In order to qualify for deduction, the expenditure must be incidental to the business and must have been necessitated or justified by commercial expediency; there must be a direct and intimate connection between the expenditure and the business

Kerala HC in the case of Seshasayee Bros. (Travancore) Pvt. Ltd. vs. CIT has made following observation:

1. As the director was not an employee of assessee company payment of pension to his widow was not, covered by the scheme which provided for payment of pension to the employees of the company.

2. Existence of any arrangement with the deceased director or existence of any practice to pay pension to the widow of director had not been established by the company—Pension was only an ex gratia payment and hence not deductible under s. 37

3. When a question arises as to whether any particular item of expenditure is deductible under s. 37(1) the nature and character of the expenditure has to viewed and adjudged in the light of the facts and circumstances of particular case and against the backdrop of accepted commercial practices and principles of trading.

4. In order to qualify for deduction, the expenditure must be incidental to the business and must have been necessitated or justified by commercial expediency; there must be a direct and intimate connection between the expenditure and the business, that is, between the purpose of the payment and the conduct of the business of the assessee. The director was not an employee of the company. The payment of pension to his widow is not, therefore, covered by the scheme which provides for payment of pension to the employees of the company. The existence of any arrangement with the deceased director had not been established by the company. There is nothing to show that there was any expectation in the mind of the director that a pension would be paid to him or his widow. There is no evidence to show the existence of practice to pay pension to widows of deceased directors. Hence, the pension is only an ex gratia payment and is not deductible under s. 37.—Gordon Woodroffe Leather Mfg. Co. vs. CIT (1962) 44 ITR 551 (SC) : TC16R.1378 and Teekoy Rubbers (India) Ltd. vs. State of Kerala (1966) 60 ITR 350 (Ker) : TC16R.1468 followed.

5. Pension paid to widow of deceased director was not deductible as business expenditure where neither the director was an employee of assessee-company nor there was any practice to pay such pension.

 

SESHASAYEE BROS. (TRAVANCORE) PVT. LTD. vs. COMMISSIONER OF INCOME TAX

HIGH COURT OF KERALA

P.Govindan Nair & V. Balakrishna Eradi, JJ.

IT Refd. Nos. 24 & 25 of 1968

13th August, 1970

(1970) 38 CCH 0280 KerHC

(1971) 82 ITR 0442

Legislation Referred to

Section 37(1)

Case pertains to

Asst. Year 1963-64

Decision in favour of:

Revenue, Remanded

Counsel appeared:

1. Swaminathan & C. s. Ananthakrishna Iyer, for the Assessee : P. K. Krishnankutty Menon, for the Revenue

BALAKRISHNA ERADI, J.

These are two references made by the Tribunal, Madras Bench “B” (hereinafter referred to as “the Tribunal”) under s. 256(1) of the IT Act, 1961 (herein after referred to as “the Act”). Two questions of law have been referred to this Court as arising out of an order dt. July 20, 1967, passed by the Tribunal disposing of an appeal filed before it by the respondent-company challenging the correctness of the orders passed by the subordinate authorities disallowing the claim put forward by the company for certain deductions in respect of its assessment for the asst. yr. 1963-64.

2. The assessee is a private company. It was functioning as the managing agent in respect of another company by name the Aluminium Industries Ltd. The relevant assessment year with which we are concerned is 1963-64 and the accounting period is the year ending December 31, 1962.

3. One Shri K. K. Raman was associated with the assessee-company as a permanent director ever since its inception. He died on October 29, 1962. At the general body meeting of the company held on May 11, 1963, a resolution was passed sanctioning the payment of a pension of Rs. 500 per mensem to Shri Raman’s widow for her lifetime. The resolution contains a statement that the said action was being taken “in consideration of the understanding and arrangement between the company and Shri K. K. Raman, under which he served the company as a whole-time director till his demise on 29th October, 1962.”

4. In the assessment proceedings for the asst. yr. 1963-64, the assessee-company claimed that they were entitled to a deduction of the sum of Rs. 1,000 representing pension paid to Mrs. Akila Raman, widow of the late Shri K. K. Raman for the two months of November and December, 1962. The ITO disallowed the claim holding that the amount in question could be regarded only as an ex gratia payment because Shri Raman was not an employee of the assessee company and there was neither any contract nor any scheme or practice in the company of giving pensions to directors or their legal representatives. An appeal filed by the assessee before the AAC having been dismissed by that authority, the company took up the matter in second appeal before the Tribunal. The Tribunal by its order dt. July 20, 1967, rejected the assessee’s contentions and held that the amount paid by way of pension to the widow of Shri Raman did not constitute expenditure laid out or expended wholly and exclusively for the purpose of business of the company. The Tribunal agreed with the view taken by the taxing authorities that the expenditure in question was only in the nature of an ex gratia payment and that the claim for deduction was not sustainable.

5. The assessee-company thereupon made an application before the Tribunal under s. 256(1) of the Act and the Tribunal has referred to this Court the following question of law :

“Whether, on the facts and in the circumstances of the case, the disallowance of the claim of the assessee-company for deduction of the payment of pension to Mrs. K. K. Raman, the widow of the deceased director, is lawful ?”

6. I T. R. No 24 of 1968 is the said reference.

7. There was another permanent director in the assessee-company by name, K. A. Varugis. He retired on December 21, 1962. On the 19th March, 1963, the board of directors of the assessee-company passed a resolution in the following terms :

“Resolved that Rs. 11,400 be paid to Mr. K. A. Varugis towards gratuity. In addition resolved that the articles be amended by means of a special resolution to incorporated payment of gratuity to directors.”

8. Subsequently, Art. 89 of the articles of association of the company was amended on May 11, 1963, by providing that “the directors will be entitled to and eligible for the provident fund or any other benefit other than bonus on the same scale and in the manner in which this benefit is enjoyed by the other members of the staff of the company from time to time”. A gratuity- cum-retrenchment scheme had been introduced by the company for its employees w.e.f. April, 1960, whereunder gratuity calculated at the rate of half a months’ average salary for every completed year of service, subject to a maximum of 15 months’, salary, is prescribed as payable to the employees. The same basis of computation had been adopted by the company in arriving at the amount of Rs. 11,400 which was paid to Shri K. A. Varugis as gratuity. The assessee-company contended before the ITO that the said sum of Rs. 11,400 should be deducted in computing its assessable income for the asst. yr. 1963-64 on the ground that it was an expenditure laid out wholly and exclusively for the purposes of its business. The ITO held that, since there was no gratuity scheme for the directors of the company at the relevant time and there was also no agreement between Shri Varugis and the company providing for payment of such gratuity, the expenditure in question could only be considered as an ex gratia payment. He further held that, in any event, the claim for deduction in respect of the accounting period ending December 31, 1962, was untenable since the amount had not been expended during the year of account. On both these grounds he disallowed the deduction. The AAC confirmed the view taken by the assessing authority. When the matter came up before the Tribunal in second appeal filed by the assessee the Tribunal accepted the assessee’s contention and allowed the claim for deduction of the said sum of Rs. 11,400. On an application filed before it by the CIT, Kerala, under s. 256(1) of the Act, the Tribunal has referred to this Court the following question of law :

“Whether, on the facts and circumstances of the case, the Tribunal is justified in law in allowing the amount of Rs. 11,400 being the gratuity to Shri K. A. Varugis for the asst. yr. 1963- 64 ?”

9. That reference has been numbered as I. T. R. No. 25 of 1968.

We shall first take up for consideration the question referred in I. T. R. No. 24 of 1968, which concerns the claim of the assessee- company for deduction of the amount of pension paid to the widow of Shri Raman. The assessee’s claim for deduction being founded soley on the provision contained in s. 37(1) of the Act, it can be sustained only if the amount covered by it constitutes expenditure laid out or expended wholly and exclusively for the purposes of the assessee’s business. When a question arises as to whether any particular item of expenditure is deductible under the above head, the nature and character of the expenditure has to be viewed and adjudged in the light of the facts and circumstances of the particular case and against the back-drop of accepted commercial practice and principles of trading. In order to qualify for deduction, the expenditure must be incidental to the business and must have been necessitated or justified by commercial expediency ; there must be a direct and intimate connection between the expenditure and the business, that is between the purpose of the payment and the conduct of the business, of the assessee.

10. In Gordon Woodroffe Leather Manufacturing Co. vs. CIT (1962) 44 ITR 551 (SC), the Supreme Court had occasion to consider the question whether the amount paid by a company by way of gratuity to one of its officers on his retirement from its service could be regarded as expenditure laid out wholly and exclusively for the purposes of the company’s business. The Supreme Court held that the proper test to be applied in such a case is :

“. . was the payment made as a matter of practice which affected the quantum of salary or was there an expectation by the employee of getting a gratuity or was the sum of money expended on the ground of commercial expediency and in order indirectly to facilitate the carrying on of the business ?”

11. Their Lordships rejected the claim for deduction put forward by the assessee in that case on the ground that “the amount had not been paid in pursuance of any scheme for payment of gratuities nor was it an amount which the employee expected to be paid for long and faithful service, but, on the other hand, it was a mere voluntary payment made not with the object of facilitating the carrying on of the business of the assessee- company or as a matter of commercial expediency but in recognition of long and faithful service of the employee”. In Teekoy Rubber (India) Ltd. vs. State of Kerala (1966) 60 ITR 350 (Ker), a similar question came up for decision before a Division Bench of this Court under the Agrl. IT Act, 1950. The contention put forward in that case was that the amount paid by a company by way of gratuity to the widow of an employee who died while in service was expenditure laid out wholly and exclusively for the purpose of deriving the agricultural income under s. 5(j) of the Agrl. IT Act, 1950. This Court held that “every ex gratia payment to an employee cannot be supported on grounds of commercial expediency. Something more is required ; something which postulates a clear nexus between the payment and the future conduct of the business”.

12. Counsel appearing for the assessee-company urged before us that Mr. Raman who was a permanent director virtually occupied the position of an employee of the company and hence the expenditure incurred in the payment of pension to his widow stands on the same footing as amounts of pension paid to the other employees of the company. Whether a relationship of employer and employee existed as between the assessee-company and Shri Raman is a question of fact and the Tribunal has recorded its finding on this point. On a consideration of all the materials placed before it the Tribunal has held that Shri Raman was in the employment of another company, namely, Seshasayee Brothers (P.) Ltd., that he was not being paid any regular salary by the assessee-company and that the mere fact that Mr. Raman’s share in the net profits of the assessee-company was assessed under the head “Salary” will not make Mr. Raman an employee of the assessee-company. Thus, the conclusion recorded by the Tribunal is that there was no relationship of employer and employee as between the assessee- company and Shri Raman. Any investigation into the correctness or otherwise of this finding of fact entered by the Tribunal is outside the scope of this reference, since no such question has been specifically referred to this Court. See CIT vs. Kamal Singh Rampuria (1970) 75 ITR 157 (SC).

13. We have therefore to proceed on the basis the Mr. Raman was not an employee of the company. The payment of pension to his widow is not therefore covered by the scheme which provides for payment of pensions only to the employees of the company. Even though it is stated in the resolution passed at the general body meeting of the company held on May 11, 1963, by which the payment of pension to Mrs. K. K. Raman, the wife of the director, was sanctioned that the said action was being taken “in consideration of the understanding and arrangement between the company and Shri K. K. Raman”, the assessee did not succeed in establishing before the Tribunal the factual existence of any such arrangement. Thus, there is nothing to show that there was any expectation in the mind of Shri Raman that such a pension would be paid either to himself or to his widow. There is also no evidence of the existence any practice in the assessee-company to pay pension to the widow of a deceased director. On these facts and circumstances, the Tribunal was, in our view, perfectly justified in holding that the expenditure incurred in the payment of pension to the widow of Shri Raman can be regarded only as an ex gratia payment and that it is not deductible under s. 37 of the Act.

14. For the reasons stated above, we answer the question referred in I. T. R. No. 24 of 1968 in the affirmative, that is, against the assessee and in favour of the Department. The assessee- company will pay the costs of the respondent.

15. We now come to I. T. R. No. 25 of 1968 where the question to be decided is whether the sum Rs. 11,400 sanctioned by the company as gratuity to Shri K. A. Varugis was an inadmissible deduction under s. 37 of the Act.

16. Counsel appearing for the Revenue contended that the reasoning of the Tribunal as well as the conclusion recorded by it on this question are vitiated by its omission to consider a most vital point, namely, whether the expenditure in question had been incurred by the assessee during the year of account. Counsel submitted that under s. 37 no deduction is permissible unless the expenditure in question is shown to have been incurred in the accounting period and that proof of such fact is a condition precedent for the grant of the benefit of deduction under that section. He invited our attention to paragraph 15 of the Tribunal’s order for showing that this contention had been specifically raised before the Tribunal by the Department. It was urged that inasmuch as the Tribunal has failed to discuss this point and to record any finding thereon the order passed by it upholding the assessee’s claim for deduction is illegal and without jurisdiction.

17. In his arguments on the merits of the above objection, counsel for the Revenue laid stress on the fact that it was only on 19th March, 1963, that the board of directors of the assessee- company passed the resolution sanctioning the payment of Rs. 11,400 as gratuity to Shri K. A. Varugis and that the necessary amendment to the articles of association of the company authorising such payment was made only on May 11, 1963. He pointed out that the relevant accounting period came to a close on December 31, 1962, on which date Shri K. A. Varugis retired. Counsel also contended that the mere fact that an amount of Rs. 11,400 was credited on December 31, 1962, to “gratuity payable account” in the company’s books is not, by itself, sufficient to constitute incurring of “expenditure” for the purpose of s. 37 of the Act, since the company was not under any legal liability as on that date to pay any gratuity to Shri Varugis nor had the amount been irretrievably paid out or away. Reliance was placed by him on the decisions of the Supreme Court in Indian Molasses Co. Ltd. vs. CIT (1959) 37 ITR 66 (SC)and CIT vs. Nainital Bank Ltd. (1966) 62 ITR 638 (SC), in support of the contention that in order that an item of expenditure should be entitled to deduction under s. 37 of the Act it must have been incurred for discharging a liability actually existing during the accounting period and that the mere setting apart of an amount to meet a liability, not actually present but only contingent, cannot bear the character of expenditure till the liability becomes real.

18. Counsel for the Revenue also challenged the correctness of the Tribunal’s finding that the expenditure incurred by the assessee in the payment of gratuity to Shri Varugis was an amount wholly and exclusively laid out for the purposes of the assessee’s business. The reasoning of the Tribunal that since there was a scheme in force in the company providing for payment of gratuity to its employees on retirement or retrenchment, Mr. Varugis who was a permanent director of the company would have had an expectation that he would also get gratuity on a similar basis, even though directors were not covered by the scheme, was attacked by the Departmental counsel as far-fetched and fallacious. It was urged that the factual assumptions and inferences on which the Tribunal has rested its conclusion are not supported by any evidence at all but are based on mere guess- work and surmise and that the decision of the Tribunal is, therefore, vitiated by an error of law. It was also contended that no nexus whatever has been established between the expenditure in question and the future conduct of the company’s business and since admittedly there was neither any scheme nor a practice in the company to pay gratuity to its directors on their resignation or retirement, the expenditure in question was a mere ex gratia payment and was not deductible under s. 37 of the Act.

19. In our opinion, counsel for the Revenue is well-founded in the contention that the Tribunal’s decision on this question is vitiated by reason of its omission to advert to a most material point arising in the case, the determination of which was absolutely essential for answering the question whether the sum of Rs. 11,400 representing the gratuity sanctioned to Shri K. A. Varugis was an admissible deduction under s. 37 of the Act For the purpose of computing yearly profits and gains, for assessment to income-tax, each year is a separate and self-contained period of time and losses and expenses incurred before its commencement or after its expiry cannot be the subject of any allowance in assessing the income of that particular year. In making the assessment for any particular year, deductions can, therefore, be permitted only in respect of expenses which are found to have been incurred in the relevant accounting period. In adjudging the admissibility of a claim for deduction, the determination of the question whether the assessee had incurred the expenditure during the relevant accounting period is an indispensable preliminary step.

20. From the Tribunal’s order itself, it is seen that an objection had been specifically raised before it on behalf of the Department that the amount of gratuity sanctioned to Shri Varugis under the resolution dt. the 19th March, 1963, could not be regarded as an expenditure incurred in the relevant accounting period, namely, the year ending December 31, 1962. Both the ITO as well as the AAC had dealt with this point in the orders passed by them. In fact, one of the grounds stated by the ITO in the assessment order-Annexure “A”—for disallowing the deduction is that the amount had not been paid by the company to Shri Varugis during the year of account and that what the company had done was only to make provision for a future payment. The AAC in his order, Annexure “B”, has relied on the fact that the resolution of the board of directors sanctioning payment of gratuity to Shri Varugis was passed only on March 19, 1963, and that the amendment to the articles of association of the company was made only on May 11, 1963. In view of this, he held that the company was under no liability and obligation during the accounting period to pay gratuity to any of its directors. In disallowing the assessee’s claim for deduction, the AAC has also taken notice of the Department’s contention that the amount had not been paid in the year of account.

21. It is thus seen that the point had been specifically raised at every stage of the proceeding and it is rather surprising that after having referred to this objection as one of the contentions raised before it by the Department the Tribunal thereafter completely omitted to deal with this vital aspect of the case. The entire discussion of the Tribunal touching the admissibility of the claim for deduction of the amount of Rs. 11,400 is contained only in paragraph 17 of its order and it is exclusively devoted to a consideration of the question whether the payment could be regarded as one made for the purposes of the business of the company. The question whether there was any existing liability incurred by the company during the accounting period or whether what had been done by the assessee was only to make provision for a contingent or future liability has not been adverted to or considered by the Tribunal. There is also no discussion at all in the Tribunal’s order of the question whether the deduction claimed by the assessee was in respect of any item of “expenditure” incurred during the relevant accounting period. The admissibility of the claim for deduction advanced by the assessee being conditional on the incurring of expenditure during the relevant accounting year, the Tribunal ought not to have proceeded to allow the deduction claimed by the assessee without considering the above objections raised by the Department.

22. Counsel appearing for the Department submitted that the necessary facts and materials are already available in the papers forwarded to this Court and that the question whether the expenditure had been incurred by the assessee during the accounting period may be decided by this Court itself. We are not inclined to accede to this suggestion because, in our view, the adoption of such a procedure would be neither correct nor satisfactory. Whether or not the expenditure was incurred during the relevant accounting period is a question of fact and it is necessary that a proper finding thereon should be entered by the Tribunal itself.

23. We, therefore, hold that the statement of the case submitted by the Tribunal is incomplete inasmuch as the Tribunal has not stated its finding on the material question mentioned above inclusive of its different aspects which we have indicated. The case is therefore referred back to the Tribunal for the purpose of drawing up and submitting to this Court a fuller statement of the case incorporating its finding on the points referred to above.

24. We are not called upon at this stage to express any opinion regarding the correctness or otherwise of the Tribunal’s finding that the payment of gratuity to Shri Varugis is an expenditure laid out wholly and exclusively for the purpose of the company’s business but reserve that point for consideration, if found necessary, after receipt by this Court of the fuller statement of the case called for under this order.

A copy of this judgment together with the records of the case will be transmitted by the Registrar to the Tribunal, Kerala Bench, Ernakulam.