Commissioner of Income Tax, Gujarat vs B.M. Kharwar

Shelat, C.J.—The question which has been referred to us in this reference is ""Whether, on the facts and in the circumstances of the case, the

sum of Rs. 40,743 is assessable to tax by applying the second proviso to section 10(2)(vii) of the Indian Income Tax Act, 1922 ?

The present reference arises out of the assessment for the assessment year 1959-60 on the assessee which is assessed as a registered firm, and

the relevant previous year is Samvat Year 2014 (October 24, 1957 to November 11, 1958). The assessee-firm was carrying on business of

manufacturing art silk cloth at surat and had still have branches at Bombay, Calcutta and Rangoon. The firm maintained and still maintains separate

books of account for each of these branches. The business of manufacturing art silk cloth at surat was carried on by the assessee-firm up to June

17, 1958, when it was taken over by a private limited company. The assessee-firm has eighteen partners and the private limited company which

took over the said business have the same persons as its shareholders, and their respective interests in the limited company are the same which

they had in the assessee-firm. One of the assets taken over by the limited company was machinery, the written down value of which stood at Rs.

9,962 in the books of account of the assessee-firm. The machinery was taken over by the limited company at the value of Rs. 62,232. It is an

admitted fact that the total amount of depreciation allowed in respect of the machinery in the preceding years came to Rs. 40,743. The original cost

of this machinery was Rs. 51,605.

The Income Tax Officer applied the second proviso to section 10(2)(vii) and brought to tax the aforesaid amount of Rs. 40,743 as profits of the

previous year in which the company took over the said business and the machinery. The Appellate Assistant Commissioner confirmed the order of

the Income Tax Officer. At the time of the hearing before him, it was pointed out to him that the Income Tax authorities, while assessing the limited

company, had applied the proviso to section 10(5)(a) so as to take the cost of the machinery in the hands of the assessee-firm. The Appellate

Assistant Commissioner, however, held that the facts was immaterial and that the transaction in question amounted to real sale of the machinery

and that therefore the amount of Rs. 40,743 was chargeable to tax in the hands of the assessee-firm. The assessee-firm thereupon went in appeal

before the Tribunal, where it was contended that the transaction did not amount to a sale in the commercial sense and was only a change in the

mode of ownership, that the two entities, namely, the firm and the company were identical and, therefore, the principle that one cannot trade with

himself and make profit applied. The Tribunal accepted the contention of the assessee-firm and relying upon the decision in Rogers & Co. v.

Commissioner of Income Tax of the High Court of Bombay, set aside the order passed by the Appellate Assistant Commissioner and held that the

said amount of Rs. 40,743 could not be brought to tax. The present reference is at the instance of the Commissioner of Income Tax.

Section 10 of the Act taxes profits and gains f business, profession or vocation carried on by an assessee. But, under sub-section (2), such an

assessee is entitled to certain deductions and allowances enumerated in clauses (i) to (xiv) thereof. Under clauses (vi), (via) and (vib), the assessee

has a right to certain depreciation allowances. Clause (vii) provides for the balancing allowance in respect of building, machinery or plant which has

been sold, discarded, demolished or destroyed. Clause (vii and the second proviso thereof, with which we are presently concerned, run as follows

:

(vii) in respect of any such building, machinery or plant which has been sold or discarded or demolished or destroyed, the amount by which the

written down value thereof exceeds the amount for which the building machinery or plant, as the case may be, is actually sold or its scrap value;

Provided further that where the amount for which any such building, machinery or plant is sold, whether during the continuance of the business or

after the cessation thereof, exceeds the written down value, so much of the excess does not exceed the difference between the original cost and the

written down value shall be deemed to be profits of the previous year in which the sale took place.

In respect of property which is sold, the basis of the allowance is the excess of the written down value over the sale price. It is necessary,

however, that the business, to the assets of which the allowance under clause (vii) related, should have been carried on for at least some part of the

relevant accounting year and, under the first proviso, it is necessary that the amount claimed by way of an allowance under this clause is actually

written off in the assessee''s books. The principle on which the second proviso is based is that the assessee should be recouped of his capital cost

of building, machinery and plant by the depreciation allowances given under clauses (vi) and (via), the allowance under clause (vii) and the sale

price or the scrap value, when he sells these assets or demolishes or destroys them. Where, therefore, an assessee is able to recover in full the

written down value out of the sale proceeds, he would not be entitled to claim the allowance under clause (vii), for clause (vii) is intended only to

recoup the balance of the cost after deducting the total depreciation allowances. what the second proviso does is to provide that if the sale price

exceeds the written down value, such excess should be taxed as profits to the extent of the total depreciation allowances granted in the preceding

years. In such a case, the proviso takes back what was granted by way of depreciation allowance in the past because the result otherwise would

be to recoup to an assessee an amount in excess of his original cost. The second proviso thus taxes the excess of the sale price over the written

down value and that is what the taxing authorities sought to do in the present case. The effect of this proviso, therefore, is that where the sale

proceeds plus the total depreciation allowances already made exceed the original cost, the excess or the aggregate of the depreciation allowances,

whichever is less, is chargeable as profits.

But the basic idea underlying the taxing of these excesses is that an assessee, as the seller, has made profits by the sale of his assets and the

profits said to have been made must be profits out of a sale which is a sale in the commercial sense and not a mere sale in the legalistic sense. That

was what was laid down by the High Court of Bombay in Rogers & Co. v. Commissioner of Income Tax the case relied upon by the Tribunal. In

that case the assessee, Messrs. Rogers & Co., carried on the business of manufacturing aerated waters as a firm till August 6, 1949, and there

were eleven partners in the firm. On August 6, 1949, this firm converted itself into a private limited company. The shareholders of this company

were the same as the partners of the firm and the shares allotted to the shareholders were in the same proportion as the shares held by them in the

partnership. The slight difference was due to the shares being rounded up to a specified number. The written down value of the bulk assets of

Messrs. Rogers & Co. in their books was Rs. 3,81,848 and these assets were transferred to the limited company at the original cost price of Rs.

4,85,354.

The revenue contended that the limited company in the assessment year 1950-51, was liable to pay tax on the difference between Rs. 4,85,364

and Rs. 3,81,848 under the second proviso to section 10(2)(vii) of the Act. As appearing from page 338 of the report, the question which the

learned judges in that case addressed themselves was, whether the transfer in that case amounted to a sale, for if it did amount to a sale, there

would be no question that the second proviso would apply and the excess between the sale price and the written down value would be chargeable

as profits. The contention of the revenue was that the sale contemplated by the second proviso to section 10(2)(vii) is a transfer for a price, that

there was in law a sale and that, therefore, the second proviso would come into play. That contention, however, was repelled, the learned judges

observing that in transactions which came up for consideration in a taxing statute, the court had to look at the real nature of the transaction and not

merely at its legal form. They observed that if the real nature of the transaction before them was examined, although the transaction would in law

amount to a sale ""substantially and really it is only a readjustment made by certain persons so as to carry on business in one form rather than in

another."" The learned Chief Justice, who spoke for the Bench, stated that there were eleven partners who were carrying on business as a firm.

Those very eleven persons made up their minds to readjust their business position and to carry on the identical business, the identical activity, by

means of a limited company. The assets of the firm now belonged to the company but no change had taken place except the legal change of a

company taking the place of a firm. The learned judges held that, in these circumstances, it could not be said that there was a sale by the firm to the

company which would attract the application of the second proviso to section 10(2)(vii). Relying upon their previous decision in Commissioner of

Income Tax v. Homi Mehta''s Executors they held that the real result of the formation of the company and the transfer of the assets to the company

was only that instead of the assets being held as partners in a firm, they were held by those very same persons as a limited company, that the

transaction in question was not a business activity entered into with the object of earning profits and was not really a sale but merely a procedure

adopted for the adjustment of their position and therefore the assessee-firm could not be said to have made any profit in a commercial sense by

transferring the assets to the limited company. An attempt was made on behalf of the revenue to distinguish the case of Homi Mehta''s Executors

on the ground that, whereas in that case the assessee had sold the stock-in-trade and the question was whether in transferring that stock-in-trade

the assessee had made any profit, in the present case before them they were dealing with depreciation u/s 10(2)(vii). The learned judges rejected

this argument also and stated that if the principle laid down in Sir Homi Mehta''s Executor''s case, was correctly enunicated, they could not see any

reason why it would not apply to the case of a sale u/s 10(2)(vii). ""It must apply"", they observed, ""to all cases of sale dealt with under the Indian

Income Tax Act, unless there is something in the section itself which makes it clear that the sale contemplated by the legislature is not only a sale

where, according, to the real transaction, from the commercial point of view, it is a sale, but even where it is a sale from a legal and technical point

of view. Why are we to construe the expression ''sale'' in the second proviso in the wide manner suggested by Mr. Joshi ? Why are we to say that

assessees have made notional profits out of a transaction when in reality that transaction is nothing more than a readjustment of the position of the

assessees qua their business ? There is no indication given by the legislature that the expression ''sale'' in this second proviso should be constructed,

not from the point view of the ordinary canon of construction laid down with regard to taxing laws, but according to some special canon of

construction. In our opinion, if Homi Mehta''s case correctly laid down the law, then we must came to the conclusion that the transaction effected

between the firm of Rogers & Co. and the private limited company was not a sale, and if it was not a sale the provisions of the second porviso are

not attracted."" On this principle, they further held that since there was not sale, the mere book entry in the books of the company that the value of

the assets of the firm taken over by the company was Rs. 4,85,354 would not have any being on the question of depreciation to which the limited

company was entitled. From a commercial point of view, the value of the assets continued to be Rs. 3,81,848 notwithstanding the transaction in

question. The entries made in the books of account did not represent the real nature of the transactions as far as the sale was concerned and, if

those entries did not represent the real nature of the transaction in that sense, they equally did not represent the real transaction from the point of

view of the price fixed for the transaction. Therefore, though for the purpose of the books of the firm and the company the price might have been

fixed at Rs. 4,85,354, the written down value of the assets continued to the Rs. 3,81,848. The principle laid down in the case of Roger & Co. and

Sir Homi Mehta''s Executor''s case was followed by the High Court of Calcutta in Commissioner of Income tax v. Mugneeram Bangur & Co. The

assessee-firm there was carrying on business of land development for many years its business being to buy lands, divide them into plots and sell

them at profit. Originally there were seven partners but two of them retired in July, 1945. The remaining five partners were not willing to carry on

the business with unlimited liability and, therefore decided to float a limited company which would take over the business of the firm. On April 8,

1948, a public limited company was formed an incorporated, the five partners being the promoters of the new company. The capital of the

company was Rs. 34,00,000 and odd divided in shares of Rs. 100 each. Out of these shares, all but seven shares were allotted to the five

partners. Rs. 34,99,300 was the consideration for which the firm transferred its business to the company, and the aforesaid amount included,

amongst other things Rs. 2,50,0000 for the goodwill of the firm. The controversy which arose between the assessee and the revenue being that

there was no goodwill in respect of the transactions effected by the parties and that by inclusion of this item, the partners were seeking to get

something from the company which really represented the increase in the value of the land and that therefore the excess of Rs. 2,50,000 over the

cost price represented the profit the profit which was made by the firm in the transaction. The assessee on the other hand contended that the

transaction was in substance a transfer by the members of the firm to themselves a company, and, consequently, it was not a business transaction

which could result in profit, as a person cannot make a profit out of himself. The assessee also contended that the transaction was in reality a slump

transaction entered into merely for the decision in carrying on business more conveniently, and relied upon the decision in Doughty v.

Commissioner of Taxes Of the four questions which were referred to the High Court, questions No. s 3 and 4 were as follows :

(3) Whether, on the facts and circumstances of this case, by the sale of the whole business concern, it could be held that there was taxable profit

in the sum of Rs. 2,50,000 ?

(4) Whether, on the facts and circumstances of this case, and in view of the finding o the Tribunal that the entire share capital of the vendee

company (excepting seven ordinary shares) was taken by the vendor firm in lieu of the sale price of the business as a whole, there was any profit in

the amount of Rs. 2,50,000, the same being taxable under the Indian Income Tax Act ?

The High Court, following Doughty''s case held as regards the third question that the transfer was a slump transaction and that, therefore, the

amount of Rs. 2,50,000 could not be said to be taxable profit. Regarding question No. 4 the High Court followed the Bombay decision and held

that the transfer could not be held to be sale in the commercial sense but was merely a readjustment. After discussing the Bombay decision and

certain other decisions cited at the bar, the learned judges, so far as question No. 4 was concerned, held as ifollows :

In my opinion the answer to question No. 4 must be that there was no profit in the transaction by which the entire stock-in-trade and the business

of the firm were transferred to the limited liability company. Again the fact that two outsiders were brought in as directors with seven shares allotted

to them out of 39,300 shares make no difference. In Sir Homi Mehta''s case, 400 shares out of 6,000 shares were allotted to Sir Homi Mehta''s

sons. Nor again can I see any differences in principle between the case of conversion of business into a private limited company and one in which it

is converted into a public limited company, if in the latter company outsiders are not allotted any sizable proportion of the shares issued.

The Commissioner took the matter to the Supreme Court by special leave. The Supreme Court as seen from its decision in Commissioner of

Income Tax v. Mugneeram Bangur & Co. however, did not go into question No. 4 as the court thought that it could dispose of the matter by

answering question No. 3. The Supreme Court agreed with the High Court that the sale was a realisation sale and, therefore, the case fell under its

previous decision in Commissioner of Income Tax v. West Coast Chemicals and Industies Ltd. and the observations made by the court in that

decision in regard to Doughty''s case Consequently, the principle laid down in the case of Rogers & Co. following Sir Homi Mehta''s Executors

case remains so far unaffected and the two Bombay decision are and continue to be binding upon us. Besides the High Court of Calcutta, the

principles laid down in the two Bombay decisions has also been followed by the High Court of Kerala in Commissioner of Income Tax v. Morning

Star Bus Service where the facts were similar to those in Rogers & Co.''s case In that case, an association consisting of five persons, who were

carrying on transport business, formed themselves into a private limited company and the assets of the association including seven buses were

transferred to the company. The written down value of the buses in the books of the association was Rs. 24,302 and their value was shown in the

books of the company at Rs. 70,000. The revenue authorities, applying the second proviso to section 10(2)(vii), assessed the difference between

Rs. 70,000 and Rs. 24,302, i.e., Rs. 45,698, as profits of the association of the year in which the transaction transfer took place. The High Court

held that what the second proviso to section 10(2)(vii) did was to bring to charge the profits that a vendor made from the vendee as a result of the

sale. If no sale or profits in the commercial sense occured because of the virtual identity of the vendor and the vendee, the second proviso would

not operate and the tax liability would not arise. The High Court further held that though the association and the private limited company were

different legal entities and in the strict legal sense of the term there was a sale of the buses by the association to the company, since the persons

who owned the buses before and after the transfer were identical in substance and effect and in the commercial sense there was no sale but only a

readjustment for the purpose of carrying on the business in another form, the amount of Rs. 45,698 was not assessable as profits of the association

under the aforesaid proviso. The learned Advocate-General, however, drew our attention to a decision of the Patna High Court in Maharajadhiraj

Sri Kameshwar Singh v. Commissioner of Income Tax where that High Court has taken a view contrary to the view taken by the Bombay,

Calcutta and Kerala High Courts. The facts as correctly stated in the headnote of the report, were that the assessee was carrying on the business

of publication of some newspaper. He floated a private limited company for the purpose of carrying on that business, and sold to the company said

business as a going concern for the sum of Rs. 12,50,000 which was received by the assessee in the shape of Rs. 12,500 fully paid up shares of

Rs. 100 each of the company. Out of the Rs. 25,000 shares in the company all but 50 share were held by the assessee and the remaining 50 were

held by his nominees. The original cost of the building, plant and machinery which were transferred to the company was Rs. 2,79,822 and their

written down value at the time of the transfer was Rs. 1,49,037. The taxing authorities treated the excess, namely, Rs. 1,30,785, as profits under

the second proviso to section 10(2)(vii) and assessed this amount to income tax. The assessee contended that for tax purposes it was the duty of

the authorities and the court to ""lift the veil of corporate entity"" and pay regard to the economic realities behind the transaction and, since, there was

really no sale to a different party but only a different method of carruing on the same business and that the excess of Rs. 1,30,785 could not be

assessed under the second proviso to section 10(2)(vii). The Patna High Court, after reviewing a number of English decisions, dissented from the

Bombay decision in Sir Homi Mehta''s Executors'' case and held that a person veiled by the mask of corporate personality could not be allowed to

pierce the veil himself for his own benefit. Though the assessee was the owner of all the shares in the company, he could not claim to be treated as

if he were identical with the company in order to promote his own benefit or advantage. The High Court also held that the assessee and the

company were distinct legal entities and that the sum in question was rightly assessed to Income Tax. This decision, however, cannot assist the

learned Advocate General, because so long as the decisions in Sir Homi Mehta''s Executors'' case and Rogers & Co.''s case are not reversed by

the supreme Court and hold the field, they are binding upon us as they are decidions given prior to May 1, 1960.

The learned Advocate Genneral on the ffooting that those decisions are binding upon us, however tried to distinguish the case of Rogers & Co.

as also the decisions of the Calcutta and Kerala High courts on two grounds (1) that in the case of Rogers & Co. the firm was dissolved on the

company, i.e., the transferee, taking over its business, and (2) that in all those cases, the entire business and not a part of it only was transferred

and taken over by the company. He argued that the principle laid down in the case of Rogers & Co. would be applicable only where the totality of

the business of the transferor entity is brought to an end and that that principle would not apply so long as the transferor entity continues to carry on

its business and remains as a taxable unit. He also argued that the object of the transferor of the Surat business to the limited company was ab

oblique object in the sense that the transaction in question was arranged in order to avoid clubbing of the excise duty levied by the excise

authorities and that oblique motive gave color to the transaction in the sense that it was a mere readjustment. His contention was that the assessee-

firm has still been carrying on business at Surat as its headquarters and has branches at Bombay, Calcutta and Rangoon, and that each branch

maintains its separate books. The assessee-firm, therefore, still subsists and is carrying on business and the only thing that has happened as a result

of the transaction is that the business at Surat only has been transferred to the company, that is, the business of manufacturing art silk and selling it.

He also tried to point out that, according to the order of the Income Tax Officer, the business at Surat was not only of manufacturing and selling of

cloth but also of purchase and sale of yarn and that by the transfer only a part of business, viz., the business of manufacturing of cloth and its sale,

and not the whole of it was transferred to the company and therefore of the decision in Rogers & Co.''s case would not apply. He pointed out that,

unlike the case of Rogers & Co. the assessee-firm was not dissolved on the Surat business being transferred to the company.

Now it is true that the Income Tax Officer has mentioned in his order that the Surat business consisted both of manufacturing and sale of cloth

and purchase and sale of yarn and that the business of manufacturing cloth and sale thereof was stopped as from June 17, 1958. But the contention

that only part of the Surat business was transferred to the company is not correct. It is clear from the order of the Tribunal and the statement of the

case submitted to this court that the revenue authorities never contended that the whole of the business at Surat was not taken over by the

company or that a part of it, namely, the purchase and sale of yarn, still remained with the firm and was continued by the firm. In paragraph 3 of the

statement of the case, the Tribunal has clearly stated that the assessee-firm carried on the business of manufacturing art silk cloth at Surat up to

June 17. 1958, and that, thereafter, the company took over that business. It may be that the Surat business might have purchased yarn and sold it,

but that must be only incidental and as part of the business of manufacturing art silk cloth and its sale. It is, therefore, not possible to say that the

entire business carried on by the firm at Surat, namely, the manufacturing of art silk cloth and sale thereof was not taken over by the company.

Though a trading firm is assessed u/s 10(1) under the main head of business, there would be cases where are such an assessee would be carrying

on several business and even having both a business as well as profession. In such a case, it is well settled that the profits of each distinct business

have to be computed separately. It is true that Income Tax is chargeable u/s 10(1), not on the separate income of each and every distinct business,

but on the aggregate of the profits of all the business carried on by an assessee. But that is done by lumping together the profits of all the separate

and distinct business and bringing the aggregate of the business profits to tax. Nevertheless, where an assessee carries on several business or both

a business and a profession he is entitled to set off loss in one business against profits is another, or loss in business against professional earnings.

The tax no doubt would be leviable on the balance of profits after deducting such losses. But through he will be chargeable under the main head of

business, each of the several business that he would be carrying on would be separate business. Since the entire business carried on by the

assessee at Surat was the subject-matter of the transaction between the firm and the company and the totality of that business was transferred to

the company, it is difficult to see how the principle laid down in the two Bombay decisions, namely, Sri Homi Mehta''s Executors'' case and Rogers

& Co.''s case can be said not to apply to the present case. The principle laid down in Rogers & Co. as also in Sri Homi Mehta''s Executors'' case

was that, where the two entities are identical or substantially identical, the transaction of transfer would not in the commercial sense constitute sale

resulting in profits which would be taxable under the Act. That principle was not based in those two cases on the ground that the totality of the

business was transferred but upon the basic principle of identity of the two entities and on the principle that a person cannot rightly be said to trade

with himself with the intention of making profits. We fail to appreciate as to how the two cases having been decided upon this principle could be

distinguished upon the ground that it was only one of the business carried on by the assessee-firm which was transferred to the company and not all

the business carried on by the assessee-firm. In our view, the attempt of the learned Advocate-General to distinguish the decision in Rogers & Co.

must fail. The decision of Rogers & Co. as we have already pointed out, laid down the basic principle which was first laid down in Sir Homi

Mehta''s Executors'' case namely, that the sale, though in a strictly legalistic sense, was a sale and the two entities were in law separate entities, the

sale was not a sale in the commercial sense and the two entities were subsequently one and the same and therefore the transaction was only a

readjustment whereby the parties, instead of trading in one form, started trading in another form. Once these principles are accepted, it would

make no difference whether only one business out of the several business was taken over by the company or the entire lot of the business and

whether the firm was continued or not for carrying on the rest of the activities. If the two entities are one and the same of substantially the same and

the taxing laws permit raising the corporate veil, it would not, in our view, make any difference if the assessee were to carry on his business partly

in one form and party in another form. The question and the basic question that would arise is whether the transaction in question, was a sale in the

commercial sense between two different entities and whether it resulted in profits. That being the basic principle, the two points of distinction relied

upon by the learned Advocate-General cannot be sustained and we must hold that, even in the case of a transaction which involves transfer of one

of the business out of the several, the principle laid down in Rogers & Co.''s case and in Sir Homi Mehta''s Executors'' case would apply. As

regards his contention that there was an oblique motive in the assessee-firm making an arrangement for the transfer of the Surat business, namely,

to avoid clubbing of the excise duty levied by the excise authorities, the only thing that need be said is that, so long as such motive does not affect

the validity of the transaction, the question of motive would be immaterial. There is nothing wrong in the parties readjusting the mode of trading or

carrying on business in one particular manner rather than the other, if by doing so they can so readjust that they would have to bear a lesser burden

of tax. There is, therefore, no question of the alleged motive, even assuming that there was such a motive, which would preclude the application of

the principle laid down in the two Bombay decisions.

We may mention at this stage the taxing authorities have applied, in the assessment of the limited company, proviso (a) to section 10(5) and

taken the cost of the machinery in the hands of the company at the written down value appearing in the books of the assessee-firm and has not

therefore permitted depreciation allowance on Rs. 62,000 and odd. This is quite correct, for, as stated in Rogers & Co. the written down value

does not change and remains the same although in the agreement of sale the parties may put down the sale price at an amount higher than the

written down value in the transferor''s books. We understand that this matter is till pending before the appellate authority. Mr. B. G. Thakore

appearing for the assessee firm assures us that the company will be content with the written down value of the machinery as appearing in the

assessee-firm''s books of account, namely Rs. 9,962. This is correct, as the assessee, who claims that the transaction was not a sale in the

commercial sense, cannot have it both ways.

For the reasons aforesaid, our answer to the question is in the negative. The Commissioner will pay to the assessee-firm the costs of this

reference.

Question answered in the negative.