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Petitioner: S. VEERIAH REDDIAR VS Respondent: COMMISSIONER OF INCOME-TAX, TRAVANCORE COCHIN, BANGALOREHonorable Justice KUMARA PILLAIP. Govindan Nair,G. Rama Iyer
1960 P T D 487
1960 P T D 487
[Kerala (India)]
Before Kumara Pillai and Joseph, JJ
S. VEERIAH REDDIAR
Versus
COMMISSIONER OF INCOME-TAX, TRAVANCORE COCHIN, BANGALORE
Income-tax Reference No. 3 of 1956, decided on 3rd December 1958.
Income-tax Act (XI of 1922), Ss. 10 (2) (x), (xv) & 13-Busi ness expenditure-Salary-Tests for allowance-Commercial expe diency-Non-applicability of standards laid down in S. 10 (2) (x) --Method of accounting-Rejection-When permissible-Low profits and absence of stock register-Whether sufficient grounds for rejection of accounts regularly maintained by the assessee.
The assessee submitted a return of income for the accounting period 1123 M. E. showing a loss of Rs. 17,100. The Income-tax Officer rejected the account books of the assessee on the grounds that the percentage of profits disclosed thereby was very low and that the assessee did not maintain a variety-wise stock register. He made an addition of Rs. 76,478 to the profits disclosed in regard to a certain category of goods, but accepted the profits shown in the rest of the trading. On appeal, the Appellate Assistant Commissioner reduced the addition to Rs. 40,909, and on further appeal, the Tribunal armed the decision of the Appellate Assistant Commissioner on the ground that the assessee had not proved that the additions were by any means excessive or unreasonable. It was not disputed, however, that the assessee had been regularly employing a method of accounting and the evidence showed that the Department had accepted the figures in his books relating to the opening stock and purchases and sales during the accounting year and that, apart from disallowing some items of deduction claimed by the assessee, all that they had done was to add a certain percentage of profits on the sales disclosed by the books. Although the assessee had not maintained a stock register he had produced before the Department an inventory showing the quantities of the closing stock and their value :
Held, on the facts, that low profits and absence of a variety -wise or regular stock register were not sufficient reasons or material on the strength of which the accounts of the assessee could be rejected under the proviso to section 13 of the Income-tax Act and an assessment made thereunder.
No assessment under the proviso to section 13 of the Income-tax Act can be sustained if the Income-tax Officer (or the appel late authority, in cases of appeal) has not considered and recorded a finding against the assessee as to whether he has been regularly employing a method of accounting or whether his income, profits and gains can properly be deduced from his method of accounting if he has been regularly employing a method of accounting. The income-tax Officer's decision on these matters is not to be a subjective or arbitrary decision but a judicial decision and cannot be accepted if there is no material to support his finding.
Commissioner of Income-tax v. McMillan & Co. (1958) 33 I T R 182; Pandit Bros. v. Commissioner of Income-tax (1954) 26 I T R 159 and Commissioner of Income-tax v. Sarangpur Cotton Manufacturing Co. Ltd. (1938) 6 I T R 36 fol.
The question whether the Income-tax authorities had con sidered whether the income, profits and gains of the assessee can properly be deduced from his method of accounting, and the question whether there was no material before the authorities for holding that the income, profits and gains of the assessee could not properly be deduced from his method of accounting are ques tions of law.
Whether or not the Income-tax Officer and the appellate authorities have considered a matter which they were bound to consider judicially under the statute and whether there was material before them for arriving at the conclusion which they have arrived at on that matter are not questions of fact but questions of law on which a reference under section 66 of the Income-tax Act is competent.
When the assessee has a method of accounting, and he has been regularly employing it, it is for the Department to consider whether there are sufficient materials for rejecting that method of accounting and computing the profits on another basis and not for the assessee to prove that his method of accounting ought not to be rejected.
The assessee had paid a sum of Rs. 36,000 as salary and Rs. 5,000 as allowances for 1123 M. E. to his nephew who acted as the general manager of his business. Although during' the accounting years 1121 and 1122 the Department had allowed the sums of Rs. 21,500 and 28,000 on account of salary to the general manager, the Income-tax Officer allowed only Rs. 9,800 for 1123 on the ground that the salary actually paid was moti vated by considerations other than for service. On appeal, the Appellate Assistant Commissioner however considered that the sum of Rs. 18,000 was quite reasonable and adequate, and he therefore raised the allowance to that figure. The Appellate Tribunal affirmed the decision of the Appellate Assistant Commis sioner, holding that a good part of the salary paid to him could not be considered as necessary for the purposes of the business on the standards laid down in section 10(2)(x) of the Income-tax Act as the assessee's business for the year in question had ended in a loss and that a salary of Rs. 18,000 for the general manager was adequate;
Held, (1) that the mere relationship of the employ to the assessee was not sufficient reason for disallowing the salary paid to him ;
(2) that the question of the assessee's profit or loss was perfectly immaterial in deciding his claim for deductions of salary paid to an employee so long as the salary was paid by him bona fide to the employee for the purpose of the business alone and not for any other consideration ;
(3) that the disallowance of part of the salary paid to the general manager could not be justified on the ground of reason ablesness under section 10(2)(x), for, in relation to salaries paid to an employee, it was not section 10(2)(x) but section 10(2)(xv) that applied ;
(4) that there was no finding by the Appellate Assistant Commissioner or the Tribunal that any part of the general manager's salary was paid on account of motives other than business considerations, and hence the disallowance of part of his salary on the ground of reasonableness from either point of view could not be justified ;
(5) that therefore the assessee was entitled to an allowance of Rs. 36,000 paid as salary to the general manager ; and
(6) the assessee conceding, that the disallowance of the allowance of Rs. 5,000 paid to the general manager was justifiable under section 10 (2) (x).
Held also, on the facts, that the assessee was entitled to an allowance of Rs. 12,000 paid as salary to his son-in-law who was the general manager of a branch of his business.
Sub-clause (x) of section 10(2) can have no application to deductions or allowances claimed on account of payment of salaries. Under sub-clause (x) the reasonableness of the allowance or deduction claimed has to be judged with reference to : (1) the pay of the employ and the conditions of his service, (2) the profits of the business, profession or vocation for the year in question, and (3) the general practice in similar business, profession or vocation. None of these considerations can seriously be allowed to affect the question of the allowance claimed on account of the payment of salaries to employees.
Commercial expediency is one of the most important factors governing payment of salary, and therefore, the standards prescribed in sub-clause (x) for payment of bonus and commission which are generally dependent upon the profits of the busi ness and the general practice in the trade cannot be made appli cable to it.
In deciding the question whether the salary paid to an employee is a permissible deduction all that the Income-tax authorities are entitled to enquire is whether it has really been paid and whether it has been laid out or expended wholly and exclusively for the purpose of the business, profession or vocation. The question of the reasonableness of the expenditure does not arise as it is for the assessee to decide how his business should be run and whether a particular item of expenditure is reasonable or not having regard to commercial expediency.
Newtone Studios Ltd. v. Commissioner of Income-tax (1955) 28 I T R 378 fol.
In considering the question whether the amounts were laid out or expended wholly for the purpose of the business it will be open to the income-tax authorities to consider whether the employees are related to the assessee and whether the payments to them were made entirely on account of business considerations or on account of other considerations also, and if there are ma terials in the case on which the income-tax authorities can legi timately arrive at a finding that motives other than business considerations have also influenced the payments it will be open to them to deduct from the claim what has been paid on account of motives other than business considerations and allow only what has been paid for the purpose of the business.
Commissioner of Income-tax v. Jainarain Jagannath (1945) 13 I, T R 410 applied.
Bombay Cycle Stores Co. Ltd. v. Commissioner of Income-tax (1958) 33 I T R 13 ; Chairman of Income-tax .Appellate Tribunal v. Y. E. Aboo (1956) 30 I T R 27 ; Commissioner of Income-tax v. Jainarain Jagannath (1945) 13 I T R 410 ; Commissioner of Income-tax v. McMillan & Co. (1958) 33 I T R 182 ; Commissioner of Income-tax v. Sarangpur Cotton Manufacturing Co. Ltd. (1938) 6 I T R 36 ; Ganga Ram Balmokand v. Commissioner of Income-tax (1937) 5 I T R 464 ; Newtone Studios Ltd. v. Commissioner of Income-tax (1955) 28 I T R 378 and Pandit Bros. v. Commissioner of Income-tax (1954) 26 I T R 159 ref.
STATEMENT OF CASE
In compliance with the directions of the High Court under section 66 (2) in O. P. No. 113 of 1955, dated 7th October, 1955, we state a case and refer it to the High Court of Judicature of Travancore Cochin at Ernaculam. The questions of law on which the Tribunal has been directed to state a case are as follows :
"(i) Whether in the circumstances of the case, the Tribunal was justified in holding that the proviso to section 13 of the Act was attracted ?
(ii) Whether on the facts and in the circumstances of the case, the disallowance out of the salary paid to the manager and the cashier can be justified on the ground of reasonableness under section 10(2), clause (x), of the Act ? ".
We shall, therefore, confine ourselves, as far as possible to the facts relevant to the above questions.
2. The assessee is a dealer in piece-goods on a large scale, both wholesale and retail, at his head office at Alleppey and a his branches at Quilon, Kottayam, Changanassery, Kayamkulamt and Trivandrum. For purposes of his business, he had a pur chasing branch in Bombay too.
3. Textile control was in operation till the month of Makaram of 1123 M. E. when it was lifted, only to be re introduced from the 15th Karkatakam of the same year. For the interim period, ceiling prices were, however, fixed. The Textile Control Regulations made it obligatory for all the distributors to maintain stock records to show the receipt and disposal of each class of goods as categorised thereunder:
4. Section 13 of the Income-tax Act is as follows:
" Income, profits and gains shall be computed, for the purposes of sections 10 and 12, in accordance with the method of accounting regularly employed by the assessee :
Provided that, if no method of accounting has been regularly employed, or if the method employed is such that, in the opinion of the Income-tax Officer, the income, profits and gains cannot properly be deduced therefrom, then the computation shall be made upon such basis and in such manner as the Income-tax Officer may determine."
5. In order that the method of accounting adopted by an assessee for his business, profession or vocation, for any " previous year " may be capable of allowing the profits to be properly deduced therefrom, the method employed must convey an accurate picture of the assessee's trading during the year. The trading activities comprise of purchases and sales for cash or credit and realisation or payment in cash, of accounts, outstanding on credit sales or credit purchases. The importance of maintaining a proper cash book, correlated with any bank account if maintained, the cash balance of which is arrived at daily or at frequent intervals and veri fied with the actual till cash, is easily understood in any scheme of accounting.
6. By maintaining a proper cash book alone, it cannot be said that the method of accounting permits the profits of the business to be properly deduced therefrom, the cash book is only a record of all the cash transactions of the business. In order that the profits of the business could be correctly deduced, the method employed must make provision for a proper check and follow up of the stock-in-trade dealt in two.
7. The trading in any year starts with the opening stock brought down from the earlier year as unsold. Purchases are then made. The profit arises to the assessee by sale of his stock so acquired and till all his purchases are sold or otherwise accounted for as damaged or lost, his true profits of the trading cannot be arrived at. Since trading is a con tinuous process, and profit ascertained has to be annual, the unsold stock at the end of the year requires to be ascertained and, in a manner of speaking, removed from the trading account by bringing it to its credit.
8. In the system of ascertaining trading profits explained above, in order that the true profits can be properly deduced in respect of the trading of an assessee during the " previous year", from the books maintained in his method of accounting, it is imperative that his books must be self-proving, being capable of verification from each of the following aspects;
(i) The purchases must be fully supported both as to quan tities and value by vouchers from the suppliers.
(ii) The sales must be fully, verified both for quantity as well as value by duplicate copies of cash or credit sales memos, machine numbered and issued in the regular course of business from day-to-day or a sales day book, containing full and complete details of the sales including the names and addresses of the customers when they are so required by any of the emergency regulations.
(iii) A proper physical identification and follow up of the stock-in-trade, item-war or variety-wise correlating with the purchases and sales, through a stock register which would show the unsold quantities at any point of time.
9. All the three above requisites are necessary to be fulfilled before the books maintained in any method of accounting can be said to allow the true profits to be deduced therefrom for purposes of the proviso to section 13 set out in paragraph 4 supra. A physical inventory of the stock-in-trade taken out at the close of the accounting, period is no substitute for the variety-wise stock tally; it is not by itself a conclusive document as the accuracy thereof requires to be further established, the only means to establish it being the variety-wise stock tally. Even an overall tally ignoring the different varieties with necessarily varying prices, will not come up to standard.
10. The stock records required to be maintained by the Textile Control Regulations referred to in paragraph 3 supra, deals with the stock in only the stated categories. As the goods in each of these categories are of varying prices such a stock tally is, for the above reasons, inadequate to prove the final inventory. After all it is only an overall tally for each category and nothing beyond.
11. When the books of account of a business are found not to be self-proving on the aforesaid facts, the proviso to section 13 gives the Income-tax Officer the necessary authority to reject the books. It does not necessarily follow that the Income-tax Officer must automatically estimate the profits and make an addition. He can make such an addition only if he finds on proper materials that the profits disclosed by the assessee are not adequate in the trading conditions of the year concerned. If, on the other hand, he is satisfied that the profits are adequate he generally accepts the book results, notwithstanding his power to reject the books, as leakage in the books, if any, cannot be of any substantial nature.
12. The books of account of the assessee for the year 1123 M.E., the "previous year" for assessment year 1124 M.E., did not include a variety-wise stock tally of the B and C quota goods traded in the head office and branches as shown below:
Rs.
Head Office
Alleppey
9,80,510
Branches
Quilon
8,01,929
Kottayam
5,74,827
Changanassery
4,97,386
Kayamkulam
5,47,058
Trivandrum
8,76,386
Total
42,98,176 (sic)
Not even the stock records under the textile regulations, which by themselves are only an incomplete overall tally, as referred to in paragraph 10 supra, were produced by the assessee.
13. The Income-tax Officer rejected the books in the absence of a variety-wise stock tally. As he found that the profits disclosed for the B & C quota of goods aforesaid were inadequate, he made an addition of Rs. 76,478. At the same time he accepted the profits shown in the rest of the trading as he found them to be adequate and reasonable.
14. The Appellate Assistant Commissioner, in appeal, upheld the rejection of the books by the Income-tax Officer, but reduced the addition to Rs. 40,909.
15. In the appeal to the Tribunal that followed, the Tribunal held that in the absence of a variety-wise stock tally, the proviso to section 13 was attached. It also upheld the above residuary addition which, in its opinion, was reasonable.
16. The above are the facts bearing on the first question directed by their Lordships and set out in paragraph 1 supra. The facts relevant to the second question are set out in the following paragraphs
17. The assessee employed one K. Lakshmana Reddiar his nephew, as the general manager of his business for a long time past, by an agreement dated 21st Thulam, 1117, a copy whereof is annexed hereunto as annexure `A' and forms part of the case The conditions of employment were that Lakshmana Reddiar would be entitled to 1/3rd share of profits of the business or as an alternative, a fixed salary of Rs. 3,000 per month. He was, however, paid a share of the profits only till the accounting year 1120 M.E. (except for accounting year 1119 M.E.) when there was a loss, as follows, even though such share was less than the fixed salary aforesaid
Accounting year
Amount
Remarks
1118 M.E.
Rs. 15,077
1119 M.E.
Rs. Nil.
There was a book loss during the year.
1120 M.E
Rs. 17,135
18. The following are the amounts paid to him for the subsequent years;
1121 M.E.
Rs. 21,500
1122 M.E.
Rs. 41,000
The salary adjusted for the year 1121 M.E. was Rs. 18,000 or Rs. 1,500 per mensem (only half of the fixed salary stipulated under annexure `A' aforesaid) together with an allowance of Rs. 3,500 making up the total credit of Rs. 21,500 aforesaid. The adjustment for 1122 M.E. however, is on the basis of the full salary of Rs. 36,000 for the year and an allowance of Rs. 5,000 to make up Rs. 41,000 aforesaid.
19. For the accounting year 1123 M.E., the "previous year" for assessment year 1124 M.E. presently under reference, Lakshmana Reddiar was paid as in the earlier year Rs. 41,000 being the full salary of Rs. 36,000 and allowance of Rs. 5,000. There was a loss in the business as revealed by the books of the year.
20. From 1st Simham, 1129 M.E., Lakshmana Reddiar has been admitted as an equal partner of the business with the assessee.
21. The following is an abstract of Lakshmana Reddiar's ledger accounts for the accounting years 1120 M.E. to 1123 M.E.
M.E.
Op. Cr.
Salary credited
Other credits
Total & Drawing
Closing
1120
44,649-15-6
17,135-11-6
1,057-3-6
62,842-14-6
13,116-2-6
49,726-12-6
1121
49,726-12-4
21,500-0-0
3,707-7-6
74,934-3-10
23,214-12-8
51,719-7-2
1122
51,719-7-2
41,000-0-0
5,596-15-0
98,316-6-2
7,919-7-5
90,396-14-9
1123
90,396-14-9
41,000-0-0
767-0-0
1,32,163-14-9
16,723-15-10
1,15,439-14-11
22. In the assessments made from 1119 M.E. to 1121 M.E. under the Travancore Income-tax Act, the claim of Rs. 15,077 for accounting year 1118 M.E. (previous year for assessment year 1119 M.E) referred to in paragraph 17 supra, was disallowed as it was not adjusted in the books. The claim of Rs. 17,135 in respect of 1120 M.E., the previous year for 1121 M.E. was, however, allowed.
23. In the assessments made for the two subsequent assessment years 1122 and 1123 M.E. completed by the Indian Income-tax Officer after the financial integration of Travancore, but under the Travancore Income-tax Act, the salary claimed as shown in paragraph 18 supra was dealt with as shown below:
Accounting year
Assessment year
Claimed
Allowed;
1121
1122
Rs. 21,500
Rs. 21,500
1122
1123
Rs. 41,000
Rs. 28,200
The reason for disallowance of a part of the claim for assessment year 1123 M.E. was that the payment has been to a near relative and found excessive compared with the scales of remuneration in similar business in the locality.
24. For the assessment year 1124 M.E., the year presently under reference; the assessee claimed Rs. 41,000 as salary and allowances to Lakshmana Reddiar, as stated in paragraph 19 supra. The Income-tax Officer considered the 'close relationship of Lakshmana Reddiar with the assessee and the scale of salaries generally paid to managers of similar business in the locality as also the amounts allowed as reasonable salary to the employee in the immediately preceding assessment year 1123 M.E. accounting year 1122 M.E. in which out of Rs. 41,000 claimed only Rs. 28,200 representing approximately 1/3rd of the net profits was allowed. Cc On these considerations, out of the aforesaid claim of Rs. 41,000 he allowed only Rs. 9,890 representing 1/3rd share of net profit approximately as reasonable and disallowed the rest of the claim.
25. The Appellate Assistant Commissioner increased this allowance to Rs. 18,000 for the following reasons, reproduced from his order dated January 21, 1954:
"The appellant's advocate urges that the Income-tax Officer's interpretation of the Appellate Assistant Commissioner's decision in respect of the assessment year 1123 is wrong and that the entire payment of Rs. 41,000 represents expenditure laid out wholly and exclusively for the purposes of the appellant's business and should be allowed in full. It is further explained by the advocate that the said Sri Lakshmana Reddiar is the soul of the whole concern having complete control over the entire business, that without him the appellant cannot run his business even for a day and that whatever payment has been made to him was made as remuneration for services rendered and' not out of any other extra-business considerations . . . .
The Income-tax Officer's reasoning for reducing the allowance to such a paltry sum is, not quite intelligible in view of the recognised importance of this employee. He is said to be an employee only in name but is in fact wielding unlimited power, and he has since been made a regular partner with half share in the entire business. To reduce the emoluments of such a person to much less than what has been allowed by the Income-tax Officer himself to other smaller branch managers does not, therefore, appear correct. The facts mentioned above show that he would have been a regular partner with 1/2 share if he had wished, but he preferred to receive a fat salary of Rs. 3,000 per month all those years which was evidently more advantageous to him. In the current year again, it appears that at the appellant's persistent request he has become a regular partner not with 1/2 share which had been previously offered but with equal share with the appellant himself with effect from 1st Simham, 1128. In view of all these circumstances and having regard to the fact that the Department has all along accepted the principle of salary to this gentleman, I am of the opinion that a higher allowance than that granted by the Income-tax Officer is called for in this case. But, whatever may be the importance of the person or his indispensability, the allowance to be granted cannot exceed the commercial value of the services rendered. What such value is of course a question of fact. A salary of Rs. 3,000 per month for such services is no doubt unheard of in businesses of this kind. In my view, an allowance of Rs. 1,500 per month or Rs. 18,000 for the whole year should in the special circumstances of the case represent a fair commercial value of the services of this gentleman and I consider this allowance quite reasonable and adequate."
26. The assessee had also employed his son-in-law,…
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