K.K. Usha, J.
1. This reference under Section 256(1) of the Income-tax Act, 1961, at the instance of the assessee, raises the following question of law arising out of the order of the Income-tax Appellate Tribunal, Cochin Bench :
'Whether, on the facts and in the circumstances of the case, the Tribunal is correct in holding that the defalcation of funds of the applicant to the tune of Rs. 3,31,565 is not admissible as a business loss?'
2. The matter arises out of the income-tax assessment for the assessment year 1977-78. The assessee, a private limited company, claimed deduction to the extent of Rs. 3,31,565.65 as business loss. The company owned estates at Vandiperiyar. The directors of the company, Messrs. K. Krishnamurthy, K. Ramachandran, K. Srinivasan and S. Subramaniam, were brothers.
3. During the calendar years 1973 and 1974, the management of the affairs of the company was entrusted with the managing director, Sri Krishnamurthy. One Anandamurthy, a close relative of the managing director, was a trusted employee of the managing director. It was later found that during the calendar years 1973 and 1974, Anandamurthy committed defalcation of the funds of the assessee-company to the tune of Rs. 6,90,887.65.
4. When the defalcation was noticed by the assessee-company in August, 1974, a special audit was arranged and the report of the audit was received on February 6, 1976. The company could recover an amount of Rs. 3,59,322 which related to bank transactions by filing a suit against the bank and obtaining a decree from the Madras High Court. On January 24, 1977, Anandamurthy was declared insolvent and the amount due from him was written off by the assessee on March 31, 1977, and the claim for deduction to the extent of Rs. 3,31,565.65 was put forward as business loss. The assessing authority took the view that Anandamurthy was not an employee of the assessee-company and, therefore, the loss sustained due to his misappropriation cannot be claimed as business loss by the company. The above view was affirmed by the Commissioner of Income-tax (Appeals) as well as the Tribunal. It was held that Anandamurthy was only an agent or employee of the managing director that the managing director was responsible for what Anandamurthy did, that it was the conduct of the managing director which enabled Anandamurthy to commit defalcation and, therefore, the loss cannot be said to have been suffered by the assessee-company in the course of its carrying on the business.
5. It is contended on behalf of the assessee that the manner in which Anandamurthy was functioning with reference to matters relating to the business of the assessee-company, would show that he was in effect acting as an employee of the company even though there was no direct formal appointment by the company. He was associated with the assessee-company for over 25 years. The cheque books and the bank account statements were in his custody. He used to go often to the bank for withdrawing amounts and making deposits for the past several years and also deputise for the managing director in all the transactions relating to the assessee-company as well as its sister concern, Harska Company. The manner in which he committed defalcation is seen from the report of the special audit. The managing director used to sign cheques prepared by Ananda-murthy with the narration 'cash' and 'pay yourselves'. The cheques were made up in such a way that sufficient space was left to effect alterations. After obtaining the managing director's signature, the figures were altered and in respect of some cheques the words 'to the credit of Anandamurthy were interpolated. Cheque leaves of the sister concern, Harska Company, were used in some cases after erasing the seal of that company and fixing the seal of the assessee-company. In such cheques also, figures were altered. There were cases where substantial amounts were transferred from the account of the assessee-company to that of Anandamurthy and such withdrawals were shown in the cash book of the assessee-company as cash withdrawal. The sale proceeds of rubber, pepper and coffee were also misappropriated.
6. It is the case of the assessee that in view of the long period during which Anandamurthy was involved in the management of the company and in view of the close relationship between the parties, it must be taken that he was treated as an employee of the company for all purposes. Under these circumstances, the loss sustained by the company as a result of his defalcation is liable to be treated as business loss. In support of the above contention, the assessee relied on two decisions of the Supreme Court in Badridas Daga v. CIT : [1958]34ITR10(SC) and CIT v. Nainital Bank Ltd. : [1965]55ITR707(SC) . Reliance was also placed on the following decisions of the High Courts also, Khaitan and Co. v. CIT : [1979]118ITR728(Cal) , Punjab Steel Stockholders' Syndicate Ltd. v. CIT , G.G. Dandehar Machine Works Ltd. v. CIT : [1993]202ITR161(Bom) and Kothari and Sons v. CIT : [1966]61ITR23(Mad) .
7. According to the Revenue, the decisions of the Supreme Court relied on by the assessee have no application to the facts of the assessee's case. On the other hand, the dictum laid down by this court in Yoosuf Sagar Abdulla and Sons (P.) Ltd. v. CIT : [1990]185ITR371(Ker) and that in Curtis v. J. and G. Oldfield Ltd. [1925] 9 TC 319 are directly applicable. Since Anandhamurthy was not an employee of the company, but was only employed by the managing director, according to the Revenue, any loss sustained through him cannot be treated as business loss of the company.
8. In Badridas' case : [1958]34ITR10(SC) , loss was sustained by the assessee firm carrying on business as money-lenders as a result of misappropriation by an agent who had a power-of-attorney conferring on him powers of management including authority to operate bank accounts. He had withdrawn money from the firm's bank account and applied them in satisfaction of his personal debts. It was held by the Supreme Court that the loss sustained by the firm as a result of misappropriation was one incidental to the carrying on of business and, therefore, it should be deducted in computing the profit under Section 10( 1) of the Indian Income-tax Act, 1922. In Nainital Bank's case : [1965]55ITR707(SC) , the question raised was whether loss incurred by dacoity can be treated as business loss. It was held that in the usual course of its business, a bank has to keep large amounts in its premises. If dacoits take away cash from the bank, the loss incurred was incidental to the carrying on of the business of the bank, deductible as a trading loss in computing the income from the banking business. In the above case, after referring to various decisions, the Supreme Court summarised the legal position as follows (at page 715) :
'Under Section 10(1) of the Act, the trading loss of a business is deductible for computing the profit earned by the business. But every loss is not so deductible unless it is incurred in carrying out the operation of the business and is incidental to the operation. Whether the loss is incidental to the operation of a business is a question of fact to be decided on the facts of each case, having regard to the nature of the operations carried out and the nature of the risk involved in carrying them out.'
9. In Khaitan Co.'s case : [1979]118ITR728(Cal) , the Calcutta High Court took the view that loss sustained by a firm of solicitors by an unknown person forging the signature of one of the partners and withdrawing money from the bank account would be loss incurred by the firm in the course of business and was incidental to its carrying on business when the possibility of restitution was nil.
10. In Punjab Steel Stockholders' Syndicate Ltd. v. CIT , the Punjab and Haryana High Court took the view that it is not necessary for the assessee to prove that embezzlement was done by a particular employee. If loss by way of embezzlement is proved, the assessee is entitled to claim set off. In G.G. Dandekar Machine Works Ltd. v. CIT : [1993]202ITR161(Bom) , the claim of the assessee was in connection with embezzlement of its money by an unknown person. The assessee had a current account with a bank which was maintained for running its business. The assessee's case was that on the basis of a forged letter written to the bank under the forged signature of the secretary of the assessee-company, the bank had issued an account payee draft in favour of a stranger. It was held that the loss caused to the assessee by embezzlement from its bank account was a loss incidental to the business of the assessee. In the light of these decisions, it is contended by the assessee before us that if loss sustained on dacoity, embezzlement, by a stranger or on defalcation, responsibility for which could not be even fixed on any particular employee, can be treated as business loss, there is no justification for denying the claim put forward by the assessee on the ground that Anandamurthy was not an agent or employee of the company.
11. In Yoosuf Sagar Abdulla and Sons (P.) Ltd. v. CIT : [1990]185ITR371(Ker) , a decision of this court, a contention was raised that the unaccounted profit was diverted by one of the directors and the assessee-company had not obtained the benefit of the same. Therefore, according to the assessee, that amount should be treated as business loss. This court rejected the plea. In Gurtis' case [1925] 9 TC 319, the managing director of a company who was in exclusive control of its business had, availing himself of his position as such managing director, withdrawn large amounts from time to time and applied them to his own personal affairs. In view of the fact that he had a large number of shares in the company and it was in substance a private company, it was considered that his withdrawal would be more like a partner overdrawing his account with the firm than an agent embezzling the funds of the employer. It was held that such withdrawal has nothing to do with the trading activities of the firm and the loss was held inadmissible.
12. Relying on the above two decisions, it was contended by the Revenue that in the present case, since Anandamoorthy was the employee of the managing director and not of the company, it is only the managing director who is responsible for his action and, therefore, the loss sustained should be treated as overdrawing by the managing director and not as business loss. We find it difficult to accept the above contention of the Revenue.
13. The defalcation to the extent of Rs. 3,31,565.65 was by means of providing false vouchers for tax payments, by taking advance from tea brokers, short credit from the State Bank of Travancore, appropriation of sale proceeds of rubber and pepper, etc. There cannot be any doubt that these are all transactions closely connected with the business of the assessee-company. It is true that technically, Anandamoorthy, responsible for the defalcation, was not an employee or agent of the company as, admittedly, there was no order of appointment issued to him by the company. But, it has to be noted that the directors of the company were all brothers, Krishna-moorthy, the managing director, was put in charge of the entire management of the company during the relevant period and Anandamoorthy, a close relative of Krishnamoorthi, was associated with the company for a long period of about 25 years. He was dealing with the bank transactions of the company regularly. He even used to deputise for the managing director in all transactions relating to the company as well as its sister concern, Harsk Company. It is relevant to note that even the auditors were also under the impression that Anandamurthy was an employee of the company.
14. It is in the background of these facts, we have to consider whether the two decisions relied on by the Revenue is of any help to support its stand. In Curtis v. J. and G. Oldfield Ltd. [1925] 9 TC 519, Rowlatt J., had observed (at page 350) :
'. . .. if you have a business.... in the course of which you have to employ subordinates, and owing to the negligence or the dishonesty of the subordinates some of the receipts of the business do not find their way into the till, or some of the bills are not collected at all, or something of that sort, that may be an expense connected with and arising out of the trade in the most complete sense of the word.'
15. But, this was not what has happened in that case as is clear from the following observation of the learned judge (at page 331) :
'It seems to me that what.has happened is that he has made away with receipts of the company de hors the trade altogether in virtue of his position as managing director in the office and being in a position to do exactly what he likes.'
16. So also in Yoosuf Sagar Abdulla and Sons (P.) Ltd. v. CIT : [1990]185ITR371(Ker) , this court came to the definite conclusion that the company had, as a matter of fact, earned the income and it was assessable in its hands. But, one of the directors who held 155 out of 161 shares unauthorisedly appropriated it or diverted it and in the absence of a plea that the company and its officers were unaware of his action and that in spite of taking proceedings there was no chance of restitution of the amounts, it was held that no loss was incurred by the company. But, it is a case of one of the directors appropriating the income already earned by the company. But, the facts in the present case as detailed above, would clearly give an entirely different picture. Here, as a matter of fact, the company has sustained loss as a result of the defalcation committed by Anandamoorthy.
17. We find merit in the contention raised by the assessee that if loss sustained by theft, dacoity, embezzlement by unknown persons, etc., can be treated as business loss, there is no reason to deny the claim of the assessee in the present case on the loss sustained by it due to defalcation committed by Anandamoorthy, the trusted employee of the managing director, who had been associated with the working of the company for a long period of time, even though not as an employee appointed by the company. The test for determining whether a particular loss will be deductible in computing business profits or not was again laid down by the Supreme Court in Ramchandar Shivnarayan v. CIT : [1978]111ITR263(SC) as follows (at page 269) ;
'If there is a direct and proximate nexus between the business operation and the loss or it is incidental to it, then the loss is deductible, as, without the business operation and doing all that is incidental to it, no profit can be earned. It is in that sense that from a commercial standard such a loss is considered to be a trading one and becomes deductible from the total income, although in terms neither in the 1922 Act nor in the 1961 Act, there is a provision like Section 51(1) of the Australian Act.'
18. In the above decision, the Supreme Court affirmed the view that if money kept in the business premises is stolen by a stranger, it has to be taken that the businessman loses such money in the ordinary course of business and the loss is deductible treating it as business loss. It is immaterial whether the money is a part of stock-in-trade such as of a banking company or a money-lender or is directly connected with other business operations. The risk is inherent in carrying on the business and is either directly connected with it or incidental to it. As mentioned earlier, Anandamurthy committed defalcation when he was engaged in activities which arose directly in the course of the business of the assessee-company. We are, therefore, of the view that the fact that Anandamurthy was not appointed as an employee or agent directly by the company is irrelevant for the company to claim loss sustained by it as a result of defalcation as a deductible loss, if other conditions are satisfied.
19. Defalcation came to the notice of the company in August, 1974. A special audit was arranged and the report of the audit was received on February 6, 1975. A suit was filed against the bank and a decree was obtained to the extent of Rs. 3,59,322. A police complaint was filed against Anandamurthy on February 13, 1985. On January 24, 1977, Anandamurthy was declared insolvent. Under the circumstances, the assessee found that there was no reasonable chance of obtaining restitution of the amounts. The amount was then written off by the assessee on March 31, 1977. The loss thus suffered by the company was directly connected with the business operations, and was incidental to the carrying on the business of the assessee-company. We are of the view that the Tribunal has erred in coming to a contra conclusion. The assessee was also justified in assuming that there was no possibility of its recovering the amount from Anandamurthy.
20. We, therefore, answer the question referred in the negative, in favour of the assessee and against the Revenue.
21. A copy of this judgment under the seal of this court and the signature of the Registrar shall be forwarded to the Income-tax Appellate Tribunal, Cochin Bench, for information.