Beedi Works (Private) Limited & Anr Vs. Commissioner of Income-Tax  INSC
272 (7 May 1993)
Reddy, B.P. (J) Jeevan Reddy, B.P. (J) Venkatachala N. (J)
1993 AIR 1751 1993 SCR (3) 606 1993 SCC (3) 252 JT 1993 (3) 526 1993 SCALE (2)896
Act 1961--S.40 (c)--Partners in firm also directors in a company--Whether
royalty payments by company to firm falls within s. 40 (c)--Held, Payments are
consideration for a valuable right parted by firm/ partners/directors of the assessee--Company
a favour of assessee--Where agreement whereunder payments made not mere device
or screen, it cannot be treated as payments made to directors qua directors--S.40(A)
partnership firm consisting of three partners was engaged inter alia in the
business of manufacturing and sale of beedies under the brand name
"Mangalore Prakash Beedies".
On May 20,1972 a private limited company called prakash beedies
Ltd. the assessee-appellant was incorporated. One of its objects was to take
over the business of the aforesaid firms which it did under an agreement dated 15 July 1972 whereby the firms sold its rights
and assets to the company. For the use of the trade name, a royalty at 10p. for
every 1000 beedies was to be paid by the company to the firm. This payment was
made ever year by the assesse on account of royalty. The three partners of the
firms were also directors of the company.
relevant assessment years were 1974-75 and 1975-76. The facts in the other
appeals are similar.
claimed deduction of the amount paid by it as royalty. The ITO allowed the
deductions as claimed. The CIT in stio motu proceedings disallow the aforesaid
deductions. On appeal, the tribunal restored the order of the ITO.
reference, the High Court answered in fan,our of the revenue as the three
directors of the assessee company were also partners in the firm. It held that
in law, a firm is merely a collection or association of individuals for
carrying on a business. Merely because the firm is an assessable entity, under
the Income Tax Act, it does not follow that it is a juristic or legal entity.
It must therefore be held that the payments to the firm were in reality made to
the 607 directors, thus attracting S. 40 (c).
this Court, it was contended for the assessee that payment to a firm is not
ipso fact payment to the partners, directly or indirectly. In any event, the
payments were made to the three persons not in their capacity of directors (qua
directors). but in consideration of a valuable right parted by them in favour
of the assessee-company. S. 40(c) was never intended to take in such payments.
They relied on the budget speech of the Finance Minister and argued that the
principle of interpretation noscitor a sociis must be applied to the words
"remuneration, benefit or amenity".
genuineness or validity of the agreement, the factum of payments as royalty,
and that the brand name carries significant business value was not disputed.
The question before this Court was whether the royalty payments fail within S.
the appeal, this Court,
Even assuming that the payments to firm were payments to partners, the said
payments did not fall within S. 40(c). The payment,-. were made In
consideration of a valuable right parted by the firm/partners/ directors of the
assessee-company in favour of the assessee. So long as the agreement whereunder
the said payments were made is not held to be a mere device or a mere screen,
the said payments cannot be treated as payments made to the directors (qua
directors). (613-H, 614-A) The payments were made by way of consideration for
allowing the to use a valuable right belonging to them viz. the brand name.
Such a payment may be liable to be scrutinised under sub-section. (2) of
section 40 (A), but it certainly did not fall within the four corners of
section 40(c). (614-A) T.T. (Pvt.) Ltd. v. ITO Bangalore 121 ITR 551, approved.
v. Avon Cycles (p) Ltd. 126 IT R 448 and India Jute Co. Ltd. v. CIT 178 ITR
649, referred to.
power vested in the ITO is to determine whether any expenditure of allowance is
excessive or unreasonable having regard to the legitimate business needs of the
company and the benefit derived by the assessee or 608 accruing therefrom. Any
payment to a relative of a director or other persons mentioned in clause (c)
will necessarily be examined applying the above test and if it is found that
they are unwarranted, unreasonable or excessive, they will be disallowed. Such
a situation does not arise herein.
CIT, Bombay v. M/s. Indian Engineering and
Commercial Corporation (p) Ltd.  distinguished. JT 683.
APPELLATE JURISDICTION: Civil Appeal No. 1452 of 1987.
the Judgment and Order dated 10.7.1986 of the Kamataka High Court in I.T.R.C.
No. 198 of 1987.
C.A. Nos. 4462/89, 1822, 1902, 1465/87,
675, 658, 4461/89, 6093/90, 6204/ 90, 6092. and 6092 A of 1990.
Salve, P.H. Parekh, Ms. Meenakshi Grover, R. Nariman, Ms. R. Gill and Ms. Simi
Kr. for the Appellants.
Ranbir Chandra and Ms. A. Subhasini for the Respondent.
Judgment of the Court was delivered by B.P. JEEVAN REDDY J. These appeals are
preferred against the judgment of the Karnataka High Court answering the
question referred to it, at the instance of the revenue, in favour of the
revenue and against the assessee. The question referred under section 256 of
the Income Tax Act, 196 1, read as follows: "Whether on the facts and in
the circumstances of the case, the Tribunal was right in holding that the sum
of Rs. 1, 79, 742 could not be disallowed under section 40 (c) of the Income
Tax Act, 1961." (The above question related to Assessment Year 1974-75.
The question referred for A.Y. 1975-76 was identical except in the matter of
the facts in all the appeals are identical it would be sufficient to notice the
facts in C.A. Nos. 6092 and 6092A/90 (Prakash Beedies (P) Lid. v. Commr. of
to 15.7.1992, a partnership firm called K.M. Anand Prabhu & Sons, Mangalore,
consisting of three partners K.M. Vishnudas Prabhu, K.M. Ramdas Prabhu and K.M.
Shankar Prabhu was engaged inter alia in the business of manufacturing and sale
of beedies under the brand name 'Mangalore Prakash Beedies'. On May 20, 1972 a Private limited company called Prakash
Beedies 609 Limited (the assessee-appellant herein), was incorporated with its
registered off-ice at Manoalore. One of its objects was to take over business
of the aforesaid firm.
an agreement dated July
15, 1972 between the
firm and the company, the firm sold its rights and assets to the company on the
terms and conditions set out therein. Clause 4(a) of the agreement, which alone
is material for the purposes of these appeals reads:
For the use of the trade name the Company shall pay royalty to the Vendor at
the rate of 10ps. for every thousand beedies sold by the Company by using the
trade name of the Vendor.
royalty shall be worked out at the end of each quarter ending on March, June,
September and December, on the sales made during each quarter. The royalty
fixed hereby shall not be varied for a period of one year and may be reviewed
and/or revised thereafter wards from time to time".
was making payments to the firm every year on account of royalty in terms of
three partners aforesaid of the firm were also the directors of the assessee-
the assessment years 1974-75 and 1975-76, the assessee claimed deduction of the
amount paid by it to the firm on account of royalty in terms of clause 4(a) of
amounts paid during the accounting years relevant to the said assessment years
were Rs. 3, 16, 526 and Rs. 3, 95, 742 respectively. The I.T.O. allowed the
deductions as claimed.
exercise of the powers conferred on him by Section 263, the Commissioner of
Income Tax initiated (suo moto) proceedings for revising the said assessments
in so far as the aforesaid deductions were concerned. After hearing the assessee,
he passed orders on September
16, 1976 whereunder he
disallowed payments to the firm over and above the ceiling prescribed in
Section 40(c). The assessee preferred appeals to the Tribunal against the
orders of the I.T.O, The appeals were allowed and the orders of the I.T.O.
reference, the High Court answered to question in the negative i.e., in favour
of the revenue and against the assessee, on the following reasoning : the three
directors of the assessee company were also the partners in the firm to which
royalty payments were made. In law, a firm has no separate legal existence; it
is not a juristic person or a distinct legal entity. It is merely a collection
or association of the individuals for carrying 610 on a business. Merely
because the firm is an assessable entity under the Income Tax Act it does not
follow that it is a juristic or legal entity. It must, therefore, be held that
the payments made to the firm are in reality payments made to the directors.
Such payments clearly attract and fall within the mischief of Section 40(c).
The Commissioner was right in saying so and the opinion of the Tribunal to the
contrary is unsustainable in law.
these appeals, S/Shri Harish N.Salve and Rohinton Nariman assailed the
correctness of the view taken by the High Court. They submitted firstly that
the payments were made not to the directors of the assessee but to a firm which
was a separate entity. A payment to a firm is not ipso facto a payment to the
partners, directly or indirectly. In a firm there may be other partners besides
the directors of the assessee-company. It may also happen that the firm has no
income to distribute because of the losses incurred by it which are set-off
against the income so received. The High Court was in error in holding that
payment to a firm is a payment to the partners. Assuming that a partnership
firm is not a separate juristic entity distinct from its partners, even so the
payments were made to the said three persons not in their capacity as directors
(qua directors) but in consideration of a valuable right parted by them in favour
of the assessee-company. Such payments do not and cannot fall within the
mischief of Section4O(c). Section 40(c) was never intended to take in such
payments. A company may take on lease the house of its directors for its legitimate
business purposes and pay rent which is reasonable having regard to the market
conditions, or it may pay even less than the market rate of rent. Whether the
rent paid by the company to its director in such a case falls within Section
40(c), ask the counsel. Another illustration given by the counsel is where a
director supplies raw material to the assessee-company for a price which is the
appropriate market price. Would such payment also fall under section 40(c),
they ask. The Budget speech of the Finance Minister in the Parliament, while
introducing the said provision, is relied upon in support of their contention.
It is also argued that the words "remuneration, benefit or amenity"
occurring in Section 40(c) must be read having regard to the context in which
they occur applying the principle NOSCITORA SPCOOS (recognition of associated
words). If so read, the payments in question can never fall within the ambit of
the said words.
the learned counsel for the Revenue justified the reasoning and approach of the
High Court having regard to the clear language employed in clause (c).
genuineness or validity of the agreement between the assessee-company and the
firm is not disputed. The factum of payments made on account of royalty in
terms of clause 4(a) of the said agreement is also not disputed. It is also 611
not disputed that in the beedi trade, brand name carries significant business
value. It is necessary to keep this factual context in mind while examining the
question at issue. Section 40(c) read as follows during the relevant assessment
years "40. Notwithstanding anything to the contrary in sections 30 to 39,
the following amounts shall not be deducted in computing the income charge able
under the head" profits and gains of business or profession",
the case of any company- (i) any expenditure which results directly or
indirectly in the provision of any remuneration of benefit or amenity to
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 of benefit, if in the opinion of the Income-tax Officer any such
expenditure or allowance as is mentioned in sub-clause (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;
where such expenditure of 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 part thereof comprised in that period:
Provided that in case where such person is also and employee of the company for
any period comprised in the previous year, expenditure of the nature referred
to in clauses (i), (ii), (iii) and (iv) of the second proviso to clause (a) of
sub-section (5) of section 40A shall not be taken into account for the purposes
of sub-clause (A) or subclause (B), as the case may be;
* * * * Explanation.-The provisions of this clause shall apply notwithstanding
that any amount not to be allowed under this clause is included in the total
income of any person referred to in sub-clause (i);" The Budget speech of
the Finance Minister, in so far as it mentions the reasons for introduction of clause
(c) of Section 40, reads as follows:
am firmly of the view that the fiscal instrument must be deployed to discourage
payment of high salaries and remunerations which go ill with the norms of
egalitarian society. I accordingly propose to impose a calling on the
remuneration of company employees which would be deductible in the computation
of taxable profits. The ceiling is being set at Rs. 5,000 per month. Together
with the existing ceiling of Rs. 1,000 per month in the case of perquisites,
the allowable overall ceiling on remuneration and perquisites, for purposes of
taxation, will be at Rs. 6,000 per month.................." The object
behind the provision undoubtedly was to discourage and disallow "payment
of high salaries and remunerations which go ill with the norms of egalitarian
society". The provision was, of course, not confined to the directors.' It
took in relatives of directors, persons having substantial interest in the
company and their relatives. The clause vested in the I.T.O. the power to
determine whether any such expenditure or allowances as is mentioned in the
said clause was excessive or unreasonable having regard to the legitimate
business needs of the company and the benefit derived by or accruing to it therefrom.
In addition to it, a ceiling was also prescribed beyond which such expenditure
or allowance could not go in any event.
this juncture, it would be appropriate to notice the provision contained in
sub-section (2) of Sec 40A. Clause, A provides that where the assessee incurs
any expenditure in respect of which payment has been made or is to be made to
any 613 person referred to in clause (b) of the sub-section, and the Income-tax
Officer 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 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. Clause (b) mentions the categories of
persons to whom the provision in clause (a) applies. It includes directors of
the company and their relatives among others. Clause b) also takes in any
payment to any company, firm, association of persons or Hindu undivided family
of which a director, partner or member, as the case may be, has substantial,
interest in the business or profession of the assessee. In short, the net is
cast very wide to ensure that excessive or unreasonable payments are not made
to the persons in control of the affairs of the assessee in the name of paying
for the goods, services and facilities rendered, supplied or extended by them,
as the case may be.
the payments made by the assessee-company to the firm on account of royalty in
terms of clause (4) (a) of the agreement fall within the meaning of the
expression 'expenditure' in sub-clause (i) of clause (c) is not disputed. The
observations in CIT, Bombay. v. M/s. Indian Engineering and Commercial
Corporation Private United (Civil Appeal Nos. 1583 and 1584 (NT) of 1977
decided on 13.4.1993 by us-reported in (1993) 2 J.T. 683 do not say otherwise.
That case arose under Section 40(A) (5). The payments in question were made to
the directors by way of commission on sales. The question was whether the said
payments fell within sub-clause (ii) of clause (a) of sub- section (5) of
section 40(A). It was held that they did not. While holding so it was observed that
it is difficult to say that payment of certain cash amount by way of commission
on sales, directly to an employee, can be said to fall within the words 'where
the assessee incurs any expenditure which results directly or
indirectly'." The said observations were made in response to the Revenue's
argument that the said payment constituted 'perquisites' within the meaning of
sub-clause (ii) of clause (a) of Section 40(A) (5). The observations are
clearly confined to the said sub- clause and have no relevance to any other
provision in the Act. The observations cannot be read dissociated from their
context. Coming back to the provisions of Section 4O(c) and the facts of the
case before us the only question is whether the royalty payments to the firm
fell within clause (c). We assume for the purpose of this argument that in this
case, payments to firm were payments to partners. Even so, we think that the
said payments did not fall within clause (C).
payments were made in consideration of a valuable right parted by the partners/
directors of the assessee company in favour of the assessee. SO long a,, the
agreement whereunder the said payments were made is not held to be a mere 614
device or a mere screen, the said payments cannot be treated as payments made to
the directors as directors (qua directors). The payments were made by way of
consideration for allowing the assessee to use a valuable right belonging to
them viz., the brand name. Such a payment may be liable to be scrutinised under
subsection (2) of Section 40(A), but it certainly did not fall within the four
corners of Section 40(c).
T Ltd. v. LTO., Bangalore 121 I.T.R. 55 1, a Bench of Karnataka High Court
comprising D.M. Chandrashekhar, CJ. and E.S. Venkataramiah,J. has taken a view
which accords with the one taken by us. Speaking for the Bench, E.S. Venkataramiah,
J. (as he then was) observed:
close reading of the above provision shows that s. 40(c) refers to an
expenditure in- curred by making periodical payments to person mentioned in that
clause apparently for any personal service that may be rendered by him.
cannot have any reference to payments made by the assessee for all kinds of
"services or facilities" referred to in s. 4OA(2) (a). It is argued
that the proviso thereto suggests that any expenditure incurred for any kind of
service which is referred to in the main part of s. 40A (2) (a) and the
expenditure referred to in s. 40(c) belong to the same category.
contention is not correct. The expression "services" in s. 40A (2)
(a) is an expression of wider import............... If the remuneration,
benefit or amenity referred to in s. 40(c) is treated as the same as what is
paid in return for "the goods, services or facilities" then
irrespective of the fair market value of the goods, services and facilities
provided by a person who may be a director or a person who has a substantial
interest in the company or a relative of the director or of such person, as the
case may be, only a maximum of Rs. 72,000 can be allowed to be deducted in
computing the income of the company in any one year. We do not think that
Parliament ever intended that such a result should follow. The goods, services
and facilities referred to in s. 40A (2) (a) are those which have a market
value and which are commercial in character. Many of the services and
facilities referred to above are those which are nowadays provided by
independent organisations.' The said decision has been followed by the Punjab
and Haryana High Court in Commissioner of Income Tax, Patiala v. Avon Cycles
(P) Ltd. 126 I.T.R. 448, The Calcutta High Court has also taken a similar view
in India Jute Co. Ltd v. 615 Commr of Income-Tax 178 ITR 649.
learned counsel for the Revenue submitted that the argument of the assessee
that only the payments made to directors as directors fall within clause (c)
and not the other payments, becomes inapt when the payments are made to the
relative,,, of the directors or to persons holding substantial interest in the assessee
company or their relatives. The ceilinG prescribed in clause (c) cannot also be
applied to such persons-says the counsel. The answer perhaps lies in the clause
itself-in the power vested in the I.T.O. to determine whether any expenditure
or allowance is excessive or unreasonable having regard to the legitimate
business needs of the company and the benefit derived by the assessee or
accruing therefrom. Any payment to a relative of a director or other persons
mentioned in clause (c) will necessarily be examined applying the above test
and if it is found that they are unwarranted, unreasonable or excessive, they
will be disallowed. Since such a situation does not arise herein, we need not
pursue the argument further.
the above reasons, we are of the opinion that the judgment under appeal cannot
be sustained. It must he held that the payments in question did not fall within
section 40(c). Accordingly, the appeals are allowed, the judgment of the High
Court is set aside and the question referred to the High Court is answered in
the affirmative, i.e., in favour of the assessee and against the revenue. No
R. Appeal allowed.