Swadeshi Cotton Mills Co. Ltd. v. Income-Tax Officer, Special Investigation Circle, C-Ward, Kanpur

1. This is a writ petition under article 226 of the Constitution directed against the order passed under section 35 of the Income-tax Act, 1922 (hereinafter referred to as the “Act”), dated the 31st March, 1962, whereby the Income-tax Officer further reduced the rebate allowed under the second proviso 1(b) of Paragraph D of Part. II of the First Schedule to the Finance Act of 1956, by reducing the paid up capital by that capital which carried a fixed rate of dividend of 4% together with the right to share such dividend with the ordinary shareholders.

2. The facts leading up to the petition are these: The petitioner is a public limited company. The relevant assessment year is the assessment year 1956-57, the accounting year being the year ending the 31st December, 1955; By an assessment order dated the 7th July, 1960, the total income of the petitioner was assessed at Rs. 48,21,860 and the amount of tax payable thereon was determined at Rs. 22,94,400. After adjusting payments of Rs. 14,00,000 made under sections 18A and 23B, the net demand payable arrived at was Rs: 8,93,658. Subsequently, by an order under section 35 of the Act dated the 9th August, 1960, the net demand payable was reduced to Rs. 8,84,605. The rectification made was not accepted by the petitioner and an appeal against that order is said to be pending. As penal interest was also levied, a revision against the latter order was filed before the Commissioner under section 33A, the prayer being for remission of penal interest under section 18A(6). This revision also is said to be pending.

3. The Income-tax Officer subsequently discovered that the rebate of corporation tax had not been reduced by the amount which was calculated on the excess of dividend declared over 6% of the paid up capital as required by the second proviso (i)(b) of Paragraph D, Part II, First Schedule, to the Finance Act of 1956. A notice was thereupon issued under section 35 of the Act to show cause why the necessary modification under the aforesaid provision of the Finance Act should not be carried out. The petitioner objected and finally on the 31st of March, 1962, the impugned order rectifying the assessment under section 35 was passed. It was held that not only the capital in respect of preference shares of Rs. 35 lakhs which carried a fixed dividend at 6% stood to be excluded but also the capital of Rs. 1,57,50,000 of preferred ordinary shares which carried a fixed dividend at 4% together with the right of such shareholders to share in the dividend declared and paid to ordinary shareholders.

4. The dividend on the preference shares of Rs. 35 lakhs at 6% worked out at Rs. 2,10,000 and at 4% fixed on preferred ordinary shares at Rs. 6,30,000. These two fixed dividends amounted to Rs. 8,40,000 and according to the Income-tax Officer stood to be excluded along with the share capital of preference shares of Rs. 35 lakhs and of Rs. 1,57,60,000 of preferred ordinary shares for the purpose of considering the reductions in rebate.

5. In this view of the matter, it was held that the rebate of corporation tax was calculated in excess by a sum of Rs. 2,22,031.25 Np. by which the total rebate of Rs. 12,05,465 should have been reduced. As this was considered to be a clerical mistake apparent from the record, the assessment was modified under section 35 of the Act and a revised demand notice was accordingly issued. The writ petition is directed against the said order under section 35 of the Act and the demand issued pursuant thereto.

6. The short but difficult question which arises is as to the interpretation which is to be placed on the expression “paid up capital” as given in the Explanation to Paragraph D of the aforesaid part of the Finance Act, 1956. The relevant portion of the Explanation runs:

“(1) For the purposes of paragraph D of this part—

(i) The expression ‘paid up capital’ means the paid up capital (other than capital entitled to a dividend at a fixed rate) of the company as on the first day of the previous year relevant to the assessment for the year ending on 31st day of March, 1957, increased by any premiums received in cash by the company on the issue of its shares, standing to the credit of the share premium account as on the first day of the previous year aforesaid…”

7. Therefore, the “paid up capital” for purpose of calculating the rebate that has to be reduced under the second proviso (1)(b) to the said Paragraph D has to be that capital which carries “a dividend at a fixed rate”. The question that has to be determined is as to what exactly is the capital which can be said to be entitled to a dividend at a fixed rate? The relevant portion of the second proviso to the said Paragraph D runs:

“Provided further that—

(i) the amount of the rebate under clause (i) or clause (ii), as the case may be, of the preceding proviso shall be reduced by the sum, if any, equal to the amount or the aggregate of the amounts, as the case may be, computed as hereunder……

(b) in addition, in the case of a company referred to in clause (ii) of the preceding proviso which has distributed to its shareholders during the previous year dividends in excess of six per cent, of its paid up capital, not being dividends payable at a fixed rate—

on that part of the said dividends which exceeds 6 per cent, but does not exceed 10 per cent, of the paid up capital at the rate of 0-2-0 per rupee.”

8. The petitioner company had issued three kinds of shares. They were as already observed: (1) Preference shares of Rs. 35 lakhs, which carried cumulative fixed rate of dividend at 6%, (2) Ordinary shares, and (3) Preferred ordinary shares of the value of Rs. 1,67,50,000. It is the character and nature of these latter shares which are the bone of contention in this petition.

9. Article 4 of the articles of the company provides:

“(4) The capital of the company is two crores ten lakhs divided into (a) Preference share capital: Rs. 35,00,000, preference shares of Rs. 100 each; Rs. 15,75,000, preferred ordinary shares of Rs. 10 each; (b) Equity share capital of Rs. 1,75,000, ordinary shares of Rs. 10 each, and the following rights, privileges and conditions attached to such shares:—

(i) The preference shares shall confer on the holders thereof the right to a fixed cumulative preferential dividend at the rate of 6% per annum free of income-tax on the capital for the time being paid up or credited as paid up thereon and in a winding up shall have priority to both the preferred ordinary and ordinary shares as to payment off of capital and arrears of dividend whether declared or not up to the commencement of the winding up and as regards return of capital shall rank in priority both to the preferred ordinary and ordinary shares but shall not confer any further right to participate in profits or assets. Such preference shares shall not carry any voting rights.

(2) Subject to the provisions for payment to the holders of the said preference shares contained in sub-clause (1) hereof, the profits of the company earned in any year after carrying to reserve or other special accounts or carrying forward such amounts as may be determined in accordance with the provisions of these articles shall be applied first in payment of a dividend at the rate of 4 per cent, per annum, free of income-tax, on the capital for the time being paid up on the preferred ordinary shares and thereafter any surplus shall be applied in payment of a dividend on the capital for the time being paid up on the preferred ordinary shares and the ordinary shares rateably. The preferred ordinary shares shall not confer any voting rights.

(3) In the event of the company being wound up the surplus assets available after payment off of the capital paid up or credited as paid up on the preference shares and the payment off of arrears of dividend, whether declared or not, up to the commencement of winding up on such preference shares in accordance with the provisions of sub-clause (1) hereof shall be applied firstly in payment off of the capital and dividend, if any, declared and in arrears, at the commencement of winding up, on the ordinary shares and the balance, if any shall be distributed to the holders of the preferred ordinary shares and ordinary shares rateably.”

10. It will be noticed that though the preference shares are cumulative, there is no express provision regarding the preferred ordinary shares. This would mean that if in any year there is no surplus left after the preference shareholders had been paid their fixed dividend of 6%, the preferred ordinary shareholders would not be entitled to get dividend at the fixed rate of 4% and, as it is not cumulative, the right to receive it would not be carried forward. Only if there is a sufficient surplus left after paying the preference shareholders that the preferred ordinary shareholders have to be paid, if possible at a rate up to 4%. Along with this, if any surplus is still left over, they will share rateably with the ordinary shareholders.

11. In the relevant year of assessment, the factual position was that the preferred ordinary shareholders received the dividend of 4% and in addition shared 71/2 per cent, dividend along with the ordinary shareholders. Therefore, they received a total dividend of 111/2 per cent, by way of dividend. It is, however, quite conceivable that in another year they may receive nothing or only 4% or something less. In these circumstances the question is as to whether it can be said that these preferred ordinary shares are entitled to a dividend “at a fixed rate”? If the answer is in the affirmative then the interpretation to be placed on the Explanation to Paragraph D of the expression “paid up capital” will have to be that the capital shall be reduced as contended for by the department by the capital relating to preference shares of Rs. 35,00,000 and the capital of Rs. 1,57,50,000 relating to preferred ordinary shares. If, on the other hand, the answer is that the preferred ordinary shareholders are not entitled to a dividend “at a fixed rate”, then from the paid up capital of 2.10 crores only the capital of 35 lakhs on preference shares will stand to be excluded in determining whether the dividend declared by the company during the previous year was in excess of 6 per cent, of its paid up capital, not being dividends payable at a fixed rate within the meaning of the second, proviso, (i)(b), Paragraph D of the Finance Act, 1956. The exact nature and character of these preferred ordinary shares has to be considered by reference to the provisions of the Indian Companies Act. Shareholding is divisible in various ways and different companies have adopted different schemes. The Indian Companies Act of 1956 has reduced the categories of shares to two: one is the preference share whether participating in further profits or not and, second, the equity shares. Preference share capital is broadly defined in section 85 of the Indian Companies Act, and provides that, in respect of dividends, it carries or will carry, a preferential right to be paid, a fixed amount or an amount calculated at a fixed rate, which may be either free of or subject to income-tax, and on winding up or repayment of capital, such share capital will carry preferential rights to repayment. An Explanation is added which reads:

“Explanation.— Capital shall be deemed to be preference capital, notwithstanding that it is entitled to either or both of the following rights, namely:—

(i) that, as respects dividends, in addition to the preferential right to the amount specified in clause (a), it has a right to participate, whether fully or to a limited extent, with capital not entitled to the preferential right aforesaid;

(ii) that, as respects capital, in addition to the preferential right to the repayment, on a winding up,… it has a right to participate, whether fully or to a limited extent,……”

12. Sub-section (2) of section 85 deals with the second kind of share capital, i.e, “equity share capital”. This means, with reference to any such company, all share capital which is not preference share capital. Sub-section (3) provides that the expression “preference share” and “equity share” shall be construed accordingly. Therefore, broadly speaking, within the framework of preference share capital and equity share capital, there are various modes of participating in the profits.

13. In Palmer's Company Precedents, sixteenth edition, Part I, at least ten different modes of participating in the profits by the preference shareholders are enumerated. These inter alia are: whether the dividend to be attached thereto is to be cumulative or non-cumulative; whether the dividend has to be permanently attached or has only to be preferential for a term of years; whether the dividend is to be paid out before carrying anything to reserves; whether the preference shares carry special right of voting or no right of voting at all; whether the preference shares have or have no preference as regards capital in winding up, etc.

14. The expression “preferred ordinary” came in for some discussion and comment in In re Powell-Cotton's Resettlement: Henniker-Major v. Powell-Cotton [1957] 2 WLR 328, where Roxburgh J. has observed:

“There is no difference………, on a logical analysis, in this context between the meaning of the words ‘preferred’ and ‘preference’…… Normally though by no means invariably, the order of classification is that preference shares rank above ordinary shares, and deferred or founder or management shares rank below ordinary shares. In that context, the language dealing with these three categories or classes of shares is related to ordinary shares which stand in the middle. At some time there developed the practice of splitting the class of ordinary shares in such a manner that some part of the ordinary class was preferred to some other part of the ordinary class. In other words it was not the creation of a new class but the sub-division of the ordinary class into two categories, one of which had priority over the other within the class. It may be but I am not so holding that…… the phrase ‘preferred ordinary’ is a contradiction in terms, because if it is ‘preferred’ it is not ‘ordinary’.

On the other hand, logically, if ordinary shares are divided into two sub-classes, one sub-class having a preference over the other sub-class, one would call them ordinary preferred stock and ordinary deferred stock… All these are only broadly descriptive titles. For the precise position it is necessary to look in every case at the instrument conferring the rights. Therefore, it seems to me that the phrase ‘ordinary preferred stock’ is logically a lawyer's description of what the market, for equally good reasons, called ‘preferred ordinary stock’. It seems to me that there is no real ambiguity about it at all, and that there is nothing logically wrong in that conclusion…… In my judgment, therefore, ‘ordinary preferred stock’ is a sub-class of ordinary stock which has some preference or priority over another sub-class of ordinary stock.”

15. It is manifest that “preferred ordinary shares” in the present case are nothing but a sub-class of equity shares which have some preference or priority over those shares. They have no concern with “preference shares”, which carry a fixed rate of dividend. The preferred ordinary shares fall within the category or class called equity shares but having certain priority in special circumstances, when participating in profits with the equity shareholders.

16. With this background, the position under the Companies Act of 1966 may now be examined in order to determine the precise point which arises here, whether the capital of Rs. 1 crore, 571/2 lakhs relating to preferred ordinary shares in the present case carry dividends at a fixed rate within the meaning of the Explanation to Para. D and whether the dividends thereon were payable at a fixed rate within the meaning of the second proviso (i)(b) of Para. D of the Finance Act, 1958?

17. For this purpose the relevant article of association of the company, reproduced hereinabove, has to be re-examined. That article advisedly does not use the word “fixed” when it provides for the rate of dividends at 4 per cents for preferred ordinary shares. This is in contrast to the expression used for preference shares. There the expression used is “fixed cumulative preferential dividend at the rate of 6 per cent.” in the articles of association. This is the only place where the word “fixed” is to be found. It is only in connection with the rat; of dividend which is to be paid on preference shares that the word “fixed” is found and it has advisedly not been placed before the rate of dividend at 4 per cent, specified for “preferred ordinary shares.” The “preferred ordinary shareholder” was not intended to be placed in the same class as “preference shareholder” but was necessarily relegated to the class of equity shareholders. The preferred ordinary shareholders were not entitled to dividend at a fixed rate inasmuch as they could not claim as a matter of right to be paid dividend at that rate. Their rights only came into existence upon the satisfaction of several conditions. The profits must first be sufficient to provide the fixed rate of dividends of 6 per cent, payable to the preference shareholders. After providing for reserves, if any profit is left, which the company considers should be distributed amongst the preferred ordinary shareholders then only will any right accrue to the preferred ordinary shareholders to a dividend. Even then they would not necessarily be entitled to the dividend at the rate of 4 per cent, if the surplus profits divisible in the shape of dividends fall below 4 per cent. There is nothing in principle or law to prevent the company from paying dividends to the preferred ordinary shareholders at a rate even below 4 per cent; Therefore, ii: there are some profits but profits are insufficient to enable dividends at the rate of 4 per cent, to be declared for preferred shareholders something less may be declared. Prima facie, therefore, when preferred shareholders in a particular year may be entitled to nothing or dividends up to 4 per cent, it becomes difficult, if not impossible, to say that such shareholders are entitled to a dividend at a “fixed” rate or that the dividend was payable at a “fixed rate”. It is true that as between equity shareholders and preferred ordinary shareholders dividend to the latter has to be paid first before the balance, if any, is again equally divided between ordinary shareholders and the preferred ordinary shareholders. In these circumstances, without doing violence to the language of the articles of association, it is not possible to hold that preferred ordinary shares carry a fixed rate of 4 per cent; dividend.

18. The words “entitled” and “payable” in the Explanation to the second proviso to clause (i)(b) convey the same meaning. “Entitled”, means entitled in law, i.e, something which could be enforced in law. “Payable” similarly means payable in accordance with law. It is impossible for any preferred shareholder to claim that he shall be paid each year, regardless of the profits made by the company, dividends at the rate of 4 per cent. If such a position could never be taken up by a preferred ordinary shareholder, then it necessarily follows that such share does not carry a fixed rate of dividend, as the rate of dividend may vary according to the circumstances prevailing in each year between zero per cent, and four per cent, and even beyond that depending upon an identical amount being declared for an equity shareholder also.

19. The word “fixed” in Corpus Juris Secundum is defined:

“A term of no technical significance, which imports certainty and definiteness both as to obligation and amount, denotes predetermination, establishment and a degree of constancy and invariability which excludes subservience alone to mere occasion, and has been defined as meaning established; firm; fastened; finally determined upon; immovable; securely placed, unalterable: lasting:…………”

20. Even according to this definition it would be difficult if not impossible to hold that the rate of dividend of 4 per cent, for preferred ordinary shareholders was unalterable, lasting or a predetermined rate.

21. In this view of the matter the assessee's computation at Rs. 26,250 only of the excess dividend declared on which rebate required to be recalled within the meaning of the Explanation to the second proviso (i)(b) of paragraph D of the Finance Act of 1956, is wholly unsustainable. This figure was worked out as follows:

Rs. Rs. Total paid up capital 2,10,00,000 Less:— Capital entitled to fixed rate dividend as held by the I.T.O:— 35,000 preference shares of Rs. 100 each. 35,00,000 15,75,000 preferred ordinary shares of 10 each. 1,57,50,000 1,92,00,000 17,50,000 Balance being 1,75,000 ordinary shares of Rs. 10 each. Dividend on the above 1,75, ooo ordinary shares 1,31,250 at the rate of o—12—o per share Less 6% on Rs. 17,50,000. 1,05,000 Excess dividend. 26,250

22. The Income-tax Officer on the other hand also put the most favourable construction in his favour which again is unsustainable and has worked out the assessee's excess dividend at Rs. 12,07,500 as follows:

Rs. Rs. Total dividends 21,52,500 Less:— Dividend on 35,000 preference shares (Rs. 35,00,000) at the rate of 6% Rs. 2,10,000 Dividend on 15,75,000 preferred ordinary shares (Rs. 1,57,50,000) at the rate of 4% 6,30,000 8,40,000 Amount of dividend considered by the I.T.O vide I.T.O's order annexure ‘M’ page 70 paragraph 6. 0—12 —0 per share on 1,75,000 ordinary shares. 1,31,250

o—12—o per share on 15,75,000 preferred ordinary shares 11,81,250 13,12,500 Less 6% on Rs. 17,50,000 (2,75,000 ordinary shares) 1,05,000 Excess dividend on which rebate has been reduced by the I.T.O 12,07,500

23. The interpretation placed by me on the Explanation to the 2nd proviso to clause (i)(b) of Paragraph D is not only in consonance with common sense but will permit comparison of like with like. This will require the exclusion from the paid up capital only the preference share capital of Rs. 35,00,000 and from the total dividend paid, the dividend at the fixed rate of 6 per cent, which that capital of Rs. 35,00,000 carries and on that basis the excess dividend will be worked out.

24. In the present case there is no dispute as to the total amount of dividend which was paid and which was Rs. 21,52,500. The excess dividend paid on the principles determined above would work out as follows:

Rs. Rs. Total dividends 21,52,500 Less:— Dividend on 35,000 preference shares (Rs. 35,00,000) at the fixed rate of 6% 2,10,000 Balance being dividend at no fixed rate on preferred ordinary and ordinary shares: Dividend on 15,75,000 preferred ordinary shares (Rs. 1,57,50,000) at the rate of 4% 6,30,000 at the rate of 0—12—0 per share. 11,81,250 Dividend on 1,75,000 ordinary shares (Rs. 17,50,000) at the rate of 0—12—0 per share. 1,31,250 19,42,500 Less 6% on Rs. 15,75,000 being preferred ordinary shares (Rs. 1,57,50,000) and ordinary share capital (Rs. 17,50,000) 10,50,000 Excess dividend 8,92,500

25. The excess dividend, therefore, should have been worked out at Rs. 8,92,500. This figure requires to be substituted for the figure of Rs. 12,07,500 taken by the Income-tax Officer.

26. The order of the Income-tax Officer would, therefore, have to be quashed only to the extent of the difference between excess dividends determined by him at Rs. 12,07,500 and the correct figure of Rs. 8,92,500. The latter figure shall stand substituted for Rs. 12,07,500 computed by the Income-tax Officer.

27. A contention was raised on behalf of the petitioner that the provisions of section 35(5) of the Act could not have been invoked for rectifying the error as the error was not one apparent from the record and was not a mere clerical or arithmetical mistake in culculation. I cannot accede to this contention. In this case the provisions of the Finance Act of 1955 contained in Paragraph D of Part II whereby the rebate given under clause (ii) of the first proviso had to be further recalled as required by clause (i)(b) of the 2nd proviso thereto, was not inadvertently given effect to and that provision being mandatory, it is idle to contend that a mistake of law apparent from the record was committed by the Income-tax Officer which justified the invoking of section 35 of the Act. I have already taken a similar view in a case, such as the present, in A.H Wheeler & Co. Private Ltd. v. Income-Tax Officer, Allahabad., Allahabad, Writ No. 3471 of 1962, decided on 9th April, 1963, wherein I followed the Supreme Court decision in M.K Venkatachalam, Income-tax Officer v. Bombay Dyeing and Manufacturing Co. Ltd. [1958] 34 I.T.R 143 and held that the provisions of section 35 were properly attracted to the case.

28. The last contention raised was that no specific notice was given to the petitioner before interest under section 18A(6) of the Act was modified by an order under section 35 of the Act. A general notice under section 35 was admittedly given as required by law as the assessment was proposed to be enhanced. That notice of enhancement necessarily included the notice for enhancement of the interest as any modification made in the assessment would necessarily by virtue of section 18A(6) also enhance the penal interest. The enhancement of the penal interest, in such circumstances, was only consequential in nature and as such there was no necessity of again issuing a specific notice, when a general notice under section 35 proposing an enhancement of the assessment had already been given. There is, therefore, no force in this contention. As the amount of excess dividend on the basis of correct computation will now have to be reduced, the penal interest will also stand to be reduced proportionately.

29. For the reasons given above a writ in the nature of certiorari will issue quashing so much of the order of the Income-tax Officer under section 35, dated the 31st of March, 1962, as determined the excess dividend to be in excess of the correct amount of Rs. 8,92,500.

30. The petition is partly allowed. In the circumstances of the case there will be no order as to costs.

31. Petition allowed in part.