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Tax Case No. 142 of 1959 (Reference No. 50 of 1959) decided on 22nd February 1962.
Business expenditure ‑ Directors' remuneration Power of Income‑tax Officer to disallow excess remuneration‑Test of reasonableness‑Indian Income‑tax Act, 1922, S. 10 (4‑A).
A, B and C were, sole shareholders and directors of a private company. By a resolution of the company each of the three directors was allowed a remuneration of Rs. 500 per month and A, who was a technician and managing director, was allowed an additional salary of Rs. 1,250 per month. The company claimed a deduction of Rs. 24,750 towards remuneration paid to directors for nine months and returned an income of Rs. 2,316. The Income‑tax Officer, acting under section 10 (4‑A) of the Income‑tax Act, allowed deduction of Rs. 11,250 paid to the managing director but disallowed the balance of the remuneration, vie., Rs. 500 each paid to the directors, and the Tribunal upheld this view:
Held, that the test of. permissibility of the allowance is that provided for under section 10(4‑A) and that is whether the allowance is not excessive or unreasonable having regard to the legitimate needs of the company and the benefit derived by it from the allowances. On the facts found the correct test had been applied and the decision of the Tribunal was right.
Section 10 (4‑A) is intended to prevent companies from claiming allowances which really benefit the directors, directly or indirectly, under the mask of allowances under section 10 (2). No allowance considered by the Income‑tax Officer as excessive or unreasonable (having regard to the legitimate business needs of the company and the benefit derived by or accruing to the company therefrom) is permissible even though warranted by section 10 (2) if it results directly or indirectly in the provision of any remuneration or benefit or amenity to a director or if it is in respect of any asset of the company used by the director wholly or partly for his own purposes or benefit.
Newton Studios Ltd. v. Commissioner of Income‑tax (1955) 28 I T R 378 ref.
T. Y. Viswanatha lyer for M. Ranganatha Sastry for the Assessee.
S. Ranganathan for the Commissioner.
This is a reference application under section 66 of the Indian Income‑tax Act. The assessee is a private limited company carrying on business at Madras as repairers of ships calling at the Madras Port. It com menced its business on and from January 1, 1955. The shareholders of the company and the number of shares held by them are as follows:
1. D. J. Hayden ... 50 shares.
2. M. V. Sastry .. 50 shares.
3. Mammu Meera Syed Muhammad ... 50 shares.
Total ... 150 shares.
All the three shareholders are directors of the company, and the first of them is also the managing director The managing director is a qualified mechanical engineer. M. V. Sastry is an electrical engineer with considerable experience. Syed Muhammad is a partner in Messrs K. P. V. Sheik Muhammad Rowther & Co., well‑known steamer agents at Madras. On and from April 1, 1955, the directors claimed to be paid remuneration at the rate of Rs. 500 per month for each director. The managing director claimed an additional salary of Rs. 1,250 per month from that date. This salary and remuneration were not drawn by the directors each month but were adjusted at the end of the calendar year 1955, which is the year of account of the assessee. For the assessment year 1956‑57, relevant to the previous year ending December 31, 1955, the company claimed the total payment of. salary and remuneration, Rs. 24,750, as permissible allow anc6 in computing its profit. It returned an income of Rs. 2,316 after deducting the said sum of Rs. 24,750. The Income‑tax Officer allowed the claim in respect of the payment of Rs. 11,250 as salary to the managing director but dis allowed the rest of the claim on ,the ground that it was excessive because 90 per cent. of the profits of the company were absorbed in the shape of remuneration and salary. The assessee went up on. appeal to the Appellate Assistant Com missioner who, however, took the view that the assessee's claim was well‑founded. The appellate authority referred t o the decision of Newtone Studios Ltd. v. Commissioner of Income tax ((1955) 28 I T R 378) and observed .:
" He (the appellant's representative) contends that the expenditure was incurred wholly and exclusively for the purpose of the business ; that 'the Income‑tax Officer has not pointed to consideration other than the purpose of the appellant's business as accounting for the payment made and that the reality of the payment has not been challenged The manag ing director is a technician and manages the entire mechanical side. Shri Sastry with 35 years' experience is in complete charge of electrical repairs, replacements, etc. The third director. Shri Syed, who is a partner of the firm of agents to Scindia and Eastern Shipping Corporation looks after canvassing orders, purchasing spare parts, etc. Evidence has been produced before me to show that on many days al the directors had to work all round the days. Considering all these factors, I feel that the entire remuneration should be allowed."
The Department filed an appeal before the Income‑tax Appellate Tribunal. The Tribunal agreed with the decision of the Income‑tax Officer and set aside the order of the Appellate Assistant Commissioner. At the instance of the assessee the following question of law has been referred by the Tribunal under section 66 (1) of the Act:
"Whether, on the facts and in the circumstances of the case, the disallowance of the remuneration of Rs. 13,500 paid to the three directors in the assessment year 1956‑57 is right in law "
The subject‑matter of dispute now before us is whether the payment of remuneration of Rs. 500 to each of the three directors of the company for nine months between April 1, 1955 and December 31, 1955, is a proper deductible allow ance in computing the income and profits of the assessee company.
The resolution to pay remuneration to the directors was passed at a directors' meeting held on May 7, 1955. The Tribunal has adverted to the ‑ fact that in the minutes book the figure 9 denoting the month in which the meeting was held is over‑written by 5. Mr. Hayden appears to have conceded before the Tribunal drat the minutes were not written by him contemporaneously with the holding of the meeting bus were written later on with the aid of memoranda made by him. The annual general meeting of the company was held ors May 21, 1956, and in that meeting the resolution of the board of directors to pay salary and remuneration to the directors was ratified. It is not necessary for us to go into the question whether there is a valid resolution binding the company to enable the directors to get the remuneration now claimed as deduction from the company's profits as we are of opinion that in any event the claim is not permissible in law.
On the question whether the directors rendered any sub stantial service to the company to Justify payment of remunera tion at the rate of Rs. 500 per month the Tribunal has discussed the matter in the following way:
" No material was placed before us to show that the actual contribution of Messrs Sastry and Mammu Meera Syed Muhammad justified the payments made to them. Admittedly the assessee‑company employed a number of workers who were actually employed for the purposes of effecting the repairs of the ships. Moreover, in the case of Mr. Mammu Meera Syed Muhammad, proof is utterly lacking for the work done by him, and, in our opinion, there is no justifi cation for paying him a remuneration for merely canvassing work for the company which itself is not proved. He is admittedly an active partner in the leading firm of Messrs K. P. V. Sheik Muhammad Rowther and it is futile to expect that he devoted his time and energy to the assessee company . . . . this is the first year of the company's business and out of a sum of Rs. 27,120 earned as profit during the year a substantial sum to the tune of Rs. 24,750 has been given away by way of remuneration to the directors. We are of opinion that the Income‑tax Officer has acted reasonably in allowing remuneration of Rs. 11,250 to Mr. Hayden together with Rs. 3,453 by way of car and entertainment expenses to the same gentleman and in dis allowing the remuneration claimed in respect of the other two directors."
We must observe that the finding of the Tribunal that the two directors, Sastry and Syed Mohammed, did not work for the company or devote their time and energy for running
the company's affairs has not been shown to be erroneous on the materials on record. It is certainly significant to note that almost the entire income of the company has been taken hold of by the directors in the shape of remuneration and salary.
In computing the profits or gains of a business, profession or vocation, the assessee is entitled to claim certain allowances which are set out in section 10 (2) of the Act. This provision is by no means exhaustive as the true profits or gains have to be ascertained and computed on the basis of recognised and accepted commercial principles. The allowances expressly provided for under section 10 (2) are in respect of expenditure, such as rent for the business premises, repairs to such premises, interest on borrowed capital, etc., or they relate to capital assets such as depreciation, development . rebate, balancing allowances and others. Section 10 (4‑A) is a special provision which reads as follows:
"10. (4‑A) Nothing it subsection (2) shall, in the computation of the profits and ,gains of a company, be deemed to authorise the making of---
(a) any allowance in respect of any expenditure which results directly or indirectly in the provision of any remunera tion or benefit or amenity to a director or a person who has a substantial interest in the company within the mean ing of sub‑clause (iii) of clause (6‑C) of section 2, or
(b) any allowance in respect of any assets of the company used by any person referred to in clause (a) either wholly or partly for his own purposes or benefit,
if in the opinion of the Income‑tax Officer any such allowance is excessive or unreasonable having regard to the legitimate business needs of the company and the benefit derived by or accruing to it therefrom.
Explanation.‑The provisions of this subsection shall apply notwithstanding that any amount disallowed under the sub section is included in the total income of any person referred to in clause (a)".
This was introduced into the statute book under section 7 of the Finance Act of 1956, with effect from April 1, 1956. This section is intended to prevent companies from claiming allowances which really. benefit the directors, directly or indirectly, under the mask of allowances under section 10 (2). No allowance considered by the Income‑tax Officer as excessive or unreasonable (having regard to the legitimate business needs of the company and the benefit derived by or accruing to the company therefrom) is permissible even though warranted by section 10 (2) if it results directly or indirectly in the provision of any remuneration or benefit or amenity to a director or if it is in respect of any asset of the company used by the director wholly or partly for his own purposes or benefit.
Now, the words of the statute are plain and do not present any complexity. The section applies only to companies. The Income‑tax Officer has to weigh the allowances against the legitimate needs of the company and the benefit derived by it from the allowances. The allowances made should not weigh down the business needs of the company and the benefit accruing to it. The allowances must be moderate and reasonable, in the opinion of the officer, who cannot of course disregard the conditions of the company's trade or business or the normal practice obtaining in such trade. A few illustra tions will be helpful to understand the real scope of this section. A director owns a building which is let out to the company for its business for rent. Normally and in the usual course the building may not get more than Rs. 100 a month. The company pays a rent of Rs. 500 to the director, the owner of the building. The building is used solely for the purpose of the business of the company. But for section 10 (4‑A) the payment of Rs. 500 per month as rent will be a properly deduc tible allowance under section 10 (2) (i). But by reason of section 10 (4‑A) the Income‑tax Officer can hold that the pay ment of Rs. 500 per month excessive and unreasonable, that it is calculated to benefit the director indirectly and that the proper allowance would not only be Rs. 100, the rent which the company could have paid if the building had not been owned by the director. Regarding capital asset of the company like building, depreciation is permitted under section 10 (2) of the Act. But if the building is used by a director for his own personal purposes or benefit the allowance by way of deprecia tion will be hit by section 10 (4‑A), clause (b).
It is not disputed that section 10 (4‑A) is applicable to this case as it came into operation on April 1, 1956, and as the assessment year for consideration is 1956‑57. The test of permissibility of the allowance is that provided for under section 10 (4‑A) and that is whether the allowance is not excessive or unreasonable having regard to the legitimate needs of the company and the benefit derived by it from the allowances. On the facts found we have no doubt that the correct test has been applied and that the decision of the Tribunal is right.
The question is answered in the affirmative and against the assessee who will pay the costs of the Department. Counsel's fee Rs. 250.
Question answered in the affirmative.
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