N. Sundareswaran vs Commissioner of Income Tax

P.A. Mohammed, J.—An exporter-firm is the assessee in the above tax references. The assessment is for the year 1978-79, the accounting period of which ended on 31-12-1977. The assessee as well as the revenue being aggrieved by the order passed by the Commissioner (Appeals), Ernakulam filed appeals before Tribunal as IT Appeal Nos. 243 (Coch.) of 1982 and 402 (Coch.) of 1982. Those appeals were disposed of by the Tribunal by a common order dated 16-7-1984. These two references arise from the said common order of the Tribunal. At the instance of the assessee four questions are referred to us for decision. Those questions mainly relate to the claim of deduction of damages occurred during the relevant accounting year. Likewise one question is referred to us for answer at the instance of the revenue and it relates to the claim of ''weighted deduction'' u/s 35B of the income tax Act, 1961 (''the Act'').

The questions referred at the instance of the assessee are the following:

Whether, on the facts and in the circumstances of the case, the Tribunal was right in law in holding that the claim for deduction of the damages payable by the assessee to foreign companies for breach of contracts was allowable only if the claim had been crystallised during the relevant accounting period?

Whether, on the facts and in the circumstances of the case, the Tribunal was right in holding that the claim for damages will be crystallised only when a claim is actually made by the foreign company and the same is either accepted or determined by negotiation, or by arbitration or by suit?

Whether, on the facts and in the circumstances of the case, the Tribunal was right in holding that the claim for damages to the extent of Rs. 12,51,625 had not crystallised during the accounting period relevant to the assessment year 1978-79?

Whether, on the facts and in the circumstances of the case, the Tribunal was right in not relying upon the copy of the letter dated 16-12-1977 from the Richard Franco Agency Inc., New York and which was produced by the assessee before the Tribunal for the first time?

In order to answer the above questions certain basic facts are required. The assessee entered into contracts with foreign buyers for the supply of cashew kernels. However, the assessee could not fulfill the obligations under the contract due to the shortage in the supply of raw cashewnuts and consequent rise in prices. It is said that due to the failure to supply the cashewnuts as per the terms of the contract, there was breach of contract and the assessee, therefore, claimed a deduction of Rs. 12,51,625 towards damages payable to the foreign companies. Though this claim was made before the ITO, he, however, disallowed it. Therefore the assessee filed an appeal before the Commissioner (Appeals) and in that appeal the claim was disallowed. The revenue filed an appeal against the said order of the Commissioner and in the said appeal the Tribunal disallowed the claim advanced by the assessee-firm.

It is necessary to examine as to how the above claim has been dealt with by the ITO in the assessment order passed by him on 4-9-1981. The relevant portion of the assessment order is extracted below:

Add: Foreign claim - Rs. 12,52,046

This is made up of 3 items as detailed below:

1.

Richard Franco Agency, New York Contract Rs. 9,957 dated 5-11-1978 for 2,600 cases, $ 1,33,500

Exchange rate Rs. 8/85

Rs. 10,49,750,00

2.

International Emporium, Hamburg.

Contract No. 2456 dated 27-10-1975

100 c/s

"No. 2457 dated"

100 c/s

"No. 2464 dated 30-6-1976

750 c/s

950 c/s

For 950 c/s $ 23,730.00

Exchange rate @ 8.50 per $

Rs. 2,01,875.00

3.

Vo-Sojuzpledo Import, Moscow, Claim for humidity against Invoice No. 76/77

Rs. 421.19

Total

Rs. 12,52,046.19"

Out of the above three items there is no dispute with regard to the item No. 3 and we are, in this reference, concerned with the items 1 and 2 alone.

The assessment order reveals that as per the contract No. 9957, dated 15-11-1978 the assessee entered into contract for the sale of 2,600 cases (320 counts wholes) of cashew kernels to Los Angles Nut House, California, through agents Richard Franco Agency, New York @ 1.30 per pound and the assessee defaulted to fulfill the contract for the reason that it could not procure raw nuts as the price of raw nuts had risen considerably. It further discloses that the agreement of contract provided for arbitration in case of breach and by letter dated 31-1-1978 Los Angles Nut House referred the case for initiating arbitration proceedings against the exporter. It appears that the assessee on receipt of the copy of the reference made by the above foreign company without waiting for the outcome of the arbitration proceedings, made a provision in the accounts for the claim of damages of Rs. 10,49,750 being the value of the 2,600 cases of kernels. Likewise the assessee claimed deduction of Rs. 2,01,875 being the damages arising out of the default made by it in fulfilment of contract for the sale of 950 cases of cashew kernels to M/s. International Emporium, West Germany. The said foreign company claimed damages for the aforesaid breach of contract as per its letter dated 1-3-1978. However, the ITO has observed that the aforesaid claims are inadmissible for the reason that they have not been established. The officer further added that those claims are in the nature of ''contingent liability'' only.

Apart from the above particulars seen in the assessment order, no further details regarding terms and conditions of contracts are made available for scrutiny by this Court. The details regarding the period of contracts, the manner of their performance, quantification of damages, etc., are not specifically brought to our notice. What this Court could positively see is that arbitration proceedings had been referred against the assessee but the damage if any had not been crystallised. In this context it is necessary to examine whether the claim put forth by the assessee is a liquidated damage or unliquidated damage. The Tribunal in its order observed that the claim advanced by the assessee is an unliquidated damage. We think that the above conclusion arrived at by the Tribunal is well founded. In this case the assessee admits that it has committed the breach of contracts and, therefore, the damages are payable by it. When a claim is made for damages for breach of contract, it has to be adjudicated by arbitration or by any process known to law. Only when the damage is so determined it can be said to be a liquidated damage. In the absence of any material evidencing the finalisation of such proceedings and quantification of damages payable by the assessee we are of the view that the claim of deduction advanced by the assessee is only for ''unliquidated damages''.

Even though the ITO has made specific reference in the assessment order as to different contracts entered into between the assessee and foreign buyers, copies of those contracts were not made available to this Court for scrutiny. They are also not seen produced before the Tribunal. If the copies of the contracts were made available it would have been possible for us to determine whether the liabilities for compensation had already been accrued. When the damage is quantified it may be a case of accrued liability. But in the present case while determining the profits and gains of business of the assessee chargeable to income tax u/s 28 of the Act it claimed deduction of damages to be paid to the foreign companies for the breach of contracts treating it as already suffered. When such claim is advanced by the assessee it can be allowed only when there is an accrued liability. It cannot be said that when liability is shown in the accounts it has been accrued ex instanti.

In channelizing the above argument, the counsel for the assessee placed reliance on section 73 of the Indian Contract Act. The first paragraph of the said section is thus:

Compensation for loss or damage caused by breach of contract. -When a contract has been broken, the party who suffers by such breach is entitled to receive, from the party who has broken the contract, compensation for any loss or damage caused to him thereby, which naturally arose in the usual course of things from such breach, or which the parties knew, when they made the contract, to be likely to result from the breach of it.

The above provision provides that where a party suffers a loss or damage in consequence of breach of contract, he is entitled to recover compensation from the party breaking the contract. It is a protection available to the injured party and not to the party who has broken the contract. The assessee who has broken the contract cannot argue that a liability is accrued against it for the reason that the right to recover compensation from assessee is recognised in the said provision. Therefore, u/s 73 what is provided is not the accrued liability but the liability to be crystallized in a process known to law.

The Supreme Court in Calcutta Company Ltd. Vs. The Commissioner of Income Tax, West Bengal, observed to the following effect:

... That undertaking imported a liability on the appellant which accrued on the dates of the deeds of sale, though that liability was to be discharged at a future date. It was thus an accrued liability and the estimated expenditure which would be incurred in discharging the same could be deducted from the profits and gains of the business and the amount to be expended could be debited in accounts maintained in the mercantile system of accounting before it was actually disbursed. The difficulty in the estimation thereof did not convert the accrued liability into a conditional one, because it was always open to the income tax authorities concerned to arrive at a proper estimate thereof having regard to all the circumstances of the case." (p. 1)

The facts of the above case are dissimilar to the facts in the present case under discussion. There the estimated expenditure had to be incurred to discharge an existing and definite obligation enforceable against the assessee in praesenti and, therefore, the court held it a permissible deduction in the computation of income. It has to be seen in that case that as per the terms of the sale assessee had undertaken an unconditional obligation which was enforceable against it. Thus, it was a case of liability incurred and not the one which requires to be adjudicated. The Supreme Court in Union of India (UOI) Vs. Raman Iron Foundry, , emphatically observed:

Now the law is well settled that a claim for unliquidated damages does not give rise to a debt until the liability is adjudicated and damages assessed by a decree or order of a Court or other adjudicatory authority. When there is a breach of contract, the party who commits the breach does not ex instanti incur any pecuniary obligation, nor does the party complaining of the breach becomes entitled to a debt due from the other party. The only right which the party aggrieved by the breach of the contract has is the right to sue for damages.

It is further observed:

But, and this is most important to note he does not get damages or compensation by reason of any existing obligation on the part of the person who has committed the breach. He gets compensation as a result of the fiat of the Court. Therefore, no pecuniary liability arises till the Court has determined that the party complaining of the breach is entitled to damages.

The Division Bench of this Court while considering exactly a similar claim by an exporter-assessee observed in Asuma Cashew Company Vs. Commissioner of Income Tax, , thus:

... On these facts, the Tribunal held that the liability of the assessee to pay compensation will arise or be crystallised only when the liability to pay damages is adjudicated and the liability itself is determined and accepted by private negotiation or is determined by an arbitrator or by a court. In other words, it was held that an enforceable liability will spring into existence only when it was determined and fixed by the arbitrators and not when the breach occurred as contended by the assessee. We see no error in the said reasoning and conclusion of the Tribunal.............." (p. 179)

In view of the above decisions, it is arduous for this Court to countenance the contention of the assessee that there is an incurred liability in this case. The said contention is, therefore, rejected.

As pointed out earlier, the assessee did not wait for the outcome of the arbitration proceeding. In order to claim the damages, it has produced two letters evidenced by Annexures D and D1 and they are dated 16-12-1977 and 29-8-1978, respectively. These letters were not produced before the ITO even though the assessment order was passed only on 4-9-1981. From the dates mentioned in the above letters it would clearly indicate that these letters were in the possession of the assessee at the time of finalisation of assessment proceeding. It is not known why they were not produced before the ITO or the Commissioner (Appeals). Those letters were produced for the first time before the Tribunal. In this context it is pertinent to note that the deduction for damages is seen entered in the account books relating to the accounting year which ended on 31-12-1977 on the basis of two letters dated 31-1-1978 and 1-3-1978 sent by the foreign companies as referred to hereinbefore. Even assuming that the liability to pay the compensation arose on receipt of those letters it can only be during the accounting year ended on 31-12-1978, the relevant assessment year being 1979-80 and not 1978-79.

The Tribunal after evaluating the materials on record came to the conclusion that the assessee has failed to establish that the claim for damages had crystallised during the accounting period. The Tribunal has also observed that the claim cannot be allowed merely because the breach of the contract was committed in the accounting period. It cannot be said that from the aforesaid findings of the Tribunal the questions of law framed at the instance of the assessee do not arise for consideration. The question Nos. 1 and 2 directly arise for decision and the 3rd question is found to be consequential in nature. The 4th question relates to the refusal by the Tribunal to rely on a letter dated 16-12-1977 from a foreign company in order to substantiate the claim of the assessee for deduction of damages. The Tribunal is legally justified in not relying upon the said letter for the reason that it was produced before it for the first time. The Tribunal in this connection has also observed that the copy of the letter by which the assessee remitted the claim before the close of the previous year has not also been made available.

The counsel for the revenue points out that there is a factual error insofar as the payment of compensation to the foreign company in the order of the Tribunal and, hence, liable to be clarified. What the Tribunal observed in the order is this: "He took note of fact that the amount has not been actually paid and that it was adjusted against amounts receivable against subsequent shipments". The counsel for the revenue submits that what the Tribunal observed above is a mistake and correct position is stated by the Commissioner thus: "The compensation has not been paid yet because according to the learned counsel trade with the U.S.A. is slack and no export has taken place subsequently. He points out that the claim will be adjusted against the amount receivable by the appellant in respect of the subsequent shipments". Therefore, it is clear that the Tribunal has misunderstood the statements contained in the order of the Commissioner. Thus, it is crystalline that the compensation claimed by the foreign companies has not been paid by the assessee.

In view of the discussion hereinabove, we answer the questions 1 to 4 referred to us at the instance of the assessee in the affirmative and in favour of the revenue and against the assessee. We will now advert to the question referred to us at the instance of the revenue. The said question is as follows:

Whether, on the facts and in the circumstances of the case, the Tribunal was right in holding that the assessee was entitled to weighted deduction u/s 35B of the income tax Act, 1961 on the commission paid in India to M/s Nut Meat Trading Co. Ltd., Bombay?

The assessee claimed ''weighted deduction'' of Rs. 66,747 u/s 35B(1)(b). It represents the commission paid to Nut Meat Trading Co. Ltd., Bombay in respect of the goods of the assessee to foreign countries. This claim was disallowed by the ITO on the ground that the said expenses were incurred within India. However, it was allowed by the Commissioner in appeal on the ground that the expenditure incurred for gathering information regarding markets outside is an allowable weighted deduction. The Tribunal also took the view that the weighted deduction can be allowed on commission paid in India if it otherwise qualifies under one or the other clauses of section 35B(1)(b). The Tribunal has also observed that the assessee had received the information about the foreign markets through the agents in India. The Division Bench of this Court in Commissioner of Income Tax Vs. Kerala Nut Food Co., P. Gopinatha Pillai, M. Shamsuddin and Co., Indian Nut Products, Asiatic Export Enterprises and General Industrial Corporation, held:

... The services are incidental to the formation of the contract falling under sub-clauses (i) and (ii) of clause (b) of section 35B(1) of the income tax Act. It is evident that the agents render positive and specific services for the marketing of the goods in which the assessee deals in the course of his business. The commission agents obtained information regarding the markets outside India regarding the goods for export. They render services to the exporters by obtaining information regarding markets outside India for the assessee''s goods and they actually give advertisement and publicity outside India in respect of the goods of the assessee and also obtain information regarding markets outside India for the goods exported by the assessee. The commission payments will certainly qualify for weighted deduction u/s 35B(1)(b)(i) and (ii) of the income tax Act...." (p. 597)

In view of the settled position emerging from the above decision, the question referred to us at the instance of the revenue can only be answered in favour of the assessee. Accordingly, the said question is answered in the affirmative and against the revenue and in favour of the assessee. The references are disposed of as above.