Natesan and Co. (P.) Ltd. vs Commissioner of Income Tax

Jagadisan, J.—The following question stands referred u/s 66 of the Indian income tax Act:

Whether, on the facts and in the circumstances of the case, the Tribunal was justified in disallowing the sum of Rs. 6,000 and Rs. 3,000 from out

of the salaries paid to Natesan and Sankaran, the managing director and the director respectively of the assessee company?

The assessee is a private limited company incorporated under the Indian Companies Act on January 6, 1945. It acquired a rice mill on February 5,

1945. Up to December 31, 1955, the only business of the company was the working of the mill. In the accounting year relevant to the assessment

year 1949-50, the income earned by the company was about Rs. 5,796. Natesan, the major shareholder of the company, was carrying on several

businesses of his own in his individual capacity. He had a wholesale business in tea, a few oil filling stations and a retail business in cement. He also

held contracts of agency for forwarding and handling goods with Bombay Burma Trading Co. and Ropeways Ltd. His business activities were

therefore many and varied. With effect from January 1, 1956, Natesan transferred all his individual business to the assessee company. He was the

managing director of the company and his son, Sankaran, was a director. Clause 6 of the memorandum and articles of association of the company

provided that Natesan shall hold office as managing director for a period of twenty years from the date of the incorporation of the company. He

was to be paid a monthly allowance of Rs. 200 and a commission of ten percent on the net annual profits earned by the company. By an

extraordinary resolution of the general body of the company passed at a meeting held on March 29, 1956, it was resolved that Natesan shall hold

office for a period of five years from April 1, 1956. During the term of his office he was to be paid Rs. 1,500 per month and a commission of ten

percent on the annual net profits. It was also resolved at that meeting that Sankaran, Natesan''s son, should be paid, during the term of his office as

a director of the company, a remuneration of Rs. 1,000 per month, with effect from January 1, 1956. Sankaran managed the business of the

company at its branches at Chalakudi, Valparai and also at its head office at Pollachi. Natesan was of course an experienced businessman and he

was the brain behind the business. As already stated the business of the company were of various types and both the father and son had to be

quite active devoting all their time to them.

In the assessment year 1957-58, the relevant previous year for the calendar year 1957, the assessee claimed the remuneration paid to Natesan

and Sankaran totalling Rs. 30,000 as deduction in the computation of the profits of the company. The departmental officers took the view that the

proper remuneration would be only Rs. 1,000 per month for the managing director and Rs. 750 for the other director and anything in excess

thereof would be unreasonable. Therefore, the deduction of a sum of Rs. 9,000 in all was disallowed. This course was adopted by the officers

presumably by the application of section 10(4A) of the Act. The assessee preferred an appeal to the income tax Appellate Tribunal and contended

that there was nothing unreasonable or excessive in the remuneration paid to the managing director and the director and that no part of that

remuneration should have been disallowed by the department. The Tribunal upheld the contention of the assessee. In its order dated June 5, 1959,

the Tribunal observed : ""We do not however think that the remuneration claimed by the assessee can be said to be unreasonable or excessive

having regard to the legitimate business needs of the company and the benefits derived by it. A statement has been furnished to us listing the

activities with which the managing director and the director were concerned in the year in question. It is an impressive list and shows the nature and

extent of the work assigned to these persons and of the responsibilities assumed by them. The remuneration paid to each of these persons was

sanctioned by a resolution passed by the company.... We do not think that any reduction is called for in the remuneration so sanctioned."" There

was no reference to this court of any question of law arising from this order of the Tribunal.

In the assessment year 1958-59 also the assessee claimed the full amount of remuneration paid as per the resolution dated March 29, 1956, as

proper deduction in the computation of its income. The income tax Officer, who made the assessment on January 27, 1959, prior to the order of

the Tribunal relating to the assessment year 1957-58, was of the opinion that there were no grounds to warrant a different conclusion from the one

which he arrived at in making the assessment for the year 1957-58. He accordingly disallowed Rs. 9,000. The assessee preferred an appeal to the

Appellate Assistant Commissioner, who, however, agreed with the decision of the income tax Officer. This order is dated April 18, 1959, which is

prior to the order of the Tribunal. The assessee preferred a further appeal to the income tax Appellate Tribunal. The Members who constituted the

Tribunal this time were not the same Members who rendered the decision dated June 5, 1959, relating to the assessment year 1957-58. The

Tribunal expressed the view that it was unable to agree with the previous decision. The result was that the decision of the department disallowing

Rs. 9,000 in all was affirmed. It is against this decision that the assessee obtained a reference to this court. The question referred has already been

set out.

The facts and circumstances leading to the resolution dated March 29, 1956, and the subsequent activities of the managing director and the

other director are not in dispute and we have already adverted to them. In the order of the Tribunal relating to the assessment year 1957-58 valid

and cogent reasons have been given for justifying the claim for deduction made by the assessee. The department did not choose to challenge the

correctness of that decision of the Tribunal. It is of course true that the department would not be bound by the decision of the Tribunal so as to

preclude it from raising the question of the propriety of the claim for deduction in the subsequent assessment year 1958-59. The question has to be

considered every year as circumstances may vary. What would be proper remuneration in a particular assessment year may be unreasonable and

excessive for the succeeding year. The question is one of fact which has to be examined as and when the claim for deduction is made.

In regard to the assessment year 1958-59 both the income tax Officer and the Appellate Assistant Commissioner who rendered their decisions

prior to the decision of the Tribunal for the year 1957-58 merely contented themselves by saying that there were no reasons for allowing the full

amount of remuneration in view of their decisions relating to the prior year. In other words they thought that unless and until their decisions are set

aside by the appellate authority they could follow their own opinion which they formed previously. There is nothing improper on the part of the

officers in having taken up that attitude. But the fact is that they never adverted their minds to the real question arising in the case, namely, whether

the claim for deduction can be properly allowed in full.

The Tribunal expressed its inability to agree with its previous decision dated June 5, 1959, but in reaching the conclusion agreeing with the

department, it was swayed by considerations which are not relevant or germane to the matter in issue. The reasons given by the Tribunal are as

follows : (1) The assets vested in Natesan and were not transferred to the company (assessee). (2) There is no agreement between the private

limited company and the recipients of the salary; only a resolution amending the articles of association of the company has been passed. (3) There

is no mention of the appointment of Sankaran in the articles of association. These are the points of infirmity which the Tribunal sets out against the

assessee for its being disentitled to the claim for deduction. We shall presently show that the Tribunal failed to have due regard to the governing

statutory provision.

Section 10(4A) is the relevant provision and that reads;

Nothing in sub-section (2) shall, in the computation of the profits and gains of a company, be deemed to authorise the making of-

(a) any allowance in respect of any expenditure which results directly or indirectly in the provision of any remuneration or benefit or amenity to a

director or a person who has a substantial interest in the company within the meaning of sub-clause (iii) of clause (6C) of section 2, or....

if in the opinion of the income tax Officer any such allowance is excessive or unreasonable having regard to the legitimate business needs of the

company and the benefit derived by or accruing to it therefrom.

This provision was inserted by the Finance Act of 1956. The object of the Legislature was to prevent avoidance of tax by companies allowing

remuneration or other benefits to directors or persons substantially interested in the company extravagantly without a due sense of commercial

propriety or without balancing it with the adequacy of the benefit obtained by their services. Prior to 1956, before the amendment, an assessee

company could claim deduction of allowance to directors u/s 10(2)(xv). But the department was forbidden to sit in the arm-chair of the

management of the company and decide what would be the proper remuneration (see The Newton Studios Ltd., Madras Vs. The Commr. of

Income Tax, Madras, ; N.M. Rayaloo Iyer and Sons, Mathurai Vs. Commr. of Income Tax Excess Profits Tax, Madras, . The company was

therefore free to be lavish in the matter of payment of such remuneration, though the department was always inclined to frown upon even a little

liberality. Now the question is what is the scope of section 10(4A). The income tax Officer is not authorised or empowered to grant any allowance

resulting in any remuneration, benefit, or amenity to a director or a person having any substantial interest in the company if in the opinion of the

officer such allowance would be excessive or unreasonable. The officer cannot of course be arbitrary or capricious. He cannot make a guess-work

relying on his instincts. He must form an opinion having regard to ""the legitimate business needs of the company, and the benefit derived by or

accruing to it therefrom"". He may say that the business of the company is such that it does not need a highly remunerated director. Or he may after

an analysis of the work done by the director reach the conclusion that the company does not derive benefits corresponding to the remuneration

paid. It is obvious that the income tax Officer must apply his mind to the nature of the business of the company, the actual work done by the

directors, the quantum of income earned by the company, the necessity to pay the remuneration to the director and to other allied considerations,

to form an opinion whether or not the payment is reasonable or excessive. The mere ipse dixit of the officer unrelated to the criteria laid down in

the statute would not be a considered opinion but dogmatic assertion. We have no doubt that the statute does not permit the department to adopt

such a course.

The order of the Tribunal relating to the year 1957-58 is certainly a relevant piece of evidence on the question whether the allowance in full of

the remuneration paid would be unreasonable or excessive. It may not operate as res judicata but it cannot certainly be ignored. The Tribunal

which reached a contrary conclusion in its order dated September 14, 1959, has completely overlooked the statutory requirements and has

confirmed the decision of the department on grounds which cannot stand a moment''s scrutiny. In considering the question whether the department

was right in disallowing the sum of Rs. 9,000, the questions, whether assets were transferred by Natesan to the company or not, whether there

was an agreement to pay remuneration dc hors the resolution, whether there was in fact an appointment of Sankaran by the company, are all

immaterial and irrelevant. The department does not say, and of course cannot say, that the company is a mere sham and that the managing director

and the director were not paid the remuneration. Such being the case we are unable to understand the viewpoint of the Tribunal in disallowing the

assessee''s claim observing that the whole of the remuneration could have been disallowed. In our opinion the Tribunal failed to take into account

the conditions of the statute and its decision cannot therefore be supported. There are no adequate grounds falling within section 10(4A) enabling

the department to disallow any part of the remuneration paid to the managing director and the other director. The question is answered in favour of

the assessee. The department will pay the costs to the assessee. Counsel''s fee Rs. 250.