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Case Referred No. 90 of 1953, decided on 19th December 1956.
S. 10(2)(iii)‑Interest on borrowed capital‑Whether Income‑tax Authorities have power to disallow, amounts paid in excess of what they consider reasonable rate‑Loans from shareholders to the extent of amounts paid up on their shares‑Interest payable at the same rate as dividends subject to minimum of 6%‑Disallowance of amount in excess of 6% Legality.
All that section 10(2)(iii) of the Indian Income‑tax Act requires, to entitle an assessee to claim an allowance in respect of interest paid on borrowed capital is : (i) that the money, i.e., the capital, must have been borrowed by the assessee, (ii) the amount must have been borrowed for the purpose of the business of the assessee, and (iii) the assessee should have paid as interest the amount claimed as an allowance. If these conditions are satisfied the Income‑tax authorities are bound to allow the amount which has in fact been paid as interest ; they have no power to reduce the quantum paid as interest to anything considered reasonable by them on subjective or objective standards ; the fact that the stipulated rate of interest was variable and was made dependent upon the rate of dividend the company declared in the relevant year, would not alter the nature of the transaction or make it any thing other than a loan. It is the quality of the interest that matters and not its admeasurement.
A private company with 21 shareholders was in urgent need of capital to carry on its business, and, as there were statutory restrictions on the further issue of capital, passed a resolution authorising its managing agent to borrow money from the share holders of the company who were willing to advance loans, to the extent of the paid‑up value of their holdings. The loans were to carry interest at the same rate as the dividends declared in the corresponding years subject to a minimum rate of 6 percent. per annum. Seventeen of the shareholders availed themselves of the offer and received for the years 1947, 1948 and 1949 interest at .the rates at which dividends were declared in those years, viz., 10%, 20% and 12%. The Income‑tax authorities disallowed the interest paid in excess of 6 percent.
Held, that, as the genuineness of borrowing of capital for purposes of the business, and the fact of payment of the amounts claimed were not disputed, the disallowance of the interest in excess of 6% out of the amounts paid was not Justified in law.
In compliance with the requisition of the High Court under section 66(2) of the Indian Income‑tax Act in C.M.P. Nos. 12113, 12114 and 12115 of 1952, dated 9th April, 1953, we state the case agreed to by the parties and refer it to the High Court of Judicature at Madras.
2. The question of law on which the Tribunal has been directed to state the case is as follows:
"Whether on the facts and in the circumstances of this case, the disallowance of interest in excess of 6 percent. of the amount paid in respect of borrowed capital is justified in law "
We shall, therefore, confine ourselves as far as possible to the facts relevant to that question.
3. The assessee, Messrs East India Industries (Madras) Limited, Madras, is a private limited company carrying on busi ness in the manufacture and sale of waterproof paper, roofing felt, tarpaulins, etc. The assessee has an authorised capital of rupees 1,00,000 divided into 1,000 shares of Rs. 100 each which was fully subscribed and paid up.
4. The assessee required funds for the business which was expanding and as there were restrictions on capital issues, the shareholders of the assessee company at the general body meeting held on 31st December, 1944, authorised the managing agent to borrow money repayable in three years from shareholders willing to advance as loan to the extent of the paid‑up value of their holdings by two instalments, i.e. 50 percent. by the end of February, 1945, and 50 percent. by the end of March, 1945. Such loan was to bear a minimum interest of 6 percent. or the same rate as the dividend declared whichever is higher. If any share holder declined to advance such a loan, the managing agent was also authorised at his discretion to receive loans from any other shareholder on the same terms: A copy of the relevant resolution passed at the general body meeting held on 31st December, 1944, is annexed hereto as Annexure A' and forms part of the case. A notice dated 12th January, 1945, was accordingly issued to the shareholders who lent in all a sum of Rs. 75,000 by 31st March, 1945.
5. In the general body meeting of the assessee company held on 21st March, 1948, the shareholders authorised the managing agent to retain for a further period not exceeding three years the sum of Rs. 75,000 already borrowed from the shareholders and to call for the balance amount of Rs. 25,000 from them on the same old terms. A copy of the relevant resolution of the general body meeting held on 21st March, 1948, is annexed hereto as Annexure A‑1' and forms part of the case. A sum of Rs. 25,000 was thus further received from the shareholders and the total borrowal made by the assessee from the shareholders was Rs. 1,00,000.
6. The assessee declared dividends of 10 percent., 20 percent. and 12 percent. for the periods ended 31st December, 1947, 31st December, 1948, and 31st December, 1949, respectively, and in accordance with the aforesaid resolutions paid interest on the amounts borrowed from the shareholders at 10 percent., 20 percent. and 12 percent. in the respective years.
7. In computing the total income of the assessee for 1948 49, 1949‑50 and 1950‑51, assessment years (the previous years being 1947, 1948 and 1949, calendar years) the Income‑tax Officer disallowed the interest claim of the assessee on borrowals from the shareholders in excess of 6 percent. His reasons for so doing inter alia were that the assessee was charging interest from its debtors at 6 percent. only and paid interest to one of its creditors, the Canara Commercial Corporation Limited at 4 percent., that 'the assessee instead of increasing the share capital owing to the restrictions that were imposed obtained funds from the share holders and agreed to pay interest at the same rate as the dividend, that such payment was an appropriation of profit by the share holders and that, in the circumstances, interest at 6 percent. will be allowed on the amounts of loans used for the purpose of the business. The explanation of the assessee before the Appellate Assistant Commissioner for the payment of a higher rate of interest was that the loans were really an additional capital collected from the shareholders.
8. It was contended for the assessee before the Tribunal that the whole claim was allowable under section 10(2)(iii) of the Income‑tax Act as capital borrowed for the purpose of business and in the alternative, under section 10(2)(xv) as expenditure laid out or expended wholly and .exclusively for the purpose of such business The Tribunal for reasons stated in the order in I.T.As. Nos. 3009, 3010 and 6632 of 1950‑51, dated 5th January, 1952, (a relevant extract whereof is annexed hereto as Annexure B' and forms part of the case) negatived the contentions of the assessee and held that the additional payments which were linked with the declaration of the dividends and the profits earned was nothing but a device to distribute the profit made among the shareholders of the assessee company.
S. Swaminathan for the Assessee.
C. S. Rama Rao Sahib for the Commissioner.
The assessee is a private limited company with twenty‑one shareholders, and a fully subscribed capital of one lakh of rupees. The company carries on business in the manu facture and sale of waterproof paper, roofing felt, tarpaulins, etc. In view of some large orders it received from the military authorities the company required further money for its business. There was a statutory restriction in 1944 on any further increase of the capital issue of companies. The only alternative was to borrow the required amount. At the general body meeting of the shareholders of the company held on 31st December, 1944; the company resolved that" in view of the large sums required for the business the managing agent be authorised to borrow money from the shareholders of the company who are willing to advance as loan to the extent of the paid‑up value of the holdings by two instalments, i.e., 50 percent. by the end of February, 1945, and 50 percent. by the end of March, 1945, which will bear a minimum interest at 6 percent. or at the same rate as the dividend the directors may recommend for the period during which such loans are used in the business of the company whichever is higher. Such loans will be returned as and in the manner the directors may think fit, provided that such loans shall be repayable within three years from the date of the loans. If any shareholder does not advance any portion of the money that he is entitled to advance within the prescribed time such moneys the managing agent may at his discretion receive from any other shareholders over and above the amounts they are entitled to advance and such loans shall bear interest at the same terms as above", and the same was unani mously passed.
Out of the 21 shareholders only 17 availed themselves of the offer made by the company to borrow money from the shareholders. A sum of Rs. 75,000 was borrowed by 31st March, 1945, in the year of account of 1945. Under a resolution of the general body of the meeting held on 21st March, 1948, a further sum of Rs. 25,000 was borrowed on similar terms in the year of account of 1948.
The assessee's year of account was the calendar year. In 1947, 1948 and 1949 the company declared a dividend of 10%, 20% and 12% respectively. Interest at the corresponding rates were paid on the loans borrowed from the 17 shareholders.
In the relevant assessment years 1948‑49, 1949‑1950 and 1950‑1951, the company claimed that the total amount expended in the corresponding accounting years by payment of interest at the rates mentioned above should be deducted in computing its assessable income. The Departmental Authorities declined to allow anything more than 6%. In the appeal the assessee preferred to the Tribunal, its claim for deduction was based alternatively on section 10(2)(iii) and section 10(2) (xv). The Tribunal held, "a payment of anything more than 6% on loans cannot be justified on any commercial consideration." It' further held : "The additional payments which are linked with the declaration of dividends and the profits earned is nothing but a mere device to distribute the profits made in this form amongst the shareholders of this private limited company."
Under section 66(2) of the Act, the Tribunal referred the following question to this Court : "Whether on the facts and in the circumstances of this case the disallowance of the interest in excess of 6% out of the amounts paid in. respect of the borrowed capital is justified in law "
The claim of the assessee both before the Tribunal and before us was rested on alternative grounds, section 10(2) (iii) and section 10(2) (xv) of the Act. If the claim falls under section 10(2) (iii), that by itself would bar recourse to section 10(2) (xv) specifically excludes "the allowance of the nature described in any of clauses (i) to (xiv) inclusive of section 10(2)." So the real question for determination is, is the deduction claimed by the assessee permis sible under section 10(2) (iii) of the Act.
The allowance that section 10(2) (iii) provides for is "in respect of capital borrowed for the purpose of the business, profession or vocation, the amount of the interest paid." We can leave out of account the proviso and the explanation to this sub‑clause.
No decided case has been brought to our notice where an identical question arose for consideration. Before we deal with the cases cited before us, we shall set out our conclusions about the nature of the transaction, which was the basis of the assessee's claim.
The sum of one lakh of rupees was the amount borrowed by the assessee to provide working capital for its expenses. What it paid annually was interest. Learned counsel for the Department could not dispute that the relationship between the shareholders of the company that lent moneys to the company on the one hand and the company on the other which borrowed those moneys was that of creditors and debtors. The genuineness of the loan and that of the payments made by the assessee were never in issue. It was only on that basis that the Tribunal could allow and did allow 6% towards interest charges. Once the factors mentioned above were established, there was no scope for limiting the deduction to what the Tribunal considered was a reasonable rate of interest. Section 10(2)(iii) did not provide for such a limitation. All that section 10(2)(iii) requires is (i) that the money, the capital, must be borrowed by the assessee ; (ii) the amount should have been borrowed for the purpose of the business of the assessee, and (iii) the assessee should have paid as interest the amount claimed as allowance under section 10(2).
Were there any factors that militated against the acceptance of the contention of the assessee that the transaction was one of loan is the next question.
The assessee borrowed money from its shareholders. While all the creditors were shareholders of the borrowing company not all the shareholders were creditors. Four out of the twenty‑one share holders declined to advance any moneys. Naturally those four were not paid anything by way of interest by the assessee. Though the assesssee was prepared to borrow only from its shareholders, no obligation was laid on any of the shareholders to advance moneys to the company. The rights of the shareholders qua share holders were in no way curtailed if they did not lend. Both classes, for instance, were entitled to participate in the profits at a uniform rate of dividend. Though, of course, only shareholder could lend, thereafter the rights of the lender were distinct from those of the shareholder. There was nothing to prevent a shareholder from parting with his rights as a shareholder, while retaining the rights as a creditor who had advanced moneys to the company. Nor was there anything to prevent the shareholder‑cum- creditor from assigning his debt to one who was not a shareholder. The right to receive interest at the stipulated rate was based wholly on the loan advanced and not on the continued possession of shares. It was only the right to lend that was correlated to the possession of shares, but that did not affect the real nature of the transaction. It was only a loan. What was repayable by the assessee under the terms of the contract was the principal, and till the principal was repaid, the assessee was bound to pay interest at the stipulated rate.
That the stipulated rate of interest was variable and was made dependent upon the rate of dividend the company declared in the relevant year did not again alter the nature of the transaction, and make it anything other than a loan. Suppose the company had contracted to pay interest at 10 percent. above the bank rate that prevailed on the 31st December each year ; it would have been a legally enforceable obligation and it would retain unimpaired the jural relationship of a creditor and a debtor. Again, if the contrac tual obligation was to pay interest at the same rate as the dividend payable by a named bank, that would not have made the transaction any the less a loan. The contractual obligation in this case was to pay interest at the same rate as the dividend declared by the company, subject to a minimum of 6 percent. The rate of dividend only provided the basis for computation of interest. What was payable and what was paid was interest and not dividend.
Was the contract the assessee entered into with 17 of its share holders a device to screen the real nature of the transaction The Tribunal recorded : "The additional payments which are linked with the declaration of dividends and the profits earned is nothing but a mere device to distribute the profits made in this form amongst the shareholders of this private limited company." In our opinion, there was no basis for that finding. We have pointed out that not all the shareholders advanced moneys to the assessee company. The right of each of the shareholders, who had lent moneys, to receive the interest depended on the money that he had advanced, and not on the number of shares he held. No dividend could be withheld from a shareholder who did nut advance moneys. The dividend could not depend on anything other than the number of shares the shareholder held. Only the lender could get interest on the moneys he had advanced, and not the shareholder, who did not lend anything. It was not a scheme to distribute dividends under the guise of payment of interest.
Besides, the declaration of dividend in a given year does not necessarily imply that the profits in that year alone were distribut ed as dividend. What section 10(2) (iii) provides for is a deduction of interest charges incurred in that year of account. If the dividend declared was higher than what the profits of that year warrant ed, still the lender would have to be paid interest at the same rate irrespective of the quantum of profits of that year. It was not a scheme to distribute dividends. It was not a scheme to distribute profits. As we stated, the rate of dividends only provided the basis for the computation of the interest that was payable on the loan. What was paid was only interest. It is the quality of that payment that matters, and not its admeasurement, in deciding whether the claim is permissible under section 10(2) (iii).
In our opinion, the claim of the assessee was within the scope of section 10(2) (iii) and should have been allowed in full.
A review of the cases cited before us does not derive from the conclusion we have recorded above.
Learned counsel for the Department relied to a considerable extent on the decision in Commissioner of Taxation v. Boulder Perseverance Limited (58 C L R 223) which turned on the statutory provisions of the Dividend Duties Act, which did not contain anything analogous to section 10(2)(iii) of the Indian Income-Tax Act. The learned Judges pointed out at page 231 : " The purpose of the Act (the Dividend Duties Act) is to tax in the hands of companies all profits they make in the State without regard to the manner in which the profits are dealt with. In this view it becomes, we think, immaterial whether the profits are earned by the employment of share capital or debenture capital. It is not denied that the fixed interest charges on debenture capital constitutes a prior deduction in the calculation of the profits made by the company. Such charges are regarded as an ordinary business expenditure. But, when the debenture contract lets the debenture holder into participation in the trading profits' over and above his fixed interest charge, it gives his debenture capital an additional characteristic, a characteristic inconsistent with that of a simple external loan by a creditor looking only for security for his capital and a certain regular remuneration for its use---------- The share in the profits appears to us to represent a right to the distribution of the fund finally earned by the business, the taxable fund."
"Earlier at pages 229‑230 the learned Judges laid down:
"...when money is borrowed for use in the business the reward of the lender in the form of interest is regarded as a necessary or proper deduction for the purpose of ascertaining the profits of the business, and the fact that the reward is made to vary with the success of the business ought not to affect its character as an expenditure incurred for the purpose of earning profit. Yet capital may be invested in a business in order to obtain a share in the profits indistinguishable from that of the proprietor. The solution of the difficulty must in every case be found in determining the point at which the ascertainment of net profits is required, and this depends upon the purpose for which they are to be computed. Profits may be regarded as a fund composed of receipts which must be applied to various purposes in succession. In this view it is a fund subject to diminution by an indefinite succession of disbursements or outgoings until it is finally dissipated. In its course from the initial receipt to its final distribution, the fund may be computed at different points for different purposes. If the purpose is to find what the business returns to its proprietors in a form which they can enjoy as they choose, a point must be taken at which every other expenditure to which the fund must be appli ed has already been deducted. But, to illustrate the difference which the nature of the purpose makes in the point at which profits are computed, an imaginary example of an opposite extreme may be taken. Suppose the purpose were to find what amount was to be provided by a business for the remuneration of labour in order to fulfil an obligation to reward all those who contributed their labour to an enterprise by dividing profits among them. In such a supposed case no deduction would be allowable on account even of wages; still less of remuneration calculated as a percentage upon the earnings of the business."
While we are in respectful agreement with the principle under lying these observations, we have again to point out that the language of the Income‑tax Act, especially section 10(2)(iii), is not in pari materia with the statutory provisions of the Dividend Duties Act, though, even in Australia, the learned Judges pointed out that when money is borrowed for use in the business, the reward of the lender in the form of interest is regarded as a neces sary or proper deduction for the purpose of ascertaining the profits of the business.
Learned counsel for the Department referred to A. W. Walker and Co. v. Commissioners of Inland Revenue ((1920) 12 Tax. Cas. 297), the principles laid down in which were followed by the same learned Judge in Com missioners of Inland Revenue v. Mashonaland Railway Co. Ltd. ((1926) 12 Tax. Cas. 1159) Walker's case was referred to with approval in Commissioner of Taxation v. Boulder Perseverance Limited. What was payable under the terms of the contract in Walker's case was a sum of 200 per half year which worked out of 5 percent. of the amount advanced as a loan, plus a further 3/20th parts of the profits in excess of 1,000 up to, but not exceeding, 3,000. The excess came to 300. The claim for 200 was allowed, and the claim for the additional 300 was negatived. Rowlatt, J., observed, with reference to the 300, that it was nothing but giving the lenders a share of the profits eo nomine. The learned Judge observed further : "They both, of course, are in consideration of the loan; that is why they are paid, there is no doubt about that, but they are different things, and the people who have lent this money have got interest and they have got a share of the profits that is the long and short of it. They have got interest 'which is payable to them as a debt, it matters not whether the concern prospers or languishes ; they have got the other thing, which is a share of what the business earns, and that is not interest, that is simply a share of the profits. If there are profits they get a share, if there are no profits they do not get anything. It is simply, as it says in the agreement, a share of the profits."
But the contract between the lenders and the assessee, we have to consider in this case, is quite different. In this case, if the assessee company declared a dividend, whether or not there were profits that year, the lenders were entitled to be paid as interest at the same rate as the dividend. It is conceivable that the company did not declare a dividend in a given year, even though profits were available. If no dividend was declared, the lender would get nothing more than 6 percent. As a further measure of caution in following the principles laid down under the English Income- tax Act, we should point out that there was nothing in that Act to correspond to section 10(2)(iii) of our Act, the scope of which was defined with precision by that Act itself.
In Lock and Trotman v. Queensland Investment and Land Mortgage Company Limited ((1896) A C 461) at page 468, Lord Herschell pointed out : ".... I think it is a fallacy to speak of this payment of interest as being a payment made to a member in his character of. member. As member he has no right to have that interest paid to him; he could not claim it. As member he was under no obliga tion to make the payments in consideration of which the company undertook to pay the interest. When, therefore, the company, although they received the money from a member, received it from him without any obligation upon him as a member to pay it, and undertook to make a payment to him in consideration of it which they were not under any obligation to make to him as a member, it seems to me that it is manifestly erroneous to describe this as a payment made to a member in his character of member". That, if we may respectfully say so, describes the position of the 17 shareholders of the assessee company who advanced the moneys to it.
In Union Cold Storage Co. Ltd. v. Adamson (H. M. Inspector of Taxes) ((1931) 16 Tax Cas. 293) the company leased lands and premises abroad under a deed reserving a rent of 960,000 per annum. The deed provided that, if at the end of any financial year it was found that after providing for this rent the result of the company's operations was insufficient to pay both interest on its charges and debentures and dividends at fixed rates on its preference shares and also at least 10 percent. on its ordinary shares, the rent for the year was to be abated to the extent of the deficiency, repayment already paid being made if necessary. In 1922 a sum of 630,000 was paid as rent, and in 1923 the full sum of 960,000 was paid. It was held that the payments were not payable out of the profits or gains and that they were allowable deductions. Lord Hanwoith, M. R., pointed out at page 322 : " .. it is important to bear in mind that it is not alleged by the Crown that this indenture of lease is not a valid and effective document, a spacious device or strategy to cloak the true facts ; it is accepted as a good agreement, and that carries one a very long way ; it is no use to say the lease must be accepted as a lease, but must be looked at with the eye of suspicion ; you have got to take its terms, and I think Mr. Justice Rowlatt is right in saying that once the Crown have admitted that it is a real document, then the case has to be decided upon the tenor of the document as it stands, without an ingenious effort to get round it because one may hold that it has the effect of withdrawing some profits from tax."
At page 324, the learned Master of the Rolls observed:
I have already stated that the Crown do not attack the lease; they only attack the effect of it. When one comes to measure the true effect of it in the light of the surrounding facts, it appears to me that Mr. Justice Rowlatt was quite right in holding that this payment was, according to the tenor of the document, a sum pay able for the purpose of seeking profits, and thus a proper deduction made..."
Thus the effect of the contract the assessee company entered into with such of its shareholders as were prepared to advance moneys in no way affected the real nature of the transaction or the real nature of the relationship between the assessee company and its lenders, or the real nature of the payments in discharge of the contractual obligations the assessee company undertook. What was paid, as we pointed out above was interest.
A payment made contingent on the quantum of profits was not a payment out of taxable profits, was what was laid down in the Union Cold Storage Co. Ltd. case. All that was done in this case was not to make the payment of interest contingent on the profits of the year but on the rate of dividend declared for that year.
Learned counsel for the assessee also referred us to the decision in Indian Turpentine and Rosin Co. Ltd. v. Commissioner of Income-tax, United Provinces ((1929) 3 I T C 219), the principle laid down in which was analogous to that laid down by the House of Lords in Lock and Trotman v. Queensland Investment and Land Mortgage Company Limited ((1896) A C 461). The Government of the U. P. was a shareholder of the assessee company. It also undertook to supply crude resin required by the company from the Forest Department for which the company had to pay a royalty. The contract provided "if the profits of the company in any year exceed 15 percent. of the capital of the company ranking for dividend then the. company will pay the Forest Department as additional royalty such proportion of 40 percent. of the amount by which the profits exceed the above mentioned 15 percent. as the number of maunds of crude resin either supplied by the Forest Department to the company or collected and extracted by the company from the channels made available by the Forest Department in the preceding tapping season bears to the total number of maunds of crude resin received by the company in that period." It was held by the Income‑tax Officer that, as this royalty was dependent on the earn ing of profits, therefore, it was an allocation of profits to one of the biggest shareholders of the company. That decision was, however, abandoned in appeal, because it was pointed out that, if the Government sold all its shares in the company, the company would still have to pay the same amount of royalty. "Therefore the payment could in no sense be regarded as an allocation of profits to one of the co‑sharers in the company. It is merely an unconnected fact that Government are at present shareholders in the company.:" To the extent to which the character in which the additional royalty was received was differentiated from that of a shareholder, the principle laid down in that case is, as we said, analogous to that laid down by the House of Lord in Lock and Tortman v. Queensland Investment and Land Mortgage Company Limited ((1950) 18 I T R 357). But we must also point out that in Indian Turpentine and Rosin Co. Ltd. v. Commissioner of Income‑tax, United Pro vinces, ((1896) A C 461) it was not the scope of section 10(2)(iii) that arose for determination.
In Devarajulu Chetty & Co. v. Commissioner of Income‑tax ((1950) 18 I T R 357) at page 367, the learned Judges pointed out, "it is the quality of the payment that is the test and not its admeasurement". With that principle we are in entire agreement.
Once the true nature of the transaction is realised, there is no scope afforded in section 10(2)(iii) to reduce the quantum paid as interest, to anything considered reasonable by the Taxing Authori ties on subjective or objective standards.
We answer the question referred to us in the negative and in favour of the assessee company. The assessee will be entitled to the costs of this reference. Counsel's fee Rs. 250.
Question answered in the negative.
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