Commissioner of Income Tax vs N. Rudrappan

V. Balasubrahmanyan, J.—Rudrappan, who is the assessee in this income tax reference, is since deceased and his legal representative has

been brought on record. The assessee Rudrappan was a partner in a registered partnership firm of eight persons called ''Universal Paper Tube

Co.'', Coimbatore. The partners'' shares in that firm were equal The assessee contributed Rs. 15,000 as and towards his share of capital in the

firm. Under the terms of the partnership, this amount had to be returned at the time when the assessee left the firm. Actually, the assessee retired

from the firm with effect from 1-4-1971. During the period of three, preceding years ending with 31-3-1971, the firm had run into losses. The

assessee''s share of the losses amounted to Rs. 20,831.28. Under the agreed terms of the retirement of the assessee, the capital contribution of Rs.

15,000 paid by him was returned to him and his share of accumulated loss, namely, Rs. 20,831.28 was also forgiven. The ITO treated this sum of

Rs. 20,831 as income derived by the assessee from the firm and subjected it to assessment as part of his assessable profits under the head

''Business''. The assessee appealed against the assessment. His contention was that this sum of Rs. 20,831 cannot be regarded as a receipt taxable

under the head ''Business'', but must be dealt with as long term capital gains. It was under this head that he had returned the amount in his return of

income. The AAC rejected the assessee''s contention. He upheld the action of the ITO in bringing to assessment the sum of Rs. 20,831 under the

head ''Business'' on the score that section 41(1) of the income tax Act, 1961 (''the Act''), justified the charge. In the further appeal by the assessee

to the Tribunal, the question in controversy was whether the amount could be regarded as long term capital gains or whether it should be assessed,

as a revenue receipt chargeable under the head ''Business''. The Tribunal found that the sum of Rs. 20,831 was styled as payment towards the

assessee''s share of goodwill in the accounts of the firm, which continued the business on the assessee''s retirement from the partnership. The

Tribunal found that the goodwill of the firm itself had not been evaluated at any time till the date of retirement of the assessee from the partnership.

On these facts, the Tribunal proceeded to examine whether the amount could be properly brought to charge as a revenue receipt taxable under the

head ''Business''. Before the Tribunal, as before the AAC, the department''s stand on this issue was that the sum of Rs. 20,831 represents a loss

which had been incurred by the assessee in the earlier years, but in respect of which the assessee obtained a relief or benefit from his firm by way

of remission from liability to share the loss. The Tribunal, however, rejected this contention holding that the loss referred to in section 41(1) is not

the kind of loss which the assessee in this case had to contend with, which was only his share of losses from the firm for the preceding three years.

According to the Tribunal, the expression ''loss'' in section 41(1) must be read along with ''expenditure or trading liability'' spoken of in that section

and in that sense such a loss can only mean that loss which enters into the computation of the profits under the head ''Business'' as a deduction or

allowance. On the above reasoning, the Tribunal held that the ITO was not right in regarding this sum of Rs. 20,831 as a revenue receipt taxable

under the head ''Business'', but it ought to be properly brought to tax under the head of ''long-term capital gains''. In this reference by the Tribunal,

made at the instance of the department, we are asked to consider the correctness of the Tribunal''s conclusion, on the basis of the following

question of law:

Whether, on the facts and in the circumstances of the case, the sum of Rs. 20,831 received by the assessee on the occasion of retirement from the

firm was not a revenue receipt taxable to income tax?

We have earlier narrated the point at controversy between the assessee on the one hand and the department on the other. We have also traced

the course of proceedings right from the assessment stage up to the order of the Tribunal in appeal. Given a broader approach, than the previous

course of proceedings permit, we might have been inclined to hold that the sum of Rs. 20,831 was a pure and simple payment towards the

assessee''s share of the partnership goodwill. Not only because it was so described, but there is nothing to show that it was anything else. Mr.

Jayaraman, the learned counsel for the department, said that this payment of Rs. 20,831 could not possibly be towards the assessee''s share of

goodwill from the firm, even though it was described as such in the firm''s accounts. The reason Mr. Jayaraman adduced was that it was an amount

which was identical with the figure of the assessee''s accumulated share of losses for the last three years. We do not think it is a proper way to

understand the nature of the settlement between the assessee and the continuing partners of the firm. A payment towards goodwill must be judged

according to the character of the payment and not on the basis of the figure it represents. It is very likely that a retiring partner may not be

interested in demanding and obtaining the entire share of goodwill to which he is entitled, but might be content to receive some lesser amount which

will simply relieve him of his share of losses. Again, if we were free to go into the correctness or otherwise of the very basis of the assessment, we

might possibly come to the conclusion that since Rs. 20,831 represents only the assessee''s share of goodwill and nonetheless so for the fact that it

is an amount identical with the assessee''s share of past losses, the question of the receipt being assessable capital, as gains, long term or short

term, would not arise, because it would be a pure and simple capital receipt under the head ''Business''. However, since the assessee himself had

not at any time claimed that this sum is not taxable at all under any head but had only claimed the amount as not being chargeable under the head

''Business'', we are saved from going into these aspects for the present purpose of disposing of this reference.

The precise point in controversy,, in the reference, we have earlier indicated, falls within a narrow compass. It is, whether section 41(1) would

apply in order to enable the ITO to bring to charge the amount of Rs. 20,831 as income taxable under the head ''Business'' in the year in which he

obtained it as a benefit. Section 41(1) lays down a procedure by which allowances and deductions granted to an assessee in prior years can be

offset in subsequent year''s assessment following later developments under which it becomes clear that the real reason for the allowance or

deduction earlier granted no longer subsists. The section speaks of an allowance or deduction having been granted in an earlier year in respect of

''loss, expenditure or trading liability'' incurred by the assessee. In such a case, where in any subsequent year the assessee obtains, whether in cash

or in any other manner, any amount in respect of any such ''loss, expenditure or trading liability'' by way of remission or cessation of that liability to

the extent the assessee is a gainer or a beneficiary, he shall be deemed to be in receipt of profits and gains to that extent and be liable to be

charged to income tax on the basis that the value of the benefit or the amount of remission represents the income of that subsequent year. On the

words of this provision, it is not sufficient that an allowance or deduction had been granted in assessment to the assessee in an earlier year, but that

the allowance or deduction so granted must relate to a loss, expenditure or trading liability. The claim of the department in this case is that the

assessee''s accumulated share of losses in the firm for the last three years amounting in all to Rs. 20,831 must be regarded as a ''loss'' incurred by

the assessee within the meaning of section 41(1). This was the argument addressed to us by Mr. Jayaraman as well.

We do not agree with this submission. The expression ''loss'' is used in business jargon as well as in the Act in at least two different senses.

Where the result of a year''s trading is a minus quantity, that is called a loss. The accountant would describe it as a debit balance in the profit and

loss account. This is one sense in which the expression ''loss'' is used. But even where the net result of a year''s trading is a profit, or a credit

balance in the profit and loss account, there may be individual items of losses incurred by the person carrying on the business which might get

imbedded in that account. Easy illustrations of these losses, which may be called itemised losses for the sake of distinguishing them from the other

kind, are loss of stock-in-trade by natural process or by fire, loss of circulating capital or money by embezzlement of an employee, and the like.

What section 41(1) deals with are losses of the latter kinds, namely, itemised losses. For it is only in respect of the losses incurred by the assessee

in the course of a business that a ''deduction'' or ''allowance'' is given or can be given. Where the year''s trading results in a net loss, that loss is not

such a loss with respect to which any ''deduction'' or ''allowance'' properly so-called is or can be given either under the Act or under any

accountancy principle. That loss is a computed loss, not a loss incurred. If it is regarded in a loose sense, as a loss incurred, it is a loss incurred in

the carrying on of the business as a whole, which is the result of a year''s trading. Itemised losses incurred in this or that item of business transaction

would come in for deduction or allowance in the computation of business results for the year as a whole, which may happen to result in a net loss

or a net profit for the year. Where itemised losses incurred by an assessee are allowed or deducted by the income tax Department in any given

assessment year, then such a loss would properly enter into consideration for the purpose of application of section 41(1), if in any subsequent year

should the assessee come by some benefit or remission with respect to that very item of loss.

In the present case, assuming that the assessee was compensated for his earlier years'' share of losses when he was given Rs. 20,831 by the

continuing partners, that amount can hardly be regarded as a benefit or a remission given to him in respect of any loss incurred by him and in

respect of which any allowance or deduction had been granted to him in any earlier assessment year, within the meaning of section 41(1) since the

loss was the outcome of the trading result of the firm in the past years and not an item of loss incurred by him in the course of any business carried

on by him.

An argument was addressed by Mr. Jayaraman to the effect that if under the partnership law a firm is to be regarded, in the broad sense, only as

a compendious term to describe the constituent partners, any loss in the business of the firm must be regarded, to the extent of the share of each

partner, as a loss incurred by that partner. This proposition might be accepted as correct if by loss is meant the loss arrived at, at the end of a

year''s trading, as a matter of computation of the year''s results. Indeed, provision for the sharing of the firm''s losses by the partners are to be

found in sections 75 and 78 of the Act and other related provisions. These provisions do not really touch the question of itemised losses even of a

firm. In the very nature of things, they cannot, because what they deal with is a loss which is a matter of computation of a year''s trading. In the

computation of the firm''s trading results for a year, there might be items of profits as well as items of losses. When a partner''s share in the ultimate

trading result of a firm is computed, then it is the net loss or the net profit which would come in for allocations. u/s 67 of the Act it is enacted that in

computing the total income of a partner of a firm, the net result of the computation of the total income of the firm, whether it is a net profit or a net

loss, must be computed first and then his share must be ascertained therefrom. This shows that any share of a partner, whether it be a share in the

net profit or net loss of the firm, cannot be dissected to discover whether it includes any share in an itemised loss of the firm. The itemised losses of

the firm get merged in the crucible of the firm''s net profit or net loss for the year.

Having regard to these considerations, we hold that the Tribunal was right in treating the sum of Rs. 20,831 received by the assessee on the

occasion of his retirement from the firm as not liable to be assessed as a revenue receipt u/s 41(1) and that it must be regarded as payment to the

assessee as consideration for his relinquishing his interest in the partnership firm including his share of the goodwill. On the assessee''s own

pleadings, the Tribunal, in our opinion, was also right in holding that capital gains have got to be levied on the amount, treating it as a long-term

capital gain considering that no other basis for tax treatment of this amount was put forward by the assessee himself at the assessment stage. In the

result, the reference is answered in favour of the assessee and against the department. The assessee will be entitled to costs. Counsel fee Rs. 500.