K.K. Mathew, J.
1. The assessee here is a limited company incorporated under the Travancore Companies Regulation and is carrying on the business of manufacturing sugar. It also runs a distillery and a tincture factory. The assessee-company was floated with a view to take over the business assets of a company called Travancore Sugars Ltd., which was being wound up and in which the State Government held the largest number of shares, the Government Distillery at Nagercoil and the business assets of the Government Tincture Factory at Triyandrum. An agreement was entered into between the Government of Travancore and Sir William Wright on behalf of Parry & Co. Ltd.. the promoters of the assessee-company. Under the agreement, the assets of all the three concerns were agreed to be sold by the Government of Travancore to the assessee-Company. It is not necessary to set out all the clauses in the agreement. Apart from the cash consideration for the transfer of the assets, Clause 7 of the agreement provided that:
'the Government shall be entitled to twenty per cent, of the net profits earned by the company in every year subject however, to a maximum of Rupees forty-thousand per annum, such net profits for the purposes of this clause to be ascertained by deduction of expenditure from gross income and also after--
(i) provision has been made for depreciation at not less than the rates of allowances provided for in the income-tax law for the time being in force, and
(ii) payment of the Secretaries and Treasurers' remuneration'.
On the 28th January, 1947, Clause 7 was substituted by another clause, which reads.
'The Government shall be entitled to ten per centum of the net profits of the company in every year. For the purpose of this clause net profits mean the amount for which the company's audited profits in any year are assessed to income-tax in the State of Travancore.'
2. For the assessment year 1958-59, the corresponding previous year being 1st May, 1956 to 30th April 1957, the amount payable to Government under the aforesaid clause came to Rs. 42,480. The Appellate Assistant Commissioner disallowed the claim of the assessee for deduction of this amount on the ground that the clause virtually provided for sharing the profits after they came into existence, On appeal by the assessee, the Income-tax Appellate Tribunal held that the case will come within the principle of the decision in British Sugar . v. Harris (Inspector of Taxes), : [1939]7ITR101(Cal) and that the payment was an expenditure made to earn the profits of the business and not an expenditure paid out of the earned profits, and allowed the appeal. At the instance of the Department, the Tribunal referred the following question to the High Court:
'Whether on the facts and in the circumstances of the case, the payment of Rs. 42,480 by the assessee to the Travancore Government under the agreements dated 18-6-1937 and 28-1-1947 was allowable under Section 10 of the Income-tax Act?'
3. This Court held that the payment of the aforesaid amount constituted capital expenditure and was not an allowable deduction under Section 10(2)(xv) of the Income-tax Act. Against this judgment, an appeal was preferred by special leave to the Supreme Court. The Supreme Court held that the amount is not capital expenditure but revenue payment and sent back the case to this Court for decision of certain questions namely, whether 'the payment of the commission is tantamount to diversion of profits by a paramount title', whether 'the transaction should be treated as a joint venture with an agreement to share profits' between the assessee and the Government, and whether 'the requirements of Section 10(2)(xv) have been satisfied in this case'.
4. When the case came before the Division Bench the question whether the transaction should be treated as a joint venture with an agreement to share the profits between the assessee and the Government was not pressed by the Revenue, Raghavan J. answered the other two questions in the affirmative and in favour of the assessee, whereas Isaac J. answered them in the negative and in favour of the Revenue.
5. So, the two questions which require consideration are: (1) whether payment of the amount is a diversion of profits before they reached the assessee by an overriding title and (2) whether the amount is an allowable deduction under Section 10(2)(xv) of the Income-tax Act.
6. The Supreme Court has held that the payment of the amount was not towards purchase price because the unpaid purchase price was neither a fixed sum nor an amount which could be ascertained by any method and so it is not in the nature of capital expenditure.
7. Whether the payment concerned Ss a diversion of the profits by a paramount title has to be decided keeping in view the principle laid down by the Privy Council in Bejoy Singh Dudhuria v. Commissioner of Income-tax, Bengal, 1933 1 ITR 135 = AIR 1933 PC 127 and by the Supreme Court in Commissioner of Income-tax Bombay, v. Sitaldas Tirath-das, : [1961]41ITR367(SC) and Murlidhar Himatsingka v. Commissioner of Income-tax, Calcutta : [1966]62ITR323(SC) .
8. In 1933 1 ITR 135 = AIR 1933 PC 127 the assessee succeeded to the family ancestral estate on the death of his father. Subsequently his step-mother brought a suit for maintenance against him in which a consent decree was made directing the assessee to make a monthly payment of a fixed sum to his stepmother and declaring that the maintenance was a charge on the ancestral estate in the hands of the assessee. In computing his income, the assessee claimed that the amounts paid by him to the step-mother under the decree should be excluded. It was held by the Judicial Committee that the sums paid by the assessee to his step-mother were not 'income' of the assessee at all and that the decree of the Court by charging the appellant's whole resources with a specific payment to his step-mother had to that extent diverted his income from him and had directed it to his step-mother, and to that extent what he received for her was not his income. At the moment when the estate passed on to him there was a liability on the estate which was not quantified and when it was so done by the decree of the Court the entirety of the estate became, so to speak, charged with it and that portion of the income payable to the step-mother had to be treated as the income of the step-mother and not of the assessee.
9. In : [1961]41ITR367(SC) , the assessee had to pay under a consent decree a certain amount every year to his wife and children by way of separate maintenance. He claimed a deduction of the amount from the income and relied on the decision of the Privy Council in 1933 1 ILR 135= AIR 1933 PC 127, Hidayatullah J., as he then was, said:--
'In our opinion, the true test is whether the amount sought to be deducted, in truth, never reached the assessee as his income. Obligations, no doubt, there are in every case, but it is the nature of the obligation which is the decisive fact. There is a difference between an amount which a person is obliged to apply out of his income and an amount which by the nature of the obligation cannot be said to be a part of the income of the assessee. Where by the obligation income is diverted before it reaches the assessee, it is deductible; but where the income is required to be applied to discharge an obligation after such income reaches the assessee, the same consequence, in law, does not follow'.
The maintenance paid by Sitaldas Tirathdas to his wife and children under the consent decree was an obligation he had to discharge from out of his income while the maintenance paid by Raja Bejoy Singh to his step-mother was a diversion before it became income in his hands. The difficulty in drawing the line between the two types of cases is illustrated by the decision of the Supreme Court in : [1966]62ITR323(SC) . In that case M. H. was a partner in firm A and he entered into a sub-partnership with his sons and grandson in firm B, under which his share of the profit and loss in firm A was to belong to firm B. The question arose whether the share of profit of M. H. in Form A had to be assessed in his individual name or to be included In the assessment ol firm B. The Supreme Court held that by an overriding obligation, namely, the formation of the sub-partnership agreement, the profit became the income of firm B, though it passed through the hands of M. H.
10. Let us look at the nature of the obligation in this case. The obligation to pay the amount arose out of an agreement, which is part and parcel of the agreement under which the assessee became entitled to the assets of the three concerns. Although the payment of the amount is not part of the consideration for the purchase of the three concerns, it is a payment which the assessee has agreed to make. It might be remembered that in addition to selling the assets of the three concerns, the Government undertook the obligations enumerated in Clauses 4 (b) and (c) and Clause 5 (c) of the agreement (See Annexure A). And the Government could have enforced by action the payment in case the assessee refused to pay. It is said that by the clause in question, there is no diversion of the profits of the assessee but only an application of a part of the profits, that the profits are earned by the assessee and then a percentage of it paid over by the assessee to the Government. Reliance was placed on the observations of Lord Macmillan in Pondicherry Railway Co. Ltd. v. Commissioner of Income-tax, Madras, 0043/1931 , to support the contention. In that case, the assessee-company, incorporated in the United Kingdom, obtained a concession for constructing a railway in the territories of Pondicherry. The assessee-company was to pay to the French Government half of its net profits. The French Government on its part gave land on which the Railway was to be built free of charge and also agreed to pay a subsidy. The question for decision was whether the monies paid by the assessee-company to the French Government were allowable deductions under the provision corresponding to Section 10(2)(xv). Lord Macmillan observed at page 170:--
'A payment out of profits and conditional on profits being earned cannot accurately be described as a payment made to earn profits. It assumes that profits have first come into existence. But profits on their coming into existence attract tax at that point and the revenue is not concerned with the subsequent application of the profits.'
But these observations have been explained in later cases. In Union Cold Storage Co. Ltd. v. Adamson, (1931) 16 Tax Cas 293 the assessee leased lands and premises abroad reserving a rent of 9.60,000. It was provided in that deed that if at the end of the financial year it was found that after providing for the rent the result of the company's operations was insufficient to pay interest or charges and debentures etc. the rent for the year was to be abated to the extent of the deficiency. In computing its profits the assessee-company claimed deduction of the rent paid in the two respective years. They were held not payable out of the profits or gains and were allowable deductions. Rowlatt J. said that the sum which was to be paid by the company was a recompense in respect of possession and use of the premises abroad and the company had entered into some liabilities by way of payment for their premises and that payment was an outgoing of the business which has to be provided for and allowed before profits of the business could be ascertained. In the House of Lords, Lord Macmillan distinguished the Pondicherry Railway Co. case, 0043/1931 by saying that in that case the ascertainment of profits preceded the coming into operation of the obligation to pay and when profits had been ascertained the obligation was to make over half thereof to the French Government. Dealing with the passage above referred to, Lord Macmillan said at pages 331-332:
'...............I was dealing with a case in which the obligation was, first of all to ascertain the profits in a prescribed manner, after providing for all outlays incurred in earning them, and then to divide them. Here the question is whether or not a deduction for rent has to be made in ascertaining the profits, and the question is not one of the distribution of profits at all.'
11. The same question was considered in Vithaldas Thakordas & Co. v. Commissioner of Income-tax, Bombay, : [1946]14ITR822(Bom) . There, the facts were: After the death of V, who had during his lifetime carried on in his own name a bullion business, the assessee, a firm of partners, entered into an arrangement with the widow of V for the use of V's name for their bullion business. Under the arrangement, in consideration of the widow having agreed to allow the partners to use the name of V, for the purpose of the partnership business the partners agreed to pay her out of the net profits of the business in the first instance an amount equivalent to two annas in the rupee of the net profits. The partners also agreed that neither she nor the estate of V would be liable for the debts or losses of the partnership and that she would not be deemed a partner in the business. The partnership deed provided that after payment of the aforesaid amount to the widow, the balance of the net profits was to be divided between the partners in certain proportions. No term was fixed for the duration of the use of the goodwill. In the accounting year the assessees made a net profit of Rs. 40,470 and the widow was paid Rs. 5,059, being her share of the profits.
In considering the question whether the amount was an allowable deduction, the Court said:
'Therefore, in every case the Court has got to consider what are the real profits of the assessee and what are the apparent profits. It is only the real profits that attract the tax; and even though the language used in the material documents may be 'net profits', the Court must look to the substance of the transaction and not the form. In this case the two documents I have referred to provide that Bai Tarabai has got to be paid two annas in the rupee of the 'net profits'. But the two annas in the rupee have to be paid for the use of the goodwill which is essential for the carrying on of the business. Therefore first the apparent profits of the partnership are ascertained and two annas in the rupee are paid out to Bai Tarabai out of those profits; and after those payments are made, the real profits are ascertained which attract the tax; and it is these real profits that are distributed among the partners in the proportion laid down in the partnership agreement, making up what is described as a unit of 14 annas.'
The observations of Lord Macmillan in Pondicherry Railway Co. case, 0043/1931 were considered in : [1939]7ITR101(Cal) . In that case a company carrying on a manufacturing business agreed with two other companies to pay them a stated percentage of its net profits. 'Net profits' were to be ascertained after payment of all expenses of the company and after providing for interest on debentures but before making any provisions for depreciation. The Court of Appeal held that in computing its profits for the purposes of income-tax, the company was entitled to deduct the sums so paid as being 'money wholly and exclusively laid out or expended for the purposes of the trade'. Lord Greene, the Master of Rolls, pointed out that 'net profits' were to be arrived at upon a conventional basis, not the basis upon which the company would ascertain its profits for commercial purposes or the basis upon which it would ascertain its profits for income-tax purposes and the percentage was to be paid out of these conventional profits and not out of the profits which were liable to tax.
Dealing with the Pondicherry Railway Co. case, 0043/1931 the learned Master of the Rolls said:
'It is to be observed that Lord Macmil-lan in that paragraph was quite clearly using the word, 'profit' in one sense and one sense only; he was using it in the sense of the 'real net profit' to which Lord Maugham referred. That he was doing that is, I think, abundantly clear when the nature of the contract that is in question is considered, which was merely a contract under which a percentage of profits was payable by the railway company to the French Government. There was no question of services or anything of that kind in the case; it was merely a sum payable out of profits. I do not find myself constrained by that expression of opinion, because it must be read, as Lord Macmillan said in a subsequent case, Union Cold Storage Co., Ltd. v. Adamson, (1931) 16 Tax Cases 293 in relating to the particular subject-matter with which he was dealing.'
The Court finally held that the sum is an allowable deduction holding that it is not an appropriation of the profits of the partnership after they had been ascertained, that the agreement was not in the nature of a joint venture or a quasi partnership, and that the payment was a revenue expenditure wholly and exclusively incurred for the purpose of the business and was an admissible deduction under Section 10(2)(xv) of the Income-tax Act.
12. In Poona Electric Supply Co. Ltd. v. Commissioner of Income-tax, Bombay, : [1965]57ITR521(SC) the Company carried on the business of distribution of electricity under a licence issued by the Government. Under the Electricity (Supply) Act, 1948, the company's 'clear profits' in any year should not exceed 'reasonable return' as defined under the Act; and the excess, if any, the Company had to distribute among its consumers in the form of rebate. The Company claimed deduction of the amounts said to have been credited to the 'Consumers' Benefit Reserve Account', and the question before the Supreme Court was whether those amounts were allowable deductions. Subba Rao, J., as he then was, observed that under Section 10(1) of the Income-tax Act, tax shall be payable by an assessee under the head 'profits and gams of business' in respect of profits and gains of any business carried on by him, and that the said profits and gains are not profits regulated by any statute, but profits in a business computed on business-principles, that what is to be ascertained is the business profits and not statutory profits. He further observed that the real profits of a businessman under Section 10(1) of the Income-tax Act cannot obviously include the amounts returned by him by way of rebate to the consumers under statutory compulsion and that it is as if he received only from the consumers the original amount minus the amount he returned to them. His Lordship summarised his conclusions at page 530 (of ITR) = (at p. 35 of AIR) thus:
'Income-tax is a tax on the real income, i.e., the profits arrived at on commercial principles subject to the provisions of the Income-tax Act. The real profits can be ascertained only by making the permissible deductions. There is a clear-cut distinction between deductions made for ascertaining the profits and distributions made out of profits. In a given case whether the outgoings fall in one or the other of the heads is a question of fact to be found on the relevant circumstances, having regard to business principles. Another distinction that shall be borne in mind is that between the real and the statutory profits, i.e., between the commercial profits and statutory profits. The latter are statutorily fixed for a specified purpose',
13. In the Poona Electric Company's case, : [1965]57ITR521(SC) computation of the profits was regulated by the Electricity (Supply) Act, whereas in the case in hand it is regulated by the contract between the company and the Government. In computing the real profits of the assessee here, I think, the payment made to the Government has to be deducted. The fact that in the substituted Clause 7, it is said that out of the net profits of the company, the Government will be entitled to 10% would not make it a payment out of the real profits of the company. There is we must remember the distinction between apparent profit and real profit. What is taxed under the Income-tax Act is only the profits of the company calculated on commercial principles.
In the Privy Council case of Indian Radio and Cable Communications Co. Ltd. v. Commissioner of Income-tax, Bombay Lord Maugham said:
'It is not universally true to say that a payment the making of which is conditional on profits being earned cannot properly be described as an expenditure incurred for the purpose of earning such profits. The typical exception is that of a payment to a director or a manager of a commission on the profits of a company. It may, however, be worth pointing out that an apparent difficulty here is really caused by using the word 'profits' in more than one sense. If a company having made an apparent net profit of 10,000 has then to pay 1,000 to directors and managers as the contractual recompense for their service during the year, it is plain that the real net profit is only 9,000'.
14. When a trader makes a payment which is computed in relation to profits, the question that arises is: Does the payment represent a mere division of profits with another party, or is it an item of expenditure the amount of which is ascertained by reference to profits. The payment would be allowable in the second case, but not in the first.
15. Now let us see whether the payment is an expenditure wholly and exclusively laid out for the purpose of the business and ascertained with reference to profits.
16. Viscount Cave, L. C. observed in Atherton v. British Insulated and Halsby Cables Ltd., (1925) 10 Tax Cas 155
'A sum of money expended, not of necessity and with a view to a direct and immediate benefit to the trade, but voluntarily and on the grounds of commercial expediency and in order indirectly to facilitate the carrying on of business, may yet be expended wholly and exclusively for the purposes of the trade'.
What is money wholly and exclusively laid out for the purposes of business must be determined upon the principles of commercial trading. Thus, remuneration of commission payable to directors, managers, agents or other employees, and ascertained by reference to profits, is deductible as business expense (See the decision in Commr. of Income-tax, Burma v. Bombay Burma Trading Corporation, 1941 9 ITR 155 = AIR 1941 Rang 145.
17. Reliance was placed by the Revenue upon the decision in Tata Hydro-Electric Agencies Ltd. v. Commr. of Income-tax, Bombay, and it was contended that the payment is not an expenditure laid out wholly and exclusively for the purpose of the business. In that case, the Tata Power Company entered into an agency agreement with Tata-sons Ltd. agreeing to pay to Tata-sons Ltd. a commission of 10 per cent, on the annual net profits of Tata Power Co, subject to a minimum whether any profits were made or not. Later on two persons D and S advanced funds to Tata Power Company on the condition that in addition to the interest payable to them by Tata Power Company they should each receive from Tata-sons Ltd., 12 1/2 per cent. of the commission earned by Tata-sons Ltd. Tata-sons assigned their entire right to the assessee-company and the Tata Power Company entered into a new agency agreement with the assessee-com-pany and the assessee-company received a commission, and out of that paid 1/4 to D and Section Relying on Pondicherry Railway case, 0043/1931 the Bombay High Court held that that was not an allowable deduction as expenditure incurred solely for earning profits. On appeal the Privy Council held that the Pondicherry Railway case, 0043/1931 did not govern the case. The nature of the transaction was held to be this that the obligation to make the payments was undertaken by the assessee-company in consideration of its acquisition of the right to property to earn profits; i.e. of the right to conduct the business, and not for the purpose of producing profits in the conduct of the business. Lord Maemillan observed:
'In the present case their Lordships have reached the conclusion that the payments in question were not expenditure so incurred by the appellants. They are certainly not made in the process of earning their profits; they were not payments to creditors for goods supplied or services rendered to the appellants in their business: they did not arise out of any transactions in the conduct of their business. That they had to make those payments no doubt affected the ultimate yield in money to them from their business but that is not the statutory criterion. They must have taken this liability into account when they agreed to take over the business. In short, the obligation to make these payments was undertaken by the appellants in consideration of their acquisition of the right and opportunity to earn profits, that is, of the right to conduct the business, and not for the purpose of producing profits in the conduct of the business.'
It might be observed that the decision turned upon the interpretation of the Section 10(2)(xv) before it was amended in 1939. Before this clause was amended in 1939, allowance was given in respect of any non-capital expenditure 'incurred solely for the purpose of earning such profits or gains'. Now under the amended law the expenditure should be laid out 'wholly and exclusively for the purpose of such business'. The two expressions are not synonymous; the latter is wider than the former. Expenditure may be for the purpose of the business although it may not be incurred for the purpose of earning the profits of the business. (See the decision in Commissioner of Income-tax v. Jagannath Kisonlal, : [1956]30ITR654(Bom) .
18. Section 10(2)(xv) requires that the expenditure should be wholly and exclusively laid out for the purpose of the business, but not that it should be necessarily laid out for such purpose. Therefore, expenses wholly and exclusively laid out for the purpose of trade should, subject to the fulfilment of the other conditions, be allowed under this clause even though the outlay is unnecessary or unnecessarily large, unless the case falls under Section 10(4A) q. v. The further test of necessity is, by contrast, imposed under Section 4(3)(vi) and Section 7(2)(iii).
19. The judgment of the Supreme Court in Eastern Investments Ltd. v. Commissioner of Income-tax, : [1951]20ITR1(SC) establishes that In the absence of fraud, the questions Whether a transaction had the effect of diminishing the assessee's taxable income, whether it was a prudent or wise transaction, and whether it was necessary for the assessee to enter into that transaction, are irrelevant in determining whether expenditure relating to that transaction should be allowed under Section 12(2); and the same considerations would apply under this clause. I think, the payment in question was an expenditure laid out wholly and exclusively for the purpose of the business and ascertained with reference to profits,
I agree with the opinion of Raghavan J. and hold that the amount is an allowable deduction and would answer the question in the affirmative and in favour of the assessee.
20. By Court (Raghavan and Isaac JJ.) after the expression of opinion by the third Judge:-- In conformity with the majority opinion, we answer the question referred in the affirmative in favour of the assessee. We also direct both parties to bear their respective costs.
21. A copy of this order will be sentto the Income-tax Appellate Tribunal asrequired by law.