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Income tax Reference No. 17 of 1958, decided on 1st February 1961.

Income tax Act (XI of 1922)-----

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Ss. 2(6 C)(fl), (iii) & 10(4 A)(a)Business expenditure Salary Amount paid as salary to Director having substantial interests in Company Whether can be disallowed or reduced.

The assessee which was the managing agent of a company received Rs. 1,000 per mensem as remuneration from its managed company as per the managing agency agreement. According to its Articles of Association the assessee paid Rs. 1,000 per mensem as salary to its director in charge who had substantial interest in the company. The assessee claimed deduction of Rs. 12,000 as amount expended for the purposes of the business. The Department contended that the arrangement had been devised with a view to escape the corporate tax and allowed only Rs. 200 per mensem as allowance, which was later increased to Rs. 500 by the Tribunal:

Held, that the salary of Rs. 1,000 per mensem paid to the director in charge of the assessee company was an allowance in respect of an expenditure falling within section 10 (4 A) (a) of the Income tax Act, 1922, and the assessee was not entitled to have the entire amount deducted under section 10(2).

The expenditure incurred by a company in paying a "salary" to its director or a person substantially interested in the company may be disallowed wholly or in part under section 10 (4 A)(a). A reference in section 10(4 A) (a) to section 2 (6 C) (iii) is only for the purpose of the definition of "substantial interest in the company" and for no other purpose. The word "allowance" in section 10 (4 A)(a) is used in the meaning of a deduction allowable by the Income tax Authorities and not an expenditure incurred by a company, because the allowance has to be in respect of any expenditure by the company.

STATEMENT OF CASE

The assessment year under consideration is 1956-57, the previous year being the year ending on 30th November, 1955. The assessee is a private limited company carrying on the business of working as managing agent to another private limited company known as the Narain Cold Storage Co. Ltd., Amritsar. Both the companies came into existence in the year 1946. The paid up capital of the assessee company consists of 200 shares of Rs. 100 each, 50%. of the amount having been paid up. Of these 200 shares, 100 shares are held by S. Sarmukh Singh and out of the balance 50 shares each are held by his two sons, S. Bhupal Singh and S. Harpal Singh. All these three persons are the directors of the assessee company, S. Sarmukh Singh being styled as director incharge. In the managed company also S. Sarmukh Singh, his wife, Smt. Balwant Kaur, and their sons hold between themselves the shares of the paid up value of Rs. 2,50,000 out of the total value of Rs. 3, 17,500, besides S. Narain Singh, father of S. Sarmukh Singh, holding shares of the value of Rs. 10,000. S. Sarmukh Singh and his sons are the directors of the managed company and S. tNarain Singh is the chairman. According to the managing agency agreement, the assessee received remuneration at the rate of Rs. 1,000 per mensem from the managed company and according to their own articles of association the assessee company is to pay to its director in charge a remuneration of Rs. 1,000 per mensem. The assessee company, according to the terms of the articles of association, paid the managing director a salary of Rs. 1,000 per mensem.

2. The Income tax Officer found "that this arrangement for all practical purposes reduces the assessee company to the position of a conduit pipe which passes on its entire business receipts to its director in charge" and that "the arrangement is devised with a view to escape the corporate tax". The income assessed or declared in the principal company's case, the remuneration received from the managed company and the remuneration in turn paid by it to the director in charge in various years is as given in the order of the Income tax Officer which is made a part of the statement of case and is marked as Annexure "A".

3. It appears that owing to losses incurred by the assessee in the first two years no objection was taken to the allowability of the expense of remuneration paid to the director in charge, S. Sarmukh Singh and the director in charge was assessed in respect of the remuneration paid to him. Thereafter, till the assessment year 1952 53 the remuneration was forgone and the consideration of allowability in the hands of the company did not arise: For the assessment years 1953 54 to 1955 56 it appears that the assessee company was allowed an expense of Rs. 12,000 per annum paid as salary to the director in charge. In the assessment year under consideration, however, the Tribunal in agreement with the department came to the conclusion that the provision of section 10(4 A) authorised the Income tax Officer to go into the question of the allowability of the entire remuneration paid and that if the allowance is excessive or unreasonable having regard to the legitimate business needs of the company and benefit derived by or accruing to it therefrom, the Income tax Officer will allow such portion as is considered to be excessive or unreasonable. The department allowed only Rs.2,400 and disallowed the balance as being excessive or unreasonable. The Tribunal however, considered that the amount to be disallowed should be only Rs. 6,000 and allowed the balance. The order of the Tribunal is made a part of this statement of the case and is marked as Annexure "B".

4. On the above facts and in the circumstances of this case in our opinion, the following question of law arises:

"Whether on the facts and in the circumstances of the case the salary of Rs. 1,000 per mensem paid to S. Sarmukh Singh, director in charge of the assessee company is any allowance in respect of any expenditure within the meaning of clause (a) of section 10 (4 A) of the Indian Income tax Act "

The clause reads as follows:

"(4 A) Nothing in subsection (2) shall, in the computation of the profits and gains of a company be deemed to authorise the making of:

(a) any allowance in respect of any expenditure which results directly or indirectly in the provision of any remuneration or benefit or annuity to a director or a person who has a substantial interest in the company within the meaning of sub clause (iii) of clause (6 C) of section 2, or

(b) ..if in the opinion of the Income tax Officer any such allowance is excessive or unreasonable having regard to the legitimate business needs of the company and the benefit derived by or accruing to it therefrom.

Explanation. The provisions of this subsection shall apply notwithstanding that any amount disallowed under this subsection is included in the total income of any person referred to in clause (a)."

5. Draft statement of case was drawn up in the presence of the parties. The assessee expressly agrees to the statement o f case as drawn up. The suggestion of the Commissioner of Income-tax has been taken into consideration and the Commissioner agrees to the statement of case as now being submitted.

B. R. Tuli and Vikram Mahajan for Petitioner.

D. N. Awasthy and Hem Raj Mahajan for Respondent.

JUDGEMENT

MEHAR SINGH, J.

In 1946 two private companies came into existence, one under the name of the Narain Cold Storage Co. Ltd. and the other under the name of Dr. Sarmukh Singh & Co. Private Ltd. The last named company is the assessee company, which is the managing agents of the first company. According to the managing agency agreement between the two companies the assessee company receives remuneration of Rs. 1,000 per mensem from the managed company. Again, according to the assessee company's articles of association, it is to pay to its director incharge a remuneration of Rs. 1,000 per mensem. The capital of the assesee company is 200 shares of Rs. 100 each; out of those shares, half, that is to say, 100 shares, are held by Dr. Sarmukh Singh and the remaining 100 shares are equally held between his two sons, Bhupal Singh and Harpal Singh. All the three are directors of the assessee company with Dr. Sarmukh Singh as director incharge. The assessee company has, in the terms of its articles of association, in the accounting year ending November 30, 1955, paid to its director in charge a salary of Rs. 1,000 per mensem. In its return for the assessment year 1956-57 the assessee company has shown an income of Rs. 12,275 out of which Rs. 275 is interest earned on certain investment and Rs. 12,000 is the amount received under the managing agency agreement from the managed company, and it is shown as paid out to the director in charge as his salary. This amount has been claimed as deduction by the assessee company because of having been laid out or expended wholly or exclusively for the purposes of its business.

The Income tax Officer has reached the conclusion that the arrangement between the two companies and the director in charge of the assessee company in regard to this amount is that for all practical purposes it reduces the assessee company to the position of a conduit pipe which passes on its entire business receipts to its director in charge and the arrangement has been devised with a view to escape the corporate tax. He has applied section 10 (4 A) of the Indian Income tax Act to the case and allowed only salary or remuneration to the director in charge at Rs. 200 per mensem, disallowing the balance as excessive or unreasonable. The Appellate Assistant Commissioner of Income tax has agreed with the Income tax Officer in this respect and so has the Income-tax Appellate Tribunal by its order of October 16, 1957, but raising the allowance from Rs. 200 to 500 per mensem as salary or remuneration of the director in charge.

On an application of the assessee company under section 66 (t) of the Income tax Act the Tribunal has stated the case and referred for opinion this question:

"Whether on the facts and in the circumstances of this case the salary of Rs. 1,000 per mensem paid to S. Sarmukh Singh, director in charge of the assessee company, is any allowance in respect of any expenditure within the meaning of clause (a) of section 10 (4 A) of the Indian Income tax Act "

The Finance Act of 1956, section 7, adds subsection (4 A) to section 10 of the Indian Income tax Act, which provides:

"(4 A). Nothing in subsection (2) shall, in the computation of the profits and gains of a company, be deemed to authorise the making of

(a) any allowance in respect of any expenditure which results directly or indirectly in the provision of any remuneration or benefit or amenity to a director or a person who has a substantial interest in the company within the meaning of sub-clause (iii) of clause (6 C) of section 2, or

(b) any allowance in respect of any assets of the company used by any person referred to in clause (a) either wholly or partly for his own purposes or benefit,

if in the opinion of the Income tax Officer any such allowance is excessive or unreasonable having regard to the legitimate business needs of the company and the benefit derived by or accruing to it therefrom."

There is an Explanation to the subsection but that is not material here. There are seven sub clauses in clause (6 C) of section 2 of the Indian Income tax Act and out of those sub-clauses (ii) and (iii) are

"Section 2 (6 C). Income' includes ....

(ii) the value of any perquisite or profit in lieu of salary taxable under section 7;

(iii) the value of any benefit or perquisite whether convertible into money or not, obtained from a company either by a director or by any other person who has a substantial interest in the company (that is to say, who is concerned in the management of the business of the company, being the beneficial owner of shares not being shares entitled to a fixed rate of dividend whether with or without a right to participate in profits, carrying not less than twenty per cent. of the voting power), and any sum paid by any such company in respect of any obligation which but for such payment would have been payable by the director or other person aforesaid; .."

It is at once clear that the director in charge of the assessee company has a substantial interest in the assessee company within the meaning of sub clause (iii) of clause (6 C) of section 2 inasmuch as he is concerned in the management of the business of the assessee company, and is the beneficial owner of half of its total share capital, which shares are rot entitled to a fixed rate of dividend, and carries thus more than twenty per cent. of the voting power. The assessee company seeks allowance of Rs. 12,000 as expenditure by it in payment of a salary of Rs. 1,000 per mensem to its director in charge, which obviously is directly a revision of remuneration to the director in charge. Thus clause (a) of section 10(4 A) squarely applies to the allowance sought by the assessee company in respect of this expenditure, and the Income tax Authorities have exercised their power under that provision to disallow half of the amount as excessive and unreasonable allowance claimed by the assessee company having regard to the legitimate needs of its business and the benefit derived by or accruing to it therefrom.

The learned counsel for the assessee company contends that in section 2(6 C), sub clause (ii) particularly relates to salary, and in the application of section 10(4 A) what is to be taken into consideration is sub clause (iii) of section 2(6 C), in which latter sub clause there is no reference to salary, and thus salary having been excluded from that sub clause it is also excluded from subsection (4 A) of section 10. The argument is not tenable because sub clause (ii) of section 2(6 C) has no bearing on any provision of subsection (4. A) of section 10, and because reference m subsection (4 A)(a) of section 10 to sub clause (iii) of section 2(6 C) is only for the purpose of the definition of the expression "substantial interest in the company", and for no other purpose. The reference to that sub clause is to find whether a director or any other person has or has not substantial interest in the company as that is explained in brackets in that sub clause. No other part of that sub clause has any reference to clause (a) of subsection (4 A) of section 10. The learned counsel for the assessee firm contends that the word "allowance'.' in clause (a) of subsection (4 A) of section 10 has reference to an allowance made by a company, as in the present case, to the director in charge, and such an allowance being in the shape of a salary is not within that clause because of its coming directly under sub clause (ii) of section 2 (6 C). This is mere repetition of the previous argument and it proceeds, to my mind, on a wrong meaning attached to the word "allowance' in clause (a) of subsection (4 A) of section 10. The word allowance in that clause is used in the meaning of a deduction allowable by the income tax authorities and not an expenditure incurred by a company, because the allowance has to be in respect of any expenditure by the company. It is with reference to deduction claimed by the company in respect of any expenditure by it that the expression is used. It is used in the same meaning in clause (b) and if in clause (b) the meaning of the word were as contended by the learned counsel that clause would not make sense, and it cannot be that in' the two clauses the word has been used with different meanings. In fact the meaning of the word is plain in the context and it is not used in the sense of expenditure by a company but in the sense of a deduction claimed in respect of expenditure by a company.

In the result the answer to the question referred is in the affirmative. In this reference the assessee company will bear the costs of the opposite party.

GROVER J.

I agree.

Question answered in the affirmative.

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