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Petitioner: M. S. P. SENTHIKUMARA NADAR & SONS VS Respondent: COMMISSIONER OF INCOME-TAX, MADRASHonorable Justice RAJAGOPALANS. Swaminathan,C. S. Rama Rao Sahib
1966 P T D 517
1966 P T D 517
[Madras (India)]
Before Rajagopalan and Rajagopala Ayyangar, JJ
M. S. P. SENTHIKUMARA NADAR & SONS
versus
COMMISSIONER OF INCOME‑TAX, MADRAS
Case Referred No. 65 of 1953, decided on 1st February 1957.
Indian Income‑tax Act (XI of 1922), S. 10 (2) (xv) Business expenditure‑Expenditure must be made for purposes of earning profits‑Contingent liability‑Payment of penalty Whether permissible deductions‑Dealer in coffee‑Damage paid to Coffee Board for not exporting cofee in breach of contract Whether allowable deduction‑Accounts‑Entry regarding liability Whether permissible.
Only an ascertained liability justifies an entry in accounts 'maintained on the mercantile basis.
Deductions are not permissible for anticipated losses or contingent liabilities, even if they are inevitable.
Payments of penalties for infraction of law fall outside the scope of permissible deductions under section 10(2)(xv) of the Income‑tax Act.
For the purpose of deduction under section 10(2)(xv) it is not enough if the loss sustained or expenditure incurred is in some sense connected with the business. Only such losses can be de ducted as are connected with the business in the sense that they are really incidental to the business itself. It .is not enough that an expenditure is made in the course of, or arises out of, or is connected with, the business or is made out of the profits of the business; it must be made for the purpose of earning the profits.
The assessee firm, which carried on business in coffee, entered into contracts with the India Coffee Board and purchased coffee in the account year 1942‑43, at a rate for below the price of coffee to be sold within India, with a contractual obligation to export the. whole of the coffee so purchased to places outside India. The assessee in addition purchased coffee from others out of their export quota, which also it was under an obligation to export. The assessee, however, exported only part of the coffee, and sold the balance within India, in contravention of its obligations. When the Coffee Board came to know in 1946 of the sales within India and called upon the assessee to explain, the assessee admitted that it had failed to export part of the coffee purchased and agreed to pay liquidated damages in accordance with one of the three alternatives provided in the contract. The damages the assessee was liable to pay for its breach of contract was assessed at Rs. 1,19,177, the assessee paid the amount in instalments in the account year 1945‑46, and claimed that the amount should be deducted under section 10 (2) (xv) of the Income‑tax Act from its profits for the account year 1942‑43:
Held, (i) until the Coffee Board made it clear which of the alternatives it chose, the liability of the assessee was only a contingent liability in the account year 1942‑43; even if the assessee had debited itself in that year, the debit would have represented only a reserve provided against enforcement in future of what was a contingent liability in 1942‑43; the liability arose in the year 1945‑46 when the claim for damages was made and was ascertained only after the assessee admitted the liability and, therefore, it could not be related back as an item of expenditure to the year 1942‑43; therefore, the deduction could not be allowed under section 10(2)(xv) from the profits of 1942‑43 ;
(ii) although what the assessee paid to the Coffee Board was called liquidated damages, the payment was really akin to a penalty for committing an act opposed to public policy, a policy that underlay the Coffee Market Expansion Act, 1942, and. which the Act left it to the Coffee Board to enforce; the breach of its contractual obligations to the Board was not in the course of the normal trading activities of the assessee; the money was not expended or paid out for the purpose of the assessee's business and was not even incidental to the business itself; therefore, the amount was not an expenditure allowable under section 10 (2) (xv).
Peter Merchant Ltd. v. Stedeford (1948) 30 Tax Cas. 496; Edward Collin's & Sons Ltd. v. Commissioners of Inland Revenue (1924) 12 Tax Cas. 773; Naval Colliery Co. Ltd. v. Commissioners of Inland Revenue (1928) 12 Tax Cas. 1017 fol.
Strong v. Woodifield (1906) A C 448 and Commissioners of Inland Revenue v. Allexander Von Glehn & Co. Ltd. (1920) 12 Tax Cas. 232 applied.
Mask & Co. v. Commissioner of Income‑tax (1943) 11 1 T R 454 considered.
[Case‑law referred to].
STATEMENT OF CASE
1. In compliance with the requisition of the High Court in C. M. P. No. 10431 of 1951, dated 13th March 1952, we state the case and refer it to the High Court 'under section 66 (2) of the Indian Income‑tax Act.
2. The point in dispute arises out of the income‑tax assess ment for the year 1944‑45 the relative previous year being the year ending 16th August 1943.
3. The assessee is firm carrying on business in. coffee, cardamoms, etc. During the year under consideration, the assessee, under contracts entered into with the India Coffee Board, Delhi, purchased 12,390 cwt. of coffee for export to the Middle East and Australia. A copy of the contract so entered into is annexed hereto as Annexure `A' and forms part of the case. In addition, it also purchased from other export licences, 8,303 cwt. of coffee which was intended for export to the said countries. The price of coffee fixed by the India Coffee Board on the export quota was far below the local price. In case of failure to export the coffee so purchased, clause 8 of the contract provided:
"If the buyer fails to ship the coffee purchased for export to a destination outside India, the Board reserves to itself the right to levy liquidated damages or to restore the status quo in any one of the following ways, at the absolute discretion of the Controller of Coffee.
(a) To recover a fixed measure of damages at Rs. 20 per cwt. to be paid to the surplus pool;
(b) to export an equivalent quantity by weight of coffee purchasing the same from pool and to recover the loss incurred in the transactions from the buyer. The decision of the Controller in the matter of price at which such coffee is purchased and sold and in the matter of fixing the loss shall be final; and
(c) to call upon the buyer to restore the stock delivered to him at a price less than the purchase price by 2 per cent. of the price for every month after the expiry of the period for export fixed above and the date when the buyer is called upon to restore the stock provided that a period of 15 days and over shall be treated as a month and a period less neglected.
The fixed damages referred to above shall be deemed as liquidated damages and the buyer shall not be entitled to any reduction thereof in any circumstances."
Out of the total quantity of 14,693 cwt. purchased for export the assessee exported only 8,784 cwt. and sold the balance of 5,959 cwt. without the knowledge and concurrence of the India Coffee Board, within India only. It did not inform the Coffee Board at any time that it had contravened the provisions of the licence granted to it to acquire the coffee. In 1946, the Coffee Controller came in possession of certain information which showed that the assessee did not, in fact, export the coffee acquired by it for that purpose and sold it within the Union territory at higher prices. The Coffee Controller investigated this and by his latter, dated 3rd May 1946, called upon the assessee to show cause why responsibility for selling the coffee which was intended for export, in the Union territory, should not be fixed on it. The assessee, in its letter, dated 20th May 1946, admitted not having shipped 5,959 cwt. of coffee and expressing regret for the happening agreed to pay damages in accordance with clause 8 of the contract. The damages were ascertained at Rs. 1,19,177, which sum, the assessee paid in four instalments between 3rd May 1946, and 18th August 1946. This sum was claimed by the assessee as an admissible deduction from the profits for the assessment year 1944‑45 (previous year being the year ending 16th August 1943).
4. The learned Advocate for the assessee urged that the aforesaid payment should also be treated as an admissible deduc tion under section 10 (2) (xv) of the Act or it should go towards increasing the price of coffee during that period. The Tribunal held that the expenditure was incurred at a period beyond the year of account and it was not known on 16th August 1943, that it was going to incur and expenditure, let alone the quantum of it. Therefore, the Tribunal held that it was not an expenditure for that year and much less a liability. It also field that the expenditure was incurred during the period 23rd May 1946, to 18th August 1946, and the consideration of it, if at all, should be within the year covering that period and not during the year ending 16th August 1943, when no liability for the expendi ture was known or incurred. In fact, if the assessment for 1944‑45 had been promptly completed, there could have been no claim by the assessee in that year. The assessee never informed the authorities either before 16th August 1943, or soon after that it had infringed the law and incurred liability by way of damages which had to be paid to the Coffee Controller. Thus, there was no liability incurred at all during the period for which the claim was made. Secondly, it was found that the impugned sum was described as liquidated damages and as such it did not from an addition to the cost of commodity purchased by Luc assessee. On these two grounds, the Tribunal negatived the assessee's claim and dismissed the appeal.
5. The question of law on which the Tribunal had been directed to state is as follows:
"Whether on the facts and in the circumstances of the case, the sum of Rs. 1,19,177 paid by the assessee as damages to the Indian Coffee Board for not exporting the coffee seed outside India under the terms of agreement is allowable as an expendi ture under section 10 (2) (xv) of the Act in the assessment year 1944‑45 ?"
S. Swaminathan for the Assessee.
C. S. Rama Rao Sahib for the Commissioner.
JUDGMENT
RAJAGOPALAN, J.‑The question referred to this Court under section 66(2) of the Income‑tax Act arises out of the assessment for the year 1944‑45, the previous year in relation to which ended on 16th August 1943. The assessee firm carried on' business in coffee among other things. In the relevant accounting year, 1942‑43, the assessee entered into contracts with the India Coffee Board, constituted under the Coffee Market Expansion Act VII of 1942, under which the assessee purchased 12,390 cwt. of coffee, with a contractual obligation to export the whole of that quantity to the Middle East and Australia. In addition, the assessee purchased from others out of their export quotas, 2,303 cwt. which also he was under an obligation to export. The prices at which the India Coffee Board sold the coffee for export were far less than those at which coffee was sold from the pool by the Board for sales within India. The assessee exported only 8,784 cwt.; the balance of 5,959 cwt. it sold within India without the knowledge of the India Coffee Board. The assessee made con siderable profits out of these sales: The 'India Coffee Board came to know of these sales in contravention of the assessee's obligations only in 1946, when it called upon the assessee to explain. The assessee admitted in his letter dated 20th May 1946, that it had failed to export 5,959 cwt. of the. coffee that it had obtained for export in 1942‑43 and the assessee agreed to pay the damages in accordance with one of the alternative terms of the contract it had entered into with the India Coffee Board.
Clause 9 of that contract ran:
"If the buyer fails to ship the coffee purchased for export to a destination outside India, the Board reserves to itself the right to levy liquidated damages or to restore the status quo in any one of the following ways, at the absolute discretion of the Controller of Coffee:
(a) To recover a fixed measure of damages at Rs. 20 per cwt. to be paid to the surplus pool. (b) To export an equivalent quantity by weight of coffee purchasing the same from the pool and to recover the loss incurred in the transaction from (he buyer. The decision of the Controller in the matter of price at which such coffee is purchased and sold and in the matter of fixing the loss shall be final. (c) To call upon the buyer to restore the stock delivered to him at a price less than the purchase by 2~1 per cent. of the price for .very month after _ the expiry of the period for export fixed above and the date when the buyer is called upon to restore the stock provided that a period of fifteen days and over shall be treated as a month and a period less neglected."
"The fixed damages referred to above shall be deemed as liquidated damages and the buyer shall not be entitled to any reduction thereof in any circumstances."
It was apparently the first of the alternatives that it was availed of by the Controller of Coffee, and the damages the assessee was liable to pay for its admitted breach of the contractual obli gation was assessed at Rs. 1,19,177 on 1st June 1946. The assessee paid this amount in instalments in the latter part of its year of account 1945‑46.
The assessment proceedings for 1944‑45 were completed by the Income‑tax Officer only on 5th August 1947. The assessee firm claimed that the sum of Rs. 1,19,177 it had paid as liquidated damages should be deducted to arrive at its assessable profits for the accounting year 1942‑43 under section 10 (2) (xv) of the Income‑tax Act. That claim was disallowed by the depart mental authorities. The assessee's appeal to the Appellate Tribunal failed.
The question referred to this Court under section 66(2) of the Act ran:
"Whether on the facts and in the circumstances of the case the sum of Rs. 1,19,177 paid by the assessee as damages to the Indian Coffee Board for not exporting the coffee seeds outside India is under the terms of agreement allowable as an expendi ture under section 10(2) (xv) of the Act in the assessment year 1944‑45."
Two points had to be determined by the Appellate Tribunal (1) whether independently of the year of account in which the expenditure of the 1,19,177 was incurred by the assessee the expenditure could be claimed at all as deduction under section 10 (2) (xv) of the Act; and (2) if it could be claimed as a lawful deduction did the fact that the amount was expended, not in the relevant year of account 1942‑43, but only in the year of account 1945‑46, for the grant of relief to the assessment year 1944‑45. Both the points were decided against the assessee by the Appellate Tribunal. The claim of the assessee firm has to be rejected if either of the points is decided against it.
The Tribunal, in our opinion, was right when it decided in the circumstances of this case that the amount expended by the assessee in 1945‑46 could not be excluded in computing the assessable income of the assessee during its account year 1942‑43.
No doubt the assessee paid the sum of Rs. 1,19,177 to the India Coffee Board as liquidated damages for breach of contract. That breach was in, the year of account 1942‑43.
The liability to pay damages under the contract between the assessee and the India Coffee Board was however only a con tingent liability, and it remained so till that year of account ended. The assessee maintained its account on the mercantile basis. The assessee did not debit itself in the year of account with the amount it eventually bad to pay in 1945‑46.
It could not claim to be in a better position than it would have been had it debited itself with that amount in its accounts during 1942‑43. Even so, that debit would have represented only a reserve provided by the assessee against the enforcement in future of what was still a contingent liability in 1942‑43. However prudent such a provision might have been from the point of view of accountancy, that would not have sustained a claim for deduction under section 10 (2) (xv) of the Act with reference to the account year 1942‑43. It would still have been an un ascertained claim for damages for breach of contract. The claim itself was not made in the year of account. That there could be no defence to the claim when it was made did not alter the fact that the claim had yet to be made and the damages yet to be ascertained.
It could not be predicated in 1942‑43 what would be the claim of the India Coffee Board, the other contracting party entitled to damages under the contract. We have already set out the terms of clause 9 of the contract. It provided for three alternatives, any one of which the India Coffee Board could claim at the discretion. of the Controller of Coffee. The quantum of damages could not possibly have been identical under each of these three alternatives open to the India Coffee Board. Which of these three alternatives gave the greatest monetary advantage to the India Coffee Board at any given point of time, with the corresponding monetary liability on the assessee, it was not possible to guess, because no claim even was made by the India Coffee Board in 1942‑43. Till the India Coffee Board made clear by its claim which of the three alternatives it chose, there could be no means of knowing what the liability of the assessee was. Up to that stage it could only be a contingent liability. For all that the assessee knew in 1942‑43 no claim might have been made at all by the India Coffee Board. That was probably what the assessee hoped for, that the breach of the terms of the contract would go un-deducted and the liability would go unenforced. Under such circumstances the assessee could not treat any sum as an ascertained liability, even if it could not be viewed as an ascertained debt due to the India Coffee Board, to justify the claim to deduct any specified sum from the assessable profits of that year. Whether the liability was discharged or not by payment, only an ascertained liability would have justified an entry in the accounts of the assessee maintained on a mercantile basis. Even had the assessee firm entered any amount in its account in 1942‑43 before such ascertainment, the claim under section 10 (2) (xv) would have been unsustainable.
To sum up, it was a contingent liability and not an ascertained liability in 1942‑43.
It should be taken as well settled now that without statutory warrant‑and there is none in section 10 (2)(xv)‑deductions are not permissible for anticipated losses even if they are inevitable, for contingent liabilities.
In Peter Merchant Ltd. v. Stedeford ((1948) 30 Tax Cas, 496) the facts were as follows. The assessee company carried on the business of managing n, factory canteens. Under the usual form of contract made between the company and the factory owner, the crockery, cutlery, and utensils used in the canteen were provided by the factory owner, but they were to be maintained in their original quantity and quality of by the company. It was found impossible in the relevant year of account, owing to scarcity and high price of the equipment concerned, to effect alt the replacements for which the company was liable. The company however charged as expenses not only the amounts of the disbursements actually made in effecting replacements, but also amounts representing at current prices the company's liability to effect replacements as soon as the required equipment became available. The company claimed the latter set of amounts as admissible deductions in computing its assessable profits. That claim was disallowed. In the assessment proceedings an accountant called in as an expert gave evidence. He stated that the accounts had been prepared in accordance with the principles of sound Commercial accounting. He added that, if he had been the auditor of the assessee company, he would not have been prepared to certify the accounts as correct, if the provisions to meet the company's liabilities in respect of equipment shortages had not been made year by year in the manner in which the accounts showed theta to have been made.
In dealing with the evidence of the accountant, Tucker, L. J., observed:
they (accounts) might well have been prepared in accordance with the principles of sound commercial accounting without being permissible deductions before arriving at the profits in a particular year."
After analysing the terms of the contract in that case Tucker, L. J., observed:
"The real liability under the contract, so far as the replace ment of the utensils goes, was a contingent liability; it was a liability which would not arise until the termination of the contract, and it was contingent upon the inability of the caterers in the meanwhile to replace the utensils. In that sense it is, I think, correct to say that the real liability under the contract was a contingent one."
It was the same principle that was held down in Edward Collins & Sons Ltd. v. Commissioners of Inland Revenue ((1924) 12 Tax Cas. 773) at page 781:
" . a prudent commercial man may put part of the profits made in one year to reserve, and carry forward that reserve to the next year, in order to provide against an expected, or (it may be) an inevitable, loss which he foresees will fall upon his business during the next year. The process is a familiar one. But its adoption has no effect on the true amount of the profits actually made, and does not prevent the whole of the profits, whereof a part is put to reserve, from being taken into computation in the year in question for purposes of assess ment. On the contrary, the balance of profits and gains is determined independently altogether of the way in which the trader uses that balance when he has got it ; and if he puts part of it to reserve anti carries it forward into the next year, that has no effect whatever upon his taxable income for the year in which he makes the profit."
Earlier the Lord President observed.
"It is a general principle, in the computation of the annual profits of a trade or business under the Income‑tax Acts, that those elements of profit or gain, and those only, enter into the computation which are earned or ascertained in the year to which the enquiry refers; and in like manner, only those elements of loss or expense enter into the computation which are suffered or incurred during that year." At page 782 the Lord President stated:
"I confess to thinking that it would be a dangerous innovation to allow apprehended losses to futuro to constitute proper matter for deduction from the present profits of commercial undertaking." He restated this later when he observed:
" ..this only serves to make it plain that what they are seeking to do is to put against the actual ascertained receipts from their business in one period a loss which is neither suffered nor incurred in that period. I know of no justification for this, either under the rules or principles of the Income‑tax Acts, or in ordinary commercial accounting."
In Naval Colliery Co. Ltd. v. Commissioners of Inland Revenue ((1928) 12 Tax Cas. 1017) the assessee‑company, which carried on business in mining, held their mines on leases which contained the usual covenants for the repair and maintenance of the mines, pits, roads etc. Owing to national stoppage in the coal mining industry, the company was forced to close down their mines from 1st April 1921 to 2nd July 1921. The stoppage of work resulted in severe dam age to the mines involving considerable amount of expenditure to recondition the mines. The reconditioning work was commenced after 2nd July 1921. For the period of account from 1st April 1921, to 30th June 1921, the assessee debited itself in its accounts with the cost of reconditioning the mines, though no expenditure was made until after the end of the accounting period. It was ultimately held by the House of Lords that, the cost of reconditioning was not a proper deduction in computing the results of the assessee‑company's trade for the accounting period ending 30th June 1921. Lord Buckmaster observed at page 1048:
"According to the appellants' contention, however, it is not the actual expenditure that is deducted, but the need for making the expenditure which is to be measured in their favour and brought into the account. This contention would involve the conclusion that the subject could choose which period he liked as the one in which the allowance is to be brought into account, either that when the expenditure became necessary or that when it was made."
The contention was repelled. If we apply the principle of ii, that contention to the claim of the assessee before us,, logically he should be in a position to claim a deduction in any of the years 1942‑43, 1943‑44, 1944‑45 or 1945‑46 at his choice. That certainly would not disclose a true picture of the assessable profits made in the year 1942‑43. At page 1049 Lord Summer…
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