M.S. Shah, J.
28th Dec., 2001
1. In this reference at the instance of the Revenue, the following question has been referred for the opinion of this Court in respect of asst. yr. 1982-83 :
'Whether, on the facts and circumstances of the case, the provisions of Section 40A(2) were applicable ?'
2. The facts giving rise to this reference, briefly stated, are as under :
2.1. The assessee is a private limited company engaged in the business of re-rolling steel into CTD bars as also the conversion work of PWD on job basis. Its directors R.R. Malhotra, A.R. Malhotra and Ravinder Malhotra, were carrying on business in partnership in the name and style of M/s Malhotra Steel Corporation. On 16th Oct. 1978, the assessee-company became a partner in that firm. Thereafter the firm was dissolved w.e.f. 30th June, 1980 and the business was taken over by the assessee-company. A dissolution deed was drawn on 1st Aug., 1980. Clause 6 of the deed of dissolution stated that the company was not in a position to make full payment of the balance standing to the credit of the above-mentioned three persons in their capital account and hence they agreed to retain amounts of Rs. 2 lacs each in each of their respective sarafi account for ten years (aggregate amount of retained capital Rs. 6 lacs). In consideration thereof, the company agreed to pay to each of them for a period of 10 years 5 per cent of the net profit of the company (aggregate 15 per cent net profit) or 15 per cent per annum on the amounts credited to the sarafi account of each of them, whichever is higher.
2.2. The accounting year in question ended on 30th June, 1981 relevant to asst. yr. 1982-83, The assessment was framed on 14th March, 1993, determining the total income of the assessee at Rs. 43,01,922. The assessee company's claim for deduction of Rs. 7.93 lacs paid to the former partners as return on their retained capital of Rs. 6 lacs was allowed on the basis of Clause 6 in the dissolution deed for payment of 5 per cent of the gross profits payable to each of the three former partners.
2.3. On 31st Jan., 1985, the Commissioner of Income-tax (CIT) issued a show-cause notice under Section 263 of the Act. The assessee-company submitted its reply dt. 22nd Feb., 1985. After considering the same, the CIT passed order dt. 12th March, 1985, holding that the order dt. 14th March, 1983, passed by the ITO was erroneous and prejudicial to the interest of the Revenue, inasmuch as the payment of Rs. 2,57,729 each to the three directors of the company had been wrongly allowed by the ITO while computing the total income. The CIT directed the ITO to revise the assessed income by adding the amount in question as the same was not allowable as a deduction. Alternatively, the CIT was of the view that the provisions of Section 40A(2) as also Section 40A(8) were applicable to the aforesaid payment, as the payment was excessive and unreasonable.
2.4. The assessee-company carried the matter in appeal before the Tribunal against the aforesaid order of the CIT under Section 263. The Tribunal dismissed the appeal holding that the CIT had rightly invoked his powers and assumed jurisdiction under Section 263. The Tribunal was of the view that provisions of Section 40A(2) would be squarely applicable in view of the close connection between the payer and the payee, as the outgoing partners were also the present directors of the assessee-company, a closely-held private limited company. While observing that it was for the assessee-company to decide whether to retain the amount of Rs. 6 lacs being the capital of the three partners (who are now directors of the company) with the assessee-company as a deposit, the Tribunal held that the payment of Rs. 7.93 lacs made by the assessee-company to the three former partners of the firm (who are now the directors of the assessee-company) as profit/interest for retaining the refundable deposit of Rs. 6 lacs for the year under consideration and also a recurring liability to share 15 per cent profits/pay 15 per cent interest (whichever is higher) for another period of nine years was excessive and unreasonable and 50 per cent of such payment was disallowed by the Tribunal for the assessment year in question i.e., 1982-83. Hence, this reference at the instance of the assessee.
3. At the hearing of this reference, Mr. R.K. Patel learned counsel for the assessee urged the following contentions :
3.1. No addition/disallowance is sustainable
(1) Once Tribunal disapproved the method of revision on alternatives by the CIT under Section 263, no addition/disallowance can be sustained on any other estimate basis.
(2) Tribunal has concluded that amounts payable to ex-partners were in the interest of business and tax authority cannot interfere with the decision of businessmen.
(3) There is a factual finding of Tribunal that transaction is not doubted and there is no attempt to evade tax.
(4) There is finding that there are huge liabilities and liabilities of outsiders are being given preference so far as discharging of business liability is concerned.
(5) Sharing of profits on the facts and circumstances of the case is not prohibited by law.
3.2. Non-applicability of Section 40A(2)
(1) Department has not proved prerequisite conditions required for the existence of excessive/unreasonableness of payments as compared to fair market value of services to outsiders.
(2) Ex-partners are taxed in higher slabs of rates of tax and the only basis for retaining 50 per cent disallowance by Tribunal is that they may not be taxed in future in higher bracket of tax rate.
(3) Reliance is placed on Circular No. 6P of 1968 dt. 6th July, 1968 (Chaturvedi and Pithisaria Vol. II p. 2431 at para 74 on p. 2432), for the purpose of contending that the powers under Section 40A(2) cannot be invoked when there is no tax evasion.
3.3. The learned counsel for the assessee has placed strong reliance on the decisions of this Court in Marghabhai Kishabhai Patel & Co. v. CIT : [1977]108ITR54(Guj) and in Voltemp Transformer (P) Ltd. v. CIT (1981) 129 ITR 105.
4. On the other hand Mr. Akil Kureshi, learned counsel for the Revenue has made the following submissions :
4.1. The power under Section 40A(2) can be invoked whenever the tax authority is of the opinion that the expenditure or payment is excessive or unreasonable having regard to the relevant considerations mentioned in the provision, so much of the payment as is considered by the Tax authority to be excessive or unreasonable shall not be allowed as a deduction. The facts are glaring. For retaining an amount of Rs. 6 lacs of the former partners (the present directors of the assessee-company), the assessee-company pays return of Rs. 7.93 lacs for one year with similar liability to pay profits at the rate of 15 per cent of the gross profits for the next five years or interest at the rate of 15 per cent per annum whichever is higher for the next nine years. This fact is too glaring to be ignored.
4.2. Malhotra Steel Corporation (i.e. a dissolved firm) was doing lucrative business and earning good profits. Hence, at the time of dissolution, the parties knew that the firm was making substantial profits and that 15 per cent of the amount of gross profit of the firm is going to be a sizeable amount.
4.3. The three outgoing partners of the dissolved firm are directors in the assessee-company (which is a closely held private limited company which, took over the business of the dissolved firm). Hence, this was a case of the payer and payee being the same persons for all practical purposes. Whatever assets in the partnership firm which they gave up in dissolution, they got them as shareholders and directors of the closely-held private limited company.
4.4. The fact that the outgoing partners (present director of the assessee-company) paid individual tax on the amounts of Rs. 7.93 lacs received from the assessee-company as return on their capital cannot wipe out the fact that even if the said outgoing partners had been paid by the assessee-company interest at 30 per cent p.a., only that part of the amount (i.e., Rs. 1,80,000) would have been deductible from the income of the assessee-company and on the balance amount of Rs. 6,13,000 the assessee-company would have had to pay income-tax at corporate rate plus the outgoing partners (who are present directors of the assessee-company) would also have to pay income-tax on dividend from the assessee-company at the individual rates (they were in the high bracket). Hence, by the arrangement in question, the directors of the company decided to pay this huge amount as return on their own capital i.e., their capital in their capacity as the outgoing partners of the dissolved firm.
4.5. In any view of the matter, the finding that the payment made by the assessee-company to the outgoing partners (the present directors of the assessee-company) was excessive and unreasonable to the extent of 50 per cent, is a finding of fact which has been given by the Tribunal after taking into consideration all the relevant facts and circumstances and that the finding of the Tribunal is not outside the bracket nor is it such that no reasonable person could have arrived at. In short, the finding of the Tribunal can never be said to be perverse. Hence, this Court may not go behind the finding of fact given by the Tribunal.
5. Before dealing with rival submissions, it is necessary to refer to the provisions of Section 40A(2) of the Act, which reads as under :
'40A(2)(a) : 'Where the assessee incurs any expenditure in respect of which payment has been made or is to be made to any person referred to in Clause (b) of this sub-section, and the ITO is of opinion that such expenditure is excessive or unreasonable having regard to the fair market value of the goods, services or facilities for which the payment is made or the legitimate needs of the business or profession of the assessee or the benefit derived by or accruing to him therefrom, so much of the expenditure as is so considered by him to be excessive or unreasonable shall not be allowed as a deduction : Provided that the provisions of this sub-section shall not apply in the case of an assessee being a company in respect of any expenditure to which Sub-clause (i) of Clause (c) of Section 40 applies.'
It is clear that the legislature has laid down the relevant considerations for enabling, and empowering, the ITO to decide whether the payment in question made by the assessee is excessive or unreasonable so as to warrant disallowance.
6. Under Section 263 of the Act, the CIT came to the conclusion that the decision of the ITO to allow the entire amount of Rs. 7.93 lacs as payment which was not at all excessive or unreasonable was prejudicial to the interest of the Revenue. The CIT disallowed the entire payment. In appeal the Tribunal held that having regard to the facts and circumstances of the case, the payment was excessive and unreasonable only to the extent of 50 per cent. Hence, 50 per cent payment was allowed as disallowed. Having heard the learned counsel for the parties, the Court is of the view that there is considerable substance in the submissions made by the learned counsel for the Revenue that the finding given by the Tribunal that the payment made by the assessee-company to the three outgoing partners (the present directors of the assessee-company) is excessive or unreasonable to the extent of 50 per cent is a finding of fact which does not warrant any interference by this Court.
6.1. We also find considerable substance in the submission made by Mr. Kureshi for the Revenue that the question arising out of Section 40A(2)(a)--whether a particular expenditure is excessive and unreasonable or not, is essentially a question of fact and does not involve any issue of law. In taking this view, we are fortified by the decision of the apex Court in Upper India Publishing House (P) Ltd. v. CIT : [1979]117ITR569(SC) decision of the Delhi High Court in CIT v. Northern India Iron and Steel Co. Ltd. : [1989]179ITR599(Delhi) and decision of the Punjab & Haryana High Court in Narain Motors v. CIT .
7. As regards the contention urged by the learned counsel for the assessee that once the Tribunal disapproved the method of revision on alternatives by the CIT under Section 263, no addition/disallowance can be sustained on any other estimate basis, the contention is misconceived. It is open to the authority to arrive at a conclusion that the order of the assessing authority is prejudicial to the interest of the Revenue by examining the matter from more than one possible angle and then to support its conclusion with more than one reason. If the authority examines all the possible arguments coming from the assessee and finds no substance in them, it is open to revisional authority to hold that, looking at from whatever angle, the assessment calls for revision in respect of a particular item the payment of which was allowed by the AO and which has caused serious prejudice to the Revenue.
8. As regards the second contention, the learned counsel for the assessee has obviously misread the order of the Tribunal. All that the Tribunal observed was that the decision of the assessee-company to retain the amount of Rs. 6 lacs (which was the capital of the outgoing partners in the dissolved firm) was the decision of a businessman looking to the business exigencies and the CIT could not have disallowed the entire payment of Rs. 7,93 lacs to the outgoing partners (the present directors of the assessee) only on the ground that the amount of Rs. 6 lacs ought not to have been retained by the assessee-company but ought to have been paid off if necessary by borrowing from outside sources. Thus, after coming to the conclusion that it was not for the Department to decide whether the assessee-company was justified in retaining the amount of Rs. 6 lacs, there was no contradiction in examining whether the return given by the assessee-company to the outgoing partners (the present directors) on the retained capital was excessive or unreasonable having regard to the relevant factors. Hence, the second contention does not carry the assessee's case any further.
9. Coming to the third contention, it is required to be noted that the power available to the Tax authority under Section 40A(2) is not available only in the case of sham or bogus transactions but it is available even in case of bona fide transactions if the expenditure or payment is found to be excessive or unreasonable having regard to the relevant factors and it is only excess/unreasonable payment, which is to be disallowed. Hence, it is not possible to accept the assessee's contention that once the transaction is not found to be mala fide or 'device' the power under Section 40A(2) cannot be exercised. It was open to the Tribunal, as an appellate authority, to enquire into the question whether the CIT's finding that the payment was excessive or unreasonable was proper or not.
10.1. At this stage, it would not be out of place to note the submission made by the learned counsel for the Revenue that even if the assessee-company had paid interest on the retained capital of Rs. 6 lacs at 30 per cent (the bank rate at the relevant time did not exceed 24 per cent), on the balance amount of Rs. 6.13 lacs (Rs. 7.93 lacs minus Rs. 1.80 lacs), the assessee-company would have been required to pay income-tax at the corporate rate and the three directors of the assessee-company (outgoing partners) would also have been required to pay income-tax on the income which they would have got by way of dividend from the assessee-company at the highest individual rates and, therefore, there is no justification for proceeding on the basis that there was no attempt to evade or avoid income-tax. The learned counsel for the assessee would, of course, counter the said suggestion by submitting that the Revenue had not led any evidence to show what would have been the income-tax payable by the present directors of the assessee-company (three outgoing partners) on the dividend which they would have received out of the amount in question (Rs. 7.93 lacs minus interest at 30 per cent or whatever may be the rate of interest).
10.2. We need not go into this dispute nor was it necessary for the Tribunal to calculate with mathematical precision or arithmetical accuracy the aggregate of the amount of tax which would have been payable by the assessee-company on the excess payment and by the three directors of the assessee-company (outgoing partners) on the amount of dividend which they would have received if the disputed amount was not paid to them by way of return on retained capital. The Tribunal has allowed 50 per cent of payment i.e., 50 per cent of Rs. 7.93 lacs as a reasonable return on retained capital of Rs. 6 lacs, after taking into consideration all the relevant facts including the fact that the outgoing partners (who are the directors of the assessee-company at the time of dissolution and thereafter) had given up a lucrative business whose goodwill at the time of dissolution could be evaluated at a huge figure and they also gave up large bundle of rights as stated in the dissolution deed which included licences, quota, tenancy rights etc. In other words, when the assessee-company paid Rs. 7.93 lacs as return on the retained capital of Rs. 6 lacs, the assessee-company has been allowed deduction to the extent of Rs. 3.91 lacs which would come to almost 65 per cent return on the retained capital of Rs. 6 lacs in the very first year. When such a large chunk of payment (65 per cent from the assessee-company to the outgoing partners (the present directors of the assessee-company) by way of return on their capital retained by the assessee-company is allowed by the Tribunal, in spite of the fact that whatever goodwill, licenses, tenancy rights, etc. which were enjoyed by the firm before dissolution were taken over by the closely-held private limited company (assessee-company) of which the outgoing partners became directors, we do not think that any detailed inquiry was required to be held by the Tribunal about the possible taxes which the assessee-company would have been required to pay on excess payment and the directors would have been required to pay on the dividend which they would have received instead of the return on their capital (i.e. Rs. 7.93 lacs minus 30 per cent interest on Rs. 6 lacs). This Court is, therefore, of the view that even though sharing of profits by the outgoing partners in lieu of return on their retained capital is not prohibited by law, the Tribunal did not err in holding that the return of Rs. 7.93 lacs on the retained capital of Rs. 6 lacs was excessive and unreasonable to the extent of 50 per cent.
10.3. The Tribunal has also referred to the following payments made by the assessee-company to the outgoing partners (the present directors of the assessee-company) for four years including the present assessment year.
Asst. yr.
Amount (Rs.)
1982-83
7,73,187
1983-84
5,78,561
1984-85
5,35,512
1985-86
90,000
19,77,260
It is after the order dt. 12th March, 1985, of the CIT under Section 263 that the assessee-company paid off all its liabilities to the outgoing partners (the present directors) by returning the capital amount of Rs. 6 lacs which goes to show that the assessee-company had made the arrangement to reduce its tax liabilities and not out of any commercial considerations.
11. In view of the above conclusion, this Court is of the view that the relevance of circular No. 6-P dt. 6th July, 1968, is of no consequence because this Court is not in a position to express a view that the assessee-company had not resorted to the arrangement in question to reduce its tax liabilities or to evade the payment of tax. This Court is not in a position to say that the arrangement made by the assessee-company was bona fide. Even otherwise, the view taken by the Tribunal that it does not approve of any method which would cast a burden on the exchequer for a period of ten years cannot be said to be perverse. This Court is of the view that the Tribunal was justified in holding that the provisions of Section 40A(2) were squarely applicable to the facts of the case and the disallowance to the extent of 50 per cent under the said provisions does not warrant any interference by this Court.
11.1. In Ved Prakash M. Patel v. CIT : [1988]169ITR591(MP) the Madhya Pradesh High Court also had an occasion to consider a similar case where the beneficiaries of the royalty under an agreement in question were being paid the royalty in sum equal to the amount of the investment. The High Court upheld the finding of the Tribunal that the payment of royalty was excessive after noting that had the beneficiaries of the royalty under the agreement not been the members of the assessee's own family and were outsiders, such an agreement whereunder a sum equal to the amount of the investment was to be paid as royalty would not have been entered into by any prudent businessman.
12. As regards the decision cited by the learned counsel for the assessee in Marghabhai Kishabhai Patel & Co. v. CIT (supra), in that case this Court had no occasion to consider the provisions of Section 40A(2) of the Act because that case related to asst. yrs. 1962-63 to 1965-66 whereas the provisions of Section 40A were inserted by the Finance Act, 1968 w.e.f. 1st April, 1968. Moreover, in the aforesaid case, the commodity in question was tobacco and the assessee had contended that it had paid higher price for better quality of tobacco. This Court was, therefore, of the view that since qualities of tobacco differ very widely and also there may be fluctuations in the market from time to time, striking an average of the price of all tobacco purchased during the entire season irrespective of qualities and of fluctuations in the market rate was a very unscientific method followed by the Department in arriving at its conclusion and the Department had no right to depart from the prices shown in the books of account unless it found the transaction not to be a bona fide one or to be a sham one or unless it found that the prices paid were not what was shown in the books of account. As already stated above, the Court had no occasion to consider the provisions of Section 40A(2) of the Act and the commodity in question was one which was susceptible to fluctuations in terms of price as well as in terms of quality. Whatever may be the fluctuations in the rate of interest on monies being borrowed from the market, it could never be 13 per cent p.a. which was the rate of return paid by the assessee-company to its directors on their capital as former partners. When the Tribunal has disallowed only 50 per cent of that amount as excessive or unreasonable (i.e. 65 per cent), the decision in Marghabhai's case (supra) cannot come to the assessee's rescue.
13. As regards the decision of this Court in Voltamp Transformers (P) Ltd. v. CIT (supra), it is true that in that case the Court did have an occasion to consider the provisions of Section 40A(2) of the Act but in that case the facts were entirely different. The assessee therein was carrying on the business of manufacture and sale of electric transformers. The assessee-company had agreed to pay commission to sole selling agency which was a partnership firm wherein the partners were wives of the directors of the assessee-company. The agreed rate of commission was at the rate of 3 per cent (three per cent) in case of sales made to Government or semi-Government institutions and 5 per cent (five per cent) in the case of sales to a private party. The commission was to be calculated on the invoice value of the goods sold by the company. Sales-tax, general sales-tax, excise duty or any other taxes, freight, transport charges, etc. were not to be included in the net invoice value for the purpose of calculating the commission. In the year in question, i.e., the year ending 30th June, 1968, relevant to the asst. yr. 1969-70, the assessee-company paid a total amount on commission of Rs. 80,977 (eighty-one thousand only) to the partnership firm in question. The question was whether this amount of commission could be . allowed. The ITO disallowed the entire commission amount on the ground that there was no commercial expediency for paying commission. It was in this set of facts that this Court held that the finding given by the Tribunal that the partnership firm business was not really carried, on by its partners and that the partnership firm did not appear to be genuine was not warranted as the partnership firm was already formed since 1965 and it had been doing considerable business in the line of electric materials. This Court also held that so far as the questions of commercial expediency and business needs of an organisation are concerned, it is not the viewpoint of a Revenue Officer which should count but it should be the viewpoint of an ordinary businessman dealing with a situation like the one faced by the particular assessee in question.
In the facts of the aforesaid case, therefore, this Court came to the conclusion that the payment of 5 per cent commission was a fair market value for the services rendered by the sole selling agency.
14. In the facts of the instant case, the Tribunal did hold that the decision of the assessee-company whether to retain an amount of Rs. 6 lacs to the capital of the outgoing partners (the present directors of the assessee-company) or to pay it off was the decision of the assessee-company as a businessman and that such decision was not to be interfered with but the Tribunal was justified in considering the question whether the return paid by the assessee-company to the outgoing partners (the present directors of the assessee-company) was excessive or unreasonable or not, This is a question of fact which the Tribunal has considered with due regard to all the relevant facts and circumstances and the criteria laid down in Section 40A(2) and thereafter the Tribunal has rightly held that payment of Rs. 7.93 lacs as return on the retained capital of Rs. 6 lacs for one year and liability to pay 15 per cent profits for the next nine years with liability of the assessee-company to refund full amount of Rs. 6 lacs after ten years was certainly excessive and unreasonable. This Court finds no reason to interfere with the view taken by the Tribunal. If at all there was any error committed by the Tribunal it was in favour of the assessee-company by making disallowance to the extent of 50 per cent only. However, we need not examine it any further as no question has been referred to us at the instance of the Revenue.
15. This Court is, therefore, of the view that the Tribunal was right in applying the provisions of Section 40A(2) of the Act to the facts of the instant case. Our answer to the question is accordingly in the affirmative i.e., in favour of the Revenue and against the assessee.
16. The reference accordingly stands disposed of with no order as to costs.
D.A. Mehta, J.
1. I have gone through the judgment of my learned Brother but for the reasons that follow I am unable to persuade myself to agree with the views expressed therein.
2. This reference is at the instance of the assessee. In reference application under Section 256(1) of the IT Act, 1961 (hereinafter referred to as 'the Act'), the assessee proposed the following five questions requesting the Tribunal to raise and refer the same for the opinion of this Court :
(1) 'Whether, on the facts and in the circumstances of the case, the Tribunal was justified in upholding the exercise of powers under Section 263 of the IT Act by the CIT when :
(i) The Tribunal had not approved of the method in which the order had been passed;
(ii) The Tribunal had held that the assessee was justified in the interest of its business in retaining a part of the amount payable to the ex-partners and that such decision could not be interfered with by the Tax authorities; and
(iii) The Tribunal had found that there was no attempt to evade taxes and that the transaction was not doubted ?
(2) Whether, on the facts and in the circumstances of the case, the Tribunal was justified in law in upholding the CIT's assumption of jurisdiction under Section 263 of the IT Act on the basis that the provisions of Section 40A(2) of the Act would be applicable ?
(3) Whether, on the facts and in the circumstances of the case, the Tribunal was justified in law in coming to the conclusion that in view of close connection between the payer and payee, the provisions of Section 40A(2) would be applicable, even when the Revenue had not been able to prove the existence of the prerequisite conditions laid down in the said section as regards the expenditure being excessive or unreasonable having regard to the fair market value of the goods, services or facilities for which the payment was made or the legitimate needs of the business ?
(4) Whether, on the facts and in the circumstances of the case, the Tribunal was empowered to override and rewrite the terms of deed of dissolution entered into by the partners merely because the Tribunal was not impressed with the terms of the arrangement and found the same to be strange, especially when the agreement was found to be genuine and was not doubted by the Revenue ?
(5) Whether, on the facts and in the circumstances of the case, the approach of the Tribunal while deciding applicability of provisions of Section 40A(2) can be said to be correct in law it having assumed that the ex-partners may not be taxed in the higher bracket on some latter stage even though they were taxed at high income at present ?'
3. The Tribunal, however, his referred the following question by stating in para. 6 of the statement of the case that :
'6. From and out of the aforesaid facts we refer the following question which would bring out the controversy sought to be raised by the five questions proposed by the applicant company :
'Whether, on the facts and circumstances of the case, the provisions of Section40A(2) were applicable ?' (emphasis, italicised in print, supplied)
Therefore, the controversy will have to be resolved in light of all the aspects raised in the proposed questions and not limited to apparent reading of the question ultimately referred by the Tribunal i.e., deciding only applicability or otherwise of Section 40A(2) of the Act.
4. The assessment year is 1982-83 and the relevant accounting period is the year ended on 30th June, 1981. As various facts have been narrated in the judgment rendered by my learned Brother, it is not necessary for me to repeat the same. I shall, however, highlight only certain salient features as available from the record. The assessment was framed on 14th March, 1983, under Section 143(3) of the Act on a total income of Rs. 42,98,598. On 31st Jan., 1985, the CIT, Gujarat-I, Ahmedabad issued a show-cause notice under Section 263 of the Act proposing to set aside/suitably modify the assessment for the year under consideration on the grounds that :
(1) The ITO should have disallowed the payment of Rs. 7,93,187 and added back the same to the total income of the company, being apportionment of profit of the company.
(2) Alternatively, the payment being excessive, the ITO should have applied the provision of Section 40A(2) of the Act and disallowed part of the payment.
(3) The ITO should also have applied the provision of Section 40A(8) of the Act as the sarafi accounts in the names of the erstwhile partners are nothing but deposits made by them.
The assessee submitted a detailed reply on 22nd Feb., 1985.
5. The CIT, however, did not agree with the explanation tendered by the assessee and after narrating various facts recorded the following findings :
'..............By retiring from the firm the three outgoing partners were deprived of their future share in the profits of the firm. It would appear that the agreement mentioned above was entered into with a view to compensate the outgoing partners for this loss. If this was not the intention, agreement would not have provided for payment for a specific period of 10 years. The assessee, itself, has stated in para four of the letter dt. 22nd Feb., 1985 that the three outgoing partners were entitled to 45 per cent of the assets of the firm including goodwill and that while making up of the accounts of the partnership for the purpose of dissolution and to determine the amount payable to them as consideration for retention of Rs. 6 lakhs this aspect that they had 45 per cent share in the assets of the firm including goodwill which they agreed to be taken over by the company obviously weighted with them and was taken into account. It is evident from this that the agreement to pay the amounts as per Clause 6 was made in order to compensate the outgoing partners for their loss due to their retirement from the firm. In other words, the agreement provided for paying their share in the goodwill of the firm during a span of 10 years instead of by a lump sum.'
xxx xxx 'I, therefore, hold that the payment made to outgoing partners for retaining Rs. 6 lakhs is nothing but sharing in the profits of the company and hence not allowable as a deduction in computing its total income.'
The aforesaid findings were in relation to his basic premises that the retention of Rs. 6 lacs by the assessee-company and making payment in relation to the same as per terms of the agreement was nothing but sharing in the profits of the company and hence not allowable as deduction while computing its total income.
6. The CIT, in the alternative, sought to apply provision of Section 40A(2) of the Act and recorded the finding vide para 17 of his order :
'17. Without prejudice to the above, I hold that provisions of Section 40A(2) are applicable in this case. In terms of Section 40A(2) if an assessee incurs an expenditure in respect of which payment has been made to a director of a company and the ITO is of the opinion that such expenditure is excessive or unreasonable having regard to the fair market value of the goods, services or facilities for which the payment has been made or the legitimate needs of the business or profession of the assessee, so such of the expenditure as is so considered by the ITO to be excessive or unreasonable shall not be allowed as a deduction. The outgoing partners of firm to whom an amount of Rs. 7,93,198 was paid during the year for retaining Rs. 6 lakhs are also directors of the assessee-company. For the reasons narrated above, it must be held that the payment of Rs. 7,93,187 was both unreasonable and excessive having regard to the fair market value of the facilities received by the assessee.'
7. He also observed that provision of Section 40A(8) are also applicable as the amount retained by outgoing partners is nothing but deposits.
8. Ultimately following effective order was framed vide para. 19 by the CIT :
'19. In view of the above discussion I hold that the assessment made by the ITO is erroneous insofar as it is prejudicial to the interest of Revenue. The assessment should be revised by adding to the total income assessed the sum of Rs. 7,93,187 which is not admissible as a deduction for the reasons stated hereinabove.'
9. Against this order the assessee preferred appeal before the Tribunal and the Tribunal in para 11 of its order dt. 10th July, 1987, stated as under :
'17. We are accordingly of the view that the CIT had rightly invoked his powers and assumed jurisdiction under Section 263. We however, do not approve of the method in which the order has been passed. The learned CIT should have pinpointed the exact provision of the Act under which he proposed to disallow the payment rather than spelling out different alternatives. He has on the one hand disallowed the entire payment and at the same time held that provisions of Section 40A(2) as also 40A(8) are applicable which envisage only part disallowance and not the whole. We are initially inclined to set aside the order and restore it to the file of the CIT asking him to pass a proper order after coming to a definite conclusion as to which was the provision of the Act which was sought to be applied in the assessee's case. We have however restrained ourselves from doing so in the interests of justice and with a view to cut short the litigation. We accordingly proceed to decide the issue on merits.'
10. Thus, as can be seen the question referred encompasses all the aspects in relation to which the assessee felt aggrieved by the Tribunal's order. Mr. R.K. Patel, learned Advocate for the applicant-assessee commenced with submission by referring to para 1 of the Tribunal's order and contended that the Tribunal itself has recorded that the appeal was directed against the order under Section 263 of the Act passed by the CIT. It was urged therefore, that the question raised and referred may be appreciated in context of the controversy which was there before the Tribunal.
11. Inviting our attention to para. 11 of the Tribunal's order he contended that the Tribunal having recorded a finding that it did not approve of method in which the CIT had passed the order, it was not thereafter open to the Tribunal to come to the conclusion that the CIT had rightly invoked his power and assumed jurisdiction under Section 263 of the Act. Mr. Patel thereafter referred to paras 14 to 16 of the Tribunal's order in support of his submission that the Tribunal had accepted explanation of the assessee that the assessee was not, in a position to discharge its liability immediately and hence, it had entered into the arrangement in question. It was also submitted that the admitted fact was that the transaction had not been doubted and hence the CIT ought not to have interfered with the assessment, inasmuch as the transaction was part and parcel of terms of the dissolution deed executed by the erstwhile partners on 1st Aug., 1980. He further urged that provision of Section 40A(2) of the Act, applicability whereof had been upheld by the Tribunal, required that the satisfaction must be of the assessing authority and not of any other authority, viz., CIT or Tribunal, That, in such circumstances it was not open either to the CIT or to the Tribunal to invoke Section 40A(2) of the Act.
12. As against this Mr. AKil Qureshi, learned counsel appearing on behalf of the Revenue has submitted that only question that was brought before the Court was applicability of Section 4QA(2) of the Act and it was not possible to take into consideration any other aspect of the matter, including various findings recorded by the Tribunal as regards the transaction. He submitted that though the terms of the dissolution deed could not be questioned its effect had to be seen i.e., on retention of Rs. 6 lacs the assessee-company had paid Rs. 7,73,187 and this was a recurring liability for another period of 9 years. That the Tribunal had taken into consideration all the relevant factors and thereafter arrived at a conclusion of fact that 50 per cent of the payment viz. Rs. 7,93,187 was excessive and unreasonable as required under Section 40A(2) of the Act. It was, therefore, urged that this was a question of fact and it was not open to the Court to go behind the same and arrive at any other conclusion.
13. Before going further in relation to the various findings recorded by the Tribunal and dealing with various submissions raised on behalf of both the sides it is necessary to take into consideration the scope of powers of the CIT under Section 263 of the Act.
14. In case of Malabai Industrial Co. Ltd. v. CIT (2000) 243 ITR 83 it is stated thus by the apex Court :
'A bare reading of provisions of Section 263 of the IT Act, 1961, makes it clear that the prerequisite for the exercise of jurisdiction by the CIT suo motu under it, is that the order of the ITO is erroneous insofar as it is prejudicial to the interests of the Revenue. The CIT has to be satisfied of twin conditions, namely, (i) the order of the AO sought to be revised is erroneous; and (ii) it is prejudicial to the interests of the Revenue. If one of them is absent--if the order of the ITO is erroneous but is not prejudicial to the Revenue or if it is not erroneous but is prejudicial to the Revenue, recourse cannot be had to Section 263(1) of the Act. The provision cannot be invoked to correct each and every type of mistake or error committed by the AO; it is only when an order is erroneous that the section will be attracted. An incorrect assumption of facts or an incorrect application of law will satisfy the requirement of the order being erroneous. In the same category fall orders passed without applying the principle of natural justice or without application of mind, The phrase 'prejudicial to the interests of the Revenue' is not an expression of art and is not defined in the Act. Understood in its ordinary meaning it is of wide import and is not confined to loss of tax. The scheme of the Act is to levy and collect tax in accordance with the provisions of the Act and this task is entrusted to the Revenue. If due to an erroneous order of the ITO, the Revenue is losing tax lawfully payable by a person, it will certainly be prejudicial to the interests of the Revenue. The phrase 'prejudicial to the interests of the Revenue' has to be read in conjunction with an erroneous order passed by the AO. Every loss of revenue as a consequence of an order of AO cannot be treated as prejudicial to the interests of the Revenue, for example, when an ITO adopted one of the courses permissible in law and it has resulted in loss of revenue; or where two views are possible and the ITO has taken one view with which the CIT does not agree, it cannot be treated as an erroneous order prejudicial to the interests of the Revenue unless the view taken by the ITO is unsustainable in law......'
It may be noted that the decision in the case of CIT v. Gabriel India Ltd. : [1993]203ITR108(Bom) and in the case of CIT v. Smt. Minalben S. Parikh : [1995]215ITR81(Guj) have been considered and impliedly approved by the apex Court in the decision in the case of Malabar Industrial Co. Ltd. (supra)
15. It must be borne in mind that the Courts have consistently held that jurisdiction can be assumed by the CIT under Section 263 of the Act, provided the twin conditions namely, the order of the AO being erroneous and, being prejudicial to interest of the Revenue stand satisfied. Section 263 of the Act is one of the provisions in the Act which empowers disturbing an order passed by the AO on the prescribed conditions being satisfied. Similarly, the provisions of Section 147 of the Act and Section 154 of the Act are the other sections which permit reopening or rectifying respectively, completed assessment. It is necessary to note that the IT Act is an act for the purpose of levy, collection and recovery of tax on income and for this purpose various provisions have been incorporated prescribing the requirements as well as the procedure for computation of tax lawfully payable by a person. The policy of law is that finality of an order shall not be lightly disturbed and the authority seeking to disturb such a completed assessment shall have to satisfy the Court, where the action of the authority is challenged, that the relevant objective factors were available from the records called for and examined by such authority.
16. Before I deal with the submissions made on behalf of the parties it is necessary to have a look at the relevant provisions of the Act. Section 40A as is relevant for the present controversy as well as Section 40(c) read as under :
'40A--(1). The provisions of this section shall have effect notwithstanding anything to the contrary contained in any other provision of this Act relating to computation of income under the head 'Profits and gains of business or profession'.
(2)(a) Where the assessee incurs any expenditure in respect of which payment has been or is to be made to any person referred to in Clause (b) of this sub-section, and the ITO is of opinion that such expenditure is excessive or unreasonable having regard to the fair market value of the goods, services or facilities for which the payment is made or the legitimate needs of the business or profession of the assessee or the benefit derived by or accruing to him therefrom, so much of the expenditure as is so considered by him to be excessive or unreasonable shall not be allowed as a deduction :
Provided that the provisions of this sub-section shall not apply in the case of an assessee being a company in respect of any expenditure to which Sub-clause (i) of Clause (c) of Section 40 applies. (b) The Persons referred to in cl. (a) are the followings, namely :
(i) Where theassessee is an individual
any relative of the assessee;
(ii) Where theassessee is a company, firm, AOP or HUF
any director ofthe company, partner of the firm or member of the association or family, orany relative of such director, partner ormember;
xxx xxx (vi) any person who carries on a business or profession :
(A) Where the assessee being an individual, or any relative of such assessee, has a substantial interest in the business or profession of that person; or
(B) Where the assessee being a company, firm, AOP or HUF, or any director of such company, partner of such firm or member of the association or family, or any relative of such director, partner or member, has substantial interest in the business or profession of that person,
xxx xxx xxx xxx' '40. Notwithstanding anything to the contrary in Sections 30 to 39, the following amounts shall not be deducted in computing the income chargeable under the head 'Profits and gains of business or profession,'
xxx xxx (c) in the case of any company-
(i) any expenditure which results directly or indirectly in the provision of any remuneration or benefit or amenity to a director or to a person who has a substantial interest in the company or to a relative of the director or of such person, as the case may be,
(ii) any expenditure or allowance in respect of any assets of the company used by any person referred to in Sub-clause (i) either wholly or partly for his own purposes or benefit,
if in the opinion of the ITO any such expenditure or allowance as is mentioned in Sub-clauses (i) and (ii) is excessive or unreasonable having; regard to the legitimate business needs of the company and the benefit derived by or accruing to it therefrom, so, however, that the deduction in respect of the aggregate of such expenditure and allowance in respect of any one person referred to in Sub-clause (i) shall, in no case, exceed -
(A) where such expenditure or allowance relates to a period exceeding eleven months comprised in the previous year, the amount of seventy-two thousand rupees;
(B) where such expenditure or allowance relates to a period not exceeding eleven months comprised in the previous year, an amount calculated at the rate of six thousand rupees for each month or............'
17. Section 40A opens with non obstante clause which operates as overriding provision vis-a-vis other provisions of the Act relatable to computation of profits and gains of business or profession i.e., Sections 30 to 39 of the Act. An expenditure which is otherwise allowable is liable to be partially disallowed under Section 40A(2) of the Act if other conditions are satisfied. Before this section can be invoked it is necessary that : (i) expenditure is incurred by a person i.e., payer, (ii) such expenditure results in payment from the payer to the payee i.e., the payer is a distinct entity from the recipient. In absence of these two basic premises provisions of Section 40A(2) of the Act cannot be invoked. Section 40A(2) of the Act is a provision which has been brought on statute book to curb payments made to connected persons where the legislature felt that the tax liability is artificially reduced by diverting business profits to relatives in the form of excessive payments for goods and services. Therefore, as a necessary corollary a finding shall have to be recorded by the authority in respect of fair market value of the goods, services, or facilities. A payment which is otherwise eligible for deduction is to be disallowed partly when the ITO is of the opinion that such expenditure is excessive or unreasonable having regard to the fair market value of the goods, services or facilities for which the payment is made, or legitimate needs of the business or profession, or the benefit derived by or accruing to the payer from such goods, services or facilities, so much of the expenditure which is considered to be excessive or unreasonable shall not be allowed as a deduction. Therefore, admittedly when the provisions of Section 40A(2) of the Act are sought to be invoked it would not be possible for the Revenue to contend that the expenditure is not incurred or that the expenditure though incurred is not allowable at all; to the contrary, the authority has to proceed on the footing that the expenditure has been incurred and is otherwise allowable and hence it is for the authority concerned to show that the payment is excessive or unreasonable having regard to the fair market value of goods, etc. in the light of legitimate needs of the business or other requirements laid down in the section.
18. Section 40A(2)(a) casts very heavy burden on the ITO to record a finding before making any disallowance under this section. For this purpose, as provided in the section he shall have to :
(i) find out the fair market value of the goods, services or facilities by taking into consideration the various surrounding circumstances in which such goods, services or facilities have been rendered and has to further proceed on the footing that the same may either be commonly available for which fair market value can be ascertained or may be of the nature which are not commonly available in market for the purpose of ascertaining fair market value;
(ii) the officer shall have to evaluate the legitimate needs of the business at a point of time when the services or facilities were obtained and this would involve an inquiry as a businessman, because in times of dire need services, which may have been obtained at a particular rate, may be obtained even at higher cost, the ultimate aim being to earn profit or to maintain the business relations;
(iii) the officer is also required to find out the benefit derived while assessing and for this purpose it is not necessary to confine to the assessment year in which payment is made but an overall view will have to be taken into consideration depending upon the peculiar facts of a case. The benefit, if not derived, but accruing to an assessee shall have to be evaluated applying the same test as in case when a benefit is derived;
(iv) the benefit derived may or may not be in the revenue field;
(v) after ascertaining the aforesaid facts, the officer shall have to afford reasonable opportunity to the assessee to rebut his prima facie finding and the decision regarding the proportion of disallowance as being excessive or unreasonable shall have to be taken only after giving effective hearing to the assessee.
In absence of availability of such facts the provision of Section 40A(2) of the Act cannot be invoked against an assessee.
19. There is one more aspect of the matter viz. proviso to Section 40A(2) of the Act which specifies that in case of an assessee who is a company provisions of Section 40A(2) of the Act shall not apply to any expenditure to which Section 40(c) of the Act applies. Section 40(c)(i) of the Act provides for disallowing any expenditure which results directly or indirectly in providing remuneration or benefit or amenity to a director or to a person having substantial interest in the company if the ITO is of the opinion that any such expenditure is excessive or unreasonable having regard to the legitimate business needs of the company and the benefit derived by or accruing to the company therefrom-then the disallowance has to be made within the limits prescribed. Thus, it can be seen that almost similar language, as is used by the legislature in this provision, is used in Section 40A(2) of the Act by virtue of proviso to Section 40A(2) an exception is carved out whereby Section 40A(2) an exception is carved out whereby Section 40A(2) is not applicable in case where Section 40(c) of the Act becomes applicable. Both these provisions were taken into consideration by Karnataka High Court in the case of T.T. (P) Ltd. v. CIT : [1980]121ITR551(KAR) and it was stated that Section 40A(2) uses the expression 'services' which is an expression of wider import while the term 'remuneration', 'benefit' or 'amenity' referred to in Section 40(c) cannot be treated on the same footing as what is paid in return for 'goods', 'services' or 'facilities' used in Section 40A(2) of the Act, because what has to be ascertained is the 'fair market value' of the 'goods', 'services' and 'facilities' in the latter section. It is further stated that the 'goods', 'services' and 'facilities' referred to in Section 40A(2) are those which have a market value and which are commercial in character. The aforesaid decision has been followed by Punjab and Haryana High Court in CIT v. Avon Cycles (P) Ltd. . The Calcutta High Court has also taken the same view in India Jute Co. Ltd. v. CIT : [1989]178ITR649(Cal) . The decision of Karnataka High Court of T.T. (P) Ltd. (supra) has been approved by the Supreme Court in the case of Bharat Beedi Works (P) Ltd. and Anr. v. CIT : [1993]201ITR1063(SC) .
20. When Section 40A(2) was introduced by the Finance Act, 1968, the CBDT issued an Explanatory circular being Circular No. 6-P(LXXVI-66) of 1968, dt. 6th July, 1968. Para. 74 of the said circulars reads as under :
'74. It may be noted that the new provision is applicable to all categories of expenditure incurred in businesses and professions, including expenditure on purchase of raw materials, stores or goods, salaries to employees and also other expenditure on professional services, or by way of brokerage, commission, interest, etc. Where payment of any expenditure is found to have been made to a relative or associate concern falling within the specified categories, it will be necessary for the ITO to scrutinise the reasonableness of the expenditure with reference to the criteria mentioned in the section. The ITO is expected to exercise his judgment in a reasonable and fair manner. It should be borne in mind that the provision in meant to check evasion of tax through excessive or unreasonable payments to relatives and associate concerns and should not be applied in a manner which will cause hardship in bona fide cases.'
21. As already seen the CIT has passed order under Section 263 of the Act by stating that sum of Rs. 7,93,187 is payment made to outgoing partners for retaining Rs. 6 lacs and, therefore, it is nothing but sharing the profits of the company and hence not eligible as a deduction in computing the total income. Even after invoking the provision of Section 40A(2) of the Act as an alternative, the CIT states that the payment of Rs. 7,93,187 was unreasonable and excessive having regard to the fair market value of the facilities received by the assessee. Ultimately in the last para of his order, in the operative portion, the direction issued to the AO is that the assessment should be revised by adding to the total income sum of Rs. 7,93,187 which is not admissible as a deduction for the reasons stated by him in his order. It is this order that the Tribunal has confirmed by holding that the provisions of Section 40A(2) of the Act are applicable.
22. The Tribunal has basically not accepted the findings of the CIT while upholding the contention raised by the assessee in relation to the question of retaining Rs. 6 lacs, being the part of the capital of the outgoing partners, due to financial stringency being faced by the company. The Tribunal finds that :
(i) on examination of the financial position though there were assets available the same were off set to a larger extent by liabilities including tax liabilities;
(ii) there were other constraints relating to bank overdraft as well as inventories taken over by the assessee-company from the erstwhile firm;
(iii) assessee-company retained a part of capital payable to erstwhile partners in the interest of business and such a decision according to the Tribunal could not be interfered with by the Tax authorities since it was for the assessee to determine what is its interest;
(iv) after referring to the details regarding returned income, tax paid and rate of tax the Tribunal finds categorically that the figures support the assessee's case to the effect that there was no attempt to evade tax;
(v) it is also an admitted fact that the transaction is not doubted since there is no whisper to the said effect in the order of the CIT and hence the Tribunal overrules the contention raised by the Departmental Representative that the transaction was a device as payer and payee are the same' set of persons.
23. After recording the aforesaid findings of fact on appreciation of evidence available on record the Tribunal states that :
(i) it is not impressed with the terms of the arrangement and finds it rather stranger that a sum of Rs. 7.93 lacs has to be paid to retain an amount of Rs. 6 lacs;
(ii) the Tribunal refers to the details filed by the assessee as regards payments made for the assessment year under consideration and the subsequent three assessment years and states that this reflects an 'arrangement which is irrational and unreasonable and does not reflect any proper basis for the terms stated therein';
(iii) that the Tribunal does not question the right of businessman to arrange his affairs in the manner best suited to him but does not approve of a method which would cast a burden on the exchequer for a period of ten years;
(iv) that though the partners are taxed in high income bracket, at present, same may not be the situation at some later stage.
24. Thereafter, the Tribunal in para 18 of its order confirms the applicability of Section 40A(2) of the Act in relation to 50 per cent of the amount claimed in the following terms :
'18. We are of the view that provisions of Section 40A(2) would be squarely applicable in view of the close connection between the payer and the payee. Before deciding the figure which is to be disallowed we have to keep in mind not only the figure of Rs. 6 lakhs retained by the assessee but also the fact that the outgoing partners had given up a lucrative business whose goodwill at the time of dissolution could be evaluated at the huge figure. In addition they also gave up the large bundle of rights stated in Clause 3 of the dissolution deed which included licences, quotas, tenancy rights, etc. Taking all these into account we would hold that 50 per cent of the amount claimed be allowed as a deduction and the balance 50 per cent be disallowed. This appears to us to be reasonable on the facts and circumstances of the case.'
25. Now before testing the correctness of the Tribunal's findings a brief resume of the decided cases on the aspect of applicability of Section 40A(2) may be considered :
(a) In case of Narayan Motors v. CIT the High Court upheld the finding of the Tribunal that Section 40A(2) was applicable when service charges were paid to sister concern of the assessee-firm. It was found from the record that the very services for which the service charges were paid were rendered free of charge earlier as assessee itself was running the workshop and the warranty services were as per agreement with the principal in respect of the tractors and motorcycles sold by the assessee and that the service charges were paid to the sister concern only after the assessee transferred the workship.
Therefore, there was specific material available on record as regards the fair market value of the services rendered by the sister concern.
(b) In the case of Ved Prakash M. Patel v. CIT : [1988]169ITR591(MP) the finding recorded by the Tribunal was that the payment of royalty was not wholly and exclusively for the purpose of the business of assessee and that the agreement was a device to reduce the tax burden of the assessee.
Thus, the question turned on the facts of the case with special reference to the finding recorded by the Tribunal.
(c) In the case of Anandji Shah v. CIT : [1990]181ITR171(Ker) the dispute was whether interest paid was excessive or unreasonable. The ITO had recorded a finding that the assessee paid interest to near relatives at 24 per cent p.a. as against 12 per cent p.a. on the amounts belonging to the manager. The ITO had further brought on record the fact that the bank's rate of interest was only 15 per cent or less during the relevant accounting period and the said statement was not shown to be controverted. Furthermore, there was no material to show that market rate of interest on Hundi and Demand Pronote from Multani Bankers was 29 per cent to 30 per cent. Taking these facts into consideration the CIT(A) and the Tribunal allowed the deduction of interest paid @ 18 per cent while disallowing the balance under Section 40A(2) of the Act. The Court upheld the findings recorded by both the appellate authorities.
As can be seen it was also a case where there was material available on record to show that the interest paid was excessive or unreasonable.
26. In light of the requirement prescribed by provision of Section 40A(2) of the Act, can it be said that in the present case there was any material, either before the CIT in proceedings under Section 263 of the Act or before the Tribunal which had in fact recorded a categorical finding that the method in which the order under Section 263 of the Act had been passed was not approved and that the CIT should have pinpointed exact provision of the Act under which he proposed to disallow the payment rather than spelling out different alternatives.
27. I am aware that the settled legal position is that the Tribunal's order must be read as a whole and it is not necessary to examine the same minutely, sentence by sentence, so as to discover a minor lapse here or an incautious opinion there to be used as a peg on which to hang an issue of law. However, is it possible to state that the Tribunal's order in the present case is one which a person acting judicially and properly instructed as to the relevant law could have passed. When a Court of fact arrives at a decision by considering material which is irrelevant to the inquiry, or acts on material, partly relevant and partly irrelevant, and it is impossible to say to what extent the mind of the Court was affected by the irrelevant material used by it in arriving at its decision, a question of law arises and in such circumstances its findings even though on question of fact will be liable to be set aside.
28. The Supreme Court in the case of Lalchand Bhagat Ambica Ram v. CIT : [1959]37ITR288(SC) was called upto to decide a matter wherein the assessee who had encashed high denomination notes of the value of Rs. 2,91,000 claimed that the said notes formed part of its accounted funds which were available in its Rokad (cash book) and in the Almirah account, and the assessee relied upon certain entries in its accounts which were interpolated prior to the date on which the High Denomination Bank Notes (Denomination) Ordinance, 1946 was promulgated. The Tribunal accepted the explanation of the assessee that it was highly probable that high denomination notes of the value of Rs. 2,91,000 were included in the entries in Rokad and the Almirah account which showed aggregate cash balance of Rs. 3,10,681, the Tribunal also accepted the books of account as genuine, but thereafter held that the assessee might be expected to have possessed as part of its business cash balance at least Rs. 1,50,000 in the shape of high denomination notes on the date of promulgation of the aforesaid ordinance, while simultaneously holding that sum of Rs. 1,41,000 had to be treated as undisclosed profits of the business as the nature of the source from which assessee derived those notes remained unexplained to the satisfaction of the Tribunal. The Supreme Court held that :
'it was not, therefore, open to the Tribunal to accept the genuineness of these books of accounts and accept the explanation of the appellant in part as to Rs. 1,50,000 and reject the same in regard to the sum of Rs. 1,41,000.'
While arriving at the aforesaid conclusion the apex Court laid down the following principles for appreciating the Tribunal's order in such cases :
'The Tribunal is a fact finding Tribunal and if it arrives at its own conclusions of fact after due consideration of the evidence before it the Court will not interfere. It is necessary, however, that every fact for and against the assessee must have been considered with due care and the Tribunal must have given its finding in a manner which would clearly indicate what were the questions which arose for determination, what was the evidence pro and contra in regard to each one of them and what were the findings reached on the evidence before it. The conclusions reached by the Tribunal should not be coloured by any irrelevant considerations or matters of prejudice and if there are any circumstances which required to be explained by the assessee, the assessee should be given an opportunity of doing so. On no account whatever should the Tribunal base its findings on suspicions, conjectures or surmises, nor should it act on no evidence at all or on improper rejection of material and relevant evidence or partly on evidence and partly on suspicions, conjectures and surmises, and if it does anything of the sort, its findings even though on questions of fact will be liable to be set aside by the Court.'
29. Therefore, appreciating the Tribunal's order at the touchstone of the principles laid down by the Supreme Court what does one find ?
(1) The Tribunal on the one hand states that it does not approve of the method in which the CIT has passed the order.
(2) That the CIT should have pinpointed the exact provisions under which the payment was to be disallowed instead of taking alternative stand.
(3) The assessee's explanation that it was experiencing financial strigency was correct.
(4) That facts and figures on record supported the assessee's case to the effect that there was no attempt to evade tax.
(5) That the transaction was genuine as the same had not been doubted by the CIT.
(6) That the contention raised on behalf of the Department to the effect that the transaction was 'device' was specifically overruled.
(7) The contention of the Department that the payer and payee are the same set of persons is overruled.
(8) The Tribunal did not question the right of businessman to arrange his affairs in the manner best suited to him.
In spite of the aforesaid finding of fact recorded by the Tribunal, in the same breath the Tribunal holds that :
(a) It is not impressed with the terms of the arrangement and finds it rather strange.
(b) That taking into consideration the payments made under the arrangement the state of affairs reflects an arrangement which is irrational and unreasonable and does not reflect any proper basis for the terms stated therein.
(c) That though it does not agree with the CIT for a complete disallowance, it agrees with him as to the applicability of Section 40A(2).
30. When the two sets of findings as extracted hereinbefore are placed in juxtaposition, it is apparent that the Tribunal has made statements which are contrary to each other on the same set of facts. Once having held that the transaction in the form of dissolution deed was genuine, that it was the right of businessman to arrange his affairs in the manner best suited to him the Tribunal could not have gone behind the terms of the agreement. The Tribunal lost sight of the fact that the dissolution deed had not been entered into, to impress the Tribunal, that the Tribunal was not empowered to function as a 'Super Commissioner' by stating that though the order was incorrect yet it was correct to the extent of applicability of Section 40A(2) of the Act, because according to the Tribunal the arrangement was irrational and unreasonable and that there was no proper basis for the terms stated in the dissolution deed. The attempt of the Tribunal to say the least, was to rewrite the terms of the dissolution deed merely because the Tribunal was not impressed with the terms of the said deed. This is beyond its powers. The Tribunal having held that it was open to a businessman to arrange his affairs in the manner best suited to him it could not have thereafter held that it did not approve of any method which would cast a burden on the exchequer for a period of ten years. In fact, the Tribunal acknowledges that the ex-partners, the recipients are taxed in the higher income bracket at present but same may not be the situation at some later stage, and therefore, it poses a question whether it would be proper to approve an arrangement whereby cost of retaining Rs. 6,00,000 may assume astounding proportions.
31. Thus, the approach of the Tribunal is bad in law with special reference to the principles of law laid down in the decision of this Court in the case of Banyan and Berry v. CIT : [1996]222ITR831(Guj) The Court has specifically stated that, (the case before the Court was in relation to dissolution deed being a device while in the present case it is accepted position that there is no device), not all legitimate acts of a taxpayer which he undertakes in the ordinary course of his business and is entitled under law to do, can be branded as being of questionable character even on the anvil of the apex Court's decision in the case of McDowell & Co. Ltd. v. CTO : [1985]154ITR148(SC) . It has been laid down as under :
'The Court nowhere said that every action or inaction on the part of the taxpayer which results in reduction of tax liability to which he may be subject in future, is to be viewed with suspicion and be treated as a device for avoidance of tax irrespective of legitimacy or genuineness of the act; an inference which unfortunately, in our opinion, the Tribunal apparently appears to have drawn from the enunciation made in McDowell's case (supra). The ratio of any decision has to be understood in the context it has been made. The facts and circumstances, which lead to McDowell's decision leave us in no doubt that the principles enunciated in the above case has not affected the freedom of the citizen to act in a matter according to his requirements, his wishes in the matter of doing any trade, activity or planning his affairs with circumspection, within the framework of law, unless the same fall in the category of colourable device which may properly be called a device or a dubious method or a subterfuge clothed with apparent dignity.'
xxxxxx
'While planning adopted as a device to avoid tax had been deprecated, the principle cannot be read as laying down the law that a person is to arrange his affairs so as to attract maximum tax liability, and every act which results in tax reduction, exemption of tax or not attracting tax authorised by law is to be treated as device of tax avoidance.'
32. If this is the ratio in case where a device is alleged then it was not open to the Tribunal to adopt the stand that it did in case where it had itself specifically held that there was no device adopted on the facts of the case. Unfortunately, the Tribunal has tied itself up in knots; it has contradicted itself in terms and the approach has been not one which a judicially and properly instructed mind would have adopted; the findings are vitiated by the reason of the Tribunal having taken into consideration the fact of the dissolution deed as casting a burden on the exchequer even while realising it was not open to the Tribunal to sit in judgment as to how and in what manner and in what terms the dissolution should be effected by the partners inter se. It was within their exclusive domain and the Tribunal on the one hand having accepted that aspect of the matter could not have thereafter gone behind the same to analyse the terms of the dissolution deed. Therefore, on this aspect of the matter the Tribunal's order is liable to be set aside as being vitiated in law.
33. I have approached and appreciated the Tribunal's order from this angle in light of various aspects sought to be raised by the applicant-assessee through five questions proposed (hereinbefore reproduced), because the Tribunal itself has stated that the question referred would bring out the controversy sought to be raised by the five questions posed by the applicant-company.
34. However, at the time of hearing, Mr. AM Qureshi, learned standing counsel submitted that the question referred to the Court was only in relation to applicability of Section 40A(2) of the Act and hence, it was not open to the Court to examine any other facet of the matter. The submissions made by Mr. Qureshi do not show how either the CIT or the Tribunal has fulfilled the requirements laid down in Section 40A(2) of the Act. There is no whisper in order of either of the authorities as to what would be the fair market value of the services or facilities taking into consideration the various surrounding circumstances, whether such services were commonly available, what were the legitimate business needs of the assessee at the point of time when the agreement was entered into, what was the benefit derived by the assessee and most important, after ascertainment of the aforesaid facts it was necessary to afford all reasonable opportunities to the assessee to rebut the prima facie finding before finally deciding as to what portion of expenditure is excessive or unreasonable requiring disallowance under Section 40A(2) of the Act.
35. To the contrary, as can be seen from para 17 of the CIT's order after narrating what is the provision of Section 40A(2) of the Act, he goes on to state that outgoing partners of the firm to whom the amount was paid for retaining capital are also directors of the company, and for the reasons narrated above the CIT holds that the entire payment was both unreasonable and excessive having regard to the fair market value of the facilities received by the assessee. The order is absolutely silent as regards what is fair market value and what is more shocking is that the CIT treats the entire expenditure as unreasonable and excessive showing total non-application of mind as to the basic condition on fulfilment of which Section 40A(2) of the Act can be invoked.
36. The Tribunal is alive to this aspect of the matter when it states in para 11 that the CIT has on the one hand disallowed the entire payment and at the same time held that provision of Section 40A(2) as also Section 40A(8) of the Act are applicable which envisage only part disallowance and not whole. Then in para 18 the Tribunal says that before deciding the figure which is to be disallowed not only the figure of Rs. 6 lacs being the capital retained by the assessee but also fact that outgoing partners had given up a lucrative business whose goodwill at the time of dissolution could be evaluated at a huge figure has to be kept in mind. The Tribunal further states that erstwhile partners also gave up large bundle of rights as described in Clause (3) of the dissolution deed, and then goes on to state that taking all these into account 50 per cent of the amount claimed should be disallowed. This appears to the Tribunal to be reasonable on the facts and in the circumstances of the case without even showing what would be the fair market value considering the legitimate business needs of the assessee.
37. Both the CIT and the Tribunal have not even cared to take into consideration that the provisions of Section 40A(2) of the Act stipulate that ITO has to arrive at opinion that the expenditure is excessive or unreasonable, having regard to :
(a) fair market value of the goods, services or facilities for which the payment is made, or
(b) the legitimate needs of the business, or
(c) benefit derived by or accruing to the assessee therefrom.
Therefore, the excessiveness or the unreasonableness has to be in the context of fair market value of the facilities or the legitimate needs of the business or benefit derived or accruing to the assessee, Neither in the order of the CIT nor in the order of the Tribunal does one get any indication that either authority is even aware and has even attempted to ascertain the excessiveness or unreasonableness 'having regard to' either the fair market value or the legitimate needs of the business or the benefit derived or accruing to the assessee. And the Revenue wants the Court to accept the ad hoc rule of thumb disallowance without there being any iota of evidence about fulfilment of the condition prescribed by the section.
38. The contentions raised by Mr. Qureshi as reproduced in para 4 of the judgment of my learned Brother are equally silent as to the requirement of the provision which is sought to be invoked against the assessee. A great deal of emphasis, as can be seen from the contention, is laid on the three outgoing partners being directors in the assessee-company and it is submitted that hence payer and payee are same persons for all practical purposes, without appreciating that this very contention was raised by the Departmental Representative before the Tribunal and the Tribunal has specifically overruled the same in para 16 of its order along with the contention of device. The contention raised loses sight of the fact that Section 40A(2) of the Act can be invoked only in case where the expenditure incurred is otherwise allowable under the provisions of the Act while computing taxable profits from the business. In case where the payer and the payee are same person there is no payment-in effect there is no incurring of an expenditure. Then the provision does not come into play. Mr. Qureshi has further stated number of hypotheses are regards what would happen if interest was paid at a particular percentage, what could happen if dividend was declared by the company, what could happen if after certain amount is deducted and balance amount was brought to tax at corporate rate, etc. etc. Similarly, he has made a statement that bank rate at the relevant time did not exceed 24 per cent. The Court has no material on record to take note of this submission as we are dealing with financial year which ended in June, 1981. There is nothing in either the order of the C1T or the Tribunal and hence, it is not possible for the Court to take cognizance of submissions made on the basis of different surmises or presumptions as regards prevailing or otherwise of a particular situation, seized as the Court is of the reference jurisdiction.
39. Mr. Qureshi had also submitted that there is no justification for proceeding on the basis that there was no attempt to evade or avoid income-tax. This contention is not available to the Revenue in light of the categorical finding recorded by the Tribunal in para. 15 as 'these figures support assessee's case to the effect that there was no attempt to evade taxes'. Similarly, the contention regarding arrangement being for the purpose of reduction of tax liability and not based on any commercial consideration is also not open in light of categorical finding of fact recorded by the Tribunal. Even as an issue of law, this contention goes against the ratio laid down by this Court in the case of Banyan and Berry (supra) and cannot be accepted.
40. I have already extracted the relevant circular which throws considerable light on the basic requirement of provision of Section 40A(2) of the Act and once the Tribunal specifically came to the conclusion that the dissolution deed was not a device, that the payer and payee are not the same set of persons, that the transaction is not doubted, that the assessee in the interest of its business thought it fit to retain a part of the amount payable to the erstwhile partners and the figures on record support assessee's case to the effect, and that there was no attempt to evade taxes, it is not possible to state that the Tribunal was justified in invoking the provision of Section 40A(2) of the Act and disallow of 50 per cent of the expenditure. As can be seen from the circular dt. 6th July, 1968, issued by the CBDT when the provision of Section 40A(2) is invoked the authority is expected to exercise his judgment in a reasonable and fair manner bearing in mind that the provision is meant to check evasion of tax, and should not be applied in a manner which was cause hardships in bona fide cases. Though the said circular is not binding on the Tribunal it is very much binding on the CIT and the Tribunal ought to have approached the matter, accordingly. The Tribunal has unfortunately failed to appreciate the legal requirement before confirming the order of the CIT as regards applicability of Section 40A(2) of the Act.
41. The Tribunal's order will have to be appraised in light of the fact that the Tribunal was called upon to determine whether the CIT had validly assumed jurisdiction under Section 263 of the Act. As already noted the CIT specifically held that the expenditure in question had to be disallowed because the agreement was entered into with a view to compensate outgoing partners for the loss of future share in profits of the firm and the CIT supports this basic premise by referring to the period of 10 years for which the payment had to be made. The CIT further reiterates that as per Clause (6) of the dissolution deed the payment had to be for compensating outgoing partners or in other words making payment for their share in the goodwill of the firm during a span of 10 years instead of lump sum payment. If this is the case there is no material on record to show : (i) whether any evaluation of the value of goodwill had been made though the Tribunal states that it could be evaluated at a huge figure; (ii) what would be the fair market value for acquiring such goodwill that would be the benefit derived or accruing to the assessee and; (iii) whether the payment was made considering legitimate business needs of the assessee-company. The Tribunal in fact accepts that the assessee was required to retain the capital in part due to legitimate business needs. Then the question that the Tribunal was required to address was whether any portion of the expenditure was excessive or unreasonable having regard to such legitimate needs of the business. There is no such finding by the Tribunal and there is no material to arrive at such finding.
42. As already seen even while invoking Section 40A(2) of the Act, the CIT had disallowed the entire payment and in the final para the effective order also states that the assessment should be revised by adding to the total income the entire sum of Rs. 7,93,187, which is not admissible as deduction. The Tribunal ought to have approached the matter in light of the settled legal position that before, the CIT exercises suo motu jurisdiction under Section 263 of the Act, twin conditions have to be satisfied viz., (i) the order of the AO has to be erroneous and (ii) it has also to be prejudicial to the interest of the Revenue.
Testing this only from the aspect of applicability of Section 40A(2) of the Act, can it be stated that there was any error committed by the AO and if there was any error, the same was prejudicial to the interest of Revenue The Tribunal in fact finds that there was no attempt to evade tax by virtue of the terms of the dissolution. Moment the. Tribunal arrives at this finding it was incumbent upon it to raise query and answer as to whether in such circumstances there was any error which could be said to be prejudicial to the interests of the Revenue. The concept of prejudicial to the interests of the Revenue as enunciated by the apex Court in Malabar Industrial Co. Ltd. (supra) is : has the legitimate revenue due to the exchequer been realised or not.
43. Therefore, examining the order of the Tribunal from any angle it is apparent that the same is not sustainable in any view of the matter. Neither on facts of the case nor in relation to the settled legal position can it be stated that the Tribunal approached the question which was posed before it in 'the manner a person acting judicially and properly instructed as to the relevant law would have approached.
44. Therefore, on the facts and in the circumstances of the case, it cannot be stated that provisions of Section 40A(2) of the Act were applicable and the Tribunal has erred in law in applying the same. The question referred to the Court is, therefore, answered in the negative i.e., in favour of the assessee and against the Revenue.
45. The reference stands disposed of accordingly with no order as to costs.
M.S. Shah, J.
In view of difference of opinion between us and in view of the provisions of Section 259(2) of the IT Act, 1961, the matter shall be placed for decision of the third learned Judge after obtaining necessary orders from the Hon'ble the Chief Justice.
A.R. Dave, J.
1. This reference was heard by the Division Bench consisting of Justice M.S. Shah and Justice D.A. Mehta. As the Hon'ble Judges differed, the Hon'ble the Chief Justice referred the matter to this Court.
2. At the time of hearing of this reference, learned advocate Shri R.K. Patel has appeared for the applicant-assessee whereas standing counsel Shri Tanvish Bhatt has appeared for the respondent-Revenue.
3. Learned advocate Shri R.K. Patel appearing for the applicant-assessee has submitted that he would not like to press this reference. He has also submitted that another reference, being IT Ref. No. 204/1989, which was referred to this Court at the instance of the same assessee, for the same controversy, was not pressed by the assessee and the learned advocates would not like to press this reference also.
4. In view of the above development, the reference stands disposed of as unanswered with no order as to costs.