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Case Referred No. 65 of 1953, decided on 1st February 1957.
S. 10 (2) (xv) Business expenditure‑Expenditure must be made for purposes of earning profits‑Contingent liability‑Payment of penalty Whether permissible deductions‑Dealer in coffee‑Damage paid to Coffee Board for not exporting cofee in breach of contract Whether allowable deduction‑Accounts‑Entry regarding liability Whether permissible.
Only an ascertained liability justifies an entry in accounts 'maintained on the mercantile basis.
Deductions are not permissible for anticipated losses or contingent liabilities, even if they are inevitable.
Payments of penalties for infraction of law fall outside the scope of permissible deductions under section 10(2)(xv) of the Income‑tax Act.
For the purpose of deduction under section 10(2)(xv) it is not enough if the loss sustained or expenditure incurred is in some sense connected with the business. Only such losses can be de ducted as are connected with the business in the sense that they are really incidental to the business itself. It .is not enough that an expenditure is made in the course of, or arises out of, or is connected with, the business or is made out of the profits of the business; it must be made for the purpose of earning the profits.
The assessee firm, which carried on business in coffee, entered into contracts with the India Coffee Board and purchased coffee in the account year 1942‑43, at a rate for below the price of coffee to be sold within India, with a contractual obligation to export the. whole of the coffee so purchased to places outside India. The assessee in addition purchased coffee from others out of their export quota, which also it was under an obligation to export. The assessee, however, exported only part of the coffee, and sold the balance within India, in contravention of its obligations. When the Coffee Board came to know in 1946 of the sales within India and called upon the assessee to explain, the assessee admitted that it had failed to export part of the coffee purchased and agreed to pay liquidated damages in accordance with one of the three alternatives provided in the contract. The damages the assessee was liable to pay for its breach of contract was assessed at Rs. 1,19,177, the assessee paid the amount in instalments in the account year 1945‑46, and claimed that the amount should be deducted under section 10 (2) (xv) of the Income‑tax Act from its profits for the account year 1942‑43:
Held, (i) until the Coffee Board made it clear which of the alternatives it chose, the liability of the assessee was only a contingent liability in the account year 1942‑43; even if the assessee had debited itself in that year, the debit would have represented only a reserve provided against enforcement in future of what was a contingent liability in 1942‑43; the liability arose in the year 1945‑46 when the claim for damages was made and was ascertained only after the assessee admitted the liability and, therefore, it could not be related back as an item of expenditure to the year 1942‑43; therefore, the deduction could not be allowed under section 10(2)(xv) from the profits of 1942‑43 ;
(ii) although what the assessee paid to the Coffee Board was called liquidated damages, the payment was really akin to a penalty for committing an act opposed to public policy, a policy that underlay the Coffee Market Expansion Act, 1942, and. which the Act left it to the Coffee Board to enforce; the breach of its contractual obligations to the Board was not in the course of the normal trading activities of the assessee; the money was not expended or paid out for the purpose of the assessee's business and was not even incidental to the business itself; therefore, the amount was not an expenditure allowable under section 10 (2) (xv).
Peter Merchant Ltd. v. Stedeford (1948) 30 Tax Cas. 496; Edward Collin's & Sons Ltd. v. Commissioners of Inland Revenue (1924) 12 Tax Cas. 773; Naval Colliery Co. Ltd. v. Commissioners of Inland Revenue (1928) 12 Tax Cas. 1017 fol.
Strong v. Woodifield (1906) A C 448 and Commissioners of Inland Revenue v. Allexander Von Glehn & Co. Ltd. (1920) 12 Tax Cas. 232 applied.
Mask & Co. v. Commissioner of Income‑tax (1943) 11 1 T R 454 considered.
[Case‑law referred to].
1. In compliance with the requisition of the High Court in C. M. P. No. 10431 of 1951, dated 13th March 1952, we state the case and refer it to the High Court 'under section 66 (2) of the Indian Income‑tax Act.
2. The point in dispute arises out of the income‑tax assess ment for the year 1944‑45 the relative previous year being the year ending 16th August 1943.
3. The assessee is firm carrying on business in. coffee, cardamoms, etc. During the year under consideration, the assessee, under contracts entered into with the India Coffee Board, Delhi, purchased 12,390 cwt. of coffee for export to the Middle East and Australia. A copy of the contract so entered into is annexed hereto as Annexure A' and forms part of the case. In addition, it also purchased from other export licences, 8,303 cwt. of coffee which was intended for export to the said countries. The price of coffee fixed by the India Coffee Board on the export quota was far below the local price. In case of failure to export the coffee so purchased, clause 8 of the contract provided:
"If the buyer fails to ship the coffee purchased for export to a destination outside India, the Board reserves to itself the right to levy liquidated damages or to restore the status quo in any one of the following ways, at the absolute discretion of the Controller of Coffee.
(a) To recover a fixed measure of damages at Rs. 20 per cwt. to be paid to the surplus pool;
(b) to export an equivalent quantity by weight of coffee purchasing the same from pool and to recover the loss incurred in the transactions from the buyer. The decision of the Controller in the matter of price at which such coffee is purchased and sold and in the matter of fixing the loss shall be final; and
(c) to call upon the buyer to restore the stock delivered to him at a price less than the purchase price by 2 per cent. of the price for every month after the expiry of the period for export fixed above and the date when the buyer is called upon to restore the stock provided that a period of 15 days and over shall be treated as a month and a period less neglected.
The fixed damages referred to above shall be deemed as liquidated damages and the buyer shall not be entitled to any reduction thereof in any circumstances."
Out of the total quantity of 14,693 cwt. purchased for export the assessee exported only 8,784 cwt. and sold the balance of 5,959 cwt. without the knowledge and concurrence of the India Coffee Board, within India only. It did not inform the Coffee Board at any time that it had contravened the provisions of the licence granted to it to acquire the coffee. In 1946, the Coffee Controller came in possession of certain information which showed that the assessee did not, in fact, export the coffee acquired by it for that purpose and sold it within the Union territory at higher prices. The Coffee Controller investigated this and by his latter, dated 3rd May 1946, called upon the assessee to show cause why responsibility for selling the coffee which was intended for export, in the Union territory, should not be fixed on it. The assessee, in its letter, dated 20th May 1946, admitted not having shipped 5,959 cwt. of coffee and expressing regret for the happening agreed to pay damages in accordance with clause 8 of the contract. The damages were ascertained at Rs. 1,19,177, which sum, the assessee paid in four instalments between 3rd May 1946, and 18th August 1946. This sum was claimed by the assessee as an admissible deduction from the profits for the assessment year 1944‑45 (previous year being the year ending 16th August 1943).
4. The learned Advocate for the assessee urged that the aforesaid payment should also be treated as an admissible deduc tion under section 10 (2) (xv) of the Act or it should go towards increasing the price of coffee during that period. The Tribunal held that the expenditure was incurred at a period beyond the year of account and it was not known on 16th August 1943, that it was going to incur and expenditure, let alone the quantum of it. Therefore, the Tribunal held that it was not an expenditure for that year and much less a liability. It also field that the expenditure was incurred during the period 23rd May 1946, to 18th August 1946, and the consideration of it, if at all, should be within the year covering that period and not during the year ending 16th August 1943, when no liability for the expendi ture was known or incurred. In fact, if the assessment for 1944‑45 had been promptly completed, there could have been no claim by the assessee in that year. The assessee never informed the authorities either before 16th August 1943, or soon after that it had infringed the law and incurred liability by way of damages which had to be paid to the Coffee Controller. Thus, there was no liability incurred at all during the period for which the claim was made. Secondly, it was found that the impugned sum was described as liquidated damages and as such it did not from an addition to the cost of commodity purchased by Luc assessee. On these two grounds, the Tribunal negatived the assessee's claim and dismissed the appeal.
5. The question of law on which the Tribunal had been directed to state is as follows:
"Whether on the facts and in the circumstances of the case, the sum of Rs. 1,19,177 paid by the assessee as damages to the Indian Coffee Board for not exporting the coffee seed outside India under the terms of agreement is allowable as an expendi ture under section 10 (2) (xv) of the Act in the assessment year 1944‑45 "
S. Swaminathan for the Assessee.
C. S. Rama Rao Sahib for the Commissioner.
.‑The question referred to this Court under section 66(2) of the Income‑tax Act arises out of the assessment for the year 1944‑45, the previous year in relation to which ended on 16th August 1943. The assessee firm carried on' business in coffee among other things. In the relevant accounting year, 1942‑43, the assessee entered into contracts with the India Coffee Board, constituted under the Coffee Market Expansion Act VII of 1942, under which the assessee purchased 12,390 cwt. of coffee, with a contractual obligation to export the whole of that quantity to the Middle East and Australia. In addition, the assessee purchased from others out of their export quotas, 2,303 cwt. which also he was under an obligation to export. The prices at which the India Coffee Board sold the coffee for export were far less than those at which coffee was sold from the pool by the Board for sales within India. The assessee exported only 8,784 cwt.; the balance of 5,959 cwt. it sold within India without the knowledge of the India Coffee Board. The assessee made con siderable profits out of these sales: The 'India Coffee Board came to know of these sales in contravention of the assessee's obligations only in 1946, when it called upon the assessee to explain. The assessee admitted in his letter dated 20th May 1946, that it had failed to export 5,959 cwt. of the. coffee that it had obtained for export in 1942‑43 and the assessee agreed to pay the damages in accordance with one of the alternative terms of the contract it had entered into with the India Coffee Board.
Clause 9 of that contract ran:
"If the buyer fails to ship the coffee purchased for export to a destination outside India, the Board reserves to itself the right to levy liquidated damages or to restore the status quo in any one of the following ways, at the absolute discretion of the Controller of Coffee:
(a) To recover a fixed measure of damages at Rs. 20 per cwt. to be paid to the surplus pool. (b) To export an equivalent quantity by weight of coffee purchasing the same from the pool and to recover the loss incurred in the transaction from (he buyer. The decision of the Controller in the matter of price at which such coffee is purchased and sold and in the matter of fixing the loss shall be final. (c) To call upon the buyer to restore the stock delivered to him at a price less than the purchase by 2 1 per cent. of the price for .very month after _ the expiry of the period for export fixed above and the date when the buyer is called upon to restore the stock provided that a period of fifteen days and over shall be treated as a month and a period less neglected."
"The fixed damages referred to above shall be deemed as liquidated damages and the buyer shall not be entitled to any reduction thereof in any circumstances."
It was apparently the first of the alternatives that it was availed of by the Controller of Coffee, and the damages the assessee was liable to pay for its admitted breach of the contractual obli gation was assessed at Rs. 1,19,177 on 1st June 1946. The assessee paid this amount in instalments in the latter part of its year of account 1945‑46.
The assessment proceedings for 1944‑45 were completed by the Income‑tax Officer only on 5th August 1947. The assessee firm claimed that the sum of Rs. 1,19,177 it had paid as liquidated damages should be deducted to arrive at its assessable profits for the accounting year 1942‑43 under section 10 (2) (xv) of the Income‑tax Act. That claim was disallowed by the depart mental authorities. The assessee's appeal to the Appellate Tribunal failed.
The question referred to this Court under section 66(2) of the Act ran:
"Whether on the facts and in the circumstances of the case the sum of Rs. 1,19,177 paid by the assessee as damages to the Indian Coffee Board for not exporting the coffee seeds outside India is under the terms of agreement allowable as an expendi ture under section 10(2) (xv) of the Act in the assessment year 1944‑45."
Two points had to be determined by the Appellate Tribunal (1) whether independently of the year of account in which the expenditure of the 1,19,177 was incurred by the assessee the expenditure could be claimed at all as deduction under section 10 (2) (xv) of the Act; and (2) if it could be claimed as a lawful deduction did the fact that the amount was expended, not in the relevant year of account 1942‑43, but only in the year of account 1945‑46, for the grant of relief to the assessment year 1944‑45. Both the points were decided against the assessee by the Appellate Tribunal. The claim of the assessee firm has to be rejected if either of the points is decided against it.
The Tribunal, in our opinion, was right when it decided in the circumstances of this case that the amount expended by the assessee in 1945‑46 could not be excluded in computing the assessable income of the assessee during its account year 1942‑43.
No doubt the assessee paid the sum of Rs. 1,19,177 to the India Coffee Board as liquidated damages for breach of contract. That breach was in, the year of account 1942‑43.
The liability to pay damages under the contract between the assessee and the India Coffee Board was however only a con tingent liability, and it remained so till that year of account ended. The assessee maintained its account on the mercantile basis. The assessee did not debit itself in the year of account with the amount it eventually bad to pay in 1945‑46.
It could not claim to be in a better position than it would have been had it debited itself with that amount in its accounts during 1942‑43. Even so, that debit would have represented only a reserve provided by the assessee against the enforcement in future of what was still a contingent liability in 1942‑43. However prudent such a provision might have been from the point of view of accountancy, that would not have sustained a claim for deduction under section 10 (2) (xv) of the Act with reference to the account year 1942‑43. It would still have been an un ascertained claim for damages for breach of contract. The claim itself was not made in the year of account. That there could be no defence to the claim when it was made did not alter the fact that the claim had yet to be made and the damages yet to be ascertained.
It could not be predicated in 1942‑43 what would be the claim of the India Coffee Board, the other contracting party entitled to damages under the contract. We have already set out the terms of clause 9 of the contract. It provided for three alternatives, any one of which the India Coffee Board could claim at the discretion. of the Controller of Coffee. The quantum of damages could not possibly have been identical under each of these three alternatives open to the India Coffee Board. Which of these three alternatives gave the greatest monetary advantage to the India Coffee Board at any given point of time, with the corresponding monetary liability on the assessee, it was not possible to guess, because no claim even was made by the India Coffee Board in 1942‑43. Till the India Coffee Board made clear by its claim which of the three alternatives it chose, there could be no means of knowing what the liability of the assessee was. Up to that stage it could only be a contingent liability. For all that the assessee knew in 1942‑43 no claim might have been made at all by the India Coffee Board. That was probably what the assessee hoped for, that the breach of the terms of the contract would go un-deducted and the liability would go unenforced. Under such circumstances the assessee could not treat any sum as an ascertained liability, even if it could not be viewed as an ascertained debt due to the India Coffee Board, to justify the claim to deduct any specified sum from the assessable profits of that year. Whether the liability was discharged or not by payment, only an ascertained liability would have justified an entry in the accounts of the assessee maintained on a mercantile basis. Even had the assessee firm entered any amount in its account in 1942‑43 before such ascertainment, the claim under section 10 (2) (xv) would have been unsustainable.
To sum up, it was a contingent liability and not an ascertained liability in 1942‑43.
It should be taken as well settled now that without statutory warrant‑and there is none in section 10 (2)(xv)‑deductions are not permissible for anticipated losses even if they are inevitable, for contingent liabilities.
In Peter Merchant Ltd. v. Stedeford ((1948) 30 Tax Cas, 496) the facts were as follows. The assessee company carried on the business of managing n, factory canteens. Under the usual form of contract made between the company and the factory owner, the crockery, cutlery, and utensils used in the canteen were provided by the factory owner, but they were to be maintained in their original quantity and quality of by the company. It was found impossible in the relevant year of account, owing to scarcity and high price of the equipment concerned, to effect alt the replacements for which the company was liable. The company however charged as expenses not only the amounts of the disbursements actually made in effecting replacements, but also amounts representing at current prices the company's liability to effect replacements as soon as the required equipment became available. The company claimed the latter set of amounts as admissible deductions in computing its assessable profits. That claim was disallowed. In the assessment proceedings an accountant called in as an expert gave evidence. He stated that the accounts had been prepared in accordance with the principles of sound Commercial accounting. He added that, if he had been the auditor of the assessee company, he would not have been prepared to certify the accounts as correct, if the provisions to meet the company's liabilities in respect of equipment shortages had not been made year by year in the manner in which the accounts showed theta to have been made.
In dealing with the evidence of the accountant, Tucker, L. J., observed:
they (accounts) might well have been prepared in accordance with the principles of sound commercial accounting without being permissible deductions before arriving at the profits in a particular year."
After analysing the terms of the contract in that case Tucker, L. J., observed:
"The real liability under the contract, so far as the replace ment of the utensils goes, was a contingent liability; it was a liability which would not arise until the termination of the contract, and it was contingent upon the inability of the caterers in the meanwhile to replace the utensils. In that sense it is, I think, correct to say that the real liability under the contract was a contingent one."
It was the same principle that was held down in Edward Collins & Sons Ltd. v. Commissioners of Inland Revenue ((1924) 12 Tax Cas. 773) at page 781:
" . a prudent commercial man may put part of the profits made in one year to reserve, and carry forward that reserve to the next year, in order to provide against an expected, or (it may be) an inevitable, loss which he foresees will fall upon his business during the next year. The process is a familiar one. But its adoption has no effect on the true amount of the profits actually made, and does not prevent the whole of the profits, whereof a part is put to reserve, from being taken into computation in the year in question for purposes of assess ment. On the contrary, the balance of profits and gains is determined independently altogether of the way in which the trader uses that balance when he has got it ; and if he puts part of it to reserve anti carries it forward into the next year, that has no effect whatever upon his taxable income for the year in which he makes the profit."
Earlier the Lord President observed.
"It is a general principle, in the computation of the annual profits of a trade or business under the Income‑tax Acts, that those elements of profit or gain, and those only, enter into the computation which are earned or ascertained in the year to which the enquiry refers; and in like manner, only those elements of loss or expense enter into the computation which are suffered or incurred during that year." At page 782 the Lord President stated:
"I confess to thinking that it would be a dangerous innovation to allow apprehended losses to futuro to constitute proper matter for deduction from the present profits of commercial undertaking." He restated this later when he observed:
" ..this only serves to make it plain that what they are seeking to do is to put against the actual ascertained receipts from their business in one period a loss which is neither suffered nor incurred in that period. I know of no justification for this, either under the rules or principles of the Income‑tax Acts, or in ordinary commercial accounting."
In Naval Colliery Co. Ltd. v. Commissioners of Inland Revenue ((1928) 12 Tax Cas. 1017) the assessee‑company, which carried on business in mining, held their mines on leases which contained the usual covenants for the repair and maintenance of the mines, pits, roads etc. Owing to national stoppage in the coal mining industry, the company was forced to close down their mines from 1st April 1921 to 2nd July 1921. The stoppage of work resulted in severe dam age to the mines involving considerable amount of expenditure to recondition the mines. The reconditioning work was commenced after 2nd July 1921. For the period of account from 1st April 1921, to 30th June 1921, the assessee debited itself in its accounts with the cost of reconditioning the mines, though no expenditure was made until after the end of the accounting period. It was ultimately held by the House of Lords that, the cost of reconditioning was not a proper deduction in computing the results of the assessee‑company's trade for the accounting period ending 30th June 1921. Lord Buckmaster observed at page 1048:
"According to the appellants' contention, however, it is not the actual expenditure that is deducted, but the need for making the expenditure which is to be measured in their favour and brought into the account. This contention would involve the conclusion that the subject could choose which period he liked as the one in which the allowance is to be brought into account, either that when the expenditure became necessary or that when it was made."
The contention was repelled. If we apply the principle of ii, that contention to the claim of the assessee before us,, logically he should be in a position to claim a deduction in any of the years 1942‑43, 1943‑44, 1944‑45 or 1945‑46 at his choice. That certainly would not disclose a true picture of the assessable profits made in the year 1942‑43. At page 1049 Lord Summer observed:
"The appellants say that in an income‑tax sense this sum is a proper debit against the profits of the three months in question, because although it was neither spent in fact nor incurred as a debt in that time, it was a prospective liability which would have to be satisfied at' another time and as soon as possible. The money was spent to enable profits to be made after 30th June 1921, not to enhance those made before that date . . . It seems to me like saying that a man is entitled to charge supper in his expenses for Sunday night because, though he went supperless to bed, he orders something extra for his breakfast on Monday morning."
In Hannan and Farnsworth's Principles of Income Tax Taxation at page 534 the learned authors quoted the dictum of the Lord President in J. Spencer & Co. v. Inland Revenue ((1950) T R 149).
"It seems to follow that, if in the earlier period there is only a provisional or contingent liability, it is not until it has been subsequently determined to be an actual liability by admission or decision that it can properly be brought into computation . . . " The position is thus summed up in Simon's Income Tax, Second Edition, Vol. II, paragraph 230, at page 203:
"In computing the profits of a trade it is the normal accoun tancy practice to allow as an expense any sum in respect of liabilities which have accrued over the accounting period, and to make a deduction of such sums from the profits. Following the decision in Peter Merchant Ltd. v. Stedeford Inspector of Taxes ((1948) 30 T C 496) however, it appears that the nature of liabilities which may be deducted on business and accountancy principles does not accord with the nature of liabilities deductible for income- tax purposes. For income‑tax purposes it was held that a dis tinction must be drawn between an actual, i.e., legal liability, which is deductible, and a liability which is future or contingent and for which no deduction can be made."
The position under section 10 (2) (xv) of the Indian Income- tax Act is the same, as the learned authors pointed out in Kanga and Palkiwala's Income‑tax, Third Edition, at page 500:
"This clause allows deduction only in respect of expenditure. A contingent liability is not expenditure and therefore cannot be subject of deduction under this clause."
Thus the position is that, even had the assessee firm in this case debited itself with the entire amount of Rs. 1,19,177 in the year of account 1942‑43, it would have represented only an estimate of its contingent liability and would not have furnished a real basis for a claim to deduct that amount under section 10 (2) (xv) of the Act. What the assessee really asked for in this case was that the expenditure actually incurred in its year of account 1945‑46 should be related back to the year of account 1942‑43 in computing the assessable profits for 1942‑43. There should be no difficulty in repelling that claim. The position is thus summed up in Simon's Income Tax, second edition, Vol. II, paragraph 181, at page 161:
"When a sum has been charged as a trade expense for a certain accounting period, no adjustment of the amount can, as a rule, be made., if, however, a liability had accrued in the accounting period in question but the amount to be charged is subsequently altered, there may be a case for re‑opening the account for the previous period so as to substitute the ascertained amount for the amount charged for that period. The question is to some extent a question of fact, but the principle is that is the liability accrued in the earlier period, the subsequently ascertained amount must be related back, to that period; while if no liability had accrued in the earlier period, the item has to be brought into account for the period in which the liability first arose."
In the case of the assessee it was only a contingent liability in 1942‑43. The liability arose in the year of account 1945‑46 when the claim was made, and after it had been admitted the liability of the assessee was ascertained. It could not be related back as a proper item of expenditure in 1942‑43.
The learned counsel for the assessee invited our attention to Severne v. Dadswell (1) where it was held that, if on the discontinuance of trade a payment for work already done has not been finally settled, the accounts could be reopened so as to bring in a payment for such work, even though it is gratuitous, which is made thereafter. That related to a receipt after the period of account. In view of the true principles applicable to relating back of expenses, we see no scope for extending the principle laid down in Dadswell's case to the claim of the assessee.
Our conclusion on this part of the case is that, even if the sum the assessee has eventually to pay in 1945‑46 as liquidated damages for breach of its contractual obligation had constituted a permissible deduction under section 10 (2) (xv) of the Act, such a claim could not have been allowed in the assessment year 1944‑45 in computing the assessable profits for the accounting year 1942‑43.
We shall next deal with the question whether the requirements of section 10 (2) (xv) could be satisfied, i.e., whether this expendi ture had been laid out or expended wholly and exclusively for the assessee's business.
What the Income‑tax Act in England does not permit among other things is (1) any disbursements or expenses not being money (1) 35 Tax Cas. 649 wholly and exclusively laid out or expended for the purpose o: trade (rule 3a) and (2) any loss not connected with or arising out of trade (rule 3e). The interdependence of the two provisions as well as the distinction between them was pointed out by Finlay, J., in Allen v. Farquharson Bros. & Co. ((1932) 17 Tax Cas. 59 at 64):
" . . . . . . . .no doubt they do run rather close to each other, but I cannot help thinking that there is a distinction between (a) and (e). Now a case might be put in which it was not very easy to say whether a thing was a disbursement or expense or was a loss. It is conceivable‑such things sometimes happen‑that there may be cases in which a thing might fall alternatively it might be either within (a) or within (e) but, nontheless, I do think that there is a distinction to be drawn between the two. (a) relates to disbursements;, that means something or other which the trader pays out; I think some sort of volition is indicated. He chooses to pay out some disbursement; It is an expense it is something which comes out of his pocket. A loss is something different. That is not a thing which he expends or disburses. That is a thing which, so to speak, comes upon him as extra. It is not very easy to formulate the thing but it is easy enough to put illustrations falling on one side or the other of the line which may show what is, I think, the distinction, and the real distinction, between these things."
In this case we are concerned with a disbursement or expense; but unless it was connected with or arose out of the assessee's business there could be no further question of the expendi ture having been incurred wholly and exclusively for its business.
In the oft‑quoted passage from the speech of Lord Loreburne, L. C., in Strong v. Woodifield ((1906) A C 448 at 452) he laid down:
"In my opinion, however, it does not follow that if a loss is in any sense connected with the trade, it must always be allowed as a deduction; for it may be only remotely connected with the trade, or it may be connected with something else quite as much as or even more than with the trade. I think only such losses can be deducted as are connected with it in the sense that they are really incidental to the trade itself. They cannot be deducted if they are mainly incidental to some other vocation or fall on the trader in some character other than that of trader. The nature of the trade is to be considered. To give an illustration, losses sustained by a railway company in compensating passengers for accident in travelling might be deducted. On the other hand if a man kept a grocer's shop, for keeping which a house is necessary, and one of the window shutters fell upon an injured a man walking in the street, the loss arising thereby to the grocer ought not to be deducted. Many cases might be put near the line, and no degree of ingenuity can frame a formula so precise and comprehensive as to solve at sight all the cases that may arise."
What Lord Davey observed in the same case has been applied as consistently by Courts in India as in England. Lord Davey said:
. . . . . . for the purposes of the trade'. These words are used in other rules and appear to me to mean for the purpose of enabling a person to carry on and earn profits in the trade, etc. I think the disbursements permitted are such as are made for that purpose.
It is not enough that the disbursement is made in the course of, or arses out of, or is connected with, the trade, or is made out of the profits of the trade. It must be made for the pur poses of earning the profits."
The application of these principles has led to the position which maybe taken as well settled now, that payments of penalties for infraction of law fall outside the scope of permissible deduc tions. The penalty in any such case is imposed as a punishment on the offender as a responsible person owing obedience to the law. Its nature severs it from' the expense of trade. It is not incurred by him in his character of trader.
The principle laid down by Rowlatt, J., in the Commissioners of Inland Revenue v. E. C. Warnes & Co. Ltd. (12 Tax Cas. 227) and followed by him in Commissioners of Inland Revenue v. Alexander Von Glehn & Co., Ltd. (12 Tax Cas. 232) was approved of by the Court of Appeal in Von Glehn case.
In Warnes' case Rowlatt, J., observed:
"I may shelter myself behind the authority of Lord Loreburn, who, in his judgment in the House of Lords in Strong & Co. v. Woodifield said that it is impossible to frame any formula which shall describe what is a loss connected with or arising out of a trade . . . but it seems to me that a penal liability of this kind cannot be regarded as a loss connected with or arising out of a trade. I think that a loss connected with or arising out of a trade must, at any rate, amount to something in the nature of a loss which is contemplable, and in the nature of a commercial loss. I do not intend that to be an exhaustive definition, 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 that is a loss connected with or arising out of the trade."
In Von Glehn's case Lord Sterndale, M. R pointed out at page 238 of the report:
"Now . . . such proceedings as those are not technically criminal proceedings. I do 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. It is in fact, under the section, a penalty."
At page 237 the learned Master of the Rolls pointed out that no moral obliquity attached itself to the conduct of the assessee who had to pay a penalty, but he observed that that made no difference. At page 238 the learned Master of n, the Rolls observed:
"Now what is the position here This business could perfectly well be carried on without any infraction of the law at all. This penalty was imposed because of an infraction of the law and that does not seem to me to be, any more than the expense which had to be paid in the case of Strong v. Woodifield appeared to Lord Davey to be, a disbursement or expense which was laid out or expended for the purpose of such trade, nor does it seem to me, though this is rather more questionable, to be a sum paid on account of a loss connected with or arising out of such trade, . . . . . ."
Warrington, L. J., observed at. page 24:
"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 applies 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."
Scrutton, L. J., was of the view that the payment of the penalty in that case was an unfortunate incident that followed after the assessee, Von Glehn, had earned his profits.
The principles laid down in Warnes case and Von Glehn's case were applied in Catterniole v. Borax and Chemicals Ltd. ((1949) 31 T C 202). The law infraction of which was alleged in that case was the law of the United States. The assessee was assessed to tax under the English law. After referring to the dictum of Lord Sterndale in Yon Glehn's case that whether the proceedings in which the penalty was incurred were criminal proceedings or not did not matter, Croom‑Johnson, J., observed:
"I can see no distinction in law as to whether the proceedings were proceedings to recover sums of money of this sort pursued in an American Court or in an English Court."
Dealing with the contention that Borax and Chemicals Ltd., paid the money in question to ensure continuity of supplies from America, Croom‑Johnson, J., observed at page 211:
"But when one is asked to say that the 16,000 dollars were wholly and exclusively expended in order to get the supplies, so to do would be to shut one's eyes, as I think, to the plain facts. There is no evidence that it was paid "wholly and exclusively" for that purpose it was one of the reasons it was paid but it manifestly was not the only reason. One of the reasons was to get as cheaply as possible a settlement with the American authorities, paying something by way of compromise agreeing with one's adversary while one is in a way with him. That is really what happened here."
The learned Judge held that the payment was not an admissible deduction.
Though the claim for deduction was upheld in J. B. Advani & Co., Ltd. v. Commissioner of Income‑tax ((1950) 18 1 T R 557) it was on the application of the principle laid down by Lord Loreburn, L. C., in Strong v. Woodifield ((1906) A C 448). At page 563 Chagla, C. J., observed:
"Now, applying these two tests to the facts of the case, in my opinion, both the tests are satisfied because the loss is incidental to the trade because it was in the course of its business of selling stationery that the directors were charged with having contravened the law and it is also in its capacity as a trader that the company was called upon to defend its directors and the salesman."
Earlier the learned Chief Justice pointed out that the expenses for the litigation were not incurred by the persons charged with the offences themselves, but they were incurred by the company in order to save those persons from the consequences of the prosecution. We have referred to this case only to show that the principles laid down in Strong v. Woodifield were not departed from in deciding whether the deduction claimed by the assessee, Advani & Co., under section 10 (2) (xv) was permissible.
The learned counsel for the assessee referred to Chandrika Prasad Ram Swarup v. Commissioner of Income‑tax ((1939) 7 I T R 269) and Mohamad Abdul Kareem & Co. v. Commissioner of Income‑tax ((1948) 16 I T R 412) in support of his contention that the illegality of a transaction was not really relevant. In both these cases the question at issue was whether the income derived from a partnership, the constitution of which was illegal, was assessable to tax. These decisions leave untouched the principle which we referred to earlier, that a payment by way of penalty for an infraction of law will not come within the scope of section 10 (2) (xv) which requires that the expenditure should have been incurred wholly and exclusively for the assessee's business.
The next class of cases to which we shall refer decided again on an application of the principles laid down in Strong v. Woodifield dealt with payments by way of damages or compensation. In Income‑tax Appellate Tribunal Bombay v. Chaganmal Mangilal ((1946) 14 I T R 206) after considering the scope of the principles laid down in Warnes' case and Von Glehn's case and in Strong v. Woodifiled the learned Judges applied the principle laid down by the Court of Appeal in Scammel and Nephew Ltd. v. Rowles ((1940) 8 I T R (Suppl.) 41) and observed at page 215:‑
"The assessee Seth Chhaganmal Mangilal was not convicted for infringement of the trade mark. The suit against him was not decided on merits. An appeal was filed against an interlocutory order in a pending suit. The compromise of the claim did not amount to an admission that he had committed an infringement of the trade mark. Instead of carrying on an expensive and uncertain litigation he considered it more prudent to compromise the claim in order to minimise his losses or to save him from the payment of damages in case the suit was ultimately decided against him. The amount of Rs. 2,000 which he paid was not on account of a penalty for infringement of the trade mark but was solely on account of costs incurred by the plaintiff in the suit . . . . .In the carrying on of his business he was involved in a litigation and he was bound to defend the case and conduct it in a prudent manner which would be for his benefit and would minimise his losses. The expenditure was laid out or expended wholly and exclusively for the purpose of such business.
We fail to see how this decision, where the facts as found were totally different from those we have to consider in this case, helps the assessee.
In Scammell and Nephew Ltd. v. Rowles the company paid 7,500 in settlement of a claim for damages for defamation. That payment was under a compromise entered into between the assessee company and Mr. Toms. The claim of the assessee company, that the payment constituted a permissible deduction, was upheld by the Court of Appeal. Affirming the decision of Lawrence, J., at page 53, Greene, M. R., pointed out:‑
. . . . . . . . There is no evidence upon which the Commissioners could find that" the object of the appellant‑company in entering into the compromise was anything except to obtain payment of as much of the balance of the account as they could persuade Mr. Toms to agree to, and that account being, us I have said, a trading account, it seems to me that the compromise was a compromise effected for the purpose of the company's trade and for the purpose of enabling them to recover the payment of a trading debt owing to them from a customer, which would come into computation in their trading account. On that basis, payments made as a condition of obtaining that compromise which secured that payment to them would have been payments wholly and exclusively laid out or expended for the purposes of the appellant‑company's trade."
The other basis on which the claim for the deduction was upheld was that it was payment to get rid of a trading relation that was disadvantageous (see the observations of Greene, M. R., at page 55). The test to apply was the same. Only in the case of Scammell and Nephew Ltd. v. Rowles the finding was that that test was satisfied.
The decision in Herald and Weekly Times Ltd. v. Federal Commissioner of Taxation (48 C L R 113) was the one on which the learned counsel for the assessee relied to a considerable extent. In that case the appellant assessee, which was the proprietor and publisher of an evening newspaper, claimed to deduct from its assessable income moneys paid by way of compensation, either before or after judgment, for damages in respect of defamatory matter published in that paper, and amounts incurred by way of costs in contesting the claims of persons defamed and in obtaining advice in regard thereto. The Court by a majority held that the monies so disbursed were wholly and exclusively laid out or expended for the production of assessable income. That decision of the majority was based on the application of tests laid down in Strong v. Wood field. Gavan Duffy, C. J., and Dixon, J., pointed out that the distinction between the case before them and Strong v. Woodifield lay in the degree of connection between the trade or business carried on and the cause of the liability for damages. At page 119 the learned Judges pointed out ;‑
"When it appears that the inclusion in the newspaper of matter alleged by claimants to be defamatory is 'a regular and almost unavoidable incident of publishing it, so that the claims directly flow from acts done for no other purpose than earning revenue, acts forming the essence of the business, no valid reason remains for denying that the money was wholly and exclusively expended for the production of assessable income." Earlier at page 118, the learned Judges observed:‑
"None of the libels or supposed libels was published with any other object in view than the sale of the newspaper. The liability to damages was incurred or the claim was encountered, because of the very act of publishing the newspaper. The thing which produced the assessable income was the thing which exposed the taxpayer to the liability or claim discharged by the expenditure."
Rich, J., put it thus:
"As publication is the common source of income and liability, the necessary connection between the carrying on of the business of newspaper and the liability which causes the expenditure is complete."
The claim of the assessee before us is on a totally different footing, as we shall presently show.
Equally strong reliance was placed by the learned counsel for the respondent on Mask & Co. v. Commissioner of Income‑tax Madras ((1943) 11 I T R 454). In that case the assessee firm, which was carrying on business in crackers, entered into a contract with other proprietors in the same line of business, under which the assessee's goods were to be sold at certain specified rates. But in breach of this contract the assessee sold crackers at lower rates. In a suit for damages for' breach of contract instituted by the other parties a decree was passed against the assessee for Rs. 5,000 and costs. The assessee claimed the amount paid by the assessee under the decree as lawful deductions. That claim was negatived. After referring to the principles laid down in Warnes case and Von Glehn's case' the learned Chief Justice observed at page 462
"In the present case, the assessee was not fined for a breach of law, but was made to pay damages for a breach of the contract entered into. The assessee's action in disregarding the undertaking given was palpably dishonest and we are of the opinion that the award of damages which followed did not constitute an expenditure falling within section 10 (2) (xii). It was not incidental to the trade."
The learned Chief Justice further observed
"This is not a case of conducting a business in a negligent manner ; it is a case of conducting a business in a dishonest manner."
In Baluswamy Iyer v. Commissioner of Income‑tax, Madras ((1955) 28 I T R 235) we had occasion to refer to the decision in Mask 8c Co. v. Commissioner of Income‑tax, Madras when the correctness of that decision was not challenged. The learned counsel for the assessee invited us to differ from the principles laid down in Mask's case. It may not be necessary to examine in this case the full implications of the decision in Mask's case or the correctness of the extension of the principles of the English decisions which it might involve. In any event we do not understand the learned Chief Justice to have laid down that, where a wilful breach of contract has been established, that is sufficient proof of dishonesty which would disentitle the assessee from preferring any claim under section 10 (2) (xv) of the Act for damages paid for breach of contract. As we shall presently show, it is not necessary to rest our decision in this case merely on the basis, that the conduct of the assessee before us, when he committed the breach of the contract, was palpably dishonest.
In Commissioners of Inland Revenue v. Great Boulder Proprietary Gold Mines Ltd. ((1952) 33 T C 91) Donovan, J., in dealing with the contention, that the 25,000 paid as damages by the company was for fraud and deceit on its part or was akin to such damages, observed at page 93
"If it is fraudulent and deceitful then the penalty it pays by way of damages cannot be deducted as a trading expense any more than could the penalty in Commissioners of Inland Revenue v. Alexander Von Glehn & Co. Ltd."
Possibly it was only the argument that was set out, because the learned Judge observed next:
"For the respondent‑company it was argued that even were the 25,000 damages, or akin to damages, for fraud and deceit it would still be entitled to deduct that sum in computing its taxable profits, but as this question in my view does not arise I say nothing about it."
The last of the cases we have to refer to on the question of damages is Fairrie v. Hall ((1947) 28 T C 200). In that case the assessee Fairrie had to pay 3,575, damages and costs, in an action for malicious libel. After referring to the principles laid down in Strong v. Woodifled Macnaghten, J., observed at page 205:
"In the present case the loss which the appellant has sustained, 550 damages and 3,025 costs, is in one sense a loss connected with his trade. Apart from his desire to injure
Mr. Rook, the appellant also desired to increase his own profits. He had that motive. He could only have increased his profits if he succeeded in giving an advantage to his own clients in Cuba or a disadvantage to the rivals of his clients. It is a case that falls, it seems to me exactly, within the words of Lord Loreburn, who said that the losses 'cannot be deducted if they are mainly incidental to some other vocation, or fall on the trader in some character other than that of a trader. The loss fell upon the appellant in this case in the character of calumniator of a rival sugar broker. It was only remotely connected with his trade as a sugar broker."
As we said, these cases were all virtually decided on the application of the tests laid down in Strong v. Woodified. It is not enough if the loss sustained or expenditure incurred is in some sense connected with the trade, for it may be only remotely connected with the trade, or it may be connected with something else quite as much or even more than with the trade. Only such losses can be deducted as are connected in the sense that they are really incidental to the trade itself. It is not enough that the disbursement is made in the course of, or arises out of, or is connected with, the trade or is made out of the profits of the trade. It must be made for the purposes of earning the profits.
Before we discuss whether these tests have been satisfied by the assessee, we have to verify what the nature of the payment was. No doubt the assessee firm paid the amount of Rs. 1,19,177 in discharge of the contractual obligation it had entered into with the India Coffee Board to pay an ascertained sum as liquidated damages for breach of contract. The contractual obligation, the performance of which the assessee defaulted, was to export the coffee which had been sold to it at a concessional price, only because it was earmarked for export abroad. The other contracting party, the India Coffee Board, was a statutory body created by the Coffee Market Expansion Act (Act VII of 1942). The control the India Coffee Board exer cised over the sales of coffee, whether for ultimate export out of India or for sales within India, had a statutory basis. It is true the Act itself did not in express terms prohibit sale within India of coffee sold by the Board for export. That what was broken by the assessee was a term of the contract and not an express provision of law does not, in the circumstances of this case, make any real difference to the principle to be applied. It was in exercise of the statutory duties imposed on the Board to regulate and control sales of coffee produced in India, in the interests of the national economy of the country, that the Board, through the instrumentality of a contract, virtually laid an embargo on sale within India of coffee that had been sold at a concessional rate for the specified purpose of export. It was that that the assessee transgressed when it deliberately and without any apparent excuse sold the coffee within India. What it had to pay was no doubt called liquidated damages. But the payment was really akin to a penalty for committing an act opposed to public policy, a policy that underlay the Act, which the Act left to the India Coffee Board to enforce. The assessee could and should have carried on its business in coffee in conformity with the obligations imposed upon ‑it, no doubt, by a contract, but under the authority of the Coffee Market Expansion Act and in furtherance of the policy of control that underlay that Act. It could have carried on the business without infraction of its obligations. That should have been its normal course of conducting its business.
Could it be claimed by the assessee, in the circumstances of this case, that what it did by selling the coffee within India was incidental to the trade itself that it carried on. Its business was among other things to buy and sell coffee. Purchases and sales of coffee were regulated by the Act and by the India Coffee Board under the provisions of that Act. It was subject to that statutory control that the assessee had to carry on its business. Transgression of that control was not a normal incident of that business, though it was in one sense connected with its business. If it had not been a dealer in coffee it could not have been in a position to buy coffee for export; and if it had not bought coffee for export it would not have been in a position to sell that coffee within India. But that connection is not enough to sustain the claim, that what the assessee had to pay the India Coffee Board was inextricably mixed up with its normal line of business. The breach of its contractual obligation to the Board was not in the normal course of business, and the liability the assessee had to discharge for such a breach was not incidental to the trade itself that it carried on.
From what we have said above it should be clear that it was not a case of a payment of damages for a mere breach of contract with nothing more. It was not of course a case of penalty paid under the terms of a statute for contravention of any specific statutory provision. In the circumstances of this case, the liquidated damages claimed and paid was, however, more akin to a penalty than the damages suffered for breach of contract in the course of normal trading activities, whether or not that breach of a contract was also dishonest. That is why we said that it may not be necessary to rest our decision in this case on the rule laid down in Mask's case. In our opinion it is the principle laid down in Von Glehn's case that should be extended and applied to negative the claim of the assessee in this case. To adopt the words of Sterndale, M. R., in Von Glehn's case the assessee's business could perfectly well be carried on without any infraction of the obligations laid on the assessee by the India Coffee Board, entrusted with the statutory duty of controlling and regulating sales of coffee. A penalty was imposed because of an infraction of these obligations and the money was not expended or laid out for purposes of the trade which the assessee carried on. Or in the words of Scrutton, L. J.
"Were these fines made or paid for the purpose of earning the profits The answer seems to me obvious, that they were not, they were unfortunate incidents which followed after the profits had been earned.
The learned counsel for the assessee relied on Devarajulu Chetty v. Commissioner of Income‑tax ((1950) 18 I T R 357), in support of his contention, that the sum of Rs. 1,19,177 paid in 1945‑46 as damages should really be viewed as addition to the price that the assessee had to pay for the coffee it had purchased and sold in 1942‑43. We are unable to see any real basis on the facts proved in this case to apply the principle laid down in Devarajulu Chetty v. Commissioner of Income‑tax. It could not be the case of the assessee that it purchased the coffee for sale in India, with a pre‑existing contractual obligation to pay a higher price, to be quantified on ascertainment at a later stage. It should be remembered that it was in breach of its contractual obligations that the assessee sold the coffee in India.
The Tribunal, in our opinion, was right in rejecting the claim of the assessee. The requirements of section 10 (2) (xv) were not satisfied. The payment was not even really incidental to the trade itself, as that principle was explained by Loreburn, L.C. in Strong v. Woodifield.
We answer the question referred to us in the negative and against the assessee. Since the assessee has failed, the assessee will pay the costs of this reference. Counsel's fee Rs, 250.
Question answered in the negative.
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