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Reference Case No. 21 of 1966, decided on 9th November 1967.

S. 10(2)(xvi)‑Business 'expen diture ‑ No allowance can be granted under S. 10(2)(xvi) on account of amount paid as penalty for infraction of law Penalty imposed for contravention of Customs Regulations and borne by assessee in terms of indemnity bond entered into by him with supplier of goods‑Such payment not "wholly and exclusively for purpose of business"‑-Held, not admissible expenses.

Messrs Haji Aziz & Abdul Shakoor Brothers v. The Income‑tax Commissioner, Bombay City A I R 1961 S C 663 fol.

British Insulated and Halsby Cables Ltd. v. Atherton 1926 A C 205 ; Commissioner of Income‑tax, Bombay City v. Bai Shirinbai K. Kooka, Bombay A I R 1956 Bom. 586; Lord's Dairy Farm Ltd. v. Commissioner of Income‑tax, Bombay North, Kutch and Saurashtra, Baroda A I R 1955 Bom. 352 ; Sir Kikabhai Prem chand, Kt. Bombay v. Commissioner of Income‑tax (Central) Bombay A I R 1953 S C 509 ; Eastern Investments Ltd. v. Com missioner of Income‑tax, West Bengal A I R 1958 S C 278 and Commissioner of Inland Revenue v. Alexander von Glehn & Company Limited 2 K B 553 ref.

Haider Mota with Mozammel Haque Khan for Applicant.

Afzalul Haque for, Respondent.

Dates of hearing : 7th, 8th and 9th November 1967.

‑The following question has been referred to us at the instance of the assessee under section 66(1) of the Income‑tax Act by the Income‑tax Appellate Tribunal, Dacca :‑

"Whether on the facts and in the circumstances of the case the Tribunal was correct in holding that penalties imposed for contravention of Customs Regulations and borne by the assessee in terms of the indemnity bonds entered into between the assessee and Messrs Eastern Rice Syndicate are not admissible expenses under the Income‑tax Act "

In answering the question referred to us the following relevant facts are to be taken notice of. Yasin (East Pakistan) Ltd., Chittagong (hereinafter called the assessee) is a private limited company and deals with cloth and other kinds of goods. In: the assessment years 1958‑59 (supplementary) and 1959‑60 the assessee was not allowed by the Income‑tax Officer any allowance on account of the Customs Penalty and demurrage. In the year 1958‑59, the Income‑tax Officer disallowed a total sum of Rs. 63,580 of which a sum of Rs. 52,504 was on account of penalty imposed by the Customs Department and a sum of Rs. 11,076 was on account of the demurrage in taking delivery of the goods. In so far as assessment years 1959‑60 is concerned, the total amount disallowed was a sum of Rs. 1,85,377 of which the amounts for Customs penalty and the demurrage were Rs. 1,18,160 and Rs. 67.270 respectively. The Appellate Assistant Commissioner before whom an appeal was preferred by the assessee maintained the order of the Income‑tax Officer in so far as the Customs penalties for a sum of Rs. 52,504 and Rs. 1,18,160 for the assessment years 1958‑59 and 1959‑60 were concerned. He, however, gave allowance for the demurrage paid at Rs. 11,076 and Rs. 67,217 for the two years as he thought these were admissible expenditure. The assessee was still dissatisfied and preferred an appeal to the Income‑tax Appellate Tribunal which affirmed the order of the, Appellate Assistant Commissioner and dismissed the appeals.

The assessee then submitted an application under section 66(1) of the Income‑tax Act (hereinafter called the Act) for reference of two questions of law arising out of the orders of the Appellate Tribunal. The Tribunal as stated at the out set referred for our opinion the question set out above.

Mr. Haider Mota, learned counsel for the assessee in an able argument attacked the decision of the Appellate Tribunal on the ground that the penalty was to be disallowed in so far as the importer was concerned but his clients who were not importers claimed deductions for these payments as the expen diture was incurred solely and exclusively for the purpose of the business. His contention is that the amounts were paid pur suant to an indemnity bond and the assessee was unable to take delivery of the goods unless such payment was made. Mr. Hyder Mota contends that the amounts so paid were deductable under subsection (1) of section 10 of the Act. His contention is that the real profits are to be ascertained under subsection (1) with reference to the costs of the goods and the realisation made by the sale of those goods. He also argues that sub section (2) of section 10 of the Act deals with certain specific eases of permissible deductions and his case clearly comes within subsection (2) of section 10 of the Act. He, therefore, submits that the Revenue erred in reaching the conclusion noticed above.

Mr. Afzalul Haque also strenuously argues that a penalty which enters into the costs structure cannot come within the ambit of clause (xvi) of subsection (2) of section 10 of the Act.

The Appellate Assistant Commissioner took notice of the Assessee's contention in the following terms :

"The assessee submits in writing that the holder of the import Licences was Messrs Eastern Rice Syndicate, Chittagong. He purchased the goods Forward' from the importer under contracts of sales and indemnity Bonds on payment of profit @ on C & F value. The penalty was imposed on the Licence holder and as such it constitutes the cost ,price of the goods in his hands."

The Appellate Assistant Commissioner expressed the opinion:

" . . . I am unable to subscribe to the assessee's view. The assessee's main argument that it was Messrs Eastern Rice Syndicate that as an importer suffered the penalty for the contravention of the customs and the trade control regulations and that the assessee only paid the penalties on behalf of the importer, and, therefore, to him the penalties and demurrages only constituted along with C & F value on the profit the cost price, appears to be wholly nullified by the Indemnity Bonds' entered into with the importer from whom the goods purchased on forward contract basis."

He then examined the facts of the case and observed:

"Subsequent to this agreement the assessee entered into Indemnity Bonds' with the sellers Messrs Eastern Rice Syndicate whereby the goods Were agreed to be sold by the Indemnified (Eastern Rice Syndicate,) to the Indemnifiers' (the assessee) on the express agreement that in addition to the price the indemnifiers will pay all the duty required to be paid by the customs authorities."

The Appellate Commissioner, however, thought that the amounts paid as penalty could not be deducted.

The Tribunal also dismissed the appeal observing as follows :‑

"True, the assessee himself did not contravene the regula tion. But before signing the Indemnity Bond he knew what goods he had contracted to purchase from Eastern Rice Syndicate in what manner the declaration form was filled up and filed by the importer. Knowing all these he had signed the. Indemnity Bond. Though under original contract the assessee was not to pay any penalty that might be imposed for contravention of the Sea Customs Act yet he had voluntarily entered into an agreement with Eastern Rice Syndicate to pay penalty if imposed by the Customs authority. The pay ment was we should say a voluntary payment which the assessee was competent to make but this cannot be regarded as an expense which is incidental to, trade."

Before we proceed further we might notice one contention of Mr. Haider Mota. He says that the Tribunal dismissed the appeal for, it thought that the assessee was not entitled to deduction if the payment was voluntarily made. This contention of, the learned counsel does not take notice of the observation that the Tribunal has made, as quoted above, that merely because a voluntary payment has been made, it cannot be regarded as incidental to trade. What the Tribunal felt was that a payment voluntarily made should also be incidental to trade, and unless it is so there cannot be a claim for deduction. It is not observed by the Tribunal that deduction cannot be claimed for a voluntary payment although it may be incidental to trade.

For a closer examination of the points raised by learned counsel for assessee, a reference to subsection (1) of section 10 is necessary. Subsection (1) is as follows:

"10(1) Subject to the provisions of this Act, the tax shall be payable by an assessee under the head profits and gains of business, profession or vocation in respect of the profits or gains of any business, profession or vocation carried on by him."

This provision of law appears to us to be quite clear. It says that tax is to be paid on account of profits or gains of business, profession or vocation carried on by an assessee and this liability to pay tax is subject to the provisions of the Act.

It is contended by Mr. Afzal‑ul‑Huq that the taxing authority, has merely assessed the profits and gains made by the assessee. According to him it cannot therefore be said that anything has been done in contravention of law. Mr. Haider Mota however referred to this subsection to emphasise that the assessee is not liable to payment of tax, unless he earned income as profits and gains of a business and therefore he was, on the terms of this subsection itself, entitled to deduction for an expenditure which was incurred by him in earning the profits and gains, for, the permission to levy tax under this subsection is only for profits and gains of a business:

This contention of Mr. Haider Mota is not contested by Mr. Afzal‑ul‑Huq What is contended by Mr. Huq is that deduction from the profits and gains appearing in the books of accounts of the assessee cannot be allowed under clause (xvi) of subsection (2) of section 10, on account of the penalty paid by the assessee for and on behalf of the importer Messrs Eastern Rice Syndicate, Chittagong, from whom the goods were purchased by the assessee.

We should at this stage quote subsection (2) of section 10 and clause (xvi) of the said subsection which are as follows :‑‑

(2) "Subject to the provisions of this Act such profits or gains shall be computed after making the following allowances, namely -‑

* * * * * * * * * *

(xvi) "any expenditure not being in the nature of capital expenditure of personal expenses of the assessee laid out or expended wholly and exclusively for the purpose of such business; profession or vocation :"

Mr. Haider Mota's contention, on the basis of subsection (2) of section 10 and clause (xvi) is that the profits and gains spoken of in the opening words of subsection (2), shall be computed only after granted certain allowances one of which is contemplated under clause (xvi). We are, therefore, now to examine the provisions of clause (xvi). It is provided therein that an ex penditure laid out or expended wholly or exclusively for the purpose of such business, profession or vocation shall be deducted from the gains and profits of the said business. The result of this case, therefore, turns on the proper appreciation of the expression used in this clause. The precise question therefore is, if it is possible for us to say that the penalties paid, in the facts and in the circumstances of the case, were "wholly and exclusively for the purpose of such business" of the assessee. We should at this stage say that we are in complete agreement with a decision of Indian jurisdiction in the case of Messrs Haji Aziz & Abdul Shakoor Bros. v. The Income‑tax Commissioner, Bombay City (A I R 1901 S C 663) in which the Supreme Court of India clearly held that no expense which was paid by way of penalty for breach of law, even though it may involve no per sonal liability, could be said to be an amount wholly and exclusively laid for the purpose of business of the assessee and fine paid by the assessee is not liable to deduction under that section. Mr. Haider Mota submits that he is not at all hit by this decision, for, in that case the penalty was paid by Haji Aziz & Abdul Shakoor Bros., who, had to pay penalty for violation of law committed by themselves and in the present case the infraction of law has been committed by the firm from whom the goods were purchased by the assessee.

Mr. Afzalul Huq, however, contends that it makes no difference, for, by this device the payment of income‑tax is being sought to be avoided by the assessees and also by the importers from whom they have purchased the goods. Mr. Huq's firm contention is that the assessee was entitled to the goods by virtue of the contract entered between the assessee and the importer on 31st May 1957 and he draws our attention to the condition that the relative goods are sold to meet with the profits of 75% on C & F value of the goods. He emphasises that this contract entitles the assessee to receive the goods on payment of 75% of the costs and freight value of the goods. He clarifies the position by saying that the penalty does not come within the meaning of expression "cost and freight" and therefore it was not incidental expenditure to be incurred by the assessee in paying the penalty. We are, however, to consider the indemnity bond by which the assessee was compelled to pay the penalty. In this connection Mr. Afzalul Hoque claims that this Court should not disregard the findings of fact arrived at by the Tribunal as quoted earlier, in the judgment. The Tribunal observed that the indemnity bond was signed by the Assessee knowing these circumstances. The Tribunal further said that under the original contract the assessee was not to pay penalty which might be imposed for contravention of the Sea Customs Act. On these findings of fact, Mr. Huq claims that it cannot be said that the payment was made for commercial purposes or the expenditure was incidental to the business of the assessee firm. We are of opinion that no allowance can be granted under clause (xvi) of subsection (2) of secti6n 10 on account of any amount paid by way of penalty for infraction of law. The importer, Eastern Rice Syndicate would not get any exemption on this account.

Now the question is if the assessee with whom we are concerned can claim deduction for the payment made on account of penalty. The assessee can claim it if it is found in the facts and circumstances of the case that the payment was incidental to trade. It is true if the Tribunal is of opinion that only an amount which was spent of necessity is allowable as deduction, it is clearly in error, for, it has been clearly held in the case of British Insulated and Helsby Cables Ltd. v. Atherton (1926 A C 205) that it is to be shown that the money was expended as of necessity and voluntarily and also to facilitate a commercial purpose. The question therefore still is if the payment was made for commercial purpose. In the case before us it will be seen that there was already in existence a valid contract for sale on the basis of which the assessee was entitled to receive the goods and there is also a finding of fact that the indemnity bond was executed with knowledge of the manner in which the declaration form was filled up by the importer Learned Advocates for the assessee as well as for the Commis sioner of Income‑tax frankly told us that they could not lay their hands on any case in which an assessee paid penalty for the firm or a person from whom the former purchased the goods and yet was allowed deduction under clause (xvi) of subsection (2) of section 10 of the Act.

Mr. Haider Mota placed reliance on the case of Commissioner of In come‑tax, Bombay City V. Bai Shirinbai K. Kooka Bombay (A I R 1956 Bom. 586). In that case Chagla, C. J. observed that it was settled law that what was to be brought to tax was the real profits of a business and in order to find out the real profits, the accounts of that business kept on commercial principles must be construed in their normal and natural sense, in a sense in which no commercial man would misunderstand. We are in respectful agreement with this observation. But we cannot say that it would be in accordance with the commercial principle to pay the penalty for the importers of the goods when such payment was neither necessary nor expedient for the purposes of the business of the assessee.

Next case relied on by learned counsel for the assessee is that of Lord's Dairy Farm Ltd. v. Commissioner of. Income‑tax, Bombay North, Kutch and Saurashtra, Baroda (A I R 1955 Bom. 352). Learned counsel relies on the following observation of Chagla, C. J:

"Section 10(2)(xv) deals with any expenditure laid out or expended wholly or exclusively for the purpose of business, profession or vocation. Therefore, the deduction contemplated by S. (2) (xv) must arise out of a voluntary act on the part of the assessee."

We should at this stage say that clause (xv) referred to above, is clause (xvi) of our Act. But the observation quoted above cannot be read divorced from other‑ observations made in the case referred to above. The learned Chief Justice also observed that it was necessary to; show that the amount was one which was wholly and exclusively for the purpose of business, profession or vocation. It will not do if it is merely voluntary ; it must also satisfy the requirement of being wholly and exclusively for the purpose of business concerned.

Our attention has also been drawn to the observation made by the Supreme Court of India in the case of Sir Kikabhai Premchand, Kt. Bombay v. Commissioner of Income‑tax (Central) Bombay, (A I R 1953 S C 509) in which case it was observed that it was a well recognised judicial principle that in revenue cases regard must be had to the substance of the transaction rather than to its mere form. True, it should be so construed, but in this case taking the facts and circumstances into consideration it appears to us that it cannot be said that it was done for the purpose of business. Mr. Haider Mota has also drawn our attention to the case of Eastern Investments Ltd. v. Commissioner of Income‑tax, West Bengal (A I R 1958 S C 278). We should at this stage say that that was a case under subsection (2) of section 12 and not under clause (xv) of subsection (2) of section 10 of the Indian Act but it is true that subsection (2) of section 12 also contains within itself expressions similar to those with which we are concerned. But in the case before us we are unable to say that the payment of the penalty which was not required by the contract for sale referred to above, was made for earning profits from the business. This question came to be considered in the case of Commissioner of Inland Revenue v. Alexander von Glehn & Company Ltd. (2 K B 553). In that case Lord Sterndale M. R. was considering if an infraction of law for which the assessee was not responsible could be said to have been incurred for the purposes of the trader for a loss connected with or arising out of trade or business and his Lordship observed:

"Of course, as Rowlatt, J, said, in a sense you may say that it was connected with the trade, because if the trade had not been carried on the penalty would not have been incurred ; there would have been no 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 that it was a disbursement under Rule 1., which applies to the first two cases, that is to say, "money wholly and exclusively laid out or expended for the purpose of such trade."

Warrington, L. J. observed in the same case:

"A firm or a company carrying on business may within certain limits treat as a deduction from profits such sum as it pleases, but for the purposes of income‑tax the deductions which may be allowed from the gross profits are strictly regulated by the Income‑tax Acts."

We would also say that the allowance as clamed by the assessee can only be granted if it comes within the provisions of clause (xvi) of subsection (2) of section 10 of the Act. Referring to the penalty paid, Warrington; L. J. further observed:

"Now it cannot be said that this disbursement was made in any way for the purpose of the trade or for the purpose of earning the profits of the trade."

Scrutton, L. J. referred to the question itself and observed:

"The question which this case raises is whether a trader in presenting the balance of profits and gains for income‑tax can deduct, either in getting at the balance or after he has got at it, penalties which have been imposed on him for carrying on his trade in an unlawful manner and I confess that to the question so stated it seems to me that the obvious answer is 'of course he cannot."

It is true Mr. Haider Mota is still entitled to say that in that case the penalty was paid by the company which itself violated the law but we take the view that if the company cannot claim exemption, then payment made by someone on its behalf cannot get the exemption. We are unable to say in the facts and circumstances of the case before us that the payment, made by the assessee was wholly and exclusively for the purposes of the business. The contention of Mr. Haider Mota that the Indemnity B Bond entitles him to claim that the payment made thereof constituted an additional price paid for the goods is of no substance. We have already indicated that it was not necessary for the assessee to pay the penalty, for the assessee had already title to the goods. We must also observe that the character of the payment which was penalty in this case‑ would not be changed simply because the payment was made by someone on behalf of the importer on whom it was imposed.

On the facts found by the Tribunal, we are clearly of opinion that the conclusion reached by it is correct and we accordingly answer the question referred to us in the affirmative. We direct the assessee to pay costs to the respondents.

‑I agree.

S. Q. Reference answered in the affirmative.

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