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PETITIONER:

M/S. MADDI VENKATARAMAN & CO. (P) LTD.

Vs.

RESPONDENT:

THE COMMISSIONER OF INCOME TAX

DATE OF JUDGMENT: 02/12/1997

BENCH:

SUHAS C. SEN, S. SAGHIR AHMAD

ACT:

HEADNOTE:

JUDGMENT:

THE 2ND DAY OF DECEMBER, 1997

Present:

Hon'ble Mr.Justice Suhas C.Sen

Hon'ble Mr.Justice S.Saghir Ahmad

Ramesh P.Bhatt, Sr.Adv. M.N.Shroff, Ms. Ragini Singh, Advs.

with him for the appellant

Ranvir Chandra, C.V.Rao, S.R.Tardol, Nagpal, and B.K.Prasad,

Advs. for the Respondent

J U D G M E N T

The following Judgment of the Court was delivered:

SEN, J.

The Tribunal referred the following question of law to

the Andhra Pradesh High Court under Section 256 (1) of the

Income Tax Act, 1961.

"1. Whether on the facts and in the

circumstances of the case, a sum of

Rs 2.95,000/- has to be taken into

account in computing the income of

the assessee from business under

the provisions of Section 28 of the

Income Tax Act, 1961?

If the answer to the above question

is in the negative-

Whether on the facts and in the

circumstances of the case, the

claim of Rs 2,95,000/- is covered

by sub-rule (J) of Rule 6-DD,

framed under Section 40-A(3) of the

Income Tax Act, 1961?"

2. "Whether on the facts and in

the circumstances of the case, the

sum of the Rs. 19.695/- incurred as

quest-expenses is allowable as

deduction?"

The assessee, to start with, was a partnership

consisting mostly of family members, in 1965, it was

converted into a public company to carry on the business of

export of tobacco. The first directors appointed at the time

of incorporation were to hold office during their lifetime

or until they resigned voluntarily.

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On the basis of the information received, a search was

conducted by the Enforcement Directorate in the assessee's

business premises. A number of latters and other documents

were seized which disclosed that the assessee had indulged

in transactions in violation of the provisions of Foreign

Exchange (Regulation) Act (for short `FERA'). It was found

that the assesee had remitted to a private party in

Singapore in violation of law. Proceedings were taken

against the assessee for infringement of Sections 4(2) and

5(1)(e) of FERA and ultimately a penalty of Rs. 35,000/- was

imposed under Section 23 (1)(a) read with Section 23-c of

the Act. The assessee in its income tax return for the

assessment year 1970-71 claimed deduction of Rs. 2.95,000/-

as business expenditure/loss. According to the assessee in

course of carrying on of its business by the year 1966. It

had accumulated 329.2 tonnes of sub-standard quality,

tobacco which it could not export over the last three years.

Since the accumulated stock of tobacco was of sub-standard

quality, it could not be sold at the floor price fixed by

the Government of India for such tobacco. According to the

assessee, it had no alternative but to sell the tobacco at a

discount of 20% to a Singapore party. On paper, the full

sale price was paid by the Singapore party but in reality

20% of the price paid by the party was remitted back to him

through one Shamsuddin. In pursuance of this agreement

tobacco was sold and the full floor price was received by

the assessee from the Singapore party. The assessee paid a

sum of Rs. 2.88,000/- to Shamsuddin who remitted the

equivalent amount in Singapore currency to the Singapore

party. Thus, according to the assessee, it had no

alternative but to enter into such a ******** with a view to

dispose of the sold unsold stock of inferior quality of

tobacco. In these facts of the case. It was claimed by the

assessee that the amount of Rs. 2,88,000/- paid to

Shamsuddin ought to be deducted as business expenditure or

treated as business loss.

The Income Tax Officer however, disallowed the claim.

According to him. Payment was not genuine and it contravened

the provisions of Section 40-A(3) of FERA. It was further

held that the payment did not fall within any of the

exceptions to Rule 6-DD. The appellant Assistant

Commissioner affirmed the order of the Income Tax Officer.

On further appeal, the Tribunal made the following findings.

(a) A sum of Rs. 2,95.000 was paid by this assessee company

to Shamsuddin which consisted of an amount payable to him

for his services and also a sum of Rs. 2,88,000/- to be

remitted to the Singapore party. The amount paid to

Singapore party was difference of 20% of the floor price of

tobacco fixed by the Government.

(b) The assessee was knowingly a party to the above

transaction and it violated the provisions of FERA. The

Tribunal also took the view that the assessee's income from

export to the Singapore party in reality was not the full

price shown to have been received from the Singapore party

i.e., 8.86,702.89. The figure had to be reduced by a sum of

Rs. 2,95.000/- because this was the sum which was really

received by the assessee. It was of the view that it was

unnecessary to go into the question whether the sum of Rs.

2,95,000/- was to be created as a deduction and if so under

which Section and further whether it attracted Section 40-

A(3) of the Act.

(c) The Tribunal held that even otherwise, the said payment

did not attract Section 40-A(3) since it was covered by sub-

rule (j) Rule 6-DD inasmuch as the said payment to

Shamsuddin was made in cash due to exceptional and

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unavoidable circumstances.

In the Department's contentions that the payment made

to Shamsuddin was illegal and could not be taken into

account for any purpose were unsustainable in law. The

income tax law did not distinguish between legal and illegal

income or between legal and illegal expenditure.

The High Court was of the view that the Tribunal was in

error in coming to the conclusions that it had reached. The

High Court pointed out that expenses tainted with illegality

could not be allowed as business expenditure under Section

37 or as business loss or on any other basis. The High court

was of the further view that the assessee could not be

allowed to achieve the same result by invoking Section 28.

The High Court also expressed the view that the assessee's

contentions that its real income from export of tobacco was

not Rs. 6.86,702.89 paise which was paid to it but its real

income was that amount minus Rs. 2,95.000/- which he had

subsequently repatriated in Singapore dollars. It was only a

facade to realise the true price of the transaction which

was 80% of the floor price. Therefore, the invoice which

showed the floor price was not the true reflection of the

real transaction between the two parties. The High Court

rejected this contention by holding that the very agreement

to receive 80% of the floor price which was the invoice

value of the tobacco was illegal. The High Court pointed out

that in law, there could not have an agreement to agree to

take anything less than the invoice price. The agreement

that tobacco was of the sub-standard quality was no answer.

An exporter was not supposed to export sub-standard tobacco.

The High Court was of the view that the sum of Rs.

2,88,000/- had not been repatriated in a straight forward

manner but has been sent to Singapore through an illegal

channel. It is not a case of money being diverted under an

overriding legal obligation. The High Court ultimately

concluded that the agreement being illegal and contrary to

law, cannot be recognised by a court of law nor can entering

into such transaction be a normal incidence of carrying on

business. The High court further held that argument based on

real price was of no substance. If a contractor received an

amount of Rs. lakhs under a contract entered into with the

Government he cannot claim that in reality, the amount was

Rs. 9 lakhs because at the time to awarding the contract he

had an understanding with the authority to pay a sum of Rs.

one lakh by way of bribe.

The High Court referred to a large number of decisions

where it has been held that payments tainted with illegality

cannot be claimed as deduction under the income Tax Act.

However, if an assessee is penalised under one Act, he

cannot claim that amount to be set off against his income

under another Act because that will be frustrating the

entire object of imposition of penalty.

One exception to this rule which has been recognised by

the Courts is where the entire business of the assessee is

illegal and that income is sought to e taxed by the Income

Tax Officer then the expenditure incurred in the illegal

activities will also have to be allowed as deduction. But if

the business is otherwise lawful and the assessee resorts to

unlawful means to augment his profits or reduce his loss,

then the expenditure incurred for these unlawful activities

cannot be allowed to be deducted. Even if the assessee had

to pay fine or penalty because of an inadvertent infraction

of law which did not involve any moral obliquity, the result

will be the same. Even in such cases, deduction will not be

permitted of the amounts paid as penalty of fine or of the

value of the goods confiscated by the statutory authority as

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expenditure wholly and exclusively incurred for the purposes

of carrying on the trade. It has been consistently held by

the English Courts that fines or penalties payable for

violation of law cannot be permitted as deduction under the

Income Tax Act. That will be against public policy. Even

though the need for making such payments arose out of

trading operation the payment were not wholly and

exclusively for the purpose of the trade. One can carry on

his trade without violating the law. In fact, Section 37

presumes that the trade will be carried on lawfully.

The English Courts have consistently held that penalty

or fine or money paid to compound and offence under another

statute cannot be allowed as a deduction under the Income

Tax Act. For the application of these principles,

consideration of moral obliquity was quite immaterial.

In the case of the Commissioners of Inland Revenue vs.

E.C.Warnes 12 Tax Cases 227, the Company had to pay a

penalty under the provisions of the Customs (Consolidation)

Act, 1876 in respect of a consignment of oil shipped by it

to Norway. The action was settled by consent on the

agreement of the company to pay a mitigated penalty of Rs.

2,000 and on all imputations as to the Company's morel

culpability being withdrawn. It was declared that there was

no intention from the beginning to the end of the

transaction that the Company had by connivance or consent

been taking part in trading with the enemy but had only been

culpable of carelessness. In defending the penalty

proceedings, the Company had incurred legal costs amounting

to 560 18s 10d. These two amounts incurred on payment of

the penalty and also legal cost have been taken for the

computation of Excess Profits Duty purposes, On behalf of

the company. if was contended that both the penalty and

costs should be allowed as losses arising out of and

incidental to trade. It was pointed out that the penalty and

the costs were solely connected with and arose out of the

trace carried on by them and as such were detectable in the

same manner that bad debts are deductible in computation of

profits. Lastly, it was argued that profits must be taken in

their commercial sense. In that sense this was loss which an

ordinary prudent commercial man would and could only write

off against the profits of the business. The Commissioners

who heard the appeal held in favour of the company. When the

matter came before the High Court Rowlatt, J. recognised

that the provision of law under which the penalty was

imposed is "one of very great and startling stringency; but

of course the liability it creates can only be regarded as a

liability of penal character" and held.

"It seems to me that a penal

liability of this kind cannot be

regarded as a loss connected with

arising out of a trace. I think

that a loss connected with or

arising out of trade must, at any

race, amount to something in the

nature of a loss which is

contemplable and in the nature of a

commercial loss.....but I do not

think it is possible to say that

when a fine, which is what it comes

to has been inflicted upon a

trading body. It can be said that

is "a loss connected with or

arising out of" the trade within

the meaning of this Rule."

This decision of Rowlatt, J. was cited with approval by

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the court of Appeal in the case of The Commissioners of

Inland Revenue vs. Alexander Von Glehn & Co., Ltd, 12 Tax

Cases 232. In that case Lord Sterndale noted that the

assessee was a firm of high standing. A great part of its

trade consisted in the exporting of goods to Russia and

Scandinavia Some goods were exported to Russia at a time

when the Customs (War Powers) Act, 1915 was in force and the

goods of the assessee had ultimately gone to the enemy

territory Proceedings were taken for infraction of law

because the assessee was not able to prove that he had taken

all reasonable steps to secure that the ultimate destination

of the goods was the destination mentioned in the

declaration. The assessee agreed to pay a fine of 3000 and

now the question was whether this amount padi as penalty was

admissible as deduction from the income of the assessee's

Company.

Lord Sterndale held that the customs proceedings were

not technically criminal proceedings; but he stated.

"I do not think that matters. They

certainly are proceedings in which

a penalty is being sued for by the

Attorney-General as representing

the Crown, for an infraction of the

law, whether technically criminal

for the purpose of appeal seems to

me to be immaterial. The money

which is paid is money paid as a

penalty, and it does not matter in

the least that the Attorney-General

has elected to take treble the

value of the goods, nor does it

matter that it may be called in the

Information a forfeiture."

Lord Sterdale stated that it was a hard case and

observed :

"It may be so, and it may seem

hard, because it was agreed that

there was no moral obliquity to use

the expression which is used in all

these cases, to be attributed to

the Appellants, But is seems to me

that those are matters which we

cannot into consideration, and

injustice to both the learned

Counsel who argued the case for the

Appellants, they did not est their

case upon any such basis as that,

but they rested it upon the broad

principle that it does not matter

whether the expense is included it

consequence of an infraction of the

law or whather it is a penalty for

doing an illegal act. So long as it

is something which reduces the

amount which comes into the

trader's pockets as the result of

his trading."

Lord Sterndale has, however, held that the payments for

infraction of law could not called to be for the purpose of

the trade. Relying upon the remarks of Lord Davey n the case

of Strong vs. Woodifield 5 Tax Cases 215. It was held that

the disbursements permitted as deductions must be for the

purpose of the trade. It was not enough that the

disbursement was made in the course of or arose out of or

was connected with the trade or was made out of the profits

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of the trade.

Dealing with the question that the disbursements were

connected with the trade. Lord Sterndale observed:

"Of course, as Mr. Justice Rowlatt

said, in a sense you may say that

it has been connected with the

trade. because if the trade has not

been carried on the penalty would

not have been incurred there would

not have been an opportunity for

the breach of the law which took

place but in the sense in which the

words are used in the Act. I do not

think that this was connected with

or arising out of such trade,

manufacture, adventure or concern

and still less do I think hat it

was a disbursement under the First

which applies to the first two

cases, that is to say. "money and

exclusively laid out or expanded

for the purposes of such

trade".............It is perhaps a

little difficult to put the

distinction into very exact

language, but there seems to me to

be a difference between a

commercial loss in trading and a

penalty imposed upon a person or a

company for a breach of the law

which they have committed in that

trading for that reason I think

that both the decision of Mr.

Justice Rowlatt in this case and

his former decision in Inland

Revenue Commissioners v. Warnes 12

T.C. 227, which he followed were

right, and I think this appeal

should be dismissed with costs."

Warrington. L.D. who agreed with Lord Sterndale

observed as under :

"Now it cannot be said that the

disbursement in the present case is

made in any way for the purpose of

the trade or for the purpose of

earning the profits of the trade.

The disbursement is made, as I have

already said and the same remark

applied to this Rule as to the

Other because the individual who is

conducting the trade has not from

any moral obliquity but has

unfortunately been guilty of an

infraction of the law."

In the case of Cattermole (H.M. Inspector of Taxes) vs.

Borax & Chemicals Ltd 31 Tax Cases 202, the question was

whether fines imposed in the United States of America upon

the company and upon its managing Directors for infringement

of anti trust legislation of the United State of America

should be allowed as deductions in computing the amount of

Company's profits. The fine was imposed in very unusual

circumstances. It was doubtful whether the Company and its

Managing Director could have been proceeded against the

American Law but they decided to submit voluntarily to the

jurisdiction of the California Court. It was done out of the

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supposed business necessity because the English Company was

subsidiary of An American Company. If the English Company

and its Managing Director alongwith the American Company did

not submit to the jurisdiction of the California Court the

result would be that its supplies would have been stopped

altogether and it would have been unable to carry on the

business with the American Company. the Company was

extremely anxious to settlement. It was argued that it was a

matter of vital importance to the American Company that the

English Company and Mr. Hatchley should appear in this suit.

The matter was ultimately settled. One of the terms of the

settlement was that the English Company would pay a fine of

10,000 U.S.Dollars and the Managing Director would pay a

fine of 6.000 US dollars.

The Commissioners took the view that the amount was

deductible as business expenditure because it was paid to

ensure the supplies. Croom-Johnson, J. held that the amount

was not paid wholly and exclusively for the purposes of

carrying on the trade. It may have been one of the reasons

but manifestly it was not the only reason. "One of the

reasons was to get as cheaply as possible a settlement with

the American authorities, paving something by way of

compromise-agreeing with one's adversary while one is in a

way with him. That is really what happened hence."

The Indian Courts have also consistently held that

payments tainted with illegality cannot be treated as money

spent wholly and exclusively for the purpose of business. A

long line of decisions was noted in the judgment under

appeal. It is not necessary to refer to all of them. We

shall refer to three cases decided by this Court.

In the case of Hail Aziz and Abdul Shakoor Bros. v.

Commissioner of Income Tax Bombay City II. 41 ITR 350 a

bench of three Judges of this Court held that the expenses

which were permitted as deduction were such as were made for

the purpose of carrying on the business. It was enough that

the disbursements are made in the course of or arose out of

or were connected with the trade. No deduction can be

allowed if the expenditure fell on the assessee in some

character other than that of a trader. If a sum has to be

paid by an asseessee because in conducting his business, he

had acted in a manner which had rendered liable for penalty

for infraction of law, it could not be claimed as a

deduction because it could not be called in commercial sense

as incurred in carrying on the business. It was emphasised

in that judgment by Kapoor, J. that infraction of law is not

a normal incidents of business.

The point that the expenditure incurred for the purpose

of unlawful activity must be allowed to find out the

commercial profits of the Company was specifically argued

and raiected in the case of The Commissioners of Inland

Revenue vs. F.C.Warnes (supra). If a penalty is imposed for

contravention of any statutory provision it cannot be said

that the commercial loss had fallen on the assessee as a

trader. Illegal activity cannot be created as a tradition

activity at all. As Lord Sterndale held that it was not

enough that the disbursement was made in the course of or

arose out of or was connected with the trade or was made out

of the profits of the trade. Only if it could be shown that

it was spent for the purpose of the trade that the deduction

can be permitted unless the entire trade was unlawful.

The case of Haji Aziz Abdul Shakoor Bros. (supra) it

important for another reason. It was categorically held in

this case that no distinction can be made in this regard

between a personal liability and a liability of any other

kind. So long as the payment has to made for infraction of

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law, it cannot be said that it was made in course of

carrying out of the trade.

In that case of Commissioner of Income Tax V. S.C.

Kothari 82 ITR 794. It was held that the loss which had

actually been incurred in carrying on a legal business must

be deducted before the true figure relating to profits which

had to be brought to tax could be computed or determined. If

a business was illegal, neither the profits earned nor the

loss incurred would be enforceable in law but that did not

take the profits our of the taxing stature. Similarly the

taint of illegality of the business could not detract from

the loss baing taken into account for computing the amounts

which had to be subjected to tax. The Tax Collector cannot

be heard to say that he will bring the gross receipts to tax

he could tax the profits of a trade or business. That cannot

be done without taking the loss and the legitimate expenses

of the business.

In the case of Commissioner of Income tax, West Bengal

v. H.Hirjee 23 ITR 427, a bench of four Judges of this Court

dealt with a case of an assessee who was carrying on the

business as selling agent of a Company, he was prosecuted

under Section 13 of the Hoarding and Profiteering Ordinance,

1943 on a charge of selling the goods at prices higher than

a reasonable price in contravention of the provision of the

Section 6 of the Act. A part of the stock of goods was

seized and taken away. The persecution however, ended in

acquittal. The assessee claimed deduction of a sum of money

spent in defending the case. The Income Tax Appellant

Tribunal found that the expenditure was incurred solely for

the purpose of maintaining the assessee's name as a good

businessman and to save his stock from being undersold if

the Court held that the prices charged by him were

unreasonable. The High Court rejected the reference

application on the ground that the decision of the Tribunal

was based on finding of fact. On appeal this Court held that

the findings of the Tribunal were vitiated by its failure to

consider the possibility of criminal proceedings terminating

in the conviction and imprisonment of the assessee. It was

held that the deductibility such expenses must depend upon

the purpose and nature of legal proceedings and could not be

affected by the final outcome of the proceedings. It was

also pointed out that the Income Tax assessment had to be

made for every years and could Tax assessment had to be made

for year and could not be held up until the final result of

the legal proceedings which pass through several Courts was

announced.

In the instant case, the asseesee had indulged in

transactions in violation of the provision of Foreign

Exchange (Regulation) Act. The assessee's plea is that

unless it entered into such a transaction, it would have

been unable to dispose of the unsold stock of inferior

quality of tobacco. Another words, the assessee would have

incurred a loss. Spur of loss cannot be a justification for

contravention of law. The assessee was engaged in tobacco

business. The asseessee was expected to carry on the

business in accordance with law. If the asseesee contravenes

the provision of FERA to cut down its losses or to make

larger profits while carrying on the business, it was only

to be expected that proceedings will be taken against the

asseesee for violation of the Act. The expenditure incurred

for evading the provisions of the Act and also the penalty

levied for such evasion cannot be allowed as deduction. As

was laid down by Lord Sterndale in the case of Alexander Von

Glehn (supra) that it was not enough that the disbursement

was made in the course of trade. It must be for the purpose

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of the trade. The purpose must be a lawful purpose.

Moreover, it will be against public policy to allow the

benefit of deduction under one statute of any expenditure

incurred in violation of the provisions another stature or

any penalty imposed under another statute. In the instant

case, if the deductions claimed are allowed, the penal

provisions of FERA will become meaningless. It has also to

be borne in mind that evasion of law cannot be a trade

pursuit. The expenditure in this case cannot, in any way, be

allowed as wholly in this case cannot, in any, way be

allowed as wholly and exclusively laid out for the purpose

of assessee's business.

We are in agreement with the view expressed by the High

Court in this case. The appeal is dismissed. There will be

no order as to costs.