section 40(A), but

it certainly did not fall within the four corners of Section

40(c).

In T. T Ltd. v. LTO., Bangalore 121 I.T.R. 55 1, a Bench

of Karnataka 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

that s. 40(c) refers to an expenditure in-

curred by making periodical payments to 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 s. 4OA(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 s. 40A (2) (a) and the expenditure referred

to in s. 40(c) belong to the same category.

This contention is not correct. The

expression "services" in s. 40A (2) (a) is an

expression of wider import............... If

the remuneration, benefit or amenity referred

to in s. 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 s. 40A (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.'

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The said decision has been followed by the Punjab and

Haryana High Court in Commissioner of Income Tax, Patiala v.

Avon Cycles (P) Ltd. 126 I.T.R. 448, The Calcutta High Court

has also taken a similar view in India Jute Co. Ltd v.

615

Commr of Income-Tax 178 ITR 649.

Mr. Ahuja, learned counsel for the Revenue submitted that

the argument of the assessee 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 relative,,, 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 power vested 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 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.

For the above reasons, we are of the opinion that the

judgment under appeal cannot be sustained. It must he held

that the payments in question did not fall within section

40(c). Accordingly, the appeals are 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.J. R. Appeal allowed.

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