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Petitioner: COMMISSIONER OF INCOME-TAX VS Respondent: STANDARD MALTINGS AND ALLIED JUDGMENT
Court Name: Gauhati High Court Judge(s): R. K. Abichandani, R. Balla Title:COMMISSIONER OF INCOME-TAX vs STANDARD MALTINGS AND ALLIED
JUDGMENT
Reported As: 1999 PTD 1269 Result: Order accordingly Judgment JUDGMENT R. K. ABICHANDANI, J.---The Income-tax Appellate Tribunal, Ahmedabad Bench "C", has referred the following question for the opinion of this Court, under section 256(1) of the Income Tax Act, 1961: "Whether, on the facts and in the circumstances of the case, the Tribunal was right in law in coming to the conclusion that the sum of Rs,2,50,348 paid by the assessee to its retiring partners was an allowable expenditure under section 37 of the Income Tax Act, 1961?" The matter relates to the assessm ent year 1975-76. The assessee which was assessed in the status of an unregistered firm, was engaged in the business of manufacturing malt for brewery units. The assessee filed its return of income on April 5, 1976, declaring a loss of income of Rs,2,10,595. As the proposed variation in the returned loss turned out to be more than Rs,1 lakh, a draft order under section 144-B was served on the assessee on March 30, 1978, to which the assessee filed its objections as regards the additions proposed. The assessee-firm had charged the profit and loss account, an amount of Rs,2,50,350 as the expenditure incurred in the name of compensation to retiring partners with the following break-up: 1. Smt. R. V. Mehta 98,250 2. Miss D. B. Mehta 48,375 3. Shri P. V. Mehta 1,02,725 According to the assessee, this expenditure was admissible as an expense of business under section 37 of the said Act, because the above erstwhile partners belonging to the group of the partner. Mr. P. V. Mehta, who did not look after the business of the assessee efficiently and due to his mismanagement, the project had failed, were, in the larger interest of business, made to retire
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by giving the above payments to them. The I.A.C.B.R.I., Baroda, held that these payments were not admissible as business expenditure, because they were made by one group of proprietors to the other for the purchase of the proprietary rights in the business. The Income-tax Officer by order, dated June 29, 1978, accordingly disallowed the said expenditure or Rs,2,50,350 claimed by way of compensation to the retiring partners. Against that order the assessee approached the Commissioner of Income-tax (Appeals) raising the same contentions which did not find favour with the Commissioner of Income-tax, who held that the payments to the retiring partners were made to acquire their rights in the business of the firm and, therefore, such payments were not deductible in the assessm ent of the firm. Thereupon, the assessee approached the Tribunal. The Tribunal while accepting the proposition that if payment of compensation was towards settlement of accounts between the partners for acquiring the rights of the outgoing partners, such payments would not be deductible under section 37 as they would amount to expenditure of capital nature, came to the conclusion that since the firm was under huge losses, nothing was payable to the outgoing partners towards their capital in the firm and, therefore, the compensation paid by the continuing partners was essentially afl expenditure incurred in the course of business and for the purpose of business. The Tribunal held that the approach of the lower authorities, which was to the contrary, was not correct because the expenditure was incurred in order to facilitate the carrying on of the business by removing the in efficient partners, whose continuance would have caused further damage to the business. The payment was, according to the Tribunal, made in order to get rid of the disadvantageous relationship at the behest of or on the recommendation of the bankers and the payment of compensation which was made in order to remove the disadvantage, cannot be equated with an enduring benefit. The Tribunal, however, observed that it was not laying down a general proposition to the effect that in every case of retirement of a partner such compensation would be an expedient expenditure allowable on revenue account. The Tribunal holding that the said amount of compensation paid to the retiring partners was allowable deduction on the revenue account, allowed the assessee's appeal. Learned counsel appearing for the Revenue contended that the expenditure incurred for acquiring the rights of the retiring partners in the assets of the firm was not revenue expenditure. He submitted that such expenditure cannot be said to have been incurred for the purposes of running the business. Referring to the deed of retirement, he submitted that it was clear that the payments made to the retiring partners, which are described as compensation, were in fact payments made in lieu of the rights of the retiring partners and there was nothing in the deed to suggest that the payments were made for the purpose of running the business. Learned counsel further argued that getting rid of an inconvenient and inefficient employee or an agent in the interest of the business of the firm was entirely a different matter from making payment to the retiring partners of the firm in lieu of their rights in the firm. Learned counsel appearing for the assessee submitted that the expenses were incurred by the firm for efficient running of its business because the management of Mr. P. V. Mehta, who was a partner, resulted in losses and the only way in which the business could be run profitably was to make his group retire. It was submitted that the firm had incurred huge losses and nothing was payable to the outgoing partners on their account and, therefore, the expenses incurred by the firm should necessarily be treated as expenses incurred on revenue account. It was further contended that a partnership-firm was a distinct taxable entity and is treated ,distinctly regardless of its position under the partnership law. Therefore, according to him, a firm which is being assessed as an independent unit under the income-tax law should be viewed as a distinct entity from its components. He submitted that the terms of the retirement deed were not relevant to ascertain the real nature of the expenditure incurred by the assessee-firm and that the Court should not view the situation in the context of the Partnership Act. He, therefore, supported the reasoning of the
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Tribunal. It is difficult to accept the contention raised on behalf of the assessee, that a firm which is assessed as an independent taxable entity for the purpose of assessment, should not be viewed in the context of the provisions of the Partnership Act. Retirement of a partner from a firm is a factor which has a bearing on the constitution of the firm. Even the scheme under the Income-tax Act regarding assessm ent of firm as a distinct assessable unit does not do away with the concept of a partnership and the rights and duties of partners inter se continue to be governed by the provisions of the Indian Partnership Act. Though, for the purpose of taxation, a "firm" is treated as a distinct unit, its meaning even in the context of the Income-tax Act remains the same as is assigned in the Indian Partnership Act. Section 2(23) of the said Act provides that the expressions "firm", "partner" and "partnership" have the meanings, respectively, assigned to them in the Indian Partnership Act, 1932, but the expression "partner" shall also include any person who, being a minor, has been admitted to the benefits of partnership. Separate provisions are made for assessm ent of firms in Chapter XVI of the said Act, which, inter alia, require an application for registration of the firm to be signed by all the partners. Such application is to be made before the end of the previous year for the assessment year in respect of which the registration is sought. The registration is for the assessm ent year and by virtue of subsection (7) of section 184 of the said Act, endures for subsequent assessm ent years, provided no change is made in the constitution of the firm or the shares of the partners. Where change is made in the constitution of the firm, a fresh application for registration is required to be made for the reconstituted firm. These provisions show that a registered firm is treated as an assessable unit only for the year during which is composition remains unchanged and on change the reconstituted firm is to be registered afresh. Furthermore, under section 187 of the said Act where there is a change in the constitution of the firm, the assessm ent is to be made on the firm as constituted at the time of making the assessment as provided therein. The provisions relating to assessment of firms under the said Act indicate, that even the said Act recognizes the fact that by change in composition, the firm gets reconstituted meaning thereby, the earlier firm composed of all the existing partners ceases and a new firm is constituted as per the change, which requires of a fresh registration. Therefore, retirement of a partner which has the effect of changing the constitution of the firm in this context is required to be viewed in the light of the provisions of the Partnership Act, which alone deals with the question of the constitution of firms, their reconstitution and dissolution, as also with the rights and duties of the continuing partners, as well as the outgoing partners. The Income-tax Act does not contain any provision having bearing on the question of constitution of the firm. It, therefore, can never be said that the provisions of the Partnership Act should be ignored the moment a firm is viewed as an independent taxable entity under the income-tax law. The partners are, in both commercial and legal terms, collectively referred to as a "firm", but with very different underlying perspectives. The commercial view reflected in the approach of most accountants, involves treating a firm much in the same way as a company, i,e,, as a distinct entity from the members composing it. The law rather looks to the partners composing the firm and any change in their number destroys the identity of the firm. What is known as partnership property is in reality the property of the partners and the firm's debts and liabilities are their debts and liabilities. Thus, a partner can be the debtor or the creditor of his co-partners, but he cannot either be the debtor or the creditor of a firm of which he himself is a partner, nor can he be employed by his firm, for he cannot employ himself. On retirement of a partner, the composition of a partnership changes and results in a technical dissolution of the existing firm and creation of a new firm, though it would not be a general dissolution involving full scale winding up of the business of the firm. We, therefore, are unable to accept the contention raised on behalf of the assessee that the change in the composition of the assessee-firm by virtue of retirement of the partners of the Mehta
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group should be viewed without reference to the provisions of the Partnership Act and the deed to retirement as also the provisions of the partnership law relating to the outgoing partners. In the present case the three partners of the Mehta group retired with effect from December 3, 1974, under a deed of retirement, dated December 4, 1974, which is at Annexure "F" in the paper book of the reference. The continuing partners were Smt. Sulochanaben Mazumdar and Smt. Yaminiben Mazumdar. Under the said deed, the terms and conditions of retirement and release mutually agreed between the parties have been recorded. Accordingly, the retiring partners had retired from the firm of Standard Malting's and Allied Products Corporation with effect from the close of business on December 3, 1974, on an express understanding and agreement, that the continuing partners shall be entitled to continue the business of the said partnership from December 4, 1974, as per their absolute choice and further that they shall be entitled to use the firm name for the purpose of continuing the business of the said partnership. It was also stipulated that the continuing partners will be entitled to all the rights, title and interest of the said partnership inclusive of all quota rights, tenancy rights, import and export licenses and all other benefits and privileges, as also contract rights. The continuing partners were entitled to the sole and exclusive right to endorse, collect and release all the out standings of the firm and its claims. The retiring partners were absolved from their liabilities from the date of their retirement. Under the said deed the retiring partners relinquished all their right, title and interest in the assets, actions, claims, demands, benefits, privileges and goodwill of the partnership and in consideration of full discharge of such rights and in full satisfaction of their claim in respect of the amounts contributed by them towards the capital of the partnership and in full satisfaction of all sums of money due to them in respect of their accounts, payments were to be made to them by the continuing partners of a total sum of Rs,20,09,000 as specified in clauses (5) and (6), read with schedule "A" of the partnership deed. The said schedule incorporated the statements of the sums of money payable by the continuing partners to the retiring partners which included the amounts payable on account of contribution of capital, current accounts, the amounts payable under the terms of the deed for diverse considerations mentioned in the deed and an amount of compensation for a period of nine months from the date of the deed stipulated as the payment period. This arrangement was to be treated as a final settlement of the account and as stipulated in paragraph 6 of the deed, the continuing partners were not entitled to deduct anything from these amounts as and by way of shares of the retiring partners in the accumulated losses of the firm and the amounts which were debited in the accounts of the retiring partners in the books of account of the firm were to be treated as duly recovered in settling the amounts payable to the retiring partners. On reading the relevant terms and conditions of the deed of retirement and release, we are fully satisfied that the outgoing partners were made payments in lieu of their right, title and interest in the partnership- firm including in its assets and goodwill. Under the said deed, the partners had agreed to quantify the amount which was to be paid by the continuing partners to the retiring partners for enabling the continuing partners to acquire the rights and interest of the outgoing partners in the firm and for getting the exclusive right to continue the business of the firm in the firm name. When the partners had chosen to attribute a specified value to the rights of the outgoing partners which were being acquired by the continuing partners under the said deed, it was not open to any outsider to suggest that there was nothing payable in respect of the rights and interests of the outgoing partners by the continuing partners and that the outgoing partners had no interest whatsoever in the firm which could be acquired by making any payment. The case put up by the assessee that the payments were made under the deed by the continuing partners for the smooth running of the business of the firm is not at all warranted, in view of the specific terms and conditions stipulated under the deed which described the payments having been made to the outgoing partners in satisfaction of their legal rights and interests in the assets and goodwill of the
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firm. We are told that the partnership firm was a partnership at will. In that event any partner could have given a notice in writing to the other partners, of his intention to dissolve the firm as provided by section 43 of the Partnership Act. The outgoing partners had, under section 36 of the Partnership Act, the right to carry on a business competing with that of the firm and under section 37 they had a right in certain cases to share subsequent profits. In a partnership at will where dissolution is made by giving a notice to other partners, the partners have a right to have the business wound up after the dissolution. There are rules laid down for settlement of accounts between the partners in section 48 of the Partnership Act. In settling the accounts of a firm after dissolution, the goodwill is to be included in the assets and can be sold either separately or with the other property of the firm. These provisions indicate that a retiring partner who otherwise had a right to participate in the business forgoes valuable rights in consideration of what is paid by the continuing partners. When the continuing partners agree to pay a quantified amount to the retiring partners without reference to the actual state of the books of account, that would be a matter entirely between them and it would be open to the partners to settle the accounts as per their agreement. Thus, we are fully satisfied that the payments which were made under the deed were made in lieu of the rights of the outgoing partners by the continuing partners and there was no question of the assessee-firm incurring any revenue expenditure in the matter and that these payments were in no way connected with the running of the business of the firm and they were, therefore, not deductible in the assessm ent of the assessee-firm. In the context of the view that we have taken, we must refer to the decision of the Andhra Pradesh High Court in C.I.T. v. Putan Das Ranchoddas & Sons (1988) 169 ITR 480, wherein a question arose as to whether payment made to the outgoing partners under the deed of dissolution towards the goodwill was a revenue expenditure. The High Court held that though the deed of dissolution did not expressly mention that the consideration of Rs,80,000 received was either towards relinquishment of the rights in the goodwill or the use thereof by the other partners, the true legal relationship resulting from a transaction was to be determined. On a perusal of the relevant clauses of the deed, it was found that there was total cessation between the relationship of the outgoing partners and the remaining partners. The Court held that it was obvious that in consideration of giving up their right, title and interest in the goodwill of the firm, the retiring partners had received the goodwill of Rs,80,000. It was held that the fact that the consideration was not adequate was not by itself a circumstance to show that what was conveyed was not relinquishment of a pre-existing right, title and interest. The Court held that when the payment was made, it was not incidental to the carrying on of the business, but was incidental to the reconstitution of the business by the remaining partners and the consideration was paid to acquire a capital asset and was a capital' expenditure. We are in respectful agreement with this proposition laid down in Puran Das Ranchoddas & Sons' (1988) 169 ITR 480 (AP). In General Auto Parts Co. v. C.I.T. (1981) 128 ITR 519 (Delhi), a similar question arose in the context of payment of amounts by the continuing partners of the firm in order to acquire the right, title and interest of the retiring partners in the assets of the former firm and the Delhi High Court took the view that, where a certain sum of money is paid by the continuing partners of a firm in order to acquire the right, title and interest of the retiring partners in the assets of the former firm, the payment made cannot be said to be incidental to the carrying on the business but that is incidental to a reconstitution of the framework of the business itself. The cases of relationship between the partners and the firm cannot be equated with the relationship that may exist between a company and its employees or managing agents. A payment made by a company to its directors or managing agents should be a payment made by a distinct legal entity, while a firm not being a distinct legal entity separate from its partners, payment made to the outgoing partners was clearly a payment of capital nature relatable to the
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settlement of accounts between the partners, inter se. The payment which was made by the continuing partners to the retiring partners was clearly relatable to the ownership of the business and towards settlement of mutual rights as owners and not as traders. By relinquishment of the shares of the retiring partners, there was a corresponding increase in the shares of the continuing partners in the firm. Such a situation cannot be quoted with a situation, where in order to get rid of a dishonest, inefficient or an inconvenient employee who is ruining the business, expenses are incurred by a firm which it can claim as revenue expenditure. A hard working fool or a scheming and unreliable person who are employed can be great potential hazards to the success of a business and, therefore, if expenditure is required to be incurred to get rid of such employee in the interest of business, that can be treated as a revenue expenditure, but the authorities which lay down that proposition cannot assist the assessee-firm in the present case where the payments made towards the rights of the outgoing partners stand entirely on a different footing. The contentions raised on behalf of the assessee cannot, therefore, be accepted. Under the above circumstances, we hold that the Tribunal was not right in law on the facts and in the circumstances of the case in coming to the conclusion that the sum of Rs,2,50,348 paid by the assessee to its retiring partners was an allowable expenditure under section 37 of the Income Tax Act, 1961. The question referred to us is, therefore, answered in the negative in favour of the Revenue and against the assessee. The reference stands disposed of accordingly with no order as to costs. RAJESH BALIA, J.---I agree that the question referred to us is to be answered in the negative in favour of the Revenue and against the assessee. I would like to add that it looks incongruous to say when existing partners amongst themselves decide to sever relationship between themselves in its entirety or between one or more amongst themselves, any amount paid as a result of such severance by the persons, who decide to retain the assets and goodwill of the firm along with the right to use the firm name and agree to pay a lump sum amount to the person or persons severing such relationship of partnership instead of sharing the assets, can in the very nature of things, invite questions of the nature urged by the assessee. One has to bear in mind that tax on an income is a specie of direct taxation which reaches the person who own or receives the income, as distinguished from indirect taxes where it reaches a thing or article or an activity, like an excise duty is a charge on the activity of manufacture, a sales tax is a tax on the event of sale. A tax on the property levied by the State is a tax on the property itself, but, on the other hand, a wealth tax or an income-tax is a tax on the person who owns the wealth or who earns the income. If keeping this distinction in mind, one were to examine the contention of learned counsel for the assessee that the amount in question was paid by the firm to its outgoing partner to save it from ruination and save the firm from the prospective losses be treated as an expenditure incurred by the firm wholly and exclusively for the purpose of its business, so as to fall in the allowable deduction under section 37 of the Act, is founded on the premise that firm as an entity of business and its income is subject to deductions of all outgoings, which may be necessary for the business irrespective of its ownership. Notwithstanding the fact that the firm has been treated to be a separate entity for the purposes of taxation independent of its partners, unlike its status under the general law, cannot detract from the fact that this fiction which has been created for the purpose of income-tax, cannot be carried beyond the purposes of income-tax, so as to govern the rights inter se between the partners and the consequences of severance of their relationship with each other. In this connection it is also to be noticed, that the right of a partner on termination of the existing relationship of a partnership with others, whether as a result of such severance the firm stands dissolved or not, are in no way different. It has not been disputed and cannot be disputed that the partners are the joint owners' of the firm and each partner has an existing right of ownership throughout the continuance of his status as a partner of the firm in all its assets. On severance of such relationship by other partners, what a partner is really entitled to and the nature of such
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entitlement is that he gets in lieu of his existing right in the firm…
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